The Fed has purchased assets at above-market prices, temporarily expanding the monetary base, but they will suck it all out at exactly the right time to avoid inflation, right? The problem with this story is that it looks at the money as a big blob that somehow supports “the economy” during this tough period. But in truth, the economic crisis and the false asset prices are inseparable. The crisis is about establishing market prices for assets that were mis-priced by credit expansion.
The nature of the unsustainable boom is that relative prices of certain assets – houses, mortgage backed securities, and all of the mystery meat that came out of the Wall Street meat grinder – became artificially high. These price distortion caused resource misallocations: too many mortgage brokers, too many home builders, too many real estate agents, and too many houses. The prices of these assets were unsustainable in the sense that they do not reflect the balance between the scarcity of savings and consumer preferences.
The nature of the crisis is that the prices of these assets stopped moving away from their equilibrium values and began to move toward those values. The price adjustments of factors drive the re-deployment of labor and capital away from their current wasteful uses toward more economic uses. Securities are an indirect method of pricing these factors. For the crisis to finish its work, relative price adjustments and resource re-allocations must take place.
But the purpose of the Fed’s program of asset purchases is to prevent relative price changes from occurring by purchasing assets at above their market value (which in some cases is zero but in other cases may be above that amount). There is no way to support the prices of the assets “temporarily” “until the crisis is over” and then withdraw the money because the nature of the crisis is inseparable from the false prices of the assets. If the injections were to be withdrawn, then the relative price adjustments, and hence the cleansing process, would continue.
As Peter Schiff said in his ASC Lecture, they want to remove the excess credit from the system but keep house prices at a level that they reached only through an excess of credit.