A month before the Quantitative Easing Explained video went viral, many experts were already debating whether a second dose of Quantitative Easing was a good idea. Jeremy Grantham has recently warned about QE collateral damage. Before that, John Hussman argued against QE2 in his October 18, 2010 newsletter. Entitled The Recklessness of Quantitative Easing, the letter makes a compelling case that QE2 won’t work, and that it may very well make things worse.
Hussman’s main argument centres around the economic principle of constrained optimization. That means that removing a barrier will only allow you to move forward if it’s the barrier that was blocking you in the first place. Essentially, he’s saying that the Fed is:
- offering solutions to problems we don’t have
- failing to solve the problems we do have
- creating new problems that we’re not equipped to handle
What Is QE2 Supposed to Accomplish?
According to Hussman, there are 2 main targets for QE:
- Lower Long Term Interest Rates: This is supposed to stimulate loan demand and discourage saving, possibly even driving real rates into negative territory. That’s where interest rates fall below the inflation rate.
- Increase the Supply of Lendable Reserves in the Banking System: The Fed would like banks to lend out more money, with the idea that it will stimulate economic activity.
The hope is that 1 + 2 will equal higher U.S. output (improved economic conditions) and lower unemployment levels. Hussman doesn’t think it will accomplish either.
Dumber Than Your Plumber
In the viral QE video referenced above, one character says that she wouldn’t trust her plumber to run the economy. The other replies: “Although when you call the plumber to fix something that is broken, they usually fix it – not break it more.” His friend replies: “This is true. The plumber is clearly smarter than the Ben Bernank.”
Whether this criticism is fair or not, John Hussman thinks QE2 is a bad idea, and that the Fed should know better. Bearing in mind the QE targets mentioned above, here are a few reasons it won’t work:
- Liquidity Trap: QE2 won’t stimulate loan demand, as rates are already at record lows. Consumers are wisely looking to deleverage, not to take on more debt. Businesses don’t see a need to borrow to invest in their enterprise because they don’t see demand for their products increasing.
- Loan Supply is Not the Problem: There is no question that many banks have solvency issues, but not necessarily liquidity problems. Banks have money to lend. But the corporate sector is hoarding cash for safety, or using it for acquisitions. Acquisitions often lead to consolidation and job losses rather than gains.
- QE1 Didn’t Save the Housing Market and Neither Will QE2: “It was the Fed’s willingness to put the U.S. public on the line for any losses sustained” by Fannie Mae and Freddie Mac that arrested the housing crash. This, coupled with FASB’s suspension of mark to market rules allowed financial institutions to suspend “truthful disclosure.” QE happened around the same time, but had nothing to do with the improvement in the housing market and bank earnings.
So QE is unlikely to help the overall economy or the unemployment picture. Hussman further offers a few reasons why the Fed’s interference may do more harm than good:
- Risks Without Benefits: Having already established that the benefits of QE are questionable at best, Hussman asserts that it presents several serious risks:
- U.S. Dollar Decline: This would raise prices on imported goods for U.S. consumers, and possibly cause major dislocations in the currency markets.
- Destabilization of International Economic Activity: Already we have seen a very rapid rise in commodity prices as well as other countries reacting to protect their own currencies against a very quick rise against the value of the U.S. dollar. Protectionism is gaining momentum across the globe.
- Loss of Confidence: Investors, consumers, and foreign governments could lose confidence in the Fed and in the U.S. government’s ability to manage it’s own finances as well as the global reserve currency if these economic dislocations persist and worsen.
- Boom-Bust Cycle: We have already seen more frequent boom-bust cycles since the Fed, originally under Alan Greenspan, started using lower interest rates to usurp the normal economic cycle.
- Using the Last Bullet: If the Fed jumps in with more liquidity now, what will they do when another true crisis hits and the public needs a jolt of confidence? They might find that no one will believe their methods are effective.
- Commodity Hoarding: Real interest rate reductions result in a lowering of the velocity of commodities. That means that people will start to hoard commodities because they believe that the prices will rise with the Fed’s inflation target.
What’s an Investor to Do?
According to Hussman, investors should reduce risk. “Demand for risky assets has not been driven by the prospects for unusually high returns. Rather, investors fee “forced” to take risk despite elevated valuations, largely thanks to Federal Reserve actions.” Although he sees signs of commodity hoarding and the price appreciation that goes with it, he thinks a lot of that is already priced in.
Hussman also offers some suggestions for policy alternatives that might actually work, including extending unemployment benefits, ensuring multi-year predictability of tax policy, infrastructure spending, and debt restructuring, among others. There is a lot more information in the full article. It’s a little above the layman’s level, but these are issues we all need to understand as they do affect our everyday lives.
What do you think? Is QE necessary or reckless?