Why QE3 will fail, and why that may be very good for the U.S. dollar

It seems to me the Great Depression has cast a long dark shadow over Fed Chairman Ben Bernanke’s thinking. The man seems obsessed by the idea, based on his own historical research that if the Fed had just done “more” the Great Depression could have been avoided.

I think he is dead wrong. And in fact it was the Fed that, through money and credit manipulation, set the stage that caused the Great Depression.

Mr. Bernanke gave a summary of why he believes the Fed was at fault for allowing the depression to become “Great” in a speech he gave back in 2004, “Money, Gold, and the Great Depression.” This speech provides an excellent insight into Mr. Bernanke’s core beliefs. Here are a few key excerpts:

During the first decades after the Depression, most economists looked to developments on the real side of the economy for explanations, rather than to monetary factors. Some argued, for example, that overinvestment and overbuilding had taken place during the ebullient 1920s, leading to a crash when the returns on those investments proved to be less than expected.

… To support their view that monetary forces caused the Great Depression, Friedman and Schwartz revisited the historical record and identified a series of errors—errors of both commission and omission—made by the Federal Reserve in the late 1920s and early 1930s. According to Friedman and Schwartz, each of these policy mistakes led to an undesirable tightening of monetary policy, as reflected in sharp declines in the money supply. Drawing on their historical evidence about the effects of money on the economy, Friedman and Schwartz argued that the declines in the money stock generated by Fed actions—or inactions—could account for the drops in prices and output that subsequently occurred.

… The transmission of monetary tightening through the gold standard also addresses the question of whether changes in the money supply helped cause the Depression or were simply a passive response to the declines in income and prices. Countries on the gold standard were often forced to contract their money supplies because of policy developments in other countries, not because of domestic events. The fact that these contractions in money supplies were invariably followed by declines in output and prices suggests that money was more a cause than an effect of the economic collapse in those countries.

This is a powerful defense for monetary easing. But by any measure, it seems that goal of increasing money and monetary supply to cure economic ills has already been achieved by Mr. Bernanke and Company. And they are fighting a losing battle.

As you can see in the chart below, bank reserves are in the ozone.

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What’s more, the money supply is still trending higher …

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But all that money is NOT stimulating the economy! The plunging rate Americans are spending is clearly shown in the following chart. I believe this drop is due to changing consumption/savings patterns as U.S. consumers attempt to recover from this serious balance sheet recession, similar to the experience of the Great Depression.

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And so far, historically low interest rates by the industrial world central banks haven’t done diddlysquat for the unemployed.

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Simply put, Mr. Bernanke must fix the plumbing before any amount of money is going to improve the real economy! The mechanism that transmits credit into the real economy is broken. And pushing rates lower only exacerbates the problem domestically and creates monetary tensions overseas.

What It Means for the Dollar

At first blush all this quantitative easing looks very bad for the U.S. dollar. And it has been to a large degree. But because QE3 actually retards the ability of the real economy in the U.S. to grow, it has a massive negative feedback on Europe and China; both require strong U.S. demand to export.

So in a sense, a very bad sense, QE3 may be very good for the U.S. dollar as it will likely trigger a major change in risk appetite for global assets markets. And that could happen once sentiment shifts and people realize that history shows there is much more to reviving a complex system such as the global economy than through pure money and credit manipulation.

And at some point, the liquidity-driven financial markets will reflect the very poor conditions of the underlying real economy here and abroad.

Best wishes,

Jack

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