NORTHERN TRUST: QE1 FAILED, WHY WILL QE2 WORK?
Most market participants are fixated with the potential for QE2 to boost asset prices and generate organic economic growth, however, without a subsequent rise in aggregate demand and productivity the program will ultimately be deemed a failure as prices readjust over time to reflect the real underlying fundamentals. Mr. Bernanke is making the same blunder that we made with the past bubbles busts – if we can create paper profits and convince consumers that they should spend those paper profits then we’ll be on our way to economic prosperity. The problems arise when asset prices readjust lower to meet their true fundamentals. It’s ponzi finance and nothing more.
As I have previously explained, the goal of QE is to increase aggregate demand by creating a fictitious wealth effect and by increasing bank loans. The market appears to think that QE1 was some sort of success, but as I have argued, QE1 was only successful because it altered bank balance sheets and alleviated the credit strains. After all, this was Ben Bernanke’s goal at the time – to alleviate the credit pressures. What QE1 did not do (and what we need now) is increase lending supported by a boost in real aggregate demand. QE does not add net new financial assets to the private sector and is not inherently inflationary though Mr. Bernanke appears to be convinced otherwise. Unfortunately, QE1 failed to succeed in contributing substantially to the economic recovery as Northern Trust recently showed:
“When the Fed embarks on QE2, all else the same, Federal Reserve Bank credit will increase. What transpires with respect to commercial bank credit will determine the effectiveness of QE2 in increasing aggregate demand for U.S. goods and services. The more commercial bank credit increases in tandem with Federal Reserve Bank credit, the more effective will be QE2 in creating aggregate demand. If, however, commercial bank credit should decrease by the same or greater amount of the increase in Federal Reserve Bank credit, then QE2 will be a failure in creating additional aggregate demand. This is what happened when QE1 “set sail.” Chart 3 shows the behavior of the sum of Federal Reserve and commercial bank credit. The shaded area in Chart 3 represents the period in which QE1 was in effect. As can be seen in Chart 3, during the “voyage” of QE1, the sum of Federal Reserve and commercial bank credit trended lower. Chart 4 shows how this came about (no sailing pun intended). A small increase in Federal Reserve Bank credit in the 16 months ended March 2010 was offset by larger decrease in commercial bank credit during the same period.”
QE1 failed to boost bank lending and aggregate demand. Therefore, why would anyone assume that this time will be different? I think the market is pricing in an economic outcome that will fail to materialize.
Source: Northern Trust
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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16 Comments
“QE1 failed to boost bank lending and aggregate demand. Therefore, why would anyone assume that this time will be different?”
Because a syringe half filled with junk didn’t cause enough of a high, let’s try a full syringe
“The market appears to think that QE1 was some sort of success…”
“I think the market is pricing in an economic outcome that will fail to materialize.”
I don’t think the primary focus of the market is the impact of the Fed’s actions with reserves or lending by banks. Several stories materialized during QE1 that suggested the Fed and/or Treasury were propping up the stock market, which helped fuel the 2009 rally. It seems like the market believes another Fed program (i.e. “QE2″) will be used to provide coverage while stock prices are artificially inflated again and the market is positioning itself for the run up. Why wouldn’t they be lining up if the Fed/Treasury are about to start handing out free money again.
The discussion about reserves, lending, and asset swaps is just the smoke screen that will be used to explain the results. “Look over there while we do this over here…again.”
Who cares if asset prices rise without a subsequent rise in underlying fundamentals? This is the point the market appears to be ignoring now. The Fed thins they can generate economic recovery by inflating assets. It is a bad plan.
“Who cares if asset prices rise without a subsequent rise in underlying fundamentals?”
Just the vast majority of Americans and all the Wall St. types who know they can get out first
The “vast majority of Americans” could care less. They have very little skin in the game.
The stock market is not only the nominal price of capital, but the society’s sentiment barometer. They care indirectly or without knowing it.
What I find amazing is that no seems to remember what happened in the 1970s. The big economic theory of the time was the Phillips Curve that “proved” a direct relationship between inflation and employment. Supposedly, higher inflation would lower unemployment. It did seem to work – for a while, but when inflation got to high, the Fed raised interest rates and unemployment then went higher than before. The end result after several years of economic experimentation was unemployment higher by about 50% and inflation doubled.
“I find amazing is that no seems to remember what happened in the 1970s”
That is probably correct QE may not add net new financial assets to the private sector but it does in the public sector. New T bill paid with new money is certainly not deflationary.
Agricultural and almost all commodities continue to skyrocket which means that price increases are on the way.
Also as the kick the can economy gets closer to the brick wall the Federal Reserve is participating in a new 1970′s kind of scenario only much worst.
However after listening and reading the latest Greenspan statement and especially Bernanke on October 4th he seemed to be sending a signal to congress that this fiscal orgy can not keep going on for very long. Its as if he said (in very different words) If we have a choice between sinking the US$ or stooping the fiscal madness and delusion the Fed can not be expected to be there indefinitely as the lender of last resort. He did not say it like that he said it in very cool and sophisticated economic jargon but its clear he was sending a clear message. That is very encouraging and could be a game changer in the coming year. Lets hope.
Bernanke is no different than John Law or John Blunt and it will end the same way.
I think it is so amusing to see so many of us shaking in our boots at the thought of QE2 working and leaving those behind who don’t believe it and refuse to risk capital to chase it….
We know that QE is less effective as a tool than rate cuts and we know that rate cuts themselves have never been able to forestall recessions and/or bear markets….
What is there to fear?
The only fears any of us should have are the implications for our country that result from the path the Fed has chosen. I fear the potential for a permanent competitive gap that could arise relative to the developing world…how long will we be forced to pick up the pieces?
This like ‘Friday the 13th’. I wonder how many sequels it will take before Freddy Bernanke jumps through the screen and pull us all through. I can already see QEIV.
Jason, not Freddy.
Seriously, I just watched a video at Steve Keen’s site “Debt watch”, and he made a pretty convincing case that it is going to take a lot more than QE to get us out of this mess. Warning, it is about an hour long speech.
“Who cares if asset prices rise without a subsequent rise in underlying fundamentals?”
Everyone still trading and investing cares. Make no mistakes, our system is no more capitalism, instead it is socialism on roids. No one has come to realize this but it is cold fact. policy change from government trump your fundamental analysis, technical analysis, and whatever. Moreover by controlling price of money, they control price of everything.
So if you still want to make money in markets you need to know why price move without fundamentals. Throw away all Keynesian, Austrian, monetarist textbooks because they do not offer answers. Read Marxist Political Economy and understand class struggle. It is going to help a little. if you find it is too disgusting you can always call quit, just like Stan Druckenmiller and Paolo Pellegrini.
Jeff Saut at Raymond James seems to think QE works:
My message remains pretty simple. With more quantitative easing (QE2) on the way, the risk of another downdraft in housing has been taken off of the table. It has also boosted commodities, which is plainly good for our “stuff stocks.” Additionally, QE2 should spur more M&A activity, increase share repurchases, and lower the U.S. dollar (good for export companies), all of which is positive for the S&P 500.
Additionally,
This is why you want to have your depreciating dollars in productive asset classes that throw off cash flows, and hopefully keep up with the inflation, which unless the laws of economics have been repealed is surely coming.
Thoughts?
Because everybody has been chased into “productive asset classes”, the CEOs and the elite have started to extract rents out of the minority shareholders with obsene comps (500x average) and share dilutions. So operating “productive asset class” EPS is quite lower than final reported, adjusted for dilution. Its yet another racket scheme, similar to banks overleveraging ans socializing losses under the illusion of regulation.