Wednesday, October 27, 2010

The Free Lunch: Part II

I suspected that my suggestion that the Fed use QE II to purchase the non-agency residential mortgage backed securities would receive a lot of negative feedback.  I was right.  Sorry that I did not have comments turn on so readers could see them, but I am still in the learning phase.

Many commentators were appalled by the wealth transfer to the banks implied in buying these securities at what undoubtedly would be a premium price.  They chose to ignore the other side of the trade.  This is where the Fed steps up and imposes significant regulatory constraints on the banks going forward.

Other commentators took issue with the idea that the Fed was willing to impose significant regulatory constraints on the banks.  They noted that the Fed tends to back off whenever the banks claim that any proposed regulation will reduce the availability of credit.

This raises an interesting question, if the Fed is unwilling to exercise its regulatory authority over banks, does it fall to the Financial Services Oversight Council to do so in its place?

Several commentators looked at inflation and asset bubbles related to QE II.  I do not claim any particular expertise to comment here.  With that disclaimer, clearly there is a correlation between the Fed pushing liquidity into the financial system to try to stimulate growth in the economy and increases in the prices of assets (like stocks, bonds and houses).  However, correlation is not the same as causation.  For example, consumption of soft drinks increases at the same time of the year that there is an increase in the number of cases of polio.  While the increase in consumption and illness are correlated, there is no reason to believe that one causes the other.

My focus in making the suggestion as to how to use QE II was on trying to restore "normal" functioning to the capital markets.  This is an area where I have some expertise and the topic of what is normal functioning will be an entry to this blog in the near future.

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