The mid-term election results appear to match what market participants expected in the days leading up to voting yesterday.  We will refrain from political commentary other than to make the observation that there is a difference between “benign gridlock” when the country’s course is essentially sound and gridlock when our fiscal situation is heading for disaster — which to us seems more like a suicide pact than a political strategy.  Meanwhile, the Federal Reserve is set to announce the details of its second round of quantitative easing later today.  QE2 is essentially a euphemism for printing money, which in our modern economy takes the form of the Federal Reserve buying treasury bonds of intermediate to long term maturities.

Bill Gross has referred to QE2 as a ponzi scheme and this criticism does not seem out of place.  An excellent critique of QE2 appeared in Greenlight Capital’s third quarter letter (pdf) to partners which was published on November 1.  Greenlight points out that the Fed’s initiative is much more likely to cause adverse consequences than to achieve any meaningful improvement in economic growth or employment.

Uncertainty or Lack of Liquidity?

Unlike the situation that prevailed prior to the Fed’s first experiment with quantitative easing, it is not obvious that today’s problems are due to liquidity constraints given the much improved financial condition of the banking sector and corporate cash hoards that have grown rapidly during the recovery.  The economy is facing massive short term uncertainty related to the implementation of health care reform and the fact that tax policy has yet to be finalized for 2011.  Additionally, the long term fiscal condition of the United States is not one that is likely to improve in a highly divided and partisan environment that will persist through the 2012 election cycle. In this environment, it is only prudent to proceed very carefully when it comes to investing or hiring.

As Greenlight’s letter also points out, the Fed’s actions are intended to manipulate interest rates in a manner that encourages two specific behaviors that have ponzi-like attributes.  First, speculators are buying long term government bonds not with the idea of holding the securities to maturity but with the goal of selling these bonds to the Fed or to other speculators at higher prices once QE2 goes into effect.  This is essentially the “greater fool” theory of investing and is bound to end in tears for those who get caught holding the securities when the music stops.  Second, the Fed is explicitly hoping that lower interest rates will increase prices of other financial assets that are commonly valued using models dependent on prevailing interest rates.

When The Music Stops …

At some point, the Fed will have to unwind the QE2 experiment to avoid generating much higher inflation.  At that point, the music will stop and we will find out how much current Fed policy resembles a ponzi scheme.  With Ben Bernanke securely in his position as Fed Chairman until January 2014, it would be refreshing to see him take a longer term view of the situation given that political figures in Washington are unlikely to have a time horizon longer than the 734 days that remain between now and the 2012 election.

Disclosures:  None.