Vernon Smith on QE2

Vernon Smith is a Nobel Laureate in Economics and one of my favorite economists.  He has written on the root causes of the housing bubble which ties into his experimental research on asset pricing.  In his Wall Street Journal article, “What Ben Bernanke May Be Thinking,” he identifies a common feature of the Great Depression and the Great Recession, questionable housing loan assets that have not been revalued, and suggests that Fed Chairman Ben Bernanke may be attempting to deal with this problem with Quantitative Easing 2 (QE2).

In both the Depression and the post-World War II era, recovery from a recession has been regularly signaled by an increase in housing investment. But new housing construction expenditures have remained stubbornly flat since the Great Recession was declared over in the second quarter of 2009.

Housing and aggregate demand have not recovered because nearly 15 million owners are estimated to owe about $771 billion more on their homes than they are worth. The banks are on the other side of this crunch, holding overvalued mortgage assets. This fuels doubt about the balance sheets of the big banks… …QE2 just might work if it is implemented as a surgical strike at the still-unresolved problems of negative equity in housing and banks. Mr. Bernanke's first round of quantitative easing in 2008-09 lifted about $1.2 trillion of shaky assets off the balance sheets of banks, replacing them with nearly a trillion dollars in excess reserve deposits. The second round will further expand these deposits.

So perhaps the Bernanke message here is for the banks to deploy those excess reserves to reset the value of their loan assets to current housing prices. They could do so by issuing new mortgages with lower principal amounts. While they would take short-term losses, this action could allay doubts about the value of the assets on bank balance sheets and would help the balance sheets of homeowners as well.

Is this what Mr. Bernanke is thinking? The rollout of QE2 was coupled with a Nov. 17 Fed announcement requiring the large banks to undergo another review of their capital and ability to absorb losses.

There is good reason for Mr. Bernanke to be worried.