Quantitative Easing Part Deux

The chatter of imminent QE2 is getting louder by the day (here, here), as the economy shows more signs of slowdown (to put it mildly). The ECRI's Weekly Leading Indicator is perilously close to -10%, which may indicate the double-dip recession in about 13 weeks. (Never mind that the economy in many parts of the country didn't even recover in the first place.)

The last time around, the Federal Reserve did the quantitative easing by buying up Treasury notes and bonds, MBS, and agency bonds from the banks; in return, the banks simply parked the proceeds at the Fed, as excess reserves. Precious little money flowed into the real economy aka Main Street. Big banks thrived, with cleaner balance sheet and virtually free money from the Fed to invest and trade. When they invested, they invested in the safest debtor - the US government - by buying Treasuries. (Never mind that we the 'small people' end up paying those interests to the banks. We are the perpetual money making machine for the banks.)

So this time around, what would the Fed buy, and how, if it actually is to attempt to "revive" the flagging economy?

Doing what it did the first time but doing it in a larger scale ($4 trillion instead of $2 trillion, for example) wouldn't likely produce a different result. Banks would probably continue to hold the proceeds as excess reserves, and would not lend. Instead of $2 trillion balance sheet, the Fed would have $4, 5 trillion balance sheet, and nothing else would change.

It's not the amount of money for QE2; it's how it is done that will have consequences.

If the Federal Reserve decides to do the Quantitative Easing part two (or the Obama administration decides for the Fed), the administration may insist that the QE2 operation benefit Main Street this time. (Never mind how the cheapened dollar with less purchase power is supposed to benefit Main Street. The people in this administration, like the ones before, are ignorant of economics.)

So what choices does the Federal Reserve have, in terms of what else to buy and how to buy?

1. The Fed buys Treasuries directly from the government (monetization), and the government spends the money.

2. The Fed buys real assets from non-bank businesses, even from individuals. It already owns an empty shopping mall and an oil rig, via Bear Stearns.

3. The Fed buys sovereign debt from troubled European countries, prints and ships US dollars to these countries. Part of it will come back to the US as these countries pay interest to the existing debt holders (Wall Street banks), part of it will be spent by their governments, perhaps artificially reviving their economies so they are more inclined to buy stuff, hopefully from the US. In a very roundabout way, the money will flow to the real economy in the US. Sovereign debt from PIIGS will be part of "assets" that backs the US dollar.

The Fed may refuse to do QE2 at all, of course, and the economy may not tank without QE2. But the perceived reality is what counts these days, and that reality is that unless the Fed does QE2 it is going to be a deflationary depression right here, right now.

As a self-proclaimed expert on the first Great Depression, Bernanke cannot risk that perception to tarnish his reputation (if he thinks he still has it), can he?

There is a way to force money into Main Street right now, without QE2. Dr. Gary North has been saying this for some time. It is to force excess reserves out of the Fed's balance sheet by charging fees on the reserves instead of paying interest as the Fed currently does, so that banks move the money out of the Fed and invest in "riskier" investments.

Banks will likely opt for investing in the Treasuries, at least initially, instead of businesses that creates capital and jobs. Once the government gets that money, unlike businesses (including banks) and consumers, it has no problem spending all and more. However inefficiently, the money will flow to the real economy.

The problem is that we do not have a free market any more, which efficiently prices the values of money, capital, labor, assets, and liabilities. The money thus unleashed into the real economy will be mispriced and misallocated. Now that the financial "reform" bill has passed the Congress, the control of money flow will be handled by a committee of politicians and the administration officials supported by technocrats. I thought that kind of experiment died with the Soviet Union.

I don't see a way out.

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