Letter 111: concerns about quantitative easing

“Fool me once, shame on you—but fool me twice, shame on me!”

--Chaucer

Overview. I must confess that I have no idea how much money has been printed out of thin air to buy treasury bills and bonds issued from the same ether layer of unreality. So, my concern may be overshooting here. Here is that concern: all those green-backs (dollars) have to go somewhere. Now they seem to be on bank balance sheets as cash and as bonds in off-shore investment funds, insurance companies and mutual funds. What happens when they come back? 

(NOTE: this essay draws the material in the Stalla CFA study course and, my faint recollection of college Economics.) 

Quantitative Easing: historical roots. The rationale of quantitative easing runs along the lines of what President Carter tried to pursue with his ‘locomotion’ monetary policies of the 1970s: if all industrialized countries flood the market with liquidity, inflation will remain low, asset values will rise and the otherwise shrewd investors, too stupid to see the ruse of the massive influx of increasingly worthless paper currency, will invest.

The macro-economic goal of Quantitative Easing grew out of a desire, after the near collapse of the international system in 2008, to avoid a general depression of falling asset values and a psychology that would preclude new investments at any price (i.e., a liquidity trap).  The plan of President Carter did not work in the 1970s because Germany rightly said, “Thanks, but no thanks. The hyper-inflation that helped bring in the Nazis occurred only half a century ago. We remember.”

Why Quantitive Easing failed in the 1970s. As monetary policy became promicuous in the United States, other governments, which had once seen the dollar as a store-value currency now unloaded their green-backs. Those bills flooded back into the Unites States, causing unprecedented inflation. President Carter, as the last Keynesian, loosened the money supply further and treasury yields spiked to 21% within a day, as predicted by the 'continuous learning', or rational, variant of the efficient markets hypothesis.

It seems that people at Goldman Sachs, First Boston, Salomon, et al. were not quite as easily fooled as the Brookings economists seemed to have assumed. What happened then may occur today. The big difference is that many others are out on the dance floor doing the locomotion. In one key respect, the dollar as a store value currency and the helium currencies have one element in common.

Each one either dampens (dollar as a gold equivalent) or coincides with low (Quantitative Easing; still uncertain) velocity.  Velocity is the rate at which a green-back changes hands. The theory goes, the higher the velocity, all things being equal, the higher the inflation rate. That is to say: rather than too many dollars chasing too few goods, one sees a static number of dollars chasing a static number of goods too fast. With higher velocity, fewer dollars are needed to chase the roughly the same number of goods.

So, if dollars remain constant, with the increased velocity, one now sees more dollars chasing the same number of goods. Thus, inflation ensues. First under President Ford, and especially under President Carter, something triggered an increase in velocity. One factor may have been the first full generation of a digitized currency through credit cards. A larger factor was likely the repatriation of dollars by non-U.S. national banks that no longer viewed the green-back as a store value currency.

These sovereign institutions switched into metals and harder currencies like the D-Mark, the Yen and Swiss Franc. All that accelerated the velocity of money changing hands, as people were exchanging dollars for other assets, mobilizing many more dollars chasing a stagnating level of goods. A similar sturm-und-drang swan song for the green-back may be lining up to create a hyper-inflation in our day.

Current effect of Quantitative Easing. These days, it seems that most dollars are dormant. They appear to be parked in foreign funds, in banks as well as in those institutions intimately involved with the welfare of the nation’s senior citizens (i.e., the Social Security Trust Fund). The fact is: all that money has to go somewhere. That somewhere includes buy-and-hold (for now) investments; grotesque valuations for start-ups that have few tangible assets to speak of and create almost no jobs; and, banks’ balance sheets. 

Worst Case. Once that money starts to move, we may see a death spiral for the American economy, perhaps others.

1. Foreign funds start to unload the dollar, preferring €uroes since the latter has shown more fiscal resolve toward wayward states (i.e., Greece).
2. That flight to discipline raises yields and cutting bond values, prompting people to start selling treasury instruments and reinvest somewhere else.
3. Some currency or rate hedges are broken and thus more selling ensues.
4. For people to buy, the real rate goes back to +2% (a hike of two to four percentage points; 200-400 basis points).
5. That craters the real estate and other capital markets and people start to sell off, likely in a panic, while buyers also add inflation premiums.
6. If a panic ensues, and perhaps driven by regulations on balance sheet standards, holders of currency and treasury instruments may ignore their hedges to get out before the market freezes 

Why F.D.R. might fail today. We slide into the menu effect of no published prices since they will be out of date by the time the ink dispensed to publish them is dry. Were anything approaching this scenario to occur, the U.S. economy would grind to a halt, quickly. Without any tricks left to spur the economy along and with the loss of the basic wealth and job creating capacity of manufacturing, even a new F.D.R. may find himself hapless, helpless, hopeless. 

The tragic flaw. The heart-breaking part of this admittedly extreme scenario would be the fact that all this adversity would not arise out of some conspiracy but out of a coincidence of thinking and out of a convergence of interests by people who are, for the most part, loyal and decent Americans.