The Fed continues to create money out of nothing

Published in The Tennessean, Sunday, November 7, 2010

The Fed continues to create money out of nothing

by Richard J. Grant

Federal Reserve Board Chairman Ben Bernanke reminds us that the Fed responded to “the worst financial crisis since the 1930s” by purchasing more than $1 trillion worth of Treasury securities and U.S.-backed mortgage-related securities. This action took several hundred billion dollars worth of risky mortgage-backed securities off the balance sheets of private financial institutions and put them on the Fed's balance sheet.

How did the Fed pay for all these securities? It used its unique statutory powers to create money out of nothing. In the last few months of 2008, the Fed doubled the base money supply to $1.8 trillion, and by the beginning of 2010 had increased it above $2 trillion.

Under normal circumstances, this would almost certainly have resulted in high double-digit price inflation. With all this new cash available, banks would have had plenty of excess reserves to lend, thereby greatly expanding the effective money supply.

But circumstances were not normal. With the property market in decline and the economy heading into recession, increasing default rates knocked down the value of mortgage-backed assets. With the asset side of their balance sheets shrinking, many banks found themselves to be more undercapitalized than usual. So when the Fed supplied them with cash, they did not lend it but held most of it as reserves.

This is why we had monetary inflation but not price inflation. Not yet.

The Federal Reserve Act, which brought the Fed into existence, gives it discretion “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Depending on which prices we look at, price inflation has been not much above 1 percent and was briefly negative. If we pretend that interest rates are “moderate” then the Fed currently scores two out of three.

But with the unemployment rate stuck over 9 percent, the Fed sees its mandate as unfulfilled. Unfortunately the Fed suffers from the same learning disability as the Obama administration: It does not learn from past mistakes. Just as government spending fails to stimulate long-term growth so does pumping-up the money supply fail.

On November 3, the Fed announced that it will purchase another $600 billion of longer-term Treasury securities through the middle of 2011. The base money supply will increase $75 billion per month. That is a 30 percent increase over eight months.

Does the Fed expect the banks to hold all this new cash as reserves? If so, then how does it expect to create even a short-term stimulus effect? If it does not, then how does it expect to avoid inflationary consequences? Only one member of the Fed committee that is responsible for this decision, Thomas Hoenig, sees the inflation risk as serious enough to dissent.

When the Fed makes large purchases of securities, it pushes interest rates below what they would have been. This creates the illusion of an increased supply of capital available as loanable funds. But, although the Fed can create money, it cannot create wealth.

The Fed gives its profits to the U.S. Treasury. So when it creates money to buy Treasury securities, it is ultimately covering government deficit spending with the money that it creates.

Does this mean that the deficit is covered without cost? No. The cost is borne by everyone that holds U.S. dollars and dollar-denominated assets. Money inflation is a tax.


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2007-2010

Richard J Grant archived at The Tennessean

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