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Bernanke leads us down the hole to wonderland! (more about QE2)

5 November 2010

Summary:  Historians will laugh at our response to QE, for the reasons discussed here.  We’re enjoying our days in Wonderland.  We may find the hangover less entertaining.  This is a follow-up to Important things to know about QE2 (forewarned is forearmed).  Links to more information appear at the end.

Our response to the Federal Reserve’s latest monetary stimulus — QE2 – makes sense only in Wonderland.  Few economists believe it will have substantial economic impact — $600 billion over 9 months is a dot to the US economy, and a microdot to the global economy.  Even fewer expect a positive impact.  It’s a desperate act, a hail Mary pass to prevent the looming deflation.  Our response has been defening applause, with a minority booing.  Both groups’ views are firmly rooted in complacency.  A more appropriate reaction would be concern.  Or fear.

Three likely (but not certain) effects of QE2:

  1. a slight decrease in medium-term interest rates;
  2. rising prices for stocks, bonds, commodities, and real estate;
  3. a falling US dollar.

(1)  The effect of the tiny decrease in rates is likely trivial.  Short rates are unaffected; long rates might even rise.

(2)  Boosting asset prices, raising spirits of the 20% of Americans who own 85% of its wealth.  The direct effect on the other 80% will be nil, as they own little except their homes (7% of total US wealth ex-homes).  With 19 million vacant homes (14%), even the God-like Fed cannot boost home prices.  QE2 attempts to create prosperity by blowing bubbles.  It never works.  It cannot work.  The danger is real, but this attempted solution is insane.  Only incompetent leaders would allow this.  Only a population of fools would applaud.

(3)  Depressing the value of the US dollar.  This will slowly boost exports and increase the cost of imports, with a small net stimulus to the US economy.  And large disruptive impacts on the global economy, as the Fed’s newly printed money floods the emerging nations.  Most have current account surpluses, and don’t need our money.  Yet the money floods in, pushing up their currencies and asset prices –  disrupting their trade and domestic economies.  Worse, any nation can engineer a drop in its currency.  Stopping the decline can be more difficult, especially once it drops below its all time lows (less than 10% away for the US dollar major currency index).

Possible results

We are sheep, so the QE2 will run smoothly (if ineffectually) at home.  We might have a recovery, in which case all will be well.  Equally likely, the US economy might continue to slowly deteriorate (as it has since Spring 2010), the necessary deleveraging prevented by a combination of complacency, stagnant wages, and government stimulus.  So household and corporate debt levels have declined only a few percent since their pre-recession peaks, while government debt has skyrocketed.

More interesting, and ultimately more important, will be decisions of the emerging nations’ governments.  Our leaders assume these nations can only accept whatever we inflict on the world’s financial system.  But in an interconnected world, even a global hegemon should consult with the other major nations before taking extreme measures that affect everybody.  Which side is right?  Since God will not say, we will never know.

It’s a match-up of the sort that sometimes changes history.  A large decaying power against collectively larger and far faster growing nations, participants in a global regime they did not make and which they have outgrown.  They have already begun to rebel.  Brazil and Thailand have instituted taxes on foreign purchases of government bonds.  More may copy them.  And these might be just the first steps, with stronger measures to follow.  Like capital controls, which were commonplace from WWII until the 1970′s.

Capital controls would end the post-WWII era.  Nations with large capital account surpluses (e.g., China) would adjust with difficulty.  Nations with large current account deficits, like us, would adjust less easily.  The geopolitical order would change as well.  For example, financing our foreign wars and world-encircling chain of bases would for the first time require sacrifices.

For more information

Posts about solutions

  1. A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
  2. A solution to our financial crisis, 25 September 2008
  3. A quick guide to the “Emergency Economic Stabilization Act of 2008″, 29 September 2008
  4. The last opportunity for effective action before disaster strikes, 3 October 2008 — How to stabilize the financial system.
  5. Effective treatment for this crisis will come with “The Master Settlement of 2009″, 5 October 2008
  6. Dr. Bush, stabilize the economy - stat!, 7 October 2008
  7. The new President will need new solutions for the economic crisis, 9 October 2008
  8. New recommendations to solve our financial crisis (and I admit that I was wrong), 23 October 2008
  9. A look ahead to the end of this financial crisis, 30 October 2008
  10. Everything you need to know about government stimulus programs (read this – it’s about your money), 30 January 2009
  11. Bush’s bailout plan is now Obama’s. His quiet eloquence guides the sheep into the pen, 30 March 2009
  12. Cash for Clunkers is madness! Let’s expand it to new horizons!, 6 August 2009
  13. The falling US dollar – bane or boon?, 14 October 2009
  14. Government economic stimulus is financial heroin, 28 December 2009
  15. A lesson from the Weimar Republic about balancing the budget, 10 February 2010
  16. Why the U.S. cannot inflate its way out of debt, 16 March 2010
  17. We’re still blinded by our fetters of the mind and so unable to fix the economic crisis, 13 September 2010
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3 Comments
  1. 6 November 2010 1:56 am

    Others see the need for a new global financial system: “Beyond Bretton Woods 2 – Is there a better way to organise the world’s currencies?“, The Economist, 4 November 2010 — Excerpt:

    WHEN the leaders of the Group of Twenty (G20) countries meet in Seoul on November 11th and 12th, there will be plenty of backstage finger-pointing about the world’s currency tensions. American officials blame China’s refusal to allow the yuan to rise faster. The Chinese retort that the biggest source of distortion in the global economy is America’s ultra-loose monetary policy—reinforced by the Federal Reserve’s decision on November 3rd to restart “quantitative easing”, or printing money to buy government bonds (see article). Other emerging economies cry that they are innocent victims, as their currencies are forced up by foreign capital flooding into their markets and away from low yields elsewhere.

    These quarrels signify a problem that is more than superficial. The underlying truth is that no one is happy with today’s international monetary system—the set of rules, norms and institutions that govern the world’s currencies and the flow of capital across borders.

  2. 8 November 2010 3:20 pm

    Doing it again“, Paul Krugman, op-ed in the New York Times, 7 November 2010 — Excerpt:

    Eight years ago Ben Bernanke, already a governor at the Federal Reserve although not yet chairman, spoke at a conference honoring Milton Friedman. He closed his talk by addressing Friedman’s famous claim that the Fed was responsible for the Great Depression, because it failed to do what was necessary to save the economy. “You’re right,” said Mr. Bernanke, “we did it. We’re very sorry. But thanks to you, we won’t do it again.”

    Famous last words. For we are, in fact, doing it again.

    … The real damage is being done by our domestic inflationistas — the people who have spent every step of our march toward Japan-style deflation warning about runaway inflation just around the corner. They’re doing it again — and they may already have succeeded in emasculating the Fed’s new policy.

    For the big concern about quantitative easing isn’t that it will do too much; it is that it will accomplish too little. Reasonable estimates suggest that the Fed’s new policy is unlikely to reduce interest rates enough to make more than a modest dent in unemployment. The only way the Fed might accomplish more is by changing expectations — specifically, by leading people to believe that we will have somewhat above-normal inflation over the next few years, which would reduce the incentive to sit on cash.

    The idea that higher inflation might help isn’t outlandish; it has been raised by many economists, some regional Fed presidents and the International Monetary Fund. But in the same remarks in which he defended his new policy, Mr. Bernanke — clearly trying to appease the inflationistas — vowed not to change the Fed’s price target: “I have rejected any notion that we are going to try to raise inflation to a super-normal level in order to have effects on the economy.”

    And there goes the best hope that the Fed’s plan might actually work.

    Think of it this way: Mr. Bernanke is getting the Obama treatment, and making the Obama response. He’s facing intense, knee-jerk opposition to his efforts to rescue the economy. In an effort to mute that criticism, he’s scaling back his plans in such a way as to guarantee that they’ll fail.

    And the almost 15 million unemployed American workers, half of whom have been jobless for 21 weeks or more, will pay the price, as the slump goes on and on.

  3. 8 November 2010 3:59 pm

    Bubble, Crash, Bubble, Crash, Bubble…“, John P. Hussman, 8 November 2010 — Excerpt:

    We will continue this cycle until we catch on. The problem isn’t only that the Fed is treating the symptoms instead of the disease. Rather, by irresponsibly promoting reckless speculation, misallocation of capital, moral hazard (careless lending without repercussions), and illusory “wealth effects,” the Fed has become the disease.

    … With no permanent effect on wealth, and no ability to materially shift incentives for productive investment, research, development or infrastructure (as fiscal policy might), the economic impact of QE2 is likely to be weak or even counterproductive, because it doesn’t relax any constraints that are binding in the first place. Interest rates are already low. There is already well over a trillion in idle reserves in the banking system. Businesses and consumers, rationally, are trying to reduce their indebtedness rather than expand it, because the basis for their previous borrowing (the expectation of ever rising home prices and the hope of raising return on equity indefinitely through leverage) turned out to be misguided. The Fed can’t fix that, although Bernanke is clearly trying to promote a similarly misguided assessment of consumer “wealth.”

    To a large extent, the Fed has assumed the role of creating financial bubbles because we have allowed it. The proper role of the Federal Reserve, and where its actions can be clearly effective, is to provide liquidity to the banking system in periods of financial stress or constraint, by replacing Treasury bonds held by the public with currency and bank reserves. But to expect the Fed to somehow bring about full employment is misguided. To believe that changing the mix of government liabilities in the economy (monetary policy) is a more important determinant of inflation than the total quantity of those liabilities (fiscal policy) is equally misguided.

    … We are betting on the wrong horse. When the Fed acts outside of the role of liquidity provision, it does more harm than good. Worse, we have somehow accepted a situation where the Fed’s actions are increasingly independent of our democratically elected government. Bernanke’s unsound leadership has placed the nation’s economic stability on two pillars: inflated asset prices, and actions that – in Bernanke’s own words – should be “correctly viewed as an end run around the authority of the legislature” (see below).

    The right horse is ourselves, and the ability of our elected representatives to create an economic environment that encourages productive investment, research, development, infrastructure, and education, while avoiding policies that promote speculation, discourage work, or defend reckless lenders from experiencing losses on bad investments.

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