No QE3

There should not be a QE3. 

The Federal Reserve via QE1 made herculean attempts to prevent a deepening of the worst recession since the 1930s. When it was evident our economy was headed back into recession in the summer of 2010, Ben Bernanke announced QE2 during the Jackson Hole conference.  With appropriate reference to the central theme of the movie Groundhog Day (a favorite of mine), the 2011 US economy followed a similar script to 2010 and required more monetary steroids when QE2 ended  — Operation Twist (OT).

What happens when OT ends in June 2012?   Will Ben launch QE3 during this year’s Jackson Hole conference?   I sincerely hope not.

In this country, the central bank (The Federal Reserve) has a dual mandate (since 1978):

• full employment
• stable prices (read as low inflation)

That’s a short list. Conspicuously absent from that list is a mandate to:

• encourage speculation,
• drive the stock market higher,
• punish investors reliant upon income or that are otherwise unwilling to place a large portion of their life savings in the Vegas-like machine that is the US stock market,
• foment international unrest from a drop in value of the US dollar.

It is true that QE1 played a very significant role in stopping an economic collapse in 2009, and that it spurred another sugar-rush unsustainable stock market rally (is that what prosperity is?).  But there was no free lunch.  QE1 managed to reverse the deflationary forces taking hold of the economy, but it also significantly debased the value of the US dollar. This in turn meant the most significant export of the United States became inflation.

QE2 took over where QE1 left off:

• another risk-on unsustainable purely speculative stock market rally,
• high quality bonds lost value again (penalizing those that were defensive and conservative),
• interest rates rose on consumer loans and mortgages,
• food and fuel inflation spiked in the US and globally. In no small part, QE2 helped induce the “Arab Spring”.

Launching QE3 might provide yet another sugar-rush stock market rally (though probably smaller). But whatever the perceived gain might be, it would be counter-balanced by the detrimental effects of heightened food and fuel inflation, and higher interest rates.  Surely the point of diminishing returns was reached with QE2.

Conventional monetary policy tools seem to have worked in rectifying previous recessions. A case could potentially be made to launch QE3 if it were obvious we were in a classic business cycle recession and that one more dose of monetary steroids might cure the ailment (not merely mask the symptoms).   But it is clear we were not (2007-2009) and are not now in a business cycle recession.  Rather, we have been and are in a much more challenging type of recession: a balance sheet recession. The best that can be hoped from monetary policy tools in a balance sheet recession is they act as an expensive snooze button. The systemic economic issues don’t go away. They merely wait to be addressed. But the cost of the most recent monetary policy tools (QE1 & QE2) are such that they’ve added to the systemic problem by increasing our public debt.  It turns out you can’t solve a debt problem with more debt.

Let’s briefly look at what joint myopic monetary and fiscal policy intrusion has delivered over the past 12 years:

• A recession in year 2000. 18 years of overspending and irresponsible myopic fiscal policy was beginning to take a toll.  Arguably, we should have taken our medicine then. But no. More monetary and fiscal steroids. The S&P500 lost 47% as demand collapsed.  The Fed dropped short term rates to 1% in response. The US Congress & White House gave us unfunded tax cuts for a decade and introduced a massive new unfunded healthcare liability (medicare part D). The result was as expected: an artificial housing and stock market bubble. A colossal mis-allocation of resources and waste of several years.  The problem was made larger and delayed for someone else to deal with.
• A recession recurred in 2008-2009 when the eventual housing and stock market bubble burst.  The S&P500 lost 57%. This time it took 0% interest rates, QE1, QE2, $ Trillions in US bailouts and Keynesian fiscal policy stimulus (spending beyond our means), and a stream of sovereign bailouts in Europe that remains unresolved.  The snooze button again.
• Another recession will likely begin in early -mid 2012.  Currently, the S&P500 is back where  it was 12 years ago. Worse, there is a very good chance stock markets will fall through the March 2009 lows.   Why shouldn’t they ?  Are the economic prospects that much better than they were 3 years ago?  Have we managed to address any of the systemic issues in our economy?   

There should not be a QE3 or any other monetary policy intrusion. Our three decade debt binge needs to be worked off.   I am mindful that this position necessarily means the US and most world economies will head into the worst recession since the 1930s and thus do not lightly espouse this.   But more monetary policy tricks will only add to the problem.

The last time we saw a balance sheet recession was the 1930s. We know what came next: WWII.  Let us try to avoid the same mistakes.    Ben, avoiding WWIII may not be part of the Fed’s mandate.  But it should be.

(August 26 2011 update:  Thankfully, the Fed decided against launching QE3 at today’s famous Jackson Hole summit.)