Yesterday I mentioned that I read a book a few years ago called the Dying of Money by Jens O. Parsson. I mentioned Parsson’s case study of Weimar Germany’s hyperinflation and related that to some noticeable similarities that exist between Weimar Germany and the U.S. currently. Today I want to discuss a couple of important things that Parsson observed and relate that to Quantitative Easing 2.0 (QE2) which should be announced next Wednesday.
Parsson wrote about how there are several markets within a country’s economy. For instance, there’s a separate market for goods and services and a separate market for assets. Within these separate markets there are even smaller, distinct markets. For instance, within the goods market you may have a separate market for refrigerators or cars. Each of these markets and sub-markets are subject to the laws of supply and demand.
- Given a fixed level of supply, the more demand there is for an item the higher the price will be for the item and vice versa.
- Given a fixed level of demand, the less supply there is for an item the higher the price will be for the item and vice versa.
The quantity of money available (per unit of time) has the ability to impact the demand side of the picture of a particular marketplace by impacting how fast people who hold the money make it available to purchase items in the marketplace. In other words, the quantity of money available (per unit of time) has the ability to impact people’s willingness/reluctance to pay a certain price for items in the marketplace.
- For instance, the average purchaser may have $10 to pay for a seller’s item. The seller recognizes that the average purchaser is willing to pay up to $10 so they’ll price their item at $10. However, if the quantity of money available to the average purchaser increases to $15 their reluctance to pay $10 over time is likely going to decrease; leading to more purchases of the item. The seller will eventually sense purchasers’ willingness to pay more for their item and will adjust their prices higher accordingly to adjust to the new demand picture.
- Thus, increasing the quantity of money/money supply in a marketplace has the ability to lead to higher prices in the marketplace.
Parrson observed that the debt market and the stock market are relief valves of inflation. The money that enters into these markets helps to keep the money from impacting the goods market where it can drive good prices higher. In addition, this money is perceived as being “beneficial” for people who hold stocks and bonds because it helps drive asset prices.
- This is an important observation that Parrson made because if money were suddenly redirected from the stock market and/or bond market to the goods market as a result of increased inflation/inflationary expectations (money is more likely to be redirected from the bond market under this scenario since certain stocks can be an inflation hedge) the price for stocks and/or bonds could drop and price increases for goods could be further exasperated.
Currently, the yields on U.S. government debt and some corporate debt are unprecedentedly low-so low that people are hardly being compensated for loaning money out for long periods of time (for instance, right now you’ll only get 2.62% for loaning the U.S. government money for 10 years). The unprecedented low interest rates are largely a result of the Federal Reserve’s own actions to keep interest rates historically low and major debt demand from those who are concerned about deflation, concerned about the direction of the economy, those who are trying to manage the value of their currency (foreign central banks like China), those who want a “safe” place to store their money, and those who are trying to profit from the Federal Reserve’s plans to buy up debt through quantitative easing.
- The unprecedented low interest rates for debt are important to mention because it is a sign that A LOT of money in the U.S. economy is located in the debt market, the relief valve of inflation. This large amount of money is not a problem at this moment because it is being kept away from causing prices to rise in the goods market, the market where price increases adversely impact ordinary people.
However, a few days ago America’s and perhaps the world’s most preeminent bond investor Bill Gross lamented about how Quantitative Easing 2.0 could spell the end of a 30 year bull market in bonds. Gross suggested that there is not a lot of money left to be made in bonds and insinuated that QE2 could eventually lead to the slaughter of bond investors with its potential inflationary consequences.
- If Gross and others’ fears about QE2 prove correct it could be the catalyst that causes much of the money contained in the bond market to move to other markets within the economy. If QE2 is as inflationary as some people fear this money could be redirected to asset classes that help people protect from or benefit from inflation. The asset class that investors usually turn to when inflation is rearing its ugly head or when inflation expectations begin to rise is commodities. If investors redirect money from the bond market to the commodity market the result could be bad for ordinary people since this redirected money would force commodity prices higher (by increasing people's willingness to pay for them). Commodities are key inputs for all sorts of items that ordinary people buy like food and energy, so higher commodity prices could potentially lead to higher prices that consumers have to pay for the items they need. If this scenario plays out the potential exists for there to eventually be inflation that may become difficult to control.
- Kansas City Federal Reserve Bank president Thomas Hoenig aptly described QE2 as “bargaining with the devil”. QE2 may stimulate the economy but could easily have side effects that are extremely harmful in the long-run.
I caution you that there are a lot of “ifs” in the above scenario. I could be completely wrong about what is going to happen as a result of QE2 in the long-run. In addition, even if I am right about the long-term adverse consequences of quantitative easing, I could completely mistime when the adverse consequences take place (for instance, the actual damage may not take place until after there's a major downturn in the U.S./global economy (a major downturn is still a real serious possibility) or if/when Fed launches QE3 or QE4). The Federal Reserve and other central banks have pulled rabbits out of their hats several times before so it’s possible that they may pull a “miracle” again. However, at some point policymakers’ luck has to run out because they are fallible like the rest of us.
