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The Fed is now firmly in make-it-up-as-you-go-along territory. As controversial as Keynesian economics is, this latest round of QE is decidedly un-Keynesian. It either violates or ignores the heart of Keynesian economics; the IS/LM model. Additional points to consider:

  1. We lasted only 7 months between end of QE1 and start of QE2
  2. At 75 billion per month, we are monetizing virtually all of the "new" deficit

Keynesian economics states that an increase in the REAL money supply will lead to an increase in aggregate demand and national income. That's just a roundabout way of saying we can buy more stuff with a stronger dollar. However, the Fed can only increase the NOMINAL supply of money. According to Keynesian economics (and the common sense), this means the increase in the money supply will be counteracted by the fact that each dollar is worth less. The net outcome will be ZERO effect on AD or real GDP.

Keynesian economics also points out an effect called the "interest rate sensitivity of demand". That's just a fancy way of saying when rates are really low (think at or near zero), there will be very little effect on the demand to borrow. This is where the term "pushing on a string" comes from. Recently, only 4% of small business owners cited lack of credit as their top concern. As of November 3, 2010, all Treasury yields for terms less than 5 years are all under 0.5%. Yields for everything under 10 years are under 1%. The 10 yr is in the low 2's and even the 30 yr is at 4.0. Where exactly are rates supposed to go, and how much additional demand can you expect even if you pound the entire yield curve flat to zero?

The 2011 federal deficit is projected to be 1.267 trillion dollars. QE2 will fill most of it where foreign lending has decided to cutoff our national Visa card. More importantly, it will fill virtually all of our "new" deficit. That is, the deficit that exceeds the average for the decade leading up to the Great Recession. From 1998-2008, federal deficits average 2.3% of GDP. With US GDP at 14.8 trillion, the "normal" deficit (based on the decade average of 2.3%) should be about $340 billion. 1267 actual-340 normal=927 billion dollars. We are within a rounding error of the $900 billion pledged.

This is not about "growing the economy." This is about saving the banking system from the collapse that unsustainable prices relative to income is calling for. With Tuesday's election results, there will be no serious spending cuts, and no serious tax increases. The result: deficits and QE to fill them as far as the eye can see. Even in the mid 1300's, gold is still a good buy.

Disclosure: No positions

Source: QE2 Throws Out Keynesian Playbook