Numbing the pain for a while will make it worse when you finally feel it.

~Albus Dumbledore, Harry Potter and the Goblet of Fire

Is the Federal Reserve a hero or a villain? You can find plenty of Nobel Laureates, pundits, and civilians like myself on either side of that debate. Nassim Taleb, author of The Black Swan has been saying for quite some time that the Fed steered us into the ditch and that it's shameful that the same group that got us here is still in the driver's seat. Perpetual overspending and record low interest rates have not only failed to solve our problems, but are the major causes of them. It is therefore ridiculous to turn to them to solve our current challenges.

Paul Krugman is probably the most vocal Nobel Laureate who supports the Keynesian spend-till-you-drop/debt-levels-don't-matter viewpoint. He has been a supporter of stimulative monetary and fiscal policy. His response to critics of higher spending, zero interest rates and quantitative easing is that central bankers and governments are not spending enough to rescue the economy. He says the stimulus would have worked if only it were bigger.

Thus, Alan Greenspan is either a messiah, evil incarnate, or simply incompetent, depending on who you ask. Ben Bernanke has mainly followed Greenspan's approach to monetary policy, although he has been forced to become a lot more creative courtesy of the economic mess he inherited from Greenspan's Fed, of which he was a member. Will continued quantitative easing work?

What on Earth Is Quantitative Easing?

Prior to, and following Fed Chairman Bernanke's key speech at Jackson Hole on Friday, cyberspace, trading floors, and water coolers were abuzz with debates over what he might say in terms of future prospects for the economy and further quantitative easing. For those who aren't familiar with the idea, QE, or quantitative easing is a way for the Fed to increase the money supply when traditional methods like lowering interest rates are no longer available, usually because rates are already at or near zero.

To implement QE, the central bank credits its own account “with money it has created ex nihilo (“out of nothing”).” It uses that money to buy assets like government bonds and mortgage-backed securities from financial institutions. The idea is to provide liquidity to the financial system in hopes that a) banks will lend that money out to consumers and businesses and b) that buying bonds will keep interest rates low.

As with any action taken to cure an illness, 4 main outcomes are possible: The remedy could work, it could actually make things worse, it could relieve the symptoms without curing the underlying illness, or it might just do nothing. We'll take a look at each of these possibilities as they relate to the QE prescription.

QE:  Cure, Cause, Palliative or Placebo?

QE as Cure

Here are a few ways that quantitative easing might be able to keep the economy from slipping into a depression:

  • Lower bond yields will force investors into other asset classes like stocks, commodities, and real estate, raising the prices of those assets and creating a wealth effect for investors. The hope is that consumers will see the value of their investments rise and feel confident enough to spend and invest more.
  • Lower interest rates will improve housing affordability and make it easier for consumers, corporations and governments to service and roll over their considerable debt loads.
  • Lower yields will weaken the U.S. dollar and help with the trade deficit.

QE as Cause

Many would argue that easy money policies created the asset and debt bubbles that are now plaguing us, so it doesn't seem like more of the same would be helpful. Here are a few ways QE might hurt more than it helps:

  • Continued low yields hurt savers, retirees, and pension plans who do not want to invest in riskier assets. In order to maintain an annual investment income of $40 000, you would need to have $2 million invested at a 2% rate of return. If yields were at 5%, you would only need to have $800 000 saved to achieve the same income level.
  • Lower yields can lead to asset and debt bubbles as people begin to feel that low rates and rising asset prices can go on forever. If rates rise and/or asset prices fall, it can get pretty ugly, as we saw in 2008.
  • Asset price and money supply increases are inflationary. If the Fed takes QE too far, we could end up with hyperinflation and extremely high interest rates. It goes without saying that higher rates in an over-leveraged financial system would be disastrous.

QE as Palliative

Quantitative easing could make it look like things are getting better, when in reality they are staying the same or getting worse. If you had a bacterial infection, you could take something to alleviate the pain, but the infection would likely continue to worsen until you got an antibiotic that actually killed the bacteria. Some believe QE has already had this type of palliative effect and will continue to do so:

  • Rising prices in assets like stocks, commodities and real estate can make us feel like the economy is recovering. But if debt levels continue to rise, they will eventually hurt the economy as consumer, corporate, and government entities are forced to use an increasing amount of their income to service debt rather than contribute to economic growth.
  • If people get the idea that interest rates will be held artificially low forever, they may take on risks and obligations that they will not be able to honour later if interest rates rise and/or the economy turns down.
  • If the U.S. dollar falls as a result of QE, commodity prices could spike as they are priced in U.S. dollars. Some may interpret the rise as a signal that the economy is improving.

QE as Placebo

You could easily argue that this one is the same as the palliative argument above, but I'll make the following distinction: While neither the palliative nor the placebo treat the root cause of the problem, the palliative at least temporarily alleviates some of the symptoms. The placebo really does nothing but make us think we might feel better even if neither our symptoms nor disease are any better in reality. Here's the placebo case:

  • Every time the Fed announces new policy measures like QE, the shorts cover their positions and we see a huge snap-back rally in equities.
  • Some investors and pundits feel better as they believe that the Fed is on the job, and they will cure what ails us.
  • Some investors will follow the Fed into Treasuries, or whatever security they are buying as they see the Fed as providing a floor for prices in those securities.

My 2 Cents

I agree with the weekend article in the Washington Post that argued that the Fed's Capacity to Stimulate the Economy Is Limited. I think QE might be a cause, a palliative, or a placebo, but I'm pretty sure it's not a cure. The problems we face are structural, not cyclical. We need structural solutions at the legislative level, not at the monetary policy level.

What does this mean for our financial plans? Of course, each of us will answer differently. I'm worried the Fed is caught in a liquidity trap where they will not be able to stimulate the economy. Quantitative easing is based on money created out of nothing. That just sounds like cheating to me. We may see strength in commodities if the fall in the U.S dollar outpaces that of other currencies, but I will remain in cash until commodities rise on real economic prosperity rather than palliative measures rooted in nothing.

Further, it seems like much of the economic and stock market success of the 1980-2000 era was created ex nihilo as well. It was built on a foundation of debt. I can't invest in that, so I'm not buying into Friday's placebo rally.

What about you? Do you think QE will work?