The Fed is insane

Einstein defined insanity as “doing the same thing over and over again and expecting different results.” By that definition, the Federal Reserve is insane. The Fed not only announced it was launching third round of quantitative easing (QE3 for short), but refused to give an end date for it (CBS):

The Federal Reserve announced that it would purchase $40 billion a month of mortgaged-back securities to spur economic growth and help reduce unemployment (aka “quantitative easing,” “QE” or “large-scale asset purchases.”) Unlike like the previous two iterations of bond buying, where the Fed put a limit on the amount of bonds it would purchase, the Fed says it will keep buying the securities until the job market shows substantial improvement.

This is mind-boggling on several levels.

For starters, it is a flat-out admission that TARP failed: the initial TARP scheme was to buy $700 billion of mortgage-backed securities in the assumption that they had become “toxic assets” (TARP itself stands for Troubled Asset Relief Program). Instead, Treasury Secretary Henry Paulsen changed course after the TARP bill became law and used the money to purchase bank stocks, thus lumping in health, non-toxified banks like Wells Fargo with weak ones like Citibank, and wiping out any remnants of confidence in the American economy. Maddeningly, Congress fully gave Paulsen the power to do whatever he liked with the money when it passed the TARP bill. Clearly, Paulsen made a mistake if the Fed feels it has to buy the very assets Paulsen rejected (on top of the $500 billion it bought in the fall of 2008).

This is not to say that any government entity buying these securities is a bad idea. The Fed already has $500 billion of this stuff on its balance sheets. Adding more will simply grow the already large moral hazard that comes with government making private debt go away – it encourages taking unwise risks in the assumption that the government will come to the rescue once more. Lest anyone think this merely hypothetical, remember that it was also one of the main objections to the Chrysler bailout – the one in 1979. Thirty-three years later, Chrysler has sucked up even more taxpayer money, become wholly-owned by Italian-car maker Fiat, and made that moral hazard argument painfully prescient.

Frighteningly enough, artificially encouraging risk is precisely the purpose of QE3 (CBS again):

In a lecture at George Washington University last March, Federal Reserve Chairman Ben Bernanke explained how QE works. Here’s the quick version: The Fed buys U.S. Treasury bonds and mortgage-backed securities, which drives up prices, pushes down interest rates and reduces the availability of these bonds in the market. With fewer bonds available, investors turn to alternate assets, like corporate bonds. This part is important: When investors buy corporate bonds, they are lending money to companies. According to the Fed, the availability of corporate credit was an essential component in promoting the economic recovery, especially during the height of the financial crisis in 2008-2009, and the byproduct of an improving economy is a rising stock market.

In other words, investments previously considered too risky become the only game in town. If we’re lucky, this will have no effect as investors decide to just buy Treasury bills instead. More likely, there will be at least some investments that shouldn’t be made but will be, creating artificial confidence (otherwise known as a bubble) that will inevitably burst. How often do we have to crash to recognize this is a bad idea?

The problem we have with corporate credit and investment is that the returns are considered to be too small. That can’t be fixed by hosing the country with dollars or expanding the Fed’s role as a 21st Century Resolution Trust Corp. The only thing that can fix the current economic rut is to make investment in businesses worthwhile. That means reducing tax rates (to lower business costs and increase expected investment profits) and reducing spending (to lower the amount of Treasury notes crowding out other investment opportunities and reduce the expectation of future tax increases).

Cross-posted to Virginia Virtucon

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