Three Reasons QEII Will "Backfire"; Pavlov's Dogs and the "No Choice" Argument Yet Again

Dr. El-Erian, CEO and co-CIO of PIMCO states several reasons why QEII will backfire.

1. The Fed is going it alone, without meaningful structural reforms
2. Emerging economies burdened by capital inflows in the wake of QEII will react with currency wars, protectionism, and capital controls
3. Resultant commodity price increases will increase input costs and reduce earnings of American companies

The position of El-Erian is interesting given that PIMCO founder, managing director and co-CIO endorsed QEII as discussed in Bill Gross' Arrogant Endorsement of Fed's QE Policy he calls History's Most "Brazen Ponzi Scheme".

Unintended Consequences of QEII

Mohamed El-Erian addresses the unintended consequences of Fed policy actions and the reasons Quantitative Easing will fail in QE2 blunderbuss likely to backfire.

The Fed faces three problems, with its solo role being the first. Having warned in late August in Jackson Hole that “central bankers alone cannot solve the world’s economic problems”, Ben Bernanke, the Fed’s chairman, is now leading an institution that is virtually on its own among US policymakers in meaningfully trying to counter the sluggishness of the US economy and the stubbornly high unemployment.

The rest of the world does not need this extra liquidity, and this is where the second problem emerges. Several emerging economies, such as Brazil and China, are already close to overheating; and the eurozone and Japan can ill afford further appreciation in their currencies.

Despite polite rhetoric to the contrary in the lead up to the Group of 20 leading economies summit in Korea this month, other countries are likely to counter what they view as an unnecessarily disruptive surge in capital flows caused by inappropriate and short-sighted American policy. The result will be renewed currency tensions and a higher risk of capital controls and trade protectionism.

The third issue relates to the gradual erosion of America’s central role in the global economy – including as the provider of both the world’s reserve currency and its deepest and most predictable financial markets. No other country or multilateral institution can displace the US, but a combination of alternatives can serve to erode its influence over time. No wonder commodity prices surged higher and the dollar weakened markedly in anticipation of QE2, pointing to increased input costs for American companies and unwelcome pressures on their earnings.

Pavlov's Dogs and the "No Choice" Argument Yet Again

Although I agree with the three major points above, I certainly do not concur with El-Erian's opening gambit "Given the high market expectations, the US Federal Reserve had no choice but to announce a second tranche of quantitative easing".

Pray tell who set those expectations if not the Fed? Moreover, given the market reacted like Pavlov's Dogs to the announcement, the Fed could have and should have toned down market expectations.

Finally given that the Fed produced a bubble in junk bonds and sent commodity prices soaring the Fed had every reason to disappoint the market today.

For more on junk bonds please see ...

• Thanks to Fed, Bubble Builds in Junk Bonds; We Know How Bubbles End


• Mad Dash Into Junk Sets October Record

Intended vs. Unintended Consequences

Add a junk bond bubble to the list of consequences (unintended or otherwise).

Bernanke is clearly misguided enough and arrogant enough to purposely blow a junk bond bubble as an "intended consequence", even though the housing bubble bust proves without a doubt the asininity of such policies.

Thus, it's hard to say if Bernanke wants a junk bond bubble or is merely willing to live with one.

Then again, Bernanke is dense enough to not have any clues about what is happening. He did not see the housing bubble, the recession, the huge rise in unemployment, and any number of other things that happened. In fact, he even denied there was a housing bubble.

In the academic wonderland in which Bernanke lives, it is perfectly possible he is oblivious to the bubbles he is creating.

However, looking at things from every angle, given that Bernanke Admits Targeting Stock Prices, I am leaning towards the first option: Bernanke is misguided enough and arrogant enough to purposely blow more asset bubbles as an "intended consequence", hoping he can deal with them later.

Missing the Obvious

I touched on the one obvious reason QEII will fail in QEII Announced, Fed Set to Buy $600 Billion in Bonds, Reinvest $250 Billion More; Fed Micromanaged Economy to Oblivion; No Miracles Coming

Doubts? What Doubts?

There is little doubt, at least in this corner, that the plan cannot possibly work. Corporate borrowing costs are the lowest in history and that hasn't spurred hiring. Will another quarter of a point lower matter? Will QEII even lower rates that much?

Simple explanations as to why QEII will fail are best: "Money’s Already Quite Cheap"

With mortgage interest rates at all time lows, is this supposed to help housing? Why?

It is sad but true economic thinking these days that the "Fed had to do Something". Why does it make sense to do something, just for the sake of doing, when it should be crystal clear that doing just adds to problems down the road.

Fed Micromanaged Economy to Oblivion

The Fed has clearly micromanaged this economy to oblivion. Greenspan's experiment short-circuited the 2001 recession but the expense was the biggest housing bubble in the history of the world, not just in the US, but globally.

A global recession soon followed.

Now on misguided calls to "do something" the Fed is blowing a bubble in commodities that cannot possibly help margin strapped small businesses.

An excerpt from $30 Billion Offer No One Wants - Small Businesses Hit by Deflation will show why. ....

No One Has To Do Anything

It is disappointing to see El-Erian perpetuate the myth the Fed had to do something when one of the biggest reasons we are in this mess is a activist Fed under both Greenspan and Bernanke felt the need to do something about LTCM, Y2K, the Dot-Com bubble, housing, motherhood, and apple pie.

At least El-Erian is not defending what Gross calls a "Ponzi Scheme" to the same foolish extent that Bill Gross did. More importantly, El-Erian makes it clear exactly what some of the consequences are, while the Gross article sounds like "jumping the shark".

Structural Reforms

El-Erian said "Without meaningful structural reforms, part of the Fed’s liquidity injection will leak right out of the US and result in yet another surge of capital flows to other countries."

I agree, but I rather doubt we are talking the same language. This country needs to ...

• Scrap Davis-Bacon
• End public union collective bargaining
• End the public union stranglehold on the cities and states
• Fix the pension problem
• Even the playing field between big and small businesses on corporate income taxes
• Get the hell out of Afghanistan
• Reduce military spending
• Rein in entitlements
• Stop being the world's policeman
• Balance the budget
• Return to constitutional money
  

Fed Fights Battle that Cannot be Won, Should Not be Fought

Given that Congress is unlikely to do many, if indeed any of those things, the Fed is fighting a battle that cannot be won and should not be fought.

We are in this mess because the Fed micro-mismanaged the economy at every critical juncture while attempting to smooth over various fiscal insanities, counter bad Congressional policies, as well as deal with the repercussions of its own monetary insanities, on a delayed chasing-its-tail basis, in a global economy that waits for no one.

Is it any wonder the Fed failed in dual mandate of price stability and maximum growth?

For more on the silliness of the Dual Mandate as well as a rebuttal to the notion "Don't Fight the Fed" please see Krugman and the Inevitable "I Told You So" - Tim Duy "Bad Things Happen When You Fight the Fed"; Final End of Bretton Woods 2?

With that key idea in mind, there are two more structural reforms glaringly lacking in the above list: Abolish the Fed and End Fractional Reserve Banking.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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