Thursday, January 6, 2011

Is QE2 a Bubble Machine?

One of the major contributors to world economic growth and development in the post-World War II years has been the ability of capital to flow relatively freely throughout most of the world. As capital began to flow more freely throughout the world in the late 1950s and 1960s, the rules of international monetary affairs changed. One of the most dramatic changes resulting from this freer movement of capital was the breaking down of the Bretton Woods system which finally breathed its last breath on August 15, 1971 as the United States removed itself from the gold system and began to float the dollar.

We are now experiencing some of the consequences of the free flow of capital throughout the world as the impact of the world’s central bank, the Federal Reserve System, is changing the behavior of nations.

One fear is that the changes are being made in the direction of imposing controls on the flow of
capital. As Nobel-prize winning economist Joseph Stiglitz has declared, the world seems to be evolving into fragments. Not exactly what the Federal Reserve had in mind.

This concern is captured by work being done within the International Monetary Fund that points to “the rising tensions as governments impose blocks on cross-border movements of speculative money.” (See “Surging Capital Flows Pull IMF into the Fray,”
“Emerging markets from Brazil to South Korea to Indonesia are complaining that a growing flood of money is boosting the value of their currencies and undermining their competitiveness. They have imposed different restrictions on investment to try to make sure those funds can’t leave the country suddenly.” (

“Fundamentally, the IMF wants to expand its oversight of capital flows and determine when restrictions make sense and when they are being misused.”

Up to now, the implied culprit causing this situation to occur has been the monetary policy of the United States, specifically the program of Quantitative Easing (QE2) initiated and executed by Chairman Ben Bernanke and the Federal Reserve System. The low interest rates created by the Fed, keeping its Federal Funds target in the 0.0 to 0.25 basis point range since December 2008 while flooding the financial markets with more than $1.0 trillion in liquidity, has provided the catalyst for the international flows of speculative money.

As international tensions continue to grow, more and more explicit focus will be placed on the behavior of the Federal Reserve System. Experts are expecting that the whole issue of capital controls to become a “big part” of this year’s discussion of the G-20. French President Nicholas Sarkozy, chairman of the Group of 20 in 2011 is seen as a role-player in raising the international profile of the issue.

These international flows of speculative money are also being given credit for a good deal of the world-wide run-up in commodity prices. Speculative movements of funds have been given credit for increases in the prices of oil, gold, silver , and copper, among other non-food commodities.

Now, the rise in world food prices is gaining attention and concern. Today,the Financial Times leads with an article that includes the claim of “Food Price Shock” ( The Food and Agricultural Organization of the United Nations has warned that the world faces a “food price shock” as its benchmark index of farm commodities prices “shot up to a nominal record last month, surpassing the levels of the 2007-2008 food crisis.” This speculative crisis may be exacerbated if certain disturbing weather forecasts for 2011 are realized.

The concern is over the unrest that these higher food prices might have on potential unrest in many developing nations. There is even fear that this unrest could reach some developed countries including those in the Eurozone.

There has been growing discussion about the role that the Federal Reserve has played in the explosion of commodity prices throughout the world. Again, there are lots and lots of dollars “out there” and the cost of borrowing dollars is close to zero, especially in markets that are experiencing various degrees of inflation. Of course, this leads to the question of “bubbles”.

No one has really gotten a handle on the concept of credit bubbles and so there is a lot of discussion about what a credit bubble actually is, if credit bubbles even exist. Like pornography, credit bubbles seem to be whatever an observer wants to define them as.

Debate still exists about the “housing bubble” of the early 2000s. Again, the Federal Reserve kept its target interest rate extremely low for “an extended period of time” in order to insure that the economy did not collapse into a severe recession. Housing prices exploded in this period at double-digit rates of increase every year. The Fed Chairman at that time, Alan Greenspan, still refuses to acknowledge the existence of anything like a bubble in housing prices. Economist Ben Bernanke provided Greenspan with the justification for not acknowledging that a bubble took place.

So, a housing bubble took place in the early 2000s, unless it didn’t take place.

Is the flow of money into world commodity markets creating a credit bubble there? Is the flow of money into the currencies and stocks of developing countries creating a credit bubble there? Is QE2 the “bubble machine” of the world?

Something new has taken place in the world. The information Congress forced out of the Fed confirmed that the Federal Reserve System became the central banker of the world beginning in 2008. A consequence of this change in roles for the Federal Reserve is that, connected with the free flow of capital throughout the world, the Fed can become the “bubble maker” for the world. What the Fed does, does not stay at home!

I have frequently quoted the work of Raghuram Rajan, winner of the Financial Times/Goldman Sachs award for the best business book of 2010. (See a review of his award-winning book “Fault Lines,” I now refer to a book written by Rajan fellow University of Chicago professor Luigi Zingales titled “Saving Capitalism from the Capitalists” (Princeton University Press). They write: “Bubbles are often pumped up by a whole new set of investors who do not have the experience or knowledge to invest carefully…There is no guarantee that even in a developed financial market the next new sector with limitless possibilities will not attract it own set of gullible investors.”

The international markets are attracting all sorts of money, a lot of it is money that is inexperienced in the investment in world commodities or the securities of emerging markets. These are the markets that have achieved a high profile in investment circles over the past twelve months or so.

QE2 seems to be working but maybe in ways that would not be recognized by Chairman Bernanke. But, he still denies that the early-2000s monetary policy of the Fed might have created a housing bubble.

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