Wow. Helicopter Ben has done it again, unleashing another round of “quantitative easing” (e.g. “money-printing”) onto our economy, promising to drop $40 billion each and every month into the purchase of mortgage-backed securities, and promising to stop dropping said $40 billion…well, never.

That’s right, he’s promised to continue spending $40 billion each month indefinitely, until employment improves…which at the rate we are going could be a very, very long time from now.

I’m dedicating the vast majority of today’s QnA to this announcement and what it means because I get frequent questions on QE…

  • What the heck is QE? (and QE2, and QE3…)
  • Why does the stock market go up when another round of QE is announced?
  • Why does gold go up?
  • Is Bernanke going to launch another round of QE? (obviously that’s now a resounding yes!)
  • What are the chances we really could have hyper-inflation here in the U.S.?
  • What is the “wealth effect” and the “great transfer of wealth” I hear talked about all of the time? How is that wealth going to be transferred, and how do I get it transferred to me?   🙂
  • Etc.

I’ve also gotten some fantastic questions this week on trailing stops and investment theses and seemingly contradictory advice—as Kenny Rogers croons, how does one “know when to hold ’em, know when to fold ’em, know when to walk away, know when to run…”?

And I want to issue a very warm welcome to all new subscribers! I was overwhelmed last week with your gracious and positive comments from Capital Account, Palm Beach Letter, Early to Rise, and Casey Research, and it is a true pleasure to have you in our Kung Fu Finance community—welcome, and please jump right in!

Now, onto this week’s questions, and the mysterious QE…

Let me start with a little history, before diving into the funny-yet-oh-so-sad hilarity of it all (and I have a treat for you…you’ve seen Peter Schiff I’m sure, but Peter Schiff on a rant is something to behold, and I’ve got a great Peter Schiff rant for you today!).   🙂

But first, a little background to answer the basics!

Who is this “Helicopter Ben” and what on earth IS “QE”?

Ben Bernanke acquired his nickname of “Helicopter Ben” via a paper he wrote in 2002, entitled, Deflation: Making Sure “It” Doesn’t Happen Here, (I am not making that up…that is the honest-to-God title of his paper). In this paper (which I encourage you to read—it’s actually not that dense and it’s always best to go straight to the source when you can), Bernanke outlined the multiple tools the Federal Reserve could use to ward off deflation if necessary, even if interest rates were already zero or close to zero percent.

He quoted Milton Friedman, “a money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money,” which meant exactly the metaphor you picture…Ben or Milton literally flying over the country in a helicopter and dropping bags of money down on unsuspecting people to “stimulate” the economy. (I certainly wouldn’t mind if someone dropped $1 million or so on my house today!)

What’s fascinating, though, is that in this now-infamous paper, Bernanke outlined exactly how he would combat deflation and perfectly explained what money-printing is and how it devalues the currency…and the example he used was ironically, gold!

Here is Helicopter Ben, in his own words, on how to fight deflation and how money-printing devalues currency:

“The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. [Kung Fu Girl Note: Remember, this was November, 2002…] Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” — Ben Bernanke, Deflation: Making Sure “It” Doesn’t Happen Here (emphasis mine)

And boy, is our government and central bank ever determined!

Ben goes on to explain how the Federal Reserve uses asset purchases to run this “printing press” — if you have time I recommend reading the paper, as it is quite prescient for all of the actions he is taking today to “stimulate” our economy (remember, he wrote this ten years ago):

“So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities…Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. [Kung Fu Girl Note: this is Operation Twist, which has been extended until at least the end of this year]

Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association) [Kung Fu Girl Note: this is the QE3 program announced yesterday].” — Ben Bernanke, Deflation: Making Sure “It” Doesn’t Happen Here

He told us exactly what he would do, way back in 2002.

So there you have the definition of “QE” in Ben’s own words…it’s “quantitative easing”, which is simply a fancy term for “money-printing”, and is how our illustrious Federal Reserve floods our economy with more currency, thus diluting the value of our dollars and creating inflation by purchasing government-backed securities. I’ve written extensively about all of this in the past and go into much more detail on my article on inflation, on fractional reserve banking, and on how the Fed POMO operations work, but that’s QE in a nutshell…please let me know if you still have questions!

So What Does This Mean To You As An Investor?

I’ll of course give you my take momentarily, but first if you have time I encourage you to watch this hilarious rant from Peter Schiff, who spells out exactly what he thinks this announcement is going to do (or rather not do…) for our economy and jobs situation (and for your money!):

In case you don’t have 17 minutes to spare, I’ll quickly net it out for you…

Peter says, “This is a date that will indeed live in infamy, because this is the date that the Federal Reserve went all in on QE. Rather than reviving the economy, the Fed has just sealed its fate and has driven the final nail in the coffin of the U.S. dollar and with it, the entire U.S. economy.”

He refers to this new policy as “Operation Screw” (which I hope takes off—great term!) because:

  • If you own dollars, you’re screwed.
  • If you own bonds, you’re screwed.
  • If you have a savings account, you’re screwed.
  • If you’re an American and working for wages and salaries and collecting a paycheck in dollars, you’re screwed.
  • If you’re hoping to retire on dollars, you’re screwed.
  • If you’re a saver, you’re screwed.

Ouch, but sadly correct!

And even worse than the screwing, Peter points out that in actuality, this decision from the Fed, their great “solution” to our economic woes, is to…

Wait for it…

Inflate another housing bubble!

(Because that worked so well the last time…)

But that is their plan—as I mentioned above the Fed is going to buy $40 billion worth of mortgage-backed securities each and every month in an attempt to bring down mortgage interest rates, because they want to “spur the housing market”.

The Fed wants home prices to go up for two reasons:

1. The wealth effect: Bernanke believes that if he can get home prices to go up, homeowners will then “feel wealthier” and will therefore go out and spend more money (on things they don’t need…) which will spur the economy. However, there is a fatal flaw here…if people do in fact go out and spend this money that they have not earned, but rather have “pulled out” via a refinance from the apparent increase in the equity of their home, we are right back where we were in 2004-2006—in a gigantic housing bubble and consumers taking on too much personal debt and wrecking their personal balance sheets.

2. Bernanke believes we can create an entire economy of the housing market, by the housing market, and for the housing market. He believes that if we can just get home prices to go up, then people will realize that they can make money by buying houses, and more people will buy houses because they are going up in price, which will encourage more home building…and we can inflate a super-housing bubble!

Peter sums it up well…

“Our new monetary policy for economic revival is for the Federal Reserve to print money and loan it to Americans at ultra-low rates, so they can go out and buy houses and push up housing prices, so we can all go on a consumption binge, and spend all sorts of borrowed money on imported products…and somehow all of this is going to create employment and not end in complete disaster like the last time the Fed tried to create a housing bubble to stimulate the economy.” — Peter Schiff

How Does QE Affect the Markets and Your Investing?

In all honesty, it shouldn’t, at least not to this extent (of course the manipulation of interest rates always affects markets, but this ridiculous display of incessant money-printing is unprecedented (gee, how do I really feel?).   🙂

Although I’m happy because my investment thesis is proving out, I’m also sad because this spells disaster for our economy. But more on that in a moment—let’s take a look at the markets first.  What went up this week after the announcement?

Unsurprisingly:

  • Gold
  • Silver
  • Oil
  • Commodities
  • Agriculture
  • Equities
  • Currencies (except the dollar)

Here’s gold:

Kitco 24-hour spot gold 09-13-2012

Gee, can you tell when Bernanke spoke? Gold up over $30/oz. by NY close...

And here’s the S&P 500:

S&P 500 Index

Apparently the news wasn't all priced in...

I won’t put up all the charts, but instead jump into the question…why does this happen?

Hopefully the gold answer is evident–gold is money and has always been money, and has intrinsic value and limited supply. It’s a real asset, and one that does well in times of crisis. Bernanke used it in his alchemy example above, but so far, no one has been able to manufacture gold—it has limited supply and you cannot simply print more of it. “Smart money” realizes when the Federal Reserve commits to printing more fiat currency, it’s time to buy real assets, not paper.

The only trick (if you’re trying to time when to buy) is determining whether or not the information is already “priced in” to the market…I was a little surprised that it went up so dramatically, but I imagine people were surprised at the open-ended commitment of “QE Forever!” rather than a limited time-period.

This applies to the stock market as well. When Bernanke announces more money-printing, the “smart money” realizes that cash is truly trash—he has committed to flooding our economy with a vast supply of currency, which devalues each and every dollar in existence. The more dollars added to the money supply, the less each dollar is worth (it’s a bit more complicated than that, but not much, as that printed money must actually make its way out into the economy, but that is the basic gist).

Additionally, when you hear that the Fed intends to keep interest rates low “for the foreseeable future”, this causes bonds, CD’s, and other non-risk assets to lose their luster (who wants to earn 2% for 30-years when inflation will be much higher than that? That’s a losing proposition!). In absence of any returns from income assets, money tends to flow into the stock market and other so-called “risk-on” markets.

What Does This Mean for You As An Investor?

First and foremost, it means that the Fed is completely committed to avoiding deflation, at all cost. They have already unleashed trillions of dollars into our economy, with extremely limited effect, and have just committed to doing “whatever it takes” to do more, even if that ignites another housing bubble and destroys our currency.

You know I strongly believe you must think for yourself and apply this to your own unique situation, but as for me, I will continue to buy gold and other real assets, along with assets not denominated in U.S. dollars.

What Does This Mean for You as a Human?

Unfortunately, here is where it gets sad…this announcement means a higher cost of living for everyone, and if people must spend more money on food, energy, and housing, they will not have as much left over for “discretionary” spending and investing! Unless somehow we can miraculously create many more jobs, I worry that this will lead to another 2008-2009 crisis, only larger.

So sorry…those of you who have been reading for awhile know that I am a “glass half full” kind of person and I certainly don’t mean to predict doom and gloom—I truly hope we solve these problems!

But in case we don’t…what are some positive steps you can take to weather any upcoming storms?

  1. Grow your financial education (which you are already doing by reading Kung Fu Finance—thank you!)
  2. Own some gold (and silver, to a lesser extent, depending on your tolerance for volatility and belief in the future direction of the global economy—silver has some industrial applications so could be affected more in a global economic slowdown)
  3. Have some cash (although you may want to diversify your cash into other currencies…but you should have some to take advantage of the upcoming volatility, and there might be some amazing opportunities for intelligent speculations with all of this bubble-blowing)
  4. Get to know other investors and learn from each other (there is nothing like connecting with other savvy investors to discuss these things together…and our community here on Kung Fu Finance is a great place to start!)

I’m going to save Kenny Rogers for next week 🙂 and let you get on with your weekend! Have a wonderful weekend, and please let me know what YOU think about this new round of QE and what it means for all of us in the comments!

And thanks as always for reading and being a part of our Kung Fu Finance community!

To your financial success,

— Kung Fu Girl

P.S. Bernanke, by the way, as two astute readers pointed out on Tuesday, did not actually live through the Great Depression, as I mistakenly said and knew better—that’s what I get for being a one-woman shop and editing my own writing, which one should never do! He was simply an avid student of the Great Depression.