Friday, November 5, 2010

Why QE 2 won't work - Part 2

Today will be another long post, and I apologize.

If you read yesterday's discussion of QE1 you know that, as a plan to "get the economy on its feet again," QE1 was deemed insufficient.

Enter QE2.

If you have not seen it, Ben Bernanke wrote an OP-ED piece in the Washington Post defending the Federal Reserve's latest actions. You can read it here.

Will it succeed?

As mentioned yesterday, 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.

It is precisely that excess which 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.

And given that the economy faces $15 trillion in writedowns in collateral and credit, the bottom line is that the Federal Reserve's QE1 and QE2 in new credit/liquidity is insufficient to achieve the Federal Reserve's objectives.

It cannot help but fail.

Consider the size of the U.S. economy: $14 trillion. The probable size of QE2, when all is said and done, will be about $1 trillion.

That means QE2 is perhaps 7% of GDP. Even a whopping $2 trillion QE would equal about 14% of GDP.

(In contrast, by some measures China opened the floodgates of credit to the tune of fully 35% of their GDP to combat the contraction caused by the global financial meltdown in late 2008)

How much collateral and credit will be destroyed as the U.S. economy rolls over into recession/depression in 2011-14? Based on the latest (September 17, 2010) Fed Flow of Funds, Charles Hugh Smith provides the following rough estimates of losses yet to be booked in assets (collateral) and credit (debt):

  • Residential real estate: current value, $18.8 trillion. Estimated value in 2014: $13.8 trillion, i.e. a decline of $5 trillion or 26%. If all impaired mortgages are written down or sold for fair market value, a full $5 trillion will need to be written off by somebody, somewhere. And Smith's 26% estimate is conservative; according to the Case-Shiller Index chart, a decline of 40% would be required to return the index to the year-2000 level.
  • Commercial real estate (CRE): The Flow of Funds only reports "nonfarm nonfinancial corporate business" so the CRE number of $6.5 trillion is a few trillion light (that is, we need to add in CRE owned by financial corporations). Smith estimates writedowns of $3 trillion - a number others have also guesstimated. Empty malls, empty office parks, empty warehouses, empty retail: they're all worth essentially zero. The cost of bulldozing them is higher than their auction value.
  • Consumer durable goods: All this "stuff" is supposedly worth $4.5 trillion, but when the millions of bulging storage units are emptied and sold, the actual market value of all this will be more like $3 trillion at best. So knock off another $1.5 trillion in collateral.
  • Corporate bonds: A huge amount of junk bonds have been sold in the last year, bonds which will be useless once inflated profits and corporate balance sheets adjust to the 2011-14 reality. Smith tags the losses here at $1 trillion, which is probably conservative.
  • U.S. stocks: Roughly $14 trillion: $6.7 trillion owned outright, $4 trillion in mutual funds and another $4 trillion in pension funds (which total about $11.6 trillion total). Once skyhigh estimates of future profits fall to Earth and the risk trade fades, then equities will get a $4 trillion haircut (i.e. they are about 30% overvalued). Investors are already exiting equities as an asset class (once burned, twice shy, and they've been burned twice in 8 years) and the next downturn will accelerate this prudence.
  • Equity in noncorporate business: The Fed sets this at $6.6 trillion, and as the economy rolls over, households and business deleverage their massive debts and taxes rise, then a fair accounting of this non-publicly-traded equity would probably drop by at least $1 trillion.

Many analysts consider each of these estimates to be conservative, and they total $15 trillion.

The Fed estimates total assets of households and nonprofits (which is of modest size compared to households) at $67 trillion, and net worth at $53 trillion (that is, liabilities are "only" $14 trillion).

A reduction in collateral of $15-$20 trillion (including the $3 trillion in CRE losses) would still leave tens of trillions in assets. But it would certainly impair the economy's ability to leverage up trillions more in new debt.

The reality is that this uncollectible, impaired or defaulted debt would have to be written down or written off. Those holding the debt - the "too big to fail" banks - would be bankrupted by these reductions in collateral.

So how do you generate the "modest inflation" which is the Fed's stated goal when $15 to $20 trillion in collateral and credit are disappearing from balance sheets? How do you goose credit enough to inflate a new asset bubble?

Excessive debt and speculative bubbles cannot be "fixed" with additional doses of debt and speculation. The Capitalist reality is this: if the Fed truly wanted to fix the U.S. economy rather than protect its over-extended, debt-ridden Financial System, then it would force the liquidation of trillions in bad debt and force a "marked to market" valuation on every balance sheet, household and corporate alike.

Anyone who believes a meager one or two trillion dollars in pump-priming can overcome $15-$20 trillion in overpriced assets and $10 trillion in uncollectible debt is in for a profound disappointment.

The Fed's tinny little QE "bazooka" will be rolled over by the M-1 tanks of deleveraging and the recognition of $15-$20 trillion in losses.

And as long as Bernanke is Chairman of the US Federal Reserve, and this philosophy is followed, you can be assured there will be a QE3, 4 and 5.

It is inevitable.

Tomorrow some thoughts on the best way to position yourself.



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  1. Whisperer,

    U mentioned a few days ago that you are hesitant about posting longer articles because you do not think people will read them.

    I, for one, relish the longer articles because they give me more to 'chew on'. The short ones leave me wanting for more.

    If someone will come here to read your comments, it is because of the content not because the articles are short.

    I very much appreciate your writting, please carry on.

    BTW - any updates on the neighbourhood 'discussions'... re: Nov.15, 2009 article?

  2. Sorry - October 15th, 2009 "Innocence". I was a month off.

  3. Is Ben Bernanke a modern day Robin Hood or Rob Ben Hood? Is QE relating to transfer wealth from the middle class and to give it to the very rich? QE raises the fear of paper currency, investors have been buying commodities driving the cost of food and oil up. QE will raises inflation, killing any saving. QE will prolong the housing bubble disaster. The list go on, but in the end, it is always the middle class that foot the bill.

  4. It is crazy to expect that a problem of too much easy money could be solved by more of the same. However, like Jim Sinclair says, there is no politically expedient alternative for QE to infinity. The big banks have assets on their books that are valued by mark to model, rather than mark to market. If these assets were correctly valued at their market value the derivatives beast would act like a black hole and devour the world financial system, leaving a skid mark and one penny.