Sunday, November 28, 2010

"WHAT’S REALLY BEHIND QE2?"

Continuing our look at iconoclastic views of the Fed's intentions.
From Web of Debt:

The deficit hawks are circling, hovering over QE2, calling it just another inflationary bank bailout. But unlike QE1, QE2 is not about saving the banks. It’s about funding the federal deficit without increasing the interest tab, something that may be necessary in this gridlocked political climate just to keep the government functioning.
On November 15, the Wall Street Journal published an open letter to Fed Chairman Ben Bernanke from 23 noted economists, professors and fund managers, urging him to abandon his new “quantitative easing” policy called QE2. The letter said:
We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. . . . The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.
The Pragmatic Capitalist (Cullen Roche) remarked:
Many of the people on this list have been warning about bond vigilantes while also comparing the USA to Greece for several years now. Of course, they’ve been terribly wrong and it is entirely due to the fact that they do not understand how the US monetary system works. . . . What’s unfortunate is that these are many of our best minds. These are the people driving the economic bus.
The deficit hawks say QE is massively inflationary; that it is responsible for soaring commodity prices here and abroad; that QE2 won’t work any better than an earlier scheme called QE1, which was less about stimulating the economy than about saving the banks; and that QE has caused the devaluation of the dollar, which is hurting foreign currencies and driving up prices abroad.
None of these contentions is true, as will be shown. They arise from a failure either to understand modern monetary mechanics (see links at The Pragmatic Capitalist and here) or to understand QE2, which is a different animal from QE1. QE2 is not about saving the banks, or devaluing the dollar, or saving the housing market. It is about saving the government from having to raise taxes or cut programs, and saving Americans from the austerity measures crippling the Irish and the Greeks; and for that, it may well be the most effective tool currently available. QE2 promotes employment by keeping the government in business. The government can then work on adding jobs.

The Looming Threat of a Crippling Debt Service

The federal debt has increased by more than 50% since 2006, due to a collapsed economy and the highly controversial decision to bail out the banks. By the end of 2009, the debt was up to $12.3 trillion; but the interest paid on it ($383 billion) was actually less than in 2006 ($406 billion), because interest rates had been pushed to extremely low levels. Interest now eats up nearly half the government’s income tax receipts, which are estimated at $899 billion for FY 2010. Of this, $414 billion will go to interest on the federal debt. If interest rates were to rise just a couple of percentage points, servicing the federal debt would consume over 100% of current income tax receipts, and taxes might have to be doubled.
As for the surging commodity and currency prices abroad, they are not the result of QE. They are largely the result of the U.S. dollar carry trade, which is the result of pressure to keep interest rates artificially low. Banks that can borrow at the very low fed funds rate (now 0.2%) can turn around and speculate abroad, reaping much higher returns.
Interest rates cannot be raised again to reasonable levels until the cost of servicing the federal debt is reduced; and today that can be done most expeditiously through QE2 -- “monetizing” the debt through the Federal Reserve, essentially interest-free. Alone among the government’s creditors, the Fed rebates the interest to the government after deducting its costs. In 2008, the Fed reported that it rebated 85% of its profits to the government. The interest rate on the 10-year government bonds the Fed is planning to buy is now 2.66%. Fifteen percent of 2.66% is the equivalent of a 0.4% interest rate, the best deal in town on long-term bonds.

A Reluctant Fed Steps Up to the Plate

The Fed was strong-armed into rebating its profits to the government in the 1960s, when Wright Patman, Chairman of the House Banking and Currency Committee, pushed to have the Fed nationalized. According to Congressman Jerry Voorhis in The Strange Case of Richard Milhous Nixon (1973):
As a direct result of logical and relentless agitation by members of Congress, led by Congressman Wright Patman as well as by other competent monetary experts, the Federal Reserve began to pay to the U.S. Treasury a considerable part of its earnings from interest on government securities. This was done without public notice and few people, even today, know that it is being done. It was done, quite obviously, as acknowledgment that the Federal Reserve Banks were acting on the one hand as a national bank of issue, creating the nation’s money, but on the other hand charging the nation interest on its own credit – which no true national bank of issue could conceivably, or with any show of justice, dare to do.
Voorhis went on, “But this is only part of the story. And the less discouraging part, at that. For where the commercial banks are concerned, there is no such repayment of the people’s money.” Commercial banks do not rebate the interest, said Voorhis, although they also “‘buy’ the bonds with newly created demand deposit entries on their books – nothing more.” ...MORE
We looked at the the debt service angle in "For My Republican/Conservative/Tea Party Friends: "Here is where all that Government Spending is Really Going" and "U.S. Government Debt Service to Surpass Military Outlays by 2016".

Some other thoughts on the Fed and QE2:

What on Earth is the Federal Reserve Doing? "...Saying One Thing But Doing Something Very Different"
"Is QE2 a Ruse by Bernanke?"
"Is QE2 A Stealthy $90 Billion Gifting Scheme To The Primary Dealers?" (BAC; C; GS; MS; JPM; HSB; UBS)
Paul Tudor Jones Questions Fed’s Bond Buying
George Soros, Henry Kissinger, China and QEII
"Tiny Cracks Forming in QE2 Trade?"
"Dave’s Top 10 Reasons Why QE Won’t Help the Economy"
"Dick Bove on QE2 as a bank-less “financial war with China”"
"ROBERT SHILLER DEBUNKS THE STOCK MARKET “WEALTH EFFECT”"