"In other words, if stock and commodity prices are in fact in a bubble and if those bubbles were to collapse, the balance sheets of the financial institutions and hedge funds making investments with the expectation of higher asset prices could suffer heavy damage, exacerbating the balance sheet recession in the broader economy. an increase in DCF values, either." And there you have it: Bernanke's all in gamble that QE2 would have been sufficient to restore the virtuous circle of the economy has failed with less than 2 months to go under the QE2 regime. As such, and with fiscal stimulus a dead end, the Fed has two choices: watch as the economy collapses in flames to a state far worse than its pre-QE1 outset, or do more of the same. That's all there is. The rest is irrelevant. And since the Fed will choose the latter option, the market would be wise to start pricing in precisely the same reaction as what happened following the Jackson Hole speech...although to the nth degree.
And some other key observations from Koo:
And the conclusion:Government borrowing has supported money supply growth
The question, then, is how to explain the modest growth in the money supply at a time when private-sector credit has steadily contracted. A look at Japan’s experience shows that the answer lies in increased bank lending to the government. As long as the government continues to borrow, banks can continue lending (by buying government bonds) even if the private sector is deleveraging in an attempt to clean up its balance sheet.
If the government spends the proceeds of those debt issues, the people on the receiving end of that spending will deposit money with a bank somewhere, leading to an increase in the money supply.
In effect, the money supplies of both the US and the UK are being supported by government borrowing. If the two governments chose to embark on fiscal consolidation, their money supplies would contract.
Portfolio rebalancing effect was primary objective of QE2
So what are the actual problems inherent in QE2? Mr. Bernanke has stated from the beginning that QE2 would not lead to an increase in the US money supply.
If so, why did the Fed carry out QE2? The simple answer is that it believed QE2 would result in a portfolio rebalancing effect. The portfolio rebalancing effect can be described as follows. When the Fed buys a specific asset (in this case, longer-term Treasury securities), the price of that asset rises. That prompts private investors to re-direct their funds to other assets, which leads to a corresponding increase in the price of those assets.
Private-sector sentiment may improve as asset prices rise, and if that prompts businesses and households to spend more money, the economy may improve. In effect, the Fed hopes that quantitative easing will lift the economy via the wealth effect. Inasmuch as the balance sheet recession was triggered by a drop in asset prices, monetary policy that serves to support asset prices may also help pull the economy out of the balance sheet recession.
Reasons for divergence of liquidity supply and money supply
The decline in private-sector credit in the US and the UK is attributable to both the unwillingness of banks to lend and the unwillingness of the private sector to borrow. The two factors are rooted in balance sheet problems and are indications that both countries remain in balance sheet recessions.
When a bubble collapses, the value of assets drops, leaving only the corresponding liabilities on the balance sheets of businesses and households. To fix their “underwater” balance sheets, companies and individuals do whatever they can to pay down debt and avoid borrowing new money even though interest rates have fallen to zero. Banks, for their part, are not interested in lending to overly indebted companies or individuals, and often have their own balance sheet problems. With no borrowers or lenders, the deposit-growth process described above stops functioning altogether.
US banks now appear slightly more willing to lend money, although that is not the case in the UK. In neither country, however, are there any signs of greater willingness to borrow among businesses and households.
Unable to buy more government bonds or private-sector debt, investors have few places to turn
In the hope of producing a portfolio rebalancing effect, Chairman Bernanke declared that the Fed would purchase $600bn in longer-term Treasury securities between November 2010 and June 2011. This was roughly equivalent to all expected Treasury debt issuance during this period.
From a macroeconomic standpoint, these purchases of government debt meant that—in aggregate—private-sector financial institutions would be unable to increase their purchases of US Treasury securities, because all of the growth in Treasury issuance would be absorbed by the Fed.
The fact that US businesses and households were rushing to repair balance sheets by deleveraging meant that—again, viewed in aggregate—private investors would be unable to increase their purchases of private-sector debt.
With the private sector no longer borrowing and all new issues of government debt being absorbed by the Fed, US institutions found themselves with few investment options.
So funds found their way to equities and commodities
The only remaining destinations for these funds were equities, commodities, and real estate. Real estate had just been through a bubble and remained characterized by heavy uncertainty. In commercial real estate, for example, banks—at the request of US authorities—are engaging in a policy of “pretend and extend” and offering loans to borrowers whose debt they would never roll over under ordinary circumstances. That means that current prices do not accurately reflect true market prices. Housing prices, meanwhile, resumed falling late in 2010.
UK house prices have been falling since mid-2010, and the Halifax House Price Index dropped 1.4% in April 2011 alone (the decline was 3.7% on a y-y basis).
The only remaining options for private-sector investors have been stocks and commodities. That, in my opinion, is why both markets have surged since the announcement of QE2.
QE2 was Bernanke’s big gamble
When the situation is viewed in this light, we come to the realization that Mr. Bernanke’s QE2 was in fact a major gamble. It was a gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices led to improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, thereby demonstrating that prices were not in a bubble.
However, I cannot help but feel that the portfolio rebalancing argument was putting the cart before the horse, in the sense that it is ordinarily a stronger real economy that leads to higher asset prices, and not the other way around.
It might be possible to sustain the portfolio rebalancing effect for some time if conditions were such that investors were totally oblivious to DCF values. But with market participants paying close attention to DCF values, any delay in the economic recovery will naturally bring about a correction in market prices, thereby causing the portfolio rebalancing effect to disappear.