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Fed's Money Creation: Hyper-Active and Inflationary (Result: Weaker Dollar)

We have already seen how the Fed's policy regarding interest rates has been for the last 29 years geared downwards to the near zero we have today. Lowering interest rates is the indirect way of pumping money into the economy, for it encourages people to borrow at lower rates and banks to issue more loans (which is a way of creating money out of thin air).  

I have argued that the Fed under Greenspan and Bernanke has been systematically lowering rates to "save" wall street from bursting bubbles when the irony is that the lowered rates (and fed money injections) have helped to inflate the bubbles in the first place, or inflated new ones down the road. 

Another mechanism by which the Fed can interfere with the money supply directly is through the use of its shadowy printing press. Every time Wall Street gets itself into a major crisis, or the Government wants to fund a foreign war, the Fed's printing presses are busy creating money out of thin air to give to Wall Street or lend to the government. During each and every economic crisis the Federal Reserve has stepped in to either cut interest rates and/or provided massive doses of liquidity to the banking system in order to stem the crisis. We saw this in 1994 following the Mexican Peso crisis, again in 1997, and especially 1998 after LTCM and the Asian Contagion crisis. Then along came Y2K (1999) and September 11, 2001 and each crisis was met with massive liquidity injections and rapid interest rate cuts. Money grew at an  average rate of  8-10% throughout the late 1990's faster than the rate of economic growth, and a great deal of the excess liquidity found its way in the stock market and aided the tech bubble. Then, with the bursting of the tech bubble, the fed stepped in again, with lowering interest rates and injecting money into the system, only to help fuel the even bigger housing bubble of 2002-2007. Now where does it all end up?

We are now in a situation where the Fed has again slashed interest rates to near zero levels, and it has injected money into the system at unprecedented levels.  The Fed has been pumping billions into the system either by lending money directly to the banks, or by lending the money to the government by purchasing T-bills. More recently, with Quantitative Easing, the Fed has gotten into the habit of printing billions of dollars every week to buy not just T-Bills but private assets like mortgage backed securities.

In an effort to track the Fed's actions, Real Time Economics of WSJ has created an interactive graphic that updates in real time the expansion of the central bank's balance sheet.


It is fun to go to the WSJ page itself and explore the interactive graphic: one can click on any point in time to see the historical accumulations. 

As of Dec 15, 2010, the Fed balance sheet sits at a whopping $2.37 Trillion. This is an incredible sum of money -- and most of it was accumulated in the last 2 years. If you move back to Sept 3, 2008, just before all the world markets take their concerted plunge, the Fed balance sheet was sitting at $888 billion, with $479 billion in US Treasuries, $169 billion in Direct Bank Lending, and only $29 billion in funds related to Bear Stears and AIG.

Now the funds allocated to Bear Stears and AIG account has mushroomed from $29 billion to $113 billion and continues to climb. Most of it is going to AIG. Actually, the deal was that the US government was to seize control of AIG for $85 billion, but that soon mushroomed to $182 billion, with the two lenders being the the government (i.e., taxpayers),  and the Fed Reserve. 

The entire story of the AIG bailout is a stark lesson in how complicit the Fed has become in the crisis. In a Nation article entitled The AIG Bailout Scandal, William Greider reports on the investigation of the five-member COP, chaired by Harvard professor Elizabeth Warren, of AIG: 

[The COP team] has produced the most devastating and comprehensive account so far. Unanimously adopted by its bipartisan members, it provides alarming insights that should be fodder for the larger debate many citizens long to hear—why Washington rushed to forgive the very interests that produced this mess, while innocent others were made to suffer the consequences. 

The report concludes that the Federal Reserve Board’s intimate relations with the leading powers of Wall Street—the same banks that benefited most from the government’s massive bailout—influenced its strategic decisions on AIG. The panel accuses the Fed and the Treasury Department of brushing aside alternative approaches that would have saved tens of billions in public funds by making these same banks “share the pain.”

Bailing out AIG effectively meant rescuing Goldman Sachs, Morgan Stanley, Bank of America and Merrill Lynch (as well as a dozens of European banks) from huge losses. Those financial institutions played the derivatives game with AIG, the esoteric practice of placing financial bets on future events. AIG lost its bets, which led to its collapse. But other gamblers—the counterparties in AIG’s derivative deals—were made whole on their bets, paid off 100 cents on the dollar. Taxpayers got stuck with the bill.

“The AIG rescue demonstrated that Treasury and the Federal Reserve would commit taxpayers to pay any price and bear any burden to prevent the collapse of America’s largest financial institutions,” the COP report said. This could have been avoided, the report argues, if the Fed had listened to disinterested advisers with a less parochial understanding of the public interest.

Greider goes on to point out that the "The most troubling revelation in this story is the astonishing weakness of the Federal Reserve and its incompetence as a faithful defender of the public interest": 

The Fed was strangely passive and compliant when it came to demanding cooperation and sacrifice from the largest financial institutions. Timothy Geithner was then president of the New York Federal Reserve Bank, the lead regulator of Wall Street’s largest banks. He briefly insisted they must accept the burden of rescuing AIG. But the bankers called his bluff and blew him off—and Geithner deferred to their wishes. The taxpayer bailout followed. The episode is relevant to the future, because Geithner is now Obama's Treasury Secretary...

So there you have it. In my interest rate article, I point out how the Fed has been in bed with Wall Street since Greenspan. Remember the Greenspan "put" -- the psychological insurance that the Fed will come to the rescue of Wall Street if any of its intoxicated gambling binges should go awry. It wasn't just that the Fed would cut interest rates, which is a form of "drink themselves sober" strategy, it was that the Fed would also inject lots of money at the gamblers themselves. Particularly if they were the big investment banks like Goldman Sachs, whose alumni are stationed in high places within the Fed and Washington. These guys have totally rigged the game in their favor: they make billions by helping to create the bubble in the first place, and they have their friends in the Fed and Washington to ensure that they make billions more when the bubble bursts.

Massive Quantitative Easing = Massive Printing of Money

In an attempt to support housing prices and keep mortgage interest rates at artificially low levels, the Federal Reserve has been implementing massive quantitative easing (Q1 and Q2) and buying $1 trillion mortgage backed securities. Before the crisis, the Fed mostly bought T-bills, and it still does buy these to ever greater degrees. But now it is heavily involved in buying mortgage backed securities. Mortgage backed securities were hailed as as great financial innovation in allowing investment banks to securitize hundreds of mortgages in financial agrements called Mortgage-backed securities (MBS), which derived their value from mortgage payments and housing prices. But as housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. And guess what? Fewer big money fools stepped into buy these crappy MBS when they were dropped back on the market. So the Federal Reserve stepped in to become the "buyer of last resort," printing massive amounts of money out of thin air in order to buy these mortgage backed securities no one wants, in order to aid the failing banks and housing prices and keep the bubble economy hobbling along. England's central banks did the same.

When the two favorite tools are not working -- interest rates are at near zero levels and government bailout plans have become unpopular -- then the Fed feels it must reflate the bubble with its printing presses. Hellicopter Ben calls it "quantitative easing," but it is really the creation of massive amounts of money out of thin air with the hope of getting the economy back on track. The idea of quantitative easing was borrowed from Japan, which used it a decade ago when it had a similar problem. The Fed uses its central-bank magic to invent (print new money) in order to purchase billions in government bonds from the banks that cannot sell these bonds. The banks then, in theory, have billions more (magnified by the fractional reserve system) to lend out to companies and people to invest and spend -- which stimulates the whole economy. 

It sounds great in theory, creating more money, getting it out there so everyone wins, but it is very controversial. It has been tried a few times and it did not work for Japan.

The Risks of Quantitative Easing

The Central bank magic of printing more money and calling it by name such as "Quantitative easing" runs the risk of deflating the home currency. Moreover, in the global market, home printed money can flood abroad and spark asset bubbles in developing economies. 

We are very concerned about the double-speak of Q2, a fancy way of saying the Fed is printing money out of thin-air, and there are others on the net that suggest even darker tidings, suggesting that Quantitative Easing is Economic Suicide

Quantitative easing is nothing more than a euphemism for printing money out of thin air. Its one-and-only purpose is to destroy the currency being printed. It is pure dilution and absolutely no different than a corporation vowing to improve its fiscal performance simply by printing a lot of new shares.

We can illustrate the inherently evil nature of this monetary abomination by working through the "mechanics" of this policy. First, the explicit goal of QE2 is to increase inflation. By now, all readers should be familiar enough about "inflation" to know that it is literally nothing more than the speed with which our currencies are being destroyed.

In the case of the Federal Reserve, we understand all too well how "successful" it has been in creating inflation. Since it was invented in 1913, the Federal Reserve has been directly responsible for the U.S. dollar losing 97% of its value (i.e. inflation has raised prices by more than 20 times what they were in 1913) -- despite the official mandate of the Federal Reserve for "price stability" (i.e. protecting the dollar). Now, Ben Bernanke is vowing to "succeed" in destroying the remaining 3% of value of the world's reserve currency.

This is chilling when you think of it. The act of "injecting money into the system" and "easing credit conditions" is creating money. It is inflation. The mechanisms might be shrouded in technical language and obfuscated by arcane financial magic, but this is inflation. The devaluation of the currency and the rising prices are simply the natural effects of this act of inflation. These things are intimately connected. They are effectively two sides of the same coin. While one might look at the current CPI and think that the 1.2% inflation rate isn't so bad, you might want to visit Shadowstats.com, operated by respected U.S. economist John Williams, and you will see that U.S. inflation has been in the range of 8.5% - 9.5% throughout 2010.

Conclusion

Obviously, quantitative easing does not and cannot "fix" any of the U.S. economy's problems, which (ironically) have all been caused by too much new debt, and new money-printing.

The Fed's lowered interest rates on loans, particularly mortgages, was a key contributing factor to the housing bubble that just recently burst.

Next, the Fed's buying $1 trillion in Mortgage Backed Securities from the banks represents an injection of not just $1 trillion to the banks but the potential of a much bigger number because the "magic" of the fractional banking system can allow the banks to lend 10 times that amount, increasing the money supply by $10 trillion. However, it takes time for this to occur. Banks are not lending against their excess reserves (which is where this newly created money has gone), and people aren't borrowing for as much as they did for a lot of reasons. You need both lending and borrowing to unleash the real expansion in the money supply.

But the lowering of interest rates and the Fed injections of money are intended to make borrowing cheap again and get the money flowing. The money supply expansion will continue growing at double digits, and the sure victim of this will be the US Dollar.

With dollars being multiplied at will, the US dollar has depreciated over 40% since 2002 against a basket of major currencies, and apart from the Euro and Pound, whose Central Banks are engaged in similar maneuvers as the Fed from 2008-2010, the US dollar will continue to deteriorate against most currencies.

In sum, since 1985, the Fed has abandoned any attempt to have a stable dollar, and in fact, it can be argued, the unofficial strategy has been to have a inflationary policy and weaker dollar (dollar made weaker because of an exponentially expanding money supply created from the Fed's low interest rates and hyperactive printing presses), in order to reflate bursting bubbles that were fueled by the same loose monetary policy.

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