Alert: QE II Has Lit the Fuse

Thursday, November 11, 2010, 1:41 pm
by cmartenson

For a very long time I have been calling for, expecting and otherwise anticipating the day that the Federal Reserve would begin openly monetizing government debt. http://www.chrismartenson.com/martenson ... st-cut-all I knew the day would come intellectually, but in my heart I hoped it wouldn't. But with the Fed's recent decision to directly monetize the next 8 months of federal deficit spending, that day has finally arrived. I have to confess, while my prediction has proven accurate, I’m still stunned the Fed actually did it.

In this report I examine the risks that this new path presents, what match(es) may finally ignite the decades-old pile of dry fuel, what the outcomes are likely to be, and what we can and should be doing in preparation.

How is this Quantitative Easing (QE) different from the prior QE?

There are two main points of departure between the two QE programs:

* The level of global support for such efforts
* Where the money was/is targeted

Let's take the second point first.

QE I consisted of all sorts of liquidity efforts that went by various acronyms, but the main act was the accumulation of some $1.25 trillion in MBS and agency debt. Some might note that taking MBS paper off the hands of financial institutions, which then bought treasuries with the cash, is little different than the recently announced QE II program because at the end of the day, money was printed and Treasuries were bought. In this regard, they're right.

But let's be clear about something: the first QE effort had the specific aim of repairing damaged bank balance sheets. That is, banks and other financial institutions had made some colossally poor and risky financial moves that didn't work out for them. They needed some help, and the Fed was more than happy to oblige by handing them free money to patch up their losses.

Of course they didn't do this outright by saying, "Here take this money!"; they did it somewhat sneakily. But when the Fed hands you huge piles of money (for your dodgy debt) and then let's you park that very same money in an interest bearing account at the Fed, there's really no difference between that and just handing you free money. No difference at all. If the Fed ever offers you free money that you can then park in an interest bearing account with the Fed, you should take them up on it, and you should do it as much as they will allow.

Indeed, that's exactly what happened. These parked funds are called "excess reserves" and this chart clearly displays the massive program undertaken by the banks and the Fed:



Now, it's also true that the Fed does not pay a lot of interest on this money, just 0.25%, but on a trillion dollars that pencils out to some $2.5 billion a year, handed straight over to the banks. I call this program "stealth QE" because it is nothing more than printing money and handing it over to the banks with a slight bit of complexity thrown in just to put the dogs off the scent. A couple of billion may not sound like much these days, but I raise it to illustrate the many and creative ways that QE I was about getting the banks back to health, and not much else.

So QE I (and the ‘stealth QE’ program) was directly aimed at banks to help them repair their balance sheets and make them whole on their terrible decisions and losses. It turned out, though, that fixing the banks did absolutely nothing for Main Street. The rest of the economy remained mired in a rut, with banks either unable or unwilling to make additional loans. They kept their QE lotto winnings and parked them with the Fed.

QE II, then is about getting thin-air money to the government which, the Fed rightly assumes, will immediately spend and push out into the economy. Here's how the head of the Dallas Fed, Richard Fisher put it in a recent talk he gave:

A Bridge to Fiscal Sanity? http://dallasfed.org/news/speeches/fish ... 101108.cfm

The Federal Reserve will buy $110 billion a month in Treasuries, an amount that, annualized, represents the projected deficit of the federal government for next year. For the next eight months, the nation’s central bank will be monetizing the federal debt.

This is risky business. We know that history is littered with the economic carcasses of nations that incorporated this as a regular central bank practice.

There it is in black and white. You might want to read it a couple of times to let it sink in. The Fed is directly monetizing the next eight months of excess(ive) spending by the federal government and is doing it despite being perfectly aware of the extent to which history is littered with the remains of those who have traveled this path before.

Presumably we are supposed to console ourselves with the idea that the Fed will be successful where others have failed, and sometimes failed miserably. Yes, we are talking about the same Fed that fueled that last two destructive bubbles by keeping interest rates too low for too long; failed to see the housing bubble as late as 2007 for what it was, and apparently entirely lacked the capability to foresee any of the current mess. That Fed.

The one run by the gentleman who said this to the House Budget Committee on June 3, 2009,

“Either cuts in spending or increases in taxes will be necessary to stabilize the fiscal situation…The Federal Reserve will not monetize the debt.â€