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We don't need QE2

Top chart: Adjusted bank reserves. Bottom chart: M2

The investing world has worked itself into a frenzy of anticipation over the arrival of a second wave of Quantitative Easing from the Fed, which is supposedly going to be announced at the FOMC meeting in early November. The idea behind QE2, as it's called, is that the economy needs to be force-fed more money in order to pump up growth; $1 trillion of added reserves in late 2008 didn't help much, so we need a lot more.

This idea deserves to be buried alongside the corpse of Keynesian economics. Government spending can't boost growth because government spends money very inefficiently (especially when the spending program is designed by Pelosi, Reid & Co., and consists mainly of transfer payments and payoffs to unions). Government spending also needs to be paid for, and the funds that are borrowed to finance the spending represent funds that are removed from the pool of capital available to finance private sector initiatives. Similarly, quantitative easing can't boost growth for the simple reason that growth only comes from initiatives that boost productivity and/or increase the total number of people working. Printing money ultimately results only in higher prices, not a bigger economy.

The only justification for quantitative easing is as an offset to a dramatic increase in money demand. That was indeed the case in late 2008. The financial crisis shocked people all over the world into suddenly wanting to hold more money, and the dollar was the favored recipient of that new-found attraction for money. The Fed needed to supply a lot of extra money to the system, otherwise we would have likely fallen into a serious deflation.

But since the economy is now largely out of the woods and money demand is slowly declining, more quantitative easing is not only unnecessary but also potentially dangerous. The gold market is telling us that investors all over the world are growing increasingly concerned that central banks are making serious inflationary errors; gold is up because their demand for money has been seriously undermined. More of the same could accelerate the process of declining money demand, and that would be like adding fuel to the inflationary fires that have already been kindled.

Putting aside the theoretical arguments, let's look at the two charts above. What they are telling us is that the Fed's provision of reserves to the banking system has been declining since the end of February, while the amount of money sloshing around the economy (M2) has been increasing. Bank reserves have fallen by $170 billion, while M2 has increased by $270 billion. M2 is currently increasing at an annualized rate of over 6%. The increase in M2 has absorbed some of the excess reserves in the system, and the Fed's balance sheet has shrunk a bit, resulting in a $228 billion decline in excess reserves since February. Conclusion: the Fed's is effectively reducing the amount of money it is supplying to the banking system, but banks nevertheless are using some of their excess reserves to create new money, and all measures of money are now growing at healthy rates. And all of this is happening as the equity market rallies.

Things are getting better on all fronts, and that means the Fed shouldn't try to fix something that isn't broken by ramping up another quantitative easing program.

As I've said many times in the past, "there is no shortage of money." Whatever problems the economy may have, a lack of money is not one of them.

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