No story has dominated the market news flow in the last year like QE2.  From its very inception I said the program was a “monetary non-event” and not going to achieve its targets for several reasons (it’s not money printing, it doesn’t alter the amount of outstanding private sector net financial assets, it’s not debt monetization, etc).  But perhaps more importantly, I’ve discussed the potential negative effects the program could have through the channels of misconception.  In other words, the myths of “stimulus”, money printing and debt monetization were all likely to fuel investors with a misguided perception as to how the program would impact the real economy.

I have called this effect an embedded disequilibrium in the market caused directly by the Fed and exacerbated by market participants who quite simply don’t understand what QE is or how it actually works.  From the perspective of the Fed, they thought they could “keep assets higher than they otherwise would be” (infamous last words of Brian Sack of the NY Fed).  But because QE had no transmission mechanism through which it could impact the real economy it in fact only created a disequilibrium between market expectations and the real economy via psychological channels.  And as the real economy has sunk we’ve seen much of this embedded “Bernanke Put” come out of the market in the last few months.

In just the last 24 hours we’ve seen the wheels come off of the “Bernanke Put” bus.  The markets appear to be realizing that the Emperor truly does have no clothes, that QE isn’t all it was cracked up to be and that the Fed can’t save the economy with their magical printing press (don’t worry – the Fed doesn’t print money anyhow, but that’s for another day).

Back in April I wrote a piece describing the enormous risks in the market due to this put:

“In a similar note to thought #1 – there is the potential for a very frightening market development in the coming years (work with me through this hypothetical). Let’s say the Bernanke Put continues to cause asset prices to deviate from their fundamentals – the economy continues to recover (marginally), but the Bernanke Put becomes so ingrained in market perception that the disequilibrium in markets expands. This results in an imbalance so severe that market bubbles appear (could already be occurring in the commodity space). What happens to the market if the disequilibrium Ben Bernanke causes results in some sort of serious market dislocation similar to 2000 or 2008? All it would take is a minor exogenous threat to cause a global panic. It could be surging oil, a slow-down in China, a repeat of the Euro scares….The result would not only be economic slow-down (into an already weak developed market), but potentially crashing asset prices as bubbles have a tendency to overshoot on the downside. But it’s not the recession that would scare the markets. It is the potential backlash against the Fed.

After three bubble implosions in less than 15 years (all somehow directly tied to Fed intervention), I think the public would call on Congress to revisit the Fed’s dual mandate, its impact on markets and whether their actions over the last 20 years have been appropriate. The rational response would be to reduce the Fed’s role in markets. From a societal perspective I think this is an enormous long-term positive. The sooner we get the Fed out of the market manipulation game the sooner this economy can stabilize, definancialize and get back to becoming the economic growth machine that it has been for so long. For the markets, however, this would be a traumatic event. Imagine 20 years of Greenspan/Bernanke Put being sucked out of the market…it might sound far fetched right now, but I have a feeling the Fed will be far less involved in markets at some point in my lifetime. It might be wishful thinking, but I am confident that America will wise up to the destruction this institution causes by constantly distorting our markets and economy.”

Now, I think it’s a bit hyperbolic to say that the markets have lost faith in the Fed entirely, but I think we’re certainly seeing the market lose some faith in the Fed’s omnipotence.  20 years of flawed monetary policy, mythical thinking about the workings of our monetary system and misguided market intervention bring us to this point.  Unfortunately, misguided policy has now created such disequilibrium in the markets that the backlash has the very real potential to cause real economic declines.    So buckle up folks.  We’re living in a golden age of economic transformation and theory.  Unfortunately, that means we have to erase the decades of myth and fantasy perpetuated by the same neoclassical economists who got us into this mess in the first place (most of whom are still driving this bus).  And that’s going to cause a great deal of policy error, misconception and uncertainty.  Hopefully in the end we’ll come out of this a bit wiser.  One can hope….

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Cullen, I agree that QE is a defective policy (though what else the Fed is supposed to do, I don’t know). I don’t agree that there is no transmission mechanism at all connecting QE to the real economy. The private sector has its preferred range of assets from liquid to illiquid. QE leaves the private sector with too much liquid stuff. So the private sector will react by trying to purchase illiquid assets: bonds, cars, houses, etc. Thus there is a finite effect on demand.

  2. May you live in interesting times…

    P.S. Someone said: “Why is M2 increasing then?”

    A few of us had a long conversation about this. This article was linked to:


    And Scott Frew pointed to certain European banks parking money with their US subsidiaries together with the changing of Regulation Q a few weeks ago to allow commercial banks to pay interest on deposits; this means that corporate cash accounts now show up where they didn’t before.

  3. I have a basic question regarding this assertion that QE does not lead to money printing

    Government issues bonds to finance spending
    Instead of these bonds going to normal investors, the Fed buys the bonds, giving the govt what we call cash which then goes towards paying the govt.’s expenses
    So investors are left with more cash than they would otherwise have been which they then apply to assets like commodities, raising the price of these commodities. Of course not all cash goes there because a lot of it seems to end up in bank reserves at the fed

    If the fed were not buying bonds, that extra cash would not be created and it would be the existing cash of investors that would just cycle through the govt to those who are paid for good and services provided to the govt

    What am I missing?

    • Euler, This is a partial answer to your question – not a complete answer.
      There are some farcical elements to the whole idea of having government borrow and spend money (which I think you have half tumbled to). Abba Lerner and many MMTers think government should simply print money and spend it in a recession, and conversely, given excess inflation, government should rein in money via extra tax and “unprint” it, or extinguish it. Milton Friedman and Warren Mosler advocate a “zero government borrowing” regime: that’s borrowing in the sense of paying interest to anyone. (Printing money, i.e. creating monetary base, could at a stretch be said to be a form of borrowing, but that is stretching the meaning of the word “borrow”). For Friedman, see here:

      For Mosler, see here (2nd last paragraph in particular):

      I’ve also run through the various arguments for government borrowing and demolished them here:

      BTW, are you related to Leonhard Euler who invented some of the basic equations governing fluid dynamics? :)

  4. Thanks Ralph. Euler just happens to be on of my favorite mathematicians :)

    I see what functional finance is getting at but I also think that the fact that we have a running total of what the govt has spent/ is spending under the current system of “borrowing” to “spend” is the biggest factor underpinning confidence in the system i.e. The Dollar. The “debt” is a counting mechanism for trading partners to determine that the US is not being irresponsible in issuing too much currency- they don’t to wait until high inflation shows up in the economy to realize that too much money was printed.

    If the US were to just keep printing because that happens to be easier to do and packs a bigger punch, then the dollar would stop being accepted around the world and inflation would no longer be controllable by domestic monetary policy alone without destroying the economy.

    I think MMT is accurate in describing the current system but it assumes that exercising the power of printing has no cost in terms of credibility which is false. The course of action thrown up as optimal by MMT is intuitively wrong because it makes a huge assumption of ceteris paribus.

    • Perception rules markets, not reality. But reality has a way of catching up with perception. When that happens, there is a sudden reversal of perception.

      No doubt a lot of people cannot distinguish between private debt that needs to be repaid out of future revenue, past revenue (saving or sales of assets), and government “debt” that is serviced merely by crediting bank accounts. These people see a cause for inflation where there is none.

      I am also hearing from some people that Ben took back his put by funding LT purchases with ST sales instead of “printing.” They are clamoring for him to reinstate the put by continuing to print instead, which has nothing to do with anything but the amount of reserves sitting in accounts at the Fed.

    • “…the dollar would stop being accepted around the world and inflation would no longer be controllable by domestic monetary policy alone without destroying the economy.”

      The world would have to find another trading partner with GDP the quarter of the world’s. How likely is that?
      Have you read Warren Mosler’s 7DIF?
      P.S. Monetary policy does not control inflation as it is.