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Bennie and the Monetary Jets

Mises Daily: Friday, February 29, 2008 by

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The old monetarist tale of the Great Depression, thoroughly refuted in the Austrian literature, is that the Federal Reserve failed to provide enough inflation (i.e., money supply) when the market started to weaken and it allowed the money supply to collapse, and, as a result, the banks failed and the economy went into a tailspin of depression.

They believe that the Federal Reserve acted properly during the 1920s in maintaining price-level stability by providing the banking system with regular injections of money. This despite the fact that the decade was called the "Roaring Twenties," that unemployment was unnaturally low, and that anyone looking at a graph of the stock market could clearly see a bubble in the making.

The new chairman of the Federal Reserve, Professor Ben Bernanke, is a student of the Great Depression and has written extensively on the subject. He famously said (as vice chairman of the Fed) at Milton Friedman's 90th birthday, not to worry, Milton, "We won't let it happen again."

So now that he is chairman of the Fed, he faces the task of trying to clean up the housing bubble and prevent the economy from slipping into depression.

It's a daunting task and he is evidently dedicated to one tactic: inflation now and forever.

Foreclosures and bankruptcies are on the rise, the credit markets are tightening because no one is sure who is holding all the bad mortgage debts, and banks are naturally risk averse with all the signs of recession, including a recent jump in the unemployment rate.

In addition, the dollar is at all-time lows against foreign currency. Oil is now over $100 per barrel, and gold is approaching $1,000 per ounce. Price inflation at consumer and wholesale levels is rising even according to government statistics. Every time the Fed cuts rates, it only makes these problems worse and undermines the value of the dollar. This is also a big problem for Bernanke because, in addition to promising no depression, he also supports inflation targeting where core consumer prices rise by no more than 2% per year.

The supposed lesson of the Great Depression looms always: the Fed tried to inflate but the banks wouldn't help. This time the Fed must find a workaround. Bernanke's technical solution is rather novel. It amounts to bribing the banks to take the money.

It is not surprising that banks don't want to lend heading into a recession. It is also quite natural that banks do not want to lend their reserves to other banks when they do not know their exposure to the subprime crisis. In addition, with all this uncertainty it is also not surprising those banks are reluctant to go to the Fed's discount window for reserves, because then you reveal that you are in trouble, and subsequently your stock price gets hammered, and all of your customers and creditors get nervous.

Bernanke is evidently dedicated to one tactic: inflation now and forever.

At the discount window, banks can temporarily exchange some of their assets for cash for which they pay the Fed the "discount rate" of interest. Actually, in researching this article, I found out that the Fed discontinued the "discount rate" data series years ago and failed to notify the public. They now chronicle a data series called the "primary credit rate" (this is not the "prime rate"). Even banks in financial difficulties can borrow "secondary credit" at a slightly higher interest rate.

So how does Bernanke jump-start the banking system? (Note to self: why is it called the banking system, rather than the banking industry?)

Bernanke decided that, instead of waiting for timid customers at the discount window, he would announce a series of auctions called Term Auction Facilities, or TAFs, where the high bidders would get the bank reserves. This maintains the bank's privacy, or at least reduces the onus of approaching the discount window, and it guarantees that new reserves will enter the system. According to the Fed:

The TAF is a credit facility that allows a depository institution to place a bid for an advance from its local Federal Reserve Bank at an interest rate that is determined as the result of an auction. By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help ensure that liquidity provisions can be disseminated efficiently even when the unsecured interbank markets are under stress. [emphasis added]

What this accomplishes is that it almost guarantees that banks and a "broader range of counterparties" will get injected with new reserves from the Fed and reduce their need to hold traditional reserves from their customers' accounts. Also, it provides banks with the opportunity to put up a "broader range of collateral" for the loans at the discount window, including performing subprime mortgages!

Rarely in economic statistics do you see straight lines, but Bernanke's mechanical if not draconian approach can be seen in the following two graphs. The first shows the amount of "term auction credit":

TERMAUC

The next straight line — straight up — is the same basic data but shown over the history of the Fed. (Note that there was little borrowing at the discount window except in the aftermath of WWI, WWII, and the Vietnam War). Basically the series stays near the zero line and occasionally pops up to a few billion dollars. Recent history — the last two months — has it soaring to close to $50 billion.

BORROW

Some commentators say that the Fed has merely taking charge, rising to the occasion, and attempting to "shake it loose together." However, others would say this is all an act of desperation. If desperate circumstances call for such drastic actions, then Bernanke's actions — rather than words — indicates that we are in desperate circumstances.

$35 $29

Whatever the case, while merchants and consumers wail about the lack of credit and high interest rates, the banks are getting rate cuts and credit mainlined via the Term Auction Facility. The Fed's policies have also greatly reduced interest rates for savers in their savings and checking accounts, certificates of deposit, and money market accounts.

It should come as no surprise to Mises.org readers that the auction rate is less than the old discount rate. Every winning bid in the first six auctions has been below the discount rate, usually by more than half a percentage rate. Lower rates and the cover of darkness — this is a nice deal for the banks. Bank borrowing from the Fed is so large that it is actually greater than their total reserves on hand.

The important question is, who's right and who's wrong. Can Bennie make the banks and the bad debts ageless? Can he live up to his promise to Milton Friedman and maintain his inflation targeting promises? It would seem that he has put the faith in monetarism and government-managed money on the line. So stick around to find who's right and who's wrong.


Mark Thornton teaches economics at Auburn University. He is a senior resident fellow at the Ludwig von Mises Institute in Auburn, Alabama, and is the Book Review Editor for the Quarterly Journal of Austrian Economics. He is co-author of Tariffs, Blockades, and Inflation: The Economics of the Civil War. Send him mail. Comment on the blog.