Leaving Himself Some Room

 | Sep 22, 2011 | 3:30 PM EDT  | Comments
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The Federal Reserve decision yesterday was pretty close what I discussed in my column on the matter last week. The Fed had two variables to solve for: duration and balance sheet size. Chairman Bernanke chose wisely, and probably necessarily, to solve for duration this time, leaving himself room to expand the balance sheet again in the future. As such, questions about what securities the Fed can and will hold have been answered.  

But the Fed also chose to act on a smaller scale than what the markets had expected. This provides insight into what the Fed is setting up for in the future.

The first round of quantitative easing involved around $1.5 trillion, the second around $600 billion, and QE3 was some $400 billion. The markets wanted something bigger than QE2 -- and they'll probably get it before next June, when this round is due to be completed.

In other words, the best way to think about yesterday's announcement was that it was QE3.1: solve for duration. QE3.2 will shift back to expanding the balance sheet. Because the Fed came in under market expectations this time, they'll have room to do so.

In short, the Fed's move yesterday was a smart one. I'll comment more in the future on monetary policy, but will conclude here with this: I expect the Fed's balance sheet will be at least doubled from its current size before that process has been completed.    

Form Before Function

Europe, should it collectively wish to do so, has the financial and economic capability to solve the issues they are facing, and to hold together the eurozone and currency. The problem faced by European authorities of all kinds is that they appear to be very rigid in their thinking. They create rules and then attempt to abide by them strictly, even when they have broken down and are clearly not workable.

I wrote about this about a year and a half ago as the Greek crisis was building. The Stability and Growth Pact, and inflation-targeting systems for fiscal and monetary policy, are not viable and must be changed. I addressed this in the column above so I won't detail it here.

But that's just one component of the issue.

The principal reason that Europe's situation has reached its current state is that these governments have been, and continue to be, reactive to the growing problems. They are deluding themselves into believing that they can violate the existing operational agreements between countries, that this situation is temporary, and that the existing rules will eventually be enforced again. That is what has led to their current stresses.  

The European Central Bank has had to step in with essentially an open-ended promise of capital to the banks -- perpetual quantitative easing. This, of course, would be in direct violation of the ECB's mandate. The first thing that must be done is for the leadership in Berlin, Paris and Brussels to admit that the existing rules are broken and not workable. They don't have to create a new set of fiscal and monetary mandates immediately. They just need to admit these acts will be necessary after they've gotten this crisis under control. Once that has been acknowledged, the focus can become the immediately necessary corrective actions, a process already set in motion when the ECB provided capital.

There are only two ways out for the European collective. One is sovereign defaults and the possibility of a disbandment of the euro and the collective. The other is moving forward now with a fiscal union and the issuance of eurozone bonds. After 50 years of planning, it is far more probable that Europe will choose to move forward with a fiscal collective, rather than move backwards and disband.

Further, the ECB, in providing the necessary capital and debt, has essentially burned the bridges behind it. At some point -- hopefully very soon -- the leadership in Europe will realize that the costs of disbandment would be more costly than the costs of fiscal union, and this process will almost certainly involve the U.S. Fed, Treasury and International Monetary Fund.

Yes, along with fiscal union comes the loss of sovereignty. But that was always the plan anyway.

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