A policy first initiated by Gordon Brown has now found its way into United States fiscal policy: an apparently complicated and novel policy described as quantitative easing. Although currently supported by those at the lofty heights of global finance, its significance and its effects could prove devastating for the U.S. economy.
Most of the countries of the world hold some level of national debt, and the freedom to amass such deficits is largely deemed as essential for the overall growth of economies. Just as individuals take out loans to buy products, or to simply tide them over, when they could otherwise not afford to do so, governments often find themselves in the same situation. Just as for individuals, if at the end of a particular month their outgoings are larger than their salary, some form of extra investment is necessary to prevent the individual or nation from going bankrupt. The method which most governments use to take out this ‘loan’ is to issue a government bond, (in the U.S. this is known as a Treasury Bond). The sale of this bond in its specialised market provides the capital for the government to pursue its policies. For the buyer, the value of their purchase is that it is redeemable from the issuing government after a certain amount of time. However, just as in a stock market, the number of bonds a government issues, and the amount of faith which investors have in them, determine their value.
The special relationship between the United States and China has always been essentially tied to the U.S. bond market. As China is overwhelmingly a net exporter of manufactured goods, and as the United States is its primary customer, an interesting arrangement has developed. The United States buys Chinese products, stimulating the growth of the Chinese economy, and in turn with this growth, the Chinese purchase U.S. government bonds. Since the Chinese feel secure in the knowledge that the U.S. is the primary world economy, investment in their bonds is considered particularly safe. In fact China is the largest holder of U.S. Treasury bonds, with a total of $800 billion as of last September. Treasury bonds are of course only one form of the debt absorbed by China, with Mortgage bonds and commercial paper money accounting for similarly large sums. The Chinese dominated East Asian market has been a net purchaser of around $1 trillion in bonds every year, with total holdings of around $7.2 trillion. The overwhelming confidence that has been placed in this relationship by the United States is expressed succinctly by Richard W. Fisher, head of the Dallas branch of the Federal Reserve as he remarked, ‘gentlemen prefer American bonds.’ The U.S. has been able to run up an enormous debt over the last few decades as China has overwhelmingly considered them to be, ‘good for it.’
However, as the financial crisis has engulfed not only the U.S. economy, but the rest of the world, cracks have begun to emerge in this arrangement. As Congress seeks greater and greater sums in finance its various ‘baliout’ and ‘recapitalisation’ policies, the funding for this has to come from somewhere. Certain estimates suggest that the Treasury will have to seek $2 trillion in 2009 alone. Obama’s various grandiose policies also come at a time when the American economy is slowing and commodity purchases are consequently falling. With their major customer not only slacking in demand, but appearing increasingly unsteady, East Asian investors are justified in being wary of investing in their long time ally. Indeed, investments have not merely slowed, but they have actively decreased. The Telegraph’s finance correspondent Ambrose Evans-Pritchard has gloomily announced that they dumped $190 billion in the four months before February this year. Amongst all the pomp and circumstance of Global Summits and international ‘arrangements’ the U.S. is in crisis.
With the United States’ largest lender refusing to fund further borrowing, and in fact calling in previous loans, the government has been forced to seek an alternative solution. The result has been the policy now known as quantitative easing. The independently administered Federal Reserve Bank has now offered to buy up the securities and liabilities of the U.S. government and its national companies. This is a landmark move in international banking, and although following the suit of the united Kingdom, it has dwarfed Gordon Brown’s proposals in its scope. The announcement, as of the 18th March, proposed the purchasing of $300 billion of U.S. treasury bonds and $750 billion of mortgage bonds, bringing the total investment to $1.25 trillion. Obama has declared that the money raised will, ‘fund a few stimulus projects, universal healthcare, a green energy system and a host of other programmes on his wish list.’ The question remains however as to where all this new money is real coming from.
The position of the Federal Reserve as the issuer of national currency makes its purchase of Treasury bonds extremely tenuous. As an independent organisation, it has the effective freedom to purchase real assets and liabilities whilst paying for them only with printed money. This however is the theory behind quantitative easing: increasing the money supply to lower its value, therefore lowering the value of debts and providing banks with more capital to lend out. Whilst this might appear good for the Fed it is certainly not good for the Chinese relationship. With the dollar falling against the Yuan as inflation takes hold, Chinese investors are worried that the U.S. may try to redeem all the bonds it sold in depreciated currency. Chinese investment is already faltering, and this latest move by the Fed is likely to completely undermine confidence in financing their partner’s debt. The results of this are already being felt with the Wall Street Journal announcing that it is 7 times more costly to buy insurance against an American government default.
All this speculation of ‘quantitative easing’ is therefore basically irrelevant to the issue: the U.S. essentially needs a loan, just as an individual would. If an individual cannot pay for rent or purchases, making fake money to pay is not the solution as it will inevitably catch up with him. The same is true of the U.S. economy. However, with their primary lender not unreasonably worried, it seems unlikely that they will be able to secure this loan. What makes this situation increasingly desperate is the scale of Obama’s financial policies, which continue to grow to ever greater heights. With no foreign source of capital investment, and with the government already in deficit, the only ‘lender’ may continue to be the Federal Reserve. The bank will be able to purchase increasing portions of the nation’s economy for ever decreasing value. If the supply of printed money does eventually stimulate the economy into growth, as even sceptics such as Irwin Stelzer presume it will, in order to prevent the effects of massive inflation the Fed will have to contract the money supply, just as they did after the Great Depression. It is unlikely that the Bank will do this at the same point as they did so in the previous case as it is far more profitable for the country, and more notably themselves to wait until the economy has more fully recovered. At this point, contraction of the money supply will mean that the debts the Bank owns will become more valuable as the value of the dollar rises, interest rates will rise and their creditors will have to pay back in real value what was lent out essentially for free.
However, this prognosis is only an extension of the existing system of Central Banking finance. A more daunting threat is put forward by the British Historian Niall Fergusson. He suggests that if confidence in American fiscal policy is significantly lowered, it could trigger a mass sell-off of U.S. treasury bonds and other liabilities by China and her other East Asian counterparts. If such a move occurred, it would be almost impossible for the Federal Reserve to absorb the debt fast enough and a total collapse of the U.S. economy would result. Of course, Fergusson doubts that this collapse would ever be allowed to happen, and war, he predicts, would be the only feasible result of this attempt to protect the U.S. bond market.