Monty Pelerin blogs at http://www.economicnoise/
November 09, 2010
The day after the election, the Federal Reserve launched QE2, the second round of Quantitative Easing. This public relations euphemism attempts to hide the fact that the Fed is "printing money" (the Fed actually does it electronically these days). "Cheating, debasing and inflating," as in stealing from the public, is a more accurate description.
Bernanke indicated from 600 to 850 billion additional dollars would be created. To put this in perspective, the Tarp package was in this range. The total Federal Reserve balance sheet was $829 billion at the end of 2004 and only $869 billion in August 2007. At the end of 2009 it had ballooned to over $2,200 billion. This announcement means it is headed to $3,000 billion (3 trillion).
Ben Bernanke weakly defended his action with the following justifications:
•... further support to the economy is needed
•Easier financial conditions will promote economic growth.
•higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.
The first two statements are true as stated, but unlikely to be affected by additional QE. The third is partially true, although it is unclear that his action will raise stock prices. Furthermore, empirical data is not supportive of the alleged relationship between stock prices and spending (see the Kass reference below).
Many economists and analysts believe that the Fed actions will not help. Several believe they will actually make conditions worse (two examples are Doug Kass and Pimco's El Erian).
The Real Reason for QE2
Mr. Bernanke's justification for committing nearly another trillion dollars does not meet the "smell" test. In prior life, Professor Bernanke would flunk an Econ 101 student for such weak justification (of course we know no one really gets an F at Princeton, no matter how deserved).
Mr. Bernanke's performance was a charade meant to hide the fact that the government is now illiquid! Mr. Bernanke instituted QE2 because the Federal Government has reached the point where it cannot pay its bills.
If the Fed does not buy government bonds (print money), checks will stop for programs like Social Security, Medicare and Medicaid reimbursements, military pay, etc.
The Madoff Model of government just ended. There are no longer enough bond buyers or taxpayers to pay for the profligate spending of the US government.
For more than a decade, responsible economists and analysts warned how this situation had to end. That point has apparently just been reached as a result of some of these reasons:
•We are increasingly viewed overseas as a profligate, fiscally irresponsible country with no willingness to change.
•Our debt levels have become dangerously high, raising the probability of sovereign default.
•Our annual deficit is 3 to 4 times larger than ever before and looks like there is no political will to address it. Interest rates are too low to compensate for the perceived risk.
•Foreign countries that supported us are now either unwilling or unable to purchase our debt.
The root cause of the liquidity problem is insolvency. Insolvency is a condition where eventually obligations cannot be met. Illiquidity then results. QE2 provides liquidity, but does nothing to solve the insolvency issue.
Unless the insolvency problem is solved, illiquidity will continue. From a mathematical standpoint, it is possible to solve the insolvency problem. From a practical or political standpoint, it is likely impossible.
Our funded Federal Debt is almost 100% of GDP. Our unfunded social obligations are about another $100 trillion. The total net worth of the country is about $55 trillion. Government has promised benefits that are twice what everything in the country is worth. To understand the math, see Spiraling to Bankruptcy.
Laurence Kotlikoff referred to a recent International Monetary Fund assessment of the US financial condition:
... the IMF has effectively pronounced the U.S. bankrupt. Section 6 of the July 2010 Selected Issues Paper says: "The U.S. fiscal gap associated with today's federal fiscal policy is huge for plausible discount rates." It adds that "closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP."
The government would have to double every tax it collects (including payroll taxes) to run 5% surpluses for decades in order to bring government obligations into manageable range. Such tax increases would plunge the US and probably the world into an economic Dark Ages.
Alternatively, current government spending could be cut by about 50%. Managing spending forward so that a 5% surplus was maintained would also work.
Bernanke's Morton's Fork
Mr. Bernanke was faced with two choices, neither of which were good. He could have refused to initiate another round of QE, which would have forced the government to make tough decisions. Such action might have put the economy into another Great Depression. He likely would have lost his job and been blamed for any economic difficulties that followed.
He chose the other option -- provide the needed funds. As such, he chose to be the Enabler-in-Chief, reinforcing the out-of-control government fiscal policies. This choice likely enabled him to keep his job (for the time being) and made him appear to be the White Knight responsive to economic needs.
Unfortunately for the country, his choice makes matters worse, much worse.
The Road Ahead
With QE2, the government will be able to pay its bills. If the shortfall were temporary, Bernanke's actions might be considered prudent. Of course if the shortfall were temporary, the government would be able to borrow in the marketplace.
Without a solution to spending excesses and social commitments that cannot be met, there is no end to our shortfalls. Welcome to QE2, soon to be followed by QE3, QE4 ... and hyperinflation.
QE2 is just another step toward "banana republic" status. We are on the same road travelled by Argentina, Brazil, Zimbabwe, Weimar Germany and many others who destroyed their currencies.
These countries did not intend that result. Each step was justified based on the expediency of keeping the government going. As Hayek pointed out:
I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.
In every case, including our own, the government had already failed. Its attempt to survive made matters much worse for its citizens.
QE2 may only represent the first step, but its effects alone are apt to be profound. Pimco's Bill Gross anticipates it will produce a 20% decline in the value of the dollar. If you were China or Japan, would you want to buy Treasury Bonds? Would you continue to hold dollar-denominated assets? These types of considerations trigger currency runs.
Mr. Bernanke has deferred the day of reckoning. His action will not prevent government collapse, it will ensure it, along with collapses in the currency, economy and likely society itself. This little man, unelected and accountable to no one, has just sentenced the country to an Economic Apocalypse.
Milton Friedman's concern seems especially appropriate:
The power to determine the quantity of money... is too important, too pervasive, to be exercised by a few people, however public-spirited, if there is any feasible alternative. There is no need for such arbitrary power... Any system which gives so much power and so much discretion to a few men, [so] that mistakes - excusable or not - can have such far reaching effects, is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic - this is the key political argument against an independent central bank.
How Will This End?
There is no pleasant ending. Political activity over the past fifty years guaranteed that. As Ludwig von Mises observed:
Credit expansion can bring about a temporary boom. But such a fictitious prosperity must end in a general depression of trade, a slump.
The best solution is for Mr. Bernanke to cease and desist from his QE policy. That would require the political class to face up to its problems. It would require a massive roll-back of the welfare state and government. It would require resizing government to a level that productive citizens would support. Transitional hardships would occur, including civil unrest and possibly a Depression.
The worst solution is the one that Mr. Bernanke has selected. If he stays on this course, fiat money will become worthless. So will Social Security checks, because they will have no purchasing power. All fixed income and savings will be wiped out. The middle class will be financially destroyed.
Markets will cease to function except on a barter system. Food and other necessities will be in short supply, possibly to the extent of health risks developing. Unimaginable civil unrest is likely.
A Greater Depression is assured. Unlike the first Great Depression, citizens would be without any financial wherewithal. Their savings and fixed income will have been stolen from them via hyperinflation. In short, it would be the worst Economic Hell imaginable.
Mr. Bernanke was unwilling to tell you what is happening. His action has moved us into the eye of a massive storm. Do not be lulled into complacency for as von Mises stated:
A fiat-money inflation can be carried on only as long as the masses do not become aware of the fact that the government is committed to such a policy.
Now you know and others will pick up on this quickly. Make like the political elite and protect yourselves from the Level Six economic hurricane that Mr. Bernanke is stoking.
The history of government management of money has, except for a few short happy periods, been one of incessant fraud and deception.