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Pros And Cons of QE II

Anyone who has been following the economic news AT ALL for the past few months has heard the term QEII. This is a shorthand way of saying a second round of quantitative easing. First let us start off with what the term means. NPR did a great job in explaining what it means in simple terms:

A big bank — Bank of America, say — has $50 billion in government bonds. They'd sell those bonds if anyone would pay enough for them, but nobody is willing to pay that much. So the bank just holds on to them.

With quantitative easing, the Fed comes along and says, "Hey, Bank of America, we'll buy those bonds for a little more than anyone else is willing to pay." Bank of America says, "OK, great, send us the money."

This is where the Fed gets to use central-bank magic. They pay for that $50 billion purchase in new money. They just invent it. That's what the Fed — but nobody else — gets to do.

So now Bank of America has $50 billion they need to do something with. The Fed is hoping that Bank of America will decide to lend that $50 billion to companies and people to invest or spend. That stimulates the whole economy.

The Federal Reserve has proposed the desire to purchase more debt instruments. Bernanke who is an expert in the great depression and has authored several books on the topic including;Essays on the Great Depression,Inflation Targeting: Lessons from the International Experience has decided to wage an all out war against deflation. He also is scared to act too early by raising interest rates and cut off the economic “recovery”, as Government policies in the late 1930s did. This seems to be why Bernanke is so keen on implementing a second round of quantitative easing.

One issue is that there is little evidence of a general decrease in prices. To the contrary, there is considerable evidence in a general rise in prices. Besides for home prices which make up a massive portion of the CPI, food prices, oil prices, and other goods seem to have appreciated in price recently (at least from my personal experience).

For the purposes of this article, it shall be assumed that there is, indeed, a general decrease in prices in motion within the marketplace using the flawed measurement of CPI. With this assumption in place, a comprehension of the effects of this activity requires a separation and inspection of the positive and the negative aspects of the Federal Reserve injecting massive amounts of newly created monetary units into the marketplace. This injection of new money is proposed to be awarded to the collective group of individual citizens presently occupying positions of political power to do with, as they deem proper. From this point, the pros and cons must be identified and separated for inspection.

Situation

National debt is increasing dramatically and Government borrowing is reaching annual levels of over one trillion dollars. Tax revenues have fallen, Congress is throwing money down the drain with programs like the stimulus package (IMHO) that had very little to do with stimulating the economy. Compounding this is the agreements made with foreign countries to reduce restrictions and tariffs on their products effectively increasing incentives to do business and hire in those countries. A large portion of domestic business interests has moved operations to those countries creating a trend of increasing unemployment in this country. This trend is not new and is largely due to allowing China in the WTO and the signing of NAFTA.

Pros

The beneficiaries of the new monetary units created by the Federal Reserve could apply some of them to problematic sectors of the economy and improve the unemployment crisis that currently has no end in sight. This is the best-case scenario. Another somewhat unscrupulous benefit of this is that the value of the individual monetary unit would decrease and in effect decrease the value of the outstanding national debt. The decrease in the value of the dollar can have very positive effects by increasing exports.

Cons

By creating the new money, the value of the existing money is decreased, naturally. Furthermore, there is little incentive for the established political body to apply this new money to help in hiring new employees. Applying it thusly could create a trend in which the value of the monetary unit falls and prices begin to rise. As the velocity increases, consumers begin to purchase more rapidly to get the most they can for the dollar they hold. This rapidly compounds into a runaway trend of rising prices and dollar devaluation.

QE I did a good job at keeping lending rates very low. However, despite the record low mortgage rates the housing market has not recovered too much. There is the possibility that the Fed is creating a bubble in the bond market which has yet unforeseen repercussions. The low rates seem to help speculators who want to borrow at low rates more than anyone else.

Conclusion

Although this easing by the federal reserve of a hypothetical fall in overall prices will reduce the value of the outstanding national debt, it runs the risk of creating a runaway inflation situation. At this point, there is no easy solution. If the monetary supply is not inflated, the national debt will remain unmanageable and necessitate some type of bankruptcy or promise of a pound of flesh. If it continues to be inflated, those who have trusted this government and lent it money will be cheated and in the process, the citizens and anyone else holding the currency will be cheated.

The cons seem to outweigh the positives. A more prudent policy would be real and painful legislation that includes massive spending cuts, and tax increases. This of course is out of the Feds’ hands, and is up to the Congress and the president. The five key areas of spending reform have to be military spending, Medicare, Medicaid, social security and pension reform. One way to get more revenue would be to gradually reduce the amount that homeowners can deduct from taxes due to mortgage payments.

Regardless, of the Feds actions the real savior or destroyer of the American economy lies in the legislative and executive branch.

http://www.valuewalk.com/

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

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