Under the label of QE, the Fed will buy long-term government bonds, perhaps one trillion dollars or more, adding an equal amount of cash to the economy and to banks’ excess reserves. Expectation of this has lowered long-term interest rates, depressed the dollar’s international value, bid up the price of commodities and farm land, and raised share prices.

Proponents of QE2 would point to Japan and say the policy known as “quantitative easing” is likely to prove ineffective. They term it a leaky hose, rather than a monetary Noah’s Flood.

QE2 would only expand the Fed’s balance sheet by about a quarter, or ~4.0% of gross domestic product. The Fed’s proposed policy of quantitative easing is a dangerous gamble with only limited upside potential and substantial risks of creating asset bubbles that could destabilize the global economy. Although the US economy is weak and the outlook uncertain, QE is not the right remedy.

As per economists, like all bubbles, these exaggerated increases can rapidly reverse when interest rates return to normal levels. The greatest danger will then be to leveraged investors, including individuals who bought these assets with borrowed money and banks that hold long-term securities. These risks should be clear after the recent crisis driven by the bursting of asset price bubbles.

The infusion of US$ 600.0 billion freshly printed greenbacks is pushing the dollar down, to the benefit of US exporters. However, they cannot be relied on to accelerate the economy all that much, as they account for a mere one-eighth of output.

The problem now extends to emerging markets, a group not directly affected in the last crisis. The lower US interest rates are causing a substantial capital flow to emerging economies, creating currency volatility.

Looking at the big picture, one might wonder: Why is the Fed doing this? It is of course worried by the weakness of the US recovery. Traditional monetary policy has already done what it can: short-term interest rates are close to zero, commercial banks hold a trillion dollars of excess reserves, and the money supply is growing more rapidly than nominal gross domestic product. But the Fed leadership does not want to be seen sitting idle when the economy is in trouble.

The other ways in which QE would raise GDP are also small. A 20 basis-point reduction in mortgage rates would have little effect on homebuying at a time when house prices are again falling. The increase in banks’ liquidity would do nothing since banks already have massive excess reserves. Big corporations are sitting on vast amounts of cash. Small businesses that are not spending because they cannot get credit will not be helped, because the banks on which they depend have a shortage of capital.

The truth is there is little more that the Fed can do to raise economic activity. What is required is action by the US government to help homeowners with negative equity and businesses that cannot get credit, to remove the threat of higher tax rates, and reduce the fiscal deficits. Any QE should be limited and temporary.

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