Ben Bernanke's purpose for QE2 is to create easier financial conditions in the form of resurgence in stock and bond markets. This would lead to improved confidence and an impetus to aggregate demand inspired by asset-based wealth effects. This has also been the policy pursued by the previous Fed chairman, Alan Greenspan, as well. Looking at what happened in the past, such policies only helps to create asset bubbles.
Currently, the Fed's policy goals include full employment and price stability. A third leg to the stool should be added – a financial stability mandate. With this additional mandate, it would be hard for the Fed chairman to ignore asset and credit bubbles.
QE2 presents a few risks to the economies in the US and the world. Below are three key risks:
- If there is an asset-market-led rebound of US consumer demand, America will run lower income-based savings rates, America's current account deficit will widen again. This would exacerbate global imbalances.
- Suppose Ben is wrong and the liquidity injection fails to make US consumers spend. This new found liquidity would leak offshore and create asset bubbles in other economies around the world.
- QE2 is dollar negative. This policy only helps to build trade tension around the world. This would push world economies down the slope of competitive devaluation, trade frictions and protectionism.
Opinion: Although the author makes a good case for including financial stability in the Fed's mandate, the author has missed out a key point. How does one pinpoint an asset bubble? There are no hard and fast rules on identifying bubbles. No one, least of the government authorities, have the ability to pinpoint bubbles. Thus, it would be difficult to implement such a mandate.
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