Best of the Week
Most Popular
1. Market Decline Will Lead To Pension Collapse, USD Devaluation, And NWO - Raymond_Matison
2.Uber’s Nightmare Has Just Started - Stephen_McBride
3.Stock Market Crash Black Swan Event Set Up Sept 12th? - Brad_Gudgeon
4.GDow Stock Market Trend Forecast Update - Nadeem_Walayat
5.Gold Significant Correction Has Started - Clive_Maund
6.British Pound GBP vs Brexit Chaos Timeline - Nadeem_Walayat
7.Cameco Crash, Uranium Sector Won’t Catch a break - Richard_Mills
8.Recession 2020 Forecast : The New Risks & New Profits Of A Grand Experiment - Dan_Amerman
9.Gold When Global Insanity Prevails - Michael Ballanger
10.UK General Election Forecast 2019 - Betting Market Odds - Nadeem_Walayat
Last 7 days
Gold Price Breaks Down, Waving Good-bye to the 2019 Rally - 12th Nov 19
Fed Can't See the Bubbles Through the Lather - 12th Nov 19
Double 11 Record Sales Signal Strength of Chinese Consumption - 12th Nov 19
Welcome to the Zombie-land Of Oil, Gold and Stocks Investing – Part II - 12th Nov 19
Gold Retest Coming - 12th Nov 19
New Evidence Futures Markets Are Built for Manipulation - 12th Nov 19
Next 5 Year Future Proof Gaming PC Build Spec November 2019 - Ryzen 9 3900x, RTX 2080Ti... - 12th Nov 19
Gold and Silver - The Two Horsemen - 11th Nov 19
Towards a Diverging BRIC Future - 11th Nov 19
Welcome to the Zombie-land Of Stock Market Investing - 11th Nov 19
Illiquidity & Gold And Silver In The End Game - 11th Nov 19
Key Things You Need to Know When Starting a Business - 11th Nov 19
Stock Market Cycles Peaking - 11th Nov 19
Avoid Emotional Investing in Cryptocurrency - 11th Nov 19
Australian Lithium Mines NOT Viable at Current Prices - 10th Nov 19
The 10 Highest Paying Jobs In Oil & Gas - 10th Nov 19
World's Major Gold Miners Target Copper Porphyries - 10th Nov 19
AMAZON NOVEMBER 2019 BARGAIN PRICES - WD My Book 8TB External Drive for £126 - 10th Nov 19
Gold & Silver to Head Dramatically Higher, Mirroring Palladium - 9th Nov 19
How Do YOU Know the Direction of a Market's Larger Trend? - 9th Nov 19
BEST Amazon SMART Scale To Aid Weight Loss for Christmas 2019 - 9th Nov 19
Why Every Investor Should Invest in Water - 8th Nov 19
Wait… Was That a Bullish Silver Reversal? - 8th Nov 19
Gold, Silver and Copper The 3 Metallic Amigos and the Macro Message - 8th Nov 19
Is China locking up Indonesian Nickel? - 8th Nov 19
Where is the Top for Natural Gas? - 7th Nov 19
Why Fractional Shares Don’t Make Sense - 7th Nov 19
The Fed Is Chasing Its Own Tail; It Doesn’t Care What You Think - 7th Nov 19
China’s path from World’s Factory to World Market - 7th Nov 19
Where Is That Confounded Recession? - 7th Nov 19
FREE eBook - The Investment Strategy that could change your future - 7th Nov 19
Is There a Stock Market Breakout Ahead? - 6th Nov 19
These Indicators Aren’t Putting to an Economic Resurgence - 6th Nov 19
Understanding the Different Types of Travel Insurance - 6th Nov 19
The Biggest Gold Story Of 2020 - 6th Nov 19
Best Money Saving FREE Bonfire Night Fire Works Show Sheffield 2019 - 5th Nov 19
Is the Run on the US Dollar Due to Panic or Greed? - 5th Nov 19
Reasons Why Madrid Attracts Young Professionals - 5th Nov 19
Larger Bullish Move in USD/JPY May Just Be Getting Started - 5th Nov 19
Constructive Action in Gold & Silver Stocks - 5th Nov 19
The Boring Industry That Hands +500% Gains - 5th Nov 19
Stock Market Chartology vs Fundamentals - 4th Nov 19
The Fed’s Policy Is Like Swatting Flies with Nuclear Weapons - 4th Nov 19
Stock Market Warning: US Credit Delinquencies To Skyrocket In Q4 - 4th Nov 19
Stock Market Intermediate Topping Process Continues - 4th Nov 19
Stock Market $SPY Expanded Flat, Déjà Vu All Over Again - 4th Nov 19
How To Buy Gold For $3 An Ounce - 4th Nov 19

Market Oracle FREE Newsletter

How To Buy Gold For $3 An Ounce

Quantitative Easing is Sinking the Fed's Status

Politics / Central Banks Nov 18, 2010 - 10:38 AM GMT

By: Robert_Murphy

Politics

Best Financial Markets Analysis ArticleUh oh, Mr. Bernanke, the natives are getting restless. Now it's not just Sarah Palin and Glenn Beck, or foreign central bankers, but more and more American economists who are starting to openly challenge the second round of "quantitative easing."

It's tough to rule the world, and sometimes the benighted masses get uppity. The first surprising pushback came in the summer of 2009, during the healthcare "town hall" meetings, which scared many legislators back to DC. More recently, Transportation Security Administration (TSA) officials seemed unprepared for the outrage over invasive pat downs and body scans.


In the realm of monetary policy, the Fed's apologists are circling the wagons against the ostensibly unsophisticated critics of "QE2," who don't want to take their inflationary medicine. In the present article I'll point out some of the latest (and most amusing) twists and turns in the debate.

Highbrow and Lowbrow Assaults on Bernanke

This open letter to Fed Chair Ben Bernanke in the WSJ has gotten a lot of coverage. Its message is straightforward enough:

We believe the Federal Reserve's large-scale asset purchase plan (so-called "quantitative easing") should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed's objective of promoting employment. …

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

As Jeffrey Tucker noted, the letter is refreshing because it doesn't merely warn of price inflation, but also acknowledges that the Fed's planned $600 billion in new purchases will "distort financial markets." What makes the letter particularly inspiring is that a few respectable economists signed it.

For those who prefer rough-and-tumble critiques, this amusing Xtranormal cartoon (which has a few naughty words) has been making the rounds. Although its author probably doesn't have a PhD in economics from MIT, it hardly matters, because most of its volleys hit their mark.

Fed Apologists Circle the Wagons

Naturally, the proponents of QE2 rushed to its defense. But in many cases, it was a very halfhearted defense. In this respect, my personal favorite was Tyler Cowen's:

I'm not sure it will work, because it won't fix the housing market, may not restore the demands for wealth-elastic goods in a sustainable manner, may not restore the normal flow of credit to small businesses, may not lower subjective estimated risk premia, and may not fix the general disconnect between expectations and reality. The effects on long-term interest rates are murky. …

Still, QEII may do some good. Money matters, even if we don't always understand how or why, and excessively tight money has never done market-oriented economics any favors. Think of QEII as a make-up for some earlier monetary policy mistakes. … QEII is not some terrifying burst of potential hyperinflation. The TIPS market is forecasting in the range of two percent inflation and it's gone up — what — sixty basis points since August? That's hardly the end of the Republic. … I've thought through "trigger models" of rapidly escalating inflation, but they don't scare me much.

Another amusing reaction came from monetary economist Scott Sumner. Recall that President Obama explained away the 2010 elections, not by saying the American people rejected the essence of his agenda, but rather by saying that the silly gooses didn't understand how much he was trying to help them. What we have here, Obama said, was a failure to communicate.

Well, Sumner takes that exact tack in explaining why all the rubes (and lesser economists) are distraught over QE2. Sumner thinks Bernanke suffers from a marketing problem. Instead of calling it "inflation," Bernanke should simply say he's trying to boost income. Then the American people wouldn't fall for foolish animations criticizing the plan.

A Possible Black Swan

Bestselling financial author Nicholas Nassim Taleb — who is familiar with the Hayekian critique of central planning and has written scathing attacks on mathematical economics — as usual offers an interesting perspective on this second burst of inflation. In a sense, Taleb is the anti-Cowen: whereas Cowen effectively said, "Hey, it probably won't work, but we might as well give QE2 a try," Taleb effectively argues, "Hey, it just might blow up the world financial system, so let's not give QE2 a try."

Let me outline a possible scenario in which the current defenders of the Fed would look back and say, "Oops!" Suppose — contrary to Paul Krugman — that price inflation continues to accelerate in the next 12 months. (After all, in the prior 12 months, the Producer Price Index is up 4.3 percent while the Consumer Price Index is up 1.2 percent — hardly the edge of a deflationary cliff.)

As expectations of price inflation rise, the yields on various bonds will begin increasing as well. At some point, some commercial banks will find it more attractive to begin lending out their nearly trillion dollars in excess reserves, rather than keeping them on deposit with the Fed, where they currently earn 0.25 percent.

"It's tough to rule the world, and sometimes the benighted masses get uppity."

At the same time, suppose that the economy is still a wreck. Unemployment is still higher than 8 percent, and the government at all levels is still projected to run massive deficits as far as the eye can see.

Then an offhand remark by a Chinese official is mistranslated. Traders around the world suddenly think that the Chinese are going to begin unloading a large portion of their Treasury holdings. Fearing a crash in the dollar, everyone rushes to dump their Treasuries first — hence leading to a crash in the dollar.

Interest rates on Uncle Sam's debt skyrocket. Rather than yielding 2.85 percent as they currently do, ten-year Treasuries suddenly yield 8 percent — which was the case in the mid-1990s.

At this point, the inflation genie is out of the bottle. The excess reserves begin flying out of the commercial banks. Rather than earning the lower interest rate that Bernanke is paying them, the banks chase higher returns now available even on relatively safe government bonds. Bernanke attempts to staunch the exodus by implementing one of his new "tools," namely by increasing the interest rate paid on excess reserves from 0.25 percent to 5 percent. However, after a few days the market begins to panic once again. It finally dawns on investors — and they all realize that they all realize it — that Bernanke can't really solve the problem of too many excess reserves by causing them to grow exponentially.

Watching the difference between yields on regular versus TIPS bonds, Bernanke and his colleagues realize that the market is forecasting annual rates of price inflation in excess of 10 percent for the next decade. Bernanke decides that he has no choice but to begin unwinding the Fed's massive balance sheet expansion, even though the "recovery" is still fragile and the move will destroy some major banks as well as the real-estate market.

Yet Bernanke must begin selling off the Fed's assets, in order to sop up some of the remaining excess reserves before the commercial banks lend them all out and create a multiple amount of new money. But to his horror, Bernanke soon realizes that, even if he were willing to return the Fed's balance sheet to its 2007 level, it won't be enough to arrest the inflation.

The problem is that Bernanke is sitting on huge piles of US government debt, which have just gotten decimated in the bond market. For example, if Bernanke in 2010 had created $1 billion of new reserves by buying $1 billion in additional Treasury debt, those securities would now be worth (say) only $650 million. So even if Bernanke sells them all back into private hands, he will only be able to eliminate 65 percent of the new reserves he had earlier created. Open market operations will not allow him to drain the system.

Bernanke and his clever colleagues would be able to postpone the crisis a few more months, perhaps even a year, by inventing all sorts of new emergency programs and "tools." For example, the Fed could issue its own debt, and "borrow" the reserves away from the banks for an extended period. But this would just be a variant of the trick of paying interest directly, and wouldn't solve the problem once investors thought through its ramifications.

At this point, the United States would suffer from double-digit stagflation, with worse on the horizon depending on how many excess reserves were still in the system at the point Bernanke (or his successor) finally lost control. Paul Krugman et al. would then declare, "Well how about that, looks like we're no longer in a liquidity trap. The government better jack up tax rates and clamp down some new regulations on the financial sector before the economy overheats."

Conclusion

The world financial system is incredibly complex. As Taleb warns, the policy of quantitative easing is analogous to someone trying to jerk ketchup out of a bottle. The first few attempts, and nothing seems to happen. But then a careless lunge can lead to disaster.

Robert Murphy, an adjunct scholar of the Mises Institute and a faculty member of the Mises University, runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. Send him mail. See Robert P. Murphy's article archives. Comment on the blog.

© 2010 Copyright Robert Murphy - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules