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Let's kick around some thoughts about QE2 and money supply.

A short time ago, HTL linked to this article in a comment:

http://seekingalpha.com/article/235809-understanding-the-mechanics-of-a-qe-transaction

HTL asked if there were any flaws in the author's logic and if not whether we should protect ourselves from too much enthusiasm about QE2 or the assumptions about what it will do in the market.

After reading the article, I responded with my thoughts, which are reproduced here.  The author was clearly on a logical path and appears to know his stuff, yet some of his conclusions and suggestions for the implications of QE2 (or more precisely lack of implications) baffled me.

Here is my original response to HTL, which he suggested we bring to an insta in order to explore more fully (hopefully with help from others!):

...This is the part that makes no sense to me,

"They are merely changing the composition of the bank balance sheet. The logical question that most people ask is: “where did the Fed get the money to buy the bonds?” They didn’t get it from anywhere. It truly is ex nihilo."

As at least one commenter pointed out, this sounds a lot like where the money is being printed.

And even if it is not being created... well let's look at my analogy.

Let's say I take a HELOC out on my house for $100,000. I haven't printed any money, I've only "changed my balance sheet." In the author's words, I have exchanged one less liquid asset for a more liquid asset with an interest penalty (the author was talking about losing out on interest income and in my example one loses via interest payments).

But you tell me, just because this is a "balance sheet adjustment" does that mean it is not inflationary? Of course not. I will spend the $100,000 and increase the velocity of the money, which is inflationary.

Swapping bonds for cash doesn't seem like the non-event the author describes. And furthermore when the cash for these purchases is not "created" but "just comes from out of nowhere", that doesn't even pass the sniff test.

I think folks arguing along these lines may be technically correct about the composition of the bark, but they are unaware they are lost in the forest. (I think that's how that saying goes...)

Attempts to spur lending have failed in the past. Why? Because all the extra liquidity always seems to get sucked up by a quicker and easier place to make money -- the stock market. So regardless of what this stunt will do to spur economic activity and regardless of whether saying it increases the money supply will get you a failing grade on a senior level economics exam, it seems clear to me that it is increasing liquidity (even the author agrees with this) and that this liquidity will be pumped into the market as dollars seek return. This is only more certain if the stated goal of QE2 succeeds and interest rates are kept low. Dollars chasing return will have no place to go but the currency, equities, and commodities markets. This will help inflate, or at least prop up these markets.

And I think Ben is okay with that. Inflating a stock bubble is -- I think by his way of thinking -- a little like giving a weak and starving person a sugary drink. He wants to get the economy moving even if the boost has no nutritional value and the crash will only make matter worse. He is afraid if we fall asleep we will die. He is hoping by inflating a bubble (the sugar rush) we will get up and find our own food. There are obvious political components of pointing to the malnourished patient on the sugar rush saying "see everything is okay". But I think the policy is quite deliberate and if he were honest he'd admit it was out of desperation.

The author implies there is a nothing to see here component of QE2. If this were the case, they would not be bothering to try this at this late hour and with all traditional ammunition spent. You can say that my $100,000 HELOC has only changed my balance sheet, but if you think it won't affect my economic activity as a result, you are sadly mistaken.

(My HELOC example is intentionally chosen for its implicit cautionary elements.)

My conclusion, therefore, is that QE2 does suggest artificial inflows into the stock market. And an equity bubble is inflationary. Even Ben hopes it is inflationary. So I disagree with the author that counting on QE2 to help push up equities is mistaken.


Disclosure: Long PM and mining stocks