This morning the chairman of the Federal Reserve Bank, Ben Bernanke told Congress that the benefits of quantitative easing were clear. He also told Congress that it needed to stop deficit spending while avoiding the upcoming spending cuts of sequestration. It was quite a bit of testimony from a man who is supposed to understand economics. Indeed, it sounded more like an advertisement for institutional hubris than a statement of economic reality.
First of all, let's talk about QE3, QE4 or whatever number we are at now. Currently, the Fed is buying treasury and agency bonds at a rate of just over one trillion dollars per year. For those who do not quite understand the operation of QE3, let me explain. By law, the Federal Reserve is prohibited from printing money to buy bonds, notes or bills from the Treasury. When the law was passed, Congress wanted to make sure that America would never just print money in order to pay its bills. QE3 is a clever way around that restriction. The Fed does not buy bonds from the Treasury. Instead, other buyers bid for the Treasury securities, then the Fed goes into the open market and uses newly printed money to buy the bonds from those who purchased them in the treasury auctions. The current expectation is that the federal government will run a deficit of just under one trillion dollars this year. That means that the Federal Reserve is going to print money to cover slightly more than the annual deficit. In other words, America is not actually borrowing money from anyone; it is printing new money to cover its debts.
At some point, all of this newly created money will cause chaos. All that is required for this chaos to appear is for all the excess money to start circulating. Right now, nearly all of the excess money is stashed away in accounts held by major banks. If the economy actually starts to pick up or if the banks begin to loan the funds to private borrowers, a flood of cash will hit the American economy. This is the classic recipe for high inflation.
Bernanke actually told Congress this morning that "Inflation is currently subdued, and inflation expectations appear well anchored.” Translating this into English, benificent Ben is telling us that the Fed is watching inflation levels and we have nothing to worry about at the moment. Here's where the hubris kicks in. Bernanke actually believes that the Fed will be able to do something that no central bank in history has ever accomplished. Bernanke wants America to believe that once inflation starts to grow rapidly because of all the excess cash, the Fed will be able to step in and reduce the money supply to stamp out inflation. The way the Fed would reduce the money supply is to start to sell all those Treasury bonds that it has been buying.
Let's do a thought exercise. Let's imagine that it is now March of 2014 and that inflation is now showing up in the data at an annual rate of 4.5% or so. This is not a disasterous level of inflation by itself, but it is a clear indicator to the Fed that much higher rates are coming, so under the Bernanke version of reality, the Fed steps in to reduce the money supply. What does that mean? Here are just a few of the effects:
1) The Fed stops buying bonds in the market and begins selling them instead. With the biggest buyer of bonds becoming the biggest seller, the prices of the bonds will go down dramatically. That means that interest rates zoom up. Just think of it: instead of a ten year Treasury bond paying around 2% it would jump up to 4, 5 or 6%. Remember, these are not really high rates by historical standards, but they would be killers nevertheless. If the shift in rates results in the government just paying one percent higher overall on the federal debt, that means that interest costs for Washington rise by just under $200 billion. It would put another hole in the budget.
2) Higher interest rates would not just hit the federal budget. All sorts of financial institutions and pension plans that hold federal debt would see the value of those bonds decline. Further, since most other sorts of debt like corporate and municipal bonds move in synch with the treasuries, the value of these instruments would also decline. It is hard to put a number on the decline in value, but it could easily top two trillion dollars.
3) Companies that need to borrow funds to cover expansion or operating costs would find loans much more expensive. That would reduce economic activity.
4) Higher interest rates would give a boost to inflation as the costs of these rates swirled through the economy.
5) Even the Federal Reserve would suffer a big loss. Just imagine how much the value of the bonds held by the Fed would decline.
6) The economy would be hit with major shots that almost inevitably would lead to a recession or a depression. Unwinding the QE3 program and those that came beforehand will mean suffering for millions of Americans as we go through another severe downturn.
In the fantasy world that Bernanke believes to exist, the policy makers at the Fed are all knowing and all powerful. They are able to know exactly what is happening and to take measures that are slight enough to permit the economy to stop inflation without all the bad side effects. Indeed, Bernanke is like all those Wall Street and Washington know it alls who were sure in 2007 and 2008 that they could handle any problem resulting from the mortgage crisis. Remember where that got us.
It concerns me that in writing this, I sound like a conspiracy theorist. Here is the doom that lies ahead! The sad thing this time, however, is that I am not describing a conspiracy. This is reality. I hope I am wrong.
First of all, let's talk about QE3, QE4 or whatever number we are at now. Currently, the Fed is buying treasury and agency bonds at a rate of just over one trillion dollars per year. For those who do not quite understand the operation of QE3, let me explain. By law, the Federal Reserve is prohibited from printing money to buy bonds, notes or bills from the Treasury. When the law was passed, Congress wanted to make sure that America would never just print money in order to pay its bills. QE3 is a clever way around that restriction. The Fed does not buy bonds from the Treasury. Instead, other buyers bid for the Treasury securities, then the Fed goes into the open market and uses newly printed money to buy the bonds from those who purchased them in the treasury auctions. The current expectation is that the federal government will run a deficit of just under one trillion dollars this year. That means that the Federal Reserve is going to print money to cover slightly more than the annual deficit. In other words, America is not actually borrowing money from anyone; it is printing new money to cover its debts.
At some point, all of this newly created money will cause chaos. All that is required for this chaos to appear is for all the excess money to start circulating. Right now, nearly all of the excess money is stashed away in accounts held by major banks. If the economy actually starts to pick up or if the banks begin to loan the funds to private borrowers, a flood of cash will hit the American economy. This is the classic recipe for high inflation.
Bernanke actually told Congress this morning that "Inflation is currently subdued, and inflation expectations appear well anchored.” Translating this into English, benificent Ben is telling us that the Fed is watching inflation levels and we have nothing to worry about at the moment. Here's where the hubris kicks in. Bernanke actually believes that the Fed will be able to do something that no central bank in history has ever accomplished. Bernanke wants America to believe that once inflation starts to grow rapidly because of all the excess cash, the Fed will be able to step in and reduce the money supply to stamp out inflation. The way the Fed would reduce the money supply is to start to sell all those Treasury bonds that it has been buying.
Let's do a thought exercise. Let's imagine that it is now March of 2014 and that inflation is now showing up in the data at an annual rate of 4.5% or so. This is not a disasterous level of inflation by itself, but it is a clear indicator to the Fed that much higher rates are coming, so under the Bernanke version of reality, the Fed steps in to reduce the money supply. What does that mean? Here are just a few of the effects:
1) The Fed stops buying bonds in the market and begins selling them instead. With the biggest buyer of bonds becoming the biggest seller, the prices of the bonds will go down dramatically. That means that interest rates zoom up. Just think of it: instead of a ten year Treasury bond paying around 2% it would jump up to 4, 5 or 6%. Remember, these are not really high rates by historical standards, but they would be killers nevertheless. If the shift in rates results in the government just paying one percent higher overall on the federal debt, that means that interest costs for Washington rise by just under $200 billion. It would put another hole in the budget.
2) Higher interest rates would not just hit the federal budget. All sorts of financial institutions and pension plans that hold federal debt would see the value of those bonds decline. Further, since most other sorts of debt like corporate and municipal bonds move in synch with the treasuries, the value of these instruments would also decline. It is hard to put a number on the decline in value, but it could easily top two trillion dollars.
3) Companies that need to borrow funds to cover expansion or operating costs would find loans much more expensive. That would reduce economic activity.
4) Higher interest rates would give a boost to inflation as the costs of these rates swirled through the economy.
5) Even the Federal Reserve would suffer a big loss. Just imagine how much the value of the bonds held by the Fed would decline.
6) The economy would be hit with major shots that almost inevitably would lead to a recession or a depression. Unwinding the QE3 program and those that came beforehand will mean suffering for millions of Americans as we go through another severe downturn.
In the fantasy world that Bernanke believes to exist, the policy makers at the Fed are all knowing and all powerful. They are able to know exactly what is happening and to take measures that are slight enough to permit the economy to stop inflation without all the bad side effects. Indeed, Bernanke is like all those Wall Street and Washington know it alls who were sure in 2007 and 2008 that they could handle any problem resulting from the mortgage crisis. Remember where that got us.
It concerns me that in writing this, I sound like a conspiracy theorist. Here is the doom that lies ahead! The sad thing this time, however, is that I am not describing a conspiracy. This is reality. I hope I am wrong.
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