Friday, April 4, 2014

Money Myth 6: The Fed is printing money

FACT: QE is not an inflationary expansion of money in the economy - it's a tax on private savers. 

There has been much fear mongering over the Federal Reserve's (the Fed) recent open market operations. The fear is that this activity is inflating the money supply and will fuel massive inflation by injecting trillions of dollars into the economy. It simply isn't so. 

It doesn't help that the Fed uses obtuse terms such as Quantitative Easing (QE) to describe what is simply the Feb buying Treasury Bonds from willing sellers.

What is this all about?

Dual Mandate

The Fed has two main mandates beyond its role in keeping the banking system healthy: low inflation and ensuring full employment (note, the Fed is not actually well equipped to do either: see Kelton's Dual mandate -- right goals, wrong agency). 

The Fed believes that it has a significant influence over the economy's growth rate through its ability to manage interest rates (i.e. it believes economic activity rises and falls based on the interest rate it sets - a somewhat dubious assumption). It manages the short term interest rate by buying or selling government bonds whenever the inter-bank interest rates moves off its target rate. 

What is QE all about?

QE is an attempt to affect the longer term rates in the hope that by bringing down long term interest rates it will stimulate more lending and help kick-start the economy.

Despite the hysteria on many web sites, QE actually has no effect on the money supply. The central bank "buys" a longer term bond (e.g. 10 Year Treasury Bills) from a willing seller. The market for such bonds is immense and no one knows when the Fed is the buyer of someone else. The seller (e.g. a bank) had invested in an interest-earning bond, and now they receive a non-interest earning reserve account balance. There's the same amount of "money" in the system. It just changed from one kind of asset to another. 

What does happen when the Fed buys bonds is that banks end up with more reserves than they can do anything with. Banks are never limited by reserves when they lend: it is the availability of credit-worth borrowers, not by the quantity of reserves (nor even the interest rate), that determines whether banks will increase lending. So what happens? The extra reserves sit in the banking system and the inter-bank interest rate (Fed Funds Rate) falls below the Fed target toward zero percent. 

What does the Fed do now? It has to start paying interest on the excess reserves or the banks lose income they were depending upon from the bonds they were holding. This is what happened in 2008 in the US. 

QE is a tax!

Economist Warren Mosler describes QE as a tax - it removes interest income from the private sector. Think about that. Rather than the stimulus it intends, QE is actually taking money out of the private sector! Any by lowering the long term interest rates, it also reduces the amount if interest income being earned by those holding long term bonds, further removing income from the private sector. 

So rather than a reckless printer of money, QE is probably better described as an anemic phantom "stimulus". 

If we want to stimulate economic activity, we need to do so via fiscal policy (more spending, less taxes), not monetary policy (interest rate targeting).

Congressional delusions

Ironically, the Fed pays most of the interest in earns to the Treasury (it's really just the Government paying itself with new money that it creates). Congress, not understanding that they could simply have the Treasury issue money for all their spending needs, got very excited when this extra interest came flowing in from the Fed to fund their budgets. Strangely, the Republicans were silent on this new tax increase... Sigh!

The Fed doesn't print money

The Fed is in some sense a currency scorekeeper, crediting and debiting accounts in response to government, private sector, and foreign financial activity. It responds to the lending activity of banks, the spending & taxing of the Treasury, and the activity of foreign account holders (mostly central banks). It can buy and sell financial assets to manage interest rates and help the banking system recover from crises. It isn't printing money. 

Money that doesn't end up in the economy buying goods and services does nothing. Reserves do nothing. Savings do nothing. It is money that is spent that creates growth in a capitalist system, and the entity that can increase spending when the economy is lacking is the Treasury. 

The Jeckyll Island creature

A few final words are worth mentioning here for those who believe the Fed is a disastrous monster created by banks to destroy America. I won't get into the history here, assuming that those who have read this far are somewhat familiar, but the conspiracy theories and anti-Fed rhetoric don't provide anything of value to a true understanding of the banking system.

In short, my view is that there are many things we can do to improve our banking system, but eliminating the Fed is not one of them. We have many vestiges of the gold standard that can, and arguably should, be done away with (like selling long term government bonds), and there needs to be much more regulation of the large private banks, but these kinds of changes are in the hands of Congress, not the Fed.

  • Yes, the Fed was created in secrecy, but for good reason as it would have been difficult to form in the open (note, the Declaration of Independence was also formed in secret for good reasons!)
  • Banking without a central bank to act as lender of last resort has proven to be very unstable with frequent and messy bank failures. 
  • The Fed is really part of the consolidated government financial sector (with the Treasury) and operates under the oversight of Congress: we could probably merge their functions in many ways and save ourselves much public confusion (and maybe then end the silly arguments that the Fed isn't a government entity, even though it has private owners). 
  • The separation of Treasury & Fed functions are largely optics. The idea was that the Treasury had to have bank balances at the Fed before it could spend and the Fed has to buy bonds in the open market to avoid the government from funding its own spending without any "market discipline". In reality, there is no market discipline and there cannot be in a system like this since i) the Fed sets interest rates, ii) there are always buyers of bonds since spending precedes bond issuance, and iii) the Treasury therefore can always ensure it has adequate funds in its Fed account - we could eliminate all these fictitious "controls". 
  • Innovations such as Federal FDIC insurance to protect depositors are good things and have gone a long was to provide confidence in our banking system. I would recommend expanding such protections on deposits while increasing regulatory scrutiny of bank lending and other activities. 
  • As mentioned above, the Fed is really the wrong institution to be managing inflation & employment since these are far more directly controlled by fiscal policy.
  • Interest rates on government securities could (should) be set permanently low since they are risk-free assets. Let the markets set interest rates on their other investments based on sound underwriting, but the Fed should mostly get out of the interest rate game.
  • Essentially, the problems in the financial sector are mostly the result of the activities of private bank risk-taking, not the presence of the Fed. We need to focus our attention on restoring oversight of banks and prosecuting criminal and fraudulent activity to bring the financial sector back to the business and serving the needs of the productive sector of the economy.

Additional reading

For more a view on what's wrong with the Fed and its response to the Great Financial Crisis, see It's Time To Reign In The Fed.

Warren Mosler's Proposals for the Treasury, the Federal Reserve, the FDIC, and the Banking System