If You Like QE, You Have to Love Deficit Reduction

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 |  Includes: TLT, UDN
by: Alhambra Investment Partners

What is the difference between Quantitative Easing and Deficit Reduction? Well, after writing the previous post about the net effect of quantitative easing and thinking about it for a while, my conclusion is that if Quantitative Easing works as Ben Bernanke thinks it should, the only difference is that deficit reduction might actually provide a stimulus to the economy. And the greatest stimulus might be when they are used at the same time.

Bernanke has said that QE works through the portfolio balance channel. In the case of QE II the Fed buys a Treasury note with newly created money. The seller of the note receives new cash and buys something else with it. Bernanke hopes it is something like a corporate bond or a high yield bond or a mortgage security. If that is true those rates will be lower than than they would have been absent QE and supposedly more investment happens. Or at least that’s the theory. Unfortunately for Bernanke, he can’t tell the Treasury note seller what to buy and it turns out that when the Fed effectively monetizes the federal debt it scares the bejabbers out of people and they buy things like gold or oil instead of the corporate bond that Bernanke wants them to buy. Or they might sell the dollars and buy Brazilian stocks. The point is that the reason QE doesn’t provide any stimulus is because rather than reducing interest rates on risky things, it tends to weaken the dollar and raise the price of things like oil, copper and gold which is a decided negative for the economy.

The whole theory of QE depends on the idea of freeing up money to invest in something productive in the US private sector. It goes off the rails because the Fed can’t force the private sector to stop hiding capital in commodities or from just selling the dollars and converting their capital to some other currency such as Australian dollars. So for QE to work we have to find a way to convince investors that it is okay to hold dollars and make productive investments with them. Now how in the world are we going to do that? The Fed is currently in the middle of buying $600 billion of Treasury Notes out of the market. What if we instead reduced the deficit by $600 billion? Isn’t that effectively the same thing? Wouldn’t reducing the deficit give investors more confidence and likely strengthen the dollar? Wouldn’t a stronger dollar reduce commodity prices and provide a stimulus to the economy? Would the economy be better off with oil at $45 or $90?

Okay, I know the Keynesians out there will say the reduction in government spending will reduce growth and you won’t actually get the deficit reduction you think you will but since we haven’t really tried that I’m not sure we really know that for sure. But just for argument’s sake let’s grant the Keynesians that argument. Wouldn’t that then mean that the most effective quantitative easing would be in the context of deficit reduction? Deficit reduction would provide confidence in the dollar to offset the negative effects of quantitative easing. Many have made a similar argument saying that we could get the same effect by enacting some kind of plan that promises to fix the deficit in the future. Unless I’m missing something the only way that will work is if the public believes the future deficit reduction will really happen. Anybody willing to crawl out on that limb? Yeah, I didn’t think so.

The answer is to enact comprehensive tax reform in the context of a credible deficit reduction plan that reduces the deficit now while the Fed pursues a policy that allows the dollar to slowly strengthen. That will give confidence to dollar holders that they can now use those dollars for more productive purposes. Capital will flow out of commodities and other hard assets. Oil, copper and gold prices will fall. And if the Fed is pursuing a rising dollar policy and the world knows that, capital will flow back here from emerging markets and other places like the aforementioned Australia. Heck it might even solve that nasty inflation problem so many of the emerging countries are desperately trying to stop.

If you like Quantitative Easing, you have to love Deficit Reduction.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.