Unlike QE1, QE2 is not about saving the banks. It’s about saving the country from Greek-like austerity measures necessitated by a burgeoning federal debt. The debt is never paid, but is just rolled over from year to year; but the interest is paid, and it is here that QE2 relieves the pressure, since the Fed rebates its interest to the Treasury.
The inflation hawks are circling, warning of the dire consequences of the Fed’s new QE2 scheme. “Quantitative easing” (QE) is Fedspeak for creating money out of nothing with a computer keystroke. The hawks say QE is massively inflationary; that it is responsible for soaring commodity prices here and abroad; that QE2 won’t work any better than an earlier scheme called QE1, which was less about stimulating the economy than about saving the banks; and that QE has caused the devaluation of the dollar, which is hurting foreign currencies and driving up prices abroad.
It might be argued, however – and will be argued here – that QE2 not only will NOT produce these dire effects, but that it is NOT actually about saving the banks, OR devaluing the dollar, OR saving the housing market. It is about saving the government from having to raise taxes or cut programs, and saving Americans from the austerity measures crippling the Irish and the Greeks; and for that, it could well be an effective tool. What is increasing commodity and currency prices abroad is not QE, but the US dollar carry trade; and the carry trade is the result of pressure to keep interest rates artificially low to avoid a crippling interest tab on the federal debt. QE2 can relieve that pressure by funding the debt interest free.
The debt has increased by more than 50 percent since 2006, due to a collapsed economy and the decision to bail out the banks. By the end of 2009, the debt was up to $12.3 trillion; but the interest paid on it ($383 billion) was actually less than in 2006 ($406 billion), because interest rates had been pushed to extremely low levels. Interest now eats up nearly half the government’s income tax receipts, which are estimated at $899 billion for FY 2010. Of this, $414 billion will go to interest on the federal debt. Raising interest rates just by a couple of percentage points would make income taxes prohibitive.
Interest rates cannot be raised again to reasonable levels until this interest tab is reduced. And, today, that can be done most expeditiously through QE2 – “monetizing” the debt through the government’s own central bank. Only its own central bank will advance credit to the government interest free. Congress also has a computer keyboard and could issue the money not just debt free but interest free, but Congress has not been so bold since the Civil War. The Fed has, therefore, had to step in.
All About Monetizing the Debt
Fed Chairman Ben Bernanke did not want to step in. In January 2010, he admonished Congress:
“We’re not going to monetize the debt. It is very, very important for Congress and administration to come to some kind of program, some kind of plan that will credibly show how the United States government is going to bring itself back to a sustainable position.”
His concern, according to The Washington Times, was that “the impasse in Congress over tough spending cuts and tax increases needed to bring down deficits will eventually force the Fed to accommodate deficits by printing money and buying Treasury bonds.”
So said The Washington Times, but bond magnate Bill Gross of PIMCO, writing the same month, said the Fed was already monetizing the federal deficit – fully 80 percent of it. Gross wrote in his January Investment Outlook that foreign investors as a group bought only 20 percent of the total 2009 deficit. The rest was substantially purchased by the Federal Reserve:
Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds…. Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance. Not likely.
“Not likely” became a virtual certainty after November 3, 2010, when Republicans swept the House. There would be no raising of taxes on the rich, and the gridlock in Congress meant there would be no budget cuts either. Compounding the problem was that over the last six months, China has stopped buying US debt, reducing inflows by about $50 billion per month.
In QE1, the Fed bought $1.2 trillion in toxic mortgage-backed securities off the books of the banks, using its power to create money with the click of a mouse. For QE2, Chairman Bernanke was expected to continue to use his QE tool to bail out the banks in this way, but that’s not what he did. Immediately after the election, he announced that the Fed would be “monetizing” the federal debt – using its power to create money to buy federal securities on the secondary market, from banks, bond investors and hedge funds. As Gross noted, these investors would then be likely to use the money to buy more Treasuries.
Bernanke said the Fed would buy $600 billion in long-term government bonds at the rate of $75 billion per month, filling the hole left by China. An estimated $275 billion would also be rolled over into Treasuries from the mortgage securities the Fed bought during QE1, which are now reaching maturity. Bernanke said more QE was possible if unemployment stayed high and inflation stayed low (measured by the core Consumer Price Index).
Addison Wiggin noted in his November 4 Five Minute Forecast:
[I]f the federal budget deficit is supposed to run $1.2 trillion during fiscal 2011 (that’s the consensus guess) … and the Fed will purchase $875 billion in Treasuries over the next eight months (that’s two-thirds of a year) … then we quickly see the Fed plans to monetize all of the debt that Treasury plans to spit out from now through the middle of next year, and then some.
He quoted Agora Financial’s Bill Bonner:
“If this were Greece or Ireland, the government would be forced to cut back. With quantitative easing ready, there is no need to face the music.”
Bonner called it “financing America’s trip to bankruptcy” with “brand-spanking-new money.” But avoiding the Greek and Irish debacles would obviously be a good thing, IF it could be done without inflation resulting; and a close look at the data suggests that this is indeed the case. The Fed’s QE power tool not only will NOT endanger price levels under existing circumstances; it could actually bring them down.
What is new and different about the Fed buying federal securities directly is that the Fed, unlike any other buyer, rebates its profits to the government after deducting its costs. In 2008, the Fed reported that it rebated 85 percent of its profits to the government. That means that bond financing through the Fed will be nearly interest-free. The interest rate on the 10-year government bonds the Fed is planning to buy is now 2.66 percent. Fifteen percent of 2.66 percent is the equivalent of a 0.4 percent interest rate, a very good deal for the government.
In eight months, the Fed will own more Treasuries than China and Japan combined, making it the largest holder of government securities outside of the government itself. While this trend, too, has been criticized, you could see it as another very good deal. Why pay interest to foreign central banks when you can get the money nearly interest free from your own central bank?
Ponzi Scheme With a Twist?
Bill Gross is not so sanguine. He calls QE2 “a bigger Ponzi scheme than Charles Ponzi’s.” He said in his November 2010 Investment Outlook:
Public debt … has always had a Ponzi-like characteristic…. [T]here was always the assumption that as long as creditors could be found to roll over existing loans – and buy new ones – the game could keep going forever….
Now, however, with growth in doubt, it seems that the Fed has taken Charles Ponzi one step further. Instead of simply paying for maturing debt with receipts from financial sector creditors … the Fed has joined the party itself…. The Fed, in effect, is telling the markets not to worry about our fiscal deficits, it will be the buyer of first and perhaps last resort…. It is not a Bernanke scheme, because this is his only alternative and he shares no responsibility for its origin…. [Y]ou and I, and the politicians that we elect every two years … deserve all the blame.
Gross calls it “a picking of the creditor’s pocket via inflation and negative real interest rates,” but he concedes that it is NOT actually a Ponzi scheme. Ponzi schemes collapse when no more new investors can be found to pay off earlier investors, or when compound interest charges become mathematically unsustainable. In this case, however, the government is not relying on new creditors to roll over the debt. The Fed itself will step in; and the Fed can always be relied on, because it can create the money on its books with a keystroke. Compounding interest charges are not a problem because the Fed can lend to the government essentially interest free.
The federal debt has not been paid off since the 1830s under Andrew Jackson; and on those few occasions when it has been paid down, the result has been to hurt, not help, the economy.
In effect, the federal debt IS our money supply, since nearly all money today originates as bank credit or debt. Better would be for a transparent and publicly-controlled Congress to issue the money it needs outright; but an interest-free loan from the Fed, rolled over indefinitely, is the next best thing.
The Quantity Theory of Money Is Obsolete
The bankers’ stock argument to keep governments in borrowing mode is that the greenback solution would be dangerously inflationary. What the bankers have failed to reveal is that their own money scheme is actually more inflationary than for the government to issue money itself. Nearly all money today is created as bank credit or debt; and this money is due back with interest. New loans must continually be taken out to cover the interest not created in the original loans, continually increasing the debt-based money supply.
The bankers rely for their argument on the “Quantity Theory of Money,” which holds that more money competing for a fixed amount of goods will drive prices up. But in a post on Minyanville on November 1, James Kostohryz showed that the “dogmatic and simplistic view of the Quantity Theory of Money (QTM), by which increases in the supply of money necessarily lead to price inflation,” is obsolete. He wrote:
[D]espite QE1 and the massive expansion of the Fed’s balance sheet that this implied, various measures of the money supply … have actually contracted ….
The fact of the matter is that numerous studies have shown rather definitively that in highly developed economies, the money supply, whatever the definition, has little or no causal connection to inflation. Some studies show a very weak positive correlation; some studies show no substantial correlation; and quite a few studies show negative correlations. And with respect to causation, virtually nothing can be established.
Adding money (“demand”) to an economy with high unemployment and unused productive capacity serves to increase productivity, increasing goods and services or “supply.” When supply and demand increase together, prices remain stable. And adding money to the money supply is obviously not hazardous when the money supply is shrinking, as it is now. Bank credit is shrinking because banks are DELEVERAGING. Bad debts are wiping out capital, which wipes out lending capacity. At an 8 percent capital requirement, $8 of capital can support $100 in loans; but when capital gets wiped out, this money multiplier effect works in reverse. When capital is written off bank balance sheets, the loans are wiped out as well – in a ratio not just of 1:1 but of 12:1.
Financial commentator Charles Hugh Smith estimates that the economy now faces $15 trillion in writedowns in collateral and credit. The Fed’s $2 trillion in new credit/liquidity, he wrote on November 2, is, therefore, insufficient to trigger either inflation or another speculative bubble. His estimates were based on projections from the latest Fed flow of funds (September 17, 2010), which shows the largest reduction in collateral and credit to be in residential real estate. Its current value is $18.8 trillion and its projected value in 2014 is $13.8 trillion, a decline of $5 trillion or 26 percent. Projecting similar declines for commercial real estate, consumer durable goods etc., brings the total to $15 trillion over the next three years, according to Smith.
If those estimates are correct, the Fed could, in theory, print $15 trillion and buy up the entire federal debt without creating price inflation.
That isn’t likely to happen, but it does make for an interesting hypothetical. If the federal debt were all held by our own central bank, which then rebated the interest to the government, the Fed could let interest rates rise to reasonable levels without worrying about the interest on the debt. Eliminating the threat of a growing interest bill would allow interest rates to rise again, benefiting those savers who rely on a reasonable return for retirement.
Raising the interest rate would also fix the surging price inflation in commodities and in emerging market investment. This inflation has been blamed on QE, but QE1 barely affected the money supply, as has been shown. This is because it merely involved swapping dollars for other assets on the books of the banks. The idea was to stimulate lending by increasing bank reserves, but the banks already had excess reserves, which they were not lending; so putting more cash on their balance sheets did nothing to increase the availability of consumer and business credit.
Despite surging commodity prices, the overall inflation rate remains very low, because housing has to be factored in, and housing prices have dropped by 28 percent from their peak. Main Street hasn’t been flooded with money; the money has just shifted around. Businesses are still having trouble getting reasonable loans and so are prospective homeowners.
What About the Inflation in Commodities?
Critics counter the deflationists by pointing to the obvious price inflation in commodities, notably gold, silver, oil and food. But what is driving these prices up is not a money supply inflated by the Fed. It is a combination of factors including (a) heavy competition for these scarce goods from developing countries, whose economies are growing much faster than ours; (b) the flight of “hot money” from the real estate market, which has nowhere else to go; (c) in the case of soaring food prices, disastrous weather patterns; and (d) speculation, which is fanning the flames. Feeding it all are the extremely low interest rates maintained by the Fed, allowing banks and their investor clients to borrow very cheaply and invest where they can get a much better return than on risky domestic loans.
This carry trade will continue until something is done about the interest tab on the federal debt, since the taxpayers cannot afford for it to shoot up, and Congress would not approve that result. Short of paying down the debt – which is highly unlikely today – the interest tab can be reduced ONLY through QE2.
QE2 is not a “helicopter drop” of money on the banks or on Main Street; it is the Fed funding the government virtually interest free, allowing the government to do what it needs to do without driving up the interest bill on the federal debt. The Fed failed to revive the economy with QE1, but it may yet redeem itself with QE2. QE2 could set a bold precedent prompting other countries to break the chains of debt peonage and fund their governments with their own national credit.