In two previous posts, The Fed's Wish, and The Fed's Wish Part II: Coup D'Etat?, I explained the recent activity of the Federal Reserve including the explosion of its balance sheet and its unprecedented creation of excess reserves. I also noted that In the process of this expansion, it has taken on unprecedented power and is "now threatening even greater usurpations of our liberty in the name of promoting financial 'stability'".
What has happened since?
In essence, the Fed has continued to purchase government securities and mortgage backed securities in the open market using money it creates out of thin air. As of October 21, 2009, the Fed's balance sheet reveals that reserve balances total $1.056 Trillion. Since "currency in circulation" has not changed as dramatically this year, these reserve balances represent the money created by the Fed in the past year. Analysts expect this number to go to $1.4 Trillion if the Fed stays committed to its treasury and agency purchase programs which are supposed to end in March 2010.
Typically, these excess reserves would be used by financial institutions to make loans to the public. Due to fractional reserve banking, this trillion dollars could be multiplied to perhaps as much as 10 trillion dollars by the banking system. Such an increase in the quantity of money would lead to hyperinflation and perhaps the total collapse of the monetary system. However, the Fed has induced these banks to leave these excess reserves at the Fed by paying them interest for the first time in history.
The problem now concerns what the Fed will do with these excess reserves? They could remove reserves by selling securities from their portfolio. However, this would put upward pressure on interest rates. They could raise the rate they pay banks to hold the excess reserves but this would only delay the inevitable and would require ever more credit expansion. They could allow the money into the banking system and cause a hyperinflation.
In addition to my first two posts, I recommend two more articles that nicely detail this problem. The Fed's Dilemma by Professor Philipp Bagus discusses the origin of the problem and possible solutions. Does the Fed Need an Exit Strategy by Robert P. Murphy provides good overview and, in particular, rebuts Paul McCulley's recent argument that the Fed can simply increase the rate they are paying banks to hold reserves.
Ultimately, there is no way to cheat reality. No matter how many PhD.'s and Nobel prize winning economists try, reality will win.
There is another interesting aspect to this problem which is rarely discussed. The bust portion of the boom-bust cycle caused by the government's credit expansion must result in a natural deleveraging process. In other words, recession or depression is the recovery process. As malinvestments (investments thought to have been sound on the basis of an expectation of continual credit expansion now revealed to be unsound) are liquidated and as firms and individuals rebuild their cash holdings, businesses go bankrupt, unemployment rises, and consumer prices tend to fall. This is the unfortunate price that must be paid to restore economic prosperity on a sound foundation.
Many economic pundits falsely characterize the path before us as one of either inflation or deflation. In other words, they mistakenly define these concepts as "increasing prices" or "decreasing prices", respectively. Consequently, they mistake the symptoms of economic fundamentals with the cause. Since they mistakenly believe that deflation is "falling prices", this natural deleveraging process described above is characterized as an evil to be avoided at any cost. Rather than understanding that falling prices are the "antidote to deflation" as Dr. Reisman explained, they advocate that the government print money on a massive scale in order to halt the so-called "deflation."
Inflation, properly defined, is an increase in the quantity of money above the increase in precious metals. If the government prints a massive amount of money as they are doing now, even though prices are not rising presently, inflation still has the same deleterious effects. Prices do not have to go up under inflation. They simply have to go down less than otherwise. In other words, in the absence of inflation, prices would naturally tend to go down due to increasing productivity. In the present circumstance, prices should drop precipitously. Due to the Fed's creation of money, prices are not falling as fast as they would otherwise. The Fed is propping up zombie banks that should go bankrupt or restructure. If interest rates were not being held artificially low, house prices would likely drop even further and even faster ultimately restoring growth to the housing market. In effect, the Fed's inflation is causing malinvestment and inducing less savings than would otherwise be the case in the absence of this money creation.
(Note, for example, that many economists currently regard increasing prices in the housing market as signs of recovery. Don't we like it when computer prices go down or when car dealers have sales? Why would rising prices ever be "good" for the economy?)
Furthermore, the Fed's purchase of government securities is enabling the federal goverment to temporarily spend with impunity. Such government spending encourages wasteful consumer spending and crowds out productive private capital investment. Currently, banks are borrowing money at 0 percent and lending to the government at 3 percent. Is this "good" for the economy?
The entire experience of Japan over the last 20 years is analogous. Rather than allowing the system to heal itself by facing reality, the Japanese government has propped up insolvent banks, rewarded politically powerful special interests, and therefore, never restored economic growth. Japan has been mired in stagnation for over twenty years.
The best thing the government could do is to recognize that it caused the problem, stop interfering, let the market heal itself naturally, and commit to a program of sound money, private property, and limited government. Yeah, right.