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What do the banks do with this money? For the past few years, dealer banks, which are basically the largest US banks, have been plugging the holes in their accounts from the financial crisis - losses arising from sub-prime loans and commercial lending for sure, but perhaps more importantly all the losses racked up from reckless investments in collateralized debt obligations (CDOs) and asset-backed securities (ABS) even more.
The other effect of the US Fed purchasing federal government bonds is that overall yields drop; and therefore push investors off the "safe" investment choices to be replaced with other possibilities such as corporate bonds and non-guaranteed (riskier) government securities such as those issued by state governments and municipalities. Whilst that trickling down of investments has indeed happened - witness the sharp run up in ABS prices for the past three years - there are still significant gaps in the functioning of various markets.
Various states such as California have highlighted issues with their borrowing programs, but the story is much worse one level down at municipalities. Small cities across the US have been badly affected by the financial crisis, with many having to shut down essential services including fire and police to cut their overall spending, even as other expenses such as pensions have remained bloated and essentially out of control due to worker legislation.
Detroit, which announced a Chapter 9 filing on Thursday, simply was the largest city to have declared a filing thus far; it is unlikely to be the last. Given all the QE sloshing around the system, why is Wall Street not funding Detroit and similar cities? Simply because the intrinsic credit risk of such cities is far too high for bankers to enter into without sufficient downside protection.
Put another way, bankers don't want to jump out of the frying pan of subprime loans into the fire of municipal bonds. It is of course rather ironic that it was the initial granting of subprime loans that helped house prices to rocket up in various cities, pushing up property taxes (collected by cities), and in turn pushing them to increase wages and services. The revenue is gone, but the cost remains - hence the spate of bankruptcies.
From an intellectual perspective though, the question begs: why is the Fed bailing out private sector entities (banks) when public sector entities (cities) are going bankrupt?
Now, I am not one to recommend bailouts of either; but the question is key as it attacks the very basis of Keynesian idiocy that underpins today's QE programs around the US, Europe and Japan. The very notion of trickle-down economics is questionable when one considers the data - high unemployment in the US and Europe - and more so when one considers the mechanics.
Economists will immediately agree that under the above conditions, lotteries will immediately add to the gross domestic product of these countries running them, rather than very circuitous way that is employed currently, which has produced precious little for economic growth and/or employment. As winners will have to spend the money on buying consumer goods or buying houses, employment will immediately increase inside these countries as well.
Jokes aside, the point being made here is that QE hasn't worked for the economies involve. Rather, it has become a pure market phenomenon that seems completely divorced from reality and is also the key cause of market volatility, as the last few weeks' ups and downs have shown. Unless more thought is put into addressing the lack of any real economic impact, QE will remain a failure; and cities/states around the world will continue to go bankrupt.