03/05/2013, 00.00
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Bernanke's choices, no help for the real economy of emerging nations

by Maurizio d'Orlando
The Fed's tricks are rooted in Keynesian and Neo-Keynesian economics. They have had a positive impact on the financial economy but raise the prospect of inflation at a time when currency wars could lead to real wars.

Milan (AsiaNews) - Despite its importance, last week's speech to the US Congress by Ben Bernanke, chairman of the US Federal Reserve, was underreported or even ignored by the media, as if it were unimportant or irrelevant. This lack of interest is understandable given the total failure of Greenspan and his successor Bernanke in correctly forecasting economic trends, whether US real estate or the subprime mortgage crisis, which sank derivatives and the Lehman Brothers. AsiaNews, this small missionary news agency, had with modesty and without conceit sounded the alarm bells back in 2005, 2006, 2007, and 2008 about the dangers of implosion, which eventually occurred in the fall of 2008, and was thus closer to the mark than the governors of the Federal Reserve.

Bernanke's speech on 27 February is laughable if we consider his claim that the Federal Reserve has "25 years of success in keeping inflation low and stable, not just in the United States but around the world".[1] Obviously, the Fed's chairman has not been in a supermarket lately or noted that the price of raw materials, especially in agriculture, which are at their highest in history. He is probably prisoner of his own scam to hide the real inflation rate via econometric tricks that measure consumer prices, and thus cannot see that the economies of the United States, the West and even the world are still in the grip of a recession that has not yet eased since the end of 2008.

At the same time though, if Chairman Bernanke's claim on inflation could be dismissed as laughable, his claim about protecting investors by pumping cash into financial markets[2] The fact that the S&P 500 index hit a new high with 1,520 after reaching 1,500.64 in 2000 and 1,565.15 in 2007 should be cause of great concern for the reasons already expressed by AsiaNews[3], namely the high probability that shares will drop by 30-50 per cent as realism reasserts itself.

In fact, even if we believe that the obvious disconnection between the Fed and reality is due to wrong economic theories-whether Keynesian or Neo-Keynesian on the one hand or monetarist or rational expectations (Chicago school) on the other-rather than high treason, the consequences of the Fed's policies on emerging nations, especially in Asia, is to distort the financial system.

QE strategies

Developed nations have adopted Quantitative Easing (QE) as their main monetary policy, first in the United States in the fall of 2008 after the collapse of Lehman Brothers, then in Europe in 2011 following the Greek crisis. With QE, the banking system to produce greater than usual money supply.

However, central banks in developed nations (Federal Reserve, European Central Bank, Bank of England and the Bank of Japan) have not adopted this policy to stimulate the economic growth but had other aims in mind.

QE targets

  • monetary (not real) funding of government budgets in the US, UK, Japan and Europe
  • greater exports (i.e. Swiss franc, Japanese yen and Euro against US dollar) via exchange rate (devaluation).

As expected, the QE led to:

  • negative earnings on deposit rates
  • greater regulation of financial markets and the economy.

With QE, the use by central bank of monetary policy to direct the economy might prove no longer feasible (something Keynesian economists like Krugman and Stiglitz did not expect). In the past, as a tool of monetary policy Quantitative Easing had effects on the real economy and was used in the short-term to stimulate economic growth. It is increasingly apparent that this is no longer the case. Indeed, other than on financial instruments (shares, securities and government bonds), QE has had zero or near zero impact on the real economy. Money markets have revived, but the real economy has not. This is the financial distortion caused in recent years by the use and abuse of QE by central banks, the real powerbrokers behind monetary policies in developed nations.

Such decisions in economic (and monetary) matters also explain the decline in real yields of asset management. Low yields due to QE means greater liabilities in covering future expenditures by pension funds, insurance companies and various moneylenders (banks, individuals and families).

We can best understand QE's effect by looking at a concrete example. A father knows that sending his son to university will cost him a certain amount of money. For this reason, he will set aside money to provide him with a certain yield. If the yield is too low compared to what he expected, he might have a shortfall. Thus, the actual value of his liabilities to cover future commitment-sending his son to college-will go up. If he cannot increase his revenue from work, he will have to invest the capital allocated for his son's education where he can get higher returns. He will not leave them in the bank but might buy some land in a village hoping to earn a higher yield. However, if he fails to get a construction permit, he might be forced to sell at a lost because he cannot find the right buyer at the right time.

One of the consequences of QE-induced financial distortion is the quest of ever higher yields, independent of the risk associated with each investment asset. Financial distortion thus has another consequence, namely the quest by lenders (pension funds, insurance companies, banks and privates) for higher yields independent of all other considerations.

This entails non-optimal allocations of resources in investments with higher risks. Since emerging nations structurally offer higher yields, this might mean that financial distortion could benefit them, especially in Asia. Let us look at it more closely.

Limited yields in emerging nations

One of the most visible effects of the Federal Reserve's Quantitative Easing between the last quarter of 2008 and last December (QE1, QE2, Operation 'Twist', QE3, and QE4) has been a drop in interest rates for all types of debt securities in developed nations as well as emerging nations. In the summer of 2008, high yield securities (bonds) in emerging nations[4] earned about 10 per cent a year. Between the last quarter of 2008 and the middle part of 2009, the yield was around 20 per cent a year peaking at 25 per cent, falling back to 10 per cent at the end of QE1 in mid-2010. Between the end of QE2 and last December[5] , index yields for emerging nations stood at 4.38 per cent on external government debt[6], 5,45 per cent on local currency government debt[7], del 4,55 per cent on corporate debt[8], 6,67 per cent on corporate high yield[9]. However, these figures hide a great deal of variation according to country and type.

Looking at the various factors, financial distortion caused by QE (the sum of the various actions) varies according to type of countries. For some emerging nations, namely agricultural producers (Africa) and oil producers (Middle East), the effect of greater investment or price increases has been to boost GDP in real terms. For instance, Mexico has been able to take advantage of its proximity to the United States and has boosted natural resource exports to Asian nations on the Pacific. For other nations like Brazil, QE has meant a stronger exchange rate. However, in general, for most Asian nations there was little or no real growth. For them, domestic inflationary pressures must be taken into account.

One thing that emerging nations share is more flexible monetary rate policies compared to developed nations. In the 2008-2012 period, rates were more restrictive (very restrictive in cases like Turkey but neutral in the case of Asia's two biggest nations, India and China), but are expected to be more flexible in 2013 heralding good nominal rates of growth this year.

Nominal economic growth becomes real growth when higher investments generate greater output of goods actually sold in markets. This is the case for a number of raw materials, especially in agriculture, that respond to population growth and better nutrition, as well as a drop in some regions of certain factors of production (farmland and irrigation). This is not the case for the goods sold to those nations, usually in the developed world, where demand has levelled off or is in decline.

In emerging nations, real interest rates (with the official inflation factored out) are not positive everywhere. Interest rates have been negative in India, Thailand and Turkey. Outside of Asia, this is also true for South Africa and Argentina. For the other Asian nations, real interest rates are very low, except for China where the official inflation rate is questionable, a classic situation if there ever was one. Hence, expected economic growth should also have an impact on domestic inflation for these nations.

Drums of war

QE is not the only factor pushing up Asian prices. Domestic factors are also important such as structural shortcomings and domestic market organisation. In some cases, inflationary pressures are due to economic policies designed to keep the national currency undervalued to boost exports. South Korea for example has favoured this approach for decades. In other cases, inflation is part of an economic strategy designed to further economic growth. This is the case of Japan.

Under the administration of Prime Minister Shinzo Abe, Tokyo has pursued a policy of devaluating the yen (about 20 per cent in recent months[10]) as a last desperate attempt to counter 20 years of economic stagnation.

En passant, the failures of Japan's economic policies in the past decades based on low interests and huge government debts are not that dissimilar from the Fed's QE. In Japan's case, manufactured devaluation is a strategy of questionable effectiveness in terms of generating real economic growth because of the country's limited capacity to reduce imports.

What is more, economic history shows that competitive devaluation can lead to currency wars and eventually trade wars. From this, a hot war may not be far off. Territorial disputes and military tensions between China and Japan over uninhabited islands may have less to do with the islands themselves than with the devaluation of the yen by Japan.

Tokyo's action on exchange rates has major consequences for its immediate neighbours, especially, South Korea, Taiwan and above all China. As the whole region needs to keep a positive export balance to avoid an economic downturn, without export-driven growth the region's underlying social and political contradictions could explode, especially in China.

To recap, in recent years QE has meant for emerging nations, especially in Asia, the potential for higher inflation, currency and trade wars as well as the possibility of real wars.

[1] Simon Black, "Lost in translation: Ben Bernanke-speak," in Sovereign Man, 28 February 2013.

[2] "[S]avers have many hats. They may own fixed income instruments, like bonds, but they also may own stocks or a house or a business. . . And those values have gone up, the stock market has roughly doubled, as you know, in the past few years", cited in Ibid.

[3] Maurizio d'Orlando, "As the world's monetary system inches its way towards collapse, winds of war sweep Asia," in AsiaNews, 5 February 2013; ibid, "Transatlantic partnership, a step towards a single currency and world government," in AsiaNews, 18 February 2013.

[4] Corporate EM bond index broad diversified.

[5] Based on Bloomberg data.

[6] EM bond index global diversified.

[7] EM global bond index.

[8] EM bond index broad diversified.

[9] EM bond index broad diversified high yield.

[10] Although stronger in recent days, the exchange rate with the dollar was at times 25 per cent higher than in September/October.

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