Why QE2 won't work - Part 1

I tend to shy away from long posts because people often don't read them.

Today is an exception and I hope you will bear with me.

Charles Hugh Smith has put together a great analysis on his website about why QE 1 & 2 will fail. This is a somewhat condensed version of that analysis.

I hope you will find this of value and useful as you search for guidance in your financial decisions. As always, please read the disclaimer at the bottom of this blog.

- Whisperer

The Original QE Plan

The US Federal Reserve's supposed goal with Quantitative Easing after the disaster of 2008 was "get the economy on its feet again" by stabilizing employment and prices.

To achieve this objective the Fed injected "liquidity" into the banking sector, enabling banks to borrow essentially unlimited sums at essentially zero interest - the infamous ZIRP (zero-interest rate policy).

The Fed also pushed down mortgage rates by buying over 10% of all outstanding mortgages in the U.S.; mortgages which the banks were desperate to get off their crippled balance sheets. In addition to this the Fed also pushed down yields on U.S. Treasury bonds ("monetizing" this newly issued debt) by buying hundreds of billions of dollars of bonds itself.

1. ZIRP and unlimited liquidity was intended to enable the banks to "earn their way back to solvency" by giving them free money which they could then loan out at much higher rates. The difference between zero (their cost) and the interest rate they charged borrowers was pure profit, courtesy of the Federal Reserve.
2. The purchase of $1.2 trillion in mortgage-backed securities was intended to stabilize housing and real estate process at far above their "natural" level set by "organic" supply and demand; in essence, the goal was to stop market prices from reverting to the mean, i.e. returning to historical trendlines which are roughly equivalent to pre-bubble valuations circa 1997-98.
3. Halting this slide in real estate prices was intended to stop the implosion of banks' balance sheets as their assets - all those mortgage-backed securities and derivatives they own - kept falling in value.
4. Halting the slide would also allow banks to slowly sell off the millions of foreclosed and defaulted homes they hold in the "shadow inventory" at prices far above where supply and demand would let them settle.
5. As a side benefit, keeping home prices inflated far above their real value would also allow the Fed to dump its own portfolio of $1.2 trillion mortgage-backed securities without suffering catastrophic losses.
6. Lastly, the goal was to lower the cost of mortgages to such ridiculously low levels that otherwise prudent citizens might be seduced into buying a house "because rates are so low." The idea was to encourage rampant home buying (for speculation or long-term ownership, it didn't matter) to prop up the market with "demand," even if that "demand" was driven by the low cost of borrowing rather than actual demand based on the need for shelter (note: there are 19 million vacant dwellings in the U.S. now).

All these policies led to super-low yields on low-risk investments.

This was a deliberate strategy so that a "cash is trash" mindset could be created. This would be powerful incentive to put capital into risk assets such as stocks, commodities and real estate. By explicitly pushing free money and zero-interest rates, the Fed made it impossible to earn any yield on low-risk assets; thus they have been explicitly pushing capital and borrowed money into the "risk trade" : emerging markets, commodities, and stocks.

The ultimate goal was to create a new "wealth effect": inflate another bubble in stocks and commodities so that owners of capital will feel wealthier and - as a result - they will start spending more.

The Fed's premise was to create a "trickle down" of wealth. Flood the economy with new "free" money, thereby sparking inflation and a new round of consumption that would inject "growth" into the economy.

In other words, the "problem" was perceived as sagging asset prices (real estate and the worthless mortgages written on homes that have lost 50% of their value) which have impoverished homeowners and impaired banks' assets.

The Fed's "solution" was to reinflate the housing bubble (or stabilize its collapse) and push investors and speculators alike into risk assets in the hopes that a new asset bubble somewhere will boost assets enough to create a "feel good" wealth effect. This would trigger massive new consumer spending and repair banks' balance sheets with higher asset valuations.

Why QE1 Failed

In the normal cycle of classical Capitalism the expansion of credit/debt and rising assets leads to mal-investment and rampant speculation: overbuilding, overcapacity, over-indebtedness and leveraged bets that misprice risk.

This is precisely what occurred in the 1995-2000 stock market bubble and the 2002-2007 housing/real estate bubble; mal-investment, over-indebtedness, overbuilding and mispricing of risk on a grand, unprecedented scale.

In the normal scheme of things, all this bad debt would be written off and the assets would be sold/liquidated.

Holders of those assets and the debt based on those assets would both suffer losses or even be wiped out.

All the overbuilt properties and overcapacity would be sold for pennies on the dollar, and the liabilities (debt) wiped off the balance sheet along with all the inflated assets.

There is no other way to clear the market for future growth.

Yet the US Federal Reserve has pursued a "solution" (to reinflate asset bubbles or keep them artificially high by injecting more credit/debt into the system) that violates all the principles of Capitalism.

You cannot eliminate the consequences of speculative bad bets and over-indebtedness with more debt and more speculation, yet that is precisely the intent of all the Federal Reserve's policies.

The Fed's unprecedented purchase of mortgages and Treasury debt have indeed reinflated the stock and housing bubbles to a limited degree, but most of that free money has flowed into emerging markets and commodities (which are now in their own massive bubbles).

In yet another pernicious consequence, the Fed's bumbling attempts to create inflation in the U.S. have failed - the inflation is raging in China. And as inflation rages there, then the cost of Chinese goods in the U.S. will rise.

Instead of sparking "good inflation" in the U.S. which they presumed (thickheadedly) would boost wages along with prices, thus enabling American debt-serfs to pay down their debts with "cheaper" money, they have sparked runaway asset bubbles in commodities and "bad" inflation in China, which means the cost of goods Americans need to survive is skyrocketing while their wages and income stagnate.

In other words, the plan completely backfired in terms of helping 90% of the citizenry.

The "wealth effect" of rising stock prices failed to boost the spirits and balance sheets of the bottom 90% who have essentially no financial capital, average incomes have declined in the recession and yet prices for commodities are climbing.

The Fed's policies have created the worst-case scenario for the average American household: stagnant income and rising prices of essentials.

Now demand is falling along with net incomes, not the supply of new debt.

By raising the costs of commodities, the Fed is actually reducing the net disposable income of households: the reverse of the "wealth effect."

Rather than allow the economy to clear out bad debt and re-set asset prices that would enable organic growth, the Fed has tried to inflate new asset bubbles to save the Financial Power Elites from suffering the losses resulting from the last two bubbles popping.

As a result QE1 was a failure.

Now we have QE2.

More on that tomorrow in Part 2.

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Email: village_whisperer@live.ca

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