Friday, February 6, 2009

Pushing on a string

From the Skeptical Optimist
The Fed has been "printing money" (purchasing assets from the public with money it has the power to create from so-called thin air) at an unprecedented pace in recent months, as we've discussed before. The objective is to stimulate lending and borrowing, which is the heartbeat of the economy. But all that new (base) money hasn't been doing much stimulating so far.

Below is a chart from the St. Louis Fed showing what the banks are doing with all that new base money: they aren't lending it out [...more precisely, they aren't using it to back new loans]; they're sitting on it, in the form of "excess reserves."

That explains why all that "money printing" by the Fed isn't causing price/wage inflation.
It's certainly true that the Fed cannot push on a string. It's also true that monetary policy takes time to take effect---anywhere from a year to two years. The Fed has tripled the size of its balance sheet in recent months. That's a lot of new monetary base.

Eventually, new money will start to show up in the economy in a big way. When it does, the Fed will not be able to benignly remove it without consequence.

If monetary policy were actually capable of improving human welfare, and if the Fed understood how to do it, we'd all be rich as God already. Commons sense (which is what good economics really is) tells us that creating more or less money is not the road to economic prosperity.

Keynesians mistake spending for production. Monetarists mistake credit for production. If you want to understand economics, it really helps to analyze whatever is the issue as if there were no money. That's not easy, because we are so used to money as a medium of exchange (a quite necessary medium, by the way).

We cannot do without money, but we can do without changes in its purchasing power. Just about any quantity of money will work, so long as people know how much of it there is and know that its purchasing power is not being systematically manipulated by 7 governors plus 5 Fed bank presidents (the Open Market Committee).

One really has to ask the obvious questions. If the Fed knows what it's doing, and if regulators know what they're doing, why are we having this financial debacle and the recession it has spawned? Keynes suggested "animal spirits." I suggest a much better answer. Neither the Fed nor the regulators can deliver what they say they can; namely, economic stability and sustainable growth with low unemployment. What they can deliver is massive uncertainty, which leads to exactly what we have now---recession and a credit crunch.

Financial instability and recessions are not accidents; they are also not random. It is most charitable to say they are caused by mistakes made by monetary policy makers (the Fed) and fiscal policy makers (the Congress). Less charitable explanations are also available.

2 comments:

Ethan Lavallee said...

whooooa!!! i thought that when banks had excess reserves they either had to lend it or send it back to the FED. thats what you told us right? then what the frig are they doing with that much in reserve >:-(

DLK said...

Banks keep reserves in an account with their regional Fed bank. Banks do not have to make new loans. Instead, if a bank has no credit worthy borrowers, the bank just has excess reserves. Of course, we wouldn't want banks to make loans to households or businesses the banks think would not pay them back.

Right now, we have so much uncertainty in the economy that banks are worried about making new loans, either to other banks, businesses, or households. That's the so-called "credit crunch."