4-Nov-10 News -- Fed announces $600 billion quantitative easing - 4-Nov-2010 - Generational Dynamics

I apologize for the lateness of this posting. I had hoped to get it posted much earlier, but life intervened.

Federal Reserve will purchase $600 billion in bonds for quantitative easing

In a widely anticipated announcement, America's central bank, the Federal Reserve, will purchase &600 billion in Treasury bonds, in effect "printing" $600 billion of new money liquidity and pouring it into the global financial system. The rate of purchase will be $75 billion per month, according to Bloomberg, and will continue through June of next year.

The move is extremely controversial. Proponents argue that it's necessary because the economy has not been growing as expected, and the additional liquidity is required so that banks will lend money to businesses that will use it to create jobs.

Opponents argue that the previous $1.5 trillion in quantitative easing does not appear to have created jobs, and that the new round will cause inflation instead of jobs.

Long-time readers of this web site will not be surprised that I believe that neither of these effects will occur, and the $600 billion in quantitative easing will have no effect on jobs or inflation, though it will create or expand asset bubbles. I'll come back to these points later.

But first I'd like to address an essay published in Thursday's Washington Post by Ben Bernanke, chairman of the Federal Reserve, explaining and defending the action.

First, I have to point out that I've been bitterly critical of Bernanke, starting in September 2004, in "Bernanke / Federal Reserve congratulates itself on jawboning policy." In that article, I criticized Bernanke for believing that the Fed could control long-term interest rates by making the appropriate statements to the press. I couldn't believe that Bernanke could possibly believe what he was saying, but indeed he did.

I also wrote, "Ben S. Bernanke: The man without agony" contrasting Bernanke's fully confident beliefs to those of his predecessor, Alan Greenspan, who clearly was beginning to believe that a new Great Depression would NOT be avoided.

So it's worth pointing out that Bernanke has been wrong time after time. He said that the subprime crisis would be "contained," and it wasn't. He said repeatedly that the recession would end and the economy would grow, and usually it didn't. He talked about "green shoots" when there weren't any.

Bernanke is considered a world expert on the 1930s Great Depression. Many times he has stated his firm belief that the Great Depression could have been avoided completely if only the Fed had lowered interest rates by a small amount. He applied his own advice to the American economy, starting in 2007, as I wrote in "Bernanke's historic experiment takes center stage."

So now, three years later, the Fed has lowered interest rates effectively to zero, and has also poured trillions of dollars into the economy, and his predictions about the effects of these policies have turned out to be completely wrong.

Having said all that, I've also said that I have a great deal of respect for Bernanke as a man, because he is apparently an honest, decent man who says what he believes without spinning it. In that he's contrasted to most people in Washington and Wall Street, who just scream "sleaze" whenever they open their mouths.

Bernanke's essay first defends the previous quantitative easing actions essentially by saying that things would have been much worse without them. He goes on:

"Notwithstanding the progress that has been made, when the Fed's monetary policymaking committee - the Federal Open Market Committee (FOMC) - met this week to review the economic situation, we could hardly be satisfied. The Federal Reserve's objectives - its dual mandate, set by Congress - are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.

[[Above, he lists the reasons why the economy is bad. Next, he says that inflation risk is minimal, and that deflation is a significant risk.]]

Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy - especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.

Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

He says, "This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action."

This gets back to my original criticism of Bernanke -- that he seems to believe that the economy depends on jawboning or other ephemeral factors. He appears to have no grasp of the underlying factors that drive the economy.

The rest of the paragraph contains vague promises about what might come of quantitative easing. Notice that the word "jobs" does not appear. If Bernanke believed that what he's doing would create jobs, he'd say so, but he doesn't.

What he does say is that stocks will go up, and that may well be the principal effect of quantitative easing. All of this money has to go somewhere, and all the "safe" investments (U.S. Treasuries) are being sucked up by the Fed itself, so this money will flow into more risky assets, including the stock market.

Expanding asset bubbles

This is a very risky strategy, because it makes the stock market bubble bigger, and risks bigger pain when the bubble bursts.

Although American investors consider all this to be "good news," not all foreign investors feel the same way. A good example is Hong Kong, which is in a huge real estate bubble, after home prices rose 50% during the last 20 months, according to Bloomberg. Hong Kong officials fear that a lot of Fed's QE money is going to pour into the local real estate market, pushing home prices up even higher.

That illustrates the problem. The QE money isn't going into people's salaries, which would cause inflation. Nor is it being invested in small businesses. Instead, it's simply pouring into increasingly risky asset bubbles, here and around the world. These include various real estate bubbles, stock market bubbles, and commodity bubbles.

The unanswered arguments

I've been writing about this subject since 2002, which is the first time that I said that we're headed for a new 1930s style Great Depression. This was based on historical analysis, that the stock market was overpriced by a factor of about 200%, and had been overpriced since 1995. (See "Updating the 'real value' of the stock market.")

Today, the stock market is still overpriced by a factor of close to 200%, and has been almost continuoously since 1995. Price/earnings ratios have been continuously well above average since 1995. By the Law of Mean Reversion, stock prices must fall below Dow 3000, and remain there for a long time.

Now, I didn't make up the Law of Mean Reversion. Furthermore, it isn't rocket science. It simply says that the average in the future should equal the average in the past. When applied to price/earnings ratios, it means that values should fall from their current levels, close to 20, to about 5, as they were in the 1980s.

Since I started writing about this subject 8 years ago, I've read tens of thousands, perhaps hundreds of thousands of articles on finance. I've see articles on just about every screwy financial measure you can imagine.

But I have never seen a single article addressing the Law of Mean Reversion, or the fact that common sense tells you that price/earnings ratios are sure to return to 1980s levels at some point.

People ask me how I can be so certain that I'm right, and here you can see the reason. The arguments about P/E ratios are not strange or exotic or overly complex. They're very simple, based on common sense and Economics 1.01.

If I were wrong, then somebody would have explained why by now. Somebody would have explained why P/E ratios will never again return to 1980 levels, or why the Law of Mean Reversion is suddenly wrong, for the first time in history.

And now we have a new quantitative easing program that apparently is specifically targeted at expanding the stock market bubble and other asset bubbles. This approach has succeeded for last couple of years -- and frankly has succeeded much better than I ever expected.

But that can't go on forever. There's another law of Economics 1.01 that I like to mention: The Law of Diminishing Returns. In 2007, all Bernanke had to do was lower interest rates by .5%, and that was enough to push the stock market up. Today he has to promise $600 billion in QE. Each new monetary program has to be significantly bigger than the last one in order to get the same effect.

So the Fed is plowing ahead, ignoring the realities of Economics 1.01 by creating more and larger imbalances. One day soon, the price will have to be paid, and the price will be far higher than it would have been without all of these monetary experiments.

Here's one thing that you can be absolutely sure of: Ben Bernanke knows what the Law of Mean Reversion is, and understands its consequences. He's probably taught about it dozens of times as a Professor of Economics at Princeton. But he certainly never addresses it, which perhaps means that he's just putting out spin, which would make him the same as other Washington politicians after all.

Other unanswered arguments

The simple Economics 1.01 arguments outlined above are never dealt with, so it's not surprising that the more complex arguments that I've raised are never dealt with either.

One issue that I've discussed many times and that is rarely addressed in the financial press is that there are hundreds of trillions of dollars of synthetic assets in portfolios around the world. This is not a figure I made up, or that I dreamed about one night. This is a figure that the Bank of International Settlements reports on a regular basis. These include several tens of trillions of dollars in collateralized debt obligations (CDOs) and credit default swaps (CDSs), as well as several hundred trillion in interest rate swaps and other synthetic securities.

When these are discussed in the financial press, it's always with the tone that these are perfectly safe, and that there's no chance of a chain reaction of bankruptcies that would crash the global financial system.

But even if you believe that, it's still true that all of these portfolios are being "deleveraged," meaning that these hundreds of trillions of dollars of synthetic securities are being dissolved. Every time just 1% of these synthetic securities are dissolved, that reduces the amount of money in the world by several trillion dollars.

So a QE program of $600 billion cannot possibly compensate for that much deleveraging.

The generational argument

Bernanke's essay says that deflation is a greater risk than inflation. He points out that previous QE programs have not resulted in inflation, and that this one wouldn't either:

He's undoubtedly right. But the argument that I always hear -- and that I've heard on tv several times in the last couple of days -- is that inflation occurred in the 1970s, and therefore will occur again in the near future. But that ignores the fact that if inflation were going to occur, then it should have occurred already.

I've been writing since 2003 that we're in a deflationary spiral, and that I expect the CPI to fall by 30%. I've pointed out that interest rates have been extremely low for most of the decade, and that if inflation were to occur, then it would have occurred already.

The 1970s argument brings us to the generational analysis. As I've said many times, economists cannot explain why the tech bubble began in 1995 -- why it began at all, and why it didn't begin in 1985 or 2005 instead. The reason is actually perfectly obvious -- because the 1990s decade was the time when the risk-averse survivors of the 1929 crash and the Great Depression all disappeared (retired or died), and were replaced by risk-ignorant Boomers in top management positions.

This explanation is incredibly obvious, just as obvious as the fact that P/E ratios will have to return to 1980s levels. But economists and journalists seem to have some mental incapacity that doesn't let them grasp the simple concept that the Great Depression survivors all retired in the 1990s.

In the 1970s, all the new businesses that had been created in the 1930s were reaching their peak of entrepreneural creativity and productivity, and were competing for the best people by paying higher salaries. I personally recall a friend who left the company I was working for (Digital Equipment Corp.) for a job at another company, then moved to a third company, then finally came back to DEC. In the space of a year, she had come back to the same job with roughly a 50% increase in salary.

Nobody in his right mind believes that anything like that could ever happen today. By the 1980s, the Generation-Xers were entering the marketplace, with a sense of entitlement that led them to claim that they should be able to have anything they wanted without having to work for it. Today, the businesses that were thriving in the 1970s are old and stale. In America, we particularly see this sense of entitlement today in labor unions. Perhaps the worst case of all is the public sector unions in France, calling nationwide strikes to try to stop a pension reform that would raise the retirement age from 60 to 62.

Today, the whole work ethic has changed from the 1970s. As we've illustrated many times, especially in the financial community, and among politicians and journalists, instead of working harder, people are willing to screw other people for their own gain.

That's why what you hear on CNBC and Bloomberg TV these days is so absurd. You hear that if the Fed does something, or if Congress passes such and such a law, or if President Obama gives such and such a speech, then investors will be "reassured" and they'll develop anew an "appetite for risk."

I hear this all the time, and it always makes me want to vomit. The current Generation-X and Boomer investors who were formerly so risk-ignorant have now become extremely risk averse, and will remain so for the rest of their lives.

To quote a cautionary tale that I heard decades ago: If a cat jumps onto a hot stove and gets burned, then he'll never jump onto a hot stove again. But he'll never jump onto a cold stove either.

That's what happened to today's investors. They're deleveraging like mad, and have no intention of investing their own money in new factories or new employees. The only ones who are investing are those who stand to make fat commissions by investing other people's money.

Predictions of inflation and hyperinflation are part of the same fabric of deception that causes analysts to lie about price/earnings ratios. If hyperinflation were to occur, then the stock market and commodities bubbles might be justified. But the reality is that we're headed for deflation, and Ben Bernanke realizes that as well.

Thus, the new round of QE will not create jobs, and will not create inflation. It will continue to create new imbalances that will worsen the global financial crisis when it finally arrives.

Generational Dynamics Web Log for 4-Nov-2010
4-Nov-10 News -- Fed announces $600 billion quantitative easing

Federal Reserve will purchase $600 billion in bonds for quantitative easing

Expanding asset bubbles

The unanswered arguments

Other unanswered arguments

The generational argument

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Generational Dynamics Web Log for 4-Nov-2010 4-Nov-10 News -- Fed announces $600 billion quantitative easing

Federal Reserve will purchase $600 billion in bonds for quantitative easing

Expanding asset bubbles

The unanswered arguments

Other unanswered arguments

The generational argument

Web Log Pages

Generational Dynamics Web Log for 4-Nov-2010
4-Nov-10 News -- Fed announces $600 billion quantitative easing