Time to taper

Nov 20 2013, 03:17 IST
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SummaryUS resurgence indicates the strength of its economy lies in physical factors of growth like labour participation and innovation, and not in measures like QE

Former US Federal Reserve Chairman Ben Bernanke described the Fed’s purchase of long-term government securities, commonly referred to as quantitative easing (QE), as “portfolio-balance”. The hypothesis underlying the justification of this programme was that the Fed’s purchases of long-term government bonds and mortgage-backed securities would reduce yields and drive savings of private investors to riskier assets class, viz equities. The demand for equities would drive up the price of equities, increase investor wealth which would finally lead to higher consumer spending, and higher GDP growth—the Wealth Effect!

The current surge in the equity markets and the improved GDP growth numbers in the US has convinced the world that QE is now a necessary ongoing stimulus for the US economy to remain in high gear. Wall Street, of course, loves QE and would like to see it expand given the higher demand for stocks justified by higher DCF valuations (lower cost of capital on the denominator).

The following analysis endeavours to prove that economic growth is a consequence of factors beyond fiscal stimulus and QE was a necessary programme at the time of the crisis but to extend its role to maintain or increase GDP growth may not yield the desired results.

It is true that the drop in economic activity in 2009, the collapse of commercial lending, the fear that gripped markets coupled with tripling of the federal deficit, made QE the lifeline without which the US may have dropped into the ocean of economic depression.

Surprisingly, a study of the GDP growth data in the US over the last 80 years suggests that the US economy has the ability to revive after a recession, and even a depression, with considerable strength, with or without large stimuli. The success of the US economy perhaps lies in physical factors such as the ability of its people to work hard and innovate. The data suggests that extended intervention has strangely led to a period of indifferent and lethargic revival and the messiah of growth, easy and low-cost liquidity, has not pushed the economy to the rates of growth recorded in previous decades.

As is evident, growth has remained fairly muted in the first decade of this century for the period 2003 to 2013—a decade when the Fed has followed a policy of flooding the economy with low-cost capital. History has explained the reasons for the growth in the US from 1938 to 1943, 1948 to 1953 and

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