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If this is the second blog on QE2 I get to call it QE2-2

I'd like to cherry pick a couple of comments made in the previous post so that we can keep the conversation going in a faster thread.  Please do re-read all the great things that have been said in the last post, but carry new comments forward to here.

John Lounsbury Said:

Hello guys - - -

You are talking about some of the QE questions that are important. I'll add my understanding and await correction from others:

1. QE is basically printing money, plain and simple.

2. QE is monetizing debt.

3. QE is not inflationary until it is inflationary. Recognizing that boundary is virtually impossible until well after the fact.

4. QE may help push stocks up, but asset bubbles in a lot of other areas, especially commodities, are a bigger affect.

5. The bubbles produced by QE in the U.S. are also in other parts of the world as well as the U.S., sometimes more elsewhere, because our trade deficit continues to push dollars overseas.

6. All that being said, QE may be useful and far from the worst way to go. Deflation because of the failure to monetize can be devastating.

Steve Hansen has been writing some good stuff on QE leakage into the rest of the world:

Two other good articles are "Did France Cause the Great Depression" by Doug and "The Myth of Expansionary Fiscal Austerity" by Dean Baker

There is no road map to the future, and in the current situation there isn't even compass. We are bushwacking with no map and no compass, just a bunch of economic theories all of which have been found wanting in one way or another. 

HTL Later said

I just got reminded of something I've read several times now about the rise in commodities. It's not inflation, according to the thoughts I read. It's a result of carry trade. With $US borrowing @ ~.25% and dollar weakness, yield is being generated by using the dollar as carry trade, just like with the yen.

That would resolve, for me, why we have the apparent conflict of inflationistas and deflationists.

The resolution occurs through the following logic mechanism.

1. Cullen is right - it's an exchange of assets, no new money flows.
2. Money always seeks yield. If yield is not available here, it leaves.
3. The best way for this to happen is to leverage by borrowing at *very* low rates to buy something that is appreciating at a much higher rate.
4. Since there is a *lot* of "free money" available to certain institutions that have *very* sophisticated trading desks, they all lever up and compete with each other for those assets that promise higher yields.
5. The assets return not only what they would "naturally" yield, but also the additional yield that is a result of increased competition for "scarce" resources - high yielding assets.

If what I guess is true, we can draw some conclusions.

1. The assets that have seen such huge run-ups are in a "bubble", or nearly so.
2. They will continue to grow a larger bubble until something pops them.
3. The most likely cause of a pop is related to changing currency strength.
4. A strengthening $US will cause an unwinding of carry trade in $US and force it back to another currency, like the yen.
5. During the adjustment, the asset prices will deflate, likely overshoot, and then return to some semblance of normalcy.

Regardless, the inflationary effects of the speculative bubbles formed by a "weak dollar policy" as implemented by BB and TG, regardless of intention or nomenclature, will be (is already being) passed through to the economy and the citizenry, to our great detriment.

So although QE II may not be inflationary in its mechanical aspects, the mindset, policies and implementation of surrounding policies set up an inflationary scenario even though QE II itself, and its predecessors, are deflationary in nature and mechanical effect.

In other words, we've properly identified the crime committed but arrested the wrong alleged "perp". With so many ingredients in the stew, it's hard to identify the meat.

Thoughts? And *if* all this is true, then a strategy based on inflation expectations solely would be a poor stance to take. We would need one that accounts for what I envisioned or its offspring. Remember that this was the intent here - get a strategy that is useful to us. And we can't be certain of that *unless* we can fathom what is *really* happening.


And John added:

I have been following your discussion with great interest.

If you will allow me to interject some thoughts: If inflation (commodities, energy, food or whatever) is in fact just another bubble, then the final deflation will be draconian and all the "liquidity" provided to the banks by QE and MBS transfer to Fannie, Freddie and the Fed will disappear into a black hole that swallows up the "liquidity" without unwinding a fraction of the excess debt.

The debt of the world is probably well over $100 trillion and that of the U.S. somewhere around $50 trillion. The total efforts in the U.S. to provide liquidity for handling the debt is of the order of $2+ trillion (heading toward $3 trillion with QE2). All this can do is provide the lubricant to keep moving the debt around. It does little to help reduce the debt. The strategy is to let the banks "earn" their way out of the hole. But if their earnings are actually derived from creating more debt (private or government), they never make much progress. Wonder why it's called extend and pretend? Kind of obvious I think.

The last over-leverage crisis was the S&L debacle mid-80's into the 90's. Most would agree the banking system was on the ropes then and that was a very small fraction of the size of the current crisis. Most banks were actually insolvent then (even with that much smaller problem) and took nearly a decade to earn enough to (sort of) get back on their feet. What did it take? A tech boom, which of course bubbled, but without a deep impact on the banks.

So we have a much bigger pit now. Where is the 10X boom (compared to the tech boom) going to come from in the next 10 years to address a crisis which is much more than 10x the S&L crisis?

Hope I didn't overstay my welcome with this long winded comment.

BTW, Dirk Bezemer has a very interesting article which discusses how the Babylonians handled debt crises: Ancient Babylonia dealt with debt crisis in a process akin to bankruptcy for speculators and support mechanisms for producers. Today we are doing just the opposite.

Lots of other great stuff was added by others, which you know by now if you have followed along, but I wanted to capture the essence of the issue and try to move the discussion here.

For my own part, I am trying to remain a devils advocate against deflation and collapse, mostly because I grew up in the 1970's and heard all this gloom and doom before.  It was arguably true then, as later crises bore out, but it was also not true in the sense of the world is still turning and we haven't yet blown ourselves up.  So it will take a lot of drama to convince me we are finally at the end point that so many have been calling for for so long.  The argument only gets stronger with each passing decade, yet if it influenced your investment strategy you would have been toast (unless you're George Soros).

So the most important question we have moving forward is the drum that HTL keeps beating -- what does all this say about how we should be positioning our investments?

Is cash in the mattress really the play of the 20-teens?  History suggests this is not the case.  Is it "different this time?"

Disclosure: Long SLV, physical silver and other related items