Fed Challenge: When to Put Brakes on Money Supply

Published October 1, 2009

Graphs of economic statistics usually meander across a page like a walk through a forest or wiggle up and down with the business cycle like an EKG machine. Only recently have we been confronted with statistics that shoot up vertically, like a lie on a polygraph test.

Statistics such as the monetary base and the money supply have gone vertical because of the Federal Reserve’s trillion-dollar bailouts of big financial institutions. Essentially, the Fed has taken possession of some of the banks’ assets in exchange for adding reserves to the banks’ accounts at the Federal Reserve.

That’s the easy part. All they have to do is make a bookkeeping entry in the account of the banks, and money is created out of thin air.

Source of Economic Problems

What happens when all that new money makes its way from bank reserves to new loans, as intended? Eventually that loaned money makes it into paychecks and then into the markets for gasoline and milk, and this means higher prices for all.

Federal Reserve officials have said they understand the importance of reversing policy and withdrawing excess liquidity to prevent price inflation. In congressional testimony, Federal Reserve Chairman Ben Bernanke said, “We understand the necessity of winding this down at the proper moment so we will not have an inflation problem at the other side.”

Hard to Reverse

Anyone can push the monetary inflation button, and interest rates will fall and the politicians will jump for joy. The hard part is reversing this policy. It will involve the Federal Reserve selling assets such as government bonds and asset-backed securities back into the financial markets.

That would soak up liquidity, but it also would reduce bank reserves, reduce credit availability and loans, and increase interest rates.

In the short term, such action will not be taken. Fed policy has been to peg overnight rates, which encourage borrowing by member banks and, policymakers hope, increased lending that stimulates the economy. That rate has been between zero and a quarter of 1 percent.

Economist Glenn Rudebusch of the San Francisco Federal Reserve argues the interest rate suppression might have to go on for years in order to deliver low enough rates to encourage recovery. Naturally, the rate cannot go below zero.

If the Fed starts the reversal before the economy recovers, it may be able to beat down price inflation in the economy, but what will the politicians and pundits say to higher interest rates and restricted credit while unemployment is still rising? If the Fed waits until the economy has recovered, however, most experts think it will be too late to prevent the emergence of higher price inflation in the future.

Firm Rules Needed

Of course a better question might be: How often does the Federal Reserve, or any central bank, reduce the money supply? Banks make money with expanded money supply, and inflation enables politicians to pay the $11+ trillion national debt with depreciating paper money.

Austrian School economists always have emphasized the importance of the gold standard, where gold and silver serve as money. Gold secures the value of money and prevents reckless government spending.

A return to some variant of a gold standard would be an efficacious solution to the inherent instability created by a fiat monetary system. Unfortunately, such a policy is ridiculed by many economists and, naturally, by government.

There are, however, alternatives that could be considered at this point. Market stability requires certainty on the part of transactors—which could be produced by setting some firm rules regarding discount rates and Fed policy generally.

The current economic downturn may end without a gold standard or a regime of rules, but if so, economic turmoil over the long run will inevitably inure to American economic policy.

Robert B. Ekelund Jr. ([email protected]) is Lowder Eminent Scholar Emeritus at Auburn University and an adjunct scholar at the Mises Institute. Mark Thornton ([email protected]) is a senior fellow and resident faculty member at the Mises Institute.