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Quantitative Easing and Funding the Deficit

The U.S. Federal Reserve (the Fed) decided last week to engage in an additional round of quantitative easing.  Financial industry experts and commentators have dubbed it QE II.  Over the next six months, the Fed will print money to purchase an additional $600 billion of government securities.  The goal is to keep interest rates low and encourage economic growth.

There has been a mixed reaction to QE II. While not offering a personal endorsement, President Obama has been supportive of QE II, but some members of Congress have been vocally critical.  Rep. Mike Pence from Indiana said the Fed was taking an “incalculable risk.”

Criticism has also come from abroad.  Finance ministers from China, France and Germany have expressed their concerns with QE II.  Granted, they are looking out for the financial interests of their respective countries.  As large exporting countries, China and Germany are concerned that increasing the money supply will further devalue the dollar and make U.S. exports more competitive globally.  China has another point of contention.  For years, the U.S. has accused China of keeping the yuan artificially low to make their global exports cheaper.  QE II seems to do the same thing we have criticized China of doing for years.

Beyond the risks of inflation and devaluing the dollar, I believe there is another correlation that needs to be made.  Congress has yet to pass a fiscal 2011 budget, and the government is operating under a continuing resolution, which keeps spending at the same level as fiscal 2010.  Although the final numbers have not yet been calculated, the 2010 budget deficit is approximately $1.4 trillion.  The 2011 budget presented by President Obama projects a $1.3 trillion deficit.

This means that the U.S. government is overspending by approximately $100 billion per month. Coincidentally, the Fed will be purchasing $600 billion of government securities over the next 6 months.

Although I don’t believe these matters are directly related or that there is some great Washington conspiracy, we are in essence self-funding our own deficit spending by printing an additional $600 billion of cash.  The U.S. government and economy may be sufficiently large enough to handle QE II.  However, I believe there is grave danger for any nation that funds its own spending and deficits by printing money, even for a short time.  It’s like lighting the fuse to a box of dynamite.  You can let it burn for a while, but if it burns for too long… be ready for an explosion.

I admit that I am not an economist or as smart as the Fed Board of Governors, but I do believe there are tremendous risks associated with QE II.  The more I analyze QE II, the more I see that Rep. Pence’s calling QE II an “incalculable risk” might be more than a partisan political statement.

The way I see it, the Fed, Congress and President have a short time to deal with the economic and fiscal challenges of this nation.  Quantitative easing may be intended to keep interest rates low and spur economic growth, but printing money – to buy government  debt – to fund deficit spending is a vicious cycle, that can have disastrous effects for the long-term stability of this nation. 

Let’s hope that QE III is the name of a new British cruise ship; not another round of quantitative easing.

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Quantitative Easing: Out of Nothing

Quantitative Easing is a monetary policy used by a nation’s central bank to stimulate the economy.  The central bank buys its own government’s bonds on the open market, thereby increasing the money supply. This additional money is supposed to stabilize or lower interest rates, and make it easier to borrow money.

So where does the central bank get the money?  It prints it.

Last week, the U.S. Federal Reserve (the Fed) decided to engage in another round of quantitative easing.  Over the next eight months, the Fed will purchase $600 billion of US government bonds. This will be in addition to the $1.7 trillion of U.S. bonds the Fed purchased between January 2009 and March 2010.  Thus, by the end of June, the Fed will own $2.3 trillion of U.S. debt. The Fed is expected to print up to $900 billion of new money to fund these purchases. 

In a Wall Street Journal article defending the decision, Fed Chairman Ben Bernanke has justified the action as part of normal monetary policy.  He stated that “We see an economy which has a very high level of under utilization of resources and a relatively slow growth rate.”

However, quantitative easing is not without risks.  A spike in inflation is one of the primary concerns.  Printing money creates assets ex nihilo (out of nothing).  Since no additional value is created, pumping more money into the system devalues the existing dollars, which often leads to inflation.  The ability to print money ex nihilo is why the U.S. government will never go bankrupt.  All it needs to do is print more money to cover its debts.  However, this technique usually results in hyperinflation.  History is full of nations that have inflicted financial ruin on themselves by using this type of monetary policy.

Apparently the Fed believes that a lack of liquidity is the cause of anemic economic growth.  I’m not an economist nor as smart as the Chairman, but something doesn’t seem to add up.  We’ve been hearing for months that banks and corporations are currently sitting on approximately $2 trillion of cash. Their reluctance to invest this money is hindering the economic recovery.  If there is already $2 trillion of excess cash, what is the benefit of creating $600 billion of additional liquidity?  Lack of demand and uncertainty of the future seems to be a greater hindrance to economic growth than a lack of money.

The first round of quantitative easing didn’t seem to have much of an effect on the economy. Time will tell if Chairman Bernanke is correct in his assessment of round two.  Hopefully it does as he expects and the economy grows.  More importantly, let’s hope it doesn’t backfire and spark a significant rise of inflation.  If so… we could easily return to the days of stagflation in the late 70’s and early 80’s.