Dollar in Dire Straits?
by Vibhas Tattu
The Federal Reserve in Washington has sailed into the blue. As widely expected by many across the world, Fed Chairman Bernake announced a massive tranche of $ 600 billion dollar “bond purchases” ostensibly to boost the flagging US economy and create jobs. This exercise has many politically correct and euphemistic names and economic theories to support it. “Quantitative Easing” is the phrase being used in world media to describe this affair. Since the first installment of the QE was already done by the Fed in 2008 / 2009 to the tune of $ 1700 billion, this second round is being referred to as “QE2”. The QE2 is being hailed as the kiss that will breathe new life into the US economy. In practical terms what the Fed Reserve has actually done is simply create, literally out of thin air, a bank balance of $ 600 billion in its own current account. The economists call this as debt financing. When my current account bank balance goes up it is usually after I have worked quite hard for a month and my employers send my salary from their account to mine as a compensation for my work. In other words, I have EARNED the credit and now I can spend it. This is by and large the mechanism by which ALL individuals or organizations throughout the world create wealth and operate their finances (at least all legal ones) . Governments don’t always work that way. They are above it all, like God, and can create things out of thin air. God said “Let There Be Light” and there was light. On Wednesday morning, Bernake & Co said “ Let There Be Money” and lo presto $ 600 billion dollars became available for the dubious “bond purchases”.
It is well to dwell a bit on this event which is raising so much expectation within the US and causing so much consternation in the emerging economies like China, India and Brazil.
Let’s review the facts. Despite astronomical and unprecedented financial injections into the US economy (QE1 = $ 1700 billion), the US unemployment rate remains at its highest since 1984. Consumer spending in the US is at its lowest in many years. The economy, it is feared, will be “deflationary” or shrink. This QE2 injection is expected to reverse this deflation by making money available cheaply to banks for lending and in turn to boost consumer spending. But who said banks don’t have money to lend? All the top banks in the US have returned to profit and are flush with funds. The likes of Bank of America, Goldman Sachs and Merrill Lynch turned in multibillion dollar profits for 2009 and multimillion dollar bonuses for their top exces. Even the black sheep of the banking community, Citibank, has shed all its fat and has returned to a modest profit. There are just no borrowers. It’s just that consumers and businesses don’t want to spend right now. So what will be the effect of this QE2 money? By most accounts, the huge infusion will cause the dollar to depreciate significantly and hence make US goods and services more competitive in the world market (now you know why China’s Commerce ministry is very upset with the QE2 - it makes their life difficult). Part of it will be invested within the US economy and generate fresh revenue streams and jobs. All this makes the QE2 sound like a wonderful thing for the American public, doesn’t it?
In fact what is most likely to happen is not so goody goody. A lot of the foreign reserves held by China ($ 1200 billion), India ($ 260 billion) and the rest of the world are in US Dollar currency. What the QE2 will do is reduce the value of these reserves (due to a depreciated dollar). This is unpalatable and will result in these emerging economies moving away from the dollar in the long run and cause a further erosion in the dollar value. The fact is that the US is no longer a net producer but rather a net consumer on the world scene. It is a fundamental truth of economics that unless your production of wealth keeps pace with your consumption of wealth, within reasonable limits, you are likely to end up as a sub-prime risk; and we all know how sub primes end up don’t we? By QE2 the US is increasing its long term chances of ending up as a sub-prime risk for itself and the world. Even in the short term the QE2 could well have very negative results. US funds are already flowing in large measure to foreign shores and it is feared by many that at least part of the QE2 funds will find their way to China and India and not be invested in the US at all. It is not very difficult to believe that the recent surge in market valuations in India are partly because the markets have already factored in the availability of the cheap QE2 money. At the Government level this sudden money flow could trigger what is being called as a “currency war” which threatens to escalate tensions between nations. Also the extent of the fund flows outside the US will restrict job creation within the US. So is the QE2 good at all? Probably not.
In the long run, a nation’s economy must be largely, if not wholly, self sufficient. The operative word being “self”. The reason America rose to prominence in the 20th century was due to its innovations as well as its domestic consumption. The reason why China and India are rising to prominence in the 21st century are also due to their own domestic innovations and consumption. As such if the US is facing hardships, it should look within to spur growth, and not try to spend its way out of it by debt financing. Already the fiscal deficit of the US is a matter of concern the world over. Continued US government excesses in the form of QE2 will dethrone the dollar from its position as the currency of choice. QE2, in the long run, will only hasten the exit of the dollar from the world stage. Austerity measures like the ones UK’s Government is taking are what are needed to save to US economy and the world economy at large.
The Fed’s desire to appear to take bold and concrete steps to stave off economic woes is laudable but sometimes no action is the best action. At the risk of sounding brutal, I would like to turn Marie Antoinette’s famous coinage on its head and say to Bernake & Co “If they don’t have cake, let them eat bread instead”. A little austerity never hurt anyone.
Vibhas Tattu hails from India and is a manufacturing engineer by profession. He has worked in India, USA and now in the United Arab Emirates. Vibhas is interested in Shakespeare, Indian music, poetry (English, Hindi and Marathi) and a new found love of writing.
Tattu has a bachelor’s degree in Production Engineering from the University of Bombay and Master’s degree in Industrial Engineering and Operations Research from the University of California at Berkeley, where he was a Fellow.