Why monetarist theory is flawed

Federal Reserve Chairman Ben Bernanke really means it this time.

He will rescue the economy.

Ben S. Bernanke for the first time pledged that the Federal Reserve will buy bonds until the economy gets closer to his goals ... . The central bank yesterday announced its third round of large-scale asset purchases since 2008, with the difference that it didn't set any limit on the ultimate amount it would buy or the duration of the program. ... Bernanke is "going to fight and fight until he sees a real improvement in the economy," said a co-head of global economics research at [a major bank]." He believes quantitative easing can help the economy, so he'll just keep at it until there's a real turn in the economy."

Bloomberg, Sept. 14

But we've all heard the definition of insanity: doing the same thing over and over and expecting a different result.

Why should we think QE-3 will work when the previous two failed? (Don't think they failed? Then ask yourself why we need a third one.)

Granted, this round of quantitative easing appears open-ended. And it includes a pledge to purchase $40 billion a month in mortgage-backed securities. But high interest rates don't explain the sluggish residential real estate market. Home purchases are slow for the same reason that many business owners haven't expanded. A Sept. 12 CNNMoney article quotes a former Fed economist:

"Businesses are not hesitant to invest and hire because interest rates are too high - they're hesitant because of the uncertainty surrounding their future prospects."

When the August jobless rate fell to 8.1%, the widely reported reason was because so many people gave up looking for work. U.S. business startups are at record lows. Food stamp rolls recently skyrocketed. Several U.S. municipalities are declaring bankruptcy. Ratings service Moody's just warned of a possible U.S. downgrade. And the national debt just surpassed $16 trillion.

Monetary policy will not fix what ails the economy. Robert Prechter explains:

Monetarist theory holds that each new dollar created can support many new dollars' worth of IOUs throughout the banking system through re-depositing and re-lending, a process known as the "multiplier effect".... Every aspect of this theory is flawed, from the assumption that credit is fundamentally good for the economy and should always expand to the bedrock theoretical assumption that human society is a machine where physics equations apply. Waves of social mood have no place in monetarist theory, but they can play havoc with the monetarists' supposed machine when they reach extremes or undergo unforeseen (what other kind is there?) reversals.

The Elliott Wave Theorist, September 2011

Few people foresee a major economic reversal just ahead. The fact that Fed policy has become "QE Infinity" (it already has a nickname) tells us that something is badly wrong with the economy. And that something is a massive credit bubble

Monetary policy cannot make the global credit bubble simply vanish. Only a deflationary crash can do that. The chart below reveals why.

Look how fast the debt deflation unfolded in 1929-1932.

Learn what EWI expects regarding today's much bigger credit bubble.

See more charts and read insightful commentary that will help you position yourself now for what's to come next.

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This article was syndicated by Elliott Wave International and was originally published under the headline Bernanke's Bigger Bubble: QE-3 and the Coming Economic Crash. EWI is the world's largest market forecasting firm. Its staff of full-time analysts led by Chartered Market Technician Robert Prechter provides 24-hour-a-day market analysis to institutional and private investors around the world.