Diary of a Financier

Bookshelf Update: Richard Koo on the QE2 Gamble That Cannot End

In Bookshelf on Wed 18 May 2011 at 09:45
  • Richard Koo reasserts that QE2 is not priniting money or creating inflation.
  • Calls QE2 a gamble that cannot end.

I’ve highlighted Nomura’s Richard Koo before.  He’s famous for being the first to explain the US crisis as a “Balance Sheet Recession,” and he’s released a new piece about the June end to QE2.

His abridged argument:

  1. The Fed is not printing money or creating inflation, because QE2 has had no positive impact on the money supply.  The $2T in excess bank reserves generated by QE is on deposit with the Fed, and governed by the Interest on Excess Reserves (IOER) rate mechanism.
  2. Bernanke made a gamble that: a) QE would push up asset values. [Accomplished]; b) Economic growth would follow. [Failed]
  3. Conclusion:

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…

…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…

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.

I can’t emphasize enough the need for fiscal stimulus from the public sector to offset household deleveraging.  At very least, monetary stimulus must accompany any fiscal consolidation–albeit an insufficient means of jumpstarting economic growth.

–Romeo (hattip ZeroHedge & Business Insider)

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