An Experiment in Scotch

Dur­ing the cur­rent eco­nomic cri­sis, the Fed­eral Reserve has increased its bal­ance sheet sig­nif­i­cantly in order to increase the mon­e­tary liq­uid­ity in the econ­omy. Many peo­ple assume they have done this by “print­ing money” which in the­ory increases the money sup­ply held by the pub­lic and over the long term is infla­tion­ary. How­ever, because the Fed did not want to increase the actual money sup­ply held by the pub­lic, they went about increas­ing the liq­uid­ity of the sys­tem in a dif­fer­ent man­ner, one that they are con­vinced will allow them to avoid unsus­tain­able infla­tion in the future. The­o­ret­i­cally, this is true. How­ever, in real­ity, it’s likely to be false for a rea­son I’ll get to in a minute.

First, we need to under­stand exactly how the Fed increased eco­nomic liq­uid­ity with­out increas­ing the money sup­ply in pub­lic hands. James Hamil­ton gives us a very thor­ough expla­na­tion. I highly sug­gest you read the whole thing which is liable to lead you down a very deep rab­bit hole but I’ll try to sum­marise to the best of my abil­i­ties. Nor­mally, if the Fed wanted to increase liq­uid­ity, it doesn’t phys­i­cally print money and start hand­ing it out to the peo­ple on the front steps. Most large banks have an account with the Fed. To get money into the sys­tem, the Fed nor­mally just adds an entry in one of these accounts as a sort of deposit. The bank now has more money than it did before. It can then use that money to pay off debt, to loan out to other banks or cus­tomers or ask for actual money. Typ­i­cally they do the one of the first two and not the other. This may go on for sev­eral steps but even­tu­ally, some­one wants the actual money and the orig­i­nal entry gets con­verted to cold hard cash.

That of course would increase the money sup­ply held by the pub­lic. The Fed did two dif­fer­ent things to increase the liq­uid­ity with­out increas­ing the money sup­ply. First, it asked the Trea­sury to bor­row a bunch of money by sell­ing T-Bills to banks. Those banks paid for the T-Bills by ask­ing the Fed to trans­fer money from the accounts at the Fed to accounts at the Trea­sury. The Trea­sury then just sits on the money and you have no increase in money sup­ply held by the public.

The sec­ond way the Fed increased liq­uid­ity was by chang­ing the terms of the accounts they held with the banks. In the past, if the Fed added an entry to a bank’s account, the bank would put that money to use, typ­i­cally by lend­ing it out overnight. They did this because the Fed did not pay inter­est on any money that sat in the account overnight and the bank could get inter­est in the overnight lend­ing trade. How­ever, dur­ing this cri­sis, the overnight lend­ing trade came to be viewed as sus­pect by most banks because they didn’t know what banks were sol­vent and what banks weren’t. So they weren’t inclined to lend that money out and the Fed helped them out by start­ing to pay inter­est on accounts. Now, the banks could just leave the money sit­ting there and still make money. This sit­u­a­tion allowed the Fed to essen­tially bor­row directly from the pub­lic because they can increase account bal­ances with­out hav­ing to worry about money get­ting into the system.

Of course, all of this is still infla­tion­ary because money is essen­tially being cre­ated out of thin air. Plenty of peo­ple worry about this and Ben Bernake wants peo­ple to know that they have a plan for get­ting out of the sit­u­a­tion once the econ­omy turns around which he detailed in the Wall Street Jour­nal Op-Ed linked above. He argues that the Fed can just increase the inter­est rates it pays on the accounts banks hold with it once the econ­omy turns around. By increas­ing the inter­est rates, it can ensure that banks will con­tinue hold­ing money with the Fed instead of loan­ing it out to the public.

This is where the­ory is going to meet real­ity in what is liable to be a very ugly street fight. Increas­ing inter­est rates sounds real easy but in fact, is a highly polit­i­cal process, one that Alan Greenspan failed at spec­tac­u­larly in 2002–2003 when the econ­omy was com­ing out of reces­sion. Increas­ing inter­est rates nat­u­rally inhibits growth because it is more expen­sive to bor­row money to fund expan­sion. Imag­ine a sce­nario where we start to come out of the worst reces­sion we’ve seen since WWII. Unem­ploy­ment is start­ing to level out, prob­a­bly around 11% or so. Spend­ing is start­ing to increase some­what. If sud­denly growth starts to shoot up a lit­tle, banks will be inclined to lend that money that the Fed gave them out. If at this point, the Fed raises inter­est rates, it takes a huge polit­i­cal risk in that it may nip the growth in the bud and return us to a reces­sion. Can you imag­ine the polit­i­cal fall­out from a move like that? The elec­torate would scream bloody mur­der and who­ever was in charge at the Fed would be the scape­goat. In real­ity, the inter­est rates prob­a­bly wouldn’t get raised at all and once the banks started lend­ing that money out, we’d see a highly infla­tion­ary environment.

Because the plan the Fed has is in effect a polit­i­cal plan and not a mon­e­tary plan, it is likely to be a bro­ken plan from the out­set. The US econ­omy is headed towards a precipice with a tiny tightrope to the other side, on one side of the rope is long term stag­na­tion and on the other a hyper-inflationary sce­nario that turns us into Argentina or worse, Zim­babwe. I highly doubt that we will have the abil­ity to walk the tightrope between the two and will likely end up in the sec­ond sit­u­a­tion because it will be an eas­ier polit­i­cal deci­sion to make. This is the prob­lem that comes up when you have highly tech­ni­cal peo­ple in con­trol of what is essen­tially a polit­i­cal prob­lem. In the­ory, their rea­son­ing goes, we can fix this, no prob­lem. In real­ity, it’s never that easy.