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QE2: Don't Expect a Wealth Effect, but Count on a Big Bubble

Like a wobbly top, QE2 has undergone a change of spin. As hope has morphed into doubt about the effectiveness of quantitative easing, the Federal Reserve program to stimulate the economy by buying $600 billion of Treasury bonds, there's a new mechanism being mooted to explain why the plan should succeed.

Having some rationale is important. Wall Street needs to explain the rally in stocks -- 15 percent since late August, 80 percent since March 2009 -- and Washington needs to justify $600 billion in added spending in a year when the fiscal deficit was already projected to eclipse $1.4 trillion.

The second part may be easier. The Fed doesn't have to borrow the $600 billion or tap the taxpayer for it. All it has to do is flip the switch on the printing presses to "on" and create it out of thin air.

No Time Like the Present
Such a move could be inflationary -- if there were any inflation to speak of. With consumer prices stable, mainly because the housing and job markets remain in the dumps, this seems to be a better time than most for the Fed to try it. Even so, QE2 may stand up to scrutiny about as well as a wobbly top defies gravity.

The original story was that QE2 would work by making more money available for banks to lend. As noted in an earlier post about quantitative easing, enthusiasm for that idea began to wane as skeptics pointed out that the first $1.5 trillion of stimulus contained in QE1 had not done the trick because banks have been reluctant to lend and businesses have been reluctant to borrow.

The rhetorical Plan B is that QE2 will accomplish its goal through an indirect route in which the billions of dollars sloshing around will serve as fuel for speculation in the stock market. The consequent rally will make people feel wealthier, encouraging them to do myriad things that promote economic growth, like hiring, shopping and investing.

Thumbs Down for the Fed
The idea was highlighted recently in writings by Jeremy Grantham, chief investment strategist of the fund manager GMO, and Jesse Eisinger, a reporter for the independent, nonprofit news organization ProPublica. Both treated it with skepticism and scorn and warned that the Fed could create dangerous market bubbles in its effort to initiate a more benign rally.

Grantham was especially acerbic in his treatment of the Fed, which he blames for serial bubble creation. He predicted that the Standard & Poor's 500-stock index would climb as high as 1,500 over the next year as the prelude to a long period of grim performance.

Bubbles are a hot topic these days, including some that are bigger than anything the Fed could engineer. NASA scientists captured the zeitgeist earlier this month when they announced the discovery of bubbles of gamma rays extending 25,000 light-years out of the plane of the Milky Way in either direction.

This Time Expect the Expected
Investors in this part of the galaxy seldom get what they expect. Does all the talk of bubbles lessen the probability that one will occur? Perhaps the stock market will just rise sedately, without culminating in a pop, say if QE2 works as advertised and the rally produces a wealth effect that sets the economy to rights.

The keyword is "if." For a reason often ignored in discussions of QE2, it's doubtful that the manipulation of stock prices will produce a significant wealth effect. That, in turn, reduces the likelihood of a healthy boost to economic growth.

One aspect of the rally in stocks off the lows in March 2009, a source of considerable head-scratching among market watchers, is that it has proceeded without the participation of ordinary investors. U.S. stock mutual funds have experienced net outflows of about $90 billion since the start of 2009, according to the research firm Morningstar.

Small investors are usually late in returning to stocks after a bear market, but they're seldom this late. One explanation for their disdain is the discordance between developments on Wall Street and Main Street.

What Wealth Effect?
Ordinary folks, confronting a backdrop of sluggish job creation and a moribund housing market, probably see the stock market's run as a non sequitur. They either don't get it or, worse, they see it as the outcome of a game rigged by and for hedge fund operators and investment bank trading desks.

Either way, there's no wealth effect because the little guy's no wealthier, not even on paper. That means no benefit to the economy, raising the odds that a bubble will expand and burst. That could occur especially violently if a frustrated public piles into stocks at the tail end of the advance, a development that history suggests is not out of the question.

The result could be something similar to what happened in 2008, with a fresh episode of cascading 401(k) plans and home values. This time, though, there won't be anything left in the Treasury's kitty for QE3 or some other stimulus plan.

That scenario may not come to pass. The Fed may pull back from the brink and allow stock prices to retreat in an orderly way, while policymakers try other steps to revive the economy. If it's business and bubbles as usual, however, the consequences will be less severe than a gamma ray burst spreading out from the galaxy, but investors who get caught in a collapsing stock market might feel as if it's the end of the world all over again.

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