Printing money won't save us from the next wave of deflation

By MoneyWeek Editor John Stepek Jul 12, 2010

John Stepek

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Let's assume for the moment that all the talk of a double-dip recession will translate into the real thing.

What's likely to happen? Well, another dose of quantitative easing – or money printing as we like to call it – seems the most likely reaction. The anti-austerity crowd will bray "we told you so". Governments will panic in response, anxious not to be accused of driving the economy into a depression.

And so the printing press will be warmed up again. And that will probably result in a rebound in asset prices.

But can it work in the longer run? Evidence from the past says no. And I'm not just talking about Japan. Quantitative easing has been tried before in the US too…

What happened when the US first tried quantitative easing

Here's something interesting I read over the weekend. The Federal Reserve Bank of St Louis has just put out a note in its latest issue of 'Monetary Trends', to remind us all that we've seen quantitative easing in the US before.

Recommended reading

When was it done last? During the Great Depression, of course. You can read the original piece here if you want it first hand. But here's roughly what it says.

In 1932, reports Richard G. Anderson, "the Fed purchased approximately $1bn in Treasury securities." This drove short-term interest rates down to around 0.5% by the end of the year, as buying by the Fed pushed up prices on government debt, and therefore drove down yields and therefore borrowing costs. And "quantitative easing continued during 1933-36".

It seems that Fed officials didn't feel particularly comfortable about doing this. They grew increasingly reluctant as by October 1933, bank reserves hit record highs (as the Fed bought bonds from them) and short-term interest rates hit record lows. The Fed held $2bn of government debt by this point. Purchases of bonds stopped in November 1933.

But as Anderson records, the quantitative easing didn't stop there. At the time, the US was still on the gold standard. In 1933, President Franklin D Roosevelt ordered that all gold in the country be sold to the Federal Reserve Banks at the then-fixed price of $20.67 an ounce. Then on January 30th, ownership was transferred from the Federal Reserve Banks to the Treasury, and the gold price was promptly increased to $35 an ounce.

Suddenly, the Treasury had made a $2bn profit on its gold (it's easy to buy low and sell high if you can set the price). It used this windfall to buy more gold on international markets, "sharply increasing bank reserves and the monetary base."

Between 1932 and 1936, the US economy actually recovered quite sharply. However, unemployment never went below 9%, so a large chunk of the population wouldn't have realised it. That's not dissimilar to today's 'recovery' – I suspect most of the 40 million or so Americans claiming food stamps don't really feel that inspired by the massive rally since March 2009. In any case, amid fears of inflation in 1936, the Fed began to tighten again. And the economy promptly slid back into recession.

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Those who back the policy of quantitative easing argue that the Fed just didn't do enough. But how much is enough? After all, quantitative easing has been tried elsewhere too. Japan is the other major example. And it didn't work there either. Again, the argument is that it didn't do enough. But how long do you have to keep an economy on life support for?

The real problem is that the banks are still broke

The real problem with the economy, as Paul Kasriel of Northern Trust points out (and as James Ferguson has regularly pointed out in MoneyWeek magazine), is that the banks are still broke. The Fed can print as much money as it wants. But if the banks don't want to lend it, then it won't drive up real economic growth.

Kasriel points out that something similar happened in the early 1990s. In short, plunging commercial property prices meant that banks were unable to extend much credit to the private sector, because they had to keep more money in reserve to account for their bad debts.

Now says Kasriel, there are "$176bn of commercial real estate loans of questionable value on banks' books. Depending on the amount of these loans that must be written off, a currently well-capitalised bank could become an under-capitalised bank down the road."

On top of this, regulators are likely to raise required capital ratios – ie the amount of money banks need to sit on to back their loans. Again, depending on these regulations, a bank which is in the clear now may end up having to raise more capital.

If banks won't lend, we'll get a double-dip recession

To cut a long story short – no wonder banks aren't keen to lend. And if they're not keen or able to lend, the economy isn't going to grow. And if that doesn't happen, we'll see a double-dip.

As other, more bullish forecasters have pointed out, a double-dip is a rare event. And Kasriel isn't predicting one yet. But nor is he ruling it out. He points out that every US recession since 1957 has been preceded by the Fed raising the federal funds rate (the key US interest rate). However, he adds, in prior cycles, bank credit was growing before rates were raised. In this case, "even with the Fed holding the funds rate at less than 25 basis points, bank credit continues to contract. Thus we are going to utter the six most dangerous words in economic forecasting: This time it might be different."

You can find out more about why we think a double-dip could be on the horizon on the current issue of MoneyWeek magazine. And in this week's issue (out on Friday), we look at one sector with some promising high-yielding defensive stocks that could prove a decent place to put some of your money during the uncertain times ahead. If you're not already a subscriber, get your first three copies free here.

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Comments (11)

Published in Economics | More articles by John Stepek

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  • 1. chris plumb

    (12 July 2010, 11:55AM)  Complain about this comment

    It would seem to me that the bond markest are telling us that rates are going to remain low because the economies of the western world are in trouble, and not growing. Therefore Western Governments either have to force their bank's to lend more so the money suppy grows and oils the wheels of recovery or if they (the banks) continue to hoard their cash at the Central Bank's then a double dip if not outright recession would seem a near certainty. The clock is ticking and the markets patience will not last beyond October 2010.

  • 2. Bob

    (12 July 2010, 02:03PM)  Complain about this comment

    What is the point of giving the banks more QE?

    They will merely hold on to it, use it to claim they have made a profit and merely hand it out as bonuses to their staff in the City & Docklands. Oh, and in Wall Street also.

    Surely we are not going to be mugs for a second time? Or is this the game politicians are playing by ensuring that the bankers and future jobs of ex-politicians remains safe and wealthy... whilst hundreds of millions of us go into the Depression?

    QE2 should be given directly to the People - oh, Bush tried that and people merely paid down their debts.

  • 3. John Chinery

    (12 July 2010, 02:36PM)  Complain about this comment

    The solution seems simple. Any economist would tell you that the problem we have here is the market structure for banking is an oligarchy where considerable power is held few players who can use their monopsonistic power to achieve super normal profits aka bankers bonuses.

    If this holds then the solution is to reduce barriers to entry and to encourage new entrants - handing the QE to these new entrants maybe? I am aware that credit unions and internet phenomena such as zopa exist and perhaps if these were assisted to grow they could provide competition to the banks.

    At the end of the day the bank are merely market makers - to savers and borrowers. Recruitment consultancy is not a monopsony - so why banking?

  • 4. jj

    (12 July 2010, 04:17PM)  Complain about this comment

    I think 2 of the comments are correct.There is no limit to what govts can do today.Bernanke became known as Helicopter Ben when he said that he would drop money out of helicopters if that would stop deflation.Anyway,the Fed did devalue the U.S. Dollar by 70% in 1933,when govt wasn't anywhere near as broke as it is today.The dollar has declined over 98% against real money,gold since 1913.I don't think this trend is going to change now.The govt has the power to eliminate all debts private and public by just paying them off with new currency.They will do that if necessary.Got GOLD?

  • 5. RogertheLodger

    (12 July 2010, 04:34PM)  Complain about this comment

    The problem is exacerbated when earners with discretionary income hoard money rather than spend it on consumption, (not that i blame them) because those savings are being included with QE and used by the banks to bolster balance sheets rather than being loaned to small businesses.

  • 6. Fund Manager News

    (12 July 2010, 09:38PM)  Complain about this comment

    The next round of QE2 is right around the corner. The Fed is paranoid about deflation and will do anything to keep asset prices from tanking.
    A lot of smart investors and money managers are now betting on the likelihood of QE2

    http://fundmanagernews.com/quantitative-easing-part-two

    It remains to be seen whether this will stave of deflation. However, you have to remember that deflation is a rarity - in most countries during most economic periods - inflation is the norm.

  • 7. Alan G.

    (13 July 2010, 03:15AM)  Complain about this comment

    Of COURSE there is going to be a double dip. Probably in October/November of this year, 2010. But hey, in the meantime lets print out some more debt and party till we drop.

  • 8. Kevin

    (14 July 2010, 02:00AM)  Complain about this comment

    Who is it exactly that the banks are supposed to be lending to....those who are unemployed or perhaps those who have already lost or are about to lose their homes to foreclosure? Haven't most Americans already reached the saturation point when it comes to the amount of debt that they can take on? Or at least pose too much of a credit risk to be given a loan?

  • 9. Poldark

    (14 July 2010, 07:17AM)  Complain about this comment

    How can banks fail to make a profit when they are paying almost 0% interest on deposits and charge up to 25% on loans?

  • 10. Michael

    (16 July 2010, 04:22AM)  Complain about this comment

    Kevin the banks have lent out too much money to sub-prime and commercial properties that were sold at highly inflated prices. However all those people who brought those properties at those highly inflated prices believe that a bigger mug than me will pay more for it. Then all of a suddenly almost every stock peaked at around 2007. Everyone in the know knew all this then. Banks are in dept to the tune of not billions but trillions of dollars and they must honour these dept’s of go under. So all the QE is simply doing is propping up the banks for as long as they can. So all this taxpayers money is not creating real wealth. It is simply paying of the enormous amount of dept that banks have accrued over the boom years. You are absolute right the tax payer cannot bail out the banks. This year alone something like 180 to 300 USA banks are expected to fail. Unfortunately this is taxpayers money which is simply going straight down the drain. There will be absolute no return on it.

  • 11. Michael

    (16 July 2010, 04:23AM)  Complain about this comment

    Kevin the banks have lent out too much money to sub-prime and commercial properties that were sold at highly inflated prices. However all those people who brought those properties at those highly inflated prices believe that a bigger mug than me will pay more for it. Then all of a suddenly almost every stock peaked at around 2007. Everyone in the know knew all this then. Banks are in dept to the tune of not billions but trillions of dollars and they must honour these dept’s of go under. So all the QE is simply doing is propping up the banks for as long as they can. So all this taxpayers money is not creating real wealth. It is simply paying of the enormous amount of dept that banks have accrued over the boom years. You are absolute right the tax payer cannot bail out the banks. This year alone something like 180 to 300 USA banks are expected to fail. Unfortunately this is taxpayers money which is simply going straight down the drain. There will be absolute no return on it.

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