Bernanke has kept his helicopters grounded…so far

(September 2008) In late 2002, when deflation fears were running rampant through the financial markets, a little-known Fed governor by the name of Ben Bernanke thrust himself into the glare of publicity by giving a speech in which he explained what the Fed could do to ensure that deflation didn’t happen in the U.S.

Like most people, when Bernanke talks about deflation he is referring to falling prices; that is, he is talking about one of the effects of deflation as opposed to actual deflation (money supply contraction). His speech, therefore, discussed the actions that could — and probably would — be taken by the Fed and the U.S. government to prevent a sustained fall in the general price level.

During this speech, he referred to the Fed’s unlimited ability to create new dollars* and to Milton Friedman’s famous quip about the government dropping money from helicopters. As a result of this speech, he came to be known as “Helicopter Ben” and to be viewed by government policy-makers as a likely candidate to succeed Alan Greenspan as Chairman of the Fed.

When the problems in the world of sub-prime mortgage debt threatened to evolve into a broad-based financial crisis in August 2007, the Fed, now with Bernanke at the helm, quickly began slashing the price paid by banks for short-term credit.

The way the Bernanke-led Fed initially reacted to the crisis lent support to the existing perception that when “push came to shove” “Helicopter Ben” would live up to his moniker, even if it meant trashing the U.S. dollar. The markets therefore began to anticipate monetary profligacy on a grand scale, accordingly pushing the foreign exchange value of the U.S. dollar downward and the prices of most commodities upward. However, what we now know is that this anticipation was off the mark, or at least premature.

Perhaps sensitive to his nickname, Bernanke did not flood the economy with new money. Instead, he attempted to shore up the banking system’s collective balance sheet in ways that did not involve net additions to the money supply. As evidenced by the Fed’s weekly H.4.1 Report, there has been a net increase of only $37 billion in reserve bank credit during the most recent 12-month period (the 12 months ending September 5, 2008). This amounts to a gain of about 4.3%, which is similar to the year-over-year percentage increase in true money supply.

However, the modest $37 billion year-over-year increase in reserve bank credit masks dramatic activity beneath the surface. The Fed has, for instance, provided the banking industry with an additional $150 billion of money via a scheme called the “Term Auction Facility” (TAF). Also, under another scheme called the “Term Securities Lending Facility” (TSLF) it has helped banks and other financial corporations by offering pristine Treasury securities in exchange for private corporations’ toxic waste (illiquid securities of indeterminable value).

All told, the Fed has, in effect, provided $337 billion of assistance to the financial establishment over the past year via the TAF, the TSLF, and a few other methods, but has “sterilized” this assistance by disposing of about $300 billion of its own Treasury securities, leaving a net change in reserve bank credit of only $37 billion and avoiding a sharp increase in the money supply. To paraphrase Edmund Blackadder, it was a plan so cunning you could put a tail on it and call it a weasel.

Understand, though, that the Fed’s ability to continue along its current path will be restricted by the fact that its holdings of U.S. Treasuries have already dwindled from $780 billion to $480 billion. The Fed will almost certainly want to retain at least a few hundred billion dollars of Treasuries on its balance sheet, so if the financial sector requires additional large-scale assistance in the future then it is reasonable to assume that the Fed will be forced to resort to methods that involve creating a lot of new money “out of thin air.” Bernanke and Co. appear to be making a high-risk bet that the situation is now under control and that such assistance will not be required.

It’s very unlikely, in our opinion, that the efforts made to date by the Fed to shore up the financial system will be the end of it. In any case, aside from any additional aid it may or may not provide to banks, the Fed will be intimately involved in rescue operations cobbled together by the U.S. Treasury, beginning with the takeovers of Fannie Mae and Freddie Mac.

A realistic appraisal of the balance sheets of Fannie and Freddie would probably reveal that the combined liabilities of these companies are hundreds of billions of dollars greater than their combined assets, and since the government doesn’t have any spare money of its own (the government is already heavily in debt and running a huge deficit), it will have to borrow the money needed to fill this liability-asset gap. In all likelihood, borrowing the money will entail issuing bonds to the Fed in exchange for newly created dollars.

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*Here is the actual quote: “U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

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(09/10/08)