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Ex nihilo. Out of Nothing the Fed risks everything.
Finance
Commentary on the News
Monday, September 27, 2010
Ed DeShields

The Fed spoke this week creating speculation that the central bank will begin a new, riskier economic policy to avoid a return to recession.   Could this signal the Fed may be out of options to save the economy?

Despite a trillion or two of stimulus money the economy continues to bounce along the bottom.  Growth is so slow it threatens a double-dip recession.  Now the Fed is digging deep in its tool bag to stimulate the economy again. 

Often considered a "last resort" to increase the money supply, “quantitative easing” or QE, is the Fed’s new policy that could mean a Japan-like future for the U.S. if it doesn’t work.  

What is quantitative easing? 

The first step is for the Fed to create more money ex nihilo ("out of nothing").  It can then use these funds to buy assets like government bonds or mortgages from financial firms such as banks, insurance companies and pension funds, in a process known as "monetizing the debt".  This money-from-thin-air flows into banks giving them excess money to re-loan to businesses that might kick start the economy.    But, it only works if the banks reloan the money.

Ordinarily, the central bank doesn’t need a QE-type approach.   They can control interest rates to indirectly influence the supply of money floating around in the economy.  But the Fed has already reduced the rate to zero so it has no more room to lower rates.   To date, the Fed’s low interest policy has not been enough anyway.  To this extent the Fed has few options left to keep the economy from deflating.   

Many economists think QE is risky and has not been proven to work.  Japan tried QE ten years ago in an effort to stop deflation of its economy with no affect.  Japan has been slogging along in a no-growth, high unemployment economy for over ten years. 

Other risks could occur if the policy actually works.  It could spur hyperinflation if banks opt to simply to pocket the additional cash in order to pay for increasing defaults in their present loan portfolios. 

With loan defaults soaring, I wouldn’t be betting the economy that our banks will have any choice but to hoard the money granted them from thin-air.   It might just give the banks the chance to keep the money and write-off millions more by foreclosing on delinquent homeowners and clean up their balance sheets.  

Money from nothing (ex nihilo) may be worth just that.  Nothing.

About Ed DeShields

Ed's last commentary: The Paradox of Second Life



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