Monday, September 19, 2011

Money 101 for the Fed

We can imagine how discomfited Ben Bernanke must be now seeing that his QEs failing to lift the US economy out of its doldrums. His frustration is a consequence of his own doing. He is under the illusion that the Fed finally has the power to vanquish the business cycle with its money printing press. When reality doesn't bear him out, instead of changing course, he is sticking to his guns, albeit very much subdued as his much anticipated QE3 may have to be scaled down to Operation Twist. Bernanke is forced to take such a course in light of the resistance from other members of the Fed Open Market Committee (FOMC) who remain ignorant on the actual causes of inflation.

It's very pathetic that the eggheads running the monetary policy of the world's biggest economy don't understand the essence of money. Something is seriously wrong with the whole economics profession and education. Time to clear the murk that's been clouding our understanding of what money really is.

We'll start with the Fed's financial statement, specifically its balance sheet over the last five years which I've tabulated below in a simplified form.
The major items, with values exceeding US$300b, are penned in red boxes. By focusing on these items, we can clearly see the Fed's strategy. At the beginning of the current crisis, the Fed embarked on QE1 in December 2008. It went on a lending spree, to both private and other central banks (see the 2008 Assets column) to stem the panic. When the crisis had subsided, it switched its investments to Treasury bills and GSE mortgage backed securities (MBS) (Assets columns 2009-2011). From US$500b of Treasuries in 2008, it increased them to $2.2 trillion of Treasuries and MBS by end 2010. Seeing that the economic recovery was still tepid, it launched QE2 in November 2010 with the purpose of lending another US$600b. The latest available figures show a combined Treasuries and MBS total of US$2.6 trillion.

Can Bernanke's QEs be considered successful? Yes on only one measure: it has managed to bring down the interest rate to almost zero. In others, it hasn't made a dent. Let's see where the Fed has sourced the funding for its investments. The 2011 Liabilities column shows that currency notes have increased to almost US$1 trillion with the balance US$1.6 trillion in the form of bank reserves placed with the Fed, earning a paltry 0.25%. In fact, from end 2008 till now, currency notes have increased by almost 6% annually while bank reserves more than 25%. In monetary measures parlance, currency notes are denoted by M0 while both currency and bank reserves with the Fed are termed monetary base. However bank reserves do not form any of the usual money measures, be they M1, M2 or the discontinued M3. The bottom line is the Fed has done nothing to boost the money supply (that is, lending); whatever increase has been due to Obama's deficit spending. Yet the talking heads have been lambasting Bernanke for money printing. Sure, the currency notes have increased by US$150 billion but this is not even a drop in the US$52 trillion credit ocean.

What has actually happened from end 2007 till now is that the Fed's holding of Treasuries and MBS has increased by $1.9 trillion. This increase has been funded by banks ($1.6 trillion), currency notes ($0.2 trillion) and others ($0.1 trillion). Now when the banks fund the Fed, that money is taken from funding elsewhere, notably Treasuries and MBS. So effectively, there's no new credit which means no new money.

The Fed's lowering of interest rate through its massive Treasury and MBS purchase is supposed to spark lending but the banks don't lend solely on interest rate consideration. More important is the risk of non-repayment which is real when demand has faltered. There's no point building factories or houses when there are no takers for the goods produced or houses built. The point is demand is zilch at the end cycle of a Kondratieff wave because wealth generation and accumulation have skewed to a narrow group of successful businesses, wherever they may be all over the globe.

Now let's see what the usual monetary measures are showing. The chart on the left from plots the M1, M2 and M3 since 2003. Note that the official M3 from the Fed ceased being published from March 2006 (red line). It's being tracked as the blue line by It was Bernanke who stopped the publishing of the M3 (the Fed's broadest measure of money) in March 2006 after he had been appointed the Fed Chairman the previous month. So Bernanke is left with M0, M1 and M2. However we can safely ignore all these measures, including the unofficial M3 as there is a better measure of the total money in the system, that is, the total credit market amount which is all encompassing. The credit market size is US$52.7 trillion while M3 is US$15.0 trillion and M2 US$9.5 trillion. Bernanke is using a metric that's less than one fifth of the real money supply measure.

Remember that all money is credit, even the currency notes. Look at the Fed's balance sheet. The currency notes appear as liabilities though the Fed is never obliged to pay out anything since they are never redeemed.

On the left is the chart that plots the annual total credit market growth from the first quarter 2006 to the second quarter 2011. This chart is more revealing than all the conventional M measures. As early as 2006, we should have known that this all encompassing money metric had reached a plateaued growth. From 2008, the growth has slowed considerably bottoming out in Q1 2010, a pattern similar to that of the M3. Now the most interesting bit: the growth for Q2 2011 has slowed whereas the M measures are still registering increasing growth. With Obama restrained by Congress from further spending increase and Bernanke still toying with his impotent tool, figure out yourself how the future will unfold.

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