March 21, 2011
Each time we begin to approach the end of an announced QE period, the nervous jitters of financial markets start to set in. Will Bernanke continue with QE (n+1) or won’t he? Now it’s true that professional traders live and die by their ability to front run rumor and perception, but for long term investors who fret over such decisions, it demonstrates a fundamental lack of understanding of what QE really is. To put it succinctly, QE is an economic deal with the Devil. Once it is begun in earnest there can be no turning back. It must be played to its ultimate conclusion.
In Bernanke’s 2009 interview on 60 Minutes, he suffered a momentary lapse into honesty and stated that Quantitative Easing was effectively money printing. So why then the complicated euphemism of Quantitative Easing? Because that is what modern central banking sponsored economics is all about – the intentional obfuscation of otherwise simple economic principles to cause the eyes of normal people to glaze over. Once accomplished, the central bankers (and their financial community brethren) are able to pursue policies that greatly benefit themselves but are devastating to everyone else.
Long term investors who worry about whether QE will continue clearly recognize the fact that everything is now correlated to the Fed’s balance sheet. What they don’t understand is how QE is related to the larger economic cycle and its mission of preventing economic recessions.
Keeping the tent inflated
Sometimes physical analogies are the most helpful in understanding complex relationships. Let’s think of the economy as a large inflated tent. The extent of the tent’s inflation is the health of the economy. Under normal economic conditions the tent is fully inflated. In the course of time, events take place that cause the need for a correction to the economic system. New technology can come along which obsoletes old industries, bad investments and debt must be liquidated etc. When this happens a free market economy will correct itself. Capital tied up in failed industries will be reallocated and invested in new businesses. New jobs will ultimately be created and people will go back to work. Of course this reorganization takes place over time and this is what a recession is – a healing process for the economy. In our tent we can think of this as a tear that forms in the fabric. While this hole is being repaired, air escapes and the tent begins to sag a little. The extent of the drooping is the extent of the recession. Once fixed, the tent and the economy go back to normal.
QE is a wholly different method of keeping the tent propped up. It does not repair the hole, but rather attempts to keep the tent inflated by pumping more air in than is escaping through the hole. This is the new money being created and pushed into the economy to offset the credit destruction in the banking system. This is a dynamic process that must be maintained. The catch is that the hole doesn’t just stay a fixed size. The tear begins to lengthen allowing greater amounts of air to escape. The economic tent begins to sag until the volume of air being pumped in is increased to overcome the outflow. This is why QE can never end. To stop now, with such a large hole, would result in a severe and frightening recession. The tent would lose a tremendous amount of air in the time it takes to make such an extensive repair.
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