Campaign For Liberty
Monday, Nov 2nd, 2009
The government has seized and spent so much in just the last year that it’s easy to focus on the issues of the day, losing track of the big picture. In this article I want to step back and survey the incredible growth, from the perspective of monetary policy and then fiscal policy. The situation is dire indeed.
The Federal Reserve and the Money Supply
Undoubtedly the biggest economic issue in free-market circles has been the extraordinary actions of the Federal Reserve since the onset of the crisis in the fall of 2008. To immediately get people to see what all the fuss is about, I like to show this chart from the St. Louis Federal Reserve:
The United States has a “fractional reserve” banking system, meaning that if you added up all of the checking account balances for the customers of a given bank, the total amount of deposits would (typically) far exceed the amount of cash reserves in the vaults of the bank. That’s why a bank run is so deadly: the bank doesn’t have enough cash on hand to satisfy its customers if they all try to withdraw their money at the same time.
Legally, banks must keep some reserves to “back up” their customers’ deposits. The exact amount depends on details that we can overlook; the rough rule of thumb is a ratio of 10 percent. Complicating things somewhat, a bank’s reserves don’t have to consist entirely of cash sitting in the vaults; a bank can also have its own “checking account” with the Federal Reserve itself, and those balances count as part of the bank’s reserves.
Now we can understand the chart above. In normal circumstances, banks will make new loans — and thus expand the total value of their customers’ checking account balances — until they are “fully loaned up,” meaning until they have hit the legal limit where their reserves are just sufficient to meet the legal requirements. This means that when a bank has “excess reserves” — namely, reserves over and above the legal requirement — the bank has an incentive to lend them out and earn interest. So that is why excess reserves historically have been very close to zero.
Yet the chart shows that starting last fall, excess reserves exploded, and are now at some $850 billion. (In a minute I’ll explain where all those new reserves came from.) But if Bernanke has created so much new money so quickly, why haven’t prices risen rapidly as well?
The answer is that we are in a fractional reserve banking system. For the most part, banks haven’t lent out the new reserves that Bernanke has injected into the banks. If and when they do start lending out their excess reserves, the money supply held by the public will grow very quickly. Using a back-of-the-envelope 10% multiplier, there are enough excess reserves in the system to support a total of $8.5 trillion in new loans.
In practice that is too much, because people will hold some of the new loans in the form of currency and so forth. Let’s be conservative and call it a mere 5 trillion new US dollars in the wallets and checking account balances of the public. To gauge how much new money this would represent, right now the monetary aggregate “M1” (basically cash held by the public, checking accounts, travelers’ checks, and other liquid assets) is about $1.65 trillion. So an injection of an additional $5 trillion would mean a quadrupling of the narrowly defined money supply held by the public. Other things equal, then, current gas prices of about $2.50 a gallon would increase to $10 a gallon when everything settled down.
Yet even this is too optimistic, because the calculation assumes the worldwide demand to hold dollars stays constant, which it surely would not in such an environment. During an email exchange with Jeff Hummel, we came to the (very rough) conclusion that if the worldwide demand to hold dollars fell in half, that would be akin to a 30% increase in the domestic money stock (using the current levels, not the inflated one). To sum up, then, if Bernanke sat back and let the banks lend out their current stockpile of excess reserves once they felt comfortable doing so, there would be enough new money created to make $11 gasoline the new reality.
How Did Bernanke Increase Reserves?
Not only did Bernanke inject the financial system with hundreds of billions of new reserves, but the way he did it was also very troubling. In general, the Federal Reserve “injects liquidity” by buying assets in what is called “open market operations.”
This is where all the magic happens, and what separates the Fed from any normal entity in the marketplace. Simply put, if the Fed wants to engage in a “loose” policy and push down interest rates, it buys assets and adds them to the Fed’s balance sheet. To pay for the assets — here’s the magic part — the Fed simply writes checks on itself. There is no finite quantity of dollars that the Fed has in its account; it can write as many checks as it wants, and they never bounce.
Normally, the Fed’s open market operations involve Treasury debt. Traditionally, when the Fed wanted to cut interest rates and stimulate the economy, it would buy Treasurys from the private sector, thereby infusing new reserves into the banking system (when the Treasury sellers deposited their new checks, written on the Fed). The new reserves were then quickly lent out, expanding the overall money supply. Going the other way, if the Fed wanted to raise interest rates and suppress economic activity, it would sell Treasurys from its balance sheet, and the checks written by the buyers (drawn on private banks) would drain reserves from the banking system once the Fed deposited them.
Yet this all changed during the financial crisis. Bernanke has been intervening not just to provide a general monetary stimulus, but has also been actively trying to resuscitate individual sectors. Look at the composition of the Fed’s balance sheet over time:
(The above chart was produced in May 2009. The most recent version is available here: http://www.clevelandfed.org/research/data/credit_easing/index.cfm.)
As the chart indicates, the Fed has been introducing programs at a pace that would have impressed a New Dealer. Some of the biggest (new) holdings are in mortgage-backed securities, Federal Agency debt (i.e. bonds issued by Fannie Mae and Freddie Mac), and longer-term Treasurys (the purchase of which has been called “quantitative easing”).
Even putting aside the specter of rampant price inflation, Bernanke’s bold innovations set a very alarming precedent. He literally has the ability to revive or destroy entire sectors in the economy, by choosing to write checks written on thin air and spend billions of dollars taking bad assets or dubious debt issued by floundering firms.
Although most commentators haven’t said much about it, I think Bernanke used the financial crisis to incredibly expand the power of the Federal Reserve, relative to traditional branches of government. Recall that the Fed itself is a dangerous mixture, giving us the worst of both worlds: It has government force backing up its privileged position, but it ultimately is a cartel of privately owned banks. Not only does Bernanke claim that the Fed has the authority to create new money on a whim and bail out whomever he wants, but he doesn’t even think he needs to tell Congress who the recipients were, let alone get their approval.
Can the Fed Unwind Everything Once Price Inflation Heats Up?
Mainstream financial analysts, as well as Fed officials, acknowledge the potential inflationary timebomb. Yet they insist that the Fed will be able to suck the excess liquidity out of the system, once the economy recovers. Right off the bat, that answer should be troubling, because it assumes that stagflation — high price inflation and high unemployment — is impossible. But we know from the 1970s — and from Zimbabwe more recently — that “excess capacity” is no guarantee of stable prices.
More specifically, Bernanke and his apologists aren’t thinking two steps ahead in their “exit plan.” The two main options at their disposal (to contain rising prices) are to (a) sell off assets from the Fed’s balance sheet, thereby reversing the initial actions, and (b) pay interest on excess reserves, in order to bribe banks not to make new loans to the public.
The problem with option (a) is that the Fed very likely paid much more for its new assets — they were dubbed “toxic” for a reason — than it will get from private bidders if and when it has to unload them. Just suppose that there is another crash in real estate, at the same time that prices begin rising at an annual rate of 8 percent. (This is certainly possible, despite media reports to the contrary.) In that case, even if the Fed sold off its entire holdings of mortgage-backed securities and debt issued from Fannie Mae and Freddie Mac, it would not collect as much from private bidders as the Fed originally paid for these assets. Therefore, it would not remove the same amount of reserves as it had originally injected into the financial system. Its moves would thus not only further wreck the teetering real estate market, but they wouldn’t even halt the escalating price inflation.
The other option, paying interest on excess reserves, at best would only postpone the day of reckoning. Remember, the problem is that there are enough excess reserves in the system to fuel an enormous increase in the money supply and hence the prices of goods and services. How can it possibly be considered a “solution” to simply allow those reserves to grow exponentially?! Yet that is the primary answer that Bernanke has given lately, on the issue of containing price inflation.
The Fiscal Nightmare
As if the monetary issues weren’t frightening enough, we’ve also got the fiscal (i.e. government taxing and spending) side to consider. The Congressional Budget Office (CBO) makes periodic long-term forecasts of these matters. Here’s the projection from their June Economic Outlook:
The two dotted lines represent different modeling assumptions concerning tax and spending policies. Notice that the top line (i.e. the more alarming one) captures the path if the Obama administration’s plans are enacted. The media has reported that “Obama would double the federal debt in a decade” — meaning that the debt as a share of the economy would rise from about 41 percent in 2008 to over 80 percent in 2019. That is what the top line in the chart above illustrates. Notice though that it keeps rising like a rocket after 2019.
A few more observations: Both trajectories in the CBO chart above make many unrealistic assumptions, in order to isolate the pure effect of various spending decisions. For example, the models assume that increasing levels of government debt will not affect interest rates or otherwise drag on economic growth. In reality, of course, as levels of federal debt accumulate, long-term interest rates will almost certainly rise and economic growth will be slower because of crowded-out private investment. Thus government expenditures will be higher than the models are forecasting (because of higher interest payments to service the debt), and government tax receipts will be lower. Finally, the CBO models assume that the present recession is basically ending. Yet if we really are just at the beginning of the second Great Depression, then the above CBO chart will seem incredibly optimistic in the years to come.
The federal government and Federal Reserve have thrown all caution and discretion to the winds during the financial crisis. It is entirely possible — some would say even likely — that the US dollar will not be the reserve currency of the world within five years. Ben Bernanke and other officials have painted themselves into a corner, and unfortunately they will end up knocking out a few walls to make their escape. Those of us forced to use Federal Reserve notes, and pay federal income taxes, can only hope that they don’t take down the entire house with them.
This article was posted: Monday, November 2, 2009 at 4:59 am