But Now You Know

The search for truth in human action

Is the Fed Wagging the Dog?


Why is the Fed causing deflationary hording, then "fixing" it with inflationary money?

In 2008, banks stopped lending as much money, helping drag the economy down.

They started holding it in extra reserves, instead.

This caused deflationary pressure the Federal Reserve has been “protecting” us from ever since.

We’re so lucky we have the Fed.

But why did the banks start holding excess reserves instead of lending? Were they simply scared of the economic conditions?

No, they are being PAID to do it, by the Federal Reserve.

That’s right…the Federal Reserve that is “saving” us from the banks’ refusal to lend, is paying the banks to do it.

How the Banks Work

See, banks usually take the money you deposit, and invest it. They make business loans, home loans, buy securities, and so on.

The profit they make doing that pays for the banking services they “give” you “free”.

In a sense, they are acting like a mutual fund for you…investing your money and paying you “interest” in the way of free banking.

But they don’t invest all of your money. The Federal Reserve requires them to hold back a bit “in reserve”. This is to ensure that they have money in case people want to withdraw it.

The Fed makes banks hold 10% of your checking account (and everyone else’s) in their Reserve.

The other 90%, the bank invests, driving the economy through business loans, buying securities, et cetera.

Or it did.

The Fed Wags the Dog

Up to 2008, EXCESS reserves were usually at 0. When the Fed started paying banks to hold them, this excess shot through the roof

But in 2008, the Federal Reserve started paying banks interest for anything they held in reserve.

Immediately, banks started holding EXTRA money in reserve. This is called “excess reserves”, and it had never happened in any large amount before.

Strangely, the Fed’s response to the banks doing what it is now paying them to do has been to complain that they’re doing it, and to expand its power even more, to “save” us from the lost money.

See, our capitalist economy depends on money being used to create wealth. With hundreds of billions being stuck in “reserves”, it’s not being invested to create wealth, and the economy is suffering.

In effect, the Fed is causing what Friedrich Hayek called “hording”, and identified as something that NO economic school considers healthy.

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.
— Friedrich Hayek’s 1932 Letter on the Great Depression

If banks respond to free market demand by increasing their reserves, that’s good.

If the government (including the Fed, acting as its agent) forces more reserves, that’s bad.

The reason the Fed has added, or says it is adding, over a trillion dollars in “Quantitative Easing” (including the recent QE2) is to fight the deflationary effects of banks “hording” in their reserves.

This “easing” is the printing of temporary money the Fed uses to buy securities. It hopes that money will get spent without going into excess reserves…but this is dangerous, because that extra money could cause inflation after the economy recovers.

The Fed hopes to sell those securities and destroy the money it gets back, but history says it will respond almost two years too late, leaving us suffering inflation.

So the Fed is risking dramatic inflation, in order to save us from the risk of deflation it is paying the banks to create in the first place.

Many thanks to Steve Horwitz for his feedback during the writing of this article.
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December 28, 2010 - Posted by | Economy, International, liberty, Politics | , , , , , , , , , , , , , , , , , , , , ,

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