Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. These days I'm retired, and I can't by law give you advice. While I do make mistakes, I try hard to do my analysis thoroughly, and to make sure my data are correct (old habits die hard!) Also, don't ask me why I called it "Volewica". It's too late, now.

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Wednesday, December 8, 2010


QE2.  No, not the ship, though it's as big as she is.  Quantitative easing.  It used to be called "open market operations".

How does it work?  The central bank -- the Federal Reserve Board ("Fed"), or in Australia, the Reserve bank of Australia (RBA -- difficult, huh?)  buys government stock or quality private sector paper such as securitised mortgages (oh, wait, those aren't quality any more) or good corporate bonds.    It pays whoever it buys them from with a cheque drawn on itself (or, in truth, these days an EFT from its account) to the seller of the paper.  The seller (in fact, his bank) then has additional cash (defining cash to include at-sight deposits at the Fed)   He will have too much cash.  If the yield curve is positive, which it is in most countries now, cash will earn very little (zero in the US, for example) while longer-dated paper (say one or two year governments) will earn a couple of percent, with loans earning even more.  Of course, that's assuming you're willing to make loans and can find sound and willing borrowers, which is a problem right now.  The sound ones aren't especially willing.  But there will be some who are willing to borrow and likely to repay, and the amount of money available to them will have risen while its price will have have gone down.  And that's what the Fed is aiming for.  Because if loans increase, investment in plant and equipment will rise, asset prices will increase as valuation rates fall, and a virtuous cycle of rising demand, employment and output will have begun.

There will be an additional effect.  The supply of US dollars will increase sharply.  This will reduce the value of the US$ relative to other currencies, i.e., the dollar will depreciate.  This will make imports into America more expensive and exports cheaper.  This will add to US demand and US employment.  It will also put upward pressure under prices, and that would be a good thing.  Measured by underlying inflation rates, we are close to deflation.  Deflation in an economy with too much debt is devastating -- it was a key factor in the collapse after the 1929 great stock market crash.  The value of the debt rises in real terms when there is deflation, making repayment harder.  Interest rates can only fall to zero, in nominal terms.  If prices are falling, then in real terms, interest rates are above zero.  Stimulus becomes harder, then as the crisis extends, impossible.

Will it work?  Well, it did before.  In 1933, after nearly four years of a steady downward grind in price levels, wages, employment, industrial production, sales, incomes and GDP, the Fed conducted open market operations.  It bought $2 billion of federal bonds.  In today's money that's less than what's proposed now, though the economy is far bigger.  Within 3 months IP bottomed, within 6 employment started to rise, and the great depression was over.  Prior to that the Fed had tightened monetary policy because it was afraid of inflation(sound familiar?)  In 1937, the Fed tightened policy again, and the government, under pressure from earlier tea-partiers, cut spending and raised taxes, and there was a very sharp downturn.  Neither Palin nor Huckabee or their ilk are intellectual giants.  There's a serious risk that mistake will be repeated, with swingeing cuts to spending.  But, if the Fed has anything to do with it, QE will happen, and my guess is it'll work.  It won't stop the savage structural problem of an economy which saves too little, has borrowed too much, and has far too much debt (and I'm not talking about the government) , but it will resuscitate the patient for a while.  The real risk will come, when as in 1937, they start to withdraw the stimulus.  2013, anyone?

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