The U.S. Monetary Base graphic (below left) shows the history of the U.S monetary base (currency plus bank reserves) since 1919.
Recently, the Federal Reserve increased this base by $1.2 trillion. This is known as Quantitative Easing 1 (QE1). The follow-up program, QE2, will increase the base by an additional $600 billion by this June.
Nothing has come anywhere close to this radical policy since the inception of the Federal Reserve.
Normally, the Fed increases the base by buying U.S. government securities. What follows is a period of monetary expansion that has been taught in money and banking courses in economics departments and business schools for many decades.
To see how monetary expansion works, assume banks are required to keep 10 percent of their loans as reserves. Also assume that the Fed now buys $1,000 of securities. Someone gets a check from the Fed for $1,000, and they deposit it into their bank. (The monetary base now goes up by $1,000.) With a reserve requirement of 10 percent, the bank is free to loan out $900 (90 percent) of the deposit. The recipient of the loan deposits the $900 in another bank. This bank takes $810 (90 percent of $900) and makes another loan that again gets deposited. The process continues until the final increase in the money supply is 10 times the initial injection of reserves.
However, because the banks are currently afraid or unwilling to lend, monetary expansion hasnt yet taken place, and the broadest definition of the money supply has actually fallen throughout 2010.
Critically, however, with all these excess reserves in their possession, the banks are now in charge of U.S. monetary policy.
Three things can now happen all of them bad:
1. The banks can shake their fears, begin to lend and start the process of monetary expansion. Upon completion of the expansion, QE1 and 2 will explode into a 300 percent increase in both the money supply and consumer prices and a collapse in the value of the dollar.
2. The banks may not lend. QE1 and QE2 were designed to encourage bank lending. However, assuming those in charge of the banks are smarter than those in charge of the Fed, they wont lend, and not necessarily because they fear default. Even if the banks eventually overcome this fear, they still wont lend because they have taken a course in money and banking, and they understand that if they collectively do lend, they can expect these loans to be repaid in the mini-dollars of the future.
3. The Fed may walk this back. This would be done by selling $1.8 trillion in U.S. government securities. Selling at the same time, the U.S. Treasury is selling trillions in bonds to finance our massive federal deficit. Until recently, interest rates have been falling because the Fed has been buying more than the Treasury has been selling. However, if they both go on the sell side, interest rates will rise dramatically.
All three possibilities spell catastrophic news for consumer and financial markets, including the stock and bond markets.
In the case of No. 1, expect a collapse in the dollar, an expected permanent tripling in consumer prices and a very significant but temporary increase in nominal interest rates. In the case of No. 2, expect a very significant drag on the recovery. In the case of No. 3, expect the real rate of interest to skyrocket.
It should be stressed that this is not speculation on my part. This historic increase in the base virtually ensures one or a combination of the three outcomes.
Over the last seven months, I have made this argument to approximately 5,000 investment professionals and academics in more than 60 lectures in 16 countries. No one has successfully challenged its validity.
Bernanke needs to resign. Now.
Bob Haugen has written 15 books on the stock market published collectively in seven languages. He is the discoverer of the Low Volatility Anomaly (low-risk stocks tend to have higher returns) and the inventor of the Expected Return Factor Model. Based on 32 articles published in the top seven academic finance journals, he was recently ranked as the 17th most prolific researcher in the history of finance, worldwide. He has held endowed professorships at the Universities of Wisconsin, Illinois and California.