The world still believes that the debt fiasco of the 1990s and 2000s, and the removal of banking controls introduced to prevent another Depression eighty years ago, can have a happy ending with a painless economic recovery. Often it is just peoples’ mood that tells them there cannot possibly be a deflationary downturn, with prices rushing to ground level. After two generations of non-stop inflation, a period of deflation to most people, is simply inconceivable.
Neither he nor the Fed can turn around the effects of a generation which believed that borrowing was the way to handle their finances all the time, and in all circumstances forever. That is why the economic wheel is turning. As it turns, it turns very slowly. And it will take a generation to find out that deflation can be just as intractable in its influence on the herd’s behaviour as the period of inflation that caused it.
Robert Prechter: To begin with, the printing analogy is flawed. The Fed does not operate a press, as the government of Zimbabwe did. It creates new money only when it buys IOUs. This may seem to be a distinction without a difference, but it’s actually very important. These IOUs are the Fed’s assets, and it doesn’t want worthless assets backing its notes.
Even if the Fed were to monetize every dime of currently outstanding, dollar-denominated debt, it would create no net inflation. The money-plus-credit supply would be the same. And price levels — especially for investments — are based on the total of monetary assets, not just base money.
Even so, there is no way that the Fed will buy up the entire world’s stock of lousy IOUs. It has always wanted pristine assets on its books. Remember, it didn’t buy Fannie and Freddie’s IOUs until it got the Treasury to guarantee them.
Then there is the so-called moral hazard — not that the Fed cares about morality — meaning that if the Fed were to begin buying everyone’s IOUs, people would immediately issue more IOUs as fast as they could and sell them to the Fed. It couldn’t keep up with the volume.
But these scenarios are fantasies. In reality, self-preservation will eventually motivate the Fed just as it motivates every other institution. Buying too many worthless assets would cause the Fed’s self-destruction, and I think it will balk at going that far.
He wants the Fed to buy IOUs and release money into the economy. But buying US government Treasuries, and not Corporate or Municipal debt is raising the spreads of these riskier assets, making their fund raising more expensive as this is sucking investor’s money into the safer Treasuries. He writes –
which assets should the Fed buy? As Alan Blinder, a former vice-chairman of the Fed, has noted, the recent policy of replacing maturing mortgage-backed securities on the Fed’s balance sheet with government debt has a secondary effect of reducing downward pressure on risk spreads, which is a pity. From that point of view, it would be better if a new phase of QE concentrated on private securities – but then the question would be, exactly which?
The other problem, Clive, is that the Fed has to look to its own credibility, and economic survival. If it buys assets that are to become worthless, the whole economic system could teeter close to collapse. I would be grateful that the Fed has eased as much as it has. The problem is that the debts in the economy have been allowed to balloon as big as they have. At some point, asset prices have got to be allowed to fall back to the point of affordability. Pumping in money only delays the day, and makes the debt problem yet bigger. Confidence in The Fed will be pivotal to any recovery. Let’s not drag the Fed into the mess any more than it has been.