Four Reasons Why QE2 Will Hurt You, And Help the Government

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by: Generation Consulting

I remember I once heard a joke about the Financial Crisis of 2008 that went something like this:

Out of all the complex Franken-Financial monstrosities created during the boom and bust, the CDOs, CDO^2, CDO^4, CDS, MBS and the lot, what was the most difficult for a banker to explain?

The argument how TARP was going to help the economy.

TARP, ZIRP, QE, and other handouts to TBTF banks (the twenty-first century version of the alphabet agencies - the main difference being not in chronology but that the organizations of yesteryear were created to aid the American people and not bank balance sheets) have socialized the debt and leverage of the banks. While the excessive debt leverage has switched hands to the government, the funny, fuzzy, and farcical explanations remain.

The quickest way to have Ben Bernanke clear his throat and adjust his necktie like the politico from the soda tax commercial is to ask not the how, though QE2’s effectiveness has already been called into question by Fed Vice-Chair Hoenig (guess who will take over after inflation “accidently” gets excessive), but the what. What is QE 2 and what exactly will QE2 do?

Stated shortly, in the most likely scenario, our central bank, utilizing their greatly increased powers, will create money out of thin air and will purchase anywhere from $100 billion to $2 trillion dollars of United States Treasuries. Goldman Sachs speculates that QE2 will be $1 trillion and is generally priced into the market. The statement, probably intended to reduce the capital inflows into to commodities, was not realized until a speech by Bernanke slightly muted enthusiasm for commodities and a coupe-de-grace delivered by the Chinese central bank raising interest rates to prop the dollar.

In a complex financial system, QE2 will have many intended and unintended effects. Its intent is to drive down the rate at which the US government can borrow. To do this, the Federal Reserve is creating funny money to add to the demand for USTs, it affects interest rates slightly because the T-Bill (amongst other things) set the interest rate. As these purchases drives down interest rates, it becomes a sweet deal for the banks who get paid a premium in cash in an environment that would theoretically be more inflationary with QE2 than without it. Most likely, the new supply of UST for QE2 will come from direct interference by the Fed in the primary auctions.

How is this inflationary? Ben Bernanke is creating the principal from thin air and handing it to the government. It’s money printing.

Now for the why and how. Why are they doing this? How will it achieve this?

1. “Foster Maximum Employment”

Ben Bernanke used this phrase in last Friday’s speech on the economy. It’s not true, but well, that sounds good to me. It sounds good to a lot of people, this clearly poll tested phrase scored 50%-42% when respondents were asked in an April NYT poll “should the government spend money to create jobs even if it means increasing the budget deficit”. Although that was the exact attempt of the stimulus package, which 68% of Americans now think was wasted, this would require causation thinking “(if increasing the deficit so the government can spend is the stimulus, and I don’t like the stimulus, then I don’t like when governments spend on deficit!!!”), thinking which clearly cannot be done when Dancing with the Stars is on television. However, the Fed stimulus is even better. Not only does the government spend money to create jobs, it doesn’t even have to borrow money anymore. It can just print it. Win-Win. I’m always amazed living in the 21st century that past governments in history have not realized until today that you can just print money to fix economic woes and create *ahem*… foster maximum employment.

Notice how Bernake said “foster maximum employment” rather than “create jobs”. Yes, it will sustain public sector jobs with funny money, a public sector that pays 60% more than private sector jobs with much more job security, benefits, and perks- not to mention the questionable economic benefits of a large bureaucracy at all. Adam Smith would be rolling in his grave babbling something about “efficient allocation of capital” but he never realized the technology called the printing press that fixes all economic and unemployment problems. So let’s officially cross this off the list.

2. “Spur economic lending”

This is absurd. How will this spur lending? The banks are forced to offer even less interest on loans. The financial firms that swapped their T-Bills for cash have a zero percent chance of lending it domestically. Let’s go over the banks possible options.

A) Leverage each dollar 1:100. Lend it to the Brazilian government for 11% a year. Have 4% appreciation on the reals vs. the dollar. Total profit 1400% your money

B) Lend it at 4.3% annually 30/yrs for a mortgage. In a housing market that’s still 30% overvalued. By putting on the street, risk losing it outright. Realize that when we have inflation down the road, the real return may even be negative at these rates.

Hmm, no wonder the banks only lend money to potential homeowners when their case is so strong they can go on local ABC in a “Banks aren’t lending!” esposé. Lending money isn’t a smart option for many banks and that is why this money will most likely end up on the excessive excess reserves chart.

3. “Spur borrowing”

Speaking of borrowing, that’s why the only one borrowing is going to be financial firms who carry trade it overseas where there are high growth rates. But on an individual level? To really get a perspective, let’s look at Joe and Joan Smith. Would the conversation go somewhat like this:

“Honey. Did you see how the Fed reduced rates? You know, I was thinkin’…

-even though we weren’t one of the stupid ones who overleveraged before 2007 when everyone else was doing it (and thereby still can leverage)…

-even though we just saw everyone who did overleverage before 2007 blow up…

-even though I live in fear of losing my job everyday…

-even though I am American, and thereby, bearish about my future economic prospects…

-even though housing prices are declining month by month and are still overpriced…

-even though buying shit you don’t need on credit is currently cultural passé…

‘Screw it. Let’s rush out and buy that second (bayside) condo in Miami Beach for $400,000. Because, with the Fed reducing borrowing rates two-tenths of one percent, that one Applebee’s dinner we would have otherwise had to sacrifice makes me want to add about half-a-million to my household balance sheet”

That’s for mortgage market but what about business and capital and labor investments? With CEO sentiment souring, and no killer app to purchase, why would a business invest in new capital? Or, why would a business invest in new labor when they can squeeze their employees for extra work as the job market is so saturated?

Not happening.

4. The “If A might equal B, B might equal C, C might equal D, and so on and so forth, A might equal G for economic growth” argument

David Rosenberg sets the argument. I will sum it up for you, please don’t hold your breath while reading this. By buying long term treasuries, QE2 will reduce long-term yields. Reducing long term yields on treasuries will reduce long term yields on other bonds. Reducing long term yields on bonds will make these bonds more valuable vis-à-vis newly issued bonds. The old bonds that are more valuable will skew the bond-to-equity ratio in portfolios. Because the bond-to-equity ratio in portfolio is skewed, investors will purchase more equities. As equities increase in price, the “wealth effect” will take hold. Consumers who feel richer will now feel free to spend more money. As profits increase, businesses will invest more in equipment, inventory, and labor. *

Wheew.

*Please note. Between steps 1 through 24, consumers will have forgotten that their equities can collapse in price, that debt leveraging is what caused the crisis three years ago, and they will have forgotten the macro-economic terror that makes 80% of them feel the country is going in the wrong direction.

Why is the government doing QE2? Simply, it’s government maneuvering in the larger international currency war. If something you read about QE2 doesn’t include these explanations or a variation of, toss it as it is pure gibberish.

Why did the cold currency war turn hot merely on the threat of QE2? This requires a brief history of the last ten years. Countries have switched from the import substitution model to export led growth. The former was implemented from the ‘50s to ‘80s that used tariffs on industrialized goods and hoped that from digging holes and burying them, an advanced industrial economy would sprout. The other picked a sector in which there was demand, worked to become competitive in that sector (through strategic central public/private cooperation), and exported cheaper/better goods to be more competitive. One is Keynesian voodoo economics and kept the developing world developing for almost a half-century, and the other is the reason why almost everything is manufactured overseas. I could go on longer about this but the important facet is that the countries following the export led model collected large hard currency reserves (as we all know now, it is not fun to be in debt) and reinvested the profits into UST and MBS to recycle into the American economy. QE2 is quite possibly the termination of that system.

Because these numbers can become mind numbing, I want to lay them out for comparison. The numbers that you need to understand for this are:

$1 trillion: Estimated QE2 bond purchases

$1.15 trillion: Estimated FY2011 federal budget deficit

$500 billion: Annual national trade deficit

.25%: Annual rate at which banks can borrow from the Fed

As we are in a ‘currency war’, I want to describe what QE2 does for the American government using war analogies.

1) Raiding the Supply Lines

The immediate thing one should notice is that everything imported into this country not exchanged for an American export will be free, FOR TWO YEARS. Really stop, swivel your chair around, and think about this. Solely due Ben Bernanke pressing “enter” on his laptop, the United States will receive the benefit of trillions of man hours, millions of increasingly scarce oil barrels, and god knows how many iPods for free … for two year. No wonder China recently decided to cut off rare earth exports to the United States, it is receiving nothing in exchange for them. Every country that runs a trade surplus with the United States will spend all of 2011 and 2012 attempting to counterbalance Ben Bernanke’s keystroke on November 3rd. QE2 allows the government to essentially “raid” excessive goods and natural resources imported into America.

2) Poisoning the Water Supply/Inflation Assault

The other thing one should notice is that the Federal Reserve is threatening to buy up all of the new debt issuances in 2011. This means countries running a trade surplus with the United States will have no way to sanitize the dollars that they receive. Think of it this way. The United States Federal Reserve drops the funny money poison (FMP) in Washington. The FMP gets spent across the country through federal programs (primarily warfare and entitlement programs) and the FMP ends up in the pockets of Americans. Whatever good they purchase oil (Middle East), fruit & vegetables (Central America), cars and electronics (Japan/Germany), cheap trinkets (China), etc. The FMP gets sent to the foreign countries as corporate profits. In order to keep their country competitive in exports, foreign countries are forced to treat that poison as gold, and give a whole bunch more local currency for that FMP than the market would dictate they really should. Now this means every country has been forced to chug FMP with very few options to sanitize this because there are less UST issuances and a dead MBS market. If the dollars catches a cold, their country is going to get very sick. This is the “inflation assault” termed recently by a Chinese economic minister.

3) Patriotic Homefront Duties

QE2 is going to force developing countries to patriotically support the American consumer and government. First, the Federal Reserve is manipulating UST interest rates by creating artificial demand for UST not seen since the war bond drive. Because the Federal Reserve in manipulating interest rates down, with 60% of our national debt due within two years, foreign countries will be forced to refinance their debt at half the interest rates that we saw only two and a half years ago. When inflation finally hits, these countries will be sitting on low-yielding USTs that will have real losses- not to mention dollar losses as the USD has fallen 30% only this summer against a commodity basket. Secondly, because countries are keeping their currency undervalued, they are allowing Americans to do their utmost patriotic duty: shop! This is financed through an “inflation tax” in the developing world because foreign central bankers must trade large amounts of local currencies for USDs to keep the exchange rate low and by linking to the USD, also experience inflation through commodity inputs as fiat currencies have fallen vis-à-vis commodities. So think about this next time you buy jeans at Wal-Mart (NYSE:WMT), that some more Chinese or Brazilian worker is forced to put more and more of his meager income into food purchase so you can buy junk for cheap.

4) Releasing Carry Trade Attack Dogs

Remember that trade. Where $1 million US can be leveraged 1:100, converted into Brazilian reals, invested into 1-Year bonds with 10% interest in Brazil, then transferred back to USD with a possible favorable change in the exchange rate. This could give 20x gains in one year of work- and shows how badass the new dollar carry trade can be. Sound pretty awesome right? Unfortunately, it doesn’t work if there is a risk of the USD appreciating as this trade is extremely risky. Please, please, for me, the next time someone tells you that the Dubai or Greek debt crisis shows the faith people have in the ‘ole Greenback as the dollar snapped back. Please tell them that was because all the currency speculators were panicking and covering their carry trade lest they blow up like LTCM. My point? A clear signal from Bernanke that the US government is going to pursue a weak currency policy gives every currency speculator the “go sign “to borrow an overvalued currency at a 0.25% rate, purchase every high yielding third world assets they possibly can kind of like someone snatching money in one of those flying dollar, whirlwind boxes you see at Bar Mitzvahs, and collect a ton of profit while pressuring countries on their currency pegs.

I can go further but I have been sitting on this article for ever and want to publish it. For recap, QE2 will have little effect on the structural imbalances that have been causing our current economic problems. QE2, however, is a volley in the international currency war that pressures other countries’ economic models.

Disclosure: Commodities, Duh.