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Friday October 29, 2010 - 13:15:17 GMT
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Random Thoughts on QE2 and EM Salvation

 The Bill Gross piece (PIMCO) on the end of the 30-year bond market rally is clever and to the point…in his unique style he manages to avoid taking sides in the political economic debate raging into the election…suspect he has learned over the decades about burning bridges…I thank the stars nightly for being self-employed. 


But one question that Gross (and Stiglitz in WSJ) alludes to and I think demands more attention is a basic econ theory dilemma…if we assume that monetary policy is ineffective in a liquidity trap (the lesson from Japan and the 1930’s), then, according to Keynes and his many followers in mainstream economics, the only effective policy response is fiscal stimulus.  Where is fiscal stimulus today in the US and elsewhere?  Contracting.  In the US we are on the downhill side of the near $800bln Obama stimulus and facing the possible withdrawal of the Bush tax cuts if Congress fails to extend or make permanent the tax cuts for the middle class and wealthy.  How could a Republican victory in the House not lead to an extension of the tax cuts?  Very easily.  The Republicans will demand that the tax cuts are made permanent, while the Democrats will say only for the middle class and not the wealthy and offer a compromise – all cuts extended temporarily, which the GOP might very easily reject.  I think the Fed is, for the foreseeable future, the only game in town and in time will try to fill the shoes of fiscal policy tied up in gridlock.  However, the econ 101 axiom of monetary policy is ineffective in a liquidity trap makes the Fed’s QE2 departure one giant placebo (potentially).  What QE2 is very likely to do is drive up (risk) asset prices and drive down the dollar…but it is far from clear this ever translates into more consumption and investment from households and firms fearing the inflation dragon.  Frankly the odds of success are very low.  So why would the Fed do this knowing the odds are stacked against it?  Because they are paid to smooth the business cycle and legislated by law to aim for price stability and full employment.  Not doing anything is not an option.  This also begs the question that doing QE2 in super size fashion versus the mini snack portion is far more justified given the poor odds that QE2 (surely QE2-lite) will work (maybe not up front in light of the hullabaloo over QE in the last few weeks). 


So if the Fed is at best tap dancing (looking busy to buy time and support asset prices…they discount future eco activity…must mean recovery of stocks are rising…right?) where is the US recovery going to come from?  Emerging markets.  It is a sad day for those longing for a US recovery and full employment when the Fed is tap dancing and a US rebound depends on strong emerging economies flipping a switch from export-led growth to domestic-demand led growth at most or balanced growth at least.  And what is the litmus test for making that transition?  Significant currency appreciation.  That condo in Wasilla with views of Russia must be looking pretty nice if you believe this one. 


With all the eggs in the emerging market basket, what is the chance of getting this right?  Well this is a G20 story and last weekend’s G20 meeting was at most a temporary ceasefire in the currency war…Brazil’s Mantega and Meirelles boycotted G20 last week.   Geithner was unable to convince anyone other than Korea to agree to a current account target-based adjustment process overseen by the IMF….ironically his last minute brain storm was an effort to move to a less controversial adjustment agreement than an FX based one.  G20 actually agreed to nothing on emerging countries letting their exchange rates appreciate (narrowed down to ones with large surpluses and actively managed FX regimes…read Asia EM).  So in all its competing interests the future of global economic expansion rests with China and Asia X-Japan getting it and turning to a new orientation of their respective economies…the next growth engine is the Asian consumer.   I’ll take two condos in Wasilla with the Russia view.  Can you see Beijing from Petropavlosk-Kamatchatskiy?  


The only thing I see clearly from Essex is years of economic underperformance in the developed world and in time serious moderation in growth in EM.  Or maybe it’s Tokyo that I see from my window.


David Gilmore


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