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QE3 Guaranteed to Fail

NEW YORK ( TheStreet) -- Whether or not the Federal Reserve opts to make more large-scale asset purchases (colloquially referred to as "QE3") remains to be seen -- but I suspect that Ben Bernanke himself is beginning to realize that QE3 is guaranteed to fail.

Bernanke told Congress on Wednesday that the Fed is ready to provide additional monetary stimulus should the U.S. see adverse economic developments. On Thursday, Bernanke qualified his statement, saying that the Fed is "not prepared at this point to take further action."

Fed Chairman Ben Bernanke is stuck in an unenviable position.

Let's analyze the situation:

So What Exactly is Quantitative Easing, Anyway?

Quantitative easing is when the United States' central bank, the Federal Reserve, buys U.S. Treasury bonds.

  • Treasury bonds are a future obligation of the United States, paid out with Federal Reserve notes (dollars).
  • Federal Reserve notes are a current obligation of the United States, redeemable for goods and services.

If the Federal Reserve purchases bonds directly from the United States Treasury, they are exchanging dollars (current obligations) for future obligations. This is inflationary if the amount of obligations (money) is increasing faster that the amount of capital (goods, services, products and ideas).

However -- the Federal Reserve doesn't buy bonds from the Treasury, it buys them from "primary dealers." Primary dealers are a network of banks (including Goldman Sachs (GS), JPMorgan Chase (JPM) and Citigroup (C)) that are obligated to buy bonds from the U.S. and serve as a trading partner with the Federal Reserve.

The triangular relationship between the U.S. Treasury, Federal Reserve and major banks can be a head-scratcher -- but make no mistake, this relationship is making some people rich (we'll touch on this point later).

Criteria for the Long Term Success of Quantitative Easing

  1. If banks are facing a liquidity crisis -- and because of this fact -- are unwilling to lend to qualified borrowers.
  2. If qualified borrowers want to borrow money -- and most importantly, are willing to invest in entrepreneurial ideas that will provide a return on invested capital.

Quantitative easing could hypothetically improve the U.S. economy, for the long term, if both of the above criteria are met. Unfortunately, this is not the reality of our situation.

Thanks to taxpayer-funded bailouts and the first two rounds of quantitative easing, major U.S. banks are adequately reserved (in other words, they are liquid). The problem lies in point No. 2: Statements from major banks suggests a drought of qualified borrowers.

Creditworthy individuals (however small this segment of the population might be) are not borrowing. We can blame the uncertainty of tax policies, the staggering unemployment figures or the overall fragility of the economy. But at the end of the day, creditworthy individuals aren't borrowing.

The banks don't need further reserves -- the people need confidence. And confidence comes from the leadership, foresight and conviction from our elected officials, not the Federal Reserve.

Is Quantitative Easing Helping Anyone?

Yes, unfortunately.

Quantitative easing is providing major banks with arbitrage opportunities (risk-free trading profits). Goldman Sachs can buy a bond from the Treasury on Monday and sell it to the Federal Reserve on Tuesday (at a profit) -- the blog ZeroHedge has named this game "Flip That Bond."

Quantitative easing is also helping elected officials shirk their duties to the American public -- in a sense, enabling politicians to spend money the country does not have (or make good on promises that should be broken). Forbes' William Baldwin illustrates this concept beautifully.

"The government wants to spend $1,000 it doesn't have. So it sells a bond. The ultimate buyer is the Federal Reserve. The Fed pays for the bond with some folding money. The Treasury spends the $1,000 on farm subsidies or whatever.

The Fed makes a show of treating the $1,000 bond as an investment. It collects $40 in interest from the Treasury. But this is a charade. The Fed declares the $40 (after some overhead costs) as profit and sends the profit right back to Treasury. In reality, the interest payment never left the Treasury building.

When the dust settles, this is what has happened. The farmer has $1,000 of cash. The government did not get this cash by collecting taxes. It got the cash by creating it."

Has Quantitative Easing Ever Been Tried Before? If So, Has It Worked?

Yes -- and to the second question, I don't see any evidence it has worked.

In 1961, the Fed embarked on a similar strategy known as "Operation Twist." But Twist was dismissed as a failure by most, while others blamed the lack of efficacy on the small scale of the operation.

Quantitative easing was attempted again -- on a larger scale -- by Japan in 2001. More than a decade later, Japan has not escaped its problems, and Masaaki Shirakawa, governor of the Bank of Japan, stated that if "short-term stimulative policy measures" are the only cure, then " policy makers face a risk of writing the wrong policy prescription."

Unfortunately, some prominent U.S. economists (notably, Larry Summers and Paul Krugman) don't view this history as a cautionary tale, instead suggesting that stimulus only fails when enough of it wasn't done. To this point, I wholeheartedly agree with Mike "Mish" Shedlock's statement, "The disgusting state of affairs is that bureaucratic fools in the EU, US and everywhere else, all believe the cure is the same as the disease if only done in big enough size."

What's the Worst Case Scenario for the Economy

The worst-case scenario is that the nation's banks, under political pressure to lend (see Masaaki Shirakawa's statement above), begin making loans to corporations and individuals that are not creditworthy. Of course, this is exactly how the financial crisis came to fruition, and like before, will end in tears for the greater American public.

Is Ben Bernanke the Problem

I do not think Ben Bernanke is evil or stupid (nor do I think he is insane), rather, I prefer to think of him as a kindly-yet-timid doctor prescribing an obese patient antidepressants. The doctor knows that only the patient can solve the patient's problems, but the doctor lacks the courage to tell the patient, "Go on a diet, get some exercise and get the hell out of my office!"

-- Written by John DeFeo in New York City



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