Jackson Hole will be a Black Hole for Those Hoping for QE3

By Marshall Auerback and Rob Parenteau

Those leading the charge for “fiscal consolidation” now seem positively shocked by the violent gyrations in the stock market, as expectations rapidly seem to be shifting toward an “L” shaped recovery or worse – a possible global recession. To those of us on this blog who have consistently downplayed the prospects of global recovery in the midst of widespread private sector AND public sector retrenchment, none of this sadly comes as a surprise. We are, as Bill Mitchell noted recently, experiencing a “self-inflicted catastrophe”, largely because of dangerously destructive myths in regard to the efficacy (or lack of it) in regard to fiscal policy. But in spite of the shrill rhetoric of the fiscal austerian brigades, the markets are beginning to intuit that a nation cannot have a fiscal contraction expansion when all other spending is flat or going backwards and yet that remains the general trajectory of policy.

To reiterate, today’s growing economic malaise is unsurprising to those of us who viewed the upturn in the global economy in the aftermath of the Lehman bankruptcy largely as a consequence of the coordinated fiscal expansion that was undertaken at that time, NOT the embrace of “quantitative easing” or other forms of monetary policy ‘stimulus’. By the same token, it is equally easy to see the current accelerating downturn as a product of the premature withdrawal of said stimulus.

No less than the new IMF head, Christine Lagarde, has recently counseled against letting fiscal brakes stall global recovery, even though the IMF has hitherto consistently been at the forefront of calling for more “fiscal consolidation.” Indeed, it is manifestly clear that the governments which have drunk from this particularly glass of Kool-Aid most enthusiastically – Ireland, Greece, Latvia, Spain – are now seeing depression-like economic data.

Given prevailing political paralysis and the obstinate desire of politicians to make things worse as unemployment grows and riots continue to multiply on the streets (see the UK as Exhibit A), a number of commentators and policy makers have shifted focus back to monetary policy. One picks up this kind of chatter on Wall Street, where there exists a residual hope that somehow Big Ben will use this weekend’s Jackson Hole gathering to ring the bell for a form of QE3.

It’s hard to see why this should work out any better than QE2 or other variants of quantitative easing tried before. (See here, here and here for fuller explanations.) As Randy Wray has pointed out several times, “quantitative easing” is a slogan, not a policy. During the entire period in which it was implemented, US GDP grew at a sluggish 1-1.5% (or thereabouts) and unemployment actually rose.

Notwithstanding the evidence, hope still springs eternal in the financial markets, where there remains the perennial hope that the Fed will “do something.” And, as market practioners we hear this sort of guff every single day. There appears little doubt that Mr. Bernanke will try to throw more spaghetti at the wall, regardless of internal discord at the Fed or the external political heat. But we are at a loss as to which strand of spaghetti will actually stick in terms of a) capturing the imagination and confidence of investors enough to put the risk on trade back on for say another 4-6 quarters (or even 4-6 months), and/or b) driving US real GDP growth above trend for 2-3 years. Which makes us think unless there is some nuclear option we believe he is prepared to launch – like pegging S&P futures for 10%+ annual appreciation or something really out of the box like that – there is not much to be gained by trying to anticipate his next flinch.

We are at the point of watching the trout thrash around at the bottom of the boat, and I think part of the higher required risk premium we are in seeing in asset markets today is that the Fed Chairman is now understood to be no more powerful than the Wizard of Oz. And this is a very, very big safety blanket that is being ripped out of the hands of a whole generation of institutional investors (especially the long only guys). Part of the severity of the recent corrections has to do with the growing recognition that the prior fiscal and monetary policy approaches have been either exhausted or politically blocked, and so now it is up to the private marketplace and the invisible hand to do its magic.

Maybe an announcement of pegging the 10 year at 1% until real GDP has grown for above 3% for 1-2 years would do it – but we are already near 2%, and people seem to realize the interest rate sensitivity of economies is lower after balance sheet recessions. Maybe an open ended QE with a similar real GDP criteria would do it; but investors must be wondering why QE2 failed to keep equity prices on a permanently higher trajectory.

Furthermore, they may have noticed that the ensuing commodity price inflation tends to trip up consumers who face slow job growth, low wage growth, and credit contraction. If anything, QE2’s impact was antithetical to growth prospects to the extent that it encouraged additional speculative activity in the commodities complex, helping to generate additional price pressures in food and oil at a time when stressed consumers could ill-afford such rises. More recently, thanks to investment, speculative and manipulative demands for oil, the Brent oil price has held up recently as the stock market has swooned. So there is a risk that the introduction of a third round of quantitative easing could well re-establish these trends.

There is something of a precedent: the first half of 2008. The global recession and credit crisis was underway. Stock prices were falling. Commodity prices including the price of oil should have fallen. Instead, thanks to the above financial market demands, the oil price soared. Without doubt that deepened the Great Recession. In the event that a new form of QE3 was introduced this weekend, that would represent is the worst of all possible worlds in terms of global growth prospects moving forward. At the very least, if the recent incipient perverse divergence in the Brent oil price and stock prices continues, the risk of a recession in the U.S. rises.

Maybe the announcement that the Fed disagrees with the Treasury about the wisdom of an ever strengthening dollar, and will henceforth unilaterally intervene to produce a steady 10-20% depreciation per year until the real GDP criteria is hit, is enough to capture investor imaginations, but we suspect they would then begin to wonder about where beggar thy neighbor policies lead.

The fact that the markets are now calling for more monetary stimulus (even as most quail against any additional fiscal stimulus on the misguided grounds of “national insolvency” ) simply reflects the intellectual cul de sac at the heart of most mainstream economics, with its manifestation of the neo-liberal bias towards monetary policy over fiscal policy. What will motivate consumers to borrow if they are scared of losing their jobs? Why would a company borrow if they expect their sales to be depressed? The problem is a failure of demand which has to be addressed via demand measures – that is, fiscal policy.

We think investors are realizing that is a null set, and so whatever Mr. Bernanke announces will have a very short half life, a la pegging the 2 year. Now perhaps in regard to sentiment, technicals, and the extreme gyrations of recent weeks, we might well get some recovery in the equity markets. But given the prevailing trajectory of policy, where we are debating tax rises versus government cuts (as opposed to the more economically productive debate of government spending versus tax CUTS), it’s hard to feel optimistic about global growth going forward. The recent turbulence witnessed in the capital markets might be a foretaste of what Main Street is about to experience again.