Don’t be reassured by Fed Chair Ben Bernanke’s bland assurances to Congress last week that the Fed can safely unwind all of the monetary expansion embodied in various financial sector bailouts over the past 23 months.
Remember that he represents the institution that helped inflate the 2004-2007 asset price bubble in the first place.
It also said no one need worry about such bubbles since it could easily clean up any mess when they popped. And its officials further assured us that any harm from the subprime mortgage mess would be “well-contained.”
History probably will show that Fed measures since mid-2007 to stabilize the financial system were critically needed. Moreover, on the whole, the steps taken often were the least bad alternative at the time.
But make no mistake. The scope and size of the Fed’s actions are unprecedented. Never before, anywhere, at any time, has a central bank created so much liquidity in so short a time. It took place as a series of ad hoc, often desperate measures.
The idea that it can be cleaned up neatly strains credulity.
The unfortunate problem is that the ability to spin a story is one of pre-requisites for being Fed chair. Investor and consumer confidence is crucial to getting out of financial sector crises and recessions and at times the bare truth from a central bank head can undermine such confidence.
Imagine what would have happened if he had said this: “We got ourselves into a hell of a mess but have been able to move to a somewhat less dangerous one. We will do our level best to work our way out of it, but no one knows for sure how it will go.” Financial markets would have gone nuts and shaky household confidence would have slid further.
But the real task is daunting. To understand it, a brief lesson about the Fed and the money supply is necessary.
The money supply is not confined, as some think, to the number of dollar bills in circulation. It does include such currency, but varying types of bank deposits make up the bulk of the money supply. Exactly which deposits are included determines technical measures of the supply — such as M1 and M2.
Banks that accept deposits are required by law to keep some as reserves. They can loan out the rest or buy certain securities such as Treasury bonds. Or they can choose to hold cash in the form of “excess reserves,” deposits not lent out or invested but above the minimum levels required. Bank reserves can be held as currency in the bank, as so-called “vault cash” or in an account at the Federal Reserve.
The Fed can create new reserves at will by direct lending to banks. The money it lends, as it has done massively over the last 18 months, does not come from anywhere else. It did not exist before. The Fed simply creates it. (And when the loan is repaid, the money is effectively destroyed.)
The Fed can also create new reserves by purchasing government bonds or, in unusual circumstances like now, private sector bonds and other securities. When it buys these on the open market, it essentially writes a check on itself. The seller deposits money that does not have to come out of an account at some other bank as it would if someone other than the Fed had bought the bond.
Both “discount window lending” and “open-market operations,” result in more reserves in the banking system that can be lent out if banks choose. To the degree that they lend actively, a given Fed-engendered increase in bank reserves causes a proportionately greater increase in the money supply.
That is because the same initial additional dollar is lent more than once. A bank makes a loan which gets deposited somewhere. That bank now can lend out most of this new deposit, less only the amount the law says they much keep as “required reserves.” The new loan gets deposited somewhere, becomes the basis for yet another loan and so on.
What the Fed controls, currency plus bank reserves, is called the “monetary base.” The money supply, currency plus bank accounts is several times larger. From 1975 to 2005, the money supply as measured by M2, the most relevant indicator, ranged from eight to 12 times the monetary base.
In its emergency operations, the Fed doubled the monetary base in the last 24 months. M2 increased by only 16 percent over the same period since banks are reluctant to lend, short-circuiting the normal monetary expansion effect described above. But if a reviving economy prompted more normal lending, the reserves lying quietly in the monetary base could make the money supply mushroom.
Total Fed loans outstanding increased from $187 million in June, 2007 to $439 billion in June 2009. Bernanke asserts the Fed can painlessly reverse this lending increase and bring the monetary base down to normal levels with no inflationary potential. Moreover, he claims, this can occur without inhibiting recovery from a stiff recession.
I hope he is right. But the history of past financial crises around the world indicates we should not place too much trust in his bland assurances.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.