On Sept. 12, the Federal Reserve announced an open-ended quantitative easing program in an attempt to stimulate the economy. Unfortunately, this new round of quantitative easing might end up hurting more than it helps. QE is a simple operation that hurts the economy while severely distorting financial markets by creating an environment that is ripe for speculation.
Before we begin, it is imperative that we understand what cash is. Cash, or Federal Reserve notes, is a very liquid United States government liability, just like a 13-week treasury bill. The only difference between the two is duration and interest. It is best thought of as the difference between a checking and a savings account.
Now, ask yourself: Do you consider both your checking and savings accounts cash? Of course you do. Therefore, it makes no sense to differentiate between the two, for they are both your assets and the government’s liability.
When you buy a treasury note, you are actually trading cash for a slightly less-liquid form of the same thing; if the government buys a treasury note, you receive the cash value of the security with less interest. We now see QE for what it is: an asset swap. Bonds are exchanged for cash, leaving the private sector with the same amount of assets. The only thing that changed was the term structure of the government’s liabilities. Armed with this understanding, it should be easy to understand why QE cannot stimulate aggregate demand, in spite of what the market seems to think.
The data confirms our thinking. During the second round of quantitative easing, colloquially referred to as QE2, home prices didn’t rise, the cost of 30-year mortgages didn’t fall, the cost of corporate borrowing didn’t fall substantially, consumers didn’t go on a spending spree, hourly wages didn’t increase, business didn’t go on an investment binge, commercial banks didn’t increase lending and it didn’t cause a surge in the GDP. If QE didn’t help the economy, what did it do?
QE2 unleashed the market’s speculative mood as participants sought to gamble on inflation. Speculators increased their buying on the margin, which appears to have stabilized markets for the time being. It does not seem like a stretch to assume that the increase in leveraged buying coincided with the market’s desire to hedge future inflation risk. This belief is consistent with the surge in commodity and oil prices, fueling higher headline inflation despite a global slowdown in economic activity.
The point here is the divergence between the real economy, which has deteriorated, and the markets, which have improved. Asset prices have been pushed up beyond their so-called fundamentals; stocks and bonds are supposed to be based on predicted future cash flows while commodities are supposed to be based on consumption relative to supply. Quantitative easing doesn’t enhance a company’s profitability nor increase consumption, but that’s not what the market thinks.
Misguided policy action has made the markets increasingly speculative. This has created the perfect environment for another financial crisis. All that is needed is a so-called exogenous shock that replaces inflation expectations with a deflation realization, to send speculators running toward the exits, only to find the doors are not big enough for everyone to get out.