SANTA BARBARA, Calif. (MarketWatch) — Dr. Frank Shostak, an Austrian theory economist who works for MF Global, and who writes for Mises.org on economics, came out with an article this week on what will happen when the Fed freezes its balance sheet in June, as they have said they will do.

I very much enjoy Shostak’s writing and have followed his ideas for years.

In this article he says:

“We suggest that once Fed policy makers freeze the balance sheet of the US central bank it will slow down the growth momentum of the Fed’s balance sheet. Consequently, this is going to exert downward pressure on the growth momentum of the money supply. Note that ultimately it is fluctuations in the growth momentum of the money supply that set in motion fluctuations in the pace of formations of bubble activities. As a result, various bubble activities that emerged on the back of the rising growth momentum of the money supply will come under pressure — an economic bust will be set into motion.

“Obviously it is possible to have a situation where commercial banks’ expansion of lending “out of thin air” counters the freezing of the Fed’s balance sheet. It remains to be seen whether this is going to be the case in the months ahead. For the time being, the Fed’s balance sheet continues to expand at a rapid pace. …

“Now, we suspect that the difficulty the Fed has had in meaningfully “reviving” the economy so far could indicate that the state of the pool of real savings or the pool of real funding is in trouble. This means that even if the growth momentum of lending does currently show some strengthening ... it is highly unlikely that, with the weakening of bubble activities on account of the Fed’s freezing its balance sheet, commercial banks will pursue an aggressive expansion of credit out of thin air. Also, it is quite likely that with the freezing of the balance sheet, Treasuries will come under pressure, and the growth momentum of banks’ holdings of Treasuries will weaken. This in turn will exert downward pressure on the growth momentum of total bank lending, which includes lending to the government. …

He predicts that CPI growth will reach 5% by year-end.

“We suggest that once Fed policy makers freeze the balance sheet of the US central bank, the growth momentum of the money supply will slow down. As a result various bubble activities that emerged on the back of the rising growth momentum of the money supply will come under pressure. A visible strengthening in the growth momentum of the CPI may prevent Fed officials from introducing QE3 as suggested by some experts.

There are several aspects of this conclusion that I wonder about. The basic issue is whether or not the Fed will let their balance sheet “freeze” at its current $2.75 trillion level or will the Fed be eventually encouraged to undertake QE3.

End of QE2 Pits Traders Against the Fed.

I agree with everything he says about the bubble consequences of the money supply expansion. The vast amount of liquidity the Fed pumped into its primary dealers have fueled the stock markets and the current M&A splurge. It has also provided liquidity to the corporate markets which makes borrowing cheap. That is why you see companies like cash rich Google GOOG, +0.01% ($35 billion in the till) borrow $3 billion on the bond market at an average of 2.33%.

It makes sense that when the growth momentum of quantitative easing stops, that this will eventually affect the markets, usually six to nine months later.

Shostak sees that this will put downward pressure on credit expansion by banks and thus the money supply will shrink. I think that is correct as well. We have seen some growth in lending activity recently and, as I have written lately on this, it is likely that this will stagnate.

But there are two factors which lead me to believe that it is more likely that we will see more quantitative easing.

While Shostak concludes that the Fed is wary of price inflation (that they are causing) and that this will deter another round of money pumping, I think the primary motivation behind QE is unemployment, not price inflation.

The consequence of taking their foot off the money pedal will lead to higher unemployment and I do not think this is politically acceptable to the Fed or to the Administration. I think they will institute a new round of quantitative easing (QE3) because politicians will demand that the Fed “do something.” Which is, of course, the worst thing they could do. It will lead to more “bubble” activities and higher price inflation. See Will Fed Insist on Trying to Ignite Unhelpful Wealth Effect?

I believe the Fed and the Administration will be willing to tolerate a higher level of price inflation and for a much longer period of time, despite the inflation hawks’ warnings. I think this new money stimulus will occur no later than during the start of the presidential election period (January, 2012), and will continue until the winner is sworn in. I think Dr. Bernanke will be fired thereafter.

This would also cast a different light on Treasurys. If I am correct, then the Treasury market would, post-QE3 remain as it is today. It is likely though, that between June and when the new QE round occurs, the freezing of their balance sheet will take some pressure off the Treasury market as Shostak suggests.

Assume that I am incorrect, and the Fed doesn’t embark on a new round of QE. Where will money go? I believe there is sufficient demand from institutional and foreign sovereign buyers to keep the market up and keep yields low, despite growing price inflation. It is likely that eurozone problems will continue for quite some time in the future -- at least two more years if I were to guess -- and that institutional and sovereign investors will continue to park money in Treasurys, despite what China, Russia, and other BRICs may say. China has no real alternative. It is conceivable that Japan will reduce its Treasury holdings, and possibly be forced to borrow on the international market in order to fund its reconstruction. But the PIIG problem will continue to drive money into Treasurys. The End of QE2: Does it Matter?

The Fed is serious about freezing its balance sheet starting in June. They will continue to buy Treasurys as issues mature and are replaced. But, as Shostak points out, the momentum of money growth will slow down and that is the key to understanding what will then happen. If Treasury rates do not take off, then my assumption about domestic and foreign demand for Treasurys will be correct. If they do take off, it will be an indication of a shrinking money supply as Shostak points out which will lead to economic stagnation or even a market bust. On the other hand, I don’t believe the Fed will play “chicken” during an election year, and when things turn ugly they will announce QE3 and that will kick the can down the inflationary road. QE3 may be the last installment of this monetary madness.