Richard Koo Explains Why An Unwind Of QE2, With Nothing To Replace It, Could Lead To The Biggest Depression Yet

Tyler Durden's picture

Over the past several days, quite a few readers have been asking us why we are so confident that QE3 (in some format: it does not and likely will not be in the form of the Large Scale Asset Purchases that defined QE1 and 2 - the Fed could easily disclose that it will henceforth sell Treasury puts, a topic discussed previously, or engage any of the other proposals from Vince Reinhart disclosed in June of 2003, or worse yet, do what the BOJ does and buy ETFs, REITs and other outright equities) will eventually be implemented by the Fed. Luckily, instead of engaging in a lengthy explanation of the logical, Nomura's Richard Koo comes to our rescue with his latest research piece. While we disagree with Koo on various interpretations of his about monetary theory (namely that the Fed is not in effect "printing" money and thus creating inflation - this is semantics and leads to a paradoxical binary outcome, whereby if there Fed was successful in boosting the economy, the economy would indeed be flooded with the nearly $2 trillion in excess reserves held with reserve banks. And good luck trying to contain this surge by changing the IOER - if the Fed indeed pushed the IOER to the required 5%+ level it would immediately destroy money markets, leading to the same liquidity freeze that marked the post-Lehman days, confirming the "Catch 22" nature of Quantitative Easing that we have observed since its beginning) we do agree with his analysis of what would happen to the economy if either stocks or commodities are in a bubble (and judging by the violent opinions out there, most investors believe that either one or the other has indeed reached bubble territory), should QE2 end cold turkey: "Viewed objectively, the central banks are trying to push up asset prices using quantitative easing and the portfolio rebalancing effect. The resultant rise in asset prices based on this effect represented a potential bubble—or at least a liquidity-driven event—from the start. The question is whether the real economy can keep pace with asset prices formed in those liquidity-driven markets. If it cannot, higher asset prices will be considered a bubble and will collapse at some point. The resulting situation could be much more severe than if quantitative easing had never been implemented to begin with." Bingo.

"In other words, if stock and commodity prices are in fact in a bubble and if those bubbles were to collapse, the balance sheets of the financial institutions and hedge funds making investments with the expectation of higher asset prices could suffer heavy damage, exacerbating the balance sheet recession in the broader economy. an increase in DCF values, either." And there you have it: Bernanke's all in gamble that QE2 would have been sufficient to restore the virtuous circle of the economy has failed with less than 2 months to go under the QE2 regime. As such, and with fiscal stimulus a dead end, the Fed has two choices: watch as the economy collapses in flames to a state far worse than its pre-QE1 outset, or do more of the same. That's all there is. The rest is irrelevant. And since the Fed will choose the latter option, the market would be wise to start pricing in precisely the same reaction as what happened following the Jackson Hole speech...although to the nth degree.

And some other key observations from Koo:

Government borrowing has supported money supply growth

The question, then, is how to explain the modest growth in the money supply at a time when private-sector credit has steadily contracted. A look at Japan’s experience shows that the answer lies in increased bank lending to the government. As long as the government continues to borrow, banks can continue lending (by buying government bonds) even if the private sector is deleveraging in an attempt to clean up its balance sheet.

If the government spends the proceeds of those debt issues, the people on the receiving end of that spending will deposit money with a bank somewhere, leading to an increase in the money supply.

In effect, the money supplies of both the US and the UK are being supported by government borrowing. If the two governments chose to embark on fiscal consolidation, their money supplies would contract.
Portfolio rebalancing effect was primary objective of QE2

So what are the actual problems inherent in QE2? Mr. Bernanke has stated from the beginning that QE2 would not lead to an increase in the US money supply.

If so, why did the Fed carry out QE2? The simple answer is that it believed QE2 would result in a portfolio rebalancing effect. The portfolio rebalancing effect can be described as follows. When the Fed buys a specific asset (in this case, longer-term Treasury securities), the price of that asset rises. That prompts private investors to re-direct their funds to other assets, which leads to a corresponding increase in the price of those assets.

Private-sector sentiment may improve as asset prices rise, and if that prompts businesses and households to spend more money, the economy may improve. In effect, the Fed hopes that quantitative easing will lift the economy via the wealth effect. Inasmuch as the balance sheet recession was triggered by a drop in asset prices, monetary policy that serves to support asset prices may also help pull the economy out of the balance sheet recession.

Reasons for divergence of liquidity supply and money supply

The decline in private-sector credit in the US and the UK is attributable to both the unwillingness of banks to lend and the unwillingness of the private sector to borrow. The two factors are rooted in balance sheet problems and are indications that both countries remain in balance sheet recessions.

When a bubble collapses, the value of assets drops, leaving only the corresponding liabilities on the balance sheets of businesses and households. To fix their “underwater” balance sheets, companies and individuals do whatever they can to pay down debt and avoid borrowing new money even though interest rates have fallen to zero. Banks, for their part, are not interested in lending to overly indebted companies or individuals, and often have their own balance sheet problems. With no borrowers or lenders, the deposit-growth process described above stops functioning altogether.

US banks now appear slightly more willing to lend money, although that is not the case in the UK. In neither country, however, are there any signs of greater willingness to borrow among businesses and households.

Unable to buy more government bonds or private-sector debt, investors have few places to turn

In the hope of producing a portfolio rebalancing effect, Chairman Bernanke declared that the Fed would purchase $600bn in longer-term Treasury securities between November 2010 and June 2011. This was roughly equivalent to all expected Treasury debt issuance during this period.

From a macroeconomic standpoint, these purchases of government debt meant that—in aggregate—private-sector financial institutions would be unable to increase their purchases of US Treasury securities, because all of the growth in Treasury issuance would be absorbed by the Fed.

The fact that US businesses and households were rushing to repair balance sheets by deleveraging meant that—again, viewed in aggregate—private investors would be unable to increase their purchases of private-sector debt.

With the private sector no longer borrowing and all new issues of government debt being absorbed by the Fed, US institutions found themselves with few investment options.

So funds found their way to equities and commodities

The only remaining destinations for these funds were equities, commodities, and real estate. Real estate had just been through a bubble and remained characterized by heavy uncertainty. In commercial real estate, for example, banks—at the request of US authorities—are engaging in a policy of “pretend and extend” and offering loans to borrowers whose debt they would never roll over under ordinary circumstances. That means that current prices do not accurately reflect true market prices. Housing prices, meanwhile, resumed falling late in 2010.

UK house prices have been falling since mid-2010, and the Halifax House Price Index dropped 1.4% in April 2011 alone (the decline was 3.7% on a y-y basis).

The only remaining options for private-sector investors have been stocks and commodities. That, in my opinion, is why both markets have surged since the announcement of QE2.

And the conclusion:

QE2 was Bernanke’s big gamble

When the situation is viewed in this light, we come to the realization that Mr. Bernanke’s QE2 was in fact a major gamble. It was a gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices led to improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, thereby demonstrating that prices were not in a bubble.

However, I cannot help but feel that the portfolio rebalancing argument was putting the cart before the horse, in the sense that it is ordinarily a stronger real economy that leads to higher asset prices, and not the other way around.

It might be possible to sustain the portfolio rebalancing effect for some time if conditions were such that investors were totally oblivious to DCF values. But with market participants paying close attention to DCF values, any delay in the economic recovery will naturally bring about a correction in market prices, thereby causing the portfolio rebalancing effect to disappear.

Full report:


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NOTW777's picture


NotApplicable's picture

Yeah, but it was the cure for the Greenspasms.

NOTW777's picture

partially agree but the toxic mushroom cloud is mostly ben's

NotApplicable's picture

Meh, it isn't like he had any choice.

I'd blame Montagu Norman and Benjamin Strong first. Which isn't to say I'm supportive of anything The Bernank has done, I'm just saying he's merely another tool in the shed, not a master carpenter. His choices were defined well in advance of his arrival.

NOTW777's picture

what about the choice to level with the american people - particularly when he s under oath.  I dont believe there was no other choice.  it started with paulson - he could have said no.  there would have been pain but primarily for those who started the mess 

10kby2k's picture

My wife should be named head of the Fed: she can stretch a dollar further than anyone.

jeff montanye's picture

bingo indeed.  long before 5%, as john hussman demonstrates, if short rates increase to 1/2%, consumer prices rise 40% in less than a year unless the entire liquidity pump of qe2 is reversed and liquidity drained.  makes a nice combo with overvalued assets and austerity. 

Sudden Debt's picture

HAHA! :)

I know that feeling, mine can say she spends 100 euro's but she needed 500 euro to do so :)


Urban Redneck's picture

In the US case- monetary, fiscal, and regulatory policy are the three heads of the cerberus which prevent the US from escaping finacial hell.

Chris Jusset's picture

Dick Koo says:

"Higher asset prices will be considered a bubble and will collapse at some point. The resulting situation could be much more severe than if quantitative easing had never been implemented to begin with."

This is why QE3 is absolutely guaranteed ... and why QE4 and QE-Infinity will happen up until the point of total collapse.  The devastation wrought by popping bubbles is far worse than if QE had never happened initially.


Banana Ben has created the mother of all bubbles, and now he has no choice but to keep the bubble inflated lest a depressionary collapse ensue.  Ben is a total fucking idiot.

NOTW777's picture

i think everyone should seriously question if QE3 is even doable.  dont give ben too much credit.  ponzi schemes always come to an end

NOTW777's picture

bens chambermaid could be right around the corner

Big Corked Boots's picture

While it is true that ponzis always end, they also seem to last far longer than anyone expects. In the meantime, the ups and downs of manipulated markets serve the manipulators well... they are rubbing their hands together as we speak.

As for Ben's chambermaid, eventually everyone gets discarded.

NotApplicable's picture

As long as "someone" accepts the paper, Ben will QE4EVA.

BTW, that someone is you (albeit via proxy).

NOTW777's picture

at this point in the ponzi who is that "someone?"

snowball777's picture

every person with a job who isn't paid under the table.

Quixotic_Not's picture

Debt-based Ponzi inflation in place - check!

Dumbed-down to succumb 'MeriKan "electorate" in place - check!

Continued price suppression of PMs in place - check!

Trend supporting monetary collapse in place - check!

Got Ag?

Popo's picture

Everyone keeps looking at internal factors for signs of QE3.   The situation is IMHO, entirely dependent on the economic (and political) fate of China, emerging market economies and the Mideast.

The ball is not in our hands.


contagiousNY's picture

Ahh hope is eternal, but this time it will be the bellboy

Chris Jusset's picture

Yes, all Ponzi schemes eventually collapse.  But Helicopter Ben will fight until his last breath to keep the bubble inflated ... to keep he house-of-cards intact ... to keep the plates in the air.  Ben is cornered, and he's running out of options.

i think everyone should seriously question if QE3 is even doable.

If the choice is between (a) QE3, and (b) a total deflationary collapse of unprecedented dimensions, Ben will go with QE3.

donde1's picture

10 yard penalty for over using puns....2nd down. 

snowball777's picture

Objection! His toe was clearly in the piddle.

mayhem_korner's picture

Ponzi schemes always end from the periphery - never from the origin.

Also, I don't buy into Ben being an idiot.  He either believes in what he's doing (overdosed on Keynesian Kool-Aid) or he realizes there's no choice for him but to row with the tide.  I think one thing to watch for would be his stepping down...could be an ominous sign of a tipping point.

Just food for thought...

bigdumbnugly's picture

i agree with that, mayhem.  so i agree with your duplicate post too.

chet's picture

I buy the basic scenario of the end of QE2 leading to a correction, forcing a QE3, but what I'm starting to wonder is:

What if QE3 doesn't work?  What if the market doesn't respond like it did to previous quantitative easing?

I mean, everyone knows it's bullshit.  If they do it again, even the MSM will start reporting on how it's artificially pumping the market.  It can't work forever can it?

Quixotic_Not's picture

Yep...3 strikes and you're out!

Real growth has been studily at -10% to -15% since 2008, and short of a collapse of wages and creation of massive productive output, there's no digging out of this scenario.

The only other possible recovery mode for the U.S. is to start massive acquisition of resources by military force.

Ready for WWIII?

Baptiste Say's picture

The only solution to a real term depression is a war?


Look buddy, just as Keynesianism doesn't work military Keynesianism also doesn't work. Killing and destroying capital will never lead to net growth.

Quixotic_Not's picture

The goal is to capture more capital than you destroy!

It's the only way the (D) & (R) Free Shit Empire™  dystopia can possibly keep the Ponzi on long-term...

You do know the function of an empire is imperialist expansion and theft of resources, right?

Besides, it'll keep all those young unemployed sheeple off the streets!

(You gotta know this a politeer/bankster wet dream)

Pentagon says Afghanistan might have world's largest lithium deposits

Baptiste Say's picture

"The goal is to capture more capital than you destroy!"


I follow you now. When I read WWIII I thought you were suggesting a few cities needed to be bombed to allow a make work rebuilding program.


I don't think resources need to be 'captured' with force at all. We have a market which allows resources to be captured at a price but unfortunately the chicken hawking war mongering nutcases in your countries capitol are not of the same opinion as I.



robobbob's picture

"your countries capitol"

you say that like Amerika in this on our own. We didn't set fire to Egpyt and Libya to help our resource supplies. And last check, the Nabucco pipeline is NOT slated to transit or terminate in North America. just saying. Iraq/Iran might be about oil, but it isn't destined for our shores.

So, if you happen to be in any western country, don't think your hands are clean. The phrase should be "our" countries capitals. We're just doing the heavy lifting when someone tries to say no to the deal you can't refuse.

jeff montanye's picture

imo rational economic aggrandizement explains only some of war (and of peace, re: individual and collective "free market" economic decisions).  

ideology and emotion are hugely powerful.  

for instance zionism, not really a profitable idea long-term, especially for the u.s., is at least as useful an explanation for the current wars as anything else.

Seer's picture

You got it!  Wars are about resources, always.  If everyone had everything they could ever want then there wouldn't be any need for war.  That's not to say that some wouldn't try just for the heck of it, but there really wouldn't be much support, most aggression would fizzle before it even got anywhere (even religious ideologies couldn't work up enough froth).

Mad Cow's picture

Power is the reason for wars. Resources are just a nice bonus.

Rynak's picture

Power is control. Control of....... what?

Mad Cow's picture

It's all just an illusion. Control only lasts a short time. This time though, they'll burn the planet in the attempt.

Fiat2Zero's picture

I saw a statistic that showed about a 12% efficiency. That is, for every 8 dollars of stimulus (i.e. POMO) we got out 1 dollar of gain. I didn't look too closely at the gain, but it would have to be asset prices (e.g. stock market).

While the measurement may not have been perfect in absolute terms, what it did show was that over time the efficiency was going way down. Consider the POMO amounts at the beginning, and the ones at the end (the size of the penultimate ones was multiples of the first). There are a variety of reasons for rapidly decreasing efficiency such as malinvestment (e.g. causing inflation).

So if and when QE3 kicks in, I'm going to hazard a guess and say that it will be in response to an (expected) shock. The shock will be what Ben needs as the excuse. His Wall Street buddies will all cry "save us Ben" in the usual media orifices. Hank Paulson may go down on one knee and beg again again (he's such a fucking giant that the visual oddity this produces is enough to make one relent).

There would have to be a decent size rush of capital to stabilize the patient, after which whatever injections are done would have to be sizeable. They might initially have better purchase as I'd think they'd try something different. Don't forget, Ben is king of the "we're going to have to get a little unorthodox this time" approach, at least based on the things he's written.

Eventually things would stop working. Just like when hyperinflation and currency collapse stop working in the last phases.

masterinchancery's picture

And that is exactly how we get hyperinflation.

contagiousNY's picture

Inflation is tracking the equity rise closely, once PMs stalled the market echoed that.

Hard1's picture

Totally agree with Koo.  The problem is how do you trade this:

-Bonds in a bubble

-Equities in a bubble

-Commodities in a bubble 

Maybe short term cash, but medium term cash is trash.

mayhem_korner's picture

Think it through.  Pop them all and what is the absolute, definitive counterbalance???


And so, if you sit in Ben's chair, the landscape calls for unabated fuel for the bubbles.  This is why QE absolutely will continue.  All that's happening now is a charade of misdirections.

The Feds Connection's picture

All this doom. I watched max keizer show on 24france yesterday. Taped on 28 oktober 2009 in which he sayd financial catastrophe would hit again in in 6-9 months. How long can this be stretched?

Seer's picture

Are you figuring that this will be televised?  Based on how you spell I'd figure that you might not be in the US and are therefore not able to see up front how many people are walking financial zombies.

At the point that it's all on the MSM (assuming that the MSM can even operate at that point) will be when it's too late to prepare.  No problem with me if people don't prepare, as it just means that I've got a better footing than those who haven't prepared: less competition for preparing.

But on the flip side would be those claiming that catastrophe isn't possible.  Clearly these folks are wrong.

A_MacLaren's picture

How many zeros can Ben digitally create? 

Start with:  i2 = [(1+(i1/n1))^(n1/n2)-1]*n2


i1 = zirp to 0.25

n1 = duration of Alphabet Soup initation thru QE2 terminus

i2 = Risk adjusted ROI on Ben's Treasury Puts, given infinite creation

Just rearrange the equation and solve for n2

baby_BLYTHE's picture

I too await that answer, my friend. All I know is reckless money printing throughout history has always lead to absolute disaster to whom ever attempts it.We will most definitley pay. The question is, ' in what way '