"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Wednesday, November 10, 2010

A QE Primer: Yves Smith on Quantitative Easing

Excellent interview by theRealNews of Yves Smith from the blog Naked Capitalism.  Yves Smith has spent over 25 years on Wall Street including working for Goldman Sachs.  Here is a summary of her conclusions:

1) Banks are essentially getting free money - at zero percent, and are in turn buying Treasury Bills for a risk free profit.  They are not lending money into the general economy, they are hoarding and recapitalizing.  This is basically a back door bailout because a bailout through Congress would not have political support.

2) Ben Bernanke honestly believes what he is doing is the correct course of action.  By buying longer term debt, he will be pushing down yields on all other similar investments: T Bills, mortgages, etc..., forcing the free riding banks to look elsewhere for a higher return: equities - the stock market.  Isn't this bubble blowing?  Didn't Japan try this in the 1990s?  In such a scenario, fixed income investors, usually retirees, feel the most pain.

3) The Carry Trade:  There is another concern with QE.  That investors get this cheap money and instead of putting it into the US stock market, the money goes abroad.  This too happened with Japan in the 1990s.  Such money flows basically create bubbles elsewhere in the world, with resultant inflation.  There is also a feedback loop here.  As investors borrow dollars to invest abroad, they need to sell their dollars as soon as they borrow them, which in turn pushes down the value of the dollar.  [note: this is why Germany and China and Brazil, among others are upset.  The US gets to cheapen its currency giving it an export advantage, while creating speculative bubbles abroad that can abruptly pop.]

4) Policymakers don't get it:  The people that support these policies reside for the most part, in Washington and New York.  Stimulus spending and easy money bubble blowing are great ways to enrich the elites of these two cities.  Therefore, they don't realize the severity of the problem.  They know nothing about "Main Street."

5) Policymakers response to the crisis has made the too big to fail banks even larger, and the financial industry even more concentrated.

6) Second mortgages have yet to be written down, and they are still on the books of the major banks at 100s of billions of dollars - at values that are not realistic.

7) Everyone knows that things will not end well, but like in early 2007, they will ride this bubble and get out just in time.  They truly believe they can exit when this bubble ends.

8) Yves believes there will likely be another banking crisis, but she is more hopeful.  She believes that the government will punish the executives of these major banks.  They will be removed in the event of another banking bailout.

The video:

Yves Smith does a fantastic job here. But I believe there is one thing we need to always keep in mind whenever we listen to an analyst. Their analysis is oftentimes linear and extremely focused because of the subject matter. Yet we live in a non-linear, chaotic world full of black swans. Right now, the Euro periphery is suffering, and the IMF may be called to assist Ireland. Municipal governments in the US are facing their own budgeting crises including pension shortfalls. And least of all, the geopolitical effects we are witnessing amongst the G20 nations: capital controls, trade disputes, currency wars, etc...

My point is that we live in an extremely fragile period. A crisis can come from anywhere and render all prior analysis moot to an extent. Prior to the crisis, sovereigns were able to bail out their banks to a degree. Now it is the sovereign balance sheets that are being questioned. In many of the advanced economies, tax revenues are falling and budget deficits are exploding. All these factors are adding pressure to the major currencies; the money we use.

We can look at QE and judge it on its own, but we also have to keep in mind that there are other unintended costs associated with such a policy.  QE is a free ride of sorts for the few, that spreads its costs to the many.  We already know how most of the US's trading partners are reacting to QE.  Tomorrow, at the G20 Summit in South Korea, we will see how this plays out.  QE is not just a financial tool used by Central Banks, it is also a financial weapon used by Sovereigns.  Thus, it's effects are never really measured or appreciated until it is too late.

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