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Monday, October 25, 2010

Some thoughts on QE

constitutionorslavery and DennisP had some very interesting questions and comments on Quantitative Easing in my last post. My response turned more into a separate post.

This is not a comprehensive list, but rather just some thoughts off the top of my head. I explored some of these topics in more detail here a few months ago: The Matter of Deficits, Sovereign Default, and Modern Monetary Theory. Also many of these ideas come from the Pragmatic Capitalist who I am convinced has been right on most of these issues for awhile now.

Quantitative Easing is an asset swap. At the end of the day, it is nothing more fancy than that.

It is not 'money printing' in how most people think of it. What the Fed and the Treasury are doing with QE is swapping interest bearing assets (Longer term Treasuries) for non-interest bearing assets (Cash or Cash equivalents).

Why are they doing this?

Under the assumption (which I believe is erroneous) that more cash (i.e. more liquidity) will get lending and borrowing going again.

But that is not the issue at all. There is already tons of reserves at banks. There is already tons of liquidity in the system. Borrowers (you know, everyday people that have been forgotten in this whole debacle) are not borrowing. Does the Fed really think that if mortgage rate drop from 4.25% to 4.00% or even 3.00% that will prop up the housing market? No. Borrowers are already over-extended. They do not want, nor need, to take on more debt even at historically cheap rates.

This is why TPC calls QE "stocking the shelves". Let's say you go to a grocery store, and nobody is buying apples. There is already a huge display of apples and nobody is buying. The manager says "let's make it a wall of apples instead of just a display!". Does the increase in the volume of apples for sale actually sell more apples? The answer is intuitively no. If nobody was buying apples before, why would more apples for sale entice them to buy?

Same is true with borrowing. If there is little lending and borrowing activity at historically low rates, why would an increase in reserves change that?

Because it won't.

QE is not inflationary. QE is not money printing.

But! (you say), the first round of QE caused a huge stock market rally!

.... uhhhh, sort of. But not for the reasons why QE proponents say that QE II will spark a similar rally.

2008 was a deleveraging and liquidity crisis. In this case the financial system was seizing up. There were no apples for sale to use the analogy above. But the Fed established absolutely gargantuan Dollar Swap lines and liquified the system to stop the freefall.

This is why QE 'worked' (used loosely) at the beginning of 2009.

And this is precisely why it will 'not work' now. Because there is no longer a liquidity crisis. There is more liquidity than is needed, and so adding more liquidity will not change anything.

There is no borrowing or confidence on the side of Main Street. And until Main Street fixes its collective balance sheet (which will take years), there is no sustainable recovery IMO.
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