My Predictions

Although I originally began this blog with the idea of keeping track of inflation and potential results for prices and prosperity in general, I haven’t engaged in prediction. My focus has been on commentary. We are, however, at a point that offers some interesting prospects for the future and I though it might be interesting and possibly helpful to suggest a possible set of outcomes.

Specifically, at this point in late 2012 the governments in the major economies have either implemented or are poised to implement some massive monetary flooding, which they call “easing.” The U.S. Federal Reserve officials have announced an open ended $40B a month scheme that will continue until either employment begins increasing or the end of time, whichever comes first. In Europe, the European Central Bank is ready to create unlimited amounts of money, claiming that it has to reduce the spread in government bond prices (between Spain and Italy, who have had to pay high interest rates, and Germany’s very low rates). China is expected to begin more “easing” in that it is currently seeing a much deeper and more significant drop in economic activity than the government seemed to expect. Apparently they thought that they were a separate, insulated entity. In response, just as any Western mixed economy government would do, the Chinese are moving toward spending newly made-up money. Japan has just begun its own easing program and England began theirs a few months ago. There is a great orgy of money creation in progress.

Those countries with “strong” currencies are also involved. They really don’t want to see their competitive position undercut by having other currencies diving in comparative cost, making their own products much more expensive on the world market. One example is that Switzerland’s central bank been buying euros for several months to keep their currency in line. As has been said by others, there is something akin to the arms race growing where every country inflates their currency in competition with the others. This process could also lead to protectionism, with higher tariffs and import controls.

As long as our economic problems are seen as the consequences of low consumption or low demand (and demand is seen as just money and not production related), we can always expect that the government response will be to create more money. There is some fear of the new money increasing consumer prices beyond a certain level (generally at an annual rate of 2% - some poison is good for you apparently). This concern is an interesting hold over from a point where government economists had a closer contact with reality. But there is little concern about the prospects for unacceptable levels of price inflation. It is the case that the upward pressure on prices from constant increases in the money supply tends to be less when production levels are low.

Consequently, we can expect that we will soon see a lot more money being created and put into the larger, more industrialized economies and interest rate will remain extremely low.

The amount of money that actually comes into the U.S. economy is a question for which I have no good answer. There is certainly some, but not as much as you might think when you hear the Fed brag about its easing. The money created by the Fed for QE1 and QE2 is mostly still sitting at the Fed in the deposit accounts for member banks receiving 0.25% a year.

 

The money supply has continued to grow, but the pace is not as fast as one might expect.

 

You can see in the graph that the average dollar amount of growth every year has been somewhat consistent. That means that the percentage rate of growth is falling. To just keep the constant percentage rate, this graph would need to show a much larger constantly increasing dollar amount, as the total grew each year.

As a result, consumer prices have moved upward modestly in the last few years (by comparison) and asset prices are mixed (housing downward and equities upward, but less than the CPI). Only bond prices have moved upward, as the Fed has moved to force down long-term interest rates as well as short-term. Long-term rates are very low, especially considering the need for capital in our economy. There is no connection today between savings, investment, interest rates, and the capital markets.

In these conditions, I wonder what the Fed believes that more “quantitative easing” or lower interest rates, could achieve. They talk about lowering unemployment as if the problem is that jobs are not being created for of financial reasons. Here we have an excellent example of theoretical, rationalist thinking that doesn’t consider even the possibility of looking at the real world. At present, there is no connection between the interest rate (including the supply of money) and investment/growth decisions. For a business, the difference between 3% and 2.5% on a long-term, profitable investment is insignificant. The real question for businesses is whether the project could be profitable. Some companies have invested when they have cash on hand. Many are considering a merger or acquisition, which doesn’t add to our productive capacity (although it might improve efficiency). But U.S. companies see no justification in future profitability to make the investment needed to put over two million people to work. The Fed and the Government, and Romney and the Republicans just don’t see that.

Another upcoming set of events in the U.S that could have a negative impact on our economy is the end of the Bush tax cuts and the spending cuts required by law. These events, both scheduled for January 1, 2013, won’t improve the capital and investment situation, although the rate of growth of government debt will slow some. At least in the short-term, if the tax cuts do end and the rate of spending slows, the immediate result will be a drag on the U.S. economy.

I am not convinced that the supposed mandatory cuts in spending are particularly important economically. Some people try to make this situation seem cataclysmic by quoting a cut of over a trillion dollars. That is fraud, since that is a ten-year number. As is always the case with government cuts, they are loaded mostly into the latter years. I think that the 2013 number is closer to $69B, which is for the full year. When you are talking about a multi-trillion budget and a deficit of over a trillion dollars, sixty-nine billion is an accounting error.

But saying “cuts” is intended to be misleading. The Congress didn’t pass a cut in spending. They authorized a reduction in the expected growth of spending. It was a cut from what they thought current laws would require the government would spend. There is not going to be a cut in spending. Let me repeat: These are not cuts in spending but small reductions in the growth of spending. Even so, there may be some companies that will feel an impact in their expected revenue from government contracts. But, economically, compared to the total level of spending and the prospect of more “easing”, big deal.

Combined, the tax cut, possible cuts in the growth of spending, and the Fed’s money flood, mean that there will be less money in people’s pocketbooks, but more, potentially, in the banking system. Remember that the way the Fed’s money gets into the economy is via bank loans. If the banks continue to maintain their stricter standards there is not going to be a significant increase in bank loans. In fact, the current trend is for lower corporate profits, meaning that businesses will be less credit worthy than before (and stock prices should decline, instead of booming). In addition, ever since the beginning of the “Great Recession,” bank regulators have been constantly checking on the “quality” of bank loans. Unless regulators are willing to loosen the strings, banks aren’t taking any riskier loans. I don’t see much of the Fed’s new money getting into the economy. That is not to say that there won’t be an effect. As in the past, there is a tendency to some money to find its way into assets.

In addition, the final Dodd-Frank regulations have yet to appear and the costly ObamaCare provisions are coming into effect. All businesses, but especially banks, are legitimately confident that their costs will increase significantly and their range of action considerably curtailed. Startup businesses have declined. dramatically. For the economic/cultural pessimist, there is much support in the U.S.

In Europe, the central bank is being pushed into acting because the market for Spanish and Italian government bonds demands much higher returns to compensate for higher risk. Personally, I think that there is no uncertainty. Neither Spain nor Italy will be able to repay their bonds in the coming years. (I equate being given worthless money with not being paid.). So the higher rates are certainly justified. But enough of the euro country governments don’t like that. The higher rates mean that Spain and Italy would have to face their insolvency soon, which would be a big problem for the other euro government countries. So the euro block is pushing the central bank to create money to avoid reality. In this case the money will go directly into government spending and will have very negative consequences. Not the least consequence will be a lessening of the pressure on Spain and Italy to solve their problems. (Spain is expected to need the euro bank bailout. No one is currently talking about Italy, but its economy is heading the same direction.) By creating money to buy government bonds the European Central Bank is defaulting on the loans by directly creating inflation and thus reducing the purchasing power of the money that bought the bonds. Everyone in Europe is ignoring that fact. In addition, there will be a lot of upward pressure on prices and everyone will feel the cost. But, most of all, the importance of freeing their economies and being fiscally responsible can be evaded. The ultimate result will be greater disasters.

I expect that China’s new money will be similar to earlier efforts, which went primarily into government owned and controlled businesses, shrinking the portion of the economy that is private. It may also be more of a “consumption” orientation, which will mean less of a push in industrialization, and a move toward Western ideas of a consumer driven economy. That government decision would necessarily reduce the growth rate even without the normal consequences of asset booms and busts.

If more “easing” won’t help solve the unemployment problem (who cares about actual production?) and thus won’t help with economic activity, what will it do?

Well, the U.S. economy isn’t going to grow much, if at all. In fact, it could contract. If the new money just sits at the Fed as before, we needn’t worry about hyperinflation. The money supply will grow, but not significantly faster than before, although those numbers should be watched carefully.

I heard someone point out that since the first “easing” the Dow has risen 4000 points and since the second “easing” nearly 3000. I am sure that the Dow and other indexes will raise some more. The Dow has already gone up a few hundred points since the Fed announcement. What would a push by the Fed be without a serious increase in asset prices? Commodity prices could also rise. Some are saying that industrial commodities, such as copper, will not because industrial production is tending to fall. But the money being created will go somewhere. You just need to keep an eye out to see where that is.

So, if you want to put your money somewhere, based upon recent history, there you are! Just be careful about your timing and don’t lose perspective about the causes of the asset price rise and its duration. Be ready to short.

Of course, economic events are really harder to predict than that, especially in a controlled economy. Something will happen that we don’t foresee and things will happen differently than we expect. One thing we do know, whatever happens, it’s unlikely to be good.

Long-term, the consequence of all of this “easing” is to probably bring the day of reckoning closer, possibly by years. With unemployment staying down, Social Security and Medicare spending will continue to widen the gap between tax income and spending. The demands upon the Treasury will increase, meaning more debt. The low levels of production will mean that wealth is not being created and our personal wealth and standard of living will continue to fall.

I think that money can be made from the chaos and misallocation of resources. You just have to pick your method based upon the circumstances and pay attention to the situation.


P.S. I just listened to Yaron Brook on the Mike Slater show (via a notification from Lassiez-Faire). He says so much of what I just mentioned. I really did work it out before. But he says it well.

Inflation Update: First Quarter, 2012

I have been writing this since the turn of the year. It has been subdivided already several times. A couple parts have appeared as other posts and several pages are just sitting around in this file, orphaned! I have again divided it so that I can get something out and the length will not evoke cursing. This section is my inflation update. Maybe some of the rest will appear in the future.

I realized recently that my most “favorite” group that constantly announced the coming of hyperinflation has only made one such announcement in the last several months, and that one was somewhat less frantic than normal. (Recently, they have been touting stocks.) In their last prophascy of doom, they did touch on issues that are important, but since they have only one economic note, hyperinflation, they don’t consider other, equally nasty, potentials, of which there are several. But apparently, hyperinflation is not the immediate threat they have often claimed. They haven’t said why they have changed their tune.

Yet, there is plenty of good reasons to be concerned about inflation in the next few years. For the fun of it, let’s divide up the issue into two separate (but certainly related) questions:

If by inflation you are asking about the money supply and its impact on asset prices and the economy: just look at the stock market! There is plenty of made up money sitting around that comes out and bids up assets when given even a glimmer of hope. True, company profits are healthy. My question is about the source of those profits. Is it just savings from leaner operations, or is it return on growing business. I fear that it is the former, which means little for future economic improvement. What reasons do we have to suggest that businesses are investing in the anticipation of growth?

There is new, made-up money floating around, for example, our balance of payments for last year was again a large deficit, perhaps smaller that in 2007, but still large. That means that a lot of electronic dollars left the country, billions of them ($110B in the third quarter, 2011; $124.7B in the second quarter, 2011), and didn’t return, won’t return (for those dollars to come back other currencies would have to be better than the dollar, and that isn’t happening). At the same time, notice that our money supply did not shrink by hundreds of billions. Think about this. We sent over $400B dollars out of the country last year, and didn’t notice it. Where did it come from? (Hint: International trade is done entirely on credit!)

The money supply within the country, in the broad measure that I use, MZM, shows the resumption in the upward trend continuing. The graph available, and widely used, is hard to read and the current trend is still only a few of months old. So what it means is unclear. What appears to be the situation at this point is that the increase is on the same growth line as before the meltdown. But since the base is larger, the growth will have less impact. Think of the difference it means to you to have a $10,000 raise when your income was $30,000 vs. $200,000. So, an additional $100B means more when the money supply was $1T in the 80s vs. today’s nearly $11T. The rate of growth in the money supply would need to be a lot steeper to be really important. The growth we see isn’t good, mind you, just not frightening.

Another important measure of the money supply is new loans made by banks. This is the method by which the Fed puts money into the economy. The Fed has been trying to push new made-up money into the economy since 2007 with little success. Recently, however, loans are beginning to increase again. Just new loans would not be an issue. After all, business needs credit, and amount would fluctuate over time. Further, with the deep recession, the amount of loans would have declined. A healthy economy would need credit to grow. If that new credit reflected new savings we would be seeing real growth soon. Of course, it doesn’t. Savings is being sucked into the Federal deficit. So, the growth of bank loans tends to indicate new made-up money being pumped into the economy, which could lead to another round of asset price inflation. The recent upward trend of new bank loans is worrisome, and needs to be watched. Again, the graph is too small to give good detail, but the slant of the upward movement isn’t too steep.

We are still sitting on a time bomb. If you look at the reserves (deposits) of banks who are members of the Federal Reserve (nearly all banks), you see that the amount of reserves they have is amazingly high. This is the Bernanke plan. Notice the last big jump to about $1.8T. That was QE2. That is to say that much of the massive amounts of money that Bernanke and his gang pushed into the economy is actually just still sitting at the Fed. It really didn’t do much except keep interest rates at stupidly low levels. It did help push commodity prices up, which is another type of asset boom. Does anyone believe that the interest rates actually reflect any element of the real economy? Low interest rates have not sparked new investment. They have merely given an unearned bonus to holders of federal debt and kept BO thinking that his deficits don’t really cost anything.

The time bomb will be the consequence when banks begin to think that they should move those reserves to their banks and expand their loan portfolios. Then we have a real inflation as the money supply explodes (once put into the economy, under current rules, each dollar moved from the reserve could become ten, or the $1.8T of excess reserves could become an additional $18T (our current money supply using MZM is almost $11T). The Fed actually knows that is a bad thing. When they first expanded the reserves with QE1 in 2008, there was a lot of talk about what they would do to sop up the excess reserves, which were then about $1T. That talk has completely disappeared as the economy failed to improve. But the problem remains and has gotten bigger. If the economy begins to grow the Fed will have to do something. Any action the Fed takes to sop up that money will raise interest rates, perhaps dramatically, and that would put a lid on the economy. That would also send interest rates up around the world and make things in Europe much worse. So ignored everywhere right now is this time bomb that will go off if the economy does begin to grow.

If you are thinking of prices as an indication of your cost of living (quality of products is often forgotten), the news is mixed. For example, the costs of health care and health care insurance is going to continue to skyrocket, especially if the quality of care is considered. (This increase in cost is only partly due to ObamaCare. Wait until that really begins to kick in!) Government interference in healthcare has never lowered cost or improved care. It has only made people feel like they were getting something for nothing.

Gas prices have risen, and will remain at higher levels until various international issues have been resolved. The last few years the pressure on prices has been due to new demand from countries that actually were developing. The current problem is due to the threatened supply because of Iran’s level of irrationality, Iran being a major oil producer. Again, the West’s willingness to allow its technology and industriousness to be hijacked by local warlords and savages becomes the source of economic shocks.

(The problems with higher food commodity prices that we had a while ago have abated, mostly due to higher crop results, e.g., the end of the draught in Russia. There are countries that are still seeing lower supply and thus more expensive food supplies. Most of these countries have governments who are controlling the markets. I can’t help but wonder if their problems are due to their governments inability to continue to subsidize food distribution.)

Reports from some U.S. food processors report that they have had to raise their prices from between 5% and 7% in the last year. No doubt we will see some upward movement in prices and no upward movement is good. Even price inflation rates of 2% are damaging. But there is no indication on the horizon that we are moving toward hyperinflation.

I just read another of Peter Schiff’s monologues. Among other things, he claims that price inflation is running at 10% (He just said inflation, but I assume he meant prices, in his writing he often switches back and forth.). He and others have constantly asserted that the CPI has been politically corrupted and that actual prices increases have run much higher. I do think that the CPI has been manipulated in many ways, and a lot of it was politically motivated, at least implicitly. But I have a problem with rates of price increases much higher than a few percent. Why? Let’s say that prices were going up at the rate of 7% a year, which is in the ballpark of many such claims. That would mean that prices today would be double what they were ten years ago (rule of 72, see below). Is that your experience? It isn’t mine. Some have argued with some justification that the quality level in many products has improved at the same or nearly the same price and that lots of technology prices have dropped. As I suggest in my review and comments of his books, I think Schiff often shoots from the hip, which I don’t find admirable. He has been right on some important things, but I’m not sure that it was because of good insight or just accident.

I did say that the situation is mixed, didn’t I. What I meant is that the news is that mixed in with the reports that prices are generally drifting upward are some reports of some really bad spots. In December, I would have said that foodstuff commodities prices had dropped, but the thinking that loosening of credit in China and Europe was going to stimulate demand has run them back up a little.

As I see it, the problem that could most affect us immediately is a financial crisis brought about by the European governments. The finance ministers in Europe are saying that they aren’t sure that this bailout will succeed. The Greeks have shown that they fail to live up to their promises, and curse others when that is pointed out. The other tottering European economies are very dependent upon low interest rates and the availability of massive amounts of made-up money. Remember, the euro zone’s long-term plan is a “fire wall” of several hundred billion euros. Where is that money going to come from?

So, my expectations for the next year or so is that our economy will continue to totter along. If unemployment moves up, or people become to understand the figures that are before them, we could see a big pull back in equities and consumption slow. That would lead to QE3 and more of a mess.

Prices will continue to inch up. Commodities will continue to have upward pressure. Basically, we will have more of the same.

There are two other considerations to watch for: The implimentation of the new rules for banks and derivatives and the actions that BO might take in anticipation of the election latter this year. Neither of these will be good for us and will be inflationary.

Having said that I should also say how reliable I regard my expectations. (Do you notice that nearly all of today’s prognosticators never look at how they did in the past?) Reliability of economic predictions is dependent upon two separate issues: One – how reality oriented is the analysis; Two – lack of omniscience. There is also one other point to keep in mind, good economic events require rationality, at least to some extent, and productivity. As good economic events are in short supply, for obvious reasons, the question is then how far off on the down side are my comments. I noted the areas that I thought that we could have major problems. There could be problems coming that I, or anyone, has not noticed. The most recent example, aside from people missing what is under their noses (the residential real mortgage meltdown), is 9/11. Another major terrorist strike could upset everything, and we would have a hard time recovering, too. So, I have tried to cover the economic bases that I can spot. But there could be others. Just keep on your toes.



P.S. I just read an article about investments in Turkish companies by venture capitalists, Now I don’t know how true the article was, although it did make Turkey sound like a much better place than I would have imagined. What I thought was so amazing about the article was that it didn’t mention the Turkish government or nationalized companies once! (Except to imply that the government wasn’t an issue!)

Inflation Watch: News!

There is in fact something to report. Get it here, few others are going to have this news. It might mean something, it might not, but it at least is a change.

In a recent blog about the money supply I talked about how to read the graphs we get from the Fed, that to understand the meaning of the information, you needed to keep the steepness of the curve and the relative amounts in mind. Now we have a example of what I meant. It is a nice example for illustration purposes; it is a bad example if it foreshadows things to come.

The US money supply, as controlled by the Fed, is generally fed by way of bank loans. Generally, the level of bank loans is the best place to look first to get a good idea of what is happening.

Surprise, a graph! Well, you can see that the recent activity, after several months of steep decline, there has been some rebound, but that seems to leveled off, at least briefly. I put no importance on such brief changes, even though it is a little unusual. But, here is the important part, while BO has been railing at banks to loan money (regardless of his criticism that the financial meltdown was because banks loaned money – to the poor), the regulatory agencies, The Comptroller of the Currency and the FDIC, for example, have been engaged in very heavy handed tactics to force banks to adhere to what the regulators consider, sound banking practices. They insist the banks have lots of collateral and keep minute, intrusive records about the borrowers. Further, banks are still trying to replace the capital and loan loss reserves that disappeared in the meltdown. Those who carry on about bank profits just are not taking the responsibility to find out what they are talking about.

After looking at bank loans, lets see what the money supply is doing. Ee have a choice where we look, since there are a few different indicators. What the hell, lets look a several.

First is M1, which is the basic money supply category and includes all physical money such as coins and currency; it also includes demand deposits, which are checking accounts, and Negotiable Order of Withdrawal (NOW) Accounts. So, this is the money you use to buy stuff with.

M2 is a little broader, it includes M1 plus all time-related deposits, savings deposits, and non-institutional money-market funds. This is money that is one small step from the availability to be spent.

Then we have the one I consider most useful, MZM, which is all money in M2 less the time deposits, plus all money market funds. It measures the supply of financial assets redeemable at par on demand, or all the money that can be realily spent.

Also available from private sources (because the government stopped publishing it) is M3, which is M2 as well as all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. The “other larger liquid assets” includes Eurodollars, which means here we can see the overhang that could drop on us. Eurodollars are dollars held in foreign, private accounts. Thus, this measure does not include dollars held by foreign central banks as reserves (if the money has been invested somewhere, and not just held as cash, it will show up in one of the Ms).

I showed you M3 for the sake of completeness, but for our purposes, in this post, let’s use the other three, focusing on domestic dollars.

I am sure that you can readily see that each seems to currently be heading straight up. Up until now, the graphs had been moving more or less on a trend line that was fairly consistent from the 1980s. These are linear graphs, meaning that a change of $100B at the bottom of the graph was the same size on the vertical axis as a $100B at the top. That means, from a practical perspective, that a recent $100B change in the money supply was not as significant as one 30 years ago. Today, $1000B is small potatoes. So if the graph was sloping the same angle, the rise in the money supply was having less and less effect.

Now, the slope has definitely increased. If it continues, the impact of the growth in the money supply will be greater. The question is, will it continue to grow at that rate or faster?

You might ask, well if the banks are not loaning more money and that is how the Fed pumps money into the system, how is the money supply expanding?

The answer to the question is that there three other sources of growth in the money supply (that have played little or no role hitherto): 1) In QE2, the Fed was playing a little with its processes and managing to get some money directly into the hands of the Treasury (see the several comments under “Making Claims About the Money Supply), and that expanded the money supply. Whether that explains this jump is unclear, at least to me. 2) Money that was in other instruments, and not available for immediate spending may have been moved. It would take a large and noticeable move to result in this jump, but this change could explain part of it. 3) Dollars kept overseas could have been moved back to the US. This is my choice. In the recent turmoil in Europe people and businesses have been fleeing the euro and the eurozone. We could easily see billions of dollars moved, not just into dollars, which has made the dollar “stronger”, but move to be deposits within the US.

If the last of my three options is the reason for the rapid increase in the money supply, I don’t think that it is sustainable and then not a threat for our consumer prices. The reason being that there is only so many dollars that can be moved quickly. There are many financial and business obligations overseas that are paid in dollars. If too many dollars come here, they will just have to go back. It would take time for those obligations to be unwound and the dollars freed up so that they could remain here. If that begins to happen, then we will see a significant influx over time and a consequent increase in dollars for asset investment and spending. We will either have another asset boom, a general consumer price inflation, or both.

But, in order for the role of dollars to begin declining in international trade and finance, there would have to be a replacement. People overseas would have to find a currency that they were willing to trust as much as they trust dollars today. It would have to be a currency that is as available as dollars are (a large quantity). There isn’t one. Nor is there one on the horizon. (I mean in terms of the recognition of the people overseas, not as a potential.) Therefore, if I am correct in my suggestion as to the source of the increase in the money supply, we need not worry about that problem right now. But we do need to keep our eyes on it.

But, we have to keep an eye on what the money supply is doing anyway. It isn’t optional, because it foretells what we will have to face.

The End of QE2

QE2, i.e., quantitative easing two, the program by the Federal Reserve Board of buying longer-term government bonds to “support the economy” ($600B this time) is slated to come to an end June 30, 2011, today. One might ask what this round of low interest rates and easy money has done? I am sure that the governmental types will proclaim to the land that they have averted major disasters and saved civilization by their actions. Sure. Others will say that the results are a significant additional amount of inflation. Perhaps. One can definitely say that the level of reserves that the banks who are members of the Federal Reserve System (nearly all banks) have risen to new, even scarier heights. Before September 2008, the total reserves of these member banks were in the $50B range. Soon after that fateful September, the reserves rose to over $1T! Now the reserves are about $1.6T. What is good is that the “money” (which the Fed merely created out of the air) is sitting in the reserves and not roaming around the economy. Other than inflating the reserve figure, I don’t see anything beneficial that the QE2 creation of an additional $600B has done. The economy is not doing well. And much of the damage of the run up to the 2008 meltdown has not been undone, either.

Maybe what has happened is that the economy has floated along on the Fed cushion for the first half of this year. It is growing slightly, say less than 2%. At this point in most “recoveries” the economy has achieved much higher growth. The current economy has not gotten back to even, yet. Some prices have fallen, e.g., real estate. Residential real estate prices have probably not fallen enough and the sector is still in poor health, with foreclosures still happening at a high level. Employment as a percentage of the working population is still low. It is even lower when the actual productivity of the many of the new “jobs” is taken into account (i.e. government “jobs” that produce nothing). Moreover, for various reasons, some having to do with money creation around the world and some having to do with enforced shortages in the face of growing demand, the prices of some basic commodities are high, meaning a lower standard of living for all.

So QE2 comes to an end. Many suggest that the economy, left to its own resources does not have the strength to continue to grow, or, if at all, at a very low level. Employment, which is only doing better because of some statistical manipulation by the Labor Department, will suffer. Our standard of living will continue to fall.

The counter trend to the government’s activities is that there are millions of people in our country running businesses and working to be more productive and profitable. In spite of all the government does, some very basic elements in our economy are growing. So much of what I see from Objectivists assumes that the government is all-powerful and ignores what the non-government sector is capable of doing. Remember, the practical attack on capitalism has been going on for over 100 years (as opposed to the philosophical attack that has been going on much longer). The attack is still only partly successful because the ingenuity of the American capitalist works around and through the laws, regulations, and direct interference put in place by our politicians. The failures, when they occur, can be big, e.g., the Gulf oil spill. But on the whole, American businesses have coped pretty will with the interference. There is a limit to how much they can overcome, and we may be getting close to that limit (re. Atlas Shrugged), but American capitalists and their workers are trying, still. Whatever QE2 and its aftermath, the real economy will influence the results. This is a major reason why the consequences of government actions are so hard to predict. It is also why people do not take the predictions of doom seriously. Long-term doom just doesn’t seem to happen (as opposed to short-term doom like the sub-prime/financial meltdown). Things don’t seem to change much on the surface. We seem to still have capitalism. To the extent that capitalism has been undermined, we are in for a rough time, unless change for the good happens. (We are experiencing long-term deterioration, but we are experiencing it like a lobster in a tub of heating water, and we aren’t noticing our losses.)

To the extent that QE2 has been propping up the economy, that support will disappear. To the extent that participants in the economy thought that QE2 was providing some real support for the economy, the loss of that support will make them weary and less confident. To the extent that QE2 has been fueling the rise in the stock market and commodity prices around the world, that fuel will disappear and perhaps those prices will drop. To the extent that QE2 has been keeping longer-term interest rates low, they will now begin to rise. To the extent that QE2 has been glossing over problems in the economy those problems will reassert themselves and they will have to be addressed by the markets in a more rational manner.

The end of QE2 will be a good thing if the government and the Fed do not start tinkering again. There is another program that the Fed has ongoing, that is not changing. It has a lot of bonds and mortgage-backed securities, say about $1T. Those securities are maturing and being paid off as time goes on. The Fed has been taking that money, and buying Treasuries, about $250B a year (according to news reports). This isn’t really a good thing, since the original funds to purchase these “toxic” securities was made-up money. It would be better if the money was retired, and the member bank reserves reduced (that is actually where the money went in the first place). But at least it isn’t new made-up money.

There is a lot of talk about the reappearance of Fed “support”, say QE3 at some point within the next year if the economy begins to founder. Right now the pressure in the much of the world is for interest rates to rise. For instance, the Bank of International Settlements issued a statement that criticized developed countries for keeping interest rates so low. Other countries have raised their rates recently. Raising rates now is inconsistent with any of the Fed’s QE’s. To engage in another round of quantitative easing the Fed may have to fight a worldwide trend. Such a trend of rising interest rates would put further pressure on U.S. Treasuries since money would tend to seek higher rates of return, and Treasuries would have to have higher rates to compete for funds. This is especially true with the recent public statements from S&P and the IMF regarding the Treasuries deteriorating soundness. The U.S. government may be ignoring the negative evaluations of U.S. government debt, but the rest of the world isn’t. (On the other hand, with the problems in the Eurozone, Treasuries are viewed as very safe by comparison and there could be no significant upward interest rate pressure on them. When things are going bad, it isn’t going to be very clear what will suffer and what won’t. That kind of uncertainty is the nature of government-induced instability.)

Once interest rates begin to rise, we shall see how badly the Fed is prepared for the real world. It is suggested that to avoid significant consumer price rises the Fed will have to aggressively soak up all the liquidity that they have put into the system since 2008. That is so even if that liquidity resides only in “member’s reserves”. “Sopping up the liquidity” means doing just the exact opposite from what the Fed has been doing the last three years. It means doing just the opposite from what Ben Bernanke has built his professional life around and what he has been hailed a hero for doing. Does anyone think that the Fed is really ready to reverse course in any significant way? If there is any reason to give credence to the hyperinflationists it is the prospect of interest rates rising and the Fed allowing the policies of the last few years to run their course. It is definitely the reality that if the Fed keeps things as it is now we could see hyperinflation. Our immediate future may depend upon how the Fed reacts to rising interest rates. To that extent our future rests in the hands of a few deluded, self-proclaimed geniuses.

I am not going to forecast what will happen over the next couple years. (I have been expecting interest rates to rise for over ten years.) We just need to keep a very careful eye on events here and abroad, especially in Greece and the Eurozone. We could also see problems in China.

Let me tie my most recent Inflation Update to the end of QE2. In the inflation update I am talking about the money supply and its effect on prices. The end of QE2 will reduce the upward pressure on the money supply some. Keep in mind that QE2 was aimed at longer-term Treasuries, thinking that lower longer-term rates would spur major borrowing. The Fed is still aiming to keep short-term interest rates low, and will continue buying Treasuries where necessary to keep those interest rates in the target area of zero to 0.25%. This upward pressure on the money supply will continue.

Let us suppose that QE2 did act as Bernanke anticipated. Businesses were attracted by the lower interest rates and did invest. Then, with the end of QE2 and interest rates increase because there is less money available to loan, then we should see less borrowing, less investing, less hiring, lower growth, and perhaps less money for the equity market. And still there will be pressure on the money supply, high commodity prices, and probable upward pressure on consumer prices (from various sources).

So, the bottom line is that the next few months offer even greater uncertainty than we have been living with since the residential real estate mortgage crisis began. I think that the only thing we can be certain of is that our governmental leaders, who have nearly unlimited sway over the money taps and financial/legal gimmicks that they can produce, are going to generally make wrong decisions.

I have final note about interest rates. I have seen reports that foreign central banks, big buyers of Treasuries in the past were absent in the last Treasury auction (and the Fed stepped in and made up the difference – indirectly). As the Fed will stop buying at the end of June, if the foreign central banks do not return, the Treasury is going to have to raise rates to attract buyers, from somewhere. I don’t want to suppose at all what levels the rates are going to have to be to sell the bonds that they need to. Actually, hitting the debt limit may be helpful to the Fed’s program because the Treasury will be limited in the quantity of bonds it can offer for the next few months. The interest rate tale will begin after the debt ceiling is lifted.

It is difficult to see what the foreign central banks are doing. There just aren’t many places for them to put the excess cash they are accumulating. Probably Japan is expecting to spend a lot on its reconstruction (meaning that their money supply will expand and the Yen vs. other currencies will get stronger as the central bank buys yen). But there really isn’t another source of even decent, high grade (which is a relative term), large volume bonds besides the US government. China has told the EU that it will continue to “support” them in the face of their expanding credit crisis. I haven’t seen an exact definition of “support”. It may mean that they won’t sell out of European bonds. It may mean that the Chinese will continue buying as they had before. I doubt that it means China will increase their buying. Europe is certainly not a candidate to replace the US as a place to park hundreds of billions of dollars a year. Remember that China has a large trade surplus with the Eurozone that rivals its dollar surplus and it is already buying lots of bonds from Europe. Is China just keeping cash? We shall see.

As was pointed out in an analysis I read (an email), the funds that the Treasury can attract to replace the foreign central bank buyers would be from the US private sector, who would want higher yields. But, if the money goes to the Treasury, it won’t go into equities or other investments, and thus, for sure, the stock market’s fun days will turn into sad ones. Also, the prospects for job creation, productive jobs, will diminish further (if that is possible). Unkle Ben is expecting a rebound in the last part of the year. HA!

So what would Bernanke do then, when interest rates start going up and the true lack of recovery is obvious? What does he advocate for every instance? What has he done? Make-up more money! Watch for QE17!!

MAKING CLAIMS ABOUT THE MONEY SUPPLY

The concept of the money supply is central to understanding events and prospects in modern, mixed economies. What the money supply is doing, and what the manipulators of the money supply are doing, are key indicators of immediate and intermediate economic events. In my blog, I refer to the money supply often. Analysts and writers who are influenced by the Austrian school of economics, and here, as always, I am referring to von Mises and his predecessors, will refer to the money supply in understanding business cycles in modern, mixed economies. So, how do we know what is happening with the money supply?

From the U.S. government we have several measurements of the money supply, called M1, M2, and M3 (no longer published). There is also MZM, my preference generally. There are also indicators such as the balance of payments, for indications of the outflow of money. Another important tool to keep in mind is the changing level of bank loans. The past two asset price inflation events have both been created by bank loans. Finally, there are some private measurements available at various websites.

As with any measurement, it is absolutely necessary to clearly understand what is being measured, how, and how those measured elements relate to your conceptual framework. You must also know how the measurement in question performed in the past, i.e., what the results meant and how the economy performed.

All too often, what I see when reading other authors is that they have chosen tools that reinforce their own expectations. They ignore other tools that currently are pointing in other directions. That is especially true of the people who are expecting hyperinflation in today’s world. I certainly sympathize with the hyperinflationists. There is reason to be concerned, from what I can see. But I do not accept their knee jerk approach.

My approach is to look at all of the indicators that I have identified and try to make sense of them and what is happening in the economy.

One indicator can also be the interest rate set by the Federal Reserve Board. One influential online group recently used the argument that since the Fed had set the Reserve rate at zero, there had been billions of dollars created. In other words, it was automatic. If the interest rate is set well below a market rate, then money will be created. This same reasoning occurs when the Fed creates reserves. For example, in 2008, the Fed created nearly $1T in member bank reserves. People immediately said that the Fed had created billions of dollars in the economy. But, there is a difference here. Lowering the interest rate and creating reserves are not the same as actually printing money. Printing money and shoving it into people’s hands through government handouts or expenditures or payrolls put money into circulation immediately. That money is in play.

But the actions of the Fed are different. The Fed can create reserves and lower interest rates, but the Fed depends upon the banks and businesses to actually put the money into play. If the banks do not lend (which requires a borrower) then nothing happens. That is what we have seen over the last two years. The Fed has tried to put more money into play, but the banks have not cooperated. The Fed’s influence is not automatic. The claim that low interest rates have created massive amounts of money is not substantiated by the level of bank loans and other indicators, e.g., MZM. It is important to objectively understand how this stuff works.

I saw an argument that claimed that it is wrong to argue if the money supply has expanded or not. According to this person, looking at the facts was not thinking in principles. Instead, he said that we should state that the Fed is, “The reality is that money has been created out of nothing and it therefore will alter behavior (otherwise why do it?). … that this money has created price increases in several sectors, commodities and oil among them, despite the ‘we haven't really increased the money supply’ theory.” Somehow, for this person, thinking in principles does not include relating one’s ideas to the real world nor having a sound, fact based argument for our position. We merely sate that the government has made money that raised prices without being able to even demonstrate it, not to mention, prove it. It does not include looking at the present, specific situation and making sense of it or presenting your position in the context of the crisis we actually face. I do not know how this person thinks that we can be convincing or persuasive.

Some will then point out that the Fed has recently been buying Treasuries from the Government directly, thus putting newly made money directly into the economy. That is true. That step leads directly to expanding the money supply and to affects in the economy, generally, to increases in consumer prices. However, given the size of the economy vs. the amount of purchases the Fed has made, the effect is not particularly significant. We would have to see closer to $1T of Fed direct purchases from the Treasury for the Fed to trigger consumer price rises.

Potentially more significant would be the return of sizable amounts of the dollars held overseas via Treasury Bond purchases. With a $1.7T deficit, if $1T was financed from overseas, we would see a mammoth flooding of dollars flooding our markets. This returning money, often as much as $500B in the past few years, has been a source of some of our price inflation. Higher amounts would put more pressure on prices.

Yet another recent argument that I have seen implies that in today’s world, real market forces (as opposed to governmental influences) have no impact on prices. The field of play, this person held, is controlled completely by governments. Again, there was no attempt to demonstrate how this is so. The position was presented as necessarily following from the fact that governments act and have bad influences, there were bad events happening (the raising of oil prices), therefore, it was completely because of government intervention. No facts about the current situation were necessary.

Thus, it is important to look at the various moving parts of the make up of the money supply and their impact. Then, it is imperative that your understanding relates these different measuring tools to the real world in an objective manner. For example, look at M2 http://research.stlouisfed.org/fred2/series/M2?cid=29 , the simple view would be that inflation is rampant and that prices should be going through the roof. But have they? I just saw an observer on PJTV who kept track of his expenditures of a few items over the last year. His personal stats did show across the board significant price increases. What is your experience? Mine has been that there has been little change for some time, with some bigger increases just recently. Even if prices are going up, does that mean that the hyperinflationists are correct in saying that general, average price increases of 20% or more (hyperinflation) are beginning soon? That is a big jump.

Some argue that because certain prices went up, there is inflation. Most recently, these are the prices of gold, oil, and food commodities. But prices go up and down for various reasons. That is especially true in a “mixed economy”, where government actions have hidden, unforeseen, and often weird, effects. You have to be careful when attributing reasons for price movements, which means actually finding a cause and effect. For example, the decades old efforts by governments around the world to control oil discovery and production in many different ways means that there are restrictions on production and supply. The result is an artificial shortage of oil. Supply shortages would mean higher prices, given level demand. In our situation today, and for the last several years, demand is actually growing. So you have three different factors pushing the price of oil upward, including whatever inflationary pressure there might be. But the price would be going up anyway. When discussing the price of oil, you cannot objectively leave out the supply restrictions and all of the reasons for increases in demand.

Turning back to the analysis of the money supply, my overall point is that many things are happening within an economy that will affect whatever actions governments take to manipulate the money supply. How it plays out and what the ultimate effect will be depends upon those factors. To accurately explain events, you need to have identified the actual causal connections and explained other details that may seem to be contrary to your conclusion. A site or writer who ignores those contrary elements only means that they are pushing their pet theory without actually relating it fully to reality. Economics is a difficult science, but it is a science. Economics is about the real world, and one’s standard of truth must be consistency with reality.

INFLATION PRIMER

More and more people are getting on the inflation and hyperinflation bandwagons lately. There may be reason to worry about inflation, several, in fact. But, for the most part, the reasons that are being offered for today’s bandwagon do not justify the conclusions that people are making.

My position is this: Real inflation is a major cause of economic disturbance and the destruction of economic value. Inflation needs to be eradicated from our lives and our political system. To remove inflation from our economy would require that we understand it at it’s root and have an accurate history of its influence. Instead, what these people tend to offer is just pointing at some prices that have risen that are special to us or in the news. Even when they mouth reference to the money supply, they do nothing to relate the money supply to the price increases they are seeing. They are just adding confusion. So, I am offering another post about inflation with a slightly different focus.

First, of course, rising prices is not inflation. Rising consumer prices may be a consequence of inflation, one of them, but it is only a consequence, not a cause, and it is the cause that we want to understand clearly. It is the cause that is the actual problem. It is the cause we need to eradicate from the economy.

The Austrians (and as further explained and expanded by Ayn Rand) are the ones who identified inflation accurately. Inflation is government manipulation, read expansion, of the money supply. When more money is pushed into the economy, prices, at least some prices, will rise. There are two important points.

First, prices cannot rise without there being more, new, made-up money. Without more money, some higher prices would just mean that fewer of those products could be sold. People would still have only so many dollars to spend. Higher prices for some goods means that the standard decisions people make as to what to buy and not buy must now account for a different price structure than before. Prices are always changing. All prices could not be rising at the same time without there being more money in circulation. Stuff would be left sitting on the shelves. Consequently, if some prices rise, other prices would have to drop, or production would have to be reduced. There are only so many dollars.

Some people try to avoid the basic physics of the issue by talking about the velocity of money, suggesting that if a unit of currency changes hands faster there is the opportunity for prices to rise without more money actually being created. No attempted explanation of inflation using the velocity of money that I have seen actually lays out how that is suppose to work. I can’t figure it out. Try it. The vast majority of people get paid on a regular rotation, i.e., weekly, biweekly, or semi-monthly. How do you fit a higher velocity into that arrangement? You can’t. Higher velocity is out.

Second, the Austrians determined that the entry point for new money makes a difference, meaning that new money does not effect the entire economy the same way, but ripples out from the point of entry. Over the past twenty plus years, the entry points for new money have been limited to just a few parts of the economy. It is easy to identify those connected directly to the Federal Budget because the prices of related items have been going up rapidly and consistently for all of those years. The list connected to Federal Government spending includes medical services and related products and higher education. Recently, Federal employee salaries can be added to that list.

Besides the budget, the other main entry point of new money is by way of the activities of the Federal Reserve System. I have gone into detail how that happens in this blog, so I am not going to restate it. The consequences of the Fed expansion of the money supply normally hit asset prices first. Stock prices and housing prices are pushed by the expansion of the money supply by the Fed – sound familiar? (Constant deficits in our Balance of Payments can also only be explained by the expansion of credit.)

Okay, so that is inflation, i.e., increases in the money supply. Well, take a look. Is the money supply expanding? Ahhhh, no. It isn’t. So where is this inflation?

What the people who are declaring that inflation is upon us are pointing to are certain, specific prices. Right now the major ones are oil, food, and commodities. Certainly, these prices are going up. But, is it inflation?

I would add another sector to the list of higher prices, the U.S. stock market, which has gone up a bunch in the last couple of years. Why has it gone up? The facts about the U.S. economy don’t support that kind of optimism. The actions of the U.S. government continue to make things worse. The market is being pulled along by a ton of money sitting around. It is the same thing that happened in the late-1990’s and mid-2000’s.

So what about the prices of oil, food, and commodities. Okay. Fact one. In any economy (where individuals can make decisions at least to some extent), in any situation, for all kinds of reasons, prices will be on the move. Some prices will go up, some will go down. We do see prices going down all of the time in our world. That is especially true of high tech stuff. Prices change because people’s preferences change. Demand changes. The supply changes because of new technology, new business structure, new sources, governmental action. There are a host of different reasons. You have to look at specific industries to understand the price movements. More than that, if it is inflation that is causing consumer prices to rise, the general trend would affect the entire economy, in a ripple effect. When the price rises are confined to specific sectors of the economy, it is necessary to look closely to determine what is happening. In is not proper to just declare that it is inflation. Looking closely at medical services, oil, and commodities results in very different conclusions for each sector. That is especially true when the best data available on the money supply (admittedly government data, but not sufficiently corrupt) show that the money supply is not expanding to speak of and credit has contracted.

I have already discussed the constant rise in the prices of medical services, which is a direct consequence of government spending. Let’s try oil. The price of oil is an international price. For its price rises to be a consequence of inflation, it would be necessary for there to be inflation of significant amounts in many countries. But, there are more obvious and immediate explanations as to why the price of oil has gone up, and may continue to rise. Two explanations, actually. First, as a result of the anti-industrial movement (which includes the ecology movement), the production of oil has been forcefully reduced nearly worldwide. In a few countries, the production is kept lower than those countries are capable of for the reason of attempting to influence the price (OPEC, of course). We all know that the supply of oil is less than a free market is capable of providing. Second, we have a couple large countries, very large countries, that have finally begun to open their economies up sufficiently that they have produced a modicum of wealth. These countries are now also buying oil in larger quantities than they have in the past. Just a little increase from these very large countries has a significant impact on the price of oil. So, we have a supply that is less than possible and a significant increase in demand, and, surprise, oil prices rise. Standard stuff. Inflation is not necessary to explain the price of oil. To the extent that there is inflation, the increase in the price of oil will be worse. If a specific country has inflation, its currency will tend to buy less internationally over time, and the price of oil in that country will rise faster.

The second half of the analysis of the oil price applies to commodities, including food. There is more international demand. Higher demand means higher prices for basic, auction-derived prices such as commodities. China and India are buying more than they did a few years ago. If there is the possibility of greater production, the higher prices will attract more supply and the price may go down, but that does not happen overnight.

Food prices, especially within a large country like the U.S., is more dependent on local factors. I have not seen sufficient reports to make a well-founded conclusion as to why prices have begun to move upward. International grain prices have moved upward, but really have only a minor impact on the prices of consumer goods in the U.S. The cost of wheat in a loaf of bread in the U.S. is only a small fraction of the price at the store. Transportation, i.e., oil prices might be more important. Weather is important. The important point is that the factors causing our food prices to rise are not an increase in the money supply and are somewhat different that the reasons why oil and other prices are rising.

Then there is the issue of inflation here vs. inflation there, in the present day case: inflation the US vs. inflation in China. China is experiencing inflation, both asset and consumer price inflation. It is also experiencing sufficient growth that allows people and businesses to buy basic materials on the world market that they couldn’t before. Both of these factors make up the fact that China is a major reason why international prices are increasing. To fully understand what the impact of China’s rise (as well as India’s) means, it is necessary, as always, to gain perspective. Don’t just focus on selected markets that fit with a particular expectation or world-view. Look at the big picture.

What is my suggested perspective maker? French wine! The prices of good French wine have gone through the roof, up maybe as much as 3 or 4 times what they were a couple years ago. The reason is that a very small percentage of China’s 2,000,000,000 people have discovered the good stuff and have the money to start buying. They have bid up the prices. The Chinese are bidding up the prices of many things right now. The world has been rolling along with a few industrial countries and a lot of undeveloped ones as the status quo. Imagine the situation if many countries were to open up their economies to individual efforts and wealth. The demand for basic commodities would skyrocket! The old, restricted level of production would not be able to respond, shortages would ensue, and prices would rise. That scenario is pretty much what we are seeing. Newly freed countries would mean periods of economic adjustment as changes in distribution patterns developed. Ultimately, either we would see greater production, and thus higher standards of living all around, or we would see massive shortages and breakdowns in the world economy. In this respect, the emergence of China and India as economic powers will be good for all of us. Countries that refuse to deregulate, like the Europeans are blindly doing, will be faced with falling standards of living and fiscal nightmares, as is happening. For those who have tied their thinking to the dominance of the U.S. in the world economy, there will be confusion. In a world that is free and prosperous, the U.S. would be a great competitor, but not the richest nation. It is not the biggest country. But it would be incomparably richer than it is now. Higher productivity and creativity worldwide would mean greater wealth for all, and we would benefit.

But, back to the point of this post, greater demand for commodities, or anything, and subsequent rises in prices is not inflation. Only increases in the money supply by government action is inflation. Keep your causes straight.

Fed and the Money Supply: Details

A thoughtful consideration of my articles on how the Fed works to expand bank credit, the Fed’s massive expansion of Member Reserve Deposits, and the steady decline in bank loans could easily result in some head scratching. My explanation of expanding bank credit (similar to what you find in Meltdown by Thomas Woods) would lead you to think that bank lending would be going crazy now, with the reserves built up to such a massive amount. There are, however, other factors at work in the process that I did not include in my discussion. I thought that my explanation of the Fed’s basic activities was long, complex, and convoluted enough without adding many other things in as well. I should also say that the degree of complexity is not really apparent until something like the present situation occurs.




What other factors? Well, there are basic banking practices, bank profitability, bank capital and loss reserve needs, and other regulators. This last factor is not minor. The banks have a galaxy of people looking over their shoulders. These regulators insist, and have the power to insist, that the banks follow certain “risk” and accounting standards. It isn’t that everyone of these standards are necessarily bad, but that the application can be arbitrary and outside of context. The standards change constantly, especially in their detail, which sometimes makes what the bank was doing in accordance with the regs yesterday, but today, that practice is wrong and subject to penalty. How this is working out in today’s circumstance is explained in this Forbes article. The author is an administration cheerleader, but he inadvertently gives you a very good idea of what is happening.


Most basic in considering a bank’s standard method of operating is that it is a business, with shareholders, employees, balance sheets, and standard operating practices that have been developed over centuries. Banks are in business to make a profit. Sound banking, to the extent that it can be found amid all of the nonsense required of banks today, also includes of many of the practices that any business needs to follow if it is to be profitable.


In addition, especially within today’s funny-money environment and the uncertainty of future of changes in regulation and government activity, a bank has to protect itself (think of the uncertainty BO’s TARP Tax created). The bank has several different accounts of its own that it maintains for financial protection. It has a capital account, what you could also call equity. The bank’s capital is reduced if it operates at a loss or if other assets are lost. The bank also has a loan-loss reserve, which is an account of cash that the bank keeps to cover bad loans and the failure of other assets, e.g., mortgage backed securities. During the financial crisis, many banks saw significant shrinkage in these two accounts. In order to restore the health of a bank, these two accounts have to be built back up. Banks cannot and will not expand their loans again until they have a healthy capital account (which would be a certain ratio to its obligations) and loss-loan reserve (also a certain ratio to outstanding and new loans). In the normal course of events, these accounts would be increased by either by going to the capital market or by retaining profits. The capital market is not functioning well right now, especially for banks, and profits are hard to come by. Sensible banking is standing in the way of the government’s (read BO and the Fed) demands for increased loans.


One might suggest that a bank could take some of the excess reserves that the Fed has given the bank and put that in either of these important accounts. But it can’t. There is no legitimate accounting method to do so. It is exactly the same problem for someone who wants to take stolen money or drug profits and put into a business. There is no way to account for it.


A bank can take money the Fed has created and placed in a bank’s “reserves”, but there is only one use that it can put that “money” toward: loans. When I wrote that a bank with an increased reserve could then make loans, I was implying a practice that is not the norm. I am not aware of any restriction preventing a bank from just expanding its loan portfolio when its reserves have been expanded, assuming that the capital and loan-loss reserves are sufficient. It may be that the accounting techniques available do not support that approach. For whatever reason, banks tend to take a different approach.


What happens is that the bank will take excess funds out of their Fed account, presumably a percentage that leaves the required deposit in their Fed account. This “money” (in quotes because it is stuff that the Fed created) the bank then loans.


The process probably goes like this. The Fed has selected a target interest rate below market for the Federal Funds/discount rate. To maintain that low rate, the Fed will be buying Federal bonds from institutions. When the bank presents the check for the purchase of the bonds to the Fed, the Fed puts the funds into the “reserve” account of that bank at the Fed. The bank now has more funds in their “reserve” account than they need for the demand deposits held by the bank. If a “qualified” loan applicant is available (qualified in quotes because low interest rates distorts, undercuts the real criteria needed to make loans, i.e., a market interest rate), the bank takes the “money” out of the reserve account, leaving at least sufficient funds to cover its reserve requirement, and loans the “money” to the applicant. And thus the money in circulation has been expanded. The funds loaned are used to pay bills related to the purpose of the loan, which means that the “money” shows up in other banks’ demand deposits, which those banks use as they use any money. They adjust their Fed reserve account to reflect the increase in demand deposits, and loan out a portion in new loans. After this process continues through its natural course of movement from bank account to bank account, the ultimate increase in the money supply comes close to equaling the reserve ratio. Today, large city banks are required to have 10% of their demand deposits in their Fed accounts (currently, they can count cash in their own vault as part of the “reserve”). Thus, an increase in the “reserves” of $1B can see an increase in the money supply of $10B.


As much as the Fed and, today, BO, would like to see an automatic process whereby the Fed can force up the money supply, just by increasing the Member’s deposits, as we see above, there are some countervailing forces. How long those forces will remain in effect is the current question.


It is also the case that as much as the Fed wants banks to begin lending again, it doesn’t want them to be lending as much as the current massively, over-funded Member’s accounts would allow. Currently, there is over $1T in excess reserves. That is more than any historical period by a factor of close to 100,000! Even the Fed, which normally ignores the actual pumping of money, is concerned about the amount of reserves currently sitting there.


But what is the Fed to do? Bank loans are actually still declining. Interest rates, according to mainstream economics, have to remain low to stimulate the economy. As soon as the Fed starts withdrawing the excess reserves, interest rates will start up, especially long-term rates, and all kinds of unwanted consequences will result, including increased interest expenses in an already bloated federal budget. BO will start yelling at the Fed and the Congress will start “investigating”! Also, the stock market will dive, (the dollar might actually strengthen, who knows?) housing purchases will decline as mortgage rates go up, and the economy will tend to slow. If it weren’t that we are all living in the middle of this circus, it would be fun to watch.


As of yesterday, the Fed again reassured everyone that interest rates will remain low. Aren’t they nice?