The Federal Reserve’s decision last week to initiate another round of quantitative easing has had its defenders and its critics. The Economist says that the Fed’s purchase of $600 billion worth of Treasury bonds is working to loosen up investment markets, while a Wall Street Journal editorial called the plan “more monetary cowbell,” intending simply to “flood the economy with more money.”

What exactly is happening with Ben Bernanke's second round of quantitative easing, known colloquially as QE2? The Fed is essentially printing more money to buy up long-term bonds, the intended result of which is for yields on these long-term bonds to decrease and, as the aforementioned Economist piece points out, that this policy “chases investors into riskier, alternative investments.” The piece continues outlining what the policy has wrought:

Share prices are up by 14% in the same period. Lower yields make the dollar less appealing: it has duly fallen by 5% against the Japanese yen, by 9% against the euro and by 5% on a trade-weighted basis. “You can declare QE to be a success already,” says one hedge-fund economist. “Whether this translates into real activity remains a question-mark. But the question of whether the mechanism would work has been answered.”

With a bit of a lag, these easier financial conditions are supposed to boost growth through three channels. First, lower real yields spur borrowing and investment. This channel is bunged up: many households cannot borrow because their homes have fallen in value and because banks are less willing to lend. But the remaining two channels remain open. Higher share prices have raised household wealth by some $1.4 trillion, which will spur some spending. And the lower dollar should help trade. American factory purchasing managers reported a sharp jump in export orders in October and a drop in imports.

The Journal, however, makes the more convincing case that this is “a terribly risky strategy” with “little economic gain” to be expected. What’s the risk? That QE2-induced inflation (remember, it’s money being pumped into the economy) could spiral out of control. As the price of the dollar falls (that is, as inflation increases), the cost of commodities in “dollar-bloc” countries will rise. That can lead to some serious unintended consequences, like ramping up the currency war.

Here's Daniel Drezner’s analysis of what will happen in the global market:

How does this end? I think it's gonna end with a lot more capital controls for a few reasons:

1) It's the political path of least resistance;

2) Capital controls are seen as strengthening the state;

3) The high-growth areas of the world don't need a lot of capital inflows to fuel their continued growth.

What intrigues me is how the financial sector responds to a situation in which their freedom of action in emerging markets becomes more and more constrained. It's possible that they could pressure the Fed to change its position in the future. It's also possible, however, that big firms could see these controls as a useful barrier to entry for new firms.

My money is on the former response, however.

Read the whole post here.

The Economist may be praising the fact that investment markets are responding as they should be to an influx of money, but what really won’t be surprising is when political institutions respond to these market distortions by closing up capital flows. And that won’t be positive for the economy—American or global.

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