Easy Money

I read this morning a delightful bit of news from Bloomberg. Apparently, two Harvard economists (please lower your head in reverence) Ken Rogoff and Greg Mankiw have requested that Fed Chairman Ben “The Liquidator” Bernanke target 6% inflation growth “for at least a couple of years”. There seems to have been calls for inflationary policy from other economists as well. I would like to be on the record (as marginally public The Founder’s Porch seems to be): this is a bad idea. There’s no simpler way to put it. The Fed should aim for price stability to avoid uncontrollable inflation.

Before we get started breaking down the issues, let’s all get caught up to speed. Monetary inflation is a function of how much currency is available and how fast it’s spent. Although expanding the money supply is typically characterized as “the Fed firing up the printing presses”, this is inaccurate. The money supply is primarily grown through issuing credit, and this is exponential. Here’s how it works (if you’re startled easily, please sit down). My explanation is a little over-simplified but in essence is true.

We have in this country what is called “fractional reserve banking”. This means that at any given time a bank only is only required to possess in reserves the cash to cover a fraction its liabilities. And to avoid confusion, a liability for a bank is the deposits from its customers. So when the lovable Ryan Seacrest deposits money at his local branch, although an asset for him it’s a liability for his bank. He can return and demand that money in cash and the bank is required to pay up. But wait, for those of you attentively following along, you’ll realize that because of the fractional reserve system a bank could have liabilities far surpassing their cash holdings. Well, you get a gold star if you caught that. Not only could a bank do that, they always do.

There are few reasons to hold “excess reserves” because when a bank keeps more than is required, they forego the income from interest on a new loan. The current reserve requirement as established by the Fed is 10%. That means when Mr. Seacrest deposits his $100 check, the bank only has to hold $10 cash in reserve to cover. And what do they do with the other $90? They loan it out, get the juice running, and you’ve got yourself an income generating depository institution.

So what does this have to do with expanding the monetary supply? Well, when Seacrest’s bank issues out the $90 worth in loans to Miley Cyrus, she deposits some portion of that money at her bank. And the cycle proceeds. So, expansion of credit is exponential. It is also largely determined by the Fed. When Miley needed a loan, she went to a commercial bank. But where does a bank for a loan? They turn to the Fed (the proverbial “banker’s bank”). The Federal Reserve is the key player in what economists call the “loanable funds market”. So if the Fed wants to expand the money supply, all they have to do is make it easier for banks to borrow from them (i.e. lower interest rates).

Here’s the grand finale. When the Fed loans out money, it’s starkly different than the rest of the market. When a bank borrows money from the Fed, new funds are simply added to their account housed there; money is literally created and added to their account. That’s the essence of the Federal Reserve’s power to create money. When they write a check, it comes out of thin air.

If that sounds a little fishy (the phrase “funny money” comes to mind), you’re on to something. There are many reputable economists (and disreputable economists as well, i.e. myself) who argue that our system of banking is in need of a little more accountability and a little less smoke and mirrors.

Thus we arrive at the first problem with Rogoff and Mankiw’s proposal. Under most conditions, banks hold little excess reserves. However, in times of crisis they become very particular and selective about how much money they will loan out (hence the term “credit crisis”). In times of great uncertainty, banks tend to hold more in reserves to avoid a “Mary Poppins”-esque run on the bank.

Prior to the current economic malaise banks held around $1-2 billion in excess reserves at the Fed. Today, the total is around $877 billion. That means that there is a huge sum of currency that is out of circulation. And if you recall, inflation is a function of quantity of money and how fast it’s spent. As soon as banks start lending again and consumer spending picks up, you can be sure those dollars in excess will become dollars chasing goods, bidding up prices, and thus causing inflation. The money is already there; the Fed can’t issue less loans. There’s little the Fed can do to curb this cascading effect on money supply.

At the very least, it will be unfathomably difficult to maintain any semblance of price stability once the economy starts genuinely recovering. For this reason alone, it is unwise to pursue a policy of discretionary inflation. The effects are extremely volatile and unpredictable. We are better off pursuing a policy that aims towards price stability, this will enable economic growth.

The easy money policies of the Federal Reserve were one of the foremost contributing factors to the economic mess we are wading through today. Let’s not make the same mistake twice. Quite frankly, as there is no sense in using dynamite to open your front door, it’s dangerous to give the central bank the mandate to flood the economy with new money.