QE2

After warning all the other major economies not to depreciate their currencies to win trading advantages, Washington is now about to depreciate its own currency by unloading tons of cash on the market.

The method for doing that is euphemistically referred to by US monetary authorities as the second round of “quantitative expansion” — QE2 for short. In this program, Washington basically prints more dollars and use those to buy up bonds in the financial market. That will push billions of new dollars into the market (in exchange for financial paper). More dollars will then be available for purchasing stocks and boosting the equities markets.

QE2 will raise the public deficit and probably stoke inflation. But US monetary authorities hope the infusion of dollars will help boost the recovery of the American economy. That, in turn, will raise employment. By bringing down the unemployment rate, domestic consumer demand will improve — thereby creating incentives for new investments and new business start-ups.

There is some debate about the wisdom of this strategy. Because it does not involve direct project spending by the government, there is really no guarantee that “quantitative expansion” of the dollar supply will produce the desired effect of job-creation. It could result in “stagflation”, an episode where inflation picks up but the real economy remains stagnant. In which case, the program will only enlarge the profits of Wall Street while leaving Main Street wallowing in even greater economic despair.

Whether or not the strategy produces the desired results in their domestic economy is, of course, Washington’s worry. Let Obama’s government deal with its success or failure.

What the rest of the world worries about is the by-product of “quantitative expansion”. More dollars in circulation and a higher inflation rate will cause mounting downward pressure on the dollar’s exchange rate.

Effectively, the dollar will be depreciated. Other major currencies, such as the euro and the yen, will tend to be overvalued.

A weaker dollar will shrink the American economy as an export destination for the other economies. The products they are trying to sell to the US market will suddenly become dearer for the American consumers.

On the flipside, US exports to the rest of the world will grow cheaper. They will undercut the prices of goods produced elsewhere. That will effectively slow down the growth rates of the other exporting economies.

The Europeans, the Japanese and the Chinese are not happy with that prospect.

At the moment, Tokyo is quickly running out of options to halt the destructive appreciation of the yen. That appreciation is ruinous because it escalates the prices of Japanese exports and makes them uncompetitive.

China is holding on to a large hoard of US dollars as its foreign currency reserve. If the dollar depreciates significantly, the value of that hoard diminishes. There will be pressure for the effective appreciation of the yuan, diminishing the price-competitiveness of Chinese exports.

The euro has strengthened against the dollar the past weeks, perhaps more than any other currency. That harms European exports and condemns the continent to a long period of low growth.

Officially, the US has not embarked on QE2 just yet. US monetary authorities will make a decision on that next week, after reviewing its own economic figures as of end-October.

There is a possibility that QE2 might not happen at all. If the October figures show a strong recovery, the entire QE2 program might just be scrapped. The American economy will be allowed to grow under its own dynamic without need for monetary intervention.

No one is betting on that, however. All the markets around the world have started pricing in the effects of a QE2. Nearly all the major trading currencies have registered gains against the dollar.

As far as the global financial system is concerned, QE2 might as well have already happened.

I count myself among the skeptics of a program like this one. Even if Washington decides to push through with QE2 next week, I doubt it will accomplish anything palpable in bringing down the unemployment rate and reinforcing the imperiled American middle class.

The problems plaguing the US economy are structural in nature and could not be solved by any short term monetary remedy. The US has not properly reformed its educational system on any scale comparable to what Singapore or China or South Korea has done. They have trained their young for the Old Economy, not the new one that will drive this century.

American tax and economic policies over the past couple of decades compressed the middle class, widened the income disparities and created a super-rich concentrated in finance and entertainment. The base of consumption demand has narrowed. That explains the mortgage crisis that sparked the last bout with recession.

American infrastructure has begun to deteriorate. The long gestation period required for strategic public investments in infrastructure to bear fruit is not an incentive for the political class which has to deal with public pressure for instant gratification from those who govern them.

American labor has simply priced itself out of competitiveness. Labor costs for producing a car are as much as ten times more in the US than they are south of the border or in India. Even if General Motors receives a windfall from the short-term stimulus measures, they will likely build their plants and hire workers outside the US economy than in it.

Even if it might do very little in helping the US economy pick itself, QE2 will imply great readjustment costs for all the other economies. We’re seeing that in the appreciation of the peso against the dollar.