Grantham Scorns QE2, the Fed and Its Zombie-in-Chief

Last Updated Nov 8, 2010 11:20 PM EST

It's probably not the worst mistake that Ben Bernanke and his Federal Reserve colleagues are making with quantitative easing, or QE2, their policy of trying to stimulate the economy by buying hundreds of billions of dollars in Treasury bonds. But if they wanted to avoid getting caught in a downpour of rhetorical vitriol, they shouldn't have announced the plan around the time that Jeremy Grantham issued his latest quarterly commentary on the economy and financial markets.

It probably didn't help, either, that zombies have risen yet again as pop culture phenomena, for it gave Grantham, chief investment strategist of the fund manager GMO, a great excuse to title his piece "Night of the Living Fed." It's an allusion to Grantham's sense of dread and horror over the potential long-term effects of QE2, sentiments expressed elsewhere, albeit less colorfully.

Grantham is also making an observation that Bernanke, much like undead beings not employed in a policymaking role, is engaged in a relentless, single-minded quest. As Grantham sees it, the Fed chief will stop at nothing in his effort to prop up the economy, no matter the size and scope of market bubbles that form as a byproduct.

Only as Rich as You Feel?
The bubbles are unintentional, of course, but they may be hard to avoid. Grantham contends that Bernanke realizes that any impact from tools like QE2 would result from boosting the stock market, creating a so-called wealth effect - the apparent tendency of people to act richer by spending money because their rising investment portfolios make them feel richer - and having that, in turn, boost the economy.

The imprecision that results when policymakers use mass movements of money to tinker with financial markets and psychology may make it far more likely than not that bubbles will form. It would be hard to rebut such an idea based on the miserable last decade of financial and economic history.

This isn't the first time that Grantham has taken the Fed to task for what he sees as loopy and downright dangerous decisions. Right at the top, he acknowledges a "diatribe against the Fed's policies" that has become "rather long and complicated."

What especially infuriates Grantham these days is partly the Fed's apparent if-at-first-you-don't-succeed strategy. Bernanke wouldn't have to give QE2 a go if QE1 had done the trick.
Grantham questions the basic premise that more liquidity - meaning more debt issuance - equals more growth. He points out that the U.S. economy hummed along just fine, growing by an inflation-adjusted 3.4 percent a year on average, between 1880 and 1980 as total indebtedness as a proportion of economic output held fairly steady. In the last 30 years growth has slowed to an annual average of 2.4 percent, even as debt has tripled relative to the size of the economy.

Debt does more harm than good, Grantham says. It can produce modest and short-lived increases in growth, but it also creates imbalances in the economy and financial system - credit crunches and such - and allows business and political leaders to skate along, ignoring structural impediments to growth.

The engineered gains in the stock market often prove ephemeral or worse too. Grantham observes that the additional money tends to drive up valuations over all and especially in more speculative segments of the market, the ones that are propped up disproportionately by easy credit and artificially induced industrial or consumer demand:

"The saddest truth about the Fed's system is that there can be, almost by definition, no long-term advantage from hiking the stock market, for, as we have always known and were so brutally reminded recently, bubbles break and the market snaps back to true value or replacement cost. Given the mysteries of momentum and professional investing, when coming down from a great height, markets are likely to develop such force that they overcorrect. Thus, all of the beneficial effects to the real economy caused by rising stock or house prices will be repaid with interest. And this will happen at a time of maximum vulnerability, like some version of Murphy's Law. What a pact with the devil! (Or is it between devils?)"
Stocks could be in for hellish times, according to Grantham's analysis, so does he think investors should get the hell out? Not necessarily. He offers rationales for being in or out of the market and maybe both. Come back Thursday for details.