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In lean economic times like these, it's only natural that rational actors consider self-preservation first and foremost among their priorities. That seems to be precisely what Ben Bernanke was doing when he cited the Federal Reserve's congressional mandate to "promote a high level of employment and low, stable inflation" to justify the Fed's repurchase of $600 billion worth of long-term Treasury securities in a recent Washington Post opinion piece -- a strategy that's since come to be known as QE2. Facing criticism from Germany, Russia, China, and others during his current trip to Asia ahead of the G-20 summit, President Barack Obama reiterated domestic priority, noting that "the Fed's mandate, my mandate, is to grow our economy" [emphasis added].
Given the results of the recent election, it's clear why politicians are focusing on the health of the U.S. economy, but the fact is that QE2 has significant ramifications -- and not always good ones -- for the rest of the world. The question, of course, is should these knock-on effects be considered in the deliberation of domestic economic policy. My answer is that given rapid globalization and the need for cooperation among both developed and emerging economic actors, they very definitely should.
The problem with QE2
The goal of QE2 is to drive down long-term interest rates, thereby making it cheaper for individuals and corporations to borrow money. But interest rates are already historically low, and creditworthy corporations such as Microsoft (Nasdaq: MSFT ) , Coca-Cola (NYSE: KO ) , and Wal-Mart (NYSE: WMT ) have recently taken advantage of these low rates to refinance billions of dollars worth of debt at record low rates, including 30-year notes at just 5%. In fact, the cost of borrowing is so low for these companies, that a commentator at The Wall Street Journal suggested at least one of them -- Microsoft -- become a bank! (Incidentally, Wal-Mart has previously considered entering banking only to be stymied by resistance from the financial community.)
In a world where creditworthy borrowers are already taking advantage of record-low rates, what good does it do to drive rates lower? The answer is that it fundamentally won't do that much good at all. The beneficiaries of QE2 are likely to either be less-than-creditworthy borrowers (the folks who helped create this mess in the first place) or borrowers who will use cheap money to make speculative investments. While both points are worrisome, the latter has the potential to be the most destabilizing -- and it's already occurring. Thanks to cheap money, emerging market stocks are up 30% since June and emerging market bonds are being driven to record-low yields.
Why that's a problem
This matters because volatile capital inflows and outflows have long been a problem with which emerging markets have struggled to cope -- with significant inflows in times of optimism quickly reversing when the market gets pessimistic. This makes long-term planning and sustainable development a tricky thing in the emerging world, and that's one reason why Brazil recently strengthened its foreign capital controls by raising taxes on foreign investment. Similarly, a recent statement by the World Bank noted that Asian economies may need their own set of capital controls to prevent the formation of asset bubbles that might be caused by the cheap money that is likely to flood out of the United States thanks to QE2.
This is one reason why China hates QE2. That country is already struggling to control real estate and stock market bubbles. Although that country already has capital controls in place, the pressure of a new round of hot money could help support prices.
But China's problems don't end there
China's other issues relate to the value of the dollar, a value that could continue to erode given the Fed's clear willingness to print money and potentially spark rapid inflation. The first is that China is the United States' largest creditor, holding nearly $870 billion (or more than 20%) of our public debt at the end of August. Since the U.S. dollar is a reserve currency, this debt is all dollar-denominated -- meaning that no matter what happens, China will eventually be repaid $870 billion regardless of what the purchasing power of those dollars may be at the time of repayment.
Should QE2 spark rampant inflation that causes the dollar to drop relative to gold, other global currencies, and strategic commodities such as oil and food, China stands to be a lot poorer in a few years than it thinks it is today. This is one reason why China has been reducing its ownership of U.S. debt (that $870 billion at the end of August 2010 is down from $937 billion at the end of August 2009). While some might think it's good for China to hold less of our debt, the fact is that if that country becomes reluctant to purchase more of it, it will make it more difficult for the U.S. to borrow or print money in the future. Put in that context, the description of QE2 as the equivalent of a Hail Mary pass in football seems appropriate.
And the last reason China hates QE2
Yet China's concerns aren't just with the value of our currency, but also with the relationship between our currency and theirs, the Chinese yuan. The relative weakness of China's yuan was a hot-button election issue, with many blaming China for depressing its currency to steal American manufacturing jobs. This is a simplistic view of the situation, but one that resonates with voters and makes for a compelling 30-second campaign ad. That reality aside, I've written in the past in this forum that Americans need to chill out about China's currency and explained why China is pursuing a slow and deliberate liberalization of its currency in order to balance domestic and global pressures.
Yet QE2, again in the event that it sparks a run on the dollar, will force China to re-evaluate its own currency policy. See, since China not-officially but-functionally pegs the value of the yuan to the value of the dollar and because the commodities China needs to buy from the world, such as oil and food, are priced in dollars, those commodities China needs stand to become a lot more expensive if the value of the dollar declines and China maintains its unofficial-but-functional currency peg. At a time when one of China's most pressing domestic problems is uneven economic development, the last thing the government wants is for food and fuel to become more expensive for rural Chinese in order to maintain subsidies for China's manufacturing sector.
In other words, QE2 threatens to force China's hand further on the currency issue, and China hates the prospect of having to deal with that pressure.
The global view
There are certainly many in the United States who will be glad to hear that QE2 might force the Chinese government to re-evaluate its stance on its currency. I believe that, however, is short-sighted.
Although our economy could benefit in the near term if some Chinese manufacturing jobs were to return to the states (though this is far from a sure thing; they could just as easily go to Mexico or Cambodia), the fact is that we can only help stabilize the global economy in the long term by promoting the economic development of major emerging markets such as China, Brazil, and India. These three countries are massive population centers, and the development of consumer classes in these countries will be the primary driver of global economic growth for the next few decades. To the extent that our own short-term economic stimulus could deter or put off sustainable development in these countries, it's actually in our self-interest to consider QE2 from a more global perspective.
When one does that, global objections to QE2 actually start to hit home.