The Fed is Insane


The definition of insanity is doing the same thing over and over and expecting different results. 

Ben Franklin

With analysts, prognosticators, Fed-watchers, reporters and many others ratcheting up speculation regarding the possibility that the Fed will engage in QE3 in the spring of 2012, everyone seems to reinforce the common belief in the omnipotent power of the Fed to prevent market collapses and create periods of economic prosperity.

Over the last three years, no matter where you turned, you heard the same propaganda that the Fed is providing liquidity to the markets, or the Fed will never allow deflation, or that the Fed and the government will bail out everyone under the sun to prevent the markets from collapsing.

However, my perspective of the Fed is quite different than most, especially when it comes to the perceived G-d-like powers over the economy everyone seems to attribute to the Fed.

I have continually attempted, in my writings, to demystify what the Fed does, but, unfortunately, very few seem to be listening, or, maybe, they simply are too scared to do so.  It is never easy to accept that man cannot exert control upon any aspect of life, especially one so essential as finances.  So, I will try to present the argument one more time, and then explain why QE3 would be nothing more than “insanity,” as referred to by Ben Franklin.

What Causes Deflation?

In order to appropriately understand how the Fed may react to deflationary pressures, we need to understand what causes deflationary pressures. 

For the last 70 years, we experienced the most significant credit proliferation in history.  When more credit was made available to the public, they had significantly greater purchasing power with which to buy the limited goods and services available in the market.  Clearly, this growth in buying power placed price pressure on the limited goods and services available in the market, thereby causing upward pressure upon the prices for those goods and services.  This was inflationary.

From an Elliott Wave perspective, we know that this historic credit proliferation was the fuel for the Supercyle 5th wave of the Grand Supercycle 3rd wave.  Once this 5 wave move in public sentiment completed at the top of the Grand Supercycle, then it became time for the subconscious sentiment of the public to shift in the opposite direction, which was simply a natural cause of events in the human psyche, and not the operative effect of some exogenous event.  Therefore, the public went from a sentiment of growth and credit expansion to a sentiment of regression and credit contraction.  This change in sentiment is deflationary.

What Tools Does the Fed Have to Fight Deflation?

The Federal Reserve has the power to print actual dollar bills and flood the system with actual physical currency. This is a simple way that they can attempt to cause inflation, since more actual money in the system will put pressure upon the limited goods and services available in the market. However, this is clearly not the path they have chosen, and it will probably be the path of last resort, which will only be embarked upon after deflation has ravaged the system.  If the Fed chose this path, it would cause interest rates to rise, which would destroy its own balance sheet, since it is comprised predominantly of U.S. Treasuries.  Furthermore, due to the speed at which deflations spiral out of control, it is quite possible that even a mass printing of cash could fail to stem the tide of deflation, which is what we saw during the Great Depression.

The manner in which the Fed has been attempting to affect the monetary base , thereby to fight deflation, is by injecting credit into the system. They do this by a process termed “monetization of debt.” The Fed acquires Treasury issued debt instruments in the open market, and then issues the seller bank a “credit” on its books for the acquisition price in its Fed account. In effect, the Fed simply creates a book credit on the bank’s balance sheet that did not exist before, as it does not send cash to the bank. Since it never retires the debt instruments it acquires, it is simply adding credit to the monetary base by these acquisitions and extensions of credit to the seller banks.  Their goal is to allow the banks to provide further loans to the investor society at large, which would, in their view, stimulate the economy with further public credit infusions.

Historical Government Action to Fight Deflationary Pressures

In order to really understand if the Fed will have a positive effect upon deflationary pressures in order to avert the impending market crash, we have to look at how Fed/government action has effected deflation from a historical perspective.

In recent history, we can look back to the significant deflationary pressures that affected our markets during the serious market decline of 2007-2009.  During that time, our government and Fed were frantically attempting to stem the tide of the deflationary pressures through the use of TARP, TALF, and QE.  However, despite unprecedented government action, the market still seemed to plummet in one of the largest and fastest declines in market history.  

As Ellioticians, we understand that any supposed “good news” announced during a period of negative sentiment will be “discounted,” and will not prevent the market from completing its intended pattern.  In 2008, any government action to stem the tide of the deflationary pressures was bound to fail for this reason, since the public was engaged in debt deleveraging while the Fed and our government wanted to provide them with more ways to add leverage.  It was as if the government was attempting to sell shoes to someone who, unfortunately, had lost their legs.

If we choose to go back further in history to the Great Depression, we may look towards Irving Fisher, an economist who actually lived through the Great Depression.  The depression caused him to change his perspective on the cause of depressions in general, and he later surmised that it was actually excess credit proliferation that ultimately leads to depressions.  Regarding the Fed’s action during the Great Depression, he noted:

The Federal Reserve System, from February to December 1931, increased the issue of Federal Reserve notes by 80%. These issues were due to bank failures which made necessary a larger use of cash.  Yet, after a wave of bank failures . . . both banks and their depositors began raiding each other in a cut-throat competition which more than defeated the new issues of Federal Reserve notes.

Irving Fisher, Booms and Depressions, 1932

What Can We Expect of Fed/Government Action?

The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, again and again, to lower the gross market rate of interest by means of credit expansion. There is NO means of avoiding the final collapse of a boom brought about by such credit expansion. 

Ludwig Von Mises, Human Action, 1949

The cause of economic despair, however, is human nature’s propensity to sway from fear to euphoria and back, a condition that no economic paradigm has proved capable of suppressing without severe hardship.  Regulation, the alleged effective solution to today’s crisis, has never been able to eliminate history’s crises. 

Alan Greenspan, Financial Times, 2008

Notice that Von Mises does not say that there is no means of avoiding a collapse brought about by credit expansion other than Fed/Government action.  He meant what he said, in that there is no means to avoid a financial collapse once we move from a credit expansionary period into a credit contractionary period.

Furthermore, even Alan Greenspan, former Chairman of the Fed, clearly understood that it is human sentiment that causes financial crises, which “no economic paradigm” can prevent.  He has also been quoted as saying that the idea that the Fed can prevent recessions is a "puzzling notion.” 

Another Fed insider who does not adopt the public’s view in the omniscience of the Fed is Alan Blinder, former Vice Chairman of Governors of the Federal Reserve System.  When asked about his thoughts in an interview with the New York Times on August 27, 2010, he stated:

The Fed has run out of the strong tools, and is turning to weak ones. When you’re fighting in a foxhole and you’ve used up the machine guns and hand grenades, then you pull out the sword and start throwing rocks.



After TARP, TALF, QE1 and QE2, our economy is still languishing with high unemployment and severely depressed real estate, and is unable to generate the intended escape velocity to bring on the next economic boom.  So, if government/Fed programs have failed in their intended consequences during deflationary periods throughout history, I guess the most reasonable path would be to attempt it again!?  Is this not the definition of “insanity,” as expressed by Franklin?

Those who cannot remember the past are condemned to repeat it.

George Santayana, Reason and Common Sense (1905)