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QE2: Economic Quicksand   November 23rd, 2010
We're sinking deeper and deeper       


More observations...

The Federal Reserve is printing money again. They're calling it "QE2" which means Quantitative Easing. They really should call it "EQ2" for Economic Quicksand, because the more we move down the road of printing money, the deeper we get and the more difficult it becomes to break free.

They call it "quantitative easing," but that's just a fancy name for printing money out of thin air so that the government can spend it. I've written about this topic several times, but the situation continues to get worse so it's worth touching on the same topics in the context of what has happened in 2009 and 2010.

QE1: March 2009

Printing money was a bad idea when they did it the first time in 2009 and it's a worse idea now. When they first did it in March 2009, I predicted they would do it again:

Me in March 2009: In order to continue funding the deficit spending, it's a pretty safe assumption that the Federal Reserve will end up printing some more money after that. $300 billion isn't enough to make up the shortfall for the proposed $1.7 trillion deficit.

Granted, I thought they'd have to restart the printing press late last year. It turns out they didn't have to do it until late this year. With so many variables in international trade and finance, along with propaganda-driven expectations of a recovery, it's difficult to predict exactly when something will happen. But the fact of the matter was that it was entirely predictable that we'd see a second round of money-printing.

As I also write in March 2009:

I wrote in March 2009: The problem with the "nuclear option" of printing money is that once you start, it's hard to stop. When the Fed announced its decision to print money, the value of the dollar immediately dropped (see graph to the right). That means that foreigners that had invested in the U.S. (Treasuries or even in the stock market) automatically lost money because the dollars they had invested are now worth less--and they'll continue to lose money if the dollar gets weaker. If that happens, foreign investors will tend to reduce future investments in the U.S. since they prefer not to lose money. With reduced foreign investment the shortfall between what the government wants to borrow and what the world wants to lend it will increase... which means the government will, again, be faced with the decision of reducing spending or printing even more money.

The decision to print money is potentially a death spiral.

Indeed, it's difficult to envision a course of events that doesn't include printing money a third time, and a fourth time, etc... As famed economist Roubini tweeted: "QE2 will be followed by QE3 and QE4 as QE2 will fail to revive the real economy and to prevent deflationary pressures" Resorting to printing money back in March of 2009 was bad enough. But the fact that we've resorted to that drug a second time in 20 months is extremely bad news.

Also consider that when the Federal Reserve announced in 2009 that it was going to print money, the reason given was, "to improve conditions in private credit markets." Market observers were surprised by the move, however, because the Federal Reserve had just recently stated "the Fed has judged buying long-term Treasuries is not the most efficient means of easing financial-market conditions." Observers at the time assumed the goal was to reduce interest rates even though, at the time, the 10-year bond (to which 30-year mortgages are closely tied) was already at a very low 3.0%. After the announcement it immediately dropped to about 2.5% before quickly going up to almost 4% and spending over a year above the 3.0% rate it started out as.

Even though the media at the time was promoting the idea that the move would drive down interest rates, reactivate the housing market, and stimulate economic activity, the move by the Federal Reserve only drove interest rates down for about a month.

Of course, the goal at the time wasn't any of those just mentioned. It was simply due to the fact that the Obama administration had just announced a nearly $1 trillion stimulus package (on top of the $700 billion TARP passed just months earlier) and there simply wasn't enough money in the world for the Federal Government to borrow. Not even China had enough. So the Federal Reserve printed new money and loaned it to the Federal Government to spend on Obama's priorities. Obviously they couldn't come out and say it because investors (rightly) frown on monetizing the national debt.

The mostly unspoken reality was that the Federal Reserve was no longer independent. It could either print the money to fund Obama's spending or we would've been facing a world where the United States of America couldn't borrow enough money--which would immediately drive up interest rates and/or cause draconian overnight spending cuts in the federal budget, probably including entitlement spending. Fed Chairman Bernanke could've pulled the plug on Obama's prolifegate spending which would have caused the Federal Government to get its spending (and debt) under control. Instead, Bernanke took the easy way out. He printed money. Obama and Bernanke played a game of chicken, and Bernanke blinked. Indeed, the independence of the Federal Reserve was so suspect that the Fed felt the need, on March 23rd, 2009, to issue a statement reaffirming its independence.

At the time, foreign countries issued warnings and Treasury Secretary Geithner was dispatched to Asia to convince those countries that their dollar investments were safe.

QE2: November 2010 (Today)

Now, in November 2010, the Federal Reserve has announced that it will be buying nearly $900 billion of government debt. Given an estimated federal deficit this year of about $1.3 trillion, that means the Federal Reserve is financing more than two thirds of our deficit spending!

Just as last year, there isn't enough money in the world for the Federal Government to finance our deficit spending. So the supposedly-independent Federal Reserve is printing some more to keep the Federal Government afloat a little while longer.

We're monetizing the debt, pure and simple. And the world knows it.

Germany complained that QE2 was nothing more than indirect currency manipulation. China noted that the Fed's management of the dollar could trouble the world economy. Turkey opposed the move. The chairman of the EuroZone finance ministers stated that it was not a good decision, and was fighting "debt with debt."

The international concern about the Federal Reserve's money-printing has led to concerns over a potential global trade war as other nations accuse the United States of manipulating its currency to gain trade advantages. A trade war could lead to trade protectionism around the globe: The same thing that happened during the Great Depression, and extended and aggravated it.

Potential Economic Outcomes

There are many potential economic consequences of what the Federal Reserve is doing. Some of them are:

  • Trade Wars. The current QE2 is already setting the stage for a global trade war that President Obama was not able to resolve at the G20 conference. . A trade war may already be inevitable. But a QE3 would almost certainly push us over the edge with governments around the world instituting protectionist schemes, either with import tariffs or by manipulating their own currency. These kinds of actions contributed to and extended the Great Depression.

  • Downward Spiral. The current QE2 already suggests that we're on the downward spiral I described last year. An even larger QE3 in the future would confirm it. The dollar would most likely lose any credibility it might still have--and with it, would lose much of its remaining value.

  • Decreasing Value of Dollar. If we engage in a trade war, or if we confirm our currency is in a downward spiral into oblivion, the value of the dollar will continue to fall. That means that everything we import (which seems to be close to everything) will become more expensive. Of special interest would be a skyrocketing price of oil. Since we import most of our oil, a weaker dollar would mean we'd have to pay more for oil. Since everything we buy requires energy to produce and transport, higher oil prices lead to higher prices of just about everything--including food.

  • Oil Not Priced in Dollars / Reserve Currency. If the future prospect of the dollar becomes weak enough, other countries will not want to hold it. This could lead to oil being priced in some currency other than the dollar and/or the dollar losing its status as a reserve currency. Either of these events (which would most likely happen close to simultaneously) would be a game changer for the United States. As it stands now, foreign countries have to buy dollars to buy oil. They also park large amounts of money in dollars which they loan to us to spend. If there were no longer a need to buy dollars to purchase oil, or if the lack of stability of the dollar was such that it no longer made sense to hold on to dollars, foreign entities would stop buying dollars and stop loaning them to the Federal Government. That would lead to...

  • Spending Cuts / Tax Increases. If fewer countries and investors want to loan money to the U.S. government, the government would have to institute austerity measures overnight. This would probably include huge huge cuts in spending (including Social Security and Medicare), and/or large tax increases. However, tax increases would have to be draconian in order to make a dent in the deficit--so draconian that they would represent a further drag on the economy, leading to less investment in private businesses and higher unemployment.

  • More Money Printing. Facing fewer countries/investors willing to loan money to the Federal Government, with spending cuts already impacting those that depend on Social Security and Medicare, and tax increases pulling down the economy even further, the government's deficits would increase even further. So, to keep the government solvent, the Federal Reserve will have to once again print money. QE3, QE4, etc. And the cycle repeats itself until it all spirals down the drain.

A Future of Accelerated Money Printing

Note that the Federal Reserve announced it was purchasing $300 billion of government debt in March 2009. 20 months later it announced the purchase of three times as much, $900 billion ($600 billion in newly printed money and almost $300 billion in reinvested money). This has all the markings of an economic situation that is spiraling out of control.

Consider the fact that, this year, the Federal Reserve will be buying $900 billion of the government's estimated $1300 billion deficit. That means foreign governments and other investors will only fund $400 billion this year. The QE2 which is already underway can only serve to weaken the U.S. dollar, reduce confidence in the dollar, and may even provoke a global trade war. Any combination of these possibilities will reduce the $400 billion that investors will loan to the United States and increase the federal deficit which means the Federal Reserve would have to print more money.

While subject to all the same variables that caused my last prediction to be off by 12 months, the current trend would suggest that an even larger QE3 is on its way--probably in late 2011 or early 2012. The ramifications of a larger QE3 coming so quickly after QE1 and QE2 could be catastrophic.

It Must Be Stopped

Our current trajectory is self-destructive. We must stop what we're doing immediately. The Federal Reserve must stop printing money and the federal government must stop its deficit spending.

It's worth noting that although I applauded Republican lawmakers' request that Fed Chairman Bernanke not proceed with QE2, there's another way to solve the problem: Republicans in the House can reduce the federal deficit.

The Federal Reserve is printing money in order to feed the hunger of the federal government to borrow and spend. Yes, the Federal Reserve could stop this vicious cycle by shutting off the printing press. But, starting in January, Republicans will be in a position to stop it, too, by simply not spending the money. If the Federal Government doesn't need to borrow $900 billion a year from the Federal Reserve, there will be no need for the Federal Reserve to print it and we can avoid further debasing our currency.

So while it's fine for Republicans to criticize the Federal Reserve, that's the easy part. The hard part will be Republicans realizing they have no excuse to outsource the tough decisions to the Federal Reserve. Republicans in the House have the power to fix it themselves.

2011 cannot be a normal political year. There is serious work to be done to save our country from an economic crisis that will be far worse than what we've gone through so far. If we don't cut spending drastically, I'm not sure where we'll be in 2012. When governments start printing money, it usually ends very badly--and often much sooner than expected.

The most immediate threats our country is facing are the out-of-control federal deficit, the growing national debt, and the ongoing debasement of our currency. They all go hand in hand. But we already have everything we need to stop it: The U.S. House of Representatives.

If our newly elected Republican majority doesn't make serious waves in terms of quickly and significantly reducing federal spending, it might be too late to fix things by the time the 2012 elections roll around. Republicans can't hedge until the 2012 presidential elections--they have to move quickly and reduce spending now.

Republican Congressmen: Please, make it count in 2011.

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