Further Thoughts On The Great Experiment

Good stuff from Ambrose Evans-Pritchard in the Telegraph today. He presents a sober analysis of the Fed’s move to ZIRP and its embrace of Quantitative Easing.

It has not only cut rates to near zero for the first time in US history, it is also conjuring $2 trillion of stimulus out of thin air. This is Quantitative Easing, or just plain ‘QE’ in our brave new world.

The key is the toxic mix of high debt and deflation. An economy can handle one at a time, but not both.

The reason why it “departs further” from equilibrium is more or less understood. The burden of debt increases as prices fall, creating self-feeding spiral. This is what Fisher called the “swelling dollar” effect. Real debt costs rose by 40pc from 1929 to early 1933 by his count. Debtors suffocated to death.

Brian Reading from Lombard Street Research has revived this neglected thesis and come up with some disturbing figures. US household debt is now $13.9 trillion, down just 1pc from its peak last year. Meanwhile household wealth has fallen 14pc as property crashes, a loss of $6.67 trillion. The debt-to-wealth ratio is rocketing.

Clearly the US is already in the grip of debt-deflation. “The obvious conclusion is that the Fed should print money to purchase private sector assets so as to drive up their price,” he said.

Mr. Pritchard goes on to point out the obvious. At some point the flood of dollars going into the economy are going to spark exactly what the Fed wants-inflation. At that point they have to turn around and begin to withdraw the liquidity in a manner that doesn’t choke off recovery.

That may be easier said than done. In fact, Bernanke and the Fed might well find themselves in a position in which they continually vacillate from easing to withdrawing money from the economy. If that should come to pass and even before it does, their actions carry the serious risk of paralyzing the private sector and the consumer. If the private sector finds itself in an environment in which uncertainty as to massive government actions in either direction rules the day then the likelihood is that it will choose to sit on the sidelines, thus exacerbating the situation. In fact, this is precisely how you place an economy in the Japanese mold of their lost decade.

A couple of days ago, when Bernanke and company took the rate down to zero I called it the Great Experiment and noted that I was a little worried. Just kind of a queasy feeling about the whole thing given that it was more theory than experienced based fact. Mr. Pritchard seems to be of somewhat the same mood.

Mr Bernanke is known for his “helicopter speech” in November 2002, when he nonchalantly talked of the Fed’s “printing press” and said it was the easiest thing in the world to “reverse deflation.”

Less known is his joint-paper in 2004 – “Monetary Policy Alternatives at the zero-bound”. By then doubts were creeping in. He admitted to “considerable uncertainty” as to whether extreme tools will actually work. Liquidity could fail to gain traction.

Put another way, the Fed is flying by the seat of its pants. It should never have let debt grow to such grotesque levels in the first place.

How do you feel about “winging it” with the economy?

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