Yesterday’s markets barely moved in any significant direction, so we will ignore them and go on to today. It’s a big day for the men who rule us. The Fed’s Open Market Committee meets to decide what to do.
On the table are a number of small steps…and one big one.
Barron’s highlights the big one on this week’s cover:
“Why the Fed will soon print $2 trillion,” is its headline. The idea behind the headline is simple enough. The recovery is a flop. All that stimulus spending has done nothing. Unemployment is not getting better. Consumers aren’t shopping. Banks aren’t lending. And the money supply is actually falling.
What to do? The Fed has already shot off its monetary ammunition. It has been lending money without asking anything in return for the last two years. What else can it do?
Well, it still has some weapons it can use. Quantitative easing, for example.
The idea of QE is that it permits a central bank to fund its government’s deficit by printing money. The Fed prints money. It uses the new cash to buy US Treasury debt (or anything else, for that matter.) Result: more money in the system.
Maybe it is fear of inflation that is driving the dollar back down. Have you noticed that after all the “end of the euro” talk, the European currency is actually back to $1.32?
Stocks, too, may be reacting largely to fears of inflation. If you think higher rates of inflation are coming, owning a piece of a real business is surely better than holding cash. Cash (or bonds) can become totally worthless. A business – if it can survive the financial crisis – will still be worth something…and maybe even more than it was before.
But inflation is no sure thing – at least not anytime soon. The Fed increased the monetary foundation of the dollar-based world by $1.25 trillion when it bought up Wall Street’s toxic debts. Still, for the most part, prices continued to fall.
How so? Because money wasn’t changing hands…because people preferred to hold onto their cash rather than spend it. Which is what people do when they’re worried about the future. Unless, that is, they’re worried about inflation. Then, they spend money as fast as possible.
Therein lies a big conundrum for the Fed.
“Damn the risks of triggering a bit of inflation and some modest investment bubbles,” says Barron’s. “The alternatives are far worse.”
But that’s just the problem. The alternatives are not worse.
The Fed cannot really create a “bit of inflation”…not when the market is scared, and generally de-leveraging. People save. They buy US Treasury bonds. They watch their money and worry. The velocity of money slows, so that even if you add more money to the system, prices still do not rise.
It is like adding snow to the top of a mountain. As long as it remains cold, it just builds up. But when it melts…watch out!
There is nearly $60 trillion worth of dollar-denominated debt in the world. The value of that debt rests on the value of the money in which it is calibrated. As long as people think the dollar is more-or-less okay, they’re willing to have and to hold US dollar debt. The snow stays where it is.
But what would happen if the Fed really did print $2 trillion? Maybe nothing. Or maybe something. Maybe something that was worse than the soft depression we’re experiencing now – an avalanche or a flood.
People might suddenly want to get rid of dollars – in all forms. Then what? Consumer (and probably asset) prices would soar. Bonds would collapse. You could forget about financing any more deficits. Then, in order to restore faith in the dollar and the Fed’s credibility, you’d have to do what Paul Volcker did in ’79. You’d have to get ahead of the inflation rate, with Fed-imposed interest rates even higher than the CPI. Those rates would send the economy into a tailspin of de-leveraging, debt cancellation and depression. When Volcker did it, America had its worst recession since the Great Depression. And that was without quantitative easing, derivatives, subprime, trade deficits, trillion-dollar federal deficits, housing bubbles, or any of the other maladies we suffer today. The next downturn would be much, much worse.
In other words, the effect of printing trillions more dollars would probably be to cause an even deeper depression than the one the authorities think they are trying to avoid.
They won’t do it…not yet.