The Fed's New Round of Quantitative Easing Is Like Trying to Patch Leaking Pipes by Pumping in More Water

Bernanke announced additional quantitative easing yesterday, primarily in the form of buying treasuries to monetize the U.S. debt.

Jeff Harding points out that those worried about deflation within the Fed won out over the scared-of-inflation camp:

The Fed Open Market Committee voted today to roll its holdings of maturing Fannie and Freddie debt into longer term Treasurys. This represents a significant change in Fed policy and it appears that the anti-deflationist wing of the Fed, led by James Bullard, president of the St. Louis Fed, won over the anti-inflationists led by Thomas Hoenig, president of the Kansas City Fed.

As I reported last week, there is a significant movement in the Fed, led by James Bullard, to increase its Open Market Operations purchases of Treasurys in order to prevent deflation. They see that money supply is decreasing and that zero interest rate policy (ZIRP) has been ineffective. In a groundbreaking paper just published by Bullard, he advocates the purchase of Treasury debt which is, in effect, a monetization of U.S. debt. They believe that such purchases, called "quantitative easing" is the only effective tool the Fed presently has to increase money supply.

This reveals that the Fed is very worried about deflation.

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Presently (as of August 4) the Fed holds a total of $2.054 trillion of debt. Commencing last year and continuing through April of this year, the Fed bought $1.25 trillion of GSE debt (MBS of the government sponsored entities, Fannie Mae and Freddie Mac) and the balance consists of Treasury paper. They intend to keep their holdings at this level. According to a subsequent release today by the NY Fed, which carries out the Fed's Open Market Operations, Treasury paper purchases will be "in the 2- to 10-year sectors of the nominal Treasury curve, although purchases will occur across the nominal Treasury and TIPS yield curves."

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While the initial impact of this new policy on the economy will be modest, it sets a precedent for the Fed to substantially increase its attempts to inflate the money supply as the economy declines.

Given that the Fed has until recently taken extraordinary measures to avoid inflation, this may be a major shift.

Tyler Durden notes:

BofA's Jeffrey Rosenberg provides the breakdown of the total amount of securities that roll off (MBS, Agency and USTs) over the next 12 months: the total is $340 billion, including the $230 billion (and possibly more) in MBS. Alas, this means that on a straight line monthly basis (and the finally outcome will likely be far more jagged), there will be on average just under $30 billion a month in incremental 2-10 Year Treasury Purchases. As Joseph Abate said earlier, this is not nearly enough to be considered a new stimulus, and at best seeks to retain the status quo. What is notable is that BofA believes today's action should have been priced into the market.

So is another round of quantitative easing the right prescription for the economy?

It depends on whether or not you think debts and deficits matter.

As I wrote last month:

"Deficit hawks" like top economic historian Niall Ferguson says that America's debt will drive it into a debt crisis, and that any more quantitative easing will lead our creditors to pull the plug. See this, this and this. Indeed, PhD economist Michael Hudson says (starting around 4:00 into video):

If the problem that is grinding the economy to a halt is oo much debt, and if no one in the government - in either party - is looking at solving the debt problem, then ... we're going to go into a depression as far as the eye can see.

Yet the U.S. hasn't reined in its profligate spending. While modern economic theory shows that debts do matter (and see this), the U.S. is spending on guns and butter.

As PhD economist Dean Baker points out, the IMF is cracking down on the once-proud America like a naughty third world developing country. (As I've repeatedly noted, the IMF performed a complete audit of the whole US financial system during Bush's last term in office - something which they have only previously done to broke third world nations.)

Indeed, economics professor and former Senior Economist for the President’s Council of Economic Advisers Laurence Kotlikoff wrote yesterday:

Let’s get real. The U.S. is bankrupt.

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Last month, the International Monetary Fund released its annual review of U.S. economic policy.... The IMF has effectively pronounced the U.S. bankrupt.

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Based on the CBO’s data, I calculate a fiscal gap of $202 trillion, which is more than 15 times the official debt.

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This is what happens when you run a massive Ponzi scheme for six decades straight....

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Bond traders will kick us miles down our road once they wake up and realize the U.S. is in worse fiscal shape than Greece.

On the other hand, as I also pointed out last month, the government isn't even stimulating in an effective way:

"Deficit doves" - i.e. Keynesians like Paul Krugman - say that unless we spend much more on stimulus, we'll slide into a depression. And yet the government isn't spending money on the types of stimulus that will have the most bang for the buck: like giving money to the states, extending unemployment benefits or buying more food stamps - let alone rebuilding America's manufacturing base. See this, this and this.

(Yes, Congress has just thrown twenty billion dollars at jobs and the states, but it is a tiny drop in the bucket compared to the many tens of trillions of dollars in handouts to the giant banks.)

Keynes implemented his policies in an era of much less debt than we have today. We're now bankrupt, with debt levels so high that they are dragging down the economy.

Even if Keynesian stimulus could help in our climate of all-pervading debt, Washington has already shot America's wad in propping up the big banks and other oligarchs.

More important still, Keynes implemented his New Deal stimulus at the same time that Glass-Steagall and many other measures were implemented to plug the holes in a corrupt financial system. The gaming of the financial system was decreased somewhat, the amount of funny business which the powers-that-be could engage in was reined in to some extent.

As such, the economy had a chance to recover (even with the massive stimulus of World War II, unless some basic level of trust had been restored in the economy, the economy would not have recovered).

Today, however, Bernanke, Summers, Dodd, Frank and the rest of the boys haven't fixed any of the major structural defects in the economy. So even if Keynesianism were the answer, it cannot work without the implementation of structural reforms to the financial system.

A little extra water in the plumbing can't fix pipes that have been corroded and are thoroughly rotten. The government hasn't even tried to replace the leaking sections of pipe in our economy.

Quantitative easing can't patch a financial system with giant holes in it.