The Catastrophic Danger of Quantitative Easing

Recently, I have spent a great deal of time analyzing quantitative easing. This is a process that is disintegrating in front of us as the U.S. Treasury bond along with mortgage bonds have been tanking despite the fact that quantitative easing is supposed to do the exact opposite.

Quantitative easing tries to accomplish two things: 1)keep interest rates low so that borrowing costs remain low and 2) pump money into the economy so that it filters through the economy and stimulates economic growth.

Now, the Fed accomplishes all this by simply creating money. They then go into the bond market and by bonds in order to keep their interest rates low. The main danger in this policy is that it masks reality and hides poor decision and thus keeps their consequences from happening until later when they explode.

In this case, the government wants to borrow an obscene amount of money. The market left to its own devices wouldn't allow the government to borrow this sum unless interest rates rose to an appropriate level to support the new level of borrowing. Instead, the Federal reserve goes into the market to buy bonds and keep their rates artificially low. By doing so, the Fed itself more and more becomes the only buyer of bonds. That's because the rest of the market would never lend at the artificially low rate. For instance, many market observers don't want to buy any more 10 year U.S. Treasury bonds until the rate gets to at least 4%. (it's now at 3.67%) So, if the Fed is to keep the 10 year U.S. Treasury at current levels it will need to buy them almost exclusively themselves.

There's another destructive effect. The Federal government wants to borrow an extraordinary amount of money. If the Fed let the market work on its own, borrowing costs would be so high that it ultmately wouldn't be able to accomplish all its goals. Instead, the Federal Reserve keeps interest rates artificially low and allows the U.S. government to continue to borrow at low rates. Without the Fed's intervention, treasury bond rates would likely be at least a full percentage point higher. Such borrowing costs would stunt their ability to borrow. For instance, without the Fed, the Obama administration would likely have to table universal health care because there simply wouldn't be enough money without it.

The economy will recover as soon as the velocity of money returns to a reasonable level. The velocity of money is the amount of times each individual dollar moves through the economy in a fixed period of time. Right now, because everyone is feeling nervous about the future, people are spending and investing money very slowly and so the velocity of money is low.

Once velocity of money picks up so will the economy. Yet, once velocity of money picks up so to will inflation. The Fed is funding the government's spending. The government's spending produces no goods and few services. As such, you will have far too much money chasing far too few goods. That is the definition of inflation.

So, in order to control inflation, the Fed will then turn around and sell the very bonds they have now been accumulating. They will take out of the economy the exact same dollars they just put into the economy. In order to control inflation, the Fed will increase interest rates dramatically.

Doing all of this will stunt the recovery and put us right back into a recession if not a depression. In the meantime though, consumers and businesses will likely have made buying, borrowing and investment decision based on the short term perception that the economy was recovering when in reality it was being manipulated. We will be right back into a recession only it will be accompanied by extremely high interest rates and out of control borrowing.

With both borrowing costs and deficits at unsustainable levels, the government won't be able to do anymore borrowing. We will be in an economic downturn with no more fiscal options to stimulate the economy.