Wednesday, August 11, 2010

Unusual Uncertainty Meets QE2

Ya gotta love them boys at the Federal Reserve (FED).  Alan Greenspan gave us asset bubbles while warning about "irrational exuberance".  Now, "Helicopter Ben" Bernanke gives us "unusual uncertainty" and "quantitative easing" (QE).

If you missed your class on QE, here's a crash course.  It refers to a series of extraordinary measures that the FED is prepared to undertake to stimulate the economy.  Bernanke earned his nickname by saying that the FED was prepared to throw money out of helicopters if that's what it took.

If the FED has been trying to inject liquidity into the system, they've done one helluva lousy job.  The broadest measures of money supply, known as M2 and M3, are plunging at record rates.  In fact, they are at Great Depression levels of reduction.  Bernanke is an academic and a student of the Great Depression.  Specifically, his interest has been to attempt to understand what went wrong.  So, the helicopter plan was borne out of this knowledge, although clearly he was being figurative and not literal.

The dropping money supply, however, is probably not entirely Bernanke or the FED's fault.  An uncontrollable variable, called "velocity", is providing a stiff headwind against the FED's efforts. Velocity is a measure of  the rate at which money circulates.  If everyone were to put their savings under the mattress, for example, velocity would be zero.  On the other hand, if folks were to be engaging in a lot of transactions and borrowing to finance growth, velocity would be high. 

Velocity is hard to control, since it's the result of trillions of personal decisions.  It is a function of consumer and business confidence.  Low confidence equals high risk aversion and no willingness to expand, therefore, low velocity. 

It is believed that the FED will monetize its mortgage portfolio and use the proceeds to purchase long term U.S. Treasury Bonds.  That will do absolutely NOTHING to increase velocity.  In fact, interest rates are at generational lows already, and may go lower if the economic downturn intensifies as we expect.  Japan, a decent analog, has sub 1% long term rates. 

Using FED funds to purchase Treasury Bonds is nothing more than a monetization of the U.S. budget deficit, now running at $1.5 trillion per year.

Unfortunately, the FED is powerless.  Yes, you read that right.  The FED is virtually powerless.  They can't reduce rates which are already near zero.  Any policy moves like changing reserve requirements or Open Market Operations will have absolutely no effect in the current business climate.  To be effective, the budget needs to be brought under control, jobs need to be created and confidence needs to be restored.  However, none of those can happen as long as the FED is powerless to stimulate the economy.  The very definition of a vicious cycle if I ever heard one. 

We are facing an impending economic death sentence.  The only remaining question is whether we die by lethal injection, electrocution or hanging.

Marko's Take

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6 comments:

  1. Trying to monetize our way out of a fiscal problem, as you identify, ain't Ben's fault. But, it is his problem. As we've discussed so often, the elections in November will bring Hope and Change, just not what The One thought he was bringing two years ago.

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  4. Velocity is the thing people don't understand. The problem is, the Fed keeps dumping truckloads of money into the economy, and since it isn't causing inflation, they think they can keep dumping truckloads more. When velocity does pick up, inflation is going to go through the roof. So if we ever do get out of the current mess... its going to be out of the frying pan and into the fire.

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  5. The FED isn't monetizing anything. They are going to take mortgage bond income (i.e. principal being paid back by home owners) and buy Treasury bonds. They are recycling the money. Now this money would normally be in the economy anyway because these mortgage bonds would have been held by private institutions and investors who would have taken that money and spent it anyway. Since the mortgage bonds are with the FED, the money goes into a black hole. So really, they should be doing this to avoid collapse since their holding of this debt is a market perversion anyway. Basically their current action will do NOTHING. However by not doing this it would cause further deflation.

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  6. problem is the banks are sitting on all the money being created; earning interest via the Fed is much better than doing business and fulfilling the mission of a bank in a capitalist system. So of course velocity is down, and consumers are too indebted, unemployed, and with reduced income to spend at rates that would create growth. Sitting on money in banks suits the financial elites because they can earn their way slowly back to solvency. (inflation can be tamed my mopping up the money lent out to the banks; deflation is the worry, by far.)

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