Is the Fed easing us straight to the brink?Article added by Dave Scranton on October 19, 2012
Dave Scranton

Dave Scranton

Joined: February 23, 2011

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Americans have been bitten so badly so many times now that they can no longer be manipulated into spending and borrowing just because interest rates are low. In fact, I think we may have created a whole generation of investors who've grown too smart to accept the drug of low interest rates from Uncle Sam.

Albert Einstein is credited with this definition of the word insanity: To constantly repeat the same action expecting a different result. I couldn't help thinking of that definition again on September 13 when the Federal Reserve announced its latest economic stimulus plan, the so-called QE3.

This third quantitative easing (QE) package by the Fed involves buying back $40 billion per month in government bonds and mortgage-backed securities with the ultimate goal of manipulating long-term interest rates downward. Hypothetically, this will lead to more borrowing by corporations, more home buying and new home building, more hiring and more spending in general — all those things that indicate a healthy, growing economy.

Of course, QE1 in 2008 and QE2 just last year had basically those same objectives, yet here we go again! This is a dangerous course to take, I believe, for two reasons. First, considering our federal debt situation, the timing could not be worse. Second, I feel QE3 is yet another artificial caffeine fix by the Fed, and will not only have little (if any) impact on true economic recovery, but may actually make matters worse.

Regarding the first point, I’ve been using this formula with my own clients to help put our federal budget picture into perspective. Imagine you had a household budget that looked like this:
  • Annual family income: $21,700
  • Money the family spent: $38,200
  • New debt on the credit card: $16,500
  • Outstanding balance on the credit card: $160,000
  • Total budget reduction measures so far: $3.85
Now, you don’t have to be a financial wiz to realize this looks like a family with no real option left but bankruptcy. But here’s what’s interesting, and by that I mean scary: If you add eight zeros to each of the figures above, you get a fairly accurate picture of roughly where the U.S. budget stands. In fact, there’s really only one reason that our government’s only option isn’t also bankruptcy; it’s because we are the world reserve currency and have the ability to just keep printing money. Take that out of the equation and our economic picture is not much better than that of Greece, and certainly no better than Spain, Portugal, Ireland or a number of other countries in serious economic turmoil at the moment.

Is a caffeine hangover coming?

Now let me expand on the second point. Even without the debt crisis, I would still consider QE3 a bad idea, and here's why. I have talked a number of times with my clients and our advisors about what I call economic caffeine fixes — artificial jolts meant to stimulate growth, increase investor confidence and boost consumer spending — that become less and less effective each time they're used.
So why keep using them? Well, this time, I believe the most likely reason the government is pursuing quantitative easing yet again is that they hope to create inflation and therefore deflate the dollar by printing money in order to deflate their debt repayments. Of course, you may be thinking, "That strategy should work. Every economics textbook I've ever read says that the printing of money by a government will create inflation." True. However, the underlying assumption in all of those textbooks is that people actually use the extra money being pumped into circulation to buy goods and services.

But this particular shot of caffeine has lost its ability to stimulate. Why? Simple. Americans have been bitten so badly so many times now that they can no longer be manipulated into spending and borrowing just because interest rates are low. In fact, I think we may have created a whole generation of investors who've grown too smart to accept the drug of low interest rates from Uncle Sam. They're putting the extra money into savings or using it to pay down debt. Good for them, bad for the government plan.

And here's the other side of the story. Those economic textbooks also tell us exactly what can happen if the extra money is put into savings or debt reduction, rather than spent to purchase goods and stimulate inflation. That's right: deflation.

What's most unfortunate (and the reason I call QE3 dangerous) is that all of the Fed's efforts to artificially heal the economy these last few years have probably only served to prolong the pain. In a newsletter to clients this past spring, I talked about the government kicking the economic can down the road. I pointed out the relationship between the interest on a 30-year treasury bond — at that time about 3.3 percent — and the interest on a 30-year mortgage, which was about 4 percent. My point at that time was that the government had not built in a sufficient buffer to account for default risk. They had decided to kick the can down the road and worry about default later. Since that writing, bond and mortgage rates have fallen again, with both currently around 3.25 percent. Houston, someone is going to have a problem.

The other point I emphasize to clients is that quantitative easing not only loses impact with overuse, it also ignores the realities of long-term secular market cycles. Remember, our current secular bear cycle began in 2000, which means, according to the lessons of stock market history, it may have another full decade yet to go. The sooner our leaders accept that and let the economy start healing according to its own natural biorhythm (while they seriously focus on the budget crisis!), the sooner we are likely to start seeing real recovery. All the Qs in the world aren't likely to make it happen any faster.
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