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The Launch of the QE2

November 4, 2010

I was on CCTV News BizAsia this morning, talking about the U.S. Federal Reserve’s plan to purchase up to $600 billion in U.S. Treasuries over the next few months, in order to inject more money into a sluggish domestic economy.  Since the move marks the Fed’s second round of so-called “quantitative easing” since the global financial crisis began, it has been nicknamed “QE2” (like the ocean liner).

My comments were more descriptive of the reasons and risks inherent in the move, rather than arguing whether it will work or not.  There are three seperate segments.  In the first clip, I discuss Bernanke’s motivation (arising from his previous academic work on the causes of the Great Depression), along with the risk that, if he overshoots or gets the timing wrong, he could end up generating inflation.  In the second clip, I evaluate fears that QE2 will fuel asset bubbles, both at home and abroad. 

In the third and last interview clip, I talk about whether the Bank of England, the European Central Bank (ECB), or the Bank of Japan are likely to follow the Fed’s example, as well as the challenges the Fed’s latest move poses for emerging economies like India and China which are in the midst of trying to tame inflation.  This Reuters report from the New York Times makes it clear those latter countries aren’t at all happy about it, and that opposition to QE2 is likely to take center stage at next week’s G-20 meeting.  You can bet China is relieved that the G-20 will be howling about someone else’s currency for once (even though, in the end, they know that a falling dollar will rachet the pressure up even higher on China to abandon the peg and let the RMB rise on its own).

4 Comments leave one →
  1. Jay permalink
    November 5, 2010 1:16 am

    China needs political reform to distribute wealth more fairly and evenly. RMB is overvalued, not undervalued.

    • prchovanec permalink*
      November 5, 2010 2:05 am

      The price of a currency (relative to any other currency), absent government intervention, is determined by the supply and demand for using each of those currencies to either buy goods or services or make investments. Under current market conditions, China sells more to the rest of the world than it buys, and attracts more investment than it makes abroad. On both counts, therefore, China brings in more foreign currency (particularly dollars) than it requires to meet its needs. When you have an excess of anything, the price drops. The dollar would normally drop in value (relative to the RMB) until dollar-denominated goods and/or investments became attractive enough in RMB terms for the rising demand to match supply (supply would also decline, because you’d see the opposite effect on the other side).

      Of course, the Chinese government can simply fix a price at which it will buy and sell RMB. It can say, in effect, if nobody wants to buy those excess dollars, we will buy them before their price drops. By doing so, it accumulates those dollars (or other foreign currency) as official reserves. If, on the other hand, the situation were reversed, and the country had a shortage rather than an excess of foreign currency, it could also fix a price. But in that case, it would have to sell dollars to meet that unmet demand, thus drawing down on its reserves (presuming those reserves were sufficient to last).

      So objectively speaking, if China’s currency is overvalued (set higher than market), official reserves will drop as people rush to sell the PBOC artificially high RMB for cheap dollars. If China’s currency is undervalued (set lower than market), the PBOC will accumulate reserves as people sell unwanted dollars for more valuable amounts of RMB.

      The fact that China is consistently accumulating greater and greater reserves — in virtually unprecedented sums — is prima facie proof that the RMB is undervalued vis-a-vis market supply and demand. It’s not a question of “should” or “ought.” It’s not a question of development strategy or economic justice. It’s not a question of nationalism — China or the US being right or wrong. It’s a question of simple arithmetic. (Saying the RMB is overvalued is like saying there are 10 hungry people and only 5 sandwiches, so the price of sandwiches should drop. Now just think about that for a second.)

      Now I need to make one important caveat to what I’ve just said. This conclusion is based on existing supply and demand. If, for instance, China lifted its controls on the capital account, and Chinese individuals and companies were free to invest abroad, that could, potentially, increase demand for dollars and other foreign currencies to be deployed in that manner. If more people want dollars to use, there are fewer unwanted dollars, and less pressure on the price of dollars to fall. Whether that source of demand would be sufficient, at the current exchange rate, to entirely offset the currency coming into China from exports and investments is unclear (probably doubtful). But still, the RMB would not be as undervalued as it was before the capital constraints were lifted.

  2. Dean Jackson permalink
    November 5, 2010 10:30 am

    The probability QE2 will revive the economy is slightly higher, but not much, than the Democrats chances of retaining the House were early Tuesday morning. The negative consequences are already evidencing themselves and we will be fortunate if the competitive devaluations do not eventually lead to much more serious trade frictions. That said, the US is no more willing to accept the unemployment Premier Wen recently suggested China could not accept if Chinese policies were changed. And obviously, similar references could be made about other surplus and deficit countries. So let the games begin. I fear it will be a high scoring affair.

  3. n/a permalink
    November 16, 2010 8:49 am

    China has adopted a governance system that combines its feudal and imperial infrastructure with a mercantilistic process that defines the State more as a corporation. As a result, it can claim to be a democracy in a vertical format, because people in corporations do not have rights, they have tasks. A corporation is not a commonwealth organized for the good of its members, its purpose is profit. According to the government philosophy, survival of the company has to take priority over the interests and benefits of individuals. Those who would prefer to fight against the company culture and goals would have to choose: leave or adjust. Since this is a country we are talking about, resigning means you leave China, while being fired means you end up in jail. This shift from the PRC as a nation-state to China as a corporation clarifies how free-market capitalists in America can so enthusiastically endorse CCP rule: both are pursuing an authoritarian capitalist model of governance, at the expense of democracy and social welfare.

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