Will There Be QE3, QE4, QE5...?

By Philipp Bagus – Mises Daily

Recently, Ben Bernanke indicated that Quantitative Easing II (QE2) might be

followed by QE3, etc. In an interview at the beginning of December, Bernanke
was asked, "Do you anticipate a scenario in which you would commit to more
than $600 billion?"

Bernanke's answer was startling. "Oh, it's certainly possible," he said. "And
again, it depends on the efficacy of the program. It depends on inflation. And
finally it depends on how the economy looks."

The answer is interesting because it not only indicates the possibility that the
Federal Reserve (Fed) will purchase more government bonds but also implies
that Bernanke thinks that inflation and QE are different concepts, because
otherwise his claim would be a meaningless tautology: more inflation depends
on inflation.

To make sense of Bernanke's technical talk, let us go back to the beginning of

the infamous QE, to the darkest months of the financial crisis. During the
boom fired by artificially low interest rates, financial institutions had financed
malinvestments, especially in the housing sector. When the bubble burst and
housing prices started to fall, these investments lost value rapidly. Bank
losses mounted, bank equity fell, and solvency problems arose. Liquidity dried
up as financial institutions started to doubt each other's solvency given the
problematic loans on their books.

When credit markets dried up in September 2008, after the collapse of

Lehman Brothers, loans that financed malinvestments did not serve as
collateral for interbank lending anymore. The Fed stepped into the breach and
accepted these bad assets as collateral for loans. In March 2009, the Fed
started to buy these assets outright in what was dubbed QE1. As a
consequence of this qualitative and quantitative easing, the Fed's balance
sheet almost tripled within a few months.[1]
How long would these extraordinary emergency measures be maintained? In
March 2009, Ben Bernanke stated that the Fed had an exit strategy from its
emergency credit policies. It could simply undo its credit policies and asset
purchases, thereby reducing the size of its balance sheet to its precrisis level.

I have argued that such an easy exit option does not exist. The Fed's
purchase of problematic assets did not solve the underlying real problems in
the economy: injecting new money does not cause malinvestments to go
away. By propping up financial institutions, necessary liquidations and
readjustments of the structure of production are only delayed. QE1 could even
cause more malinvestments and thereby aggravate the problem. The
consequence could be a Japanization of the banking system, with insolvent
banks held afloat by the central bank.

If the Fed would exit the emergency situation, reduce its balance sheet, and
stop accepting problematic assets as collateral for loans, financial institutions
would be back to the initial situation of September 2008. If housing prices do
not return to their bubble level, many of the problematic assets will continue to
be bad and not serve as good collateral. If valued at the market price, these
assets might eat up banks' equity. If the Fed ended its emergency measures,
we would effectively be back to the initial situation of frozen interbank markets
and general illiquidity.

In October 2009, I concluded that the Fed could not go back to its initial
balance sheet without causing the collapse of the financial system. One
possible way out would be to reinflate the bubble. Rising asset prices — and
especially housing prices — would make many problematic bank assets
valuable again. The Fed could increase the quality of its assets by inflating the
housing bubble.

In the winter of 2010, no one is talking about reducing the Fed's balance sheet
or about exit strategies anymore. On the contrary, the Fed has chosen the
path of more inflation and dubbed this strategy "QE2."

QE2 has a slightly different purpose than QE1. QE1 directly supported
struggling banks by buying their problematic assets. QE2 supports the
government.

The inflationary policies of the Fed have been coupled with the Keynesian
fiscal policies of the US government. The US government engaged in deficit
spending to bail out financial institutions and automakers, disrupting a fast
liquidation of malinvestments and a smooth adaption of the structure of
production to consumer wants.

QE2 is a direct response to this deficit spending, which obliges the

government to issue more bonds. With QE2, the Fed supports the
government by buying these bonds. The Fed thereby actively helps the
government in its Keynesian policies, which disrupt recovery. While QE1
supported the financial system, QE2 supports the government. Granted, this
difference is not substantial given that the fates of the financial system and
the government are interwoven. The banking system finances the government
that in turn grants the privilege of fractional-reserve banking and implicitly
gives guarantees for banks' losses.

Of course, Ben Bernanke does not say that he wants to help finance the
government's deficit via money creation. The official excuse for QE2 is, yet
again, the scapegoat "deflation."[2] Price inflation is too low. James Bullard,
president of the St. Louis Federal Reserve Bank, states that "it's important to
defend inflation from the low side as we would on the high side."

In other words, if prices rise too slowly, we must print money so that things get
more expensive faster. Bernanke even denies that QE2 would be inflationary:
"One myth that's out there is that what we're doing is printing money. … The
money supply is not changing in any significant way."

Bernanke plays a semantic trick in this statement. Of course, the Fed does
not create the bulk of its new money by literally "printing." Rather, the Fed
creates money by manipulating digits in its computer. When the Fed buys a
$1,000 government bond from a bank, it transfers 1,000 new dollars as a
payment to the bank. It is true that the Fed does not print the money and ship
it over to the bank physically. Rather, it increases the account that the bank
holds at the Fed by $1,000. It is more convenient to just create the new
money in a computer.

However, the fact that the new money is created electronically does not mean
that QE2 is not inflationary. QE2 is inflationary in several ways:

"In other words, if prices rise too slowly, we must print money so that things
get more expensive faster."

First, base money (bank reserves) increases. When the Fed buys a
government bond, it creates money that it transfers to the bank selling the
bond. At the end of the operation, the bank has more bank reserves and the
Fed owns the government bond.

Second, the quality of money tends to decrease.[3] The average quality of

assets that the Fed holds decreases when it buys government bonds. The
percentage of gold of total assets that could be used in a monetary reform
decreases, while the percentage of government bonds increases. Moreover,
these bonds are for a government that is ever increasing its debts.

Third, prices will be higher than they would have been otherwise. Prices
would probably have fallen substantially without QE1 and QE2. The injection
of new bank reserves inhibited a credit contraction and falling prices. In fact,
one aim of QE2 is to bid up asset prices.

Money flows into the stock market, bidding up stock prices. In March 2009,
when QE1 started, the Dow Jones was below 7,000 and rose to 10,800 until
QE1 expired. When the Dow fell below 10,000 again, markets began to
speculate about the possibility of QE2, and a new rally started.
While the newly created money flows to asset-price markets, consumer prices
might not surge strongly. But sooner or later, these investments will flow out of
asset-price markets and start to bid up consumer goods' prices.

Fourth, the exchange rate will be lower than it would have been otherwise.
Market participants will value the dollar lower, given that the base-money
supply increases and the dollar's quality decreases. This devaluation is
another aim of QE2. It is a way to give exporters an advantage. The
devaluation is not as crude an instrument as a tariff but has similar effects. It
makes consumers poorer. They have to pay higher prices for imported goods.

Consequently, QE2 is, despite Bernanke's words, inflationary. In fact, it is a

euphemism to call the policy QE2. The term quantitative easing conceals the
true inflationary nature of the instrument. Furthermore, it sounds technical.
The added number "2" makes it even more so. People who know little about
economics might ignore news on QE2. Why bother to understand something
so technical — let the experts deal with it. The term also has a positive
connotation. Who does not want "ease"?

As Walter Block has repeatedly pointed out, we should carefully watch our
language. Language is crucial to clear communication. The use of the term
quantitative easing generates a smog to hide the production of new money.
Words, as Block states, can be mightier than pens or swords. They guide our
thoughts and writings. The invention of the term quantitative easing prevents
people from thinking about the consequences of inflation. The term distorts
thinking.

Why not name QE for what it is? Why not name it after the effects it has?

"The term quantitative easing conceals the true inflationary nature of the
instrument."

Money printing cannot make society richer; it does not produce more real
goods. It has a redistributive effect in favor of those who receive the new
money first and to the detriment of those who receive it last. The money
injection in a specific part of the economy distorts production. Thus, QE does
not bring ease to the economy. To the contrary, QE makes the recession
longer and harsher.

The injection of new money into the economy reinflates old bubbles and
generates new ones. Most importantly, QE facilitates government deficit
spending — additional distortions and rigidities in the economy.
Malinvestments can endure. Factors of production are not shifted to places
where the consumer wants them to be most urgently.

Thus, QE2 would be better called, "Quantitative Straining," "Quantitative

Destruction II," or "Crisis Prolongation III."
Or we might name it after the intentions behind it: "Currency Debasement I,"
"Bank Bailout I," "Government Bailout II," or simply "Consumer
Impoverishment." Finally, we might also name it after its essence: "Money
Printing I and II." Or, if we follow Bernanke, who pointed out that most of the
new money is created in a computer, we can call it "Money Creation I and II."
This might be the most neutral term.

The rhetorical tricks should not distract us from the fact that QE is simple
money creation. The aim of Money Creation II is to finance government
spending, debasing the dollar. We should dismiss the term QE and instead
call money creation what it is: inflation.

Philipp Bagus is an associate professor at Universidad Rey Juan Carlos. He

is the author of The Tragedy of the Euro.

Notes

[1] See Philipp Bagus and David Howden, "The Federal Reserve and the
Eurosystem's Balance Sheet Policies During the Financial Crisis: A
Comparative Analysis" in Romanian Economic and Business Review 4, no. 3:
pp. 165–85.

Qualitative easing may be defined as a deterioration of the average quality of

assets the Fed holds, while quantitative easing can be defined as an increase
in the quantity of its assets.

[2] See Philipp Bagus, "Deflation: When Austrians Become Interventionists" in

Quarterly Journal of Austrian Economics 6, no.4: pp. 19–35.

[3] See Philipp Bagus, "The Quality of Money," in Quarterly Journal of

Austrian Economics 12, no. 4: pp. 22–45.