Nomura 1

The dollar has appreciated against other currencies over the past two weeks as

government debt sold off around the world and Japanese equities rose. The driving

factor was criticism by US economists of QE2, which was launched by the Bernanke

Fed at the beginning of November, and subsequent speculation that the program could

be scaled back or discontinued altogether.

Denunciation of QE2 has come not only from these academics but also from the

conservative Tea Party. For Chairman Bernanke, known as a conservative who is close

to the Republican Party, this represents an attack from within.

On the international stage, as noted in my last report, the US found itself almost

completely isolated at the Seoul G20 summit, with the other member nations opposing it

18 to 2 or 19 to 1 over QE2. It would not have been difficult to conclude that the US

would be forced to modify the program.

* QE2 condemnation also helps brake yen’s rise

The first result of this criticism was a selloff in government debt around the world and a

corresponding rise in interest rates. In the US, bond prices fell sharply on the day that

the economists published an open letter.

Forex market participants concluded that the Japan–US interest-rate differential would

not contract as much as initially projected. They responded by selling the yen and buying

the dollar, halting the yen’s long upward climb.

Japanese stocks, which had been lagging significantly behind global equities, finally

turned higher once the yen’s rise had been checked. In summary, the yen fell, bonds

slipped, and stocks rose.

* Market presumes Fed would actively pursue further easing

In addition to criticism of QE2 from both inside and outside the US, I think another

reason for this turn of events was that the markets did not initially understand the Fed’s

message.

I am referring specifically to comments by Fed Governor Kevin Warsh several days after

the announcement of QE2. His remarks made it clear that the meaning of the expression

“adjust the program as needed,” which was contained in an explanatory article written by

Chairman Bernanke when QE2 was launched, differed from the market’s interpretation of

the phrase.

Many initially interpreted this expression as meaning that the Fed was ready to carry out

QE3 if necessary. What it actually meant, however, was that the Fed was willing to scale

back or discontinue the untried policy in the event of unforeseen consequences.

The tone adopted by Governor Warsh in his comments was far from enthusiastic—

essentially he said that, while QE2 is not the best policy, the Fed had to do what it could.

This also gave the impression that the Fed would move quickly to alter the policy if

something unexpected happened.

A careful reading of the explanation of QE2 published in the Washington Post by Mr

Bernanke reveals that nuance, but market participants saw the document as confirming

their own bias that a third round of quantitative easing was possible.

* Criticism of QE2 also confused

Incidentally, the arguments made by those opposing QE2 were also quite confused.

Many missed the mark entirely.

This confusion stems from the fact that neither the supporters of QE2 nor its critics

understand the significance of the fact that the US is not in an ordinary recession but

Richard Koo: growing criticism of QE2 and its implications

Richard Koo r-koo@nri.co.jp

30 November 2010

(issued in Japanese on 29 November 2010)

Please read the important disclosures and disclaimers on pp. 8–9.

Nomura Securities Co Ltd, Tokyo Japanese Equity Research – Flash Report

30 November 2010

Nomura Research 2

rather in a balance sheet recession. This is a once-in-several-decades event in which the

private sector struggles to pay down debt even though interest rates are at zero.

When a collapsed asset bubble has left private sector balance sheets underwater and

businesses and households are paying down debt to repair their finances in spite of zero

interest rates, the money multiplier is negative at the margin. This means the Fed can

supply as much liquidity as it wants, but the mechanism that would ordinarily transmit

those funds from the financial system out into the real economy is no longer functional.

Fed purchases of Treasury securities at such times leave banks holding cash instead of

Treasury securities. But unless there are businesses or households willing to borrow

those funds, the banks’ only alternatives are to hold that cash or to use it to buy other

existing assets.

If the banks purchase an existing asset, that simply represents a change of ownership,

and there is no impact on GDP. While the price of the asset may change somewhat,

there is no guarantee that the money used to buy that asset will enter the real economy.

To use the analogy of an antique market, it is as though someone who had previously

shown no interest in antiques suddenly began buying them in large quantities. While

those purchases could drive up the price of antiques, the positive impact of the higher

prices on the real economy would be quite small in relation to the amount of money

spent buying the antiques.

In other words, there will be a positive impact on GDP if people who received more than

they expected by selling their antiques to this new buyer used some of their profits to

engage in additional consumption. However, such expenditures will necessarily be quite

small in relation to the selling price of the antiques.

* Lowering interest rates will not change behavior of private sector intent on

repairing its balance sheet

If private loan demand was at ordinary levels, Fed-supplied liquidity would support new

investment by businesses and households via bank lending and would at the same time

increase the money supply. The simultaneous expansion of investment activity and the

money supply would proceed in accordance with traditional money multiplier theory and

have a positive impact on both GDP and inflation.

In contrast, the economic stimulus from a slight increase in the price of existing assets is

only a fraction—possibly a tiny fraction—of what can be achieved with ordinary monetary

easing.

Moreover, the fact that businesses and households are focused on fixing their balance

sheets and have shown no interest in borrowing despite historically low interest rates

suggests that further decreases in (long-term) interest rates will have little effect. Unless

the argument is that people’s behavior will change suddenly once interest rates fall to

some critical level, we cannot expect a further 25–50bp decline in interest rates to

produce significant changes.

In other words, we cannot expect modest changes in the yield curve due to Fed

purchases of longer-term Treasury securities to prompt a change in private-sector

behavior at a time when balance sheet problems have reduced the private sector’s

sensitivity to interest rates to a level approaching zero.

In that sense, it is a mistake to assume that the Fed’s QE2 will generate inflation, just as

it was a mistake to believe that the BOJ’s version of quantitative easing 10 years ago

could create inflation in Japan, which found itself in exactly the same situation as the US

today.

* Interest rate sensitivity of US private sector has fallen precipitously

In a speech in Frankfurt on 19 November, Mr Bernanke argued that the term

“quantitative easing” was not an appropriate description of the Fed’s $600bn purchase of

longer-term Treasury securities. His reasoning was that QE ordinarily refers to the

30 November 2010

3 Nomura Research

purchase of short-term government securities (and the corresponding supply of funds) to

increase commercial banks’ reserves. The recently announced program, on the other

hand, involves the purchase of bonds with relatively long times to maturity.

I suspect that Mr Bernanke was trying to distinguish the policy from Japan-style

quantitative easing, which was demonstrated to have little effect, by stressing that it was

not quantitative easing but rather a purchase of longer-term government securities. But

at a time when balance sheet problems are forcing businesses and households to

deleverage, I think the private sector is no more able to respond to changes in long-term

interest rates than it is to short-term rates.

If private sector sensitivity to interest rates has fallen not only with respect to short-term

rates but across the yield curve, the Fed’s attempt to supply funds by purchasing longer-

term securities will have the same effect as Japan-style quantitative easing, in which the

BOJ bought short-term government securities.

At one point the yield on 10-year Japanese government bonds fell to a historic low of

0.4%, but even that was unable to provoke a change in private-sector borrowing

behavior. In other words, the interest rate sensitivity of Japanese businesses and

households had fallen with respect to the entire yield curve.

More than two years have now passed since the collapse of Lehman Brothers. During

that time the Fed chairman has not only doubled the size of the Fed’s balance sheet to

supply liquidity to the market but has also kept interest rates at zero for two years.

Despite these efforts, there has been no acceleration of US money supply growth or

inflation. The Fed’s argument that this time the policy will work because it is buying

longer-term debt is therefore difficult to accept.

US long-term interest rates have also returned to where they stood before talk of QE2

emerged, which suggests that Mr Bernanke’s professed reason for why the policy should

work has already disappeared.

In summary, neither those who fear QE2 will spark inflation nor those who argue it will

boost the economy understand the importance of the dramatic drop in private sector

interest rate sensitivity.

* Damage from QE2 evident in dollar weakness

A closer look at the remarks of Governor Warsh noted above and those of Mr Bernanke

in the 19 November speech gives the impression that both officials now recognize that

QE2 is more likely to have no effect at all than to spark inflation.

I suspect the Fed’s decision to implement QE2 regardless is probably based on the view

that, while the policy may not be particularly effective, it cannot hurt. This also recalls the

BOJ decision in 2001 to launch quantitative easing as a result of political pressure.

This time, however, QE2 has resulted in actual damage in the form of dollar weakness.

The area in which the Fed’s version of quantitative easing produced the greatest relative

change in existing asset prices was the currency market.

The dollar fell even before QE2 was launched as market participants concluded that a

drop in US long-term interest rates would, all else being equal, serve to weaken the US

currency. This is similar to the way that long-term interest rates fell prior to QE2,

prompting investors to buy stocks. Nearly all media reports at the time cited expectations

of QE2 as the reason for the dollar’s decline.

* Bernanke seeks to evade responsibility for US isolation

In his speech on 19 November, however, Mr Bernanke argued that QE2 was not

responsible for the dollar’s recent weakness. Instead, he attributed it to the fact that the

euro had returned to its earlier levels as the problems in Greece—which had been

weighing on the European currency since spring—finally faded into the background.

30 November 2010

Nomura Research 4

But in my view it is difficult for the Fed chairman to take credit for higher stock prices and

bond prices during this period while at the same attributing dollar weakness to external

factors.

And a closer look shows that the dollar did not fall exclusively against the euro during

this period—it also dropped against the yen, the Brazilian real, the Swiss franc, the

Korean won, and the Australian dollar. And starting in early November, when the market

began to doubt whether QE2 would be continued, the dollar appreciated against all of

these currencies.

Ultimately, I think Mr Bernanke is trying to evade responsibility for the humiliating

isolation experienced by the US at the Seoul G20 summit, where it found itself

outnumbered 19 to 1.

Of all the factors capable of explaining the dollar’s weakness, the Fed chairman has

focused on the one that does not cast him in an unfavorable light and declared that to be

the primary cause. However, I suspect there are few currency market participants who

share his view.

What concerns me about his statement is the possibility that the former academic still

does not understand how markets operate and simply believes whatever is most

convenient.

* Political considerations also force caution in implementing QE2

In any case, such desperate statements are evidence that the Fed Chairman is well

aware of the criticism of QE2 coming from both inside and outside the US. I suspect he

would be particularly worried if there were people within the Obama administration who

felt that QE2 was responsible for the humiliating sense of isolation they experienced at

the Seoul G20 meeting.

Recent surveys show the American public’s trust in the Fed has fallen far more than their

trust in other government institutions. One wrong decision by Mr Bernanke at this

juncture could increase Congressional support for those seeking to strip the Fed of its

authority.

In that sense, I think the Fed will be very careful in administering QE2 and will be ready

to discontinue the policy if it has unforeseen results.

* Bernanke argues that weak economies running trade deficits should have

weaker currencies

I find Mr Bernanke’s remarks on 19 November to be extremely interesting inasmuch as

they were intended as a rebuttal of the case against the US made at the Seoul G20

summit. In his speech Mr Bernanke argues, albeit in a somewhat roundabout fashion,

that a weaker currency is a good thing for nations struggling with weak economies and

trade deficits.

His argument is based on the assumption that exchange rates are freely determined by

the market. If that is the case, currencies in the emerging economies, which are

characterized by high growth rates and interest rates, should appreciate against the

currencies of the developed nations with their low growth rates and interest rates. Given

that the emerging nations are currently running trade surpluses and the developed

nations are running trade deficits, this should lead the global economy in the right

direction, according to Mr Bernanke.

Specifically, stronger currencies will help curb inflationary pressures in the emerging

economies and prompt producers there to focus more on the domestic market. In the

developed nations, meanwhile, weaker currencies will help stem deflationary pressures

and encourage producers to place greater emphasis on overseas markets. The end

result will be a much more balanced global economy, according to the Chairman.

And if this mechanism propels a recovery in the US economy, he says, the dollar will

eventually strengthen, which would also be a positive for the emerging economies.

30 November 2010

5 Nomura Research

* Post-bubble recovery and rectification of trade imbalances cannot be achieved

simultaneously

While there is something to be said for Mr Bernanke’s argument, the question is whether

it is appropriate to simultaneously pursue two goals: a recovery from the economic shock

triggered by the collapse of housing bubbles in the US and Europe, and the rectification

of ongoing trade imbalances. The concern here is that by running after two hares, we will

catch neither.

With the global economy as fragile as it is today, an attempt by certain nations to

increase exports by devaluing their currencies would naturally force their trading partners

to defend themselves. After all, their own economies are not that strong.

This would lead to a repeat of the competitive currency devaluations of the 1930s and

the protectionism that followed with a crippling effect on global trade and the world

economy. Today’s situation closely resembles that of the 1930s. As such, I think it is

critical that countries refrain from behavior that could lead to competitive devaluations.

At the recent G20 meeting it was this issue that led to such heavy criticism of QE2. Other

countries criticized the US for pushing ahead with QE2 because its only impact during a

balance sheet recession is to weaken the local currency. Nations like China, Brazil, and

Germany in particular were angry at the way the US announced QE2 just before the

Seoul summit in spite of the fact that they had made their concerns about this issue clear

at the mid-October meeting of central bankers and finance ministers in Gyeongju, Korea.

* What is needed now is fiscal stimulus, not monetary accommodation

So what should be done? The reason Mr Bernanke’s arguments are a dead-end is that

policy authorities around the world are relying on monetary policy in their attempts to

jump-start the economy. The addition of fiscal policy to the mix would create many new

possibilities.

By using fiscal stimulus to support GDP, countries will be able to boost their

economies—which is essential for countries experiencing balance sheet recessions—

with no change in exchange rates.

At the emergency meeting of the G20 held in Washington immediately after the failure of

Lehman Brothers, the 20 member nations agreed to carry out fiscal stimulus. That action

prevented a deflationary spiral and averted a global economic crisis. Once their

economies had stabilized, however, the countries mistakenly concluded that the time for

fiscal policy was over and decided that further economic support would be provided

using monetary policy.

But with most Western economies now experiencing balance sheet recessions,

monetary policy is unable to boost domestic demand; its only effect is to weaken the

local currency. Only fiscal policy is capable of supporting the economy under these

conditions. Yet Western nations are still trying to provide stimulus using monetary policy,

which leads to competitive devaluations.

There was also a rush to devalue currencies in the 1930s as countries attempted to fight

the recession using monetary policy (in which I include currency policy) because they did

not want to increase their fiscal deficits.

Mr Bernanke, a self-proclaimed expert on the Great Depression, did not understand that

the Great Depression was actually a balance sheet recession. This has led him to the

mistaken conclusion that the US economy shrank as much as it did because the Fed did

not sufficiently ease monetary policy.

Mr Bernanke decided to ease exhaustively in order to prove the validity of this theory,

and QE2 represents the latest iteration in the cycle. We are effectively reliving the 1930s,

when policymakers did not realize they were dealing with a balance sheet recession and

attempted to stimulate the economy using monetary and currency policy.

30 November 2010

Nomura Research 6

* Even Bernanke admits need for fiscal stimulus

However, Mr Bernanke is finally being forced to reconsider his theory, as keeping

interest rates at zero for two full years while supplying massive amounts of liquidity to the

market has been unable to spark a recovery. In his speech on 19 November, the Fed

chairman was clearer than before in his support for fiscal stimulus.

After stating that the Fed alone could not cure the recession, Mr Bernanke said “the

Federal Reserve is nonpartisan and does not make recommendations regarding specific

tax and spending programs. However, in general terms, a fiscal program that combines

near-term measures to enhance growth with strong, confidence-inducing steps to reduce

longer-term structural deficits would be an important complement to the policies of the

Federal Reserve.”

This represents a major turnabout from a year ago. Then Mr Bernanke was arguing that

fiscal policy had fulfilled its role, that it was time for fiscal consolidation, and that any

adverse economic impact could be offset with monetary accommodation from the Fed.

In this way, the Fed chairman appears gradually to be revising the views he formed as

an academic. But he has yet to acknowledge that monetary policy is basically ineffective

during a balance sheet recession.

* China responded most appropriately to Lehman collapse

Inasmuch as fiscal stimulus is essential to overcoming a balance sheet recession, the

most appropriate policy response has come from China, which engaged in massive fiscal

stimulus early on.

I suspect Chinese officials are upset with the way the US and Europe have taken every

international conference as an opportunity to bring up the currency issue. After all, China

has managed to avoid recession by adopting the right policies, yet it finds itself being

blamed by the US and Europe for recessions resulting from their own misguided policies.

In his speech on 19 November, Mr Bernanke praised the emerging economies—of which

China is the largest—for their actions. Many countries, including Japan, have benefited

greatly from China’s efforts to boost its economy with fiscal stimulus.

* Currency and trade imbalances can be dealt with after economy recovers

The RMB4trn fiscal package announced by the Chinese government in November 2008

was roughly three times the size of the Obama administration’s $787bn package in GDP

terms. Moreover, unlike the US package, it was quickly implemented.

China’s fiscal stimulus package was also implemented against the backdrop of steeply

falling housing and stock prices. Had China not acted in the way it did, it could have

fallen into the same kind of balance sheet recession now dogging Europe and the US.

If China had substantially devalued the RMB in the wake of the Lehman-inspired crisis,

the US and Europe might be able to make the case that China was responsible for the

subsequent recession. But that is not what happened. The Western nations have fallen

into recession not because of Chinese currency manipulation but because their own

asset price bubbles collapsed, plunging their economies into balance sheet recessions.

I agree that China’s currency policy is a problem. However, there is little likelihood China

will change its policy after seeing the Western nations focus exclusively on China’s

currency issue while putting off necessary measures in their own economies. From a

Chinese standpoint, it is clearly unfair for China to have to shoulder the world’s burden

with both fiscal policy and currency policy.

It would be more difficult for China to reject the arguments of Europe and the US if the

Western nations had carried out necessary fiscal stimulus before asking China to alter its

forex policy. But they have not.

With a Republican victory in the recent midterm elections making it more difficult for the

US to implement fiscal stimulus and Europe having adopted a staunch pro-fiscal

30 November 2010

7 Nomura Research

consolidation stance, I think China—whose economy continues to benefit from the

correct policy of fiscal stimulus—is unlikely to give in easily to Western demands on the

currency front.

* International coordination impossible with US authorities singing from different

hymn sheets

Instead of trying to rectify trade imbalances and spark an economic recovery at the same

time, the US and Europe should set their priorities and achieve a recovery before they

set about trying to rectify trade imbalances. The global economy is simply not strong

enough to allow both objectives to be achieved simultaneously.

A senior Obama administration official I met with in October held the same view and

went on to say that since the Lehman Brothers failure he had never once argued the US

private sector should start saving more. Increased US household savings would help

correct the nation’s external imbalances, but would also have a negative impact on the

economic recovery.

In contrast, Mr Bernanke said in his speech on 19 November that “higher private saving

would also help.” The two positions are clearly contradictory.

Similarly, Treasury Secretary Geithner stated on a number of occasions around the

Seoul G20 meeting that the US did not seek a weaker dollar. But as noted above, the

Fed chairman said on 19 November (albeit indirectly) that a weaker currency is good for

countries—like the US—with trade deficits and low growth rates.

This is clear evidence that US policymakers do not share the same priorities. I think

these kinds of contradictions in US policy are one reason for growing distrust of the US.

The US should be serving as a leader of the global economy. But as long as the present

state of affairs continues, I think the G20 will be unable to function in its intended role as

promoter of global coordination.

Richard Koo’s next article is scheduled for release on 14 December 2010.

8

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