Yellen's coming crisis.

• Author: Nakamae, Tadashi

How has quantitative easing failed? Let me count the ways.

Janet Yellen will face a daunting task when she takes the helm at the Federal Reserve: weaning the United States and the global economy off a highly addictive program of easy money. Quantitative easing creates economic and financial distortions. These often emerge in the form of asset bubbles, which can be seductive in the short-term, making policies to deflate them unpopular. Nonetheless, Yellen needs to craft policies which address these and other dangerous distortions.

Yellen could continue to flood the economy with more money. Or she could emulate Ben Bernanke, the departing head of America's central bank, who currently seems to have decided not to step up the program and merely manage the perceptions of market participants. Alternatively, Yellen could decide to wind down the central bank's asset purchases and face a painful, but necessary, period of adjustment.

For quantitative easing has not worked. Neither the Federal Reserve, which launched its ultra-easy policies at the end of 2008, nor the Bank of Japan, which started easing in 2001, has succeeded in accelerating economic growth or creating inflation.

Instead, the economy has become distorted. At home, quantitative easing has pushed up asset prices, especially equity prices. Stock markets have shot up; investment valuations, such as price-to-earnings ratios and price-to-book ratios, have risen even more. This phenomena is increasingly difficult to sustain. Big companies have raised their earnings by cutting costs rather than lifting revenues (a strategy that is limited), while many smaller companies have yet to see their earnings improve at all. The stubbornly weak economy also hurts. The Federal Reserve says the lackluster economy is why it has not tapered its quantitative easing purchases so far, a strategy that exacerbates the distortions that fuel these bubbles.

The government bond market is also experiencing an artificial boom. With the Fed buying over $1 trillion worth of bonds a year against a fiscal deficit of $680 billion (the Bank of Japan is buying [yen] 70 trillion against a [yen] 50 trillion deficit), government bond market transactions are shrinking even as its prices are controlled by the central bank.

Quantitative easing has also created bubbles in emerging market economies. These countries have received huge amounts of capital as investors (using cheap dollars) look for higher returns. Emerging market...