The Fed’s Old Tricks in New Times

We’ve been telling anyone who will listen that the Fed has gone where the central bank has never gone before. Pre-crisis, the Fed’s available resource looked like it always had in the postwar period. Nearly overnight, thanks to its magical money creating powers of buying debt with funds it created, the Fed’s balance sheet shot up — like straight up. In fact, it tripled — from $900 million to more than $3 trillion. It’s not stopping either: the Fed will soon have $4 trillion in its coffers.

Why does Bernanke say he did this? To give the economy a jolt and thereby fix unemployment. It’s true that headline unemployment could sink below 6.5 percent. If that were to happen, Bernanke and his posse might douse their QE campfire and head home.

Trouble is that this isn’t likely to happen anytime soon. The latest unemployment number is 7.9 percent. And in the last quarter, productivity as measured by the GDP fell. Fell!

Think of it: the Fed will have quadrupled its balance sheet in five or six years time. The results: stagnation and persistent unemployment.

What’s missing from this catalog of bad effects of loose money? You and I might have expected prices to soar. Back in 2008, if you had known that by the end of 2013 the central bank would triple its balance sheet, and that a year or two later it further expanded its footings to four times, you might have thought we’d been making history Zimbabwe-style by now.

Why haven’t we seen historic levels of hyper-inflation? The necessary triggers are not there. The demand for holding money (instead of spending it) is higher than normal. The banks are licking their crash inflicted wounds, parking reserves at the Fed insteading of lending. You have to have lending in order to have money creation and hyperinflation. That isn’t happening.

How unusual is this conundrum? It’s happened before. In fact, the Fed’s balance sheet has ballooned even more just after the Fed was created in 1913. The sorry tale is chronicled in Economics and the Public Welfare by Benjamin Anderson.

After the Fed was created, It didn’t take long for the Fed’s Board of Director’s first chairman, Charles Sumner Hamlin, to figure out how to grow his business. He wasn’t even a banker. He was a lawyer, academic, and unsuccessful gubernatorial candidate.

The Fed wasn’t even in operation when the Austrian crown prince was assassinated in Sarajevo on June 28, 1914. Investors in Berlin and Paris pushed the panic button in late July. The Vienna exchange closed on July 27 and Austria declared war on Serbia.

In the next few days, stock markets around the world closed. On July 31, 1914, the London market closed. Five hours later, just before it was to open for trading, the authorities of the New York Stock Exchange told brokers they would not ring the bell.

The next day, Germany declared war on Russia and on August 4th, England declared war on Germany.

Talk about markets tightening up! Of course in those days the world was on a gold standard. Benjamin Anderson writes: “when grave uncertainties arise, and, above all, when unexpected war comes, men prefer gold to real estate…With the apprehension of war, however, the effort is made to convert illiquid wealth into liquid form as rapidly as possible, even though heavy sacrifices are involved.”

But New York’s loss of gold abruptly turned and gold began flooding in “a rate never dreamed of before,” writes Anderson. Over a billion dollars of gold flowed in from December 1914 to May 1917. The dollar strengthened, the pound and other currencies dropped. Goods were flying out of America, but only gold was coming back.

After the U.S. entered the war in 1917, the Federal Reserve Act was quickly amended to allow the issuing of federal reserve notes against both gold and commercial paper. Member bank reserve requirements for demand deposits were reduced to 13 percent in central reserve cities, 10 percent in reserve cities, and 7 percent in country banks. The percentage had been 25 percent not long before that.

“Bank credit was easy,” writes Anderson. “It was easy to float new securities.”

The wartime boom was on. And the Fed’s balance sheet exploded in size. The Fed’s total resources on November 26, 1915 were $637 million. The vast majority of that was cash and gold. Member bank reserves made up most of the liabilities..

By late October 1918, just prior to the Armistice, cash and gold at the Fed quadrupled. It’s reserves stood at $2.1 billion. Once you add in war bonds, discounted obligations, and bills bought in the open market, you get a grand total of $5.3 billion — all in three short years.

Meanwhile, member banks added to their reserves. Bank deposits also jumped up from $17.4 billion in June 1914 to $28 billion in June 1918.

Sounds like a prescription for hyperinflation, does it not? But this didn’t happen.

Anderson explains why: the markets were broken.

This is a remarkable exhibition of restraint in the employment of bank credit in a great war. We had to finance the government with its four great liberty loans and its short-term borrowing as well. We had to transform our industries from a peace basis to a war basis. We had to raise an army of four million men and send half of them to France. We had to help finance our Allies in war, and, above all, to finance shipment of goods to them from the United States and from a good many neutral countries.

Anderson explains that credit rationing served to hold down bank credit expansion. Nonessential industries needing funding were turned down. Then as now, banks know where their bread is buttered. Besides, loaning to the government is safer than lending to the widget maker down the street, especially in a time of war.

Construction and other ordinary activities were crowded out as bank credit was steered to wartime needs. After the war, restraint ended, and the boom expanded. Yet, Anderson writes that “money and bank credit was not the dominating factor in the postwar boom…”

However, the growth in bank deposits and the size of the Fed during the war years is undeniable. Plus, bank loans and investments grew another 25 percent from the spring of 1919 to April 1920. Federal debt had exploded because of wartime expenditures.

By war’s end annual consumer price inflation rates had jumped well over 20 percent. In response, the New York Fed ratcheted up its rate (and the other Fed banks followed). Rates moved from 4.75 percent in November 1919, to 6 percent in January 1920, and to 7 percent in June of that year.

Following the war, the government slashed spending from $18.5 billion to $6.4 billion–a 65 percent reduction. The result was a crash in wholesale and retail prices and a moderate decline in wages. Unemployment soared.

You’ve likely never heard of America’s 1920-21 depression because it came and went so quickly. Anderson explains, “we took our losses, we readjusted our financial structure, we endured our depression, and in August 1921 we started up again.”

The current Federal Reserve is emulating its wartime expansion of 1915 to 1918. The federal government is copying FDR’s New Deal of the 1930’s. It is showing the same results: a broken banking system, a stagnant economy, high unemployment, but also price restraint.

We’re five years and counting of Ben Bernanke’s fight to the death with deflation. There’s nothing new or path breaking about it. Experience tells us this modern version of a stupid policy will create many more years of stagnation.

When will the inflation arrive? Maybe later, but maybe never. The point of the monetary policy was to keep overextended banks from going bust. But that comes with other results that are different from what many people might have expected. We’ll pay the price but not in the same way as Zimbabwe and Weimar Germany. Our coming chaos will likely take a different form.

Doug French

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