Bernanke Paints Himself Into a Corner
Unfortunately, Bernanke has gotten himself into a position where the only way to prevent massive price inflation is to cut-off the financial sector’s life support and to jack up interest rates.
First, we should define some terms. The monetary base consists of currency in circulation, plus bank reserves held on deposit with the Fed itself. The base is the narrowest definition of money, and is directly controlled by the Fed. This is why economists often look at the monetary base to gauge whether the Fed is loosening or tightening.
If we broaden the scope of our definition of money, we have M1, which consists of currency in circulation, demand deposits (i.e. checking account balances), traveler’s checks, and a few other extremely liquid assets. For our purposes in this article, the essential differences between the monetary base versus M1, is that the base includes bank reserves with the Fed (while M1 doesn’t), and M1 includes checking deposits (while the base doesn’t). We’ll see in a minute why these differences are important to understanding the danger of the current situation.
At the risk of triggering nauseating flashbacks to mandatory college lectures, let’s review how the Fed creates money which in turn leads to price increases. Normally, when the Fed wants to engage in “loose” monetary policy, it engages in open-market operations by buying assets from the public. For example, the Fed might buy $10 million worth of government securities from private-sector holders. In the transaction, the Fed acquires the $10 million worth of Treasury debt, and writes a check on itself for $10 million.
This is the precise spot where money is created “out of thin air.” When the Fed writes a check on itself, the recipient deposits it at his bank, and the bank in turn deposits it with the Fed. So the Fed bumps up that particular bank’s account balance by $10 million; in other words, that bank’s reserves with the Fed have gone up by $10 million. Yet there is no counterbalancing debit anywhere else in the system.
When Joe Smith writes a check for $10,000 to Bill Jones, total deposits haven’t changed; Jones’ checking account goes up by $10,000, while Smith’s goes down by $10,000. Yet when the Fed writes a check for $10 million, some bank’s reserves go up by that amount, while no other bank’s reserves fall. The additional $10 million in reserves was created by changing the 0s and 1s in the Fed’s computer system.
As readers may recall, the process does not stop there. Because of the fractional reserve nature of our banking system, an injection of new reserves can lead to a multiple increase in the overall money stock. For example, if the reserve requirement is 10%, then the bank depositing the $10 million is able to make new loans of up to $9 million. Businesspeople may come in and win approval for loans, and receive new checking accounts with a total of $9 million in their balances. They can go out into the community and start writing checks on these balances, pushing up prices. At the same time, the original person who sold Treasurys to the Fed, still thinks he has $10 million more in his checking account too. Thus, while the monetary base has increased by $10 million (i.e. that’s how much total bank reserves have increased), M1 has increased by $19 million.
And the process continues. The merchants who receive payments from those taking out new loans will in turn deposit the checks with their own banks, and some of the “excess reserves” (i.e. the $9 million that the original bank held over and above the legal minimum needed to back up the first person’s deposit) are transferred to other banks. They in turn can now make new loans, because the 10% reserve rule applies to their new reserves as well.
In the end, if we assume a 10% reserve requirement, and that all of the banks are fully “loaned up,” then the original purchase of $10 million in Treasurys will yield an increase of $100 million in total checkbook balances in the community. Prices for goods and services will be higher than they otherwise would have been, because there is now an extra $100 million in household “cash” chasing them.
The process works in reverse, too. If the Fed grows concerned about price inflation, it can slam on the brakes by engaging in open-market operations to sell off assets from its balance sheet. When the public buys an asset from the Fed, the transaction ultimately reduces the reserves that member banks hold with the Fed, meaning that they will need to contract the total outstanding checking balances of their customers. (We are assuming the banks had originally been fully loaned up, i.e. that they held no excess reserves.) Assuming a 10% reserve ratio, if the Fed sold $10 million of securities that it had been holding, that could lead to a reduction of $100 million in the quantity of money held by the public.
Now back to the current situation. The chart below shows the banking system’s total excess reserves, meaning how much banks are holding that could be used as the base on which to pyramid loans to customers.
The above chart is startling. Notice that the timeline goes back to 1929; nothing even remotely close to our current situation has occurred, even during the depths of the Great Depression.
What is happening is that the Fed has allowed its balance sheet to explode during the last year, from $920 billion in December 2007 to $2.3 trillion in December 2008. (See this excellent summary article.) Yet because of general fear, as well as various gimmicks (such as paying interest on reserves held with the Fed), the banks are sitting on these huge injections of reserves, rather than granting new loans to their customers. This is why prices have been falling, even amidst this unprecedented expansion in the monetary base.
Another way to see the discrepancy is to contrast the growth in the monetary base with the growth in M1. Remember that the Fed directly controls the base, whereas it is M1 (a measure that includes checking deposits) that most accurately captures how much money the public has available for immediate spending. Look at how much more the base has grown, compared to M1:
Sometimes when economists focus too much on the supply of money, it leads to a neglect of the demand for money. As the second chart above illustrates, M1 has indeed grown remarkably in the last year, even while prices have been fairly stable. This is because the recession and general panic has led the public to demand greater cash balances. In other words, people want to concentrate much more purchasing power in extremely liquid assets (including Treasury debt as well as currency and FDIC-insured checking accounts). Thus, even though the total stock of money has risen considerably, prices haven’t followed suit.
The general price level is the flip-side of the dollar’s strength, and so if the demand to hold dollars goes up, then its “price” goes up too, meaning its exchange value versus real goods and services goes up. In the summer, one U.S. dollar traded for a quarter-gallon of gas. Now that the dollar has considerably strengthened against gasoline, one dollar fetches (say) three-quarters of a gallon. The “gas-price” of a dollar has risen, meaning that the dollar-price of gasoline has fallen. The same is true – to a lesser extent – with other goods and services.
Even though increases in the demand for U.S. dollars can offset increases in its supply – so that its market value doesn’t plummet – this observation is no cause for comfort. Using back-of-the-envelope calculations, the year/year growth in demand deposits (i.e. checking account balances) was about 38% in December. In contrast, the year/year growth in reserves was more than 1,400%. If the banks became optimistic about the future of the economy and began loaning out their excess reserves, right now there is enough slack in the system for the public’s money supply to increase by a factor of 14.
There is nothing conspiratorial about the points I have made above. (Indeed, I have run these thoughts by other economists who are experts on the banking system and they generally endorse the analysis.) Analysts simply assume that once the recovery begins, Bernanke will wisely suck the excess reserves back out of the system, in time to tame price inflation.
But is that really going to be politically feasible? The federal government is currently borrowing money at amazing rates: if we include not just the on-budget (cash flow) deficit, but also the government’s overall long-term financial liabilities, then the total federal debt increased by more than $1 trillion in 2008 alone. When we consider that Bernanke and Paulson have extended more than $5 trillion in new taxpayer exposure with all of their bailouts, the pressure on Uncle Sam in the coming years could be enormous.
Why is the federal debt relevant to our discussion? Well, recall that in order to soak up excess reserves from the banking system, the Fed will need to sell off its assets. If it uses its vast holdings of Treasury debt to do so, then the massive dumping will raise U.S. interest rates, just as surely as if the Chinese government decided it no longer thought the U.S. government were creditworthy and dumped all of its Treasurys. Bernanke will therefore be reluctant to go that route.
But his other options won’t be pretty either. The Fed has acquired all sorts of dubious assets in the last year, in an effort to provide “liquidity” to the financial sector. Is Bernanke really going to paralyze the big banks by throwing billions of mortgage-backed securities onto the market, just as the economy limps out of recession and into recovery?
The Federal Reserve under Ben Bernanke’s leadership has painted itself into a very tight corner. He has cleverly managed to stave off utter disaster so far, but he is running out of options. Ironically, the effects of his incredible injections of new reserves have been masked simply because the financial sector is still paralyzed. If and when the economy begins to improve, Bernanke will have to decide whether to allow double-digit price inflation or instead contain prices by strangling the incipient recovery.
Robert P. Murphy
for The Daily Reckoning
Editor’s Note: Robert P. Murphy has a PhD in economics from NYU and is author of The Politically Incorrect Guide to Capitalism (Regnery 2007).