QE2 is hailed by some economists as the tool needed to jumpstart the laggard US economy. The mechanism here is - The build-up of the monetary base eventually leads to rising inflation expectations. This is supposed to then encourage people to start buying things now, in anticipation of rising future prices, which then leads to a positive multiplier effect for the economy. There are several flaws in this belief. Here are reasons that I could think off the top of my head:
Debt among economic agents is ignored/inflation expectations is over-estimated. Debt does make a difference. Inflationary measures can be hindered in a recession economy with a lot of debt, because the indebted that are undergoing deflation, i.e. balance sheet recession, will not be induced to make more purchases if paying off the debt is already eating up much of their income. They will hope that the non-indebted ones will come to the rescue, and be induced to consume more via increased inflation expectations. But then, the non-indebted have to be convinced that the ongoing balance sheet recession among the indebted will not counteract any of the inflationary measures.
This was effective on the way up to becoming a debt society. Now no longer.
Transmission to the larger economy will be via even more debt. QE2 puts more reserves on the banks, but no money goes directly to people who will spend it on consumption. For this to get to the end-consumers, those remaining non-indebted will have to take one for the team, get into debt, and spend it in the local economy.
On the way towards becoming a debt-centered society, people managed to continue their consumption activities by getting into more debt. They were able to secure debt because they were able to borrow against the increasing values of homes and investments. This increasing value was only possible for as long as more people were chasing into appreciating assets, but had to stop when many people can no longer realistically afford the increasing prices. The debt deleveraging that follows results in depreciating assets, and which leads to more insolvencies, leading to even more deleveraging.
Getting into new debt will be the last thing on the minds of those currently deleveraging.
It floods the banking system with trillions in reserves but zero new capital. Banks do not need reserves to do their lending activities. If a bank is to grant more loans, it needs adequate capital, in order to buy risk-weight assets, and needs to have credit-worthy borrowers. If it has both of these, it can always raise any deficiency in its reserves, i.e. deposit base, by borrowing in the interbank market, or from the Fed’s discount window. If it doesn’t have adequate capital, or a compelling borrower, no loans will be extended.
The continuing deleveraging doesn’t help in building up bank equity, or confidence to lend.
It assumes that in deciding to borrow, companies care more about cost of funds than improving sales and profit. QE2 is supposed to decrease long-term interest rates. That’s meant to elicit more company borrowing for long-term capex. But without improvement in aggregate demand, sales prospects and profits do not improve. Also, to the extent that QE2 results in more funds being diverted towards asset bubbles, it’s going to make cost of funds more expensive.
These arguments doesn’t necessarily mean that I believe monetary policy/quantitative easing will have no effect on sentiment whatsoever. I think the effect will not be evident while having a long build-up. In the end, there will be a big snap. This comes when people lose confidence in the debased currency (which is toxic when not matched by a growing economy), and people begin to trash it.