QE II Might Stop Working If Stocks Fall

Project Syndicate February 25, 2011

larger | smaller

comments: 1

Quantitative Easing and America's Economic Rebound

CAMBRIDGE "“ There is no doubt that the American economy rallied strongly at the end of 2010. But how much of that was due to the United States Federal Reserve's temporary policy of so-called "quantitative easing"? And what does the answer mean for the US economy in 2011?

Until the fourth quarter of last year, the US economic recovery that began in the summer of 2009 was decidedly anemic. Annual GDP growth in the first three quarters of 2010 averaged only about 2.6% "“ and most of that was just inventory building. Without the inventory investment, the growth rate of final sales averaged less than 1%.

But the fourth quarter was very different. Annual GDP rose by 3.2% and growth of final sales jumped to a remarkable 7.1% year-on-year rate. True, much of that was due to a sharp decline in imports; but even the growth rate of final sales to domestic purchasers rose at a healthy 3.4% pace.

The key driver of the increase in final sales was a strong rise in consumer spending. Real personal consumer spending grew at a robust 4.4% rate, as spending on consumer durables soared by 21%. That meant that the acceleration of growth in consumer spending accounted for nearly 100% of the increase in GDP, with the rise in durable spending accounting for almost half of that increase.

The rise in consumer spending was not, however, due to higher employment or faster income growth. Instead, it reflected a fall in the personal saving rate. Household saving had risen from less than 2% of after-tax incomes in 2007 to 6.3% in the spring of 2010. But then the saving rate fell by a full percentage point, reaching 5.3% in December 2010.

A likely reason for the fall in the saving rate and resulting rise in consumer spending was the sharp increase in the stock market, which rose by 15% between August and the end of the year. That, of course, is what the Fed had been hoping for.

At the annual Fed conference at Jackson Hole, Wyoming in August, Fed Chairman Ben Bernanke explained that he was considering a new round of quantitative easing (dubbed QE2), in which the Fed would buy a substantial volume of long-term Treasury bonds, thereby inducing bondholders to shift their wealth into equities. The resulting rise in equity prices would increase household wealth, providing a boost to consumer spending.

To be sure, there is no proof that QE2 led to the stock-market rise, or that the stock-market rise caused the increase in consumer spending. But the timing of the stock-market rise, and the lack of any other reason for a sharp rise in consumer spending, makes that chain of events look very plausible.

The magnitude of the relationship between the stock-market rise and the jump in consumer spending also fits the data. Since share ownership (including mutual funds) of American households totals approximately $17 trillion, a 15% rise in share prices increased household wealth by about $2.5 trillion. The past relationship between wealth and consumer spending implies that each $100 of additional wealth raises consumer spending by about four dollars, so $2.5 trillion of additional wealth would raise consumer spending by roughly $100 billion.

That figure matches closely the fall in household saving and the resulting increase in consumer spending. Since US households' after-tax income totals $11.4 trillion, a one-percentage-point fall in the saving rate means a decline of saving and a corresponding rise in consumer spending of $114 billion "“ very close to the rise in consumer spending implied by the increased wealth that resulted from the gain in share prices.

None of this appears to augur well for 2011. There is no reason to expect the stock market to keep rising at the rapid pace of 2010. Quantitative easing is scheduled to end in June 2011, and the Fed is not expected to continue its massive purchases of Treasury bonds after that.

Without that increase in stock-market wealth, will the saving rate continue to decline and the pace of consumer spending continue to rise more rapidly than GDP? Will the strong economic growth at the end of 2010 be enough to propel more spending by households and businesses in 2011, even though house prices continue to fall and the labor market remains weak? And does artificial support for the bond market and equities mean that we are looking at asset-price bubbles that may come to an end before the year is over?

Only time will tell, of course. But these are the questions that investors and policymakers alike should be asking.

Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan's Council of Economic Advisers, and is former President of the National Bureau for Economic Research.

Copyright: Project Syndicate, 2011.www.project-syndicate.orgFor a podcast of this commentary in English, please use this link:http://media.blubrry.com/ps/media.libsyn.com/media/ps/feldstein33.mp3

You might also like to read more from Martin Feldstein or return to our home page.

Share Tweet

Reprinting material from this website without written consent from Project Syndicate is a violation of international copyright law. To secure permission, please contact distribution@project-syndicate.org. var OB_langJS = 'http://widgets.outbrain.com/lang_en.js'; var OBITm = '1292502431965';var OB_raterMode = 'none';var OB_recMode = 'rec'; var OutbrainPermaLink='http://www.project-syndicate.org/commentary/feldstein33/English'; if ( typeof(OB_Script)!='undefined' )OutbrainStart(); else { var OB_Script = true; var str = unescape("%3Cscript src=\'http://widgets.outbrain.com/OutbrainRater.js\' type=\'text/javascript\'%3E%3C/script%3E"); document.write(str); } print recommend Send link clip secure rights COMMENTS

You must be logged in to post or reply to a comment. Please log in or sign up for a free account.

COMMENTS

You must be logged in to post or reply to a comment. Please log in or sign up for a free account.

Username Password New registration Forgotten password dinantw 04:10 25 Feb 11

You are talking annual income of 11,4tn, but in a quarter US citizens only save from a fourth of the annual income, thus the extra consumption was "paid" from other sources as well.

AUTHOR INFO Martin Feldstein Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan's Council of Economic Advisers, and is former President of the National Bureau for Economic Research. MOST READ MOST RECOMMENDED MOST COMMENTED The Poverty of Dictatorship Dani Rodrik Our G-Zero World Nouriel Roubini Why Egypt Should Worry China Barry Eichengreen The End of China's Surplus Martin Feldstein The Inequality Wildcard Kenneth Rogoff A New World Architecture George Soros Did the Poor Cause the Crisis? Simon Johnson No Time for a Trade War Joseph E. Stiglitz America's Political Class Struggle Jeffrey D. Sachs Avatar and Empire Naomi Wolf The False Promise of Green Jobs Bjørn Lomborg Are Terrorists Insane? David Patrick Houghton The Poverty of Dictatorship Dani Rodrik Why Egypt Should Worry China Barry Eichengreen Unsettling America Robert Skidelsky ADVERTISEMENT PROJECT SYNDICATE

Project Syndicate: the world's pre-eminent source of original op-ed commentaries. A unique collaboration of distinguished opinion makers from every corner of the globe, Project Syndicate provides incisive perspectives on our changing world by those who are shaping its politics, economics, science, and culture. Exclusive, trenchant, unparalleled in scope and depth: Project Syndicate is truly A World of Ideas.

Project Syndicate provides the world's foremost newspapers with exclusive commentaries by prominent leaders and opinion makers. It currently offers 50 monthly series and one weekly series of columns on topics ranging from economics to international affairs to science and philosophy.

PROJECT SYNDICATE War and Peace Shlomo Ben-Ami Is an Islamic civil war underway? Can democracy take root in the Middle East? Is the "war on terror" winnable? ...read more Roads to Prosperity Dani Rodrik Is free trade always the best policy? Did the global financial crisis of 2008 prove that developing countries should not open their financial systems? ...read more After the Storm Nouriel Roubini Has the global economic crisis bottomed out, or will conditions grow worse due to inadequate government responses? ...read more © Project Syndicate 1995 - 2011 How to become a member | Member papers | Support us | About us | Contact us var gaJsHost = (("https:" == document.location.protocol) ? "https://ssl." : "http://www."); document.write(unescape("%3Cscript src='" + gaJsHost + "google-analytics.com/ga.js' type='text/javascript'%3E%3C/script%3E")); try { var pageTracker = _gat._getTracker("UA-10108778-1"); pageTracker._trackPageview(); } catch(err) {} _bizo_data_partner_id = 790 var OBCTm='1292510578203'; var _comscore = _comscore || []; _comscore.push({ c1: "2", c2: "8756795" }); (function() { var s = document.createElement("script"), el = document.getElementsByTagName("script")[0]; s.async = true; s.src = (document.location.protocol == "https:" ? "https://sb" : "http://b") + ".scorecardresearch.com/beacon.js"; el.parentNode.insertBefore(s, el); })(); _qoptions={ qacct:"p-f8E80KYHdFRZg" }; try{ clicky.init(66386088); }catch(err){}

You must be logged in to post or reply to a comment. Please log in or sign up for a free account.

You are talking annual income of 11,4tn, but in a quarter US citizens only save from a fourth of the annual income, thus the extra consumption was "paid" from other sources as well.

Read Full Article »

Comment

Show comments

QE II Might Stop Working If Stocks Fall

Related Articles