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Rising deficits and a global economic slowdown, coupled with a financial market meltdown, have put into question the effectiveness of policy, both fiscal and monetary. With Hayekians bashing Keynesians for excessive spending and demanding deep budget cuts, the Levy Forecasting Center’s head researcher explains how QE2’s failure to spark a “wealth effect” delivered its own failure, and why there will be a double-dip recession given a lack of efficiently allocated fiscal stimulus. Gold’s skyrocketing price is a reflection of a “loss of confidence in the economy’s ability to produce goods and services,” says the economist.
Ideology comes to the fore in times of adversity, as has been made clear by the emergence of a theoretical debate in the mainstream media, and certain pundits, which would’ve never debated the virtues of Austrian Economist Friedrich Hayek and the vices of Keynesian spending. (Check out the Hayek vs Keynes rap video below).
“It’s the private sector's problems that caus the public sector's problems,” says Srinivas Thiruvadanthai, director of research at the Jerome Levy Forecasting Center. Economist and accredited financial analyst, Srinivas highlights the failure of QE2, apparently taking a more rightist, conservative approach, while noting that the economy will contract given a lack of additional spending. But his view is much deeper than that.
Quantitative easing failed on every front, Srinivas believes. Most importantly, QE was supposed to spark a “wealth effect” by raising equity prices and sparking a positive feedback loop by which confident firms revved-up business investment, increasing employment and therefore consumption.
Despite an incredible bull market in several asset classes, equity markets have erased all of their QE gains (Srinivas questions how much of these can be attributed to QE and not to a stabilization of the situation in Europe, for example), firms were unwilling to spend and employment remained high. This occurred as a consequence of private sector deleveraging, with firms becoming leans and households paying off debt. “All of the things that create wealth and produce goods are credit sensitive, they need financing,” says Srinivas, when that financing isn’t there, wealth creation won’t occur. (Read The Failure Of QE2: A Look At Gold, Oil, Equities, Treasuries, Emerging Markets, And The Dollar).
QE’s failure is also a consequence of monetary policy’s incapacity to activate the banking sector. “Normally, banks go along with monetary policy,” explains Srinivas, “but while the Fed is expanding its balance sheets, banks are refusing to do so because they are still in a stage of deleveraging.”
At the same time, lowering interest rates with a flat yield curve for Treasuries is ineffective. The Fed didn’t withdraw risky assets from the market, notes Srinivas, who criticizes the Fed for withdrawing only the safest assets from the markets. “The ECB’s qualitative easing, as I call it, worked” because it withdrew Italian and Spanish sovereigns, where rates had gone through the roof, out of the market. “Imagine,” he says, “if the Fed would have been buying Bank of America’s busted assets?” (Read Gold And 10-Year Treasuries' Mirror Image: Stagflation Or Deflation" Bad Outcome Either Way).
Anticipating deflation in what he believes is a coming recession, Srinivas added that QE’s attempt to create inflation that would spur consumption was also a failure. “Inflation was supposed to somehow fix the economy by forcing people to spend today,” explains Srinivas, “but 1% to 2% inflation isn’t enough, it just helps durable goods” and sparks investment in safe assets like gold.
Srinivas understands gold as a measure of investors’ lack of confidence in the economy’s capacity to grow productively, to produce goods and services. “The process of wealth creation is broken,” says the economist, who adds “prosperity comes only when the private sector is growing, the government can only avoid recessions.”
While that may initially sound like a Republican critique of Bernanke and the U.S. economy, one stemming from the right, Srinivas quickly distances himself from that position. “To avoid falling into a depression, the private sector has to put claims on wealth, and, with companies deleveraging, the only that can step in to help is government.”
Srinivas thinks it’s time for more fiscal stimulus, not less. “Not all economies can print IOUs, but the U.S. can” he explains. Spending cuts will tip the economy into recession. “A Hayekian decline,” the economist says, “will destroy the social fabric, and it’s not clear that the economy will pick up as before.”
Taking a Hayekian stance would imply cutting spending and forcing a deflation so that asset prices would return to a point where they reflect the underlying value of assets. In other words, letting the price mechanism, and not a distorted, intervened market do it inefficiently. Srinivas agrees the price mechanism is the most efficient resource allocator, but he doesn’t believe it is necessary suffer the blow of a mass deflation. “It’s just better to manage the decline rather than having a huge explosion,” he says.
But, with political gridlock in Washington, weak political leadership in both parties, and an absolute reluctance to spend more, Srinivas is pessimistic. "This depression will last most of the decade," he says.