Do We Need QE3?

Yesterday was an interesting one for the stock market. There was plenty of negative news hitting the wire — from the EU’s continued inability to decide on a course of action, to the continued standstill of our own budget debate.

But investors glommed onto a suggestion from the minutes of the last FOMC meeting that QE3 could happen if the economy continues to struggle, and stocks rallied sharply right at 2 pm. The mini-rally reversed just as quickly as it began.

The stock market would clearly like more quantitative easing. But it would not be a good thing for the economy in the long run. It is time to let this economy slog through the housing problems and the unemployment problems without flooding the market with cash.

Let’s hope that Bernanke remembers his statements that QE2 sparked commodity inflation and other imbalances. The last thing we need is new asset bubbles while we struggle with debt.

I would chalk yesterday’s relative strength of the stock market up to earnings season. We get the first round of heavyweights tomorrow in JP Morgan (NYSE:JPM) and Google (Nasdaq: GOOG), and it would seem that investors expect to hear good news.

Both stocks can certainly move the market, though I’m sure JP Morgan is the big one. Expectations have been ratcheted lower over the past couple of weeks. And the reasons run the gamut from lower trading revenue, fixed investment revenue and the effects of financial regulation and new capital requirements.

JP Morgan is usually a good bet to beat estimates. We’ll see if the company can manage another good report.

I know a lot of people don’t like George Soros. But he’s a great investor who can be counted on to offer great insights and quotes about investing and the stock market. I came across a few tidbits from Soros that I wanted to share…

The collapse of the financial system as we know it is real, and the crisis is far from over.

The crisis in which we find ourselves is … a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse.

If you don’t know, the Efficient Market Hypothesis says that all information that can be known, is known, and is priced into the stock market. According to this theory, it should not be possible to outperform the market consistently over time.

Of course, that’s just silly. But the reason Soros brings it up is important. He is saying that regulators and investors themselves too often believe that the market polices itself in a form of enlightened self-interest when it comes to risk-taking.

It should be very clear in the wake of the financial crisis that this simply isn’t true or realistic. For instance, former Fed chief Alan Greenspan used to like to say that derivatives spread risk around and so lessen it. He was wrong, but that attitude is pervasive.

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend toward equilibrium… It can be summed up in two propositions:

1. Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality.

2. Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect.

In order to control asset bubbles it is not enough to control the money supply; you must also control the availability of credit… The best-known tools are margin requirements and minimum capital requirements. Currently, they are fixed irrespective of the market’s mood, because markets are not supposed to have moods. Yet they do, and the financial authorities need to vary margin and minimum capital requirements in order to control asset bubbles.

These observations seem obvious, but Soros is suggesting a pretty radical departure from current monetary policy. In fact, the tactics he is recommending sound a lot like what China is doing to fight inflation there.

Soros’ solution to asset bubbles basically entails clamping down on banks and other lending institutions. Interest rates haven’t worked so far, but that’s in part because whoever is at the switch has been slow to recognize an asset bubble.

And of course, part of the reason that we have asset bubbles is because investors are emotional. It’s probably not realistic to expect our central bankers to be unemotional.

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