Friday, March 25, 2011

A Soft Economy Amidst a Sea of Liquidity

Some parts of the economy have returned to pre-crisis levels. The stock market for one. The stock market is now well ahead of where it was just prior to the collapse of Lehman Brothers. Prices of the best buildings in NYC and London are nearing the peaks reached in 2007, if not exceeding them. Luxury homes are on the rebound. Yet the overall US economy is moribund and headed nowhere. How can this be?

The simple answer is the Federal Reserve. The Federal Reserve is monetizing substantial amounts of US treasuries (buying treasuries, in other words). This is equivalent to printing money instead of selling debt from the point of view of government financing. This is QE2. This process, QE2, adds enormous amounts of liquidity to the financial system, available to whatever suits the fancy of the financial system. Normally, such excess liquidity feeds directly into asset prices -- stocks, bonds, high end real estate -- and that is exactly what has been happening.

Business is not really using the excess liquidity to expand capital equipment and employment. Business is not optimistic about the future, mostly because business understands all too well what the Obama Administration is all about. Instead the excess liquidity is being soaked up into an asset bubble -- a bubble that will inevitably end badly.

Don't look for further rallies in asset prices. QE2 is coming to an end soon and there is not likely to be a QE3. Incredibly slow economic growth will continue on pace for the next two years as we slog our way to a 7-8 percent unemployment range with rising inflation -- a condition known as stagflation. Stock prices will stall here and bond prices will get hammered. High end asset prices, rising now from Bernanke's foolishness, will settle back to earth. There won't be a crash or a double dip, but the asset price rally will be ending soon while the economy will continue to trudge along.

The big unknown is the exploding debt nightmare. That nightmare could upset the slow moving turtle that is the American economy.