In business and economic circles, quantitative easing is all the buzz these days. Last Tuesday, the American electorate made it fairly clear that there is not going to be another round of fiscal stimulus anytime soon. Ironically, on Wednesday, Federal Reserve chairman Ben Bernanke reaffirmed his commitment to a different kind of stimulus- monetary stimulus. Starting this month, and continuing up until mid-2011, the Fed intends to buy $600 billion in US treasury bonds in the open market. This is the second round of "quantitative easing" and hence is being called QE2.

Quantitative Easing ("QE") is when the Fed goes into the markets and buys financial assets like Treasury securities. They pay for these by printing more money. The objective is to reduce long-term interest rates and encourage growth. The first round of QE (roughly $1.7 Trillion) in 2008 was designed to help clean bad assets off the banks' books, reassure spooked markets, and ultimately prevent a global depression. QE2 is all about shaking the economy out of it doldrums.

Chairman Bernanke outlined his plans and rationale last week with OpEds in major newspapers. He said "Notwithstanding the progress that has been made, when the Federal Open Market Committee met this week to review the economic situation, we could not be satisfied. The Federal Reserve's objectives -its dual mandate, set by Congress, are to promote a high level of employment and low stable inflation." He acknowledged the weak job market. And, he expressed concern that underlying inflation is running below 2 percent and could, in the "most extreme case" morph into deflation and economic stagnation.

QE2 is supposed to boost growth through three channels. First, when the Fed buys long-term bonds, it increases the demand for such bonds and increases their prices. Because the interest rate or yield on bonds fluctuates inversely with the price of bonds, Fed bond buying produces lower long-term interest rates. These theoretically, spur borrowing and investment. Second, because yields are lower, investors look for higher returns, even if these are somewhat riskier. Much of the new debt created by QE is being used to purchase other higher yielding asset classes, such as stock, bonds and commodities. The initial phase of QE is one of the principal reasons that stock prices have increased approximately 15% in the last twelve months. Higher stock prices in this period have increased household wealth by $1.4 trillion, increasing consumer confidence and boosting consumer spending somewhat. Third, the lower dollar should help international trade for US companies. In the last five months, the US dollar has lost 14% to the euro and 13% to the yen. The Economist reported in its November  6^th issue that American factory managers reported a sharp jump in export orders in October and a drop in imports.

Despite its lofty goals, critics of QE2 abound, both here in the US and abroad. The principal concerns are that QE is ineffectual, may lead to runaway inflation that could derail the economy or produce future asset bubbles that could endanger economic stability over the long term.

Despite QE, borrowing is shrinking not growing. Demand is just not there. Unemployment is still 9.6%. Many homeowners have negative equity in their houses. Others are voluntarily deleveraging. Corporations are sitting with billions of dollars of cash on their balance sheets, deferring investments. They are operating at 70% of capacity and need significantly more sales to justify new plants, equipment and employees. Banks have tightened their loan standards since 2007 and are focusing on increasing their equity rather than lending more to US homeowners, consumers and businesses. 

Critics of QE2, including some Fed members, believe that too much monetary stimulus might ultimately lead to runaway inflation that could derail the economy, or future asset bubbles that could endanger economic stability over the long run. Last Thursday, David Stockman, Reagan's Office of Management and Budget Director, put it this way on Bloomberg TV "Fed QE is injecting high grade monetary heroin into the financial system of the world and one of these days it is going to kill the patient (meaning economies and people). "

QE2 has also drawn international criticism. Germany's finance minister, Wolfgang Schaeuble, said on November 5^th, that "With all due respect, U.S. policy is clueless." Europe's central bank issued an implicit criticism of the policy when it decided it would not follow suit. Yesterday, global backlash grew with  both China and Russia scolding the US and China warning that the Fed's action was equal to exchange rate manipulation that could leave to a global currency war.   

Dr. Bernanke concluded his OpEd by indicating that "the Fed cannot solve all of the economy's problems on its own." He suggested that it will take time and the "combined efforts of the central bank, Congress, the administration, the regulators and the private sector." He also indicated that the Fed will regularly review the (QE program) and adjust as needed.

While the motivation for QE2 remains sound, it is quite sad that it is now seemingly the only tool left standing to help our sluggish economy. History tells us that printing money to make jobs is a dangerous inflationary game. History also tells us that there are unique periods when these kinds of policies work. Let's hope the Fed and Chairman Bernanke can steer QE2 through perilous waters and use just the right amount of QE to help cure the patient.

Here are some of our references:

For more information from the Economist, click here.

For more information on the Huffington Post, click here.

For more information on Wikipedia, click here.

For more information from CNN Money, click here.

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