The Weight of the Fed in the Voters' Decision

In science there are lots of facts but only a few theories. Fewer still, perhaps, are the "laws" of science, one of which is the Law of Conservation of Matter, which holds that matter can neither be created nor destroyed. The laws of science, however, aren't good enough for the Federal Reserve -- you see, the Fed creates money.

Since the financial crisis of 2008, the Federal Reserve has created trillions of new dollars. The Fed creates money when it buy assets, which is called "quantitative easing," or QE. The assets the Fed buys can be "whatever assets it likes: government bonds, equities, houses, corporate bonds or other assets from banks." For instance, when it launched QE2 in Nov. 2010, the Fed bought back $600B of its own Treasury bonds.

Just as the Fed creates money, it also destroys money. The Fed destroys money when it sells assets. When the Fed sells its assets, it takes money out of the system; that money is then no longer out in the economy where folks can use it. (I'm not sure if the Fed hits the delete button when the checks for its sales clear, or if that even matters.)

One would think with so many trillions of new dollars pumped out into the world that "price inflation" would erupt. That hasn't happened because the Fed's new money isn't circulating; it's "sitting on the sidelines." That the Fed's new dollars are idle may be a boon as regards price inflation. If commercial banks were indeed loaning their new money out, the number of dollars in circulation would be even greater than what the Fed has created. That's because of the money multiplier effect of our "fractional reserve" banking system. But, if the Fed's new money started to be used in the economy, price inflation should return with a vengeance. In which case the Fed would need to end QE and begin what analysts call the "exit strategy."

But the Fed's exit strategy for preventing price inflation -- i.e., sucking money out of circulation by selling assets -- has snags. One snag involves the prices the Fed's assets will fetch. If the market for the Fed's assets is down, the Fed might have to accept a lower price than it paid for them, thereby leaving money in the system.

If the sales of its assets doesn't go as well as is needed to drain money out of the system, another snag might trip us up: the Fed may have to sell new Treasuries. And to attract buyers, the Fed may have to pay higher interest rates for those new bonds. Those higher interest rates can spread throughout the entire market and affect the price of everything. So the Feds' very strategy for combating price inflation... can produce it.

Not only that, those new Treasuries will someday mature, and unless Congress starts running a budget surplus, those Treasuries will have to be rolled over by finding yet more buyers for U.S. debt. So the total number of U.S. bonds would continue to grow, placing the taxpayer on the hook for an escalating number of interest payments whatever their rates.

The Fed has recently embarked on QE3, the third round of money creation. But QE3 is different, as it is an open-ended commitment to create $40B a month -- money creation without end. And this time the Fed will not use its new money to buy back its own bonds, as in QE2. The Washington Post reports:

One of the key benefits from the easing policy is to push down interest rates for mortgages and other long-term loans, such as certain corporate investments. The policy includes buying $40 billion of mortgage-backed securities, issued by the likes of Fannie Mae and Freddie Mac, each month. That means the Fed is funneling newly created money directly toward home loans to try to make it cheaper for Americans to buy or refinance a house.

This seems very similar to the easy money policy that caused the mess in the first place.

With QE3, the Fed is not only manipulating the money supply, it is also intruding into the real-estate market, trying to prop up the prices of houses. The Fed thinks deflation is the problem, not inflation. But one fix for deflation is simply to create more money, exactly what they've been doing. Regardless of whether it is successful in raising the price of real estate, QE3 will more likely jack up commodity prices, such as costs for food and fuel.

Another problem QE3 could create is when interest rates return to normal -- while the banks will be paying higher interest to depositors, their cash flow from making loans under QE3 will be less. Perhaps you remember the savings and loan crisis of the 1980s, when "S&Ls, stuck with long-term loans at fixed rates, often had to pay more to their depositors than they were making on their mortgages."

What does it say about the health of a nation's economy when its central bank is in a long-term program of buying assets no one else seems to want? Perhaps it says previous programs that were aimed at fixing the economy, including the previous QEs and the various stimulus programs, have failed. QE3 is an indication that nothing has worked. We have this stagnant economy and yet, after four years, we still haven't fixed the structural problems, particularly entitlements, that threaten to unravel everything. So now the Fed is yet again devaluing our money through inflation exactly as if the dollar isn't weak enough. The Fed must think that Americans don't mind that their dollars buy less.

And looming over everything is the anxiety over the Fed's "exit strategy," and whether the brainiacs in charge will have the wits to take that exit before they go too far and inflation turns into hyperinflation, which leads to doom, "deep and darker than any sea-dingle."

With the power of creating and destroying, it must be very heady being a central banker. Hell, one might even start to think of oneself as... a god. Central bankers should guard against taking themselves too seriously, though, even if their egos require it.

It may be good and even necessary for a nation to have a central bank. A nation needs to be able to borrow, especially for wars and emergencies. But with its "dual mandate," the Fed has been given duties that conflict. Perhaps the Fed's only concern when creating and destroying dollars should be the strength of those dollars, while programs to increase employment should remain in the domain of Congress.

Deemed by many as the most important in our lifetimes, the November 6 election is about the direction of this country -- what kind of nation do we want America to be. The Fed should play a major role in that consideration. Without the Fed and its ability to create fiat money out of nothing, the entitlement state that America has become could not exist. It is Congress's insatiable demand for money that is taking America to ruin, and the Fed is Congress's enabler.

There's a good reason one saw "End the Fed" signs at Tea Party rallies -- the Fed is too damned powerful. And it's accountable to no one. The Fed helped to cause the housing and financial crises, and now they think they can fix those problems with the very same tools that caused them.With its inflationary policy of creating dollars, the Fed risks destroying the value of all pre-existing dollars. The currency itself may even be at risk.

It is time to ratchet back the power of the Fed. The question for the voter is: which party is more likely to do that? The answer should be easy when you consider that the Federal Reserve, like ObamaCare, was created by progressive Democrats. (Read the FedBasher's analyses and spirited rants here, here, here, here, here, here and here.)

This just in: Thomas Hoenig, former president of the Kansas City Fed, is being discussed as a possible replacement for Ben Bernanke. Hoenig "objected repeatedly to the Fed's easy money policies throughout 2010 when he served as a voting member of the group." That news might give the Tea Party some hope for change.

Jon N. Hall is a programmer/analyst from Kansas City.

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