First under the Bush Administration and even more so under President Obama, the federal government has been seizing power and spending money as it hasn’t done since World War II. But as bold as the Executive Branch has been during this financial crisis, the innovations of Fed chairman Ben Bernanke have been literally unprecedented. Indeed, it is entirely plausible that before Obama leaves office, Americans will be using a new currency.
Bush and Obama have engaged in record peacetime deficit spending; so too did Herbert Hoover and then Franklin Roosevelt (even though in the 1932 election campaign, FDR promised Americans a balanced budget). Bush and Obama approved massive federal interventions into the financial sector, at the behest of their respective Treasury secretaries. Believe it or not, in 1932 the allegedly u201Cdo-nothingu201D Herbert Hoover signed off on the creation of the Reconstruction Finance Corporation (RFC), which was given billions of dollars to prop up unsound financial institutions and make loans to state and local governments. And as with so many other elements of the New Deal, FDR took over and expanded the RFC that had been started under Hoover.
In the past year, the government has seized control of more than half of the nation’s mortgages, it has taken over one of the world’s biggest insurers, it literally controls major car companies, and it is now telling financial institutions how much they can pay their top executives. On top of this, the feds are seeking vast new powers over the nation’s energy markets (through the House Waxman-Markey u201CClean Energy and Security Actu201D and pending Kerry-Boxer companion bill in the Senate) and, of course, are trying to u201Creformu201D health care by creating expansive new government programs.
For anyone who thinks free markets are generally more effective at coordinating resources and workers, these incredible assaults on the private sector from the central government surely must translate into a sputtering economy for years. Any one of the above initiatives would have placed a drag on a healthy economy. But to impose the entire package on an economy that is mired in the worst postwar recession, is a recipe for disaster.
Debt and Inflation
Conventional economic forecasts for government tax receipts are far too optimistic. The U.S. Treasury will need to issue far more debt in the coming years than most analysts now realize. Yet even the optimistic forecasts are sobering. For example, in March the Congressional Budget Office projected that the Obama administration’s budgetary plans would lead to a doubling of the federal debt as a share of the economy, from 41 percent of GDP in 2008 to 82 percent of GDP by 2019. The deficit for fiscal year 2009 (which ended Sept. 30) alone was $1.4 trillion. For reference, the entire federal budget was less than $1.4 trillion in the early years of the Clinton administration.
Clearly the U.S. government will be incurring massive new debts in the years to come. The situation looks so grim that economist Jeffrey Hummel has predicted that the Treasury will default on its obligations, just as Russia defaulted on its bonds in 1998. But another scenario involves the Federal Reserve wiping out the real burden of the debt by writing checks out of thin air to buy up whatever notes the Treasury wants to issue.
Many analysts are worried about Fed chairman Ben Bernanke’s actions during the financial crisis; Marc Faber is openly warning of u201Chyperinflation.u201D To understand what the fuss is about, consider some facts about our monetary and banking system.
The United States has a fractional reserve banking system. When someone deposits $100 in a checking account, most of that money is lent out again to other bank customers. Only a fraction — typically around 10 percent — needs to be held u201Con reserveu201D to back up the $100 balance of the original depositor. A bank’s reserves can consist of either cash in the vault or deposits with the Federal Reserve itself. For example, suppose a given bank has customer checking accounts with a combined balance of $1 billion. Assuming a 10 percent reserve requirement, the bank needs $100 million in reserves. It can satisfy this legal requirement by keeping, say, $30 million in actual cash on hand in its vaults and putting $70 million on deposit in the bank’s account with the Fed.
Normally, the Fed expands the money supply by engaging in u201Copen market operations.u201D For example, the Fed might buy $1 billion worth of government bonds from a dealer in the private sector. The Fed adds the $1 billion in bonds to the asset side of its balance sheet, while its liabilities also increase by $1 billion. But Bernanke faces no real constraints on his purchasing decisions. When the Fed buys $1 billion in new bonds, it simply writes a $1 billion check on itself. There is no stockpile of money that gets drained because of the check; the recipient simply deposits the check in his own bank, and the bank in turn sees its reserves on deposit with the Fed go up by $1 billion. In principle, the Fed could write checks to buy every asset in America.
Since the start of the present financial crisis, the Federal Reserve has implemented extraordinary programs to rescue large institutions from the horrible investments they made during the bubble years. Because of these programs, the Fed’s balance sheet more than doubled from September 2008 to the end of the year, as Bernanke acquired more than a trillion dollars in new holdings in just a few months.
Bob Murphy [send him mail], adjunct scholar of the Mises Institute, is the author of The Politically Incorrect Guide to Capitalism, The Human Action Study Guide, and The Man, Economy, and State Study Guide. His latest book is The Politically Incorrect Guide to the Great Depression and the New Deal.