Unintended consequences of stimulus policies

Quantitative easing devalues the dollar's status and creates an unstable world, warns HSBC's chief economist Stephen King.

Policy measures pursued in one part of the world may be “filtered, warped and distorted in other parts of the world, giving rise to a set of completely unintended consequences”, according to Stephen King, HSBC’s group chief economist.

Quantitative easing has had such “unintended consequences”, he told media at the bank’s Asian Outlook 2011 conference at Hong Kong’s Marriott Hotel on Friday.

The main effect of stimulus policies in the US and Europe – employed both as an immediate response to the credit crisis and again in the autumn 2010 -- has been in the emerging world because of its smaller debt levels, lower per capita income (income elasticity is stronger in emerging countries) and secular growth trend. And, “for a given global growth rate, any shift in the balance away from the developed towards the emerging world is likely to be associated with higher commodity prices”, said King.

In addition, when, as now, investors lose confidence in paper assets, they prefer to buy real assets, giving a further boost to commodity prices. The net effect on emerging countries is rising inflation – especially increases in the price of food, which might bring the prospect of social instability similar to 2008.

“In a desperate – and doomed – attempt to return to ‘business as usual’, Western policy makers have unleashed inflationary pressures elsewhere in the world, which have only served to make the recovery in the West more difficult,” said King.

He also warned that what started off as stimulus measures could end up undermining economic activity in developed nations.

“The debt problem has not gone away, but the problem now lies in the public sector rather than the private sector, raising the risk of default, devaluation and a further bout of financial instability”.

The US has been forcing the dollar lower, shifting the burden to foreign creditors and away from domestic creditors. Long-term, this will have a deleterious effect on the dollar, ultimately threatening its status as the world’s reserve currency.

And, if policymakers fail to convince investors and the general public of their intentions, “the risk is that the monetary system as a whole simply snarls up completely”.

A serious, possible consequence could be more debt restructurings and even an “Act of Union” (linking or even unifying the fiscal policies of member states) in the eurozone. This might be the harbinger, or at least a dress rehearsal, of a major dollar crisis, with the US having to negotiate with major creditors such as China, Russia and Saudi Arabia – and ultimately the end of the dollar’s reserve currency status.

Meanwhile, emerging countries need to search for protection against inflation and asset bubbles. Likely policy responses are higher interest rates and stronger currencies, counter-cyclical capital ratios and higher bank reserve requirements, tighter fiscal policies and even capital controls. Of course, there has been ample evidence of all of these actions being imposed across the emerging world during the past six months.

King’s analysis and envisaged scenario leave little room for optimism. Even the early abandonment of the short-term Keynesian palliative and long-term toxin – quantitative easing and the over-worked currency printing press – might be premature and would lead to a deflationary, Japan-style cycle in the West.

Instead, fingers crossed that it works, that inflation picks up, unemployment falls, consumption rises – and investors are convinced.

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