I’ve shown in rather elaborate detail in recent weeks that quantitative easing does not help the real economy generate a sustained recovery.  This can be summed up as follows:

“QE’s effect on raising aggregate demand and prices was often limited” (Ugai, 2006)

  • QE has been shown to have had little to no impact in the U.K.  (also see here).
  • While QE worked to ease the strains in the credit markets in 2008 and also improved bank balance sheets there was no change in interest rates during the entirety of the program in the USA and borrowing has remained very weak.
  • Because the US has a demand side problem and not a supply side problem QE is unlikely to result in higher aggregate demand and revenues (see here).
  • QE is likely to negatively impact corporate margins as investors falsely interpret QE as “money printing” and seek the safety of hard assets (see here).
  • The “wealth effect” of QE is likely to fail.  Attempts to keep asset prices “higher than they otherwise would be” will always fail (see here).
  • Since QE has been shown to have no discernible long-term impact on interest rates or aggregate demand there is no fundamental reason for stocks to move higher due to the program (see here).

All of my work regarding QE has me wondering why the Fed would implement such a policy when the evidence appears to point to little to no gain in economic growth?  The only logical answer is that QE2 is really just another case of the Federal Reserve proving that this is a country centered around the bankers, by the bankers and for the bankers. Before you brush me off as some conspiracy theorist please consider the evidence.

The problem with a policy like QE is that it does not actually add net new financial assets to the private sector.  This is ultimately the primary misconception regarding QE. The expansion of the monetary base is not net new money in your pockets.  Thus, it will not help finance new spending or investment, it will not create jobs, it will not increase aggregate demand, etc.  Therefore, any policy effectiveness is based on a shuffling of assets and hopes for a sustained psychological change.  A sitting member of the FOMC has (finally) admitted that QE is unlikely to do anything for the economy:

“What is the ultimate impact on the overall economy of this shift in risk? In the baseline models used by central banks, all bondholders are taxpayers. In these models, QE is essentially  shifting risk from one pocket to another. As a result, the increase in tax risk (what I’m calling the fourth effect of QE) completely undoes the decrease in interest rate risk (the third effect of QE). QE ends up having no effects, except for those associated with any new forward guidance that it signals.”

But there is one distinct benefit of such a policy – it alters the composition of bank balance sheets.  At the end of the day it’s really just an asset swap and a transfer of risk via bond duration or bond type.  The kicker here, is that if you’re a bad bank with a few trillion dollars in bad mortgage paper you’re delighted if a AAA rated entity comes in and swaps those assets out with their highly rated paper.  This is exactly what the Fed did in 2009 and make no mistake – it was hugely successful in clearing the credit markets and altering the composition of bank balance sheets.  This was Mr. Bernanke’s goal after all.  He was simply trying to clear the credit markets and improve the banking system and he believed that would ultimately fix the problems in the US economy. Unfortunately, he misdiagnosed a household balance sheet recession as a banking crisis.  QE1 provided liquidity in the credit markets and it gave the banks some much needed breathing room.  Unfortunately, the impact on the real economy was far more muted.

I think Ben Bernanke knows all of this.  He has added $1T in reserves to the banks already and it hasn’t resulted in a surge in borrowing or self sustaining economy recovery.  It doesn’t take a genius to understand that adding another trillion won’t change anything either.  If there is low demand for apples putting more apples on the shelves does not improve the apples salesman’s ability to sell more apples.

But Mr. Bernanke is seeing the same thing that I am seeing.  He sees a weak economy and a housing market that appears to be rolling over again.  Knowing that the banks are extremely fragile here and understanding that there is absolutely no political will for another bailout Mr. Bernanke is creating his own bailout by bypassing Congress.

Some of my colleagues say I am giving Mr. Bernanke far too much credit here.  After all, this would require a great deal of foresight and a level of proactivity that hasn’t really been a trademark of his in recent years.  I am not so certain.  In fact, I don’t doubt for one second that Mr. Bernanke is fully prepared to do whatever he must to avoid another bank meltdown.  He continues to believe that this is a supply side problem and not a demand side problem.  He may have failed in his mandate of full employment, but when it comes to the banking sector Mr. Bernanke is more than accommodative.

What’s unfortunate in all of this is that the policy is being sold to the American public as if it’s a Main Street stimulant.  There is, arguably, some merit in doing what Mr. Bernanke is doing.  After all, another bank meltdown would be truly traumatic (though probably necessary).  So, there’s an argument in favor of being prepared.  But selling it as another Main Street stimulant is disingenuous at best.  And unfortunately, 99.9% of the public is too oblivious to:

1. Understand QE

2. Raise a fuss.

The implications are obvious.  The Fed will likely start with a rather small round of QE this week.  After all, if I am correct Mr. Bernanke doesn’t want to unload all of his shells too early.  He wants to be fully prepared in case the banks relapse so he can step in with a sizable bank bailout.  So, don’t be one bit surprised this week when Mr. Bernanke announces a small round of Treasury purchases with the option to buy MBS in the future.  In all likelihood, this program will remain open until it’s clear that the U.S. economy is sustaining recovery and another bank meltdown is off the table.  Don’t be fooled into thinking that this is some economic panacea.  Unless of course, you’re a banker.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

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. I wonder if he has enough foresight to see the potential threat from Paul heading up the House Fin Services sub-committee and the limitations that may put on him using any of his remaining shells in the future.

    It’d be interesting if that is at any level factoring into his decision making on initial QE2 program size.

  2. TPC
    I Love You Man, but if I hear you say “asset swap” again I am just going to puke.

  3. and to think we could have “had” a swedish model.

    oct ’07 right before i started reading here, told my naval architect buddy wyatt,we should “RTC” all the banks that are in trouble…….better in the long run.

    when they did what they did i bought gold…..up 92% now…..far from over.

    they make their irrational move….knowing that people are irrational,i’ll make mine.

  4. Good thoughts. The evidence is overwhelming the QEII will not rekindle growth in the economy if we just look to QE I..Or if it does it will be temporary 2% or less GDP growth despite the enormous fiscal/monetary stimulus. I somewhat agree with you theory in the Banks but I suspect Ben knows that we are potentially facing a funding crisis with our Federal Debt. 60% or $5.2 trillion of our debt matures in the next three years….rising rates could derail the economy to a point where Ben cannot pump it up fast enough. I suspect the signal is the Fed will be involved in the coming years in a measured way and will be by the phone to make sure our auctions run smoothly in the coming years. He realizes we need to extend the maturities on the debt while keeping rates low and the Fed stands ready to help out Timmy here.

    I agree with everything you are saying but I wonder In the face of this WHY DOES THE MARKET CONTINUE TO GO UP? IS THE DAY OF RECKONING COMING? OPINIONS…. The collective market obviously doesn’t see a problem.

  5. TPC,

    I’m glad you put this post up, as it goes a long way towards answering a question from before about why the FED would actually go ahead with QE2 this week. In addition to the backhanded bank bailout, I think Uncle Benny believes a higher stock market will ultimately lead to economic growth through the wealth effect, increased spending, etc. and it seems he also believes that QE will continue to drive equities higher. It’s nice to see a growing body of analysts refute this notion, and when it becomes mainstream for traders, they will begin to shun QE as well. It should be interesting to watch how quickly greed leads to fear as investors finally begin to realize this fact and once again price equities according to their economic reality. However, it is hard for me to project how far they may actually take markets before sanity sets back in.

    To lend some credence to your bank bailout theory. Look at Wilmington Trust (WL) today. They sold the business for just about half of market value based on Fridays close. Is this a one off event, or a possible indicator of the true value of the regional banks, if not the entire banking system. Pretty soon the QE2 chatter will inevitably turn to Bank Bailout 2, or Tarp 2.

  6. Makes sense.

    MBSs remain a huge problem, especially now that it’s being determined that they were incorrectly/fraudulently constructed from the start. Any way of getting more of this mess off the bank books and absorbed by the taxpayer is a winning formula for the banking system. Especially if the Fed can absorb the legal / payout costs that are coming from these. Otherwise, as Whalen has been saying, the banks might not be profitable for years to come.

    And we can’t have that.

    Also, correct me if I’m wrong, but I don’t believe the Finance subcommittee has any actual real power over the Fed. Thus I don’t see what, other than long public haranguings, Ron Paul will be able to do about the Fed’s actions. The Pubs may stop Dem stimulus programs (while upping their own variety), but AFAIK the Fed can effectively do what it wants, as that is how it was initially set up.

    In addition, I find it hard to believe the Pubs are honestly going to bite the hand that has so often fed them. Ron may go on a tirade or two, but the rank-and-file Pubs know from whence their bread is buttered. If the Fed serves the banks, and the Pubs serve the banks, then despite whatever public circuses may ensue over the coming months, no real change is likely to occur. Theater there may be, but I suspect there will be as much change from the upcoming legislative body as there was from the last.

  7. IMHO – QE 2 is TARP III.

    QE 1 (AKA Tarp II) was a dud. Of course much heralded QE 2 is just another TARP III bailout of the fatcat banks since the Feds are buying the very Treasuries the Treasury sold the banks using freshly minted cash.

    Here is how this rigged PONZI scheme goes:

    1. Fed gives near ZERO % money to the banks
    2. Banks buy Treasuries from Treasury for juicy “safe” 2% return and finances our deficit
    3. Feds buy BACK Treasuries from the bank AKA QE with freshly minted USD
    4. Back to 2 and 3

  8. Mr Bernanke:

    The market will not move the economy its the economy that needs to move the market. Have you not learned any thing from the Mr Greenspan.
    Doing the same thing and expecting a different result is delusional.

  9. We’ve had this huge rally in part on QE expectations. But the economy looks fine according to the ISM data and whatnot. Why do we need QE if the economy is improving?

  10. Thats it.
    So, in reality this is not so neutral swaps. If the fed is in fact purchasing existing bonds but the banks are replacing them buying new Treasuries from Treasury does this not Increase the money base?

  11. Agreed, TPC, that this is a disguised fiscal operation to bolster bank solvency in addition to liquidity by buying up more toxic assets at inflated prices for the Fed’s books, with the Fed taking the losses instead of the banks. SS @ 10:35 links to Randy Wray’s post explaining why this can’t work. The level of toxic assets is on the order of 20T and there’s no way Fed is going to take 20T on its balance sheet. That’s impossible politically and would risk Fed independence. In the end, the banks are going to be forced to write down the debt that cannot be paid, or pretend and extend is going to last until a shock exposes that the emperor is naked. You can’t get blood out of stones.

  12. TPC,
    Sometimes I wish your words were flowing out of my mouth (or fingered onto my keyboard).

    Great article.

  13. But you can try for as long as politically able, at the expense of everything and everyone else.

  14. Unfortunately, but see Ravi Batra’s The Coming Golden Age: The Coming Revolution Against Political Corruption and Economic Chaos (Palgrave Macmillan, 2007), for his ideas on how this is going to unfold as social revolution. Obama’s landslide victory and the Democratic sweep was an indication of it, but the new administration and Congress quickly sold out to the oligarchy after promising change in the campaign.

    The Tea Party is turning out to be the first overt manifestation of social revolt. However, the TP political leadership has largely been co-opted by the ultra-conservative wing of the GOP Establishment, even before being sworn in. They will be digging into Obama’s birth certificate, not going after the fraudsters, corrupt politicians, and complicit government officials in that caused the crisis.

    This is not the end of the story, however. The actual Tea Party is quite small. The rising public anger is spreading widely and is nonpartisan. Stand by for the next installment.

    Randy Wray has a satire on what’s likely to happen here. I think he is probably close to the mark.

  15. Oba Mao suggest that the banks are using the money from QE to buy longer term Treasuries. But, I have read that one of the reasons the banks are in trouble is that they can’t use that money except on Treasury bills or six month notes and they can get a better interest rate of .25% from the fed on excess reserves. Could anyone clear this up for me?

  16. The banks have been borrowing at close to ZERO % from the Feds. They then use good ol leverage and go long on bonds/securities or just buy 2/10 yr Treasuries yielding 2+ percent. Funny thing is that aren’t the Fed going to buy liquid and illiquid papers from the banks which also include the Treasuries? This sounds more like rigged system to me.

  17. Dear TPC,

    This is much more worthwhile read than any pretense in crushing some spacey notion, so keep it up. Grouchy but I do compliment.


  18. So be it.

    “Experience hath shewn, that even under the best forms of government those entrusted with power have, in time, and by slow operations, perverted it into tyranny” – Thomas Jefferson

  19. Not sure what Ben is invested in, but i DO know that since becoming Fed Chair he refinance into a 30-year fixed rate mortgage. Perhaps wants to pay back with cheaper future dollars??

  20. I’m not sure what all the fuss is about. QE has been tried so many times and it never works. The goal is always the same: 1) reduce interest rates & 2) reduce the trade weighted currency. But if you look at Japan, the UK and the USA in QE1 you’ll notice that rates rose during all three events and their currencies rose also. And just like today, we saw only near-term effects. Markets initially sold off on the news as the Yen, Pound and Dollar all declined at the onset of QE. But they then sharply corrected when investors realized that this was a non-event (as TPC likes to call it). The same phenomenon was also seen with interest rates.

  21. Remember that QE1 was a credit easing program and it worked. But we don’t need credit easing. We need higher aggregate demand. QE2, as you noted, will not do that.

  22. Guess I’m a tad more cynical. When I see and hear that Paulson and Bernanke are hijacking the world economy, I don’t assume for a second they are doing it to save the banks.

    What they are really doing is giving money to BANKERS for their private accounts via bonuses for utter failure, in the trillions. Frankly if the FED chooses to add quadrillions to banks I couldn’t care less. But to know that a sizeable portion of that money is going to the most magnificent failures in global financial history is enough to make me believe that once again we need to rid the world of the financial Tzars and their families and retake the wealth they have been given for massive fraud, failure, avarice and arrogance.

  23. Okay i see you have come around to my way of thinking. QE is a bank bailout, pure and simple. This is usurping congressional authority by taking our country’s resources to favor one segment of the economy over the whole. This is clearly outside of the fed’s mandate and i suspect illegal. The question is, how do we stop them?

  24. The FED (Ben B) has his finger on the trigger of the biggest Financial Weapons of Mass Destruction, making derivatives look like conventional bombs … we might as well duck under the desk and kiss our *ss goodbye.

  25. So your point is(which I agree with on a housing double dip)Big Ben sees the writing on the wall and is preemptively organizing his own bailout? Now call me crazy, but what’s to stop the banks from taking QE2 money and leveraging up again to chase performance and year-end bonuses? QE2 fixes some of their short term problems, but again there is no mechanism to force them to be responsible with that money (see citi’s new Too Global to Fail initiative and $144 billion in bonuses given out this year).

    That and there will be hell to pay if POMO’s start coming in short… With expectations set at roughly $15 – $20 billion a week, its going to get nasty if POMO’s start coming in under $10 billion a week.