Would it really be “treasonous” for the Federal Reserve to increase the money supply over the next 15 months? Rick Perry says it would be.
Virtually all economists, liberal or conservative, Republican or Democrat, academic or Wall Street – even those who are highly critical of Fed policy over the past four years – would disagree with the Texas governor and Republican presidential candidate. But why should the average citizen care?
The answer is that the economy still is in trouble. Unemployment is still high and output well below our nation’s productive capacity. There are signs of economic slowing, and deflation is always a danger in recessions that follow financial crises. And while the acute financial-sector problems of 2008 have subsided, the dangers of another such situation arising are real. Given all of this, it is important that our nation have a central bank that is willing and able to act as any situation may demand in the months ahead. And that might involve further substantial increases in the money supply.
Perry’s assertion, however, says much about the current state of the electorate and of public understanding of the Fed’s role in our economy. Many obviously are angry about what has happened and think the Fed has played a harmful role. Are they right?
First, let’s review of what central banks do:
The Fed does many things. It regulates banks, clears checks, operates electronic money transfer networks, handles the federal government’s checking accounts and circulates currency. Most important, it increases and decreases the money supply and thus lowers or raises interest rates. And it acts as a “lender of last resort” to financial institutions when a financial-sector crisis threatens to bring down the economy.
This last function, while rarely needed, is the most important, the most misunderstood and, right now, the most resented by the general public.
Since the most recent debacle began to unfold in August 2007, the Fed has intervened nearly continuously and has increased the underlying base of the money supply by unprecedented amounts. Much of this increase took place from March 2008, when the investment bank Bear Stearns went broke, into the first months of 2009 as the shock waves of the failure of Lehman Brothers echoed through the economy.
Some of the increases in the money supply occurred via open-market operations, the purchase or sale of government bonds or other securities. When the Fed buys a bond, it pays for it by creating new money. Such operations are the bread-and-butter way the Fed has regulated the money supply for 80 years. There were two differences this time. First, the amount of base money created was unprecedented. Second, the Fed bought mortgage-backed bonds and other securities it never would have touched before.
The Fed also made direct loans to commercial banks, investment banks and even insurance companies like AIG. This was the most visible, and hated, part of what the public knows as “bank bailouts.”
After the financial sector stabilized in 2009, but as the U.S. economy fell further into recession, the concern of the Fed shifted from preventing immediate collapse to ensuring the economy did not slip into a deflationary spiral. The degree to which deflation is more to be feared than moderate inflation, especially in the wake of a financial crisis, is something the general public does not appreciate, but on which economists generally agree.
Finally, over time, but especially in 2010, the Fed increased the potential money supply in an attempt to increase national output and reduce unemployment. This third effort, that of general stimulus, is controversial even among economists. Keynesians support it while members of other schools do not. Moreover, it is anathema to many rank-and-file Republicans, even if some noted Republican economists support it.
The fears of collapse that pervaded 2008 have abated, as has the immediate threat of a deflationary spiral. So is Perry right? Does the Fed have any reason to increase the money supply over the next 15 months? Would doing so constitute goosing the economy for the electoral benefit of an incumbent president, as Arthur Burns did for Richard Nixon in 1972?
The answer to that depends on one’s views of the probabilities of either a lapse into a second officially defined recession or a second acute financial-sector crisis, perhaps triggered by events in the eurozone.
Most economists, even those who oppose general monetary stimulus, see these as real dangers and thus would support the Fed’s taking emergency actions, if necessary, that inherently would involve increasing the money supply. Bernanke and his Fed colleagues take their own oaths of office seriously and won’t swear off this capability because of political sniping. Rick Perry, Michele Bachmann and other candidates seeking support from the tea party wing of the Republican Party implicitly downplay the risks of a recession or another financial crisis, or dispute the responsibility and capability of the Fed to act. The general public will have to decide whose judgment merits the most trust.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.