Reply #33: Your puzzle is missing some pieces

[girl gone mad]

Quantitative easing was an attempt to push up asset prices by increasing bank liquidity. The Fed was hoping to reinflate housing, ultimately. That was never going to happen for reasons which should have been obvious to all at the time. Instead, the money flowed into commodities and equities. The problem is that the real economy never recovered enough to sustain the new liquidity-driven prices formed in these markets. In other words, the Fed merely blew more bubbles. Now markets are signalling that we're on the precipice of another sharp reversion to the mean.

Here's Koo's statement from April:

In the hope of producing a portfolio rebalancing effect, Chairman Bernanke declared that the Fed would purchase $600bn in longer-term Treasury securities between November 2010 and June 2011. This was roughly equivalent to all expected Treasury debt issuance during this period.

From a macroeconomic standpoint, these purchases of government debt meant that—in aggregate—private-sector financial institutions would be unable to increase their purchases of US Treasury securities, because all of the growth in Treasury issuance would be absorbed by the Fed. The fact that US businesses and households were rushing to repair balance sheets by deleveraging meant that—again, viewed in aggregate—private investors would be unable to increase their purchases of private-sector debt.

With the private sector no longer borrowing and all new issues of government debt being absorbed by the Fed, US institutions found themselves with few investment options. So funds found their way to equities and commodities

The only remaining destinations for these funds were equities, commodities, and real estate. Real estate had just been through a bubble and remained characterized by heavy uncertainty. In commercial real estate, for example, banks—at the request of US authorities—are engaging in a policy of “pretend and extend” and offering loans to borrowers whose debt they would never roll over under ordinary circumstances. That means that current prices do not accurately reflect true market prices. Housing prices, meanwhile, resumed falling late in 2010. The only remaining options for private-sector investors have been stocks and commodities. That, in my opinion, is why both markets have surged since the announcement of QE2.