By Jeff Harding.
Dr. Frank Shostak is Chief Economist for MF Global, the former trading arm of Man Financial, the world’s largest hedge fund. Man spun off MF Global as a stand-alone company. I believe he is the best (Austrian school) economist out there in applied economics because he makes his living prognosticating for a commercial investment firm.
I am republishing in its entirety his most recent article, “Is the Fed’s Pumping Inflationary?” from the Mises Institute site where his articles appear. It is a very important article because he believes that (1) we will see substantial inflation, and that (2) “real savings” formation is being eroded which will inhibit economic growth. Regular readers will find this material familiar.
Dr. Shostak’s writing is very clear but it is highly condensed which makes careful reading a necessity. I am adding a synopsis to make it more understandable to those not familiar with Austrian theory. I have also italicized some of this key ideas. This makes this a fairly long article, but it’s rewarding, so please bear with me.
Synopsis
The Fed has a difficult task. It flooded the financial system with credit in order to prevent what it perceived to be world financial collapse. While it believes that its efforts have succeeded, it now has to contend with the threat that this ocean of money and credit it created will result in massive inflation.
Money supply has increased 14% YoY as of August of this year. There has been a substantial amount of reserves piling up in bank balance sheets as they find themselves reluctant to lend the money because of perceived risk and new reserve requirements. It is obvious that the Fed’s attempt to stimulate business activity is not working.
The Fed tries to control the amount of money and credit in the system by setting interest rates which they believe will cause the economy to grow or contract. This is set by the Federal Funds rate. When the Fed tightens rates it sells assets it holds to banks and sops up cash and reduced the money supply, thus raising interest rates. It buys assets (Treasury debt) when it wishes to lower interest rates. Its balance sheet inhibits its ability to set target rates because if they push or pull too much, they will affect the Fed Funds target rate which upsets their monetary policy.
In order to get around this, the Fed has come up with the idea that they will pay banks interest on their excess reserves. This way, they believe they can keep their interest rate target intact yet sop up the cash in the system or at least prevent bank reserves from being lent out to flood the system with cash and cause inflation. In essence they think they are cutting the tie between interest rates and monetary expansion.
If only it were that simple.
Dr. Shostak skewers this concept. First, if the Fed believes it is not creating money by expanding the money supply because the banks are sitting on reserves, they are dead wrong. All things being equal, in order to keep the interest rate at the target rate, the Fed has to create money to keep interest rates from going up. When banks lend money they need cash so they sell some assets (such as Treasury bills) that comprise their excess reserves to fund the loan. This cash will end up in bank accounts eventually which increases the money supply. Unless the Fed increases the money supply, interest rates will go up, thus upsetting the Fed’s target rate of interest. Thus this huge pool of reserves created by creating money (i.e., “printing” money) is an inflationary time bomb.
Secondly, paying interest on bank reserves will not prevent banks from lending to customers. It’s pretty obvious that banks know they can make more on a commercial loan than with the Fed so they have every incentive to lend. Also, they are in the business of lending and if they don’t take care of their customers at a point when other banks are willing to do so, they will lose their customer base.
Thus, there is nothing really stopping this new money from working its way into the economy and causing inflation. Shostak sees this as a recipe for disaster, threatening to destabilize the entire economy. While it’s difficult to predict when this cash will work its way into the economy, when banks’ balance sheets are repaired and the mass of debt created during the boom is more or less liquidated, there is nothing to stop banks from lending.
Shostak points then to the most important aspect of all this and that is the inhibition of the formation of real savings. “Real savings” is primarily an Austrian theory concept of what savings and capital really are. It’s not money. Real savings are consumer goods produced by a manufacturer that are not sold or consumed. For example, the blacksmith makes 10 hammers, sells 6, and keeps 4 for the future. Perhaps he will trade them for a new bellows to increase production. In more modern times the 4 saved hammers was replaced by commodity money such as gold. But the “real savings” were the 4 hammers, not the pieces of gold. To further understand this concept, please see: Shostak, “What is the Condition of U.S. Savings?“
If the gold is replaced by paper dollars as we have today, then the printing of dollars doesn’t create wealth, only more paper. Only real savings is wealth. But what deflated dollars and low interest rates does to real savings is distort the role of interest rates by sending a signal to producers to produce even if there are no real savings, no real wealth.
That is what Shostak believes is happening now. He thinks that real savings are being wasted or not being created. Inflation causes people to consume, not save. Today, while consumer savings are increasing, he believes that these savings are not necessarily real wealth and the lack of real savings will jeopardize any recovery and slow economic growth.
Is the Fed’s Pumping Inflationary?
Given the recent, massive increase in commercial banks’ excess reserves, many commentators are of the view that banks will sooner or later start employing these reserves in lending and thus cause an increase in the inflation rate.
Even former Federal Reserve Chairman Alan Greenspan is alarmed by the massive pumping by the Fed and other central banks. Speaking via satellite to a conference in Mumbai on September 8, 2009, Greenspan said that central banks need to defuse the large increases in their assets.
He stated that failing to shrink central-bank balance sheets could lead to very high price inflation: “I am not talking 3–5 per cent inflation; I am talking double-digit inflation in the US.”
In August 2008, excess reserves stood at $1.9 billion. At the end of August 2009, excess reserves stood at almost $800 billion. By early September 2009, they had reached $823 billion.
Some other commentators hold that banks’ decision to sit on their massive surplus cash rather than lend it out raises the likelihood that the Fed’s loose monetary policy remains ineffective. They argue that if the policy had worked, banks would have used the pumped reserves to make loans by now.
… Continue reading Exit Strategy: Can The Fed Stop Inflation?
