Here’s a flash. Things aren’t always as they seem in Washington.
Case in point: This week headlines around the world screamed that the Federal Reserve Board is making lowering unemployment, not controlling inflation, its key objective. It will continue holding down interest rates and expanding the money supply so long as unemployment remains above 6.5 percent. This means it will extend its unprecedented four years of quantitative easing indefinitely.
Yet on the same day some papers noticed that, as the Financial Times reported, “The US Federal Reserve is carrying out its first ever system-wide stress test of bank liquidity…”, in effect requiring that banks increase reserves even more than they already have. In other words, even as the Fed doubles down on quantitative easing, it will also double down on a process that started with Dodd-Frank and the international banking agreement called Basel III and demand that banks up their holdings of cash and highly liquid assets (primarily government bonds) at the expense of loans, a process that to monetarists looks like the exact opposite of quantitative easing.
And with the government continuing to push banks back into the housing market as if no one has learned a thing from the crisis of 2008-9 and with major corporations and their stellar credit ratings continuing to be favorites of regulators as well as bankers, those who feel this tightening most painfully will be small and medium-sized businesses. But wait. Aren’t those the kinds of enterprises that created all the net new jobs over the last three decades?
It is nothing new for the Fed to move in opposite directions.
Economist Steve Hanke is perhaps the world’s leading expert on hyperinflation, which many worry will be the outcome of all the quantitative easing. He notes that since September 2008 the Fed’s “balance sheet has increased roughly three and a half times… from about 6.5 percent of the total money supply… until now it’s about 15 percent….” He calls these holdings “state,” meaning government-issued, money, as opposed to the money created via lending, which he calls “bank” money.
And of bank money, he adds, regulation and rising reserve requirements “have in effect imposed ultra-tight monetary policy on the banking system and bank money… [w]hich accounts for 85 percent of the total money in the economy.”
The upshot Hanke concludes is that “relative to trend we’ve got a deficiency of 7.5 percent in broad money.” You would think that after four years the Fed would figure out this contradiction, and no doubt it has. So what is it actually up to?
Consider this: Four years ago, Fed Chairman Benjamin Bernanke and his colleagues were presented with two crises. The first was the collapse of the housing bubble. Brought on by the demands of congressional Democrats led by Rep. Barney Frank and then-Sen. Chris Dodd that banks become extensions of federal social policy, the housing bubble swept away tremendous volumes of bank capital when it burst. It wasn’t that this bank or that bank was too big to fail, but that a vast number of banks were suddenly capital deficient and endangered. By creating large volumes of “state” money while restricting the expansion of “bank” money, the Fed has spent the last four years, in effect, recapitalizing the American banking system.
In its current phase, the second crisis also began in 2008—the crisis in government debt and unaddressed entitlement liabilities. The media is full of talk about the fiscal cliff. Will we go over it? Will we not? But if you are sitting at the Fed (and working closely, as Bernanke has throughout his tenure, with the secretary of the Treasury), you have to assume that, whatever the outcome of the current White House-Congress negotiations, the government’s unprecedented volume of borrowing will continue indefinitely.
So, now, assume you are Chairman Bernanke. You ask yourself, “How do we finance all those deficits?” You answer, “What if we at the Fed print lots of ‘state’ money and buy the debt ourselves?” But then you think, “If we do that, how do we protect the nation from late ’70s-early ’80-style runaway inflation?” Then you think, “Bingo, we’ll clamp down on ‘bank’ money?”
How simple. Two crises, one solution.
Here is how the Fed’s words and actions of the last couple of days add up. Mr. Bernanke sees both crises continuing indefinitely. Announcing that lowering unemployment is the goal buys him time with his most worrisome Hill and White House critics but doesn’t necessarily mean that “state” and “bank” money policies will move measurably relative to one another.
Bank capital will continue to build. The government will continue to be funded. Growth will continue to crawl.