QE2: Extend or End?

  by Dirk Ehnts

The people at Alphaville have recently quoted Deutsche Bank as saying:

The $2 trillion in purchases have literally gone down a black hole. Required reserves haven’t been required to increase and the Fed reserve add has literally simply been hoarded as cash. Excess reserves at the Fed have subsequently soared by the same. In short, QE has been a spectacular disappointment in its impact on bank lending, whether via whole loans or securities. It was as if the banks conducted the very sterilization of QE that many thought perhaps the Fed should do to “contain” inflation expectations.

I find this evaluation quite confusing. While the Fed never said it in plain English, I understood QE1 as a strategy to push down the value of the US dollar vis-a-vis its trade partners. This would stimulate exports, put downward pressure on imports and thereby generate the impression (and expectations) that the US economy would gather steam.

Paul Krugman thinks so, too. QE would make it easier to export and also drive up stock market prices, which would make people feel wealthier. Let me reproduce the graph used by Paul Krugman:

Now there was nothing on the real economy in the Deutsche Bank paper, at least not in the excerpts cited by Alphaville. If so, it would be a very typical case of financial guys not looking at the real economy. The real economy people often don’t look at the financial implications, and often what results is a discussion where blind people argue with deaf people why the colors are so bright and where the noise is coming from. You need both inputs from the financial and the real side to make a qualified comment about economic policy. Yes, it might be named monetary policy, but that does not mean that it does not affect the real economy – and vice versa.

With the rise of the euro after the rise in the interest rate, the pressure on the Fed to conduct additional QE2 is easing. On the other hand, the j-curve effect might still cloud the issue, as Bloomberg reports on the newly published data for February 2011:

Economists at Morgan Stanley and Barclays Capital Inc. were among those cutting estimates for first-quarter growth after the data showed exports dropped along with imports, failing to make up for a slowing in consumer spending. The earthquake and tsunami in Japan may further reduce trade in coming months after parts shortages caused some factories to close.

When the dollar is weaker, exports which are priced in local currency get cheaper in dollar terms, therefore causing export values to fall, given quantity, which will react only later on to the change in the exchange rate. Imports are more expensive, and given that contracts from the past determine today’s imports, the total import bill might increase in the short run before falling back below the original level. Since imports have been falling in February, there might be something else going on in the background.

Now, originally the US had a huge trade deficit vis-a-vis China, and the BoP of the European Union with the rest of the world was more or less zero. Of course, the member states of the EU are a very heterodox bunch by now. While Germany would welcome cheaper US imports as a way to stop inflation rising, Spain with 20% unemployment and slight inflation worries would probably want to stop this new leakage of demand away from domestic products. However, the euro does not allow for a heterodox policy response. If an extension of QE2 (or QE3?) comes and the ECB continues to let the euro zone’s interest rate rise, there will be additional pressure developing for a resolution of the fiscal problems in Europe.

 Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101.  Curriculum Vitae.