The Federal Reserve was well aware of the severe inflationary dangers when it directly created almost a trillion dollars as part of its separate bailout of Wall Street. If this cash – which exists in highly liquid form right now – escapes into general circulation, the result could be immediate and major inflation that would devastate the value of the dollar and all of our savings. To prevent the aforementioned, however, the Fed set up a series of barriers to contain the new cash and ultimately return it to the void from whence it came, lest the new cash break out and wreak monetary havoc. Words: 2735
In further edited excerpts from the original article* Daniel R. Amerman (www.DanielAmerman.com) goes on to say:
The creation of the new money, the barriers to contain it, and the strategy for destroying it are understood by very few in the media or on the web yet, the significance is profound and there are powerful, game-changing implications for the economy, the housing market, the inflation/deflation debate and the very fundamentals of long-term and retirement investing.
The Horse Has Already Left The Stable
The problem is not just one of growing future inflationary pressures – but that one of the most inflationary events in US monetary history has already happened: In 2008 and 2009 the Federal Reserve directly created more new money out of nothingness than total physical currency created in the previous 230 years.
The Fed bought close to a trillion dollars of securities, at 100 cents on the dollar, meaning that it quite deliberately overpaid, and covered what the banks’ losses would have been if they had sold into a free market. The largest source of funds for this massive market manipulation for the benefit of banking insiders, came through the Fed’s creating $819 billion in “excess reserve balances” and giving those balances to the banks in exchange for the troubled investments.
What If The Cash Escapes?
The danger with paying cash – which is effectively what excess reserves are, freely expendable cash – is that the banks can do whatever they want with these excess reserves. For instance, banks are free to do what banks are supposed to do, which is to go out and make loans. So if the banks took $1 trillion, for round numbers, and then went out and made $1 trillion worth of loans, that money would go out into the economy and much of that money would come right back into the banks in terms of increased bank balances at that bank and other lending institutions – who’ll then take those balances and lend them out again.
This Econ 101 concept is known as the multiplier effect. If this were to happen with this trillion dollars, then all of a sudden, instead of having $1 trillion in brand-new money in the economy, we might have an additional $4 or $5 trillion running around in the economy. This is a potentially colossal inflationary event. Now, keep in mind that this danger is not theoretical – this is the situation as it exists right now. That freely expendable cash has already been created and is on the bank’s balance sheets right now. The salient question is whether this existing inflationary event, this creation of money out of thin air that has already occurred, can be contained and unwound as intended, or whether it will break free into general price levels.
Creating The Corral
As covered in the Ben Bernanke’s speech,** “The Federal Reserve Balance Sheet: An Update”, the Federal Reserve is keenly aware of this danger, and was so even as the cash was created. (The “Exit Strategy” section is of particular interest.) Therefore, even as $1 trillion was created out of the nothingness to buy the banks out of the trouble they had gotten themselves into, so was the containment strategy.
It used to be that the Federal Reserve did not pay interest on the reserve balances that banks were required to maintain at the Fed. This was for good reason, as the purpose of the banks is to lend money. If the Fed was paying an attractive rate of interest on reserve balances, the banks would not have the incentive to lend. So the Fed did not pay banks any interest on reserve balances, and “excess reserve balances” were a miniscule item on the Federal Reserve balance sheet.
Times have changed, however. Now we have almost $1 trillion in excess cash that was needed for the private bailout of the banks, but which the Federal Reserve badly does not want to get out into general circulation because of the potentially severe inflationary consequences. Thus, by act of Congress, the Federal Reserve rules were changed so that for the first time the Fed pays interest on excess balances.
The investments that the Federal Reserve purchased are loans and the theory is that the loans will pay off over time and the money will flow back into the Fed at which time it essentially disappears back into the void from whence it came – or, if the markets get strong enough, the securities can be sold back to the banking institutions or other investors, and the cash can be pulled out of the system and the money supply in the same way. If that doesn’t quite work out, however, the Federal Reserve can pay the banks to keep their money out of the overall system and thereby contain the inflationary danger.
The Reverse Repo Lasso
Even if that money did somehow slip out of the Fed’s internal accounts (if the horse jumps the corral fence), Bernanke describes a multi-tier Fed strategy for throwing a lasso around the neck of the money, and pulling it back out of circulation. One central strategy is through entering into what are known as reverse repurchase agreements. The jargon may be intimidating, but the essence is not that difficult. The Fed wants to take the bank’s cash temporarily out of circulation, so it sells securities to the banks, which the banks pay for by giving up their cash. Simultaneously, the Fed agrees to buy the securities back on a specific date at a higher price in the near future (often overnight), meaning the Fed returns the bank’s original cash plus a little more cash. (The investments that are bought and sold are almost irrelevant other than being acceptable collateral.)
The locked in difference between purchase price and resale price effectively becomes an attractive rate of interest on their money for the bank, so they send their free cash to the Federal Reserve. Again, as the Fed can offer essentially no credit risk and an ability to pay a higher rate than anyone else, they are confident that they can completely contain the cash at will without it getting out of the system and setting off general inflation.
This creates a very ironic situation in terms of the difference between what is being presented to the world through the media, what’s being presented to Congress and what is actually happening here. What the public is being told is that the banks aren’t doing their part, that they are supposed to be going out there and making loans, but they are reluctant to do so. However, what’s really happening here is the Fed is going to a great deal of trouble and has elaborate strategies on multiple levels in place to make darn sure that the banks don’t take anywhere close to the full amount of this new cash created for them and actually lend it out, because of the potentially disastrous inflationary consequences that the Fed is very well aware of.
Using Infinite Money To Control Infinite Money
Now let’s step back and consider what’s really happening here. A huge sum of money, over a trillion dollars (total Fed balance sheet growth) was created quite literally out of the nothingness with no assets or taxes. It’s just pure monetary creation, and it was distributed in such a way as to yield the maximum benefit for some very well connected political insiders, the executives of the banking industry but we don’t have to worry about the inflationary consequences, as the money can theoretically be contained indefinitely by the Fed paying the banks a higher rate of interest than anyone else. This high interest rate can be either directly on the excess balances or through the reverse repos and other methods the Fed can use to pull money out of circulation.
What is the source of the Federal Reserve’s perfect credit and its ability to pay higher interest rates than anyone else in the market which, in the Fed’s opinion, makes it certain that this cash will be contained? The source is the direct creation of money. Because the Fed can directly create money, it can pay however much interest it takes.
When it comes to “reverse repurchase agreements” and similar arrangements, what do they really come down to? The Federal Reserve drains money from banks by making the banks deals that are too attractive to refuse, through giving them back even more money at the end of the short term contract. Each round of reverse repos that is used to contain excess money, ends up leading to still more money out there in a matter of days, that then needs to be contained in the next slightly larger round. Repeat, repeat and repeat as needed – for there are no limits.
The theory is that a potentially infinite sum of money can be created and passed to politically connected insiders, but the damage can be contained through the creation of infinite money to pay them off, to keep them from actually spending the money that was given to them. In my opinion, this is a crazy strategy for preserving the value of our money — but it is our current reality.
The Fatal Flaw
There is good news and bad news about how this strategy has performed in practice. The good news is that the first round from the fall of 2008 actually worked. The original investments were commercial paper and emergency loans to banking institutions, each of which are quite short term in nature. The commercial paper has paid off. The great majority of the bank loans have already been repaid.
There is troubling news as well. According to the theory behind the original plan, as each loan payment came in, the money should have been extinguished, and a proportionate amount of excess reserve balances forced back into general circulation where the need to invest could potentially stimulate the economy. By the end of 2009, the excess reserve balances should have been gone and the Federal Reserve balance sheet should be back down to about $800 to $900 billion, with the “liabilities” consisting almost entirely of physical currency. The desperate measures successfully taken in the fall of 2008 should already be a historical footnote, being discussed only in graduate student seminars over the coming decades.
However, in the real world, the excess reserves are still there, and the new Federal Reserve is still almost triple the size of the old Federal Reserve because the fatal flaw in the plan is that the real world isn’t about economic equations, but rather people.
The Federal Reserve is run by people with quite human motivations, who are subject to the temptations of power and hubris. Money is power, and a trillion dollars is a great deal of raw power for the small group of un-elected economists who run the Federal Reserve. Each board member knows that the trillion dollars shouldn’t be there, because of the threat to the value of the currency they are supposed to maintain but they got the money and they got it scot-free. More money than an entire year’s individual income taxes for a nation (as recently as 2004), and they don’t have to answer to Congress on how they spend it. The Federal courts are uninterested, the press has no idea what’s going on, and neither does 99% of the public.
In other words, the members of the Federal Reserve board find themselves with an awesome amount of power that is essentially extra-constitutional, without the usual checks, balances or semblance of accountability. So naturally, the members of the Federal Reserve Board are exercising that power, and the bad news is that they entirely spent the newly created money as it came back to them. (Who does hand power on that scale back?) This second round is however far more ambitious – and far more dangerous – than the original very temporary intervention into short term and relatively high quality investments.
The Federal Reserve decided to intervene on a massive scale and essentially create an artificial market for mortgages. The goal was to prop up the United States housing market through offering below market mortgage rates. The method used was radical – use money created out of thin air to finance essentially 100% of home purchases for an entire nation.
The risk is that if the intervention fails, then housing and mortgage rates find their natural levels regardless of government intervention, but meanwhile the value of everyone’s savings has been destroyed in the attempt leading to tens of millions of impoverished retirees, among the other economic casualties.
The Societal Bottom Line
Let’s review. In their shortsighted greed and hubris, in their pursuit of extraordinary personal wealth, a small group of exceptionally wealthy and politically well-connected bankers took enormous and obvious risks that nearly destroyed the global financial system. In response, two separate bailouts took place. One was the congressional sideshow that gathered all the media attention, and the other was the real deal, with over $12,000 per household in money created and another $150,000 per household committed to be created if necessary.
The $12,000 per household was paid in cash, freely spendable cash. Cash that could take a big chunk out of the value of the US dollar if it got out into general circulation, both directly and via the “multiplier effect”. So the Fed began paying off the bankers not to spend the massive amount of cash that had been created and given to them under highly favorable terms.
One could liken this situation to that of a loaded revolver (a six-shooter to continue the horse and corral theme). In essence, the Federal Reserve dealt with those mischievous risk-takers at the banks who had nearly destroyed the financial world by handing to them a loaded revolver that was pressed against the heads of all the nation’s savers, investors and retirees. A revolver that could destroy most of the value of your personal savings. Then the Fed said “Please don’t pull the trigger! We will create however much money is needed and pay it into your personal bonus pools, just so you won’t pull the trigger on that revolver we just handed to you.”
This is essential to understand, because what does paying higher rates than the banks could otherwise get on excess balances and reverse repos really mean? It means higher profits and bonuses.
Ultimately, the Fed’s official inflation containment strategy is to always be able to offer banks a better deal than any private investment alternative. A better deal means the bank taking in more income, which means the banking executives involved get bigger bonuses. The source of funding for this ability to always pay more than the private markets is the ability to directly create a limitless amount of money. At this point it is a very low interest rate, but the rate can go as high as needed, when inflationary pressures build.
This may sound outrageous, but all it really does is demonstrate the true nature of the Federal Reserve. It is owned by the banks. It is run by the banks. As we are seeing demonstrated right now, its job in times of crisis is to manage the money supply for the benefit of the banks, regardless of the harm inflicted on the rest of the nation.
– The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
– Permission to reprint in whole or in part is gladly granted, provided full credit is given.
– Sign up to receive every article posted via Twitter, Facebook, RSS feed or our Weekly Newsletter.
– Submit a comment. Share your views on the subject with all our readers.
– Buy the book below from Amazon. It’s pertinent to this article and inexpensive too.