simply Capitalism

posted by Doug Reich @ 9:50 AM

In a previous post, The Fed’s Wish, I attempted to analyze the recent changes in the Fed’s balance sheet and the explosion of the monetary base as a means to understand the mechanism by which the government creates money and understand better the potential effects of such actions on the economy. As well, my purpose was to provide a more philosophical interpretation of the act of money creation in so far as government counterfeiting represents an attempt to evade the law of identity or reality and therefore constitutes a “wish” that reality is not what it is. In analyzing the technical details of the Fed's actions, I followed the analysis done by econbrowser and attempted to distill it into terms that might be more understandable to the non-economist. Econbrowser has two recent posts linked here and here that are very good at explaining what is going on and serve as a good follow up to my post. I will attempt to explain the recent activity in very brief big picture terms and refer you to his post if you want more detail and supporting charts and data.

The Fed’s goal has been to lend money to financial institutions (including foreign financial institutions) that are in trouble as a result of holding asset-backed securities (mostly bonds collateralized by real estate). But where does the Fed get the money to loan to these institutions? Up until about September of 2008, it sold some of its own assets (treasury securities) and used the cash it obtained from the sale. This meant that the Fed was primarily just changing the composition of its own balance sheet (going from holding mostly treasury securities to holding a combination of treasury securities and asset-backed bonds). It then realized that the problem was much bigger than it thought and if it wanted to continue lending money it didn’t have enough treasury securities to sell to raise the money needed. So where could it get the money?

As I explained in more detail in my last post, it has created the money out of thin air. But, if the Fed is creating money out of thin air and giving it to banks, won’t this inflation of the money supply lead to massive increases in prices?

The Fed has found a few "tools" that it has used to keep the money it has created from entering the economic system. Mostly, it began paying banks interest to hold excess reserves at the Federal Reserve. In the past, the Fed would not pay interest on excess reserves so banks would find something else to do with it – like lend or invest it. Since the Fed is paying interest (and because they are scared of lending it), the banks decided mostly to just keep this extra cash at the Fed. In other words, the Fed has created money to lend to troubled financial institutions, and then essentially found a way to keep the money at the Fed so that it doesn't immediately affect the general price level.

To summarize, the Fed has created a pile of money and lent it to banks. The banks leave it at the Fed and this big pool of money is sitting in an account available to be withdrawn at any time and turned into cash. What happens if banks start to pull this money out of excess reserves and begin to lend it? Such an outcome could lead to massive inflation or potentially even hyperinflation.

To prevent these reserves from going into currency in circulation, the Fed could simply sell some of the asset backed securities or fail to renew the loans. This would reduce their assets and correspondingly reduce the excess reserves in the system. However, the post offers this quote from the President of the Federal Reserve Bank of Philadelphia:

It is true that a number of the Fed's new programs will unwind naturally and fairly quickly as they are terminated because they involve primarily short-term assets. Yet we must anticipate that special interests and political pressures may make it harder to terminate these programs in a timely manner, thus making it difficult to shrink our balance sheet when the time comes...

In other words, there will be political pressure on the Fed not to unwind these loans. So then what?

...the following clause in the joint Fed-Treasury statement suggests that perhaps the Fed intends this, like most of the previous balance sheet changes, to not be allowed to impact total currency in circulation:

"the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves."

John Jansen (hat tip: Tim Duy) construes that clause to mean that the Fed is going to request the ability to borrow directly as well as for exemption of any borrowing done by the Treasury on behalf of the Fed from the congressional debt ceiling.

This means that the Fed wants to issue its own debt or borrow endlessly from the Treasury in order to remove the money that it has created! This would have multiple potential effects. First, it would put an unelected body, the Federal Reserve Board, in charge of determining fiscal priorities on a massive scale, i.e., this board would effectively be risking taxpayer money on programs that it deems worthwhile. Not only would it put the taxpayers on the hook for its investments, such borrowing would represent a massive drain on private capital which could otherwise be used to fund productive investments. Although the Fed is doing this to some extent now, the contemplated legislation would provide a formal sanction of these activities which are far beyond the parameters specified by the Federal Reserve Act. Such a sanction would represent a massive transference of power to the Federal Reserve and may actually represent an all out coup d'etat.

Such are the consequences of evading reality. The government caused the economic crisis with a combination of easy money and policies designed to facilitate and encourage reckless lending and borrowing. The government, instead of limiting its errors by allowing bankruptcies, is now compounding its evasion by attempting to bail out banks without having to tax Americans. So it counterfeits money which will lead to a hidden tax in the form of more inflation or it will borrow the money which will crowd out private capital, increase the debt burden on taxpayers of the future, and severely dampen economic growth. In the meantime, ever more power is being conferred to the Federal Reserve and the federal government which will in turn demand control over the enterprises which it chooses to shower with its largess. Such controls and attempts at central planning will lead to more destruction and more failures and more calls for regulation and/or an easy money fix. Investors, faced with massive uncertainty and the threat of arbitrary and/or confiscatory government policies will lessen or stop investing in productive assets altogether and seek the safety of unproductive government bonds or hoard precious metals.

Such an economic spiral accompanied by profound losses of freedom or outright fascism in the form of the loss of private property rights, confiscatory taxation, debasement of the currency, price controls, arbitrary regulations or imprisonment of businessmen, and potentially even the loss of freedom of speech as the state moves to silence its critics (see this post) can only be fundamentally stopped in one way. The ultimate solution is the complete abolition of the Federal Reserve system accompanied by the recognition of a fully private banking system based on sound money, i.e., precious metals. Such a system would be fully compatible with the principle of individual rights including private property and would entail a necessary delimitation of the federal government's role to its proper function as the protector of rights. Although constitutional limitations on the government's abridgment of the freedom of production and trade would be ideal, practically speaking, a system of private banking based on precious metals would necessarily limit the government's ability to intervene in the economy as it would no longer have the ability to fund its deficits surreptitiously through the creation of money.

The Federal Reserve's activities must be monitored closely. This rogue pseudo-government agency has mostly caused the boom bust cycle including the Great Depression as well as the latest fiasco, and is now threatening even greater usurpations of our liberty in the name of promoting financial "stability" (see this post). The first step on the path to abolishing the Federal Reserve is to expose their activities. HT to econbrowser for helping us towards this goal.