QE2 Is Not Just A Ship, It's The Titanic

Perhaps you were celebrating the first World Series victory for the Giants in the city of San Francisco. Perhaps you were contemplating the shift in politics in the 2010 election. Perhaps you were even optimistic based on the jobs report released on Friday. This past week was certainly full of big events. However, the biggest event affecting all of us was the one that the public gave very little attention to.

On Wednesday, November 3,, 2010, Federal Reserve Bank Chairman Ben Bernanke announced that the Fed would be buying $600 billion in Treasury bonds in an effort to stimulate a stagnant U.S. economy. So what does this exactly mean and how does this affect us?

In normal economic times, the Federal Reserve usually controls the amount of money in circulation through the increasing or decreasing of borrowing interest rates. By increasing interest rates, currency is more expensive to borrow and thus is more restrictive. This action is usually taken to slow down an economy that is growing at too fast a rate. If the Fed decreases interest rates, currency is less expensive to borrow and thus is less restrictive. This action is usually taken to stimulate an economy that is too slow.

However, this recent economic crisis has put the Fed in a bind. They have lowered interest rates essentially to zero with no significant impact on the economic recovery. They have tried $1.7 trillion in stimulus money (known as Quantitative Easing). The result was a sluggish economy with no reduction in the unemployment rate.

With no other weapons left in the arsenal, the Fed is now left with taking desperate measures. Known as Quantitative Easing 2 (or QE2), the announcement on Wednesday was significant. Essentially, the United States would print $600 billion out of thin air and lend it out to banks for free in order to jump start the economy.

On Thursday, the stock market jumped nearly 2% on the QE2 announcement, so it looked like Wall Street liked the action taken by the Fed. However, commodity prices jumped over 5% on the same day. Remember, in our series entitled Currency, Money and the Economy, we defined inflation as an expansion of the currency supply. Prior to this financial crisis, the amount of “extra” currency in the economy, known as the Fed balance sheet, stood at just under $1 trillion dollars. With the introduction of QE2, the Fed balance sheet now stands at over $3 trillion dollars. This means that in less than three years, the United States has printed and circulated over $2 trillion dollars, all in the name of economic stimulus.

The problem with this is that you cannot print that much currency without having adverse consequences. The rise in commodity prices is a direct reflection of this policy. Gold is just a fraction away from $1400 an ounce. Silver now sits at 30-year highs. Oil is pushing $90 again, despite the fact the economy is much weaker than when oil used to be $90. Sugar, grain, coffee and other agricultural prices are also shooting upwards. As a result, General Mills announced this week a price increase on all of their products. In other words, the dollars you currently hold in your bank accounts and retirement plans will buy less because of all the extra currency in circulation the Fed has printed.

While the Fed is focused on stimulating the economy, it cannot possibly predict the outcome on a policy it has never tried. The Fed assumes that when the economy is back to “normal”, they will “simply” withdraw the currency from circulation. However, there are two problems associated with this assumption.

1) What if QE2 does not work? Just like the previous $1.7 trillion spent in QE1, what if businesses and consumers use that currency not to grow the economy, but to pay down debt? The economy will still be sluggish, and removing QE2 will send the economy into a tail spin. At that point, the Fed will probably introduce QE3.

2) Let’s say that QE2 works and economy is growing at 5% again. Then what? If you remove the currency from QE2, you will restrict the flow of currency, which will slow down the economy again.

Therefore, while the Fed is hopeful that one day QE2 will be removed from circulation, the bottom line is that chances are it can never be removed for fear of tanking the economy. In the past 30 years, no money that has ever been printed by the Fed has ever been withdrawn. The spending policies of the United States government have continually added debt and QE2 will simply add to the pile.

Think about it this way. The Fed has just pushed a small snowball down a hill in order to get a bigger snowball down at the bottom of the hill where all the United States citizens live. However, the Fed also believes it can control the size and speed of the snowball and that it will be able to pull the original snowball out. If this sounds ridiculous, well, you are right. If a huge snowball forms, no one will be able to control its size and speed, meaning it will most likely crash at the bottom of the hill, which is bad news for everybody.

So what then are we to do? Well, if you have cash lying around, you need to put it to work for you now in things that have real value. With near-zero interest rates, and inflation on the rise, the cash you have on hand will devalue at an accelerated rate. Normal investments (mutual funds, buy and hold, etc.) will increase in price, but not value due to the devaluation of the dollar.

The key is to find investments that will increase in value when the value of the dollar decreases. Investments such as commodities are a good starting point. Also, companies where revenues are generated in countries where the currency is stable or strengthening against the dollar are also advantageous. Companies with access in Brazil, Russia, India, China, Australia, and Canada are such examples.

China stated this week that the United States was a hypocrite. While the U.S. government has constantly accused China of currency manipulation to maintain a trade advantage, it has been printing dollars like there was no tomorrow. Regardless of who is right in this argument, one thing is clear. The policy of QE2 will have a more profound effect on the United States than any amount of currency manipulation by China.