The Federal Reserve finally yielded. After resisting increasing pressure for months, QE3 is now a fact. What this means is that the Federal Reserve will be printing up money – $40 billion a month to be precise – to buy mortgage-backed securities. Or, to use even simpler language: They will be saving those who made a bad investment decision and bought mortgage-backed securities, thereby distorting the market and saving investors from the consequences of their very own actions.

How many of you here remember the bailout? Unless you’ve been living under a rock for five years (and if you have, you may as well crawl back in under that rock – this isn’t really a good time to come out to be honest), chances are you do remember it. But do you remember specifically what the bailout was supposed to do?

Oh yeah, that’s right: Buy mortgage-backed securities (this was back in the days when government officials were honest enough to refer to such securities as “toxic assets” – which is what they were and still are). So what happened? Or, to be more clear: Why are we still buying mortgage-backed securities, wasn’t $800 billion dollars enough?

Well, here’s the thing: The last $800 billion wasn’t spent on buying toxic assets. The people in charge of the bailout program quickly realized that that would take too long time. The door was closing, and they had to act fast. Instead of spending weeks, possibly months, finding out which assets were toxic and not, they just decided to dump the bailout money into the banks and let them to whatever they wanted with them. Presumably, they would lend them out, make a profit on the loans, and that would then offset the losses from the toxic assets. Problem solved… right?

Well, except the increase in lending didn’t happen. Oh, and those toxic assets I was talking about? They turned out to be more toxic than anyone thought, and much harder to get off the balance sheet than anyone had suspected. And, as housing prices kept falling, more and more assets turned toxic.

But then, doesn’t that mean that the Federal Reserve is finally doing things the way they’re supposed to be done? Buying mortgage-backed securities, thereby solving the problem that the bailout couldn’t solve.

Except this won’t solve the problem either. Here are five reasons why QE3 is bound to fail:

1) Solving unemployment – not the Federal Reserve’s job. One of the things about QE3 that makes it so special is that its focus lies on unemployment, not inflation, which usually is the Feds biggest concern (after all, stabilizing inflation is technically speaking the main reason why the Federal Reserve exists in the first place). Not a word about inflation when it comes to QE3, and don’t you dare mention stagflation! The Fed is simply going to be buying mortgage-backed securities until unemployment is back at acceptable levels – inflation targets be damned. Now, people talk about this as if it’s an unprecedented move, but it really isn’t. The last time the Federal Reserve fought unemployment and ignored inflation was… during Carter… uh oh.

2) The housing market doesn’t really need intervention. House prices are now back at fairly normal levels, where they should be. Somehow, the Federal Reserve thinks this is a bad idea. They seem to want to create another housing bubble (because the first one worked so well, didn’t it?). The truth is, when something is overvalued, it’s best if its allowed to fall to its normal value – even if that process is painful. No matter how much cash the banks have, they’re not going to lend out money with unemployment at these levels. It’s simple math: Whether or not you’re approved for a loan depends on a lot of factors, but mainly on credit history, income, and the perceived risk that you will lose your job. An author or a freelance journalist for example may have a hard time getting a loan, because their income streams are so unstable (sure, your last book may have sold well, but that doesn’t guarantee your next book will). In this economy, pretty much everyone has a (relatively) high risk of losing their job, and so naturally fewer people qualify for loans. It’s also very common for workers to have part-time, temporary jobs rather than full-time, permanent ones – which means they won’t qualify for loans of any significant size. You want to get the credit market moving? Start at the supply side. This recession was not a keynesian, demand-side recession. The reason why its dragged on for so long is because of the problems on the supply side. Employers don’t want to hire because of Obamacare, the threat of tax hikes and regulations. Fix that, and the rest will follow.

3) Stagflation is a serious issue. While the Federal Reserve talks about fighting unemployment, the truth is that they are creating inflation. Now, there is a negative relationship between inflation and unemployment, so in theory this could work. In practice though, we know that inflation doesn’t automatically mean growth, even though they often go hand in hand. The most obvious example of this is the stagflation experienced by the US and other countries during the 1970’s. Keynesians like to pretend that this could never happen again, that it was a “one-off” fluke that we shouldn’t take so seriously. Yes, there were some pretty special circumstances back in the 1970’s, I have no problem admitting that the original cause behind the stagflation was the oil crisis. However, even if we assume that stagflation was caused only by the oil crisis (in reality, destructive leftist policies at the time played a large role), we should note that the very same thing can happen today. I understand it’s not the job of Chairman Bernanke to be an expert on foreign policy, but you’d wish there were someone at the Fed who’d at least have a basic understanding off it. The situation with Israel and Iran is heating up and a stand-off seems very near. With the arab spring failing in Libya, Egypt and basically everywhere else, it’s not hard to see scenarios developing where oil prices would increase sharply (as they often do when there’s unrest in the middle east). In a worse case scenario, you could have inflation from both ends: The Fed printing money to bail out banks, and oil prices doubling (or worse) due to the situation in the middle east. The Federal Reserve would then have to raise interest rates sharply, eliminating whatever lending there currently is, and leaving the banks alone with the toxic assets they counted on getting rid off. Exactly what happens after that we don’t know, but it sure won’t be pretty. A deep recession is almost certain.

4) Incentives are distorted. Inflation distorts incentives, that’s common knowledge among conservatives. But QE3 is even worse than the usual inflation: By saving the banks from the consequences of their actions (which is what the Federal Reserve is doing when they buy mortgage-backed securities), they are setting a dangerous precedent. Whatever good has come or will come out of increased financial regulation is negated by this move (and of course by previous similar actions by the government to save the bankers from their own actions). Now, some keynesian is bound to point out that financial regulation is going to stop a new subprime mortgage crisis from occurring, and so saving the bankers this one time is risk-free – they won’t be able to repeat the mistakes of the past anyway. The problem, however, is much broader than that: If you save a group of people from the consequences of their actions, they will screw up again. How, we may not know. But they will find a way to screw up and leave you with the bill. It shouldn’t come as a surprise that bankers are good at that – they got decades of practice, after all.

5) Quantitative easing: No good record. Well, the graphs below really says it all: Quantitative easing has no good record when it comes to lowering unemployment, but does increase inflation (CPI = Consumer Price Index).

What should Romney do? 

The next question then becomes; what should Romney do? Many conservatives suspect that this move is a case of Obama and Bernanke teaming up against Romney, which isn’t all that unrealistic to me: A completely independent central bank have never existed and never will. The only problem with that argument is that this program isn’t actually expected to lower unemployment that much; on average, economists believe that it will lower unemployment by 0.1 % per year. In other words, it’s grossly inefficient and certainly won’t lower unemployment enough to win the election for Obama. Even if Bernanke wanted to help Obama; Would he really be that stupid as to risk his credibility with a move that’s not even going to impact on the election? I guess we’ll never know for sure.

So should Romney openly campaign against the Federal Reserve? Should he be plastering the airwaves with ads exposing Obama and Bernanke and their far-too-close relationship? It definitely is tempting. However, the lack of proof that this is indeed a collaborated move makes such a claim unwise.

What I think Romney should do instead is to focus on the negative things about QE3 and point out that this kind of policy (ignoring inflation, printing money etc) has been in Obama’s platform all along. He may not have come up with QE3, but he sure doesn’t mind it and the shortsighted thinking is absolutely in line with his overall economic policy.

Another question we need to ask is: Why now? Why is the Federal Reserve suddenly so desperate to relieve the banks of toxic assets? Just a few months ago, Bernanke was very clear that there would be no QE3 whatsoever. And yet here we are. Could it be that the Federal Reserve knows something that we don’t know? Could they possibly be sitting on some insider information? Maybe they know that something bad is about to happen, something that will make for example housing prices fall even more, thereby creating new toxic assets? Is that why they’re in such a hurry to get the current toxic assets off the books?

I would personally not be surprised if this turns out to be the case.

Either way, “Our economy under Obama is so bad the the Federal Reserve has to intervene again, just to keep the ship floating – why do we have to rely on the Fed, why can’t we have a president who can lead and bring us out of this mess?” can make for a pretty good commercial.

I’ll stop here. Thanks for reading.

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