Bernanke Blows Bubble

Bernanke Blows Bubble

Check out the following commentary by Economics Finance blog contributor Alex Knapp.

QE2 or not to QE2, that is the question. Ben Bernanke and the Federal Reserve have been strongly hinting at the fact that they are planning on more quantitative easing, which has widely been referred to as QE2. Because of the economy’s recent sluggish growth, people are pressing the Fed to act to spur a more rapid recovery. There are a few questions, however, that need to be asked when considering this request; 1. After a period where we went through the worst recession since the Great Depression followed by a robust growth V-Shaped bounce, is continued double digit growth even possible, 2. Is it even in the Fed’s mandate to do such things, 3. Does the Fed have the tools to create more growth based on current conditions, and 4. What are the consequences of implementing policies that could lead to higher growth. In the following article I will try to address these questions to give the reader a better understanding of what this “QE2” talk really means.

When looking at what we have gone through in the past few years we need to realize that we are in the recovery phase. The recession officially ended in June of 2009, which means that we have been in recovery for almost a year and a half now. Usually immediately following recessions there is a large spike in growth, which creates the V-Shape recovery you hear about. What you do not hear about is that after that initial spike things tend to level off, as those high double digit growth rates cannot be sustained. Currently, the economy is expanding not shrinking. Although it is not sustaining the 30-50% rates we have seen recently we are continuing to grow.

The second question raises the point as to whether or not Bernanke and the Fed should even be in charge of tackling this issue in the first place. If you look at the original mandate of the Fed, their objective is to stabilize the currency and to curtail inflation to between 1 and 2 percent. Based on what Bernanke has said in his recent public statements, you would never be able to imagine that considering he has said, “Inflation is way too low”. If Benjamin Strong heard a Fed Chairman say he wanted higher inflation he would roll over in his grave. The fact that the Fed is going directly against its mandate of stabilizing the currency by purposefully devaluing it is a scary thought. Their rationale is that if we can devalue our currency we will be able to export our way to growth. The problem with that thought is that countries like Germany and Japan, with the some of the highest currency values in the world, are also leading world exporters.

New quantitative easing will add more liquidity to a market that has the most liquidity in its history. Banks have more in their reserves than ever, companies are sitting with more cash on their balance sheets than ever, interest rates are near zero, and consumers are continuing to increase their savings rates. Lack of liquidity is not a problem our economy is facing today. Injecting more liquidity, most likely created by monetarizing our debt, which is the process in which the Fed will buy up treasuries and issue currency backed by those treasuries, will only increase inflationary pressures. These inflationary pressures will in turn devalue the debt they are issued against, creating even more inflation. So my advice would be for Bernanke and the Fed to go back and revisit their original mandate and see if QE2 is still such a good idea.

The third question asks, even if the Fed did decide to try to tackle this mission of being a “growth creator”, which it looks like they will, do they even have the ability to do so? The reason that this new initiative is being called QE”2”, is because we have already had QE1. The fact that QE1 saved us from a depression, which most people will agree it did, is a great thing. When we look at it as a means of recovery, it does not bode quite as well. The fact that the government has spent the most amount of money as a percent of GDP in its history and we are not seeing these sustained double digit growth rates - which I still believe is normal and should be expected - should show us that the problems we are facing are not monetary. Our economy is made up by 70% domestic consumption, and when 10% of those consumers are unemployed that is clearly going to adversely affect the economy. You cannot fix unemployment with monetary policy. The fact is that we are in a recovery and things are getting better, but in a recovery employment is always the last thing to bounce back.

In September, we saw one of the largest amounts of mergers and acquisitions in a single month in the market’s history. This shows you that companies are staring to spend that cash they have been sitting on. Along with M&A, companies are staring to spend on CAPEX (Capital Expenditures), which will eventually lead to hiring employees to work on those CAPEX projects. Rates are already near 0%, companies have more cash as a percentage of their balance sheets than in recent history, adding more liquidity won’t create more jobs. We have to realize that employment bounces back last in a recovery and that monetary policy can’t speed up that process.

I tried to answer the last question within each of the others, showing that there are policy measures that can be taken to “fix” one aspect of the economy, but that they will also adversely affect others.

I do not envy Mr. Bernanke or the other members of the Fed, as they have a pretty complicated puzzle to solve, but I do believe that sometimes the best action you can take is the one you don’t.