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Most market participants are fixated with the potential for QE2 to boost asset prices and generate organic economic growth, however, without a subsequent rise in aggregate demand and productivity the program will ultimately be deemed a failure as prices readjust over time to reflect the real underlying fundamentals. Mr. Bernanke is making the same blunder that we made with the past bubbles busts – if we can create paper profits and convince consumers that they should spend those paper profits then we’ll be on our way to economic prosperity. The problems arise when asset prices readjust lower to meet their true fundamentals. It’s ponzi finance and nothing more.

As I have previously explained, the goal of QE is to increase aggregate demand by creating a fictitious wealth effect and by increasing bank loans. The market appears to think that QE1 was some sort of success, but as I have argued, QE1 was only successful because it altered bank balance sheets and alleviated the credit strains. After all, this was Ben Bernanke’s goal at the time – to alleviate the credit pressures. What QE1 did not do (and what we need now) is increase lending supported by a boost in real aggregate demand. QE does not add net new financial assets to the private sector and is not inherently inflationary though Mr. Bernanke appears to be convinced otherwise.

Unfortunately, QE1 failed to succeed in contributing substantially to the economic recovery as Northern Trust recently showed:

When the Fed embarks on QE2, all else the same, Federal Reserve Bank credit will increase. What transpires with respect to commercial bank credit will determine the effectiveness of QE2 in increasing aggregate demand for U.S. goods and services. The more commercial bank credit increases in tandem with Federal Reserve Bank credit, the more effective will be QE2 in creating aggregate demand. If, however, commercial bank credit should decrease by the same or greater amount of the increase in Federal Reserve Bank credit, then QE2 will be a failure in creating additional aggregate demand. This is what happened when QE1 “set sail.” Chart 3 shows the behavior of the sum of Federal Reserve and commercial bank credit. The shaded area in Chart 3 represents the period in which QE1 was in effect. As can be seen in Chart 3, during the “voyage” of QE1, the sum of Federal Reserve and commercial bank credit trended lower. Chart 4 shows how this came about (no sailing pun intended). A small increase in Federal Reserve Bank credit in the 16 months ended March 2010 was offset by larger decrease in commercial bank credit during the same period.

QE1 failed to boost bank lending and aggregate demand. Therefore, why would anyone assume that this time will be different? I think the market is pricing in an economic outcome that will fail to materialize.

Source: Northern Trust

Source: Northern Trust: QE1 Failed; Why Will QE2 Work?