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.
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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, subscribe to MoneyWeek magazine.
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