OPINION:Is America 'printing money' to get itself out of recession? Should we be worried?
THE RECENT decision of the US Federal Reserve – in effect, the US central bank – to buy $1.2 trillion of securities is a bold move, particularly for central bankers who, traditionally, are reluctant to create money because of potential inflationary consequences.
During the Great Depression of the early 1930s this action would have been unthinkable but it would also have been impossible because of the straitjacket of the gold standard. If a country did not have the bullion and was not prepared to change its currency’s parity to gold then it could not increase the money supply.
The advantage of the gold standard was that it imposed discipline on governments but it also greatly constrained their scope for discretionary action. That is one of the main reasons why the Great Depression was so deep and long-lasting.
By buying these securities (mortgage-backed assets and treasury bills) the Fed is signing a huge cheque which will be lodged in the banks which are selling the securities. This will increase their ability to lend by a multiple of the amount lodged.
If the ordinary citizen signs a cheque he or she must have funds in their account to start with, ie the money must already be there or the cheque will bounce.
But the Fed does not have to have any of its own money on deposit anywhere. By signing the cheque it is creating money out of thin air. Central banks and governments, and they alone, have legal power to do this. This is fiat money; it is made by fiat.
Money is usually defined as deposits and current accounts and a few other items that have the “liquid” properties of money. When ordinary banks extend loans they are creating money because a deposit account is set up for the borrower and because the loan, when spent, will find its way back as deposits in another bank.
But there is a limit on the power of all banks to create money.Ordinary banks have to have deposits before they can make loans. Central banks can create money without having deposits. Money-creation is sometimes associated with the use of the printing press. This harks back to the days when currency was king and before the invention of the chequebook. The recent swap of securities for cash by the Fed is more sophisticated than this and is sometimes called “electronic money creation”. It is also called “quantitative easing” because a greater quantity of money is being provided. The alternative of lowering interest rates further is not really possible since they are close to zero in the US.
But it is a risky strategy. The first risk is inflation, which can emerge up to two years after an injection of money. What sometimes happens is that if people find themselves with excess money balances they will spend and drive prices up.
It is to be hoped that the Fed’s monetary injection will get bank lending going again and that this will increase the supply of goods and services to meet the extra demand. If this happens it should offset the inflationary impulse.
If, on the other hand, the monetary injection results in bank lending which is not very productive there could be difficulties. Some commentators believe it may have the effect of pushing house prices up again.
This, presumably, is not the Fed’s intention! But we must never ignore the law of unintended consequences.
Indeed, we cannot completely rule out a “liquidity trap”, ie a situation where the banks are not willing to use their new-found ability to lend.Money-creation need not be a bogeyman if it gets the real economy moving. Once that happens policy-makers should be able to deal with any emerging inflationary trends by raising interest rates.
What can be said now is that Ben Bernanke is not frozen in the headlights, and that in itself is encouraging.