December 22, 2010
The Federal Reserve: Aging Magician of the Welfare StateBy Mikiel de Bary
Almost two years ago, still in the early months of the financial crisis, money supply growth started to falter, frustrating Federal Reserve Board policy. Soon, this turned into tenacious rates of decrease. This little-discussed development could profoundly affect the course of our history.
The production of money at rates greater than what a gold standard would permit is what central banks are all about. For many decades, the Fed has been marvelously good at producing money. Its method -- simply to nudge up the "monetary base" (that is, to increase the so-called reserves of banks by its own asset purchases) -- was "quantitative easing" avant le mot. Our banks would then willingly translate these new bank reserves into new actual money through the magic of our fractional reserve system of "credit money" -- money created in the process of extending loans*.
Let's look at the years from 1960 to 2000. During that period, with minor exceptions, the Fed policy of increasing reserves became routine and succeeded in producing gobs of money, the annual increases averaging 7.6 percent. Looking at those forty years in eight "half-decade" segments, we observe that the average of their respective annual money growth rates was 8.1 percent. In a middling year in the 1960s, the economy would receive a net injection of more than $7 billion in fresh money; in the 1970s, more than $27 billion; and in the 1980s, $83 billion. By the 1990s, the Fed was arranging for over $192 billion in new money in the average year.
Money supply components ($ billions) 1960 to 2000**
Checkable Money Decade's annual 5-yr. annual
December Currency deposits__ supply_ average increase growth rate
1960 29.3 114.8 144.1
1965 36.7 135.4 172.1 3.6 %
1970 49.5 169.7 219.2 7.5 5.0 %
1975 74.1 221.9 296.0 6.2 %
1980 117.4 373.7 491.1 27.2 10.7 %
1985 170.1 698.1 868.2 12.1 %
1990 249.0 1,078.9 1,327.9 83.6 8.9 %
1995 376.3 1,533.4 1,909.7 7.5 %
2000 535.6 2,714.1 3,249.7 192.2 11.2%
This new money sloshed around nicely and reliably produced rising "GDP" -- the mother of all aggregate spending statistics that, macroeconomists ask us to believe, reveals something called "economic growth" for the reason that they have purified it of changes in the "price level." It is as if so superlative was the Fed's "management" of the economy that it had to create three trillion dollars just so Americans could properly appreciate how wealthy they were all becoming.
But the Fed's gifts of new money also created inflation-induced profits and climbing nominal asset values. Not to put too fine a point on it, unrelenting money supply expansion was from the start a financial drug, which came to be administered in steadily increasing doses. Not just in recent years, but over several decades, the provider of the drug, the Fed, has effectively cooked the nation's books and, crucially to our theme, contributed mightily to tax collections while substantially easing the strain of financing government debt increases at all levels. On the basis of the money supply increases' effects on aggregate spending statistics, the Fed, despite a few minor bobbles (called "recessions"), found that it could claim exemplary "stewardship" of the American economy. Also taking credit were several generations of politicians -- the Fed's sponsors and, ultimately, its bosses -- who authorized and delegated the Fed precisely to orchestrate the chief statistical outcomes of our economy.
The Fed's principal product -- new monetary base -- has always substantially reduced, perhaps never more so than at present, the political challenges inherent in financing government spending. But the Fed's principal achievement -- sustained and accelerating expansion of money supply itself, along with an accompanying "economic growth" -- now eludes it. Metaphorically, our central bank has the look of an over-the-hill athlete whose performance statistics are on the decline.
The year-over-year increase in money supply surpassed 17 percent in 2007, eventually reaching what appears now to be "peak money" at nearly $6 trillion in the first quarter of 2009. But in August 2009, money supply had increased a mere 5.6 percent year-to-year, and the increase fell to 4.6 percent the following month. Was something wrong? By October 2009, the year-to-year rate of increase had fallen to 1.8 percent. Despite the Fed's best efforts to reverse the trend, the decline in the rate of increase then devolved into a rate of decrease. Just last month (November 2010), the money supply stood at close to $5.3 trillion, having declined close to 5.0 percent in twelve months. The political problem is that negative, or even stagnating, money growth gravely threatens the financing of government deficits and therefore, for practical purposes, expenditures on the scale budgeted in a mature welfare state.
Money supply components ($ billions) 2005 to 2010**
Checkable Money 5-yr. annual One year
December Currency deposits__ supply_ growth rate increase__
2005 728.9 3,233.3 3,962.2
2006 754.5 3,538.3 4,292.8 8.3% 330.6
2007 763.8 4,298.5 5,062.3 17.9% 769.5
2008 818.7 5,066.8 5,885.5 16.3% 823.2
2009 865.4 4,713.7 5,579.1 -5.2% -306.4
2010 (Nov. est.) 916.8 4,381.1 5,297.9 -5.0% -281.2 (11 mos.)
Can the Fed engineer a recovery in broad money supply growth? Possibly, but it has not managed such a thing yet, despite trying now for about two years. To expand the money supply in the traditional way, the Fed needs a general optimism, a broad-based confidence, to take hold. Our mechanism of money creation requires this since dollars come into existence by the extension of bank credit -- loans made as "checkable deposits." But loan growth depends on banks' confidence in borrowers, and on borrowers' confidence in their business plans. Such confidence, in turn, depends on such factors as a government that protects property rights; does not threaten business owners with regulation, mandates, and tax increases; and has its own financial affairs in order. Such confidence also depends on bank and business perceptions that neither government nor Fed policy is to prop up asset values artificially. We are still far from achieving any of these confidence-building factors or perceptions, and therefore, we may be far from seeing a rise in the money supply achieved in the traditional way.
Can the Fed prop up the money supply untraditionally -- say, by dramatic increases in its monetization of government spending? There is little doubt that it is trying, and under current "QE2" asset purchases, the money supply category "M1 demand deposits" has accelerated. But how far the Fed will go down this path is unclear. After all, direct monetization of gigantic federal deficits implies a significant mutation in the American economic system, a virtual declaration of war on the private sector, and a brazen commitment to a brute inflationist creed. Aside from its scary irrationality, such adventurism risks self-defeat under our credit money system. Were the government to disseminate vast quantities of new dollars to its employees, its contractors, its welfare recipients, etc., a terrified business world might further drop its own financing demands, resulting in a prolonged stagnation or even a continued decline in total money supply.
Paradoxically, the very possibility of the Fed's somehow regaining its money-producing powers should be a source of unease rather than hope, for a resurgent Fed would imply resumption in the growth of the welfare state, which is to say an intensification of governmental burdens on the private sector. Back in the saddle, the Fed would also likely introduce the next central bank-generated cycle of boom and bust, with the next financial crisis coming at a time when governments' obligations could be much higher even than now and their resources to meet them -- private-sector assets -- much lower.
As it is, the struggle of the Fed to ignite substantial growth in the money supply has enormous implications for American politics. It was "no accident" that the golden age of Fed money production -- 1960, say, to "peak money" in 2009 -- was an era that encompassed the long buildup of welfare-state entitlement programs. Unless the Fed soon recaptures its money-boosting dexterity, its days as the great financial wizard of our welfare state may be over. Without a Fed able to create the appearance of more economic success than is actually occurring, more Americans will question government largesse at their expense. And an anemic money supply will provide no further disguise for government financial voracity.
The basic mechanism of central bank money creation relies on two essentials. The first, of course, is the determination of its managers to expand reserves persistently over the years. The second is the largely unconscious complicity of the banking and business community in responding with confidence to the continual offers of easy credit. The modern system has lost the technological simplicity exploited by coin-clipping kings or printing-press Peronistas. This amounts to a serious threat from the point of view of advocates of perpetual growth of the modern state, since business confidence may fail, cutting off fiat money growth. It is a mechanism by which fear can negate the growth in those spending statistics known as the "macroeconomy."
There is irony in the fact that an inadvertent design flaw may end up starving the beast. The Fed's perpetual growth machine -- the welfare state itself -- may being thwarted not by intelligent economists, rational politicians, or even the common sense of the people, but by the delegation of half the task of monetary expansion to the business community.
The Fed has been a true and faithful ally to politicians during their happy decades of growing the welfare state. If the old Fed magic has gone for good, politicians will repeatedly find it necessary to impose additional taxes merely to maintain, let alone expand, the massive structure of entitlements. Unpopular, crushing, and overt taxation will be required, absent the old Fed wizardry, to address the fiscal horror of deficits premised on the survival of Social Security, Medicare, and all the other programs.
No serious proposals for dismantling the most fiscally threatening welfare state entitlements have been so much as hinted at. All proposals aim at salvaging them. Conservative politicians argue for low tax rates for the reason that they will "bring in more [tax] revenue" -- i.e., will feed the welfare state. The American people themselves have not turned against entitlements. Far and wide, the cry is for the macroeconomists' version of "recovery" -- understood by all to mean the resumption of the business-as-usual growth of the welfare state on the back of a private economy expected to slave forever in subordination to ever-growing statist schemes.
President Obama, easily the most profligate president in our history, amusingly called into being a prestigious commission to propose a plan for "fiscal responsibility and reform." The implicit mandate of that commission was to provide the political establishment with a menu of various modest adjustments to preserve welfare-state entitlements with as little disruption as possible. But we hear of no "Plan B" to address the contradiction in terms that we may actually face: a welfare state bereft of an effective central bank.
*"Money supply" is best understood to include currency and all "checkable deposits" -- i.e., the cash and demand accounts that people consider and treat as their money, not as their investments. To be comprehensive, "checkable deposits" should certainly include money market fund balances. The more narrowly defined money aggregates M1 and M2 have shown much less weakness than the broad money supply, even modest increases, but this is deceptive, as they have benefited from large, persistent conversions of money market fund balances into government-insured bank deposits. I exclude time deposits and savings accounts in general as being, now more than ever, potentially illiquid, especially under any renewed bank difficulties. Their likelihood of becoming illiquid, and therefore more like an investment than a "money," is also currently evidenced by their paying significant rates of interest as compared with money market fund balances.
**Sources: "Checkable deposits" here include M1 demand deposits and other checkable deposits, retail, and institutional money fund balances. You can find these, along with "currency," in Tables 5 and 6 of the release "Money Supply (H6)" at http://www.federalreserve.gov/releases/h6/hist/ and https://www.newyorkfed.org/publications/frame2.cfm?url=http://www.federalreserve.gov/releases. I also include in "checkable deposits" the "sweep accounts" found at www.research.stlouisfed.org/swdata.
Mikiel de Bary is a securities industry professional in New York City. His email address is email@example.com.