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Showing the Money

So much cash is flooding into the economy that experts are now worried that it may be too much. But in fact, Bernanke and friends have it about right.

If you want to give yourself a jolt on one of these winter evenings, go to the Federal Reserve Bank of St. Louis' website, and check out its chart showing what's happened to the amount of money in the U.S. economy. What you will see is a flat line that turns, suddenly and sharply, upward.

The chart represents the total amount of money in the economy that the Federal Reserve directly controls-bills and coins as well as the reserves that the biggest banks keep at the Fed. In normal times, the monetary base grows at about the same rate as total spending. Between November 2007 and August 2008, as the economy expanded modestly, it increased from about $850 billion to about $875 billion. Then something remarkable happened. Between the middle of September and the end of last year, as the Fed pumped liquidity into the financial system following the bankruptcy of Lehman Brothers, the monetary base shot up. When other liabilities are thrown in, the amount increased by $1.35 trillion.

Month by month, the acceleration has been stunning. Between August 27 and November 5, the monetary base rose at an annualized rate of almost 500 percent. Between October 8 and December 31, its annualized rate of increase was 922 percent.

The Fed has issued lots of money in previous times of stress, such as in the runup to Y2K, but never before on this scale. History tells us that if a central bank persists in creating money at triple-digit rates, inflation will skyrocket and the currency will lose much of its value. In the German hyperinflation of the 1920s, shoppers had to lug big bags of near-worthless marks to pick up their groceries. Zimbabwe provides a tragic contemporary example. As of November, the annual inflation rate in the ravaged African nation, according to one estimate, was 89,700,000,000,000,000,000,000 percent, which means that prices were doubling every five days.

Nobody is seriously comparing the United States to the Weimar Republic or Zimbabwe. But Ned Schmidt, publisher of the Value View Gold Report, called the Fed's opening of the monetary spigots a "banana republic" policy, saying it could cause the dollar's value to fall 50 percent. Martin Hutchinson, a commentator at PrudentBear.com, said, "We should expect consumer prices to be increasing at an annual rate of more than 10 percent within 18 months of today." Expressions of concern weren't confined to goldbugs and stock market bears. "The Fed can't just indefinitely create money without creating horrendous problems for the future," William Poole, a former president of the Federal Reserve Bank of St. Louis and member of the Federal Open Market Committee, told Bloomberg Radio.

Some of the FOMC's current members also appear to have misgivings. At the committee's December meeting, they pushed for the establishment of official targets for the monetary base, which would limit Fed chairman Ben Bernanke's freedom to issue greenbacks as he sees fit. The Fed announced it would consider the matter further, while at the same time confirming its intention to create a lot more money in the months ahead.

What is going on? Are we really headed for double-digit inflation and the end of the dollar's role as the world's reserve currency? I doubt it. There is much confusion about what the injection of funds means. When most people hear that the Fed is issuing large quantities of money, they imagine the printing presses cranking up, with sheets of new Andrew Jacksons and Benjamin Franklins rolling off the production line. Actually, the amount of currency in circulation hasn't risen very much. On September 3, it was about $837 billion; by January 7, it had increased to $885 billion. In an economy where annual spending is about $14.5 trillion, an extra $48 billion in coins and bills is trivial.

Most of the dollars that the Fed has created during the past six months have stayed inside the financial system, where they are propping up such tottering institutions as Citigroup. The rest of the economy shows no sign of excess liquidity or incipient inflation. Current yields on Treasury Inflation Protected Securities indicate that the market expects the inflation rate to be less than 1 percent 10 years from now.

The Fed has, so far at least, pulled off a very delicate trick. Under normal circumstances, the cash it has poured into the market would be inflationary. But with so much of the money being hoarded, that hasn't happened. In fact, the risk is that the economy will starve from the lack of spending, causing deflation. The Fed's challenge is to know when to respond, closing the spigots as soon as spending finally opens back up.

Bernanke is making up for past mistakes. With unemployment soaring and output falling, deflation-a general fall in prices-will most likely be a bigger threat to the economy than inflation, and it justifies the Fed taking some risks. Bernanke conceded to me last fall that he initially underestimated the economic threat posed by slumping real estate prices and a collapse in the market for subprime-mortgage securities. Since the start of 2008, however, he has acted aggressively, slashing interest rates and setting up a series of lending programs through which the Fed has allowed stricken financial firms to swap illiquid securities for dollars and Treasurys. He has been so aggressive because the banks have been so stingy with their money.

In allowing Lehman to go under, in September, Bernanke, along with former Treasury Secretary Henry Paulson and his successor, Tim Geithner, who was then head of the New York Fed, unleashed a global financial panic that terrified many Americans, who responded by clamping their wallets shut. The stock market slumped, and the economy went into free fall, leaving Bernanke no choice but to inject more money into the financial system. Had the Fed failed to act, the system would have seized up completely.

The monetary transfusion kept the patient alive, but it wasn't enough to prevent a dangerous drop in spending, output, and prices. If a deflationary psychology takes hold, consumers will scale back their outlays even further, while borrowers-credit-card users, homeowners, businesses-will find the deflation-adjusted cost of their debts rising. Based on what happened to Japan in the 1990s and this country in the 1930s, we know what this scenario yields: economic stagnation that lasts for years.

It was against this backdrop that the Fed announced in December that it would deploy "all available tools" to revive the economy, including the maintenance of exceptionally low interest rates and the provision of yet more liquidity.

Almost all of the expansion in the monetary base has come in the form of additional bank reserves at the Fed, which aren't necessarily inflationary. Just like you and me, big banks maintain bank accounts, but theirs are at the Fed. Deposits in these accounts are known as reserves, and banks use them to settle transactions with one another. (If Chase owes Bank of America $50 million, rather than sending a check or wiring the money, it can simply instruct the Fed to debit its account and credit B of A's account.)

What has happened in recent months is that the Fed, in seeking to keep credit flowing, has greatly expanded its lending programs, allowing banks and other financial institutions to exchange yet more illiquid assets, such as mortgage securities, for dollars. Before the onset of the subprime crisis, the Fed demanded ultrasafe securities like Treasurys as collateral when it extended loans to banks. Today, it has greatly broadened the range of collateral it accepts. The result has been a massive increase in bank reserves. At the end of August 2008, they totaled about $100 billion; by the end of December, they had grown to more than $820 billion.

The Fed isn't finished yet, not by a long shot. On January 5, in an effort to ease the credit crunch and bring down mortgage rates, it launched a program to buy up to $500 billion in mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae, with the aim of encouraging those institutions to make home loans again. It has committed another $200 billion to supporting the purchase of securities backed by student, auto, and credit-card loans, along with loans guaranteed by the Small Business Administration. The Fed said it intended to finance both of these initiatives by creating more new reserves. (Speaking in London in January, Bernanke said this policy should be thought of as "credit easing," rather than "quantitative easing," but that is just a matter of labeling.)

One result of all this activity is clear: The Fed and the taxpayers, who provide the central bank's capital, have been taking on additional credit risk. (As Wall Street cynics like to say, the Fed has been exchanging "cash for trash.") The inflationary implications are less obvious. When the Fed credits a bank with, say, $100 million in new reserves, the bank faces a choice: It can leave the money at the Fed, earning a modest rate of interest; it can ask the Fed to send over the cash in an armored car; or it can use the money to make additional loans.

The second and especially the third option raise the prospect of the new dollars being used to bid up prices, but so far there is no sign that banks are extending more credit. To the contrary, as anybody who has spoken to a loan officer recently will testify, bank money is harder to get. Since the end of October, the total value of commercial and industrial bank loans outstanding has been falling steadily. This may well lengthen the recession, but from the perspective of individual banks, it is a rational response to the deteriorating economy. Rather than risk making new loans that may never be repaid, they prefer to maintain a high level of reserves at the Fed and pocket the interest.

The reserves also offer a bit of reassurance to bank shareholders, who have been spooked by the long credit crisis.
The fall in bank lending underscores the scale of the task facing Bernanke. The good news is that some of the Fed's new initiatives are working: Interbank lending rates have fallen significantly, the commercial paper market has revived, and mortgage rates have come down to 5 percent or even lower. Eventually, this improvement in financial conditions should help the economy. Once that happens and the threat of a downward deflationary spiral is removed, the Fed can mop up any excess liquidity in the economy by raising interest rates and scaling back its lending programs.

It would be a major policy error if the Fed were to abandon its newfound radicalism out of a misplaced fear of inflation. Fortunately, this is unlikely to occur. In a recent interview with the Financial Times, Bernanke said, "One of my conclusions from my study of the Great Depression is that people tend to think of orthodoxy as safe. But strategy should depend on the situation. In a severe crisis, orthodoxy can prove to be a very bad strategy." At various points in the past 18 months, I have criticized the Fed chairman's actions. Now he is right on the money-in every sense of the phrase.

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