Economic Recovery? – Quantitative Easing Examined.

Ben Bernanke will retire from the position of Chairman of the Federal Reserve on January 31st, 2014, after having served 8 years. He was originally nominated by President Bush in 2006, and re-nominated in 2010 by President Obama. Bernanke has presided over the worst economic crisis since the Great Depression, and will likely be remembered most for his use of the “Quantitative Easing” (QE) method to attempt combating the effects of the economic downturn. Establishment Talking Heads swear that QE has been our salvation and is heralding a recovery for the common man; “The Private Sector is doing just fine”, as the illustrious President Obama famously quipped in 2011.

QE may seem complicated, but on-the-whole it is actually somewhat simple. I will explain it simple terms. QE is a process in which the Federal Reserve buys securities from large financial institutions (mostly Wall Street banks), effectively creating the cash to pay for these securities out of thin air. (A Security, for those of you who don’t know, is defined as any tradable asset; common stocks and bonds are examples of securities.) The Federal Reserve is the institution that creates money, so they are allowed to do this. This method has a two-fold purpose: It alleviates financial institutions of bad or “toxic” securities that have lost value and are dangerous to financial health (such as mortgage-backed securities, many of which went “toxic” after the housing crash of 2008), and also to push these institutions out of the markets for “safe” securities (like U.S. treasury securities) and into riskier investments, such as regular stocks or loans to private organizations. This is intended to facilitate optimism in the private sector, encouraging businesses to spend money on expanding operations and making transactions, which is meant to jump-start the economy back into a healthier state. This is why QE is sometimes referred to as “priming the pump.” Businesses are pessimistic about the state of the economy and do not want to make risky investments; QE is supposed to alleviate those fears.

You may have noticed recent headlines proclaiming the Stock Market reaching all time highs, near 16000. To someone who does not know better, they might think this a sign that the economy must be in serious recovery and that most individuals are returning to a state of good financial health. This is not true, unfortunately. We know it is untrue: salaried jobs for degree-holders are still scarce, interest rates on savings accounts and even CDs are pathetically low, household debt levels are at all-time highs in spite of the lack of savings, the number of people applying for welfare benefits increases every year. The Stock Market field days are not indicative of the recovery of the common man. The recent mania seen in the Stock Market is due entirely to the Federal Reserve’s QE program, not a genuine recovery in the financial lives of millions of Americans.

QE is a dream-come-true for large banks and corporations allowed to sell to the Federal Reserve. They get to unload low-value securities in exchange for fresh cash. As you may know, an increase in the money supply produces Inflation, a decrease in the purchasing power of money (PPM); but the financial institutions participating in QE spend this money into the economy before the general market for dollars adjusts itself for inflation and damages the PPM. By the time the new money reaches you and I, its value (and the value of our savings) has been damaged by inflation, which has caught up by that time.

Only Wall Street directly benefits from the QE program. We see the reflection of this in the Stock Market. If Bernanke even HINTS at another possible round of QE, the Stock Markets spike in giddy anticipation. Conversely, whenever a round of QE ends, the Stock Markets correspondingly dip. In September of 2012, Bernanke announced QE Phase 3, which is open-ended; whereas the previous QE programs lasted for a predetermined set of time (usually a few months), QE3 will ostensibly remain ongoing for whatever length of time the reigning Chairman of the Fed deems necessary. In theory, it could go on forever if deemed necessary. This idea pleases large financial institutions.

QE, however, cannot go on forever, lest serious consequences eventually be produced. The most serious potential impact is hyperinflation, when the supply of money becomes so large that each dollar is nearly valueless. Imagine people literally using dollars as toilet paper. Recall that through QE, the Federal Reserve basically creates money out of thin air to buy securities from banks. Since 2008, the QE program has caused the monetary base in America to rise nearly 1700%. Look at the chart. It is astounding.

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If all of this money were to hit the market for actual day-to-day use by individuals, we would face hyperinflation. There is no doubt. However, the banks which receive funds through QE keep most of their newfound cash in care of the Federal Reserve, in what are called “excess reserves” (think of the Federal Reserve as a Banker’s Bank, in this situation). Financial institutions keep this money with the Federal Reserve because they are afraid to loan it out to individuals and small business (and even large businesses, in some situations); further complicating the situation is the current unwillingness of businesses and individuals to take out loans and thereby take on more debt. They are both pessimistic about the economy and the ability of the debtors to pay back the loans. They are afraid of losing significant amounts of money. Furthermore, the Federal Reserve offers an interest rate on “excess reserves”, a figure near 0.25%. It is not a high rate of return, but it is technically 100% secure. Banks are OK with this low interest rate on-the-whole in return for the security offered by the Federal Reserve. Interest rates on the private market are currently not very competitive anyway, for the amount of risk they carry. The Federal Reserve offers this interest rate namely to stave off the impact listed above, hyperinflation (or at least severe inflation), by encouraging banks to keep excess reserves away from the market. To make a long story short, I do not think hyperinflation will occur in America. Hyperinflation would destroy the banks along with the entire financial system; there is no logical reason they would commit suicide this way. Nevertheless, severe inflation is a distinct possibility, should the banks begin releasing these funds on a large scale. QE enables this scenario.

You may have noticed something strange within my explanation: The Federal Reserve wants banks to loan these funds to businesses and the general public in order to stir the economic pot… but at the same time, they encourage banks to withhold funds from the public in “excess reserves”? The official explanation put forth by Bernanke is that when the Federal Reserve determines that the market is healthy enough to stand on its own once again, they will cease QE and begin selling securities back to private banks to soak-up excess reserves. Basically, they are toeing the line. The problem is that many of the securities now held by the Federal Reserve have lost a great deal of value that is not likely to come back. If the Federal Reserve decides to start selling off securities, some estimates predict that the Federal Reserve can only retrieve about 60% of excess reserves in this case. Furthermore, selling off these securities (mainly treasury securities and debt from the housing market) would cause interest rates to spike throughout the financial and real estate markets; as more assets are available, thereby reducing their individual value, people would demand higher interest rates in order to preserve some kind of value. Interest rates are currently kept extremely low due to the high volume of purchases by the Fed, but should they rise by any significant level, we would likely witness the crash of 2008 repeated all over again. The Federal Reserve, by aiding a rise in interest rates, would be undoing all it has done over the past 4 years.

Often speculated on is the Federal Reserve’s “exit strategy”; how the Fed will exit these securities markets without causing a major recession and/or inflationary spiral. Bernanke has hinted within the past few days that the Federal Reserve will begin to taper its purchases within the next few months. On the other hand, Bernanke has explicitly stated that the Federal Reserve will not begin their exit unless one of two conditions becomes true: unemployment reaches 6.5%, or prices inflate by more than 2% per year. Neither of these conditions is true. Unemployment is currently 7.6%; to think that it will fall by a full percentage point anytime soon seems wildly optimistic and unrealistic. Large banks continue to rely on the Federal Reserve to stay profitable and afloat. If the Fed ceases to pick up “toxic” assets from large banks, many will go bust the way they naturally would have gone bust in 2008 had the Federal Reserve not bailed them out. They rely on the Federal Reserve. Homeowners rely on the Federal Reserve to drive prices up through the purchases of bonds from Fannie Mae and Freddie Mac. This is a repeat of the conditions that drove the 2000s housing bubble. I do not think another bubble is necessarily growing as the previously insatiable demand is not there, but the prices are being kept artificially high nonetheless.

My point to all of the rambling is this: There is no exit strategy. There never has been. All talk of “exit strategies” in the media, all the hot air blown over what people think Bernanke will do, all of the speculation on tapering here or tapering there; it is all an exercise in silliness. The term “exit strategy” implies that the Federal Reserve will ride off into the sunset on its monetary horse as the economy returns to a comfortable normality, while the townspeople wave goodbye to their selfless and brave hero. This is a hallucination. The only “exit strategy” Bernanke refers to is his own exit on Jan. 31st, 2014. He will retire with accolades and establishment talking heads will sing his praises for seeing the economy through these turbulent times. Some other poor sucker will eventually take the blame for the resulting negative impacts when the Fed finally exits. The Federal Reserve has no exit strategy. They can exit, but there will be no “strategy” to it.

The Federal Reserve has created an unsound foundation for the post-2008 financial world. Investors throughout the financial system continue to make decisions and allocate resources based on the expectation that the Federal Reserve will continue to bail out large banks and provide regular cash infusions. This is a form of unorthodox Centralized Planning in the financial sector. It is not explicitly centralized, but because so many investors and organizations rely on and take cues from the Federal Reserve, the current financial sector suffers from the unfortunate side effect of centralized planning: misallocation of resources. It is happening. Quantitative Easing is allowing inefficient investors and financial institutions to stay afloat in spite of their inefficacies. They are being fed at the trough by QE and the Federal Reserve. QE cannot continue forever; when it ends, the Business Cycle will rear its ugly head. It is the process by which the Free Market sheds inefficient investors and businesses kept afloat by unnatural (typically governmental) economic boom conditions.

Quantitative Easing may seem to have helped the common man in the short-term, in the sense that the financial system did not go belly up in 2008; but the can has merely been kicked down the road. The consequences of the pre-2008 financial silliness on the part of the Federal Reserve and large banks are still waiting for us just outside the door. QE is only delaying the inevitable, and is acting as an escape route for bankers, bureaucrats, and politicians to “get out” while they still can.

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