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Lotterman: Don't trust Fed Chairman Ben Bernanke's soothing words

Published: 08/03/09

Federal Reserve Chair Ben Bernanke assured Congress last week that the Fed can safely unwind all the monetary expansion embodied in various financial-sector bailouts over the past 23 months.

But remember that he represents the institution that helped inflate the 2004-07 asset-price bubble in the first place.

The Fed also said no one need worry about such bubbles as it could easily clean up any mess when they popped. Its officials further assured us any harm from the subprime mortgage mess would be "well-contained."

History probably will show Fed measures since mid-2007 to stabilize the financial system were critically needed. Moreover, on the whole, the steps taken often were the least bad alternative at the time.

But make no mistake. The scope and size of the Fed's actions are unprecedented. Never before, anywhere, at any time, has a central bank created so much liquidity so quickly. It took place as a series of ad hoc, often desperate measures.

The idea it can be cleaned up neatly strains credibility.

The unfortunate problem is that the ability to spin a story is one of the prerequisites for being Fed chair. Investor and consumer confidence is crucial to getting out of financial crises and recessions, and at times the bare truth from a central bank head can undermine such confidence.

Imagine what would have happened if he had said this: "We got ourselves into a hell of a mess but have been able to move to a somewhat less dangerous one. We will do our level best to work our way out of it, but no one knows for sure how it will go." Financial markets would have gone nuts, and shaky household confidence would have slid further.

But the real task is daunting. To understand it, a brief lesson about the Fed and the money supply is necessary.

The money supply is not confined, as some think, to the number of dollar bills in circulation. It does include such currency, but varying types of bank deposits make up the bulk of the money supply. Exactly which deposits are included determines technical measures of the supply - such as M1 and M2.

Banks that accept deposits are required by law to keep some as reserves. They can lend out the rest or buy certain securities such as Treasury bonds. Or they can choose to hold cash in the form of "excess reserves," deposits not lent out or invested but above the minimum levels required. Bank reserves can be held as currency in the bank as so-called "vault cash" or in an account at the Federal Reserve.

The Fed can manufacture new reserves at will by direct lending to banks. The money it lends, as it has done massively over the past 18 months, does not come from anywhere else. It did not exist before. The Fed simply creates it. When the loan is repaid, the money is effectively destroyed.

The Fed also can create reserves by purchasing government bonds or, in unusual circumstances like now, private-sector bonds and other securities. When it buys these on the open market, it essentially writes a check on itself. The seller deposits the check in a bank account as with selling a bond to anyone. But when the check clears, the funds do not come out of someone else's account. The funds instead are new money, created by the Fed.

Both "discount-window lending" and "open-market operations" result in more reserves in the banking system that can be lent out if banks choose. To the degree they lend actively, a given Fed-engendered increase in bank reserves causes a proportionately greater increase in the money supply.

That is because the same initial additional dollar is lent more than once. A bank makes a loan that gets deposited somewhere. That bank now can lend out most of this new deposit, less only the amount the law says it must keep as "required reserves." The new loan gets deposited somewhere else, becoming the basis for yet another loan, and so on.

What the Fed controls, currency plus bank reserves, is called the "monetary base." The money supply, currency plus bank accounts, is several times larger. From 1975 to 2005, the money supply as measured by M2, the most relevant indicator, ranged from eight to 12 times the monetary base.

In its emergency operations, the Fed doubled the monetary base in the last 24 months. M2 increased by only 16 percent over the same period since banks are reluctant to lend, short-circuiting the monetary expansion effect described above. But if a reviving economy prompted normal lending, the reserves lying quietly in the monetary base could make the money supply mushroom.

Total Fed loans outstanding increased from $187 million in June 2007 to $439 billion in June 2009. Bernanke asserts the Fed can painlessly reverse this lending increase and bring the monetary base down to normal levels with no inflationary potential. Moreover, he claims, this can occur without inhibiting recovery from a stiff recession.

I hope he is right. But the history of global financial crises indicates we should not place too much trust in his bland assurances.

Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at



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