The Federal Reserve's Self-Imposed Dilemma

by Gary North
by Gary North

The Federal Reserve System faces a dilemma of its own creation: the doubling of the monetary base. You can see it here.

The only thing that is keeping this from creating mass inflation is the decision of commercial bankers to deposit the bulk of this increase with the Federal Reserve. The banks are not lending out this money. Neither is the FED. This money does not legally belong to the FED.

President Obama has said that banks that receive money from the Federal government as part of the bailout operation are going to be required to lend money. As to how this is going to be enforced, he did not say. Rep. Barney Frank insists that there will be specific legislation mandating that banks lend money to the public.

If the Federal government gets into the business of allocating bank loans, the results will be disastrous. For a nice survey of the bad effects that such intervention will cause, read the article by Michael Rozeff, a retired professor of finance.

SUBSIDIZING EXCESS RESERVES

There is a reason why the banks are not lending money to the public. Instead of taking the risk of lending, the banks are depositing hundreds of billions of dollars with the Federal Reserve. Beginning last October, the Federal Reserve began paying low rates of interest on money above the legal reserve requirement that banks must deposit at the Federal Reserve System. This new policy was not to go into effect until October of 2011, but the banking crisis forced the Federal Reserve to speed up the legal timetable. Congress, of course, did nothing.

Because the banks place their money with the Federal Reserve, this money is taken out of the fractional reserve process. The Federal Reserve System does not lend this money to borrowers. It is not part of the FED's balance sheet. The FED keeps the money in reserve. The banks were initially paid only 1.25% for these deposits, and this was dropped to 1% before October was over. Because of the Federal Reserve's new target for the federal funds rate, which is now approximately 0%, banks are not receiving any interest on the money they have on deposit with the FED. Yet they have to pay interest to depositors. So, the excess reserves are causing banks to hemorrhage money. The money is safe, but the losses are guaranteed. The banks have almost no money coming in as interest payments from the Federal Reserve, but they have money going out as interest payments to depositories. This cannot go on forever.

The new Administration understands that something is wrong. Advisors know the banks are not lending. They do not seem to understand why the banks are not lending. They are not lending because bankers are fearful that they will not be repaid. They are so terrified by this economy that they would rather put the money with the Federal Reserve System, receive essentially no interest, and suffer losses on interest paid to depositors. They would rather lose a little money, month by month, then put their money at risk by lending it. This gives some indication of just how bad the present economy is.

If bankers are afraid to lend money to senior American corporations for 90 days, and if they are afraid to lend money to the United States Treasury to buy long-term bonds, there appear to be no profitable opportunities for investors, either. The banks are certainly not going to put the money in the stock market. Why should you? They are afraid to put it in the corporate bond market. I can hardly blame them. They are afraid of doing anything with the money.

The Federal Reserve now faces a problem. It faces a series of problems. We need to understand the nature of the problems that the Federal Reserve is facing in order to understand what Federal Reserve policy is today.

A ZERO-BOUND ECONOMY

The Federal Reserve wants to avoid price deflation. In the terminology of Keynesian central bankers, this is called a zero-bound condition. We are now in that condition. The federal funds rate is so low that banks ought not to be lending to the Federal Reserve. Nevertheless, they are lending to the Federal Reserve at approximately one-tenth of 1% interest. They are not lending to the general public. If the economy continues to contract, as Keynesian theory says it will contract if the banks do not lend, then prices will fall, and interest rates on Treasury debt will remain essentially zero at the short maturities. This will make it difficult for the Treasury to get foreign investors to lend money to it.

The Federal government is facing a $1.2 trillion deficit, and foreign central banks are unlikely to lend to the Treasury at a quarter of a percent interest, the rate for 90-day T-bills. Foreign central banks are also saying that they no longer wish to lend on long-term T-bonds.

According to Keynesian economic theory, when interest rates fall to zero, increases in central bank purchases of debt obligations, which would otherwise stimulate the economy, no longer occurs. Why not? Because banks refused to lend. This stops the fractional reserve banking expansion process. The economy stagnates. Economic growth contracts. Prices fall. The process accelerates. It is a downward economic spiral. This is what Milton Friedman said caused the Great Depression. Almost everybody today believes Friedman. So, they are frightened that we have reached a situation where Federal Reserve expansion of the monetary base will not lead to an expansion of the money supply. This means that the economy will continue to fall even faster.

AN EASY SOLUTION WITH DISASTROUS CONSEQUENCES

There is an easy solution to this problem. The Federal Reserve knows exactly what the solution is. Nobody mentions it. The suggestion that the Federal Reserve would attempt it would probably bust the bond market. The Federal Reserve would announce that, from this point on, all money deposited by banks as excess reserves will be charged a storage fee. This fee could be 2%.

Not only would banks not make any interest on the money deposited with the Federal Reserve, they would begin suffering a loss of 2% per annum on the money held as excess reserves. These losses would be in addition to the losses sustained by the banks because they have to pay interest to depositors. The banks would find that the guaranteed loss of the combined payments would be so great that it would be safer to lend the money to the general public. Banks would then start lending to corporations and to the Federal government. They would certainly buy Treasury bills at a quarter of a percent per annum rather than holding excess reserves at –2%. The Treasury would spend the money into circulation. This money would then multiply through the fractional reserve banking process.

This would create another grim scenario for the Federal Reserve. The Federal Reserve has more than doubled the monetary base since September 2008. This has been offset by the decline in the money multiplier, which has been caused by bankers' decisions to hold money as excess reserves with the Federal Reserve. If the Federal Reserve begins charging a storage fee to banks that deposit excess reserves with the FED, the money multiplier will immediately reverse. It will go back to something approaching normal. At that point, the increase in M-1 will begin to affect the economy. There will be more money available for consumers to spend.

Some people are afraid that consumers will save money. Why? Bad economic theory. Thrift does not have any effect on the money supply in a fractional reserve banking system. If one group of consumers saves more money, this does not affect the money supply. These thrifty people will increase the amount of money that they have deposited at their local bank. This does not change the monetary base.

When a small percentage of consumers stops spending on consumer goods and increases holdings of bank accounts or money market funds, this will have no effect on the total money supply. It means that one group of consumers will cut back on spending, but it means that other groups of consumers will increase spending.

People who borrow money at a bank intend to spend it. Maybe they are going to spend it on business activities. Maybe they are going to spend it on consumer goods. But they are going to spend it. Nobody increases his debt in order to put it in a bank account. Nobody pays a bank 7% or 10% per annum in order to put it in a bank account that pays 2% per annum. If he does, he is doing this only for very brief time until he spends the money.

FEAR OF PRICE INFLATION

Why hasn't the Fed adopted this policy of a penalty payment? I think this should be obvious. Banking theory teaches that when the monetary base doubles, the money supply will double. If the money supply doubles, consumer prices will also come close to doubling. There will usually be a time lag, but the process is clear. An increase in the monetary base, which is called high-powered money, multiplies through the fractional reserve banking system. All schools of economic opinion agree on this point.

If the Federal Reserve is unwilling to impose a penalty payment on excess reserves, it is afraid that banks are going to do the rational thing: lend money to the general public. It is clear that the Federal Reserve System's policy-makers are afraid that banks are going to do what banks are supposed to do with reserves: lend money to the general public. The Federal Reserve is attempting to sterilize the increase of the monetary base, which it created. Federal Reserve economists know that if banks start lending reserves that are being held the Federal Reserve beyond the 10% legal limit, there is going to be mass inflation in the United States. The Consumer Price Index will double.

Any additional spending by the Federal Reserve to prop up the Treasury bond market will be immediately reflected in an increase in M-1. Long-term interest rates will soar. The market for Treasury bonds will collapse. At that point, the Federal Reserve will have to intervene and purchase Treasury bonds. This will drastically raise interest rates on corporate bonds and mortgages.

The Federal Reserve is now trapped by its own policies. It has dramatically increased the monetary base, and it does not want this money to be spent into circulation. Federal Reserve economists understand the fractional reserve banking process. They know that the only way that the M-1 money supply will not match the doubling of the monetary base is for the Federal Reserve to impose an increase in the reserve requirement. It has not done this. Instead, it has paid a small amount of interest to banks to persuade bankers to see keep money on deposit with the Fed, which sterilizes the increase in the monetary base.

If banks begin lending money to the general public, the Federal Reserve will have to sell assets in order to offset the increase in its balance sheet, which is a result of the big bank bailouts and buying T-bills. The problem is, the Federal Reserve is running out of Treasury debt certificates to sell. The only asset that the Federal Reserve now holds in its balance sheet that can be sold at face value to the general public is Treasury debt. There is no way for the Federal Reserve to unload the toxic assets that from the banks.

Furthermore, with the proposal of the so-called bad bank, which is one of those rare circumstances where the name given to it is appropriate for what the organization is, somebody has got to buy the toxic assets that are unloaded by the banks, so that the banks can get their balance sheets solvent again. Who is going to put up the money to buy all of this debt? The Treasury can buy it, but then the Treasury then must sell a comparable amount of debt to the general public. Who is going to buy that? Whoever does will invest money in a government-guaranteed bailout rather than in the private sector. Kiss the recovery goodbye.

Once the banks get their balance sheets in good shape again, by unloading hundreds of billions of dollars of junk assets onto the bad bank, they will start lending again. They will reduce their holdings of excess reserves at the Federal Reserve System. At that point, the money multiplier will start multiplying again, M-1 will grow dramatically, and we will be into mass inflation. I don't mean 10% or 20% or 30% price inflation. I mean 50%, 60%, or 100% per annum.

The vast increase of the monetary base, once it is translated into an increase in M-1, will create mass inflation in the United States. That money will be spent. Anyone who thinks the US Treasury will not send money to Social Security recipients, Medicare insurance programs, and all the other groups that are clamoring for bailouts, has been smoking something funny.

DELIBERATE POLICY

The reason why the banks are not lending is because a Federal Reserve policy has been established that pays banks not to lend. But now that the expansion of the money supply has been so great that the federal funds rate has been dropped to a tenth of a percent, the Federal Reserve's plan to sterilize its own expansion of the monetary base is threatened by constant losses to commercial banks, because they have to pay interest on deposits. Furthermore, the plan to sterilize the monetary base is also threatened by Congress and by the President, who insist that legislation is going to be passed which forces the banks to lend money.

People who are predicting price deflation, meaning significant price deflation of 5% to 10% per annum or more, operate on an assumption that the fractional reserve banking system no longer expands the money supply. They are assuming that banks will not lend. They are therefore assuming that the expansion of the monetary base which is already taken place is not going to be translated into an expansion of the money supply, because the Federal Reserve's program of asset sterilization by paying interest on excess reserves is going to be successful.

If success is defined as "falling prices and a collapsing economy," success is not going to be allowed by the United States Congress and the Obama Administration. They have made it clear that they are going to mandate that the banks lend. As soon as the banks start lending, the fractional reserve banking process takes over, and the money supply will double.

I think we are beyond the point of no return. I think the expansion of the monetary base by the Federal Reserve System cannot be sterilized much longer. Congress is going to force the un-sterilization of bank reserves. The Federal Reserve System can do this on its own authority, simply by imposing a penalty payment on excess reserves. This is not rocket science. This is simply a matter of the Board of Governors passing a new rule that imposes a 2%, 3%, or 4% penalty payment on excess reserves.

If I understand this, you can be certain that Federal Reserve officials understand this. You can also be certain that Ben Bernanke understands this. If Bernanke and the Federal Reserve's Board of Governors have refused to impose such a penalty payment, there is a reason for this. It is the same reason that the Federal Reserve began paying interest on excess reserves last October. The reason is clear: the Federal Reserve is terrified by its own policies. It knows exactly what is going to happen, once banks lend excess reserves into the general economy. It does not matter one way or the other who gets the money. It can be the United States Treasury. It can be large corporations. It can be people borrowing money to buy real estate. It can be any or all of these recipients of money. The public is willing to borrow whatever the banks are willing to lend at some interest rate. Contrary to John Maynard Keynes, the money will be borrowed, and the money will be spent.

My belief is that the banks will pull money out of excess reserves, either because they are forced to by the Federal government or because the Federal Reserve System begins imposing a penalty payment on excess reserves. Why would the FED do this? In order to forestall Congress. Also, in order to escape the zero-bound crisis that Keynesian economics says is the result of central bank policies that lower interest rates to zero.

The thought that nobody in the general public is willing to borrow money at 1% or 2% is ludicrous. Tens of millions of Americans have credit cards, and they pay 10%, 15%, or more on these cards. Americans will rush to buy houses if they can get mortgage rates at 2% or 3%. The idea that the interest rate does not balance the supply and demand of credit is so utterly ludicrous that it takes a Ph.D. in economics to believe it. This idea has been a dominant idea among economists all over the world ever since Keynes wrote the General Theory. It is a preposterous concept, and it is universally held. This is why economists throughout America are now clamoring for more bailouts by the Federal government. This is why they are demanding that the Federal government spend the money on anything and everything in order to make certain that the money gets spent by consumers.

CONCLUSION

The case for price deflation rests on one primary idea: banks will not lend, even though they have reserves to lend. So far, this has proven to be the case. Banks are keeping excess reserves with the Federal Reserve, thereby refusing to lend money to the general public.

Congress is not willing to accept this much longer. Neither is the Obama administration. So, the Federal Reserve System is going to have to fish or cut bait. It is going to have to decide whether or not it is going to subsidize the banking system: the decision of bankers to hold reserves with the Federal Reserve, thereby sterilizing the expansion of money that the Federal Reserve has produced since last September. I don't think the Federal Reserve wants either outcome. On the one hand, it is terrified by the zero-bound economy that it has created. On the other hand, it is terrified by the thought of what the expansion of the Federal Reserve's monetary base will do the money supply, and from there do to consumer prices. I feel their pain. I prefer not to.

We are all going to feel a great deal of pain over the next few years. The basis of this pain is already in the monetary pipeline. The relevant question now is this: "How soon will the FED decide to un-sterilize its monetary base?"

This raises a practical question: "What can a small minority of investors do to beat the rush to the lifeboats, before they fill up?" The majority will not be able to escape the sinking ship of state.

February 4, 2009

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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