Who Pays the Bill for the QE2?

from Kevin P. Gallagher

To no one’s surprise, the Federal Open Market Committee has sanctioned another round of quantitative easing – or “QE2”, as it is fashionably referred to. The Fed’s QE2 may not have the desired effect on the US economy, but will certainly accentuate currency tensions in the developing world. So, the US should not be surprised when its proposals to fix global finance are met with stiff resistance at the G20 meeting next week. 

To its credit, the US Fed seems to be the sole believer (with any power) in the need for expansionary policies in the United States. The outcome of the US midterm elections has tied the hands of the government to engage in expansionary fiscal policy. The Fed alone has the power to act.

The problem is, the US is still in a liquidity trap, so it is not clear whether QE2 will have much of an effect. First, the Fed actions will be timid so as not to inflame inflation hawks. Second, if QE2 has the desired effect on long-term interest rates, it is not a foregone conclusion that banks will actually lend or borrowers borrow.

In today’s world of financial globalisation, the implications of QE2 go far beyond the US. Lowering rates in the US will accentuate the “carry trade” where investors borrow cheaply in the US and park their money in developing countries where interest rates are relatively higher: private speculators reap profits on the interest rate spread and the appreciation of developing country currencies.

Such massive inflows of hot money into emerging markets will have the destabilising effects of rapid currency appreciation and asset bubbles. Indeed, the carry trade has already played a role in accentuating the Brazilian real by 37% since the end of 2008.

Developing countries will have to resort to defending their currencies by accumulating reserves, through imposing capital controls, or both. Many developing countries have much more leeway to take this route than in years past, but it will be costly.

After witnessing how the International Monetary Fund (IMF) botched East Asian recoveries following the 1997 financial crises, many developing nations “self-insured” against needing to resort to the IMF by running current account surpluses and accumulating reserves to defend their economies in the event of future crises. That day came in 2008 – and spending on reserves has been daily practice ever since.

Piling up reserves for this purpose has been a costly business for developing nations, which could otherwise invest those funds in their own economies – and earn a much higher rate of return. A World Bank study on China found that the marginal rate of return ranges from 37% to 63%, yet China has chosen to purchase US treasuries at a much lower rate.

Using more conservative estimates for the developing world as a whole, Dani Rodrik of Harvard University estimated that the social cost of accumulating reserves has been 1% of GDP on an annual basis across the developing world.

To defend their currencies from the carry-trade effects of QE2, developing countries will have to draw on their own currencies to accumulate reserves yet further now, to purchase dollars in order to try to keep their currencies competitive. This time, the return on the treasury bonds that will be purchased will be even less than before. Indeed, recent issuances of US debt have had a negative interest rate!

The other option is for developing nations to impose controls on inflows of capital. Capital controls have been shunned by the IMF and many economists for years. Yet, a number of recent high-level studies have turned the tide and taken the stigma away. The National Bureau of Economic Research, the Asian Development Bank, and the IMF itself have all recently shown that capital controls on inflows can be key measures to prevent or mitigate financial crises. Indeed, last week, it was the IMF that recommended the use of capital controls in Colombia. Now, it is Colombia that is resisting.

Capital controls are a welcome “new” addition to the toolkit to recover from this crisis and prevent the next one, but they are harder to impose than they used to be. Capital controls are now illegal under many US trade and investment treaties and can be evaded by unregulated speculators.

Ultimately, neither capital controls nor reserve accumulation are substitutes for comprehensive global financial reform. To that end, when the US shows up in Seoul, South Korea for the G20 meetings on 11 and 12 November, and demands that the world discusses “currency wars” at the expense of other issues, they will have even fewer allies than before this latest round of quantitative easing.