The Bush administration subjected us to a deluge of fiscal and monetary expansion, the likes of which we haven’t seen since the 1960s. The federal budget ballooned 112 percent from $1.86 trillion in 2001 to a projected $3.94 trillion in FY2009. From a surplus of $128 billion in 2001, the federal budget is projected to be in deficit $1,752 billion in 2009. The projected deficit in FY2009 is on par will the level of all federal expenditures in 2001. On top of this, the amount of the liquid money supply in the economy—measured by Money Zero Maturity (MZM)—grew from $4,791 billion in Jan. 2001 to $9,383 billion on Jan. 2009, a prodigious 96 percent.
Obama shows no interest in changing course. His first budget plans to maintain federal spending in FY2010 at $3.6 trillion with a budget deficit of $1.2 trillion.
In summarizing the frenetic response of Bush and Obama to the economic downturn, Bloomberg reported on March 31 that “the U.S. government and the Federal Reserve have spent, lent, or guaranteed $12.8 trillion.” That figure is in the ballpark of the country’s entire GDP last year.
And yet, even more troubling than the torrent of fiscal spending and monetary inflation we’ve already suffered is the potential for monetary inflation never before seen in this country. In August of last year, banks held around $45 billion in total reserves, of which only $2 billion were excess reserves. On these required reserves of $43 billion, banks and other financial institutions had produced a money stock (measured by MZM) of $8,707 billion. Every dollar of required bank reserves was supporting $202 of money stock. Excess reserves are reserves against which banks have not yet issued any money stock. They, therefore, represent the potential that banks have for expanding the money stock. Back in August, with excess reserves of $2 billion, banks could have set in motion an increase in the money stock of $404 billion (or 4.6 percent) to $9,111 billion. As of the first week of April, banks were holding around $862 billion in total reserves, of which $805 billion were excess reserves. With these reserves at the same ratio of money stock to reserves, the money stock could expand by $162,610 billion, or 1,627 percent, from its first week of April level of $9,414 billion.
In other words, President Obama’s policy has the potential to produce monetary inflation of Zimbabwean proportions.
Fed Chairman Ben Bernanke started down this inflationary path last fall in an attempt to save the banking system that had been shattered by his and Alan Greenspan’s policy of monetary inflation and credit expansion over the last decade. The process works as follows: Fed regulations require banks to hold either checking account balances at the Fed or cash as reserves against their own issue of checking accounts. The Fed sets the fraction of reserves that banks are required to hold against their issue of checking accounts. As of the first week in April, banks had issued $797 billion of checking accounts to their customers and held $57 billion, or around 7 percent, in required reserves. To inflate the money supply and expand credit, the Fed simply buys assets and pays either with a check drawn on itself or with newly printed money.
Let’s say the Fed buys $100 million of Treasury Securities from banks and credits the payments to the checking accounts that these banks hold at the Fed. Bank reserves would then increase by $100 million. With a 7 percent reserve-requirement ratio, banks could then issue $1,429 million in checking account balances to their customers. They do this by extending loans to them.
From Jan. 2001 to Sept. 2008, the Fed expanded the monetary base, which is cash plus Fed-issued checking accounts, by 52 percent, from $591 billion to $901 billion. On top of this base, banks expanded the credit on their books over the same period by 82 percent, from $5,243 billion to $9,566 billion. To extend credit on the basis of mere monetary inflation, banks must lend to less credit-worthy borrowers and riskier projects. The government can channel these riskier loans into areas it prefers by sheltering banks from the consequences of the greater risk.
This was the role of Fannie Mae and Freddie Mac. They directed the extension of riskier loans into real estate by providing banks with a ready secondary market for mortgages. Banks could sell the riskier mortgages they had written to Fannie and Freddie. As Government Sponsored Enterprises, Fannie and Freddie had implicit government guarantees of their debt, which permitted them to borrow heavily at low interest rates to fund their mortgage purchases. When the Treasury Department took over Fannie and Freddie last September, they owned or guaranteed over $12 trillion of mortgages, which was around half of the entire U.S. mortgage market. Given this secondary market, banks disproportionately increased real-estate loans during the credit expansion. From Jan. 2001 to Sept. 2008, bank real-estate loans still on their books rose by 112 percent, from $1,663 billion to $3,658 billion.
The further the process of credit expansion goes, the more fragile credit markets become as they are loaded more heavily with riskier loans. Eventually, investors become unwilling to pay higher and higher prices for stock shares of banks and other financial institutions that are loaded with risky debt, or that have earnings dependent on the continuation of credit expansion into riskier loans. As investors sell the stock of such enterprises, the equity of these banks and other financial institutions shrinks. Once investors gain an accurate picture of the magnitude of the bad loans made by banks, their stock selling pushes banks into insolvency.
Bernanke’s unprecedented measures to arrest the insolvency and illiquidity of banks haven’t worked. The Fed is set to report the results of its stress tests of the economy’s 19 largest banks on May 4. Preliminary reports on the solvency of these banks (for example, here and here) aren’t encouraging. And Bernanke’s measures have only solved the banks’ illiquidity problem in a superficial way. As of the first week in April, banks were holding $862 billion in total reserves and $797 billion in checkable deposits. Banks’ checkable deposits are now completely covered by reserves. But their illiquidity problem remains, since only $50 billion of their total reserves were vault cash that could be paid out during a bank run. That the Fed could build up hyperinflationary potential in banks without making them either solvent or liquid doesn’t inspire confidence in Bernanke’s claim that he can unwind the monumental inflationary potential in a controlled fashion at the right time.
Obama doesn’t have to go down in history as the man who destroyed the dollar and wrecked the economy through hyperinflation. The reckless policy of the Fed in creating the potential for hyperinflation presents an opportunity for fundamental reform of the banking system:
The Fed could declare that the excess reserves that are needed to back all checkable deposits 100 percent with cash be required reserves. Then the Fed could swap cash with the banks for their checking account balances at the Fed. Making banks 100 percent cash reserve would neutralize the inflationary potential and completely and permanently insulate banks from bank runs. Thereby protected from system-wide failure from runs spreading from one bank to another, and collapsing even those banks that are solvent, the liquidation of bad loans could be left to the normal process of the market in downturns: mergers, acquisitions, and bankruptcies. These measures have already been used in financial markets (the latest example is Wells Fargo’s purchase of Wachovia) and Obama himself has endorsed them (here and here) by imposing them on the auto companies. Government-directed liquidation is redundant at best and less efficient in any case. Investors and entrepreneurs on the market, as they do every day in good times and bad, handle the liquidation and reallocation of assets. After the market liquidation, banks could start normal operations again on a sound, non-inflationary basis.