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Paging Dr. Bernanke

Since Fed Head Bernanke announced Quantitative Easing III (QE3) last week, I have been reading as much analysis about it as possible.  It is another in a series of bold steps to triage the patient.

But, first, quantitative easing occurs when the Fed Reserve buys bonds.  By accepting the bonds, the Fed then credits the checking account of whomever sold them the bonds.  In this case, the seller (U.S. Treasury) now has cash to spend.  That’s how you finance a deficit.  It also provides a demand for bonds that did not otherwise exist, and, as everybody knows, if you increase demand for something, the price usually rises.  When the price of bonds increase, that means the yield goes down, since the interest rate is fixed.

Previously, when the U.S. Treasury sold bonds to finance its deficit, there were always plenty of buyers in the marketplace for those bonds.  Then, the Treasury started selling more than the market wanted.  In addition, the Chinese announced they had a bellyful and would increase their holdings of Treasury bonds much more slowly.  (Since they own over a trillion dollars of our bonds, that is probably enough, I think.)

To sell all these new bonds, when the demand is decreasing, the market would normally demand higher interest to be paid.  That would have increased the burden of interest expense for taxpayers and raised the borrowing cost for private debt, such as bank loans and mortgages.  Rising interest rates may be great for savers but awful for an economic recovery.

Does quantitative easing increase the Money Supply?  Theoretically, QE would not increase the money supply if the Fed “sterilized” its purchases, which means they sell a bond every time they buy one.  As a practical matter, I believe it absolutely does increase the Money Supply.

Is that inflationary?  Theoretically, it would not be inflationary if the Fed is agile in decreasing the money supply once the economic recovery becomes permanent.  As a practical matter, I believe it is absolutely inflationary.

Most analysts characterize QE as a “sugar-high.”  All that new liquidity washes over the capital markets driving up the stock market.  When people see their 401Ks increase in value, they will feel more wealthy and spend more money, which is critical for a sustainable recovery.  Economists call this the “wealth effect.”

It must be working because the stock market has rebounded much more than the economy has.  Maybe, that is because the new money created is not getting into the economy.  It is stuck in the capital markets, providing the “sugar-high.”

Other analysts characterize the  Fed’s action as a dope-dealer supplying drug-addicts on Wall Street.  The expectation is that there would be no other reason to buy stocks in the face of such a weak economy, which is struggling under the wet blankets of (1) the European financial crisis, (2) the elections, and (3) the fiscal cliff.

My perspective is that the Fed is a good, kind doctor, who is injecting large quantities of both blood and painkillers into one arm of a patient, while a grizzly bear gnaws lazily on the other arm.  Economic policy consists of monetary policy, controlled by the Fed, AND fiscal policy, controlled by Congress.  Both arms are essential to protect the body and fight recession.

As long as Congress is more protective of their political parties than the country, fiscal policy is useless, reducing economic policy to a one-armed fighter.  But, what happens when Dr. Bernanke runs out of blood plasma and painkillers?