The U.S. Federal Reserve on Wednesday stunned markets by announcing it would pump another $1 trillion into the ailing U.S. economy by buying long term government debt for the first time since the 1960s and by expanding its purchases of mortgage bonds.
This comes on top of actions the Fed has already taken over the past year which has exploded its balance sheet to over $2 trillion including an increase in the monetary base of approximately $1 trillion. The Federal Reserves actions right now will likely have an impact for years to come and may even result in a total breakdown of the economic system. In this post, I hope to reiterate some general insights from past posts related to inflation and some technical insight to the more economically inclined.
For the non-economist, the analysis can be reduced to a simple principle: there is no such thing as a free lunch. Wealth results from production. Paper notes can be created which are contractually redeemable for wealth - such as a certificate that entitles one to a certain amount of gold. In that case, the paper would represent a form of money. But the process can not be reversed, as any preschooler could probably tell you. In other words, one can not create the paper out of thin air and then pretend that it stands for wealth. If you do not believe me, go to a deserted island, and bring paper with $100 stamped on it and see what it gets you. Amidst all the complicated machinations of the Federal Reserve and all of the technical jargon of professional economists, in reality, it is this simple.
The act of counterfeiting money, which is essentially all the Fed does, like any form of fraud, is incredibly destructive as I have discussed in past posts [1,2] which include links to the most comprehensive explanation of inflation I have found, Dr. Reisman's treatise, Capitalism (if you wish to study the economic effects of inflation further, I highly recommend Chapter 9, of Capitalism: A Treatise on Economics by Dr. George Reisman. A fully downloadable and searchable version of the book appears on the author's site and can be downloaded by clicking this link) . In a wider sense, inflation is an example of a principle that I have often quoted - Ayn Rand's principle that fundamentally, all evil is a consequence of the attempt to evade the law of identity, i.e., the attempt to wish that reality is not what it is. In this case, the Federal Reserve is wishing that the paper they create will actually function as real capital. Quoting Atlas Shrugged (by Ayn Rand, 1957, p. 960-961):
“And that is the whole of their shabby secret. The secret of all their esoteric philosophies, of all their dialectics and super-senses, of their evasive eyes and snarling words, the secret for which they destroy civilization, language, industries, and lives, the secret for which they pierce their own eyes and eardrums, grind out their senses, blank out their minds, the purpose for which they dissolve the absolutes of reason, logic, matter, existence, reality – is to erect upon that plastic fog a singly holy absolute: their Wish.
“The restriction they seek to escape is the law of identity. The freedom they seek is freedom from the fact that an A will remain an A, no matter what their tears or tantrums -that a river will not bring them milk no matter what their hunger - that water will not run uphill, no matter what comforts they could gain if it did, and if they want to lift it to the roof of a skyscraper, they must do it by a process of thought and labor, in which the nature of an inch of pipe line counts, but their feelings do not - that their feelings are impotent to alter the course of a single speck of dust in space or the nature of any action they have committed.
For the more economically inclined, the purpose of the following is not to discuss the effects of inflation which I have discussed before (links above), but rather to trace the actual steps the Fed has been taking to inflate the money supply. The actual mechanism the Fed uses is important in order to understand the practical consequences of its actions and to help avoid confusion.
In a previous post, I discussed recent Federal Reserve policy by analyzing changes in its balance sheet. I am not adding much to that analysis or to what the links offer. I hope I can clarify it a little and put the most recent news into that context. I primarily relied on several good sources for insight on this topic, which you can find in the original posts especially this one at Econbrowser. I also have found a few more sources which I will link here.[1,2,3]. If you want a primer to better understand the Fed's balance sheet see this. Here is a link to the weekly release of the Federal Reserve's balance sheet.
The essential way in which the Fed "prints" money is through a process known as "open market operations." The Fed purchases treasury bills (short term government bonds) on the open market (through its New York trading desk) from primary dealers. The Fed gets the treasury bills which are an asset and the dealer gets a credit from the Fed. In other words, the Fed creates money out of thin air to pay for these treasury bills. It simply tells the dealer that they now have a credit with the Federal Reserve bank which the dealer can use any way it wishes. If you look at the Fed's balance sheet, you will see holdings of treasury bills on the asset side. It then carries a corresponding liability in the "currency in circulation" line item to offset this. Currency in circulation is technically a "liability" on the Fed's balance sheet, but, of course, federal reserve notes are only redeemable in federal reserve notes so its really not a true liability.
Another aspect to this is that when the Fed purchases treasury bills and holds them, the U.S. Treasury is obligated to pay the Fed interest rather than a member of the public. This is important because the Fed can't keep profits, it turns over the earnings to the Federal government. So, in effect, the federal government does not really pay interest to the Fed. (Why doesn't the Fed just buy all the government debt? Because even they know it would cause a massive inflation. Again, the Fed would buy the debt with fake money and the monetary base would increase by orders of magnitude. They "print" money but historically have not done so in a way that would cause a Latin American style hyperinflation.)
As I noted in the previous post, this was a pretty straightforward process (albeit evil) until last year. To make a long story shorter, starting last year, the Fed wanted to bail out banks that were holding securities (mortgage backed bonds among others) that were quickly becoming worthless (and threatening these banks with bankruptcy). The Fed could simply buy this "bad" or "toxic" paper with fake money as described above but it knew that would be inflationary so it tried a few things first. First, it actually sold off some of its treasury holdings to raise cash which it turned around and lent to the banks through various programs with fancy acronyms like TAF and so on. In other words, it allowed the banks to pledge the bad paper as collateral in exchange for loans. This was legitimate. It sold an asset, got cash, and lent the cash to the banks. Fine. The problem was that it quickly began running out of treasuries and it realized that it would need to sell more than it owned in order to accomodate all of this lending. Where could the Fed get the money if it was no longer willing to sell its own assets? It created it out of thin air which had the effect of increasing bank reserves (by about $1T), however, it did two things to stop this increase in reserves from hitting the banking system and causing massive inflation.
First, it did a deal with the Treasury. The Treasury went out and auctioned about $500 Billion worth of treasury bills to the public. It thereby sucked $500Billion out of the system. It took this money and simply parked it in an account at the Fed. This program was called the "Treasury Supplemental" program. It is still a major item on the liabilities side of the Fed's balance sheet. Second, it began paying banks interest on "excess reserves" (reserves the banks have over and above their legal requirement.) The Fed had never before paid interest on excess reserves. This provide an incentive for banks to keep their money on reserve which kept the money from getting into the banking system. Also, usually, banks lend out money to one another in the inter-bank market. Banks became leery of lending to each other and they gladly began accumulating excess reserves at the Fed since they were getting interest. Now that the Fed Funds rate is zero, banks are effectively getting 0% interest on their excess reserves and paying out something to depositors meaning they are losing money. Apparently, they rather lose a little bit and keep their money at the Fed than lend it to companies or the public.
Therefore, the Fed has been increasing the monetary base (currency in circulation + reserves) by increasing reserves but not by increasing currency in circulation (currency in circulation has barely moved in the last year despite a $1T increase in its assets). However, it has not increased the effective money supply since the increased reserves have been parked at the Fed in the ways I described above. The Fed's balance sheet has ballooned as a result of this process meaning that its assets and corresponding liabilities have increased from about $1 Trillion to $2 Trillion.
This means the Fed has lowered the quality of its own assets (by replacing treasuries with worse credit paper), and put the taxpayers on the hook. The public faces more interest on the debt by virtue of it being held by the public, it faces the possibility of the Treasury having to raise more money through lending if the Fed can not pay it back, and it faces the potential of massive inflation if the excess reserves find their way back into the banking system.
That was all before the announcement referenced above. Yes, it gets worse!
The recent announcement implies that the Fed will be flat out buying $300 Billion of long dated treasuries in the open market. This is directly inflationary since it appears that the Fed will simply buy the treasuries with fake money as described above when discussing open market operations. The Fed also states that it will purchase up to another $1Trillion in non-treasury securities. And where will it get this money? Of course, it will create it out of thin air. How will the Fed keep this increase in reserves from getting into the banking system which then gets multiplied through the fractional reserve system? Will banks continue to sit on the excess reserves? That is the question. How they do this and when will determine the short run effects. The state of the markets will also have an effect. I imagine if the economy began recovering, it could unwind some of the paper it is holding and begin to reign in its balance sheet.
As Dr. Reisman points out, inflation is not increasing prices. Inflation is an increase in the quantity of money above the increase in precious metals. This is important because it helps separate cause from effect. There is no doubt the Fed is going to massively increase the money supply. Will it lead to a massive increase in prices? It is impossible to know for sure by how much and how quickly. The best indicator is the gold market and bond prices. If you follow the prices in those markets and integrate it with observing the weekly changes in the Fed's balance sheet - it can give you insight.
From an economic perspective, the government's actions are profoundly destructive. Rather than allowing banks and companies to fail and go through a proper bankruptcy along with corresponding reductions in prices and wages which ultimately would end the recession, the government is going to prop up banks and create money out of thin air. This is on top of the so-called "stimulus" package which will further increase the debt of the federal government, rob the taxpayer of his income, crowd out private capital, and create more pressure on the Fed to print money to keep interest rates low. Related to this last point, as the government continues its massive borrowing, there will be upward pressure on interest rates. The only way the government can stop this in the short run is by printing more money (having the Fed buy the paper with fake money). You would then have rampant inflation and rising interest rates.
Given the Fed's past statements, it appears that it will do anything to stop prices from falling (which it mistakenly believes is "deflation"). Some pundits have estimated that the Fed may have to take its balance sheet to $10 Trillion to have the desired effect. This is insanity. If it continues down this path, we could end up with a hyperinflation and a total economic collapse - something akin to Weimar Germany in the 1920's, i.e., rising fascism and runaway hyperinflation. It demonstrates another point which can be seen throughout the history of money and banking and in any real life situation in which you attempt to evade reality rather than take your medicine. The situation always gets worse and reality happens.
(I had more to say, but I'm depressing myself too much - need take a break....)