The purpose of stimulus is basically to manipulate the markets, which have taken the bait and have gone up relying on expected economic growth. But if the stimulus does not appear or simply does not work, the markets could be in for a large disappointment and larger correction

It is my understanding that during recessions followers of Keynesian economics advocate government stimulus. The government is supposed to step in and provide money when investors are reluctant to invest and consumers are reluctant to buy. Government policy is supposed to provide extra aggregate demand. This can be accomplished in two ways. The government can affect monetary policy by reducing interest rates or by fiscal policy where the government invests in infrastructure. In either case, the extra demand would be sufficient to boost an economy back into equilibrium.

Since the crash almost four years ago, we have seen different governments all over the world trying all sorts of methods, both fiscal and monetary, to stimulate their economies. Presently markets wait breathlessly for every pronouncement from any central banker and oscillate, sometimes wildly, after every belch or rumour. But after four years, we have to ask ourselves, does this stimulus actually work? Will extra stimulus actually result in increased economic activity that the market seems to predict? Or is all this stimulus simply impotent and merely results in short term market distortions?

For example, the US central bank, the Federal Reserve (Fed) has been threatening more quantitative easing (the process of printing money and buying US Treasuries in order to put money into the US economy). Since this is the third time the Fed has tried this, it goes by the name—QE3. But why do we need a third quantitative easing? What happened to the first two?

The real intent of the QEs is to lower interest rates. They didn’t. Interest rates actually rose during both QEs. They only fell after the programs ended. If this version of QE doesn’t actually lower interest rates to stimulate the economy into longer term growth, what will it be followed by? QE4? QE5?  Besides, there is a significant risk.

Central banks in Japan, Europe and the US own vast assets of bonds. The Japanese and Europeans own close to 30% and the Americans and British close to 20% of GDP. The value of the Fed’s pile of $2.6 trillion worth of fixed income assets can go down as interest rates increase. The program also hurts pensions and pensioners who rely on quality fixed income investments.

The other way to create stimulus is to use fiscal policy by increased government spending. But the increased spending from increased taxes, acts as a drag on the economy. So governments prefer to borrow the money, assuming you can. Japan has a huge debt equal to 208% of its GDP. The US’ debt is equal to 102% about as much as the so called PIGS (Portugal – 106%, Ireland – 104%, Italy – 120%, Greece – 160%, and Spain – 69%). Debts this large make additional borrowing almost impossible.

Japan is a good example of the efficacy of these policies. Interest rates have stayed near zero for almost a decade. In that time using deficit spending and fiscal stimulus, they have created the largest debt in the world. Yet in all those years their growth rate never exceeded 2% and has often been negative.

Still markets not only have faith in the Fed stimulus, but stimulus from China as well. The Chinese stimulus has used a different method, but no less dramatic. Rather than the government trying to use monetary or fiscal methods, the Chinese simply ordered their banks to lend and lend they did. Since 2009, Chinese banks have lent two to three times what they lent before then. Initially it was highly effective, but since 2010, the Chinese economy has been slowing.

We have been told that the slowing economy is due to more restrictive monetary policy, but is this in fact true? In 2009, the Chinese banks lent 10.3 trillion yuan, three times the 3.5 trillion they lent in 2008. They lent less in 2010 and 2011, 8 trillion and 7.47 trillion, respectively. To control inflation they were supposed to lend less in 2012, but up to August the Chinese banks have made 5.278 trillion yuan in new loans, just slightly less than the 5.292 trillion they lent by August of 2011.

The Chinese government has announced all sorts of new infrastructure projects, but none of these will be initiated, because they rely on local government funding. Local government funding relied on land sales which have been restricted to tame an out-of-control housing bubble. So, local governments are broke.

There is a very dangerous consequence to this entire promised stimulus. The purpose of stimulus is basically to manipulate the markets. The markets have taken the bait and have gone up relying on expected economic growth. But if either the stimulus does not appear or simply does not work, which seems to be the case, the markets could be in for a large disappointment and a larger correction.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected].)