Will QE lead to class warfare?

Further to my last post about the risks of quantitative easing, I saw a couple of warnings from the IMF that are worrisome. First, they warned that the risks to financial stability remain high. Moreover, they indicated that Basel III won’t ward off another financial crisis.


Policy makers appear to be in my-only-tool-is-a-hammer-so-every-problem-is-a-nail mode. The consensus solution of choice are further quantitative easing, competitive devaluation and trade protectionism (mostly directed at China).

Blowing more asset bubbles
Jeff Rubin, former chief economist at CIBC World Markets, recently wrote that further quantitative easing only benefit the providers of capital, i.e. the wealthy. In other words, QE means more asset bubbles. Rick Bookstaber also commented on the income gap and looked towards a hypothetical 2025:

For those who have the money to burn, demand is moving increasingly toward things that cannot be produced. Land, art, rare wines and Super Bowl tickets are being bid up to unthinkable levels. The major economic pastime that remains to differentiate the rich from the rest of us is picking new stuff to throw into the fray. The latest one is scholar stones from the Sung Dynasty. All that money has to go somewhere. But that only leads to a transfer of income from one well-to-do pocket to another without generating any production. Sadly for those grounded in the middle class, this means more of these things are moving out of reach. But no matter. It all seems silly and abstract to most of us, like the amusing eccentricities of the English upper class a century or two before.

Notwithstanding the fact that IMF chief Strauss-Kahn is warning against using currency as a weapon, noted China watcher Michael Pettis wrote that forcing China to revalue the RMB too quickly will also result in further asset bubbles [emphasis added]:

Most probably Beijing will do the same thing Tokyo did after the Plaza Accords and Beijing did after the renminbi began appreciating in 2005. It will lower real interest rates and force credit expansion.

This of course will have the effect of unwinding the impact of the renminbi appreciation. As some Chinese manufacturers (in the tradable goods sector) lose competitiveness because of the rising renminbi, others (in the capital intensive sector) will regain it because of even lower financing costs. Jobs lost in one sector will be balanced with jobs gained in the other.

But there will be a hidden cost to this strategy – perhaps a huge one. The revaluing renminbi will shift income from exporters to households, as it should, but cheaper financing costs will shift income from households (who provide most of the country’s net savings) to the large companies that have access to bank credit. So China won’t really rebalance, because this requires a real and permanent increase in the household share of GDP. Instead what will happen is that it will reduce Chinese overdependence on exports and increase China’s even greater overdependence on investment.

This will not benefit China. It will fuel even more real estate, manufacturing and infrastructure overcapacity without having rebalanced consumption. Expect, for example, even more ships, steel, and chemicals in a world that really does not want any more.

The Federal Reserve is no doubt aware of these risks. Fed Vice Chair Janet Yellen, who is usually perceived as an inflation dove, also weighed in on the bubble risks of excessive easy monetary policy in a speech on October 11, 2010 [emphasis added]:

I noted previously--and it is now commonly accepted--that monetary policy can affect systemic risk through a number of channels.First, monetary policy has a direct effect on asset prices for the obvious reason that interest rates represent the opportunity costs of holding assets. Indeed, an important element of the monetary transmission mechanism works through the asset price channel. In theory, an increase in asset prices induced by a decline in interest rates should not cause asset prices to keep escalating in bubble-like fashion. But if bubbles do develop, perhaps because of an onset of excessive optimism, and especially if the bubble is financed by debt, the result may be a buildup of systemic risk. Second, recent research has identified possible linkages between monetary policy and leverage among financial intermediaries. It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system.

What happens after the next Crash?
We learned the hard way in 2008 and 2000 that asset bubbles end quite badly. If Basel III doesn’t ward off the next Crash, what happens then?

Michael Norton and Dan Ariely wrote a short paper entitled Building a better America, one wealth quintile at a time that surveyed Americans about their perception of wealth distribution and contrasted it with the actual figures.

Not many Americans realize that the 80-20 rule applies here. Roughly 20% of the population have 80% of the wealth, which is not only very different from the estimates, but different from the popular ideal.

No doubt in the next Crash, the bulk of the adjustments will be borne again by the middle class. I hate to keep quoting Simon Johnson but as he says, we seem to keep playing the same song over and over again:

To IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out...

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.

Depressingly, the developed and emerging markets have switched places today. The most recent IMF economic outlook confirms that:

“The world economic recovery is proceeding,” IMF Chief Economist Olivier Blanchard told a press conference. “But it is an unbalanced recovery, sluggish in advanced countries, much stronger in emerging and developing countries.”

Add to the mix with American net worth is already down 26% and the fact that the rich don’t feel rich anymore.

At what point does that lead to class warfare?