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Reasons Why QE2 Will Fail

Interest-Rates / Quantitative Easing Nov 04, 2010 - 06:37 AM GMT

By: Mike_Shedlock


Best Financial Markets Analysis ArticleDr. El-Erian, CEO and co-CIO of PIMCO states several reasons why QEII will backfire.

1. The Fed is going it alone, without meaningful structural reforms
2. Emerging economies burdened by capital inflows in the wake of QEII will react with currency wars, protectionism, and capital controls
3. Resultant commodity price increases will increase input costs and reduce earnings of American companies

The position of El-Erian is interesting given that PIMCO founder, managing director and co-CIO endorsed QEII as discussed in Bill Gross' Arrogant Endorsement of Fed's QE Policy he calls History's Most "Brazen Ponzi Scheme".

Unintended Consequences of QEII

Mohamed El-Erian addresses the unintended consequences of Fed policy actions and the reasons Quantitative Easing will fail in QE2 blunderbuss likely to backfire.

The Fed faces three problems, with its solo role being the first. Having warned in late August in Jackson Hole that “central bankers alone cannot solve the world’s economic problems”, Ben Bernanke, the Fed’s chairman, is now leading an institution that is virtually on its own among US policymakers in meaningfully trying to counter the sluggishness of the US economy and the stubbornly high unemployment.

The rest of the world does not need this extra liquidity, and this is where the second problem emerges. Several emerging economies, such as Brazil and China, are already close to overheating; and the eurozone and Japan can ill afford further appreciation in their currencies.

Despite polite rhetoric to the contrary in the lead up to the Group of 20 leading economies summit in Korea this month, other countries are likely to counter what they view as an unnecessarily disruptive surge in capital flows caused by inappropriate and short-sighted American policy. The result will be renewed currency tensions and a higher risk of capital controls and trade protectionism.

The third issue relates to the gradual erosion of America’s central role in the global economy – including as the provider of both the world’s reserve currency and its deepest and most predictable financial markets. No other country or multilateral institution can displace the US, but a combination of alternatives can serve to erode its influence over time. No wonder commodity prices surged higher and the dollar weakened markedly in anticipation of QE2, pointing to increased input costs for American companies and unwelcome pressures on their earnings.

Pavlov's Dogs and the "No Choice" Argument Yet Again

Although I agree with the three major points above, I certainly do not concur with El-Erian's opening gambit "Given the high market expectations, the US Federal Reserve had no choice but to announce a second tranche of quantitative easing".

Pray tell who set those expectations if not the Fed? Moreover, given the market reacted like Pavlov's Dogs to the announcement, the Fed could have and should have toned down market expectations.

Finally given that the Fed produced a bubble in junk bonds and sent commodity prices soaring the Fed had every reason to disappoint the market today.

For more on junk bonds please see ...

Intended vs. Unintended Consequences

Add a junk bond bubble to the list of consequences (unintended or otherwise).

Bernanke is clearly misguided enough and arrogant enough to purposely blow a junk bond bubble as an "intended consequence", even though the housing bubble bust proves without a doubt the asininity of such policies.

Thus, it's hard to say if Bernanke wants a junk bond bubble or is merely willing to live with one.

Then again, Bernanke is dense enough to not have any clues about what is happening. He did not see the housing bubble, the recession, the huge rise in unemployment, and any number of other things that happened. In fact, he even denied there was a housing bubble.

In the academic wonderland in which Bernanke lives, it is perfectly possible he is oblivious to the bubbles he is creating.

However, looking at things from every angle, given that Bernanke Admits Targeting Stock Prices, I am leaning towards the first option: Bernanke is misguided enough and arrogant enough to purposely blow more asset bubbles as an "intended consequence", hoping he can deal with them later.

Missing the Obvious

I touched on the one obvious reason QEII will fail in QEII Announced, Fed Set to Buy $600 Billion in Bonds, Reinvest $250 Billion More; Fed Micromanaged Economy to Oblivion; No Miracles Coming

Doubts? What Doubts?

There is little doubt, at least in this corner, that the plan cannot possibly work. Corporate borrowing costs are the lowest in history and that hasn't spurred hiring. Will another quarter of a point lower matter? Will QEII even lower rates that much?

Simple explanations as to why QEII will fail are best: "Money’s Already Quite Cheap"

With mortgage interest rates at all time lows, is this supposed to help housing? Why?

It is sad but true economic thinking these days that the "Fed had to do Something". Why does it make sense to do something, just for the sake of doing, when it should be crystal clear that doing just adds to problems down the road.

Fed Micromanaged Economy to Oblivion

The Fed has clearly micromanaged this economy to oblivion. Greenspan's experiment short-circuited the 2001 recession but the expense was the biggest housing bubble in the history of the world, not just in the US, but globally.

A global recession soon followed.

Now on misguided calls to "do something" the Fed is blowing a bubble in commodities that cannot possibly help margin strapped small businesses.

An excerpt from $30 Billion Offer No One Wants - Small Businesses Hit by Deflation will show why. ....

No One Has To Do Anything

It is disappointing to see El-Erian perpetuate the myth the Fed had to do something when one of the biggest reasons we are in this mess is a activist Fed under both Greenspan and Bernanke felt the need to do something about LTCM, Y2K, the Dot-Com bubble, housing, motherhood, and apple pie.

At least El-Erian is not defending what Gross calls a "Ponzi Scheme" to the same foolish extent that Bill Gross did. More importantly, El-Erian makes it clear exactly what some of the consequences are, while the Gross article sounds like "jumping the shark".

Structural Reforms

El-Erian said "Without meaningful structural reforms, part of the Fed’s liquidity injection will leak right out of the US and result in yet another surge of capital flows to other countries."

I agree, but I rather doubt we are talking the same language. This country needs to ...

  • Scrap Davis-Bacon
  • End public union collective bargaining
  • End the public union stranglehold on the cities and states
  • Fix the pension problem
  • Even the playing field between big and small businesses on corporate income taxes
  • Get the hell out of Afghanistan
  • Reduce military spending
  • Rein in entitlements
  • Stop being the world's policeman
  • Balance the budget
  • Return to constitutional money

Fed Fights Battle that Cannot be Won, Should Not be Fought

Given that Congress is unlikely to do many, if indeed any of those things, the Fed is fighting a battle that cannot be won and should not be fought.

We are in this mess because the Fed micro-mismanaged the economy at every critical juncture while attempting to smooth over various fiscal insanities, counter bad Congressional policies, as well as deal with the repercussions of its own monetary insanities, on a delayed chasing-its-tail basis, in a global economy that waits for no one.

Is it any wonder the Fed failed in dual mandate of price stability and maximum growth?

For more on the silliness of the Dual Mandate as well as a rebuttal to the notion "Don't Fight the Fed" please see Krugman and the Inevitable "I Told You So" - Tim Duy "Bad Things Happen When You Fight the Fed"; Final End of Bretton Woods 2?

With that key idea in mind, there are two more structural reforms glaringly lacking in the above list: Abolish the Fed and End Fractional Reserve Banking.

By Mike "Mish" Shedlock

Click Here To Scroll Thru My Recent Post List

Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at .

© 2010 Mike Shedlock, All Rights Reserved.

© 2005-2016 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


04 Nov 10, 12:33

The facts are that shedlocks been wrong on just about everything !

Deflation, stocks, bonds, economy, commodities.

04 Nov 10, 16:57
Bernanke VS China

There's and old saying: "You can't make a silk purse out of a sow's ear". Our current economy is without doubt a "sow's

ear". There are two facets of the economy--Main Street and Wall Street. Main Street is unbalanced, weak, lacks a

manufacturing sector, and its labor is not competitive on the world market. Wall Street is excessively speculative, corrupt, unproductive, and rife with criminality. But the main problem of the economy is debt--some economic studies put the total US debt at over 700 trillion dollars. Obviously the economy can not be transformed back to its prior supereminent state ("recovered") with a few drops of Bernanke holy water. (I leave it to the reader and/or Bernanke to define the era of our past "supereminent" economy).

Bernanke is certainly the King of Unforeseen Consequences. I was much surprised by the widespread acrimony and rancor of the world governments' immediate response to Bernanke's announcement of QE-2. There are two aspects of this reaction. One is that it will pejoratively complicate and otherwise affect political and diplomatic relations of the United States with

other foreign governments. The other is that many of these governments are talking about economic reprisals. I wonder if Bernanke had any notion of the diplomatic and economic damage that his QE-2 announcement would cause.

Not only are various governments angry, but the the peoples of these countries are also very upset. Who knows how many will not vacation in the US, not fly in US airplanes, or boycott goods of US origin. I know that many will say that I am making a mountain out of a mole hill, but if you get enough mole hills, you'll have a mountain!

The goals of reprisal will be to replace the US dollar as the global currency wherever possible, and to minimize its use where it can't be replaced. And money has many uses. For example, when bribing foreign government officials, the CIA may need to pay the bribe in Chinese yaun rather than in good old American dollars.

One country that had a very subdued reaction to Bernanke's announcement is China, which is the one country that has the most to lose from Bernanke's currency manipulation disguised as an economic stimulus. The Chinese spokesman said "China will act in its own best interest". This seems like an empty non sequitur--of course China will act in its own best interests. But Chinese diplomats are very clever people and do not waste words. The message they are sending Bernanke and the USA is: "China will act in its own best interest, and this will do a great deal of harm to the economic and world political interests of the United States".

05 Nov 10, 00:34
Big Ben

Big Ben will destroy China. There's one and only one weapon to defeat "fixed exchange rate", and that's depreciation.

China will learn soon enough.

Ben vs China. No American has the ball and or with the sack to take on China.

Go Ben....!

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