QE or no QE? If easy money ends, US will be back to 2008

By Shanmuganathan Nagasundaram

In what has to be an overt over-reaction to a typical Ben Bernanke speech on 17 June, we have witnessed a fairly turbulent two weeks in equities, bonds, currencies and commodities. The speech in itself was slightly different from his earlier speeches where he usually outlines the possibilities of increasing the US Fed’s bond buying plans (Quantitative Easing, or QE) if the economy worsens and decreasing it if it improves - more often than not in vague terms that leave plenty of room for whatever interpretation one wants to draw.

This time around, in addition to the usual increase-and-decrease expositions, he laid out a specific timeframe of how the Fed plans to exit the current QE “if” its own forecasts of employment and GDP growth are met.

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That’s a very big “if”. Especially if one were to go by the track-record of Bernanke’s economic forecasts. A couple of the elephant-in-the-room examples would be his refusal to acknowledge the housing bubble even after it had burst and his assessment of the impact of the housing burst on the US economy. So there’s no particular reason to believe that he is going to be correct this time around.

But can he be right simply on account of the law of averages? Since the direction of future QEs would determine market movements, this merits a more serious consideration than a Bernanke-is-always-wrong response.

For starters, despite the unprecedented stimulus, the US Economy is still tottering along with a record number of citizens on food stamps and with disability claims. While the unemployment numbers seem to have improved, the explanation really lies in the labour force participation rate that has dropped down to 63 percent - the lowest it has been since the Paul Volcker days of the late seventies. The official “U6” unemployment rate still hovers around 15 percent and if we use the same methodology as was used during the seventies, this number works out to 23 percent .

So despite the official claims of improving employment numbers, there is no reason to believe that the scenario has improved. If anything, it has been worsening all the time.

As regards inflation, the story seems to be no different. While the official CPI still hovers around 1 percent, more reliable private estimates put the number at around 5 percent , which should really imply that the US has been in recession as we have to use a much higher GDP deflator than is officially indicated. A situation that would be consistent with the hard statistics such as trade and budget deficits, manufacturing numbers as well as the unemployment numbers explained above.

But let us leave the numbers aside for now. What would Ludwig von Mises tell us about the recovery forecasts of Bernanke? Essentially the US Fed inflated one of the biggest housing bubbles ever witnessed through a combination of artificially low interest rates, lax lending standards and government guaranteed mortgages. When this bubble burst in 2008, as all bubbles eventually do, instead of allowing the liquidation of the malinvestment made during the bubble period, the US Fed stepped in to prop up the failing institutions as well as the overvalued assets through a combination of near zero interest rates as well as the unprecedented QE programme that created a market for these illiquid assets (they are illiquid because prices are inflated).

So what the Fed has managed is to blow some air back into the bubble to prevent a complete collapse of the housing market. And whatever the little “official” improvements in employment, housing stats or consumption numbers, it is entirely on account of this reflated bubble. Or, in other words, QE is the basis of the current US economy and any withdrawal of the QE would take the US right back to 2008.

A valid question at this stage would be, if 2008 was the consequence of the original housing bubble, what is going to be the consequence of this current reflation? In the process of reflating, the US Fed has more than quadrupled it’s balance-sheet since 2008 and we have now in place a treasury bubble that is many times the size of the original housing bubble. So when Bernanke says he wants to taper off QE, it is with the intention of not allowing this treasury bubble to grow bigger.

But whatever his intentions on this front, he just cannot taper - at least not for any sustainable periods of time. The low interest rates and the accompanying QE are the reasons for the moderate levitation of housing prices and, if this is withdrawn, we are back so square one - and that too with US government finances in a rather precarious position this time around. Interest rates would skyrocket and prick the treasury bubble that will take down not only the housing market, but also the US economy along with it.

We are really now in the realm of speculating what Bernanke would do. But if past actions and the voting trends in the Federal Open Markets Committee (FOMC) are any indication, the chances of tapering are next to nothing. That does not mean that the Fed would not attempt one - they might make a token cut and the sharp market reactions would make them up the ante soon after. So we are far more likely to witness a $100 billion a month QE than $50 billion a month (as against the $85 billion currently).

But if he cannot taper, how does all this end? My guess is that the US Fed will keep up the QE till we have a bursting of the treasury bubble, which will almost immediately manifest in a full blown currency crisis. I think Bernanke well recognises the course he has put the US dollar on and does not want to be seen as the chairman who destroyed the US dollar. He wants to at least talk of an exit strategy. But Economics 101 tells us that once the route of easy money has been chosen, there really is no exit without a liquidation of the malinvestment - i.e. unless Bernanke comes clean and says he will withdraw the QE quite independent of the consequences for the US economy, there really cannot be an exit.

Shanmuganathan “Shan” Nagasundaramis the founding director of Benchmark Advisory Services - an economic consulting firm. He is also the India Economist for the World Money Analyst, a monthly publication of International Man. He can be contacted at shanmuganathan.sundaram@gmail.com