The day after the Fed announced the $600 billion Quantitative Easing, Chairman Bernanke explained his logic. His objective is to avoid a debt-deflation bust and a subsequent liquidity trap. The problem is that Bernanke´s solution will not work, in large part due to unintended consequences. Here is why.
Chairman Bernanke said:
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.
Chairman Bernanke provided 7 lines to justify his position. Let´s look at each justification, which are provided in indented italics.
1. This approach eased financial conditions in the past and, so far, looks to be effective again.
This is not so. Longer term, this approach has caused an asset bubble which has had severe adverse consequences for the American economy in 2007 to 2009 and is a continuing problem. The easy money and low interest costs led to unreasonably high house prices that inevitably had to fall. Ask the 9 million American families who are in the process of losing their homes because they cannot pay for it. Ask the 20% plus of unemployed or underemployed American citizens. Note, this position rests on the idea that the Fed maintenance of low interest rates produces the same results whether they are called Quantitative Easing in 2010 or TARP in 2008. Likewise, in the monthly Fed meetings during 2003 and 2004, the Fed made similar low rate decisions. These low interest rates created the real estate housing bubble in 2006. While Quantitative Easing focuses more on longer-term bonds and the decisions of 2003 and 2004 focused more on lower rates generally, the effect on the economy is pretty much the same.
2. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action.
This argument is misleading. First, it appears investors bought the rumor and are more likely to sell the fact. Additionally, only a narrow segment benefits from increasing stock prices and lower long-term rates. They are principally the rich and large corporations. There is no evidence to support the idea that this helps the lower and middle classes in the short term. The idea is that this trickles down to the poor and middle class, and that is not going to happen in a substantive way in a few months. Corporations are not investing in new plants nor are they hiring new employees. They are buying companies and then reducing jobs in the purchased company to “make it more efficient”. Also, a $100 billion a month or so for 6 months does not seem large enough to have much impact anyway. The Fed seems to be trying to talk the market up rather than making a substantive effort.
3. Easier financial conditions will promote economic growth.
Again, there is no indication this is a true statement in this economic cycle. On the contrary, there is much evidence to suggest we are making another asset bubble affecting commodities. A bubble which raises the costs of cotton, oil, gold, silver, etc. We are devaluing the dollar, which will promote higher costs to consumer using foreign-produced goods. Wal-Mart (WMT) customers watch out for price increases!
The middle aged and retired no longer can live on their retirement income due to the extremely low or non-existent interest rate income. There is no significant indication we are increasing employment which will benefit the 20% plus of Americans who are unemployed or underemployed. The list of unintended consequences here is truly profoundly long. Inflation, the Fed objective, without increases in employment and salaries will hurt Americans, not help them. And there is no evidence that the Bernanke policy will actually create new employment and higher wages for those still having employment.
4. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance.
It is true that a number of Americans will get their mortgage financed at a lower cost and for a small number of people this may actually make the difference in staying in their home. More important is the approximate 9 million homes in foreclosure or likely to have to be foreclosed. The amount of foreclosures avoided by the lower interest rates is statistically insignificant. Also important is the distortion of the market place caused by lowering long-term rates. Vast numbers of people, particularly the middle aged and the elderly, are investing in risky bonds to get interest income to live on. This will come back to haunt them with major losses in bond value as interest rates normalize at higher levels. Many business are being bought at high prices with low cost money which will probably soon come back to look like lousy purchases when interest rates return to normal levels.
5. Lower corporate bond rates will encourage investment.
There is no demonstrable evidence that this is producing investment in new business and new jobs. On the contrary, this writer has spoken often of the idea that there is no place to profitably invest and thereby create jobs late in a mature economic cycle, which is our case. There is a lot of demonstrable evidence that the money is being invested in buying other peoples businesses, which does not produce new jobs or increase spending.
6. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.
Increased stock prices without increased jobs and wages will do very little to increase spending.
7. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
The presumption of increased spending, particularly by lower and middle-income people, is not supported by the facts and the analysis above. The critical flaw in the Bernanke statements is the lack of job creation, which creates the ability to spend more. Therefore, there is no virtuous circle.
The results that Chairman Bernanke has promised simply will not happen.
On the contrary, there will soon be an outcry from the unintended consequences. First, there will be a cry from the middle aged and senior citizens in terms of dramatically reduced earnings from their savings. There will be a cry from the lower and middle class who suffer from higher prices of imported goods and commodities while their incomes are not going up. There will be a cry from the unemployed and underemployed who were promised that things would get better, when the reality is that U.S. businesses still don't add real new employees. The 9 million homes in repossession or likely to be repossessed (after there is a solution to the mortgage documentation problem) will create profound dislocation for many Americans. The losses to the banking system, particularly in view of the mortgage documentation problem, will be life threatening to at least those banks heavily engaged in mortgage loans. This is a much more likely scenario of what we can expect over the next couple years.
The laudable objective of Bernanke is to avoid the debt-deflation bust and subsequent liquidity trap. Regrettably, he will not be successful.
Disclosure: No stocks are mentioned.