How Does the FED Do It?

Finally our daily newspapers accurately describe how the Federal Reserve puts $1.7 trillion into the economy:
"Are Tax Payers on the hook?
No, the Fed prints money. Not literally--the Treasury ... makes the nation's paper currency. Instead the Fed creates the money to buy the Treasury bonds and other securities. It then adds those securities to its balance sheet .... "

The Associated Press, LSJ, March 20, has this part right, but could do the public a service if it added that it is the same basic process that adds to the money supply when a commercial bank makes a loan.

"Are there any downsides to this? The main risk is that the flood of new dollars will increase inflation as more dollars chase the same amount of goods."

Here the AP goes wrong--the new dollars will create new output, maintenance of state and local roads, schools, etc. The amount of goods is not fixed.

The FED always faces the difficult task of adjusting the money supply (in normal times via monetary policy) to the capacity of the economy to produce. But, does anyone think we can't produce more if we put the unemployed to work?? Sure, they could make a mistake and maintain the stimulus when we again reach full capacity. But, we are far from that now. The greatest danger is that because of old myths and superstitions, we will not put in enough new money. The danger of deflation is greater than the danger of inflation.

Fed to Buy $1 trillion in Securities

The New York Times writer keep labeling the FED's purchase of securities as "creating money out of thin air." Of course it is, but this is nothing different than when a commercial bank makes a loan and writes a credit besides the borrowers name. All money is debt and and created. There is no other kind. If our government gives commercial banks the power to create money, surely the government's own bank, the Federal Reserve, can do it also when private borrowers will not borrow enough to use all of the economy's resources.

Galbraith on Bank Policy

Bank Policy Suggestions of Jamie Galbraith, Sept. 25, 2008, Washington Post
"With banks, runs occur only when depositors panic, because they fear the loan book is bad. Deposit insurance takes care of that. So why not eliminate the pointless $100,000 cap on federal deposit insurance and go take inventory? If a bank is solvent, money market funds would flow in, eliminating the need to insure those separately. If it isn't, the FDIC has the bridge bank facility to take care of that.
Next, put half a trillion dollars into the Federal Deposit Insurance Corp. fund -- a cosmetic gesture -- and as much money into that agency and the FBI as is needed for examiners, auditors and investigators. Keep $200 billion or more in reserve, so the Treasury can recapitalize banks by buying preferred shares if necessary -- as Warren Buffett did this week with Goldman Sachs. Review the situation in three months, when Congress comes back. Hedge funds should be left on their own. You can't save everyone, and those investors aren't poor."

Wouldn't it be simpler to change the FED rule requiring that banks take a charge against capital for bad loans?

Galbraith on Bank Policy

Bank Policy Suggestions of Jamie Galbraith, Sept. 25, 2008, Washington Post
"With banks, runs occur only when depositors panic, because they fear the loan book is bad. Deposit insurance takes care of that. So why not eliminate the pointless $100,000 cap on federal deposit insurance and go take inventory? If a bank is solvent, money market funds would flow in, eliminating the need to insure those separately. If it isn't, the FDIC has the bridge bank facility to take care of that.
Next, put half a trillion dollars into the Federal Deposit Insurance Corp. fund -- a cosmetic gesture -- and as much money into that agency and the FBI as is needed for examiners, auditors and investigators. Keep $200 billion or more in reserve, so the Treasury can recapitalize banks by buying preferred shares if necessary -- as Warren Buffett did this week with Goldman Sachs. Review the situation in three months, when Congress comes back. Hedge funds should be left on their own. You can't save everyone, and those investors aren't poor."

Wouldn't it be simpler to change the FED rule requiring that banks take a charge against capital for bad loans?

Citi Group

The government has already loaned Citi Group a ton on money. Now, it is considering taking common stock in exchange. Here is the supposed reason as suggested in the Washington Post:

"Many investors concluded that the government money did not count as part of Citigroup's capital reserve against future losses, because the investment looked like a loan. The company was required to issue the government shares of preferred stock, which carried an interest rate that spiked after five years to encourage repayment.

By allowing Citigroup to issue common shares to replace those preferred shares, the government hopes to convince investors that the company has a sufficient capital reserve to survive its problems."

If the FED changed its rule requiring that loan losses be a charge against capital, the above would not be necessary.

Banks & Toxic Assets

When a bank makes a loan, it creates money. If the loan can't repaid (inevitable if housing bubble breaks), under current rules this is a charge against the bank's capital and given the size of the revaluation, it can bankrupt the bank. But this charge against capital is merely a rule that can be changed. In these extreme circumstances, this rule should be suspended and let the banks start over with new loans and get the economy going.
There is no reason to buy these bad loans and put them in a toxic bank at great taxpayer exposure to loses. Let the banks substantially write them off and start over.

Schooling the Chicago School

John Cochrane, University of Chicago economist was quoted in a story in Bloomberg Muse of December 23, 2008

“We should have a recession,” Cochrane said in November, speaking to students and investors in a conference room that looks out on Lake Michigan. “People who spend their lives pounding nails in Nevada need something else to do.”

(Sure. like nothing to do as in unemployed. Spoken like a man with a secure job!)

Diedre McCloskey now an economist at the University of Illinois, Chicago, remembers laughing with fellow Harvard undergraduates in 1963 at Friedman’s claim that free markets allocate resources better than governments. She says Harvard-trained bureaucrats enjoyed prestige following World War II. She switched her support to Friedman after the Vietnam War destroyed her faith that such bureaucrats knew what they were doing.
(The problem is that Wall Street may not know what it is doing!)

ON The Other Side:
On Oct. 14, 2007,about 250 students and professors debated an administration-backed plan for a $200 million research center to be named for Friedman. The protesters argued that the institute would enshrine policies that have brought economies near collapse.

“When Friedman’s Platonic ideas of free-market virtues are put into practice, they have too often generated a systemic orgy of competitive greed -- whose remedies, ironically, entail countermeasures of nationalization,” Marshall Sahlins, an emeritus professor of anthropology, said during the debate, speaking in a room adorned with murals of female students parading through the campus in medieval gowns.
Sahlins, 77, noted a few weeks later socialist and capitalist countries alike are regulating or nationalizing financial institutions in a rebuff to Friedman.
Off campus, the global meltdown is stirring anti-Chicago economists, who were voices in the wilderness during decades of lax government oversight of markets.

Joseph Stiglitz, who won one of Columbia’s economics Nobels, says the approach of Friedman and his followers helped cause today’s turmoil.
“The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self- adjusting and the best role for government is to do nothing,” says Stiglitz, 65, who received his Nobel in 2001.
University of Texas economist James Galbraith says Friedman’s ideology has run its course. He says hands-off policies were convenient for American capitalists after World War II as they vied with government-favored labor unions at home and Soviet expansion overseas.
“The inability of Friedman’s successors to say anything useful about what’s happening in financial markets today means their influence is finished,” he says.

Robert Lucas, Chicago economist who won a Nobel in 1995 for a theory that argued against governments trying to fine-tune consumer demand, says deregulation may have gone too far.
Depression-era laws that separated commercial and investment banks helped depositors decide if they wanted secure accounts or riskier investments. Today, without these distinctions, people can’t be sure if their investments, or those of their customers, are safe.
“I’m changing my views on bank regulation every week,” Lucas, 71, says. “It was an area I saw as under control. Now I don’t believe that.”
Lucas says he voted for Obama, the only Democrat besides Bill Clinton he’d supported in 44 years.
(There is hope, some people learn!)