Tuesday, December 6, 2011

What actually happens when the Federal Reserve Bank prints money?

Balanced government budget and fiscal austerity have been promoted as the viable long term solutions to the developed world’s debt crisis.  However, just as often, we have seen monetary policy, especially the “printing of money” as a short-term solution to the crisis at hand.  Certainly, a number of people have credited the U.S. quantitative easing program (QE) with saving the U.S. economy from plunging into a depression after the global financial crisis.  To this end, it is useful to examine the mechanism behind quantitative easing and to understand what has been accomplished in reality.

What actually happens when the Federal Reserve Bank “quantitatively” ease?
Many people think of the “printing of money” by the Federal Reserve Bank (FRB or the Fed) quite literally as printing crisp $100 bills.  While it isn’t entirely accurate, the analogy is not far off.  Digital money is created by the FRB; that money can be used by the FRB to purchase financial assets. The printing of money is one element of the FRB’s quantitative easing program.  When easing, the FRB “creates” digital money out of thin air and buys long-term Treasury bonds (and potentially other financial assets) from banks.

It is important to note that when the FRB creates money, it records a debit on its balance sheet.  For example, let’s imagine the FRB starting with zero assets and liabilities on its balance sheet.  Suppose it then creates $1 billion in money and use that to purchase $1 billion worth of long-term U.S. government bonds from Goldman Sachs.  At the start of the transaction, the FRB has nothing on its balance sheet; Goldman Sachs has $1 billion worth of Treasury bonds on its book.  At the end of the transaction, the FRB has $1 billion worth of Treasury bonds on the asset side of its balance sheet and $1 billion worth of debt on the liability side of its balance sheet (this debit item is from the creation of money).  Goldman Sachs has $1 billion worth of money, which it can use to make other investments or pay salaries and expenses.  The two parties are no richer or poorer, from a balance sheet perspective, as the result of quantitative easing.

The Federal Reserve Bank incurs liability when it creates digital money or physical currency.  Since ultimately, the FRB is a government entity, its liabilities are government liabilities.  One easy way to understand this is to think of these digital cash and physical currency as short term government debt.  Often, in large quantitative easing programs, the FRB focuses on buying U.S. government long bonds.  In this situation, QE is nothing more than the U.S. government refinancing its long-term bonds with short-term papers.  At other times, QE may be targeted toward buying other more illiquid assets; this is generally conducted to provide price support for distressed financial assets and liquidity for financial institutions holding them.  This often can have the flavor of government bailout.

Why “quantitative easing” and what impact does it have?
If QE primarily changes the maturity mixture of the government’s outstanding debt, that hardly seems to justify the media attention.  Of course, there is more.  Quantitative easing allows the Federal Reserve Bank to push long term interest rates downward by buying long bonds aggressively in the open market.  This serves to lower the cost of long-term financing for the government as well as other borrowers by creating artificial excess demand for long maturity bonds.

What makes QE interesting and a very powerful (if not dangerous) tool is that the Federal Reserve Bank can theoretically expand its balance sheet infinitely by creating unlimited digital cash to buy government bonds from financial institutions.  In theory, the U.S. can issue as much debt as it wants to banks and then “coordinate” with the FRB to buy these Treasury bonds back at high prices.  As long as FRB remains a large and committed buyer in the Treasury bond market, banks face little to no risk in buying Treasury bonds at low interest rates. 

QE, targeted toward buying Treasury bonds, is therefore sometimes referred to as implicit monetization of government debt.  Explicit government debt monetization occurs when a central bank is forced to purchase government bonds directly.  Explicit debt monetization is against the law in most developed countries.  However, it is obvious that QE, under a willing FRB chairman, essentially achieves the identical outcome—just in a two stage process.  In that regard, the U.S. government will always be able to roll over its maturing debt at attractive rates through collaboration with the FRB.  This has given rise to the claim that the U.S. will never default on its debt.

If you take QE to the limit, it means the government can run perpetual deficits with exploding debt without being exposed to the discipline of the capital market.  There is, a catch; as there always is.  Unlimited and unchecked government spending will lead to hyper-inflation and ultimately the collapse of the currency.  The capital market directs “credits” to productive activities and effective enterprises and rations “credits” to the opposite.  When the government short-circuits the system and bypasses the “invisible” hand of the market, it generally seeks to finance unproductive activities (negative NPV [net present value] activities) and re-direct resources away from the more efficient enterprises.  An unlimited supply of credits for negative NPV projects, without doubt, produces a lot of inflation!  This is why the FRB and other centrals banks are mandated to only provide temporary relief and against monetizing government debt.

The mechanism for inflation
Many talking heads often speak in abstract terms and conclude with undue authority that since the Federal Reserve Bank is printing money, it must therefore be sowing the seed for inflation.  However, the relationship between the “printing of money” and inflation is more subtle and indirect than what is so often suggested.

Ultimately, inflation is too much “nominal purchasing power” (in terms of financial wealth as well as lines of credit) chasing too few “goods and services.”  Imagine that we have a large increase to our nominal disposable wealth, which increases our desire to consume.  If there has been no increase to goods and services produced, inflation will ensue as we compete for consumption by outbidding each other.  Fed Chairman Bernake once famously suggested that inflation could be created easily by printing and raining $100 bills onto people from a helicopter.  This is perhaps not as outlandish as it sounds.  Franklin Roosevelt’s hole digging/filling program during the Great Depression was similar in spirit.  Essentially the government paid people money for doing make-work.  It is important that we notice the two essential components for the inflation mechanism—the creation of money to buy new government debts by the FRB (essentially QE) and the spending of that money through fiscal programs in non-productive activities.  

Here is another example to drive home the point; think of Napoléon amassing troops to advance on Russia.  The French government printed massive quantity of money and exchanged them for guns and soldiers.  The activity was highly unproductive (ex ante and ex post).  There was correspondingly a massive distortion in the labor market as young men were directed toward producing death instead of goods and services.  Hyper-inflation ensued when the nominal financial wealth, created through Napoléon’s printing and spending of money, was met with massive decrease in consumable goods and services.  Most wars, generally, are very inflationary for obvious reasons.

Yes, the Federal Reserve Bank does have a printing press, but the printing of money alone does not produce inflation.  It needs its partner in crime, the government raising debt to spend on unproductive activities, to complete the virtue-less cycle.  Otherwise, the FRB merely serves to alter the government’s debt financing toward shorter maturity, which isn’t necessarily all that inflationary.

The lender of last resort
So why is the Federal Reserve Bank given the unique power to bypass the capital market to provide what amounts to unlimited credit to the government and at times like the global financial crisis, to private entities?  I believe there is a fundamental suspicion, on the part of the government, that the market may malfunction during crises, therefore ceasing to provide capital to good people and good businesses.  The Federal Reserve Bank is tasked to be that lender of last resort in that time of crisis, where central planning might make better choices than the free market. 

But make no mistake about it, this powerful policy hammer is central planning in nature and, as such, is subject to all of the criticisms and abuses due such a system for resource allocation.  One does not have to look very far back nor appeal to examples so extreme as financing wars to understand the potential risk of over-riding the market mechanism.  Not too long ago, the U.S. government coordinated with the Federal Reserve Bank (with global central banks following suit with similar measures) to encourage wider home ownership through low interest rates.  The resulting real estate bubble gave us the 2008 financial crisis, which nearly wiped out the global banking sector.
     
Conclusion:
The Federal Reserve Bank, with its ability to print money, serves an important purpose of financing government activities, which, at times, may not be valued/endorsed by the capital market.  If, indeed, the said activities are unproductive, inflation follows as does a permanent increase in government indebtedness.  The FRB’s printing press should be understood as a tool for dealing with temporary liquidity crisis rather than an instrument for solving structural problems.  The risk is always an abuse of this printing press, which would ultimately lead to exploding government debt and hyper-inflation.

But in the meantime, “Eat your heart out, Greece and Italy! You should have kept your central bank and the ability to print money.”

by jason c hsu

33 comments:

Anonymous said...

Dr. Hsu, Do you think ECB should do the same as the Fed?

jason c hsu said...

I think this is a likely outcome!

Lewis Dawson said...

A lot of umbrella companies have the influence to monetize loans from the federal reserve on accounts of the central bank being a medium. Large deficits means more issued printing where a country's gold reserves are devalued in each print volume.

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