America may just do the right thing when all options are exhausted.
History has an uncanny way of repeating itself. But governments prefer to pay heed to the optimistic voices in times of crisis, as the US has done so far. Three years after the financial meltdown was triggered by the fall of Lehman and two rounds of quantitative easing, the world is slowly veering towards more sensible reading of the situation.
For the longest time, noted US economists Carmen Reinhart and Kenneth Rogoff have been saying since mid-CY08 that financial crises are protracted affairs and are unlike a regular business-cycle driven recession.
Their analysis of financial crises over the past century suggests that the “down” phase following a crisis typically lasts five years. This means that the world probably has to go through two more years of pain at the very least if not more before the world returns to a modicum of normalcy.
Furthermore, western governments can’t push up growth by infusing liquidity into the system alone. A classic example of this is Japan in the ’90s, which expanded its balancesheet and yet the stock markets stayed subdued. Late last year, when markets were rising, after the QE2 started, nobody anticipated that the markets would fare badly in 2011. CitiFX revisits its December 2010 outlook note this month, which had predicted that markets would move from a high to a low zone in 2011. Reiterating its outlook in August, CitiFX says: “We believe that the high to low move will be in the region of 26-27 per cent taking the S&P towards 1,000-1,015 and the DJIA towards 9,400-9,500.” On Thursday DJIA closed 170 points down at 11,149.82.
While the world is likely to be subjected to QE3 sooner than later, this time around it may not be easy as the fiscal situation is deteriorating, growth is slowing, consumer sentiment is down, oil is higher, geopolitical risks are greater and euro zone is in a mess. Any or all of these could eventually become the proverbial last straw. However, what will force the Fed to announce QE3 will be a technical bear market in the US because it cannot allow the markets to fall into a morass.
The US is the world’s largest economy and issuer of the reserve currency, so it will be in nobody’s interest to see a sovereign debt dynamic as bad as that of Europe. The only option it has, is to repair its balancesheet and not just undertake cosmetic interventions. This implies that the era of cheap money may end and CitiFX says this “may be the point that we finally see the turn in the bond market to much higher yields, which will eventually lead to Winston Churchill’s statement coming to fruition…. “America always does the right thing once it has exhausted all the alternatives.”
