But Now You Know

The search for truth in human action

What Bernanke Means: QE2 Will Not Boost Money Supply


Most of the loudest critics of the Federal Reserve are aghast at Ben Bernanke’s recent interview, in which he stated that:

We’re not printing money.

The amount of currency in circulation is not changing.

The money supply is not changing in any significant way.

– Ben Bernanke, 60 Minutes Interview, December 2010

What on earth, people wonder, does he mean by that? How could he say such an obviously crazy thing?

I mean, he is spending NEW money buying up bonds and notes…everyone but Bernanke is calling this QE2 (Quantitative Easing)…and the whole point of this is to add money to the economy.

How can he say the money supply is not changing?

But he isn’t simply crazy…he means something specific, and sane (if misguided).

He means this:

Quantity Times Velocity

The real money supply is not simply the number of dollars in existence. As Nobel-laureate economist Friedrich Hayek pointed out, real money supply is really a multiplication of the amount of money, times how much the money is moving around.

(S)upply equals (Q)uantity times (V)elocity.

This chart of the movement of MZM, the best measure of money people can actually use, tells the tale of woe...velocity, and therefore REAL money supply, has fallen deeply, despite the Fed's hopeless efforts to stop it.

And right now, money velocity is as low as it’s been since the Great Depression…not surprising, since this is the first depression the US has suffered, since.

That means it’s moving very little. In fact, it’s mostly sitting around in banks, doing nothing. It is, as Bernanke implied, effectively out of circulation.

That money is as absent from the economy as if it did not exist. This is the Fed’s fault, because they started paying interest on reserves held idle right at the beginning of this depression, but that’s a separate article.

So even though we now have more Quantity than ever, it’s multiplied by an abnormally low Velocity, to the real supply is lacking.

Right now, Austrians like Hayek and socialists like Keynes would agree that our real money supply is actually at a traumatic low, because much of the quantity is sitting around, unavailable.

Let’s hear Hayek agree with Keynes, himself:

On the first issue — whether to use one’s money or whether to hoard it — there is no important difference between us. It is agreed that hording money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation is in itself desirable.

— Hayek in an open letter to Keynes, 1932, regarding how to respond to the Great Depression

 

Money, money, everywhere, but not a cent to spend.

Like the ocean in my favorite poet’s most famous poem, the money sitting around in banks is, ironically, unavailable for the real money supply.

Bernanke is trying to fix this, by temporarily buying up bonds and treasury notes, therefore bypassing the banks’ massive reserves, putting money directly in the economy.

For the moment, he is correct, that this isn’t boosting the real money supply, because so much of the money is lying salted in (virtual) bank vaults, useless.

Temporary Money

Now his critics, those who know enough monetary theory to understand about velocity the way you now do, say this doesn’t matter, because eventually the velocity will recover, and then we’ll have normal velocity times much more quantity. And that would mean inflation…there’s no way around that.

Bernanke would point out, correctly, that this is not correct, either…

See, the Fed doesn’t consider the money it is printing real. It is ephemeral, temporary money, like a Virtual Particle in physics…popped into existence for a bit, then gone.

And this is true:

When the Fed lends money to a bank overnight, the bank is required to pay it back the next day, plus interest. The same for its more recent, unhealthy bout of lending for thirty or ninety days…after that time, the bank pays the money back, with interest.

And when that money is paid back, it literally “vanishes”, into the “thin air” out of which it was created.

For now, the banks keep re-borrowing money, keeping the extra Quantity in a cycle…but when the Fed decides things are getting better, it can start making that borrowing less desirable, so banks re-borrow less, causing the Quantity of money to decline.

When it engages in Quantitative Easing (Bernanke hates that term, and calls it Credit Easing…bureaucrats love euphemisms), the same thing happens;

The Fed buys notes, adding money to the economy…but later it can SELL those notes, and destroy the money paid for them. It will probably sell them at a higher price than it bought, allowing it to actually destroy MORE money than it created, if it chooses.

So it could, in theory, keep the real money supply at a constant, stable level, allowing prices to be natural.

So Bernanke is Right, Everything Is OK?

Unfortunately…no.

The first problem is that Bernanke, and his peers, don’t understand some economic basics:

We’ve been very, very clear that we will not allow inflation to rise above two percent or less…We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time.

Now THAT is the part that makes me gasp in horror…he thinks he can stop inflation in fifteen minutes? Doesn’t he know the fishtail effect?

Bernanke’s predecessor, Alan Greenspan, and the Nobel Laureate Chicago school economist Milton Friedman, both understood that when the Fed meddles with the economy, its effects take up to EIGHTEEN MONTHS to show up.

So the day that Bernanke decides “Oh, we’ve hit two percent inflation”, he will raise rates…and then inflation will KEEP GOING UP for at least the next eighteen months.

Eighteen months is a LONG time, in economic terms.

Fishtail Effect

It’s long enough that the Fed will become frantic, as its efforts fail to show any results…they’ll keep raising rates, selling notes and bonds, destroying money, until the economy finally seems to be turning around…weakening.

Then they will have overshot the actual mark by around 18 months. For the next 18 months the economy will KEEP getting worse, KEEP getting slower, until it enters into a recession. Because of the amount of money the Fed bubbled in during this depression, and has to suck out, it will probably be the worst recession since the Stagflation of the late seventies and resulting recessions, which were the worst in history.

It’s like when you are on an icy road, and you try to turn…the car doesn’t respond, so you turn the wheel more, and more…by the time the car responds, you’ve turned too much. You straighten the wheel happily, but the car KEEPS turning past where you wanted. So you turn in the other direction…but it keeps turning the original direction. By the time it responds, you turned too much the other way…et cetera.

This is the source of the modern “business cycle” of recessions, that have happened since the US left the Gold Standard in the 1930s. The Fed, and the rest of government, are constantly meddling with the economy, and then discovering the damage they did when it shows up years later, then reacting to that with even more damaging behavior, back and forth in an endless cycle of unintended consequences.

Now this has, up to now, been better than the “business cycle” of depressions and panics the US suffered from 1873-1933, when the US was on a fiat gold standard. But now we’re suffering a depression, despite being off the gold standard, so that’s all out the window.

What we need, of course, is for the Federal Reserve’s monopoly dollar to be replaced by a free market in money, as Friedrich Hayek proposed.

But, failing that, we need the Fed to at least go back to mostly staying out of the economy, as Alan Greenspan tried to do, instead of constantly expanding its meddling, as Bernanke has done, helping lock us into this cycle of economic devastation.

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December 9, 2010 - Posted by | Economy, International, Philosophy, Science | , , , , , , , , , , , , , , , , , , , , ,

4 Comments »

  1. [...] “easing” is the printing of temporary money the Fed uses to buy securities. It hopes that money will get spent without going into excess [...]

    Pingback by Is the Fed Wagging the Dog? « But Now You Know | December 28, 2010 | Reply

  2. [...] QE2 and the Money Supply – Article explaining inflation and the money supply, how the two are related. [...]

    Pingback by What’s Worse than the Ballooning Federal Deficit? « Carey's Financial Musings | December 14, 2010 | Reply

  3. Thank you. This is one of the best articles I have read. If anything I think the 18 month fish tale is an understatement – it seem to be more like 30 months. It tends to be 3 years of inflation rising, then 3 years of inflation lowering.

    Comment by Mundi | December 14, 2010 | Reply

  4. Kaz, I think this article might be of interest to you. It deals with a subject you’ve dealt with many times; for instance when talking to the “Neo-Austrians”, as you’ve labeled some libertarians.

    “[...] self-described Austrians bear blame for this situation too by not making clear the distinctions among “Austrian economics,” “libertarianism,” and their particular views on historical or policy issues.”

    http://www.coordinationproblem.org/2010/11/what-austrian-economics-is-and-what-austrian-economics-is-not.html

    Comment by Nix | December 11, 2010 | Reply


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