In Europe, the tail risk of a eurozone break-up and a loss of market access by Spain and Italy were reduced by last summer’s decision by the European Central Bank to backstop sovereign debt. But the monetary union’s fundamental problems – low potential growth, ongoing recession, loss of competitiveness, and large stocks of private and public debt – have not been resolved.

Moreover, the grand bargain between the eurozone core, the ECB, and the periphery – painful austerity and reforms in exchange for large-scale financial support – is now breaking down, as austerity fatigue in the eurozone periphery runs up against bailout fatigue in core countries like Germany and the Netherlands.

Austerity fatigue in the periphery is clearly evident from the success of anti-establishment forces in Italy’s recent election; large street demonstrations in Spain, Portugal, and elsewhere; and now the botched bailout of Cypriot banks, which has fueled massive public anger. Throughout the periphery, populist parties of the left and right are gaining ground.

Meanwhile, Germany’s insistence on imposing losses on bank creditors in Cyprus is the latest symptom of bailout fatigue in the core. Other core eurozone members, eager to limit the risks to their taxpayers, have similarly signaled that creditor “bail-ins” are the way of the future.

Outside the eurozone, even the United Kingdom is struggling to restore growth, owing to the damage caused by front-loaded fiscal-consolidation efforts, while anti-austerity sentiment is also mounting in Bulgaria, Romania, and Hungary.

In China, the leadership transition has occurred smoothly. But the country’s economic model remains, as former Premier Wen Jiabao famously put it, “unstable, unbalanced, uncoordinated, and unsustainable.”

China’s problems are many: regional imbalances between its coastal regions and the interior, and between urban and rural areas; too much savings and fixed investment, and too little private consumption; growing income and wealth inequality; and massive environmental degradation, with air, water, and soil pollution jeopardizing public health and food safety.

The country’s new leaders speak earnestly of deepening reforms and rebalancing the economy, but they remain cautious, gradualist, and conservative by inclination. Moreover, the power of vested interests that oppose reform – state-owned enterprises, provincial governments, and the military, for example – has yet to be broken. As a result, the reforms needed to rebalance the economy may not occur fast enough to prevent a hard landing when, by next year, an investment bust materializes.

In China – and in Russia (and partly in Brazil and India) – state capitalism has become more entrenched, which does not bode well for growth. Overall, these four countries (the BRICs) have been over-hyped, and other emerging economies may do better in the next decade: Malaysia, the Philippines, and Indonesia in Asia; Chile, Colombia, and Peru in Latin America; and Kazakhstan, Azerbaijan, and Poland in Eastern Europe and Central Asia.

Farther East, Japan is trying a new economic experiment to stop deflation, boost economic growth, and restore business and consumer confidence. “Abenomics” has several components: aggressive monetary stimulus by the Bank of Japan; a fiscal stimulus this year to jump start demand, followed by fiscal austerity in 2014 to rein in deficits and debt; a push to increase nominal wages to boost domestic demand; structural reforms to deregulate the economy; and new free-trade agreements – starting with the Trans-Pacific Partnership – to boost trade and productivity.

But the challenges are daunting. It is not clear if deflation can be beaten with monetary policy; excessive fiscal stimulus and deferred austerity may make the debt unsustainable; and the structural-reform components of Abenomics are vague. Moreover, tensions with China over territorial claims in the East China Sea may adversely affect trade and foreign direct investment.

Then there is the Middle East, which remains an arc of instability from the Maghreb to Pakistan. Turkey – with a young population, high potential growth, and a dynamic private sector – seeks to become a major regional power. But Turkey faces many challenges of its own. Its bid to join the European Union is currently stalled, while the eurozone recession dampens its growth. Its current-account deficit remains large, and monetary policy has been confusing, as the objective of boosting competitiveness and growth clashes with the need to control inflation and avoid excessive credit expansion.

Moreover, while rapprochement with Israel has become more likely, Turkey faces severe tensions with Syria and Iran, and its Islamist ruling party must still prove that it can coexist with the country’s secular political tradition.

In this fragile global environment, has America become a beacon of hope? The US is experiencing several positive economic trends: housing is recovering; shale gas and oil will reduce energy costs and boost competitiveness; job creation is improving; rising labor costs in Asia and the advent of robotics and automation are underpinning a manufacturing resurgence; and aggressive quantitative easing is helping both the real economy and financial markets.

But risks remain. Unemployment and household debt remain stubbornly high. The fiscal drag from rising taxes and spending cuts will hit growth, and the political system is dysfunctional, with partisan polarization impeding compromise on the fiscal deficit, immigration, energy policy, and other key issues that influence potential growth.

In sum, among advanced economies, the US is in the best relative shape, followed by Japan, where Abenomics is boosting confidence. The eurozone and the UK remain mired in recessions made worse by tight monetary and fiscal policies. Among emerging economies, China could face a hard landing by late 2014 if critical structural reforms are postponed, and the other BRICs need to turn away from state capitalism. While other emerging markets in Asia and Latin America are showing more dynamism than the BRICs, their strength will not be enough to turn the global tide.

This piece is cross-posted from Project Syndicate with permission.

The global economy this year will exhibit some similarities with the conditions that prevailed in 2012. No surprise there: We face another year in which global growth will average about 3 percent, but with a multispeed recovery—a subpar, below-trend annual rate of 1 percent in the advanced economies, and close-to-trend rates of 5 percent in emerging markets. But there will be some important differences as well.

“The combination of all of them going in the wrong direction, and they don’t have to become virulent – if we have a bigger fiscal drag, if the problems in the eurozone become worse, if the landing of China is hard rather than softer, and, short of a war between Israel and Iran, if negotiation and sanction fail, then Israel is going to start to talk about war: the fear premium goes up … and that is a negative for the global economy.”

Regarding instability in the Middle East, brought to the fore this week with Israel’s election and recent events in North Africa, Nouriel emphasizes multiple pressure points for global markets:

“Instability in the Middle East is an issue: and the instability is not just tension between Israel and Iran – that if there were to become violent they could spike global oil prices to double the current level and tip the global economy into recession. If you look at the Middle East,  all from Maghreb, Algeria to Afghanistan and Pakistan, there is geopolitical tension that could have economic consequences.”

He also notes geopolitical tensions in Asia—territorial disputes “between China and Japan, in Korea, in Indonesia, in Vietnam, in India, you name it,” that have already negatively impacted regional trade and FDI.

While he concedes a reduction of tail risk in the eurozone, Nouriel argues that fundamental problems in Europe have not been addressed.

The tail risk of something disorderly in the eurozone – like a Greek exit or Italy and Spain losing market access that were severe risks in the middle of last year – have basically been reduced because they have announced this new program of bond purchases, the OMT, there is this new ESM, there is another half a trillion euros out there for banks and sovereign, because there is talk about a banking and fiscal union, and because now Germany has used the words about the periphery of the eurozone that are more constructive.

But if you look at the fundamental problem in the eurozone: lack of economic growth and continued recession, low potential growth because of demographics and lack of reforms, 2) debt sustainability - official and private – are too high, and 3) lack and loss of competitiveness, and a large external deficit that the private sector does not want to finance – those fundamental problems of the eurozone have not been resolved, they may have been pushed by a few quarters, but fundamental problems of growth, competitiveness and sustainability have not been resolved.

Later, Nouriel provided nuance to his slightly less bearish views on the U.S.

View the interviews below:

Since then, risks have abated significantly, thanks to a number of factors:

• The ECB’s OMT has been incredibly successful in reducing the risks of breakup, redenomination and a liquidity/rollover crisis in the public debt markets of Spain and Italy. Although the ECB has yet to spend a single additional euro to buy the bonds of Spain and Italy, both short-term and longer-term sovereign spreads against German bonds have fallen substantially.
• Following a number of political and legal hurdles, the successful operational start of the European Stability Mechanism (ESM) rescue fund provides the euro zone with another €500 billion of official resources to backstop banks and sovereigns in the euro zone periphery, on top of the leftover funds of its predecessor, the European Financial Stability Facility (EFSF).
• Realizing that a monetary union is not viable without deeper integration, euro zone leaders have proposed a banking union, a fiscal union, an economic union and, eventually, a political union. The last is necessary to resolve any issue of democratic legitimacy that might result from national states transferring power from national governments to EU- or euro zone-wide institutions. This transfer of power also would have to involve the creation of such institutions to ensure solidarity and risk-sharing are developed in the banking, fiscal and economic unions.
• The open talk in the summer by some German authorities about an exit option for Greece has turned into a tentative willingness to prevent and postpone such an exit. There are several reasons for this. First, Greece has done some austerity and reforms in spite of a deepening recession, and the current coalition is holding up. Second, an orderly exit of Greece is impossible until Spain and Italy are successfully isolated. Such an exit would lead to massive contagion, which would hurt not only the euro zone periphery but also the core, given extensive trade and financial links. Third, an economic disaster in Greece would be damaging to the CDU Party’s chances of winning the German elections. Thus, even when Greece inevitably underperforms on its policy commitments, Germany and the troika (the IMF, EU and ECB) will hold their noses and keep the funds flowing as long as the current coalition holds up.

Given these developments, the risk of a Greek exit in 2013 has been significantly reduced, even if the risk of an eventual Greek exit from the euro zone is still high, close to 50 percent by my estimation. Meanwhile, the narrowing of Spanish and Italian sovereign spreads has significantly diminished the risk that either country will fully lose market access and be forced to undergo a full troika bailout like Greece, Portugal and Ireland. Both Spain and Italy may in 2013 opt for a memorandum of understanding (MoU) that opens the taps of ESM and OMT support, but such official financing would inspire confidence as it would not be associated with rising, unsustainable spreads and a loss of market access.

While there is a much lower likelihood of disorderly events in the euro zone, there are still significant obstacles to deeper integration, as well as country-specific economic and political vulnerabilities. The biggest obstacle to the formation of a banking, fiscal, economic and political union is that Germany is pushing back against the time line for action, with the initial skirmish on ECB supervision of euro zone banks. This backpedaling reflects deep German skepticism on whether the resolution of the eurozone crisis requires a move toward greater union. Without a more credible commitment to austerity and reforms from euro zone periphery countries, lurching forward would imply that risk-sharing will turn into a large, long-term transfer union, which is unacceptable to Germany and the core. Thus, Germany will do whatever is necessary to delay the integration process, at least until after elections in fall 2013.

Meanwhile, there is a deep recession in the eurozone periphery that is spreading even to parts of the core: France will experience a recession in 2013, and even Germany is sharply decelerating as two of its main export markets, the euro zone periphery and China, contract and slow, respectively. The balkanization of economic activity between the eurozone core and the periphery persists. The balkanization of banking is ongoing as cross-border flows, interbank flows and smart money have left the periphery banks and found shelter in the core; in the case of public debt markets, balkanization and domestication continue as cross-border investors have left the periphery public debt markets, in spite of reduced yields, on top of abandoning periphery banks and corporates.

The eurozone periphery recession will continue in 2013: Fiscal austerity is ongoing; the euro is still too strong; periphery banks have capital shortages and liquidity concerns, and thus are achieving required capital ratios by contracting credit and selling assets; and consumer and business confidence is still depressed given falling output and employment. Moreover, private and/or public debts are still very high and possibly unsustainable over the medium term in a number of periphery countries, while the lack of growth adds to the debt sustainability risks. Potential growth is still very low in most of the periphery as demographic aging is ongoing, while structural reforms are occurring too slowly and only affect productivity growth after long lags.

Underlying all this is the issue of the loss of external competitiveness associated with external current account deficits that private foreign investors are unwilling to finance. Some internal devaluation is ongoing, leading to a reduction in unit labor costs, but that process is recessionary and occurring too slowly. Thus, though financial conditions have improved and tail risks have lessened, the fundamental problems of the euro zone remain.

This piece is cross-posted from Reuters.com with permission.

Two months, in fact. If no action is taken by March 1, $110bn of spending cuts will commence. At about the same time, the US will hit its statutory debt limit, known colloquially as the debt ceiling.

That is only the beginning. Later in 2013, and not before time, a bigger debate on medium-term fiscal consolidation will begin. This will lead to another dispute between Republicans, who want to shrink the size of the federal government, and Democrats, who want to maintain it but are unsure how to pay for it.

So expect a big fight about entitlements, and a series of little fights over tax reform: should the US introduce a value added tax? A flat tax? Higher (or lower) income taxes? A carbon tax? Should we close corporate tax loopholes to raise more revenue? It’ll soon get messy.

President Barack Obama and his allies will argue that the deal concluded on Tuesday raises only $600bn of revenues over 10 years rather than their initial target of $1.4tn – and therefore there is further room for tax rises, at least for the wealthy. Republicans will argue that spending should now be radically cut, since this week’s deal did not address that side of the national balance sheet. (Even the 2011 debt ceiling deal reduced prospective spending by $1tn).

In the meantime, the likely fiscal adjustment in 2013 will be about 1.4 per cent of gross domestic product. (Spread between the expiry of the payroll tax cut, the increase in the tax rates of the rich, and some eventual cuts to spending.)

This translates into a 1.2 per cent of GDP drag on the economy during the year. If the economy was happily growing above trend – at say 3.5 per cent – that would not be such a big deal, as growth would still be above 2 per cent. In the past few quarters growth already averaged about 2 per cent. So the US could quite easily come perilously close to stall speed this year – or worse, if the eurozone crisis worsens.

The longer-term picture is bleaker still. The reality is that America is yet to wake up to the full extent of its fiscal nightmare. Even the typical Republican voter is not – being on average older and poorer than a Democrat voter – in favour of gutting the welfare state. Tea Party extremists are more noise than signal. That is why the plans of Mitt Romney and Paul Ryan, the Republicans’ losing presidential ticket, postponed all the tough spending cuts on Social Security and Medicare by a decade.

Neither Democrats nor Republicans recognise that maintaining a basic welfare state, which is right and necessary in our age of globalisation, rapid technological change and demographic pressure, implies higher taxes for the middle class as well as for the rich. A deal that extends unsustainable tax cuts for 98 per cent of Americans is therefore a pyrrhic victory for Mr Obama.

For now, he is being helped by the quiescent financial markets. It will probably take years for the US to confront the reality of its fiscal position and raise revenues to a level sufficient to fund a reformed – but not gutted – welfare state. Large fiscal deficits will remain the norm for the next few years, at least so long as the bond market remains quiet, as I believe it will.

Bond market “vigilantes” have no appetite for destruction. Why should they? Growth is low and inflation lower; the US still has the global reserve currency; US Treasuries remain haven assets; interest rates are at zero; the US Federal Reserve is committed to QE; and China and other emerging economies will keep accruing US dollars to resist appreciations in their own currencies. All this guarantees the cheap financing of the US deficit for years to come. But eventually, the vigilantes will wake up.

In short, the “mini deal” on the fiscal cliff dodged all the important questions. By not including spending cuts in the deal, the Democrats have emboldened Republicans who are determined to slash taxes but lack a plan to pay for it. It is again up to Washington’s policy makers to fix the problem before the market does it for them. Tuesday’s deal suggests this will not happen with any ease.

This post originally appeared on the FT and is reproduced here with permission. 

Asked whether he’s bullish on the U.S., Nouriel responded, ”In the long term, I think that the fundamentals of the U.S. are a lot stronger than other advanced countries. In the short run I think we will have another year of very anemic economic growth. Next year we will have barely 1.7% including a modest amount of fiscal drag and lots of tail risk could make it worse in the U.S–bigger fiscal cliff, the euro zone crisis, a Chinese hard landing, maybe tensions will raise oil prices in the Middle East–so the downside scenario is actually having a meaningful probability.”

Regarding whether a U.S. housing recovery is definitely underway, Nouriel said, “I do believe there is a housing recovery but I think that those that are more optimistic about it are going to be proven wrong next year. Housing can increase say 10 to 15% in real terms of residential investment but at the peak it was 6% of GDP, right now it’s only 2% of GDP, so the direct effect on GDP growth is going to be very small.”

In terms of positives in the U.S. economy, Nouriel pointed to “a housing recovery, shale gas revaluation, some reshoring of manufacturing, some job creation, QE3 is going to help. But even in a scenario where we avoid the cliff, we expect there will be a fiscal adjustment of 1.4% of GDP next year….you will have a 1.25% drag on growth in an economy that is barely growing.”

Nouriel highlighted the problems with gridlock in Washington, saying, ”Republicans are vetoing tax increases and Democrats don’t want entitlement reform. People talk about the cliff, but there are several things. There’s the issue about the budget in 2013, then there will be the debt ceiling debate, another debate about medium term fiscal consolidation, within that we will have a debate about fundamental tax reform and then we have entitlement reform.”

Asked whether he would accept the position of treasury secretary if President Obama were to offer it, Nouriel said, ”He is not going to call on me. There are great people out there. I was in politics, it was two great years, but I think as a public intellectual, I can provide input to the debate where I am now.”

Watch below, or go to Bloomberg:

Together with Ian Bremmer, founder of the Eurasia Group, Nouriel argues that, while politics have long been central to progress (or a lack thereof) in developing markets, the political process now has the power to derail recovery efforts, define future growth prospects, save or condemn ailing sovereigns and minimize headwinds in developed markets also. Freeland writes:

As Mr. Roubini puts it, the developed markets are “submerging,” or reverting to an emerging-markets-style world in which politics drives almost everything. Mr. Bremmer calls it “Europe’s existential moment,” and that is ultimately a matter for politicians.

The economic conversation has focused on financial regulation and corporate taxation/incentivization this year, amid a constant news cycle of abusive/vulture practices in the financial sector, and a scarcity of seed money, as corporates hoard funds against poor sentiment and keep hiring plans on ice. This further underscores the power of political figures to impact the business environment, through fiscal and monetary policy. Freeland invokes the change underway:

Mr. Roubini…argues that the familiar macroeconomic toolkit isn’t working anymore. That means we need to create one, an inevitably political process.

Lastly, Nouriel talks about income inequality, which has commanded attention as divergence between the rich and poor in the U.S., the core and periphery of the eurozone, and Asia’s rabbits and tortoises becomes more apparent.

“This is an issue that is coming, but it is not there yet,” he said. “It is clear in the U.S. we are talking about inequality. It is not clear we will do anything about it.”

Global central banks and political leaders hold all the chips as the world enters 2013, with developed markets set to face down immediate threats (the U.S. fiscal cliff, Spanish, Greek and Italian debt obligations, widespread growth-crippling austerity, deficit targets) and longer-term crises (energy security threats, competitiveness challenges in the eurozone, environmental issues, debt burdens). The current “negotiations” in the U.S. over the man-made fiscal cliff (following failed negotiations in summer 2011) typify the outsized role of politics in the immediate future; likewise, the co-opting of the debt ceiling, routinely raised by prior Congressional bodies, is an example of the polarization over fiscal policy—divergent views present two very different paths forward. So, in 2013, you can expect an ongoing focus on the nexus of economics and political science.

Read the full piece here.

“You have to realize that the problems of Greece are long-term, it’s going to take 10 to 20 years to do the austerity and the reform to stabilize Greece and therefore you have to give money and you have to be patient.”

Policy makers have spent numerous summits mulling over how to ring-fence Spain and Italy from Greece, and facilitate an orderly exit. But, ahead of 2013 elections, German leaders have realized that there is “no such thing” as an orderly exit:

“I think the Germans have realized that if there was a disorderly collapse of the euro zone, the loss and the damage would not be just for Greece, Ireland, Portugal, Italy, Spain — but also for Germany,” which, as a creditor of these countries, would see its own financial institutions and government shoulder the burden of a bankruptcy…A disorderly collapse of the euro zone is not in anybody’s interest.”

Nouriel continued to argue for backloaded austerity, noting the crippling effects on growth policies directed by the EZ core and troika have had on periphery countries.

Starting with the advanced countries, the eurozone recession has spread from the periphery to the core, with France entering recession and Germany facing a double whammy of slowing growth in one major export market (China/Asia) and outright contraction in others (southern Europe). Economic growth in the United States has remained anemic, at 1.5-2% for most of the year, and Japan is lapsing into a new recession. The United Kingdom, like the eurozone, has already endured a double-dip recession, and now even strong commodity exporters – Canada, the Nordic countries, and Australia – are slowing in the face of headwinds from the US, Europe, and China.

Meanwhile, emerging-market economies – including all of the BRICs (Brazil, Russia, India, and China) and other major players like Argentina, Turkey, and South Africa – also slowed in 2012. China’s slowdown may be stabilized for a few quarters, given the government’s latest fiscal, monetary, and credit injection; but this stimulus will only perpetuate the country’s unsustainable growth model, one based on too much fixed investment and savings and too little private consumption.

In 2013, downside risks to global growth will be exacerbated by the spread of fiscal austerity to most advanced economies. Until now, the recessionary fiscal drag has been concentrated in the eurozone periphery and the UK. But now it is permeating the eurozone’s core. And in the US, even if President Barack Obama and the Republicans in Congress agree on a budget plan that avoids the looming “fiscal cliff,” spending cuts and tax increases will invariably lead to some drag on growth in 2013 – at least 1% of GDP. In Japan, the fiscal stimulus from post-earthquake reconstruction will be phased out, while a new consumption tax will be phased in by 2014.

The International Monetary Fund is thus absolutely right in arguing that excessively front-loaded and synchronized fiscal austerity in most advanced economies will dim global growth prospects in 2013. So, what explains the recent rally in US and global asset markets?

The answer is simple: Central banks have turned on their liquidity hoses again, providing a boost to risky assets. The US Federal Reserve has embraced aggressive, open-ended quantitative easing (QE). The European Central Bank’s announcement of its “outright market transactions” program has reduced the risk of a sovereign-debt crisis in the eurozone periphery and a breakup of the monetary union. The Bank of England has moved from QE to CE (credit easing), and the Bank of Japan has repeatedly increased the size of its QE operations.

Monetary authorities in many other advanced and emerging-market economies have cut their policy rates as well. And, with slow growth, subdued inflation, near-zero short-term interest rates, and more QE, longer-term interest rates in most advanced economies remain low (with the exception of the eurozone periphery, where sovereign risk remains relatively high). It is small wonder, then, that investors desperately searching for yield have rushed into equities, commodities, credit instruments, and emerging-market currencies.

But now a global market correction seems underway, owing, first and foremost, to the poor growth outlook. At the same time, the eurozone crisis remains unresolved, despite the ECB’s bold actions and talk of a banking, fiscal, economic, and political union. Specifically, Greece, Portugal, Spain, and Italy are still at risk, while bailout fatigue pervades the eurozone core.

Moreover, political and policy uncertainties – on the fiscal, debt, taxation, and regulatory fronts – abound. In the US, the fiscal worries are threefold: the risk of a “cliff” in 2013, as tax increases and massive spending cuts kick in automatically if no political agreement is reached; renewed partisan combat over the debt ceiling; and a new fight over medium-term fiscal austerity. In many other countries or regions – for example, China, Korea, Japan, Israel, Germany, Italy, and Catalonia – upcoming elections or political transitions have similarly increased policy uncertainty.

Yet another reason for the correction is that valuations in stock markets are stretched: price/earnings ratios are now high, while growth in earnings per share is slackening, and will be subject to further negative surprises as growth and inflation remain low. With uncertainty, volatility, and tail risks on the rise again, the correction could accelerate quickly.

Indeed, there are now greater geopolitical uncertainties as well: the risk of an Iran-Israel military confrontation remains high as negotiations and sanctions may not deter Iran from developing nuclear-weapons capacity; a new war between Israel and Hamas in Gaza is likely; the Arab Spring is turning into a grim winter of economic, social, and political instability; and territorial disputes in Asia between China, Korea, Japan, Taiwan, the Philippines, and Vietnam are inflaming nationalist forces.

As consumers, firms, and investors become more cautious and risk-averse, the equity-market rally of the second half of 2012 has crested. And, given the seriousness of the downside risks to growth in advanced and emerging economies alike, the correction could be a bellwether of worse to come for the global economy and financial markets in 2013.

This piece is cross-posted from Project Syndicate with permission.

Many now argue that QE3’s effect on risky assets should be as powerful, if not more so, than that of QE1, QE2, and “Operation Twist,” the Fed’s earlier bond-purchase program. After all, while the previous rounds of US monetary easing have been associated with a persistent increase in equity prices, the size and duration of QE3 are more substantial. But, despite the Fed’s impressive commitment to aggressive monetary easing, its effects on the real economy and on US equities could well be smaller and more fleeting than those of previous QE rounds.

Consider, first, that the previous QE rounds came at times of much lower equity valuations and earnings. In March 2009, the S&P 500 index was down to 660, earnings per share (EPS) of US companies and banks had sunk to a financial-crisis low, and price/earnings ratios were in the single digits. Today, the S&P 500 is more than 100% higher (hovering near 1,430), the average EPS is close to $100, and P/E ratios are above 14.

Even during QE2, in the summer of 2010, the S&P 500, P/E ratios, and EPS were much lower than they are today. If, as is likely, economic growth in the US remains anemic in spite of QE3, top-line revenues and bottom-line earnings will turn south, with negative effects on equity valuations.

Moreover, fiscal support is absent this time: QE1 and QE2 helped to prevent a deeper recession and avoid a double dip, respectively, because each was associated with a significant fiscal stimulus. In contrast, QE3 will be associated with a fiscal contraction, possibly even a large fiscal cliff.

Even if the US avoids the full fiscal cliff of 4.5% of GDP that is looming at the end of the year, it is highly likely that a fiscal drag amounting to 1.5% of GDP will hit the economy in 2013. With the US economy currently growing at a 1.6% annual rate, a fiscal drag of even 1% implies near-stagnation in 2013, though a modest recovery in housing and manufacturing, together with QE3, should keep US growth at about its current level in 2013.

But there is no broader rebound underway. In both 2010 and 2011, leading economic indicators showed that the first-half slowdown had bottomed out, and that growth was already accelerating before the announcement of monetary easing. Thus, QE nudged along an economy that was already recovering, which prolonged asset reflation.

By contrast, the latest data suggest that the US economy is performing as sluggishly now as it was in the first half of the year. Indeed, if anything, weakness in the US labor market, low capital expenditures, and slow income growth have contradicted signals in the early summer that third-quarter growth might be more robust.

Meanwhile, the main transmission channels of monetary stimulus to the real economy – the bond, credit, currency, and stock markets – remain weak, if not broken. Indeed, the bond-market channel is unlikely to boost growth. Long-term government bond yields are already very low, and a further reduction will not significantly change private agents’ borrowing costs.

The credit channel also is not working properly, as banks have hoarded most of the extra liquidity from QE, creating excess reserves rather than increasing lending. Those who can borrow have ample cash and are cautious about spending, while those who want to borrow – highly indebted households and firms (especially small and medium-size enterprises) – face a credit crunch.

The currency channel is similarly impaired. With global growth weakening, net exports are unlikely to improve robustly, even with a weaker dollar. Moreover, many major central banks are implementing variants of QE alongside the Fed, dampening the effect of the Fed’s actions on the dollar’s value.

Perhaps most important, a weaker dollar’s effect on the trade balance, and thus on growth, is limited by two factors. First, a weaker dollar is associated with a higher dollar price for commodities, which implies a drag on the trade balance, because the US is a net commodity-importing country. Second, any improvement in GDP derived from stronger exports leads to an increase in imports. Empirical studies estimate that the overall impact of a weaker US dollar on the trade balance is close to zero.

The only other significant channel to transmit QE to the real economy is the wealth effect of an equity-market increase, but there is some circularity in the argument that QE3 will lead to a persistent rise in equity prices. If persistent asset reflation requires a significant GDP growth recovery, it is tautological to say that if equity prices rise enough following QE, the resulting increase in GDP from a wealth effect justifies the rise in asset prices. If monetary policy’s transmission channels to the real economy are broken, one cannot assume that QE will have a significant effect on economic growth.

 Fed Chairman Ben Bernanke has recently emphasized the importance of an additional channel: the confidence channel, through which the Fed’s commitment to maintaining generous monetary conditions for longer could improve private spending. The issue is how substantial and durable such effects will be. Confidence is fragile in an environment characterized by ongoing deleveraging, macro uncertainties, weak labor-market growth, and a fiscal drag.

In short, QE3 reduces the tail risk of an outright economic contraction, but is unlikely to lead to a sustained recovery in an economy that is still enduring a painful deleveraging process. In the short run, QE3 will lead investors to take on risk, and will stimulate modest asset reflation. But the equity-price rise is likely to fizzle out over time if economic growth disappoints, as is likely, and drags down expectations about corporate revenues and profitability.

This post was originally published at Project Syndicate and is reproduced here with permission.