Fed's mistake was to extrapolate

Chinese policymakers have been quicker than their US counterparts to face up to the perils of policies initiated in response to 2008 crisis

The temptations of extrapolation are hard to resist. The trend exerts a powerful influence on markets, policymakers, households, and businesses. But discerning observers understand the limits of linear thinking, because they know that lines bend, or sometimes even break. That is the case today in assessing two key factors shaping the global economy: the risks associated with United States' policy gambit and the state of the Chinese economy.

Quantitative easing, or QE (the Federal Reserve's program of monthly purchases of long-term assets), began as a noble endeavor - well timed and well articulated as the Fed's desperate antidote to a wrenching crisis. Counterfactuals are always tricky, but it is hard to argue that the liquidity injections of late 2008 and early 2009 did not play an important role in saving the world from something far worse than the Great Recession.

The combination of product-specific funding facilities and the first round of quantitative easing sent the Fed's balance sheet soaring to $2.3 trillion by March 2009, from its pre-crisis level of $900 billion in the summer of 2008. And the deep freeze in crisis-ravaged markets thawed.

The Fed's mistake was to extrapolate - that is, to believe that shock therapy could not only save the patient but also foster sustained recovery. Two further rounds of QE expanded the Fed's balance sheet by another $2.1 trillion between late 2009 and today, but yielded little in terms of jump-starting the real economy.

This becomes clear when the Fed's liquidity injections are compared with increases in nominal GDP. From late 2008 to May 2014, the Fed's balance sheet increased by a total of $3.4 trillion, well in excess of the $2.6 trillion increase in nominal GDP over the same period. This is hardly "mission accomplished," as QE supporters claim. Every dollar of QE generated only 76 cents of nominal GDP.

Unlike the US, which relied largely on its central bank's efforts to cushion the crisis and foster recovery, China deployed a 4 trillion yuan fiscal stimulus (about 12 percent of its 2008 GDP) to jump-start its sagging economy in the depths of the crisis. Whereas the US fiscal stimulus of $787 billion (5.5 percent of its 2009 GDP) gained limited traction, at best, on the real economy, the Chinese effort produced an immediate and sharp increase in "shovel-ready" infrastructure projects that boosted the fixed-investment share of GDP from 44 percent in 2008 to 47 percent in 2009.