Q&A

I have had a number of questions regarding my last blog "QE3 is Here" so this blog is dedicated to answering some of these so that we can see the differing opinions regarding the money printing press that is the Federal Reserve.

Steve – I’m no economist, but tell me if I am incorrect in dumbing this down – as I understand this.

1)     The banks have been sitting on these toxic, essentially worthless mortgage backed securities.

2)     The Fed says, hey Mr. Bank, we’ll take them off your hands/books at no cost

3)     …and we hope that this will help you feel a little bit better now so you can bloody well start making it easier for your customers and potential customers to take out loans

4)     …which in turn means more spending on business start-up, cars and so forth – from the loans

5)     And the Fed believes that people take out loans not necessarily in good times, but in weak times because in weak economic times people need loans if they want something tangible.

So if I am correct, then no money is being printed and as for the additional debt? Well, it moved from the banks to the Fed. And if the banks make more loans (and more money flows into the economy from the folks who took out these loans) then this begins to offset the mortgage-backed securities (the debt) that the Fed took over from the banks.

Am I off base here?

 

Answer:  This is definitely the theory.  Pass the toxic debt from the banks to the Federal Reserve in the hopes that the banks lend again and the economy recovers.  This presents numerous problems though:

1. The Federal Reserve has as its mantra that it "shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates and provide price stability in the form of inflation control." (from the Federal Reserve Act)  The idea is that with price stability you maintain a healthy economy as businesses are able to plan for the future based on this price stability and this in turn will keep the economy at full productivity and low unemployment levels.  The problem is that their current policies are not creating jobs but are creating a massive wave of debt that will somehow have to be repaid.  As we will see below this has boxed them in!
2. It is one thing to create a loose monetary environment to stimulate the economy, it is an entirely different matter when you are taking on the toxic assets of banks.  This creates morale hazard whereby bankers are rewarded for taking large risks but do not feel the consequences of these risks as they end up being shouldered by the Federal Reserve and by default therefore the tax payer.  I have argued that the Federal Reserve has crossed the line by taking this junk off the banks hands as they are not in the game of saving banks and companies.  The market needs to take care of itself but by coming to the rescue of these companies the Fed has created a morale hazard that is not in line with what they have been established to do.  Transferring the problem to the taxpayer while the bankers walk away from the problems is not their job!  It undermines their credibility and creates a bigger mess later and this is just what is happening.  Let the market wash the slate clean by impacting the banks, the bankers and their investors but not the tax payer.  Transferring toxic debt over to the government who cannot default on this obligation is not what makes capitalism work as the people that took the risks are not taking the pain.
3. If they are trying to stimulate the economy then providing financing for job ready projects would be a far better use of funds than taking toxic debt off the banks hands.  Another potential help would be to cut the student debt load or at least the interest charged on those loans to zero.  The banks pay nothing so why not the students?  The young are the demographic that acquire the most assets and keeping them swimming in debt at high interest rates while providing the bankers with financing at no cost makes no sense. Another idea is to issue more build America type bonds that target projects that hire people to repair the country's infrastructure.  This would get people to work and help the country rebound far quicker.  However now you have to deal with the politicians which is why neither of these will happen in the near future but it is these types of structural changes that need to be made to the political system to stimulate growth rather than blindly pumping more debt into the system.
4. The type of financing provided by the Federal Reserve to the banks is not able to be controlled.  It is given to the banks at no interest and they invest where they see fit.  This is why you see the stock market rising, oil prices shooting higher and other commodities spiraling higher.  The consumer feels the upward movement in these prices and this crimps demand for other goods and services slowing growth further.  Slow consumer spending reduces growth and means companies will cut back further creating a vicious spiral that is not solved this way.
5. The mountain of debt that is being created will crowd out the private sector and will create another drag on growth.  Just as the consumer suffers from too much debt, governments are eventually hamstrung by a mountain of debt and this debt and the cost of servicing the debt slow economic growth creating a drag that lasts for decades, just look at Japan.  This crowding out is already creating a drag on GDP growth and I doubt that the economy will grow faster than 2% per year until this debt burden is under control and to me that is decades away if ever.  Allowing these banks to suffer at the expense of their investors and themselves creates a clean slate and makes it a far easier path to prosperity. 
6. Letting banks fail is part of business.  If bad banks fail this creates a vacuum which is quickly filled by new "good" banks (banks with no toxic debt).  These new banks are keen to lend as they are effectively gaining from the other banks poor investment strategies.  By lending money to consumers at low asset values they ensure that they are stable and are able to function in the normal way regardless of what happens to the other banks.  This is capitalism and is how it should work but by saving these institutions they have created morale hazard.  This has resulted in banks and institutions that are too big to fail which has, in my opinion, been created directly by the Federal Reserve overstepping their bounds and sticking their head into places where they should not.  Certainly at the peak of the crisis it was imperative to save the financial system but since then the market should have taken care of its problems while the Fed concentrated on using the tools at its disposal to create jobs and not support poor businesses.

Steve

Ben has to keep printing money and buying bonds.  If he doesn't, there won't be as much of a market for those bonds and without buyers, the rates go up.  They can't risk that.  With $16 trillion in debt, an unbelievable number, each 1% increase in rate being paid increases the federal deficit by $160b.  That magnifies the deficit and could touch off a debt spiral we cannot get out of.  So, like Japan, the idea is keep rates low or non existent at all costs so the deficit doesn't balloon out of control.

 

Answer: I do not disagree with this comment, in fact I believe like the sender of the comment that the Federal Reserve is completely boxed in.  Without printing more interest rates are sure to rise and this will cause serious damage to the so called economic recovery.  However, more debt will eventually implode on itself and will result in a major financial calamity of the likes we have never seen.  Can they get themselves out of this hole?  My thought is that without structural policy changes it is impossible and looking to the politicians is looking at the problem but it really is up to them to solve this and I have little faith that either candidate will step up to the plate.

For all of these reasons I remain out of the stock market as money prinitng has created a false bull market based not on economic fundamentals but on the fact that there is nowhere to invest that produces a return.  Companies around the globe are ratcheting down their growth forecasts and are continuing to lay people off but the market continues higher.  That is not to say that some companies are not performing well, but it is a manipulated market that will hurt a lot of investors in the long run.  Stay away from trying to make a few dollars in the short run and focus on wealth preservation.