Guest Post: QE2 Will Sink Us

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Submitted by Gonzalo Lira

QE2 Will Sink Us

Ben Bernanke and the Federal Reserve are preparing for QE2—a second round of Quantitative Easing.

The
rationale is that the United States’ economy is circling the
deflationary drain—something Bernanke and the Fed are absolutely
terrified of. Certainly deflation is hitting the U.S. economy full bore,
but it’s yet to be proven that this deflationary trough has twisted
itself into a self-reinforcing vicious cycle. I would argue that the
chances of the U.S. economy twisting into a deflationary death spiral
has yet to be made. But be that as it may, it doesn’t matter if the
economy is in a deflationary death spiral—Bernanke and Co. think that that’s the imminent danger. And they're the ones with their finger on The Big Red Money-Making Button.

Some
people are claiming that the first version of QE was not enough. Like
Paul Krugman whining that the stimulus package wasn’t big enough to
restart aggregate demand, the aggregate asset crowd—the monetarists—are
bitching that Bernanke didn’t really open the monetary flood gates with
the first version of QE.

These people conveniently forget that the Fed more than doubled its balance sheet, in order to carry out QE v.1.0. This interactive chart
tells that story better than words can—from less than a trillion
dollars, to $2.2 trillion in under 60 days. Clearly, Bernanke now owns
the land speed record for monetary expansion. And to any talk that
Bernanke is contracting the Fed balance sheet too quickly, let’s just
say that a shrinkage of less than $30 billion from a peak of $2.333
trillion is not exactly “drastically reducing” the balance sheet.

Still,
with all that liquidity the Fed has been making available, the banks
aren’t lending—they’re too weak to lend, their balance sheets too
precarious. So banks are hoarding their cash (or carrying out the
Treasury’s stealth monetization program). So asset prices are falling
(even with over a trillion dollars’ worth of MBS’s shovelled onto the
Fed’s balance sheet). So deflation. So monetarists are freaking out: And
the Fed is dominated by monetarists.

 

Hence,
QE2—another go-around of massive monetary expansion, to both prop up
asset prices, and prevent a (supposed) deflationary death spiral. And
Benny’s not gonna screw around: If Bernanke does a for-real QE2—a
no-fucking-around, damn-the-torpedoes, full-steam-ahead! quantiative
easing—he’ll expand the Fed’s balance sheet from $2.3 trillion to at
least $4 trillion, if not $4.5 trillion.

 

Here
is my fearless prediction: If Bernanke does QE2 for-real (which is not a
sure thing yet, but likely), then this monetary expansion will become
the hyperinflationary kindling—but not the spark.

 

The
spark will come from someone selling a big position in Treasuries. The
obvious culprit could be China. China’s economy is tanking—and China has
a whole lot of Treasuries, which they will need to dump so that Beijing
can prop up its own asset bubble. China’s the likely candidate, but
hell, it could be Bill Gross.
Regardless: The
Fed has been buying up mortgage backed securities from the Too Big To
Fail banks, in order to bail out the banks. The TBTF banks have in turn
used the cash to soak up all those Treasuries the U.S. Government has
been emitting to finance its stimulus spending. China’s sale of
Treasuries—to prop up its homegrown asset bubble—will need to be
purchased by someone: The U.S. cannot allow its debt to tank.

 

Enter
QE2, stage right: QE2 will be used to prop up Treasuries—and this will
spook the markets. People will realize that Treasuries are as vulnerable
as Greek euro-bonds—which they are, of course. So people will want to
get out of Treasuries.

 

So the Fed will be
forced to defend Treasuries—with QE2 cash. Instead of buying up mortgage
backed securities, they’ll be forced to buy Treasuries. It’ll be 2008,
only Treasuries tanking, rather than MBS’s.

 

This
will light the hyperinflationary fire. People will lose faith in the
dollar, and try to get out of it—at all costs, all at once. As I've
written in other posts, hyperinflation is not the economy overheating,
like regular inflation—hyperinflation is when nobody wants to be caught
dead with a currency.
This is how deflation
will trip over into hyperinflation. And this will happen within 24
months, perhaps as soon as this coming autumn. And even if QE2—by some
miracle—does not bring about hyperinflation, then in 18 months or so,
Bernanke and the Fed will do QE3: Their rationale will be that they did
it “successfully” with QE in 2008 and QE2 in 2010, so why not QE3 in the
fall of 2012?

 

If your only tool is a hammer,
then every problem looks like a nail. Bernanke and the Fed will bring
about hyperinflation—obviously. They are so irrationally terrified of
deflation—and they are so committed to defending aggregate asset prices,
regardless of what it takes—and since their only real power is monetary
expansion—that they will let loose the QE spigot until they break the
back of the Demon Deflation. And in their zeal, they will kill the U.S.
economy.

 

But hey, I’m probably wrong. BTW,
that gold necklace you’re wearing—you wouldn’t be interested in selling
it, now would you? I got me some freshly minted dollars . . .