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Whatever It Takes, For As Long As It Takes

At the beginning of August, I posted a blog called “When Will The Fed Print Again?”. Now we know. The answer is now. On September 13th, the Fed announced that it will create $40 billion per month and use that money to buy agency mortgage-backed securities in order to push down long-term interest rates so as to support economic growth. Furthermore, the Fed’s press release stated, “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

This round of money creation differs substantially from the two rounds that came before. During both of the earlier rounds of Quantitative Easing (QE) the amount of money to be created and the duration of the exercise were announced from the beginning. This time no limits on either quantity or time were announced. In other words, this time the Fed is going to continue creating fiat money for as long as it takes to bring down the unemployment rate. Some economists have dubbed this exercise “QE Infinity” instead of QE 3 due to the opened-ended nature of the Fed’s commitment.

But why did the Fed launch this extraordinarily aggressive program of open-ended money creation just now? In my August 2nd blog, mentioned above, I outlined four triggers that would force the Fed to switch back on its printing presses: 1) a stock market crash; 2) much higher government bond yields; 3) deflation; or 4) a jump in the unemployment rate. None of those criteria were met between then and now. Moreover, the spike in food prices brought about by the US drought should have deterred the Fed since there is a clear cause and effect relationship between paper money creation and food price inflation. Nevertheless, the Fed went ahead anyway. Why?

Some commentators have expressed the opinion that the Fed acted to help President Obama get reelected. I don’t believe that is the reason. If the Fed had wanted to help reelect the President, it would have acted sooner to ensure the economy was powering ahead by election day in early November. It waited too long for that. It’s going to take more than a month or two for this measure to begin to meaningfully impact economic growth.

I believe the Fed acted now because it is afraid – afraid that our global economy is about to go under. In the past, I have written that it is useful to think of the global economy as a big rubber raft, but one inflated with credit instead of air. On top of the raft float not only all the asset classes – stocks, bonds, commodities and real estate – but also the world’s seven billion people. So much credit has been created globally that the raft is now fundamentally defective because the income of the world’s population is insufficient to pay the interest on all the debt. The raft is full of holes and the credit keeps leaking out as one group after another is forced to default on its debt. Therefore, the natural tendency of the raft is to sink. But, if the raft sinks not only will asset prices crash, people will begin to die – just as they did during the 1930s and 1940s, after the credit-inflated global economy of the Roaring Twenties went down.

Signs abound that the global economy is beginning to submerge. The US economy grew by only 1.3% during the second quarter. The UK is in recession. Europe’s economy is in crisis. And Japan’s economy, which has been in crisis for 22 years, is deteriorating rapidly due to a sharp contraction in exports. Even China’s great economic boom is over. Chinese exports grew by only 1% year-on-year in July. It should come as no surprise that China’s export-led growth model cannot work when all of China’s trading partners are in crisis.

With the global economy going down fast, the Fed has begun to panic. Having already cut short-term interest rates to close to zero percent, it has only one policy tool left to keep the global economy afloat. That is to create more money and inject it into the raft in order to reflate it.

The Fed is not acting alone. In recent weeks, the European Central Bank has announced it will do “whatever it takes” (i.e. print as many Euros as it takes) to hold down the interest rates on Spanish and Italian government bonds so that the Eurozone does not disintegrate. And, in late September, the Bank of Japan announced it would expand its own version of Quantitative Easing by the equivalent of $126 billion. The Bank of England has been the most aggressive player of all, having bought up approximately 30% of all UK government debt with newly created money.

The central bankers are at emergency stations and manning the pumps. They are pumping credit into the global economy as fast as they dare. If they don’t pump in enough, the raft will sink. If they pump in too much, it will turn into an inflationary balloon and float away.

Will this work? It will – for a while. Then it won’t. So much fiat money creation would have caused very high rates of inflation long ago had it not been for one, separate factor: globalization. Because of globalization, the marginal cost of labor has fallen 95%. It is no longer necessary to pay a factory worker $200 per day in Detroit to build a car. That job can now be done with $5 a day labor in India. This unprecedented collapse in wage rates has been extraordinarily deflationary; and that deflationary pressure has completely offset the inflationary pressure produced by the enormous increase in fiat money creation in recent years.

For the moment, fiat money creation is keeping the global economy afloat and globalization is preventing inflation by driving down wages in the developed world. This arrangement is inherently unsustainable, however. The global economy is in crisis (and sinking) because the income of the world’s population is insufficient to service the interest on all the debt. With median income in the developed economies shrinking because of globalization, it is inevitable that credit defaults will accelerate, causing the global economy to sink that much faster.

The only lasting solution to this crisis will be one that causes incomes to rise.