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Why QE Is Deflationary

To understand why QE didn't lead to inflation, one needs to understand that much of economics is counterintuitive, conflicting and inconsistent. There simply isn't one economic theory that can define all economic conditions. That is why there are so many competing theories of economics, and not all of them work equally well for each economic environment. There is Classical, Neo-Classical, Keynesianism, Neo-Keynesian, Monetarism, Austrian and Supply-Side Economics.

If all you ever studied was Classical and/or Austrian economics, the Fed printing money and it not resulting in inflation makes absolutely no sense at all. To these fields of economics it is basically dogma. The Austrian School goes so far as to re-define the definition of inflation as simply printing money. Clearly these theories are very lacking when it comes to explaining the modern economy.

Keynesian economics can explain part of why we have near deflation, but is totally discredited on the government spending part of its theory. Keynesian economics is big government economic. Keynesians have never met a spending program they didn't like. If you ask a Keynesian economist why there is such slow growth and high unemployment in America they will say the government didn't spend enough money.

"The economics is really easy," says Krugman, "If we were to spend more money at the government level and ... rehire the schoolteachers, firefighters, police officers who have been laid off in the last several years because of cutbacks at the state and local level, we would be a long way back towards full employment.

You can get a Nobel Prize in Keynesian economics, and believe that you can solve unemployment by hiring firefighters, police and teachers. Considering that firefighters, police and teachers get paid with tax dollars, if everyone worked for the government, who would be left to pay the taxes? What products would fill the shelves of our stores made by these firefighters, police and teachers? This obvious flaw is simply ignored by Keynesian economists, and why I consider it more a political philosophy than an economic theory. Since President Obama took office the US debt has increased by $6 trillion, and unemployment has increased and growth slowed. Those statistics are bad enough by themselves, but considering that we had record low interest rates during that period pretty much debunks Keynesian economics for the third time in its history. Government spending didn't end the Great Depression, reversing the FDR policies did, government spending didn't solve the stagflation of the 1970s and government spending didn't solve the great recession that started in 2008. Spending money for the sake of spending money, especially when the money is being spent on non-productive ventures and non-comercially viable industries that have an expected negative rate of return isn't an economic recovery plan. It is a plan for greater debt.

Why I say Keynesianism can partially explain deflation with QE is that Keynesians view monetary policy as a very weak policy tool. They describe monetary policy as "pushing on a string," and on this issue they are correct. Because monetary policy is viewed to be ineffective by Keynesians, they use it to justify any and all government spending programs. Clearly since 2008 the Keynesians have been proven wrong once again, but unfortunately we had to rack up $6 trillion in debt, tolerate anemic growth and high unemployment to once again learn this lesson.

Monetarism provides the formula to put everything together called the "Quantity Theory of Money." MV=PQ is the theory in a nutshell, and since 2008, the velocity of money "V" has collapsed. To compensate the Federal Reserve dramatically increased the monetary base, but because of the anemic growth and lending, money supply hasn't increased at a rate to compensate for the collapse in velocity. Put everything together, V is falling, Q (real growth) is anemic, M (money supply) is increasing but not at a satisfactory rate, so P (price level) is stalled near zero. That explains mathematically why QE may lead to deflation, but it doesn't explain operationally why QE may lead to deflation.

To understand why QE can cause deflation requires understanding Neo-Classical economics and its "rational expectations hypothesis." Thanks in part to Ron Paul and his "End the Fed" and "Audit the Fed" campaigns, the Fed has embarked upon an unprecedented transparency campaign. The Fed had gone to great lengths to tell the markets exactly what it is planning to do. The Fed has even gone so far as to name exact targets for inflation and unemployment. More important is that they have been telling the markets that they plan to keep rates low for an extended period of time, and have followed up those claims with one episode of QE after another, all designed to lower and/or keep rates low. The Fed even implemented an unusual program called "operation twist" where longer maturity treasury bonds and mortgages were added to their balance sheet.

What this has done is encourage consumers, especially home buyers, to postpone or delay making purchases in expectation of lower borrowing rates in the future. Why buy today when the interest rates will be lower tomorrow? QE, which was intended to stimulate consumption, actually inhibited consumption by establishing the expectation that interest rates were going lower, and that buyers would be rewarded for postponing buying. QE, through establishing market expectations of lower rates in the future, actually resulted in the exact opposite result that it was intending to produce.

If we reject the Austrian School of Economics definition of inflation, and accept the traditional definition of inflation as being too many dollars chasing too few goods as the definition used by the markets then things begin to make sense. QE resulted in reducing the number of dollars chasing goods as people changed there expectations and shifted their consumption into the future. Keynesian economics proved itself a complete failure when $6 trillion was wasted on non-job and growth producing investments, so at best there was a very short-term and unsustainable boost in dollars chasing goods, but not enough to even register a significant impact. While the immediate spending didn't have a lasting impact, the resulting debt will weigh heavily on the minds of tax payers that are likely to reduce consumption today in expectation of higher taxes in the future, further reducing consumption today.

Lastly, Supply-Side Economics can't really explain why QE resulted in deflation, but like Keynesian economics, can help explain the decrease in dollars chasing goods. Increasing taxes and regulations have created extreme uncertainty in the economy which has resulted in employers becoming paralyzed as they wait for the bills and laws to pass so they know the rules and can estimate the costs. This has resulted in many employers postponing expansion into the future. This has resulted in fewer dollars chasing goods today. The resulting higher unemployment has also reduced the number of dollars chasing goods.

In conclusion, the post-2008 era has done a great job flushing out what economic theories have credibility and what ones don't. Gold bugs are finding out the hard way about adhering to an economic theory that isn't credible. Unfortunately, the one theory that would have most likely resulted in restoring growth much sooner, Supply-Side Economics, was deliberately avoided in favor of repeating the failed but politically preferable Keynesian policies. Because the Keynesian policies were such a miserable failure all the heavy lifting was left to monetary policy. Unfortunately, Ron Paul was successful in getting the Fed to be more transparent, which resulted in the markets being able to form expectations with a much higher degree of confidence. Those expectations were for lower interest rates in the future, which resulted in consumers postponing consumption, especially big ticket items, into the future. The end result was fewer dollars chasing too many goods, and that is why QE has resulted in at or near deflation.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

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