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March 15, 2011

Quantitative Easing: Our Tiger by the Tail

By Monty Pelerin
Friedrich Hayek's A Tiger by the Tail: The Keynesian Legacy of Inflation was published in 1978. It seems an appropriate description of what Quantitative Easing (QE) has produced. We are far along on a journey that cannot be stopped without enormous damage.

Quantitative Easing is a euphemism for money creation. Money creation is, by definition, inflation. Eventually inflation produces higher commodity and other prices. Inflation can be created by other Fed policies besides QE. However, for purposes of this article, QE will be dealt with as if it is the primary cause (which it has been recently).

According to Chairman of the Federal Reserve Ben Bernanke, we are in phase 2 (QE2) of "money printing." Those knowledgeable of history find this characterization amusing, because the Fed has engaged in almost continuous money creation from its founding in 1913. Since then, 96% of the dollar's purchasing power has disappeared with much of the loss occurring subsequent to the mid-1970s.

Mr. Bernanke initiated his so-called QE2 ostensibly to improve traction for the weak economic recovery. According to Bernanke, the program will end in June. With regard to his promise, Mr. Bernanke resembles Charlie Brown's friend Lucy placing a football.

QE will end but not in June, at least not permanently. It will not end as a result of political decision or Fed mandate. It will fall victim to Stein's Law: "if something cannot go on forever, it will stop."

Why Quantitative Easing?

Money creation is never proper economic policy. It does not improve or create wealth. Its purpose is to fool citizens. As such, it is a fraud employed by governments to deceive and steal. If high enough, QE results in societal disruption. At worst, it produces hyperinflation, violence and government overthrow. History offers numerous examples.

The famed economist John Maynard Keynes did not invent inflation, but he was instrumental in making it seem acceptable as economic policy. In his General Theory, he advocated solving unemployment problems by "fooling" workers with higher nominal wages. He assumed workers were too obtuse to differentiate between nominal and real wages.  

Keynes also was aware of the more devastating aspects of inflation:

The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

He probably was not advocating the destruction of capitalism, although his economic system and his elitism were not inconsistent with such an outcome.

What is Wrong With QE?

Inflation, as a policy, is a politician's dream. As Friedrich Hayek noted:

... moderate inflation is generally pleasant while it proceeds, whereas deflation is immediately and acutely painful.

Given the short-term orientation and desire to please, inflation is an easy political choice. From an economic standpoint, however, inflation is always harmful. Keynes' ideological opponents understood the short-term benefits, but knew inflation's dangers. Ludwig von Mises stated:

Credit expansion can bring about a temporary boom. But such a fictitious prosperity must end in a general depression of trade, a slump.

In a swipe at Keynes notorious short-term focus, Mises stated:

In the long run we are all dead. But unfortunately nearly all of us outlive the short run. We are destined to spend decades paying for the easy money orgy of a few years.

The absurdity that money creation can produce economic benefits was illustrated in this Mises' observation:

If it were really possible to substitute credit expansion (cheap money) for the accumulation of capital goods by saving, there would not be any poverty in the world.

All economists recognize that cessation of a monetary expansion will contract the economy. Regardless of how beneficial a cessation might be, it is politically untenable to be seen deliberately engineering such an outcome. That is why QE will not end as a result of conventional political means.

Why QE is Unsustainable

Economic stimulus via monetary expansion has a limited life because inflation, in order to provide stimulus, must continuously accelerate. As described by Milton Friedman:

Inflation is like a drug. Its stimulating effect is temporary. Only larger and larger doses can sustain the stimulus, before the chaos of hyperinflation removes all the gains.

Friedman's "larger and larger doses" are necessary, but not sufficient. These increases must also "fool" or thwart the expectations of economic decision makers. As Hayek expressed it:

Inflation thus can never be more than a temporary fillip, and even this beneficial effect can last only as long as somebody continues to be cheated and the expectation of some people unnecessarily disappointed.  Its stimulus is due to the errors which it produces. It is particularly dangerous because the harmful after-effects of even small doses of inflation can be staved off only by larger doses of inflation.

When it becomes apparent what is happening, people anticipate future government action and act to protect themselves. Once enough people understand the game, the charade ends either as a deep recession/depression (cessation of inflation) or a hyperinflation. The latter occurs when people spend money as quickly as they receive it in order to avoid the loss of purchasing power. In effect, money ceases to be used and society deteriorates to a barter economy.

Why QE Will Continue Until Hyperinflation Stops It

From a purely economic perspective, QE and inflation should never have occurred. From a political standpoint, it is a means of hiding the critical economic condition of the country. A stoppage of the program would result in two likely outcomes:

  • 1. A Depression
Economic and financial performance has been artificially inflated by QE. A bubble in both areas has developed as a result of QE.  Chris Martenson explains:

The Fed has been dumping roughly $4 billion of thin-air money into the US markets each trading day since November 2010.  The markets, all of them, are higher than they would be without this money.  $4 billion per trading day is an enormous amount of money.  As soon as the QE program ends, the markets will have to subsist on a lot less money and liquidity, and the result is almost perfectly predictable.

From the standpoint of economic stimulus, many analysts believe that QE has run its course or even failed. Edward Harrison states:

QE2 has only been successful insofar as it has increased business credit and raised asset prices. In my view, QE2 has been a bust as it adds volatility to the system and will have negative unintended consequences down the line.

If QE no longer provides economic stimulus, then why continue it? Quite simply, stopping QE would potentially cause markets to collapse and the economy to enter a depression. Stopping it also would risk bankrupting the Federal government.

  • 2. A Government Unable to Pay its Bills
The Federal government is insolvent. Without QE it would likely be illiquid. It is doubtful the US could sell enough debt to arms-length buyers to sustain its current spending. The current estimate of the deficit is $1.7 Trillion.

Without QE there would be added distress for government and the economy. Domestic interest rates would rise to whatever level necessary to attract market funding. Higher interest rates would provide a further drag on the economy. They would also dramatically widen government deficits. Kyle Bass quantifies what a return to more normal interest rates would do to government spending:

... a move back to 5% short rates will increase annual US interest expense by almost $700 billion annually against current US government revenues of $2.228 trillion (CBO FY 2011 forecast).

Added on top of current spending, this cost would increase the deficit to $2.4 Trillion, more than projected revenue collections this year. The government would then be spending more than 200% of what it collected.

Traditional Treasury investors (foreign individuals, other sovereigns and US investors) are likely unwilling to buy the amount of debt necessary to support US deficits. The biggest non-government buyer of Treasuries, Pimco, the world's largest bond fund, has eliminated Treasuries from its holdings as reported by Zerohedge:

Based on still to be publicly reported data by Pimco's flagship Total Return Fund, the world's largest bond fund, in the month of January, has taken its bond holdings to zero.

In June 2010 Pimco held a record $147.4 billion of US government securities. Since then, these holdings have dropped to zero. Pimco now holds record cash balances.

Serious concerns over continued US profligacy have been expressed by foreign lenders. China, Japan, Britain and other sovereign nations have neither the ability nor the inclination to continue to support our sovereign version of Blanche du Bois's depend-upon-the kindness-of-strangers. Their economic conditions are at least as dire as ours and as much in need of funding.

Money invested in US Treasuries by foreign sovereigns has produced losses. A report issued by the Bank of International Settlements (BIS) in 2008, observed and warned:

Foreign investors in U.S. dollar assets have seen big losses measured in dollars, and still bigger ones measured in their own currency. While unlikely, indeed highly improbable for public sector investors, a sudden rush for the exits cannot be ruled out completely.

The dollar has depreciated since the BIS warning, further increasing losses to foreign investors.

Is There a Way Out?

The fraud that the US government has become over the past several decades is now apparent. Our economy has been hollowed out as a result of "bubble economics." Consider just some of these facts:

  • Many citizens have filed bankrupted as a result of the financial and housing bubbles.
  • Housing prices are expected to fall another 10 - 20%.
  • Retirements have been deferred and many will never happen.
  • Capital has gone overseas to be treated better with respect to taxes and regulations.
  • Jobs have left with the capital.
  • Unemployment is near all-time highs if measured correctly and many economists believe it will remain extraordinarily high for a decade or more.
  • The social welfare network is under irreparable pressure and will be recognized as bankrupt within the next few years.

In short, our economy is in a shambles despite what the propaganda machine spews. Harry Schultz, famed investment advisor and newsletter author, wrote at the age of 86 in his final newsletter:

Roughly speaking, the mess we are in is the worst since the 17th century financial collapse. Comparisons with the 1930's are ludicrous. We have gone far beyond that. And, alas, the courage & political will to recognize the mess & act wisely to reverse gears, is absent in the U.S. leadership, where the problems were hatched & where the rot is by far the deepest.

Mr. Schultz has seen a lot in his lifetime. His description, unfortunately, is correct. We are on the brink of a massive collapse -- economically and politically. There are only two choices left for our political class. They were laid out by Ludwig von Mises long ago:

There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.

Their choice seems obvious. QE will continue until total catastrophe occurs in the form of a hyperinflationary depression. Politicians will then point fingers at everyone but the real culprits - themselves. In the enlightened era of alternative news, their strategy probably cannot work.

If I were a politician, I would resign immediately and head for safety before it becomes apparent to the masses what is going to happen.

A parting caution: While I expect QE to run until a hyperinflationary collapse ends it, an announcement that it has been terminated could cause a severe collapse in financial markets. Be aware of the possibility of this "Lucy football strategy" by a desperate and reeling Ben Bernanke. Expect QE to be reinstated quickly once some pain is felt.

Monty Pelerin blogs at www.economicnoise.com 
on "Quantitative Easing: Our Tiger by the Tail"