Edward Lotterman
Managing the money supply of a modern economy is a dirty job, but somebody has to do it.
For some 110 years, we have had an operating central bank, the Federal Reserve system, to do that. It could reduce harm to businesses and households from bank failures. Well thought-out, it could increase or decrease the money supply as needed to maintain credit availability without inflation.
So how has it done?
The answer is “pretty well,” at least for the first 85 years. The Fed made mistakes, especially in the 1930s and 1970s, but so did virtually all central banks around the world. Yes, central bank mistakes contributed to the Great Depression, but the causes of that went deeper.
Ditto for the high inflations hitting most economies in the 1970s. The Fed under chairs Arthur Burns and G. William Miller let the money supply grow far too fast. But there also were commodity-price shocks. Prevailing economic doctrines proved flawed. However, by the 1990s, growth was strong, unemployment low and prices stable. Yes, many farm lenders had failed, as did a class of banks called “savings and loans.” But these problems had been handled. On the whole, the economy during this period was in fine fettle. But harsher challenges would present in the new millennium.
Most recently — and current Chair Jerome Powell would probably acknowledge this — the Fed misjudged how long the sharp inflation following COVID would last, and this became a political liability for President Donald Trump’s first term, and more dramatically for his successor, Joe Biden.
To understand the Fed’s role in all of this, one must understand that the key function of any central bank is to manage the money supply — not “set” interest rates. Nearly all the general public doesn’t get this. News reports stating that the Fed raised or lowered interest rates don’t tell us what’s really happening — that the central bank is actually increasing or decreasing the amount of money in circulation. Hardly anyone in politics or the media adequately explains the correlation, including virtually all reporters covering finance as well as general news. This also points to failures in the teaching of economics.
An often-used analogy is that if a driver decides to move the speedometer from 50 to 70, they have to step harder on the gas. It is the flow of fuel to the motor that is important. The speedometer only indicates the result. In the same way the flow of the money supply determines interest rates.
Next, one must understand key indicators showing how much money is in the economy. The “money supply” consists of currency, physical bills or coins, plus bank deposits. Subdivisions to various degrees, depend on which deposits count, from simple checking, to long-term CDs. The Fed has great influence over the money supply, but does not “control” it.
The “monetary base” consists of currency plus bank reserves. These are deposits not loaned out. The Fed can control this closely. Historically here and in many other countries yet today, the “reserve ratio,” or minimum percentage of deposits that must be kept in reserve, is a key variable. In the U.S. there no longer is a reserve requirement but prudent banks still keep reserves.
The money supply and monetary base look at assets, money held by banks or the general public. But the point of view of the central bank also is key. It can create or destroy money by changing the level of reserves in a nation’s banking system as a whole. This leads to an important point that takes up an entire econ class session to explain. So just understand that in a system of “fractional reserve banking,” an increase in total banking reserves by a central bank causes a much greater increase in the money supply.
A central bank has a number of ways to increase reserves.
First, it can change the required reserve ratio. Decreasing it lets banks lend more. Increasing it does the opposite. This was important when the Fed was established and still true in much of the world, but is moot for the U.S. because we no longer have required minimums.
Second, the Fed can make direct loans to banks at its “discount window.” The framers of the Federal Reserve saw this as its central function. (This was described in the Feb. 15 column.) Again, understand that when the Fed makes such loans, it creates the money out of thin air. It does not come from the U.S. Treasury or anywhere else. And when such loans are repaid, money goes poof and disappears.
Third, it can inject new money into the economy by going into open bond markets where bonds issued by the U.S. Treasury, corporations, or anyone else are traded. To increase the money supply, it buys bonds by paying for them with newly created money. To decrease money in the system it sells bonds and the money received disappears.
Historically, the Fed only bought and sold U.S. Treasury bonds. This was extended to include “repurchase agreements” or “repos” and “reverse repos.” These are derivative securities based on Treasury bonds.
Such central bank buying and selling of bonds to increase and decrease bank reserves, and thus the money supply, is called “open-market operations.” That is why Fed officials who decide how much to buy or sell make up the “Federal Open-Market Committee.” It includes the seven members of the Board of Governors that includes a Chair, currently Powell, plus the 12 presidents of Fed district banks. However, while all participate, only five of the 12 vote in any given year.
Such buying and selling is analogous to feeding more or less gas to a car. The FOMC chooses a short term interest rate to target just as a driver decides to drive at 55 mph or 70 mph. To raise interest rates, the Fed sells bonds. To lower them, it buys more.
The original Federal Reserve Act did not include such bond market actions. But discount window lending depended on banks seeking loans. If the economy needed more liquidity, but no banks came to borrow, available money did not change. Benjamin Strong, president of the New York Fed, implemented open-market operations in the 1920s. The New Deal Banking Acts of 1933 and 1935 incorporated them and created the current Fed structure. Over time, discount window lending dwindled and open-market operations dominated Fed control of the money supply.
The ability to create new bank reserves and thus more money is how central banks quelch financial crises of the type that plagued the U.S. economy prior to 1913. It can stop chains of bank failures that were once common. But this creates huge danger. If any central bank steps in too often and too drastically, it creates “moral hazard,” incentivizing banks to lend carelessly and excessively. Large banks that are deemed “too big to fail” get a “heads we win and tails the Fed loses” mentality. Which brings us to today. Such perverse incentives have plagued the U.S. financial system for 40 years.
Yes, the Fed failed to intervene effectively in the 1930s, contributing to the Great Depression. It let the money supply grow too fast in the 1970s, contributing to inflation. But then, in 1984, when Continental Illinois, the seventh largest U.S. bank, was going bust, the Fed and the Federal Deposit Insurance Corp. intervened to bail it out. This led critics, especially at the Minneapolis Federal Reserve and in key university economics departments, to warn of the enormous moral hazard thus created.
They were right. New legislation was intended to limit this, but in 1998, the Fed stepped in when a hedge fund, Long Term Capital Management, went broke. It later flooded the economy with liquidity after 9/11. And then, when a financial crisis in very short term lending broke out in August 2007, followed by the failure of investment banks Bear Stearns in March 2008, and Lehman Brothers that October, a panicked Fed opened money taps to an unprecedented degree. This included creating ways to directly buy mortgage-backed securities rather than only Treasury bonds.
It more than tripled its holdings of securities, Treasury and private, from about $900 billion in August 2008 to $2.9 trillion in August 2011. Then, fighting a recession that regulatory failures had helped create, it lifted this total to $4.5 trillion by late 2014. Pausing, it let its holdings ebb to $3.6 trillion in mid-2019. But the outbreak of COVID in 2020 prompted even greater injections, reaching $7 trillion in June 2020 and $9 trillion in mid-2022. What happens to all this extra money? In this case, it caused the inflation that ejected Trump, then Biden four years later, from office and stoked the roaring stock market, crypto, “private debt” and “private equity” bubbles dominating financial news today, as well as inflated house prices benefitting baby boomers at the cost of anyone younger. In short, moral hazard on steroids.
The monetary base has fallen from a peak in late 2021, but remains nearly seven times as high as in March 2008. The broader M2 money supply, currently at $22.4 trillion, is three times as high over the same period. Gross domestic product, the total value of all goods and services produced, has only doubled.
Kevin Warsh, Trump’s nominee to be the next Fed chair, has been outspoken in calling for the Fed’s balance sheet to be reduced. This means selling off many of the securities the Fed gorged on in a stair-step of crises over the last 18 years. Yet such a move would raise interest rates and slow the economy. Trump wants him to do the opposite. How this will play out is unknown.
The media, blind to the central role of the money supply, fails to see this conundrum. We’ve gotten pretty good at predicting and responding to disastrous weather events, but nearly everyone ignores looming financial storms to our perhaps greater, and longer-lasting, peril.
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St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.
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