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The Fed’s $600 billion QE2: Love Boat or Titanic?

Editor’s update: The global backlash against last week’s Federal Reserve decision to pump billions of dollars into the U.S. economy continues, with finance ministers from Germany, Russia and China roundly criticizing the move.

Editor’s update: The global backlash against last week’s Federal Reserve decision to pump billions of dollars into the U.S. economy continues, with finance ministers from Germany, Russia and China roundly criticizing the move. Brazil’s president-elect Dilma Rousseff went even farther: “The last time there was a competitive devaluation of currencies it ended up where it did, in the Second World War.” President Barack Obama, meanwhile, played defense: “The Fed’s mandate, my mandate, is to grow our economy. And that’s not just good for the United States, that’s good for the world as a whole.”

In the first week of November, investors drove stock prices to pre-crisis levels, elated by the news that the U.S. Federal Reserve Bank was going to launch what’s been dubbed “QE2.”

In case you thought the U.S. government was suddenly getting into the cruise line business, here’s a primer on QE2, and an explaination of why you should batten down the hatches, pay attention to how this plays out over the coming years, and steer clear of the fallout.

Obscure as QE2 may sound, any working stiff should care about it for the same reasons that you should have paid attention to mortgage-backed securities in the 2000s: your job, your bills and your financial well-being may depend on it.

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So here’s what QE2 is: the Federal Reserve (the U.S. government’s central bank) is essentially printing $600 billion, and using it to purchase U.S. Treasury bonds. This increases the quantity of money available in the economy, easing the pressure on banks and other financial institutions — the “QE” part of the name stands for “quantitative easing.”

The Fed is trying this strategy for the second time (hence QE2). The first time came during the dark days of the financial crisis. Many economists lauded that first round of quantitative easing for helping to thwart an economic depression. This time around, the Fed is hoping that it will help the economy pick up steam.

But there’s ample evidence that QE2 is the wrong medicine for the what ails the economy – that the real problem is in part a lack of good ideas, as well as an obtuse and dogmatic unwillingness to see that the private sector can’t solve all the economies problems.

So how does quantitative easing work? According to basic economics, when a government prints money, interest rates drop and inflation rises. This is simply a matter of supply and demand: the same way that corn is cheap in the summer when it’s plentiful, the Fed is making it cheaper to borrow dollars, by flooding the market with them.

As a result of QE2, interest rates — which are basically the rent that borrowers pay to lenders — will (almost certainly) decline. Likewise, since there are more dollars out there chasing goods and services in the economy, prices will likely go up (i.e., inflation will rise).

Higher prices ward off the dangerous specter of deflation (when prices go down, causing the economy to slump and forcing companies to layoff workers due to sagging revenues).

Finally, flooding the market with new money makes it easier for foreign countries to buy dollars (again, it’s a question of supply and demand). This will cause the U.S. dollar to drop compared to other currencies, making our exports cheaper, hence easier to sell.

In a nutshell, the Fed is bolstering an era of easy money. This should help the economy grow.

But easy money is not without its risks. For most countries, printing too much money can be devastating. An extreme example of this is Zimbabwe, where strongman Robert Mugabe’s government attempted in the mid-2000s to pay off foreign debts by printing trillions of Zimbabwe dollars. Inflation ran as high as a billion percent — meaning that a product that cost $1 might cost a billion the next year. By 2008, US$1 bought some 10 billion Zimbabwe dollars.  Zimbabwe’s currency became so worthless that the government printed 100 billion dollar notes before finally abandoning it in favor of foreign currencies.

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For the U.S., the situation is different. What the Fed is doing with QE2 is nowhere near as irresponsible as Mugabe’s printing-press mad antics. Compared to the $14 trillion dollar U.S. economy — by far the world’s largest — $600 billion is a relatively modest figure; it’s unlikely to trigger hyperinflation.

Moreover, the U.S. is different from the rest of the world’s economies in one very important way: the greenback is the currency of global trade. Any country that wants to buy oil, steel or food on the international market is almost certainly going to make those transactions in dollars. That means the dollar is essential (for now, at least). The world’s two hundred-odd countries are constantly converting their own currencies into U.S. dollars to pay bills overseas.

For other countries, if the value of their national currency drops, their bills (payable in dollars) get more expensive. This phenomenon helped trigger the Asian financial crisis in the late 1990s: Thailand devalued the Baht, which meant that the many companies that borrowed in U.S. dollars suddenly needed a lot more Baht to make their loan payments.

The fact that the U.S. doesn’t need to convert its currency purchase goods in the world market gives us one very powerful privilege: we can print dollars (i.e., devalue the currency, as explained above) to pay back our debts — within limits, that is.

The risk is that the world’s biggest economy could catch a small case of what ailed Zimbabwe. The dollar could get overly feeble, making it prohibitively expensive for Americans to travel abroad and pay salaries overseas. And foreign products could get prohibitively expensive. Most importantly, an overly aggressive policy of printing money to repay debt could make dollars a bad investment for foreign governments (especially China, which holds trillions), by making their dollar holdings less valuable. Eventually, this could possibly jeopardize the greenback’s status as the currency of choice for commerce — which would be very destabilizing for the global economy.

In brief, the Fed is betting that $600 billion is a small enough sum to give the U.S. economy the appropriate jolt, without risking the dollar’s special status. It’s betting that the right amount of quantitative easing could be a good thing for the U.S., by warding off deflation, by making our exports cheaper (via a cheaper U.S. dollar) and by making investment less expensive (via lower interest rates). If the plan works as the Fed hopes, QE2 could spur economic growth and create much-needed employment, digging the economy out of its current rut.

The big question, however, is this: what will happen to all the extra money flowing into the economy from QE2? Will it be invested wisely – building jobs and businesses that will generate revenue and in turn help grow the economy? Or will the money chase down bad investments, leading to more waves of bad debt like we’ve experienced over the past several years?

As any close observer of the news knows, we’ve been down this road before. There are plenty of signs that while some good will come of QE2, in the long term the money may not be spent wisely.

For starters, easy money has a troubled track record. Over the past decade, the Fed kept a loose money policy for far longer than many economists were comfortable with. The result: investors threw cheap money at bad deals.

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In the late 1990s, this led to the dot-com bubble — when any half-baked business idea that slapped a “dot-com” at the end of its name was suddenly worth a fortune, regardless of its prospects for earning money. We deluded ourselves into thinking that any could generate truckloads of cash. Accolytes of the digital revolution preached a frictionless economy, disparaged bricks and mortar, and predicted a 20-year boom.

This ended, of course, in the 2000 dot-com crash, when worthless companies with soaring stock prices suddenly couldn’t pay their bills, causing mass bankruptcies and wiping out trillions of dollars in paper wealth.

After the crash, as an economic pick-me-up, the Fed once again made dollars easier to obtain. Suddenly, bricks and mortars were in vogue. Investors poured the cheap money into real estate. This made everyone feel rich again for a while, and changed the American landscape. In Florida, California, and Nevada and across the nation, new housing developments sprung up like mushrooms on a rainy day.

Meanwhile, as all that easy money was flowing to real estate, prices rose quickly. Suddenly sitting on houses whose values had skyrocketed, American homeowners used their mortgages as ATM machines, refinancing loans to cash in on paper profits. And bankers — hungry for fees — gave loans to anyone who could sign their name, and some who couldn’t.

We now know that we built too much, and we built a lot of substandard housing that no one wanted. Money was too easy, and the real estate investment ideas simply weren’t good enough to create the growth that would sustain the economy. The bubble inflated, and then it burst. This time around, instead of dot-coms, the most immediate victims were the Wall Street firms that had borrowed far too much – Bear Sterns, Lehman Brothers — forcing the government to rescue others, to ward off a complete collapse. Main Street, where all those new homes were built, suffered as well.

That’s not to say that easy money is a bad thing. On the contrary, the Fed has largely used versions of this strategy for decades, to tweak the economy when it’s down, and to rein it in when it gets too hot — albeit not always quickly enough.

The trick is to make money just difficult enough to obtain so that it lands in the right hands, funding worthwhile ideas, while avoiding, for example, and cheesy housing.

So the big question now is, where exactly will all the new money go? Are there great ideas out there that are just waiting for interest rates to drop, so that they can create useful products and services, putting Americans back to work?

Maybe not. What appears to be lacking are good new ideas, not cheap money. Already, there’s a huge amount of cash out there now, lying dormant, ready to be invested by some of the country’s most sophisticated, determined and ambitious executives. Unfortunately, these executives aren’t finding enough good ideas to invest in.

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America’s major corporations are sitting on trillions of dollars in reserves that could be put to use, without borrowing a dime. Apple alone holds a staggering $51 billion in cash. Surely, if executives saw ways that they could invest it to make more money, they would; that’s precisely what they’re paid big salaries to do. So will QE2’s modest decrease in interest rates spur them into action? Probably not.

The problem isn’t limited to big companies. These days, some of America’s best and brightest business minds work for private equity firms – companies whose job it is to invest money for wealthy institutions and individuals. Like corporate America, these firms are also sitting on billions in reserves, unable to identify compelling enough business ideas to commit their funds to.

So really, does business need more cash? What will it change?

Here’s a radical idea: maybe the private sector doesn’t have the right arms to fight this battle. At its core, economic activity is all about fulfilling society’s material needs. Surely, America has plenty of needs: better infrastructure and schools, for example, or trains that can improve efficiency by moving us from New York to Boston or LA to San Francisco at 200 miles an hours, like the bullet trains that shuttle around our competitors in China. Moreover, as billionaire oil tycoon T. Boone Pickens has argued, America also needs to rethink its power grid, to build a green economy, and stop the annual three-quarters of a trillion outflow of U.S. dollars to oil exporters.

The problem is, the private sector is ill-equipped to take the lead in tackling these needs. They’re matters that demand government leadership. QE2 won’t help, and with the anti-government tea party movement on the rise, any solution led by the government is probably off the table.

So if America’s best business minds can’t figure out what to do with its extra cash, and if government spending is a non-starter, where will all the Fed’s easy money flow? As GlobalPost pointed out earlier this week, emerging nations — currently in vogue with investors who see better potential returns there than in the developed world — are concerned that they’ll be the target. If the past is a predictor, their equities markets could soar, then crash, starting the whole process over again, and leaving the wrecks of QE2 — and all the pain the we’ve been suffereing lately — on their shores.

Author David Case heads GlobalPost Research, a custom research service for private clients.