The Federal Reserve Act of 1913 created the United States Federal Reserve, for the purpose of avoiding financial booms and busts, the latest of which had occurred in 1907 and nearly ruined the country’s financial system. The savior of the crash of 1907 was J. Pierpoint Morgan, who stepped into the crisis decisively. He browbeat his brother bankers into coughing up sufficient money, time and time again, and succeeded eventually in stopping the ongoing runs on banks all over the country. J. P. Morgan saved the day in 1907, and has gone down in history as a true American hero.
The purpose of creating the Federal Reserve was to create a source of money to do exactly what J. P. Morgan did, for future financial emergencies. Sad to say, this noble purpose has failed miserably. Why? Because committees of people are never as smart as J. P. Morgan, or even lesser humans, and the history of the Fed is a history of abject failure and disaster.
The Fed’s Performance In The Great Depression of the 1930’s
It is well known that economists of all persuasions agree that at the onset of the Great Depression the Fed made a colossal and tragic mistake in slowing money growth. Indeed, Milton Friedman, Anna Schwartz and Allan Meltzer (and even Ben Bernanke) have written that the Great Depression not only was made much worse by this misguided and ill-advised Fed action, but that the Great Depression actually would not have occurred but for this unbelievable perverse and misguided screw up by the Fed.
The Fed’s Performance 2000 to 2012
Starting in 2003-2005 the Fed held interest rates too low for too long, thereby encouraging excessive risk-taking and stimulating a housing bubble. It then jumped interest rates too quickly, resulting in a bust, culminating in the panic of 2008. (To be fair, Congress also bears a large responsibility for the housing bubble by passing laws to encourage risky lending.)
Reacting to the panic of 2008 the Fed lowered interest rates to basically zero, and has promised to keep rates at zero well into 2014. In the latter half of 2008 the Fed also embarked on large scale purchase of mortgage backed securities (MBS’s) and longer term Treasury securities. This is known as “quantitative easing”, and has occurred twice now, QE1 (November 2008 to March of 2010), and QE2 (November 2010 to July 2011).
QE1 and QE2: How Much Has The Fed Balance Sheet Grown?
With QE1 and QE2 the Federal Reserve under Ben Bernanke has pumped $2 Trillion Dollars into the US Financial System, consisting of vapor ware, i. e. numbers entered into a computer. This is not even “printing money” like the Weimar Republic did, since no paper money is produced – it is just numbers changed on a computer screen by Ben Bernanke.
The top figure shows a reddish line, denoting the the money (in billions of dollars) that was “deposited” by the Fid into financial institutions in the US and worldwide. The Fed “exchanged” these dollars for MBS’s (Mortgage Backed Securities and other securities) held by the financial institutions. For example, this amounted to zero dollars in August of 2008, then increased to $700 Billion in November of 2008, and then increased to $1.2 Trillion in January of 2010.
More accurately, the financial institution transferred the MBS’s ownership to the Fed, and the Fed in return allowed the financial institution to add the supposed value of the MBS to the account of the financial institution, by keyboarding that dollar amount into the financial institution’s account. Cute, n’cest pas?
QE1 and QE2: What Effect Did It Have On Equities and the Stock Market?
The impact of the Fed infusion of money on the Dow Jones Index may be gauged by comparing the Dow performance from January of 2008 to March of 2012, to the amount of money injected. Obviously, the Fed action created a bull market during the Fed’s QE1 and QE2 bond purchase periods, as shown in the top figure. Clearly, Ben Bernanke and the Fed achieved one of their goals, namely creating a bull market in equities. But at what cost?
Cost of QE1 and QE2: Inflation
When the QE1 and QE2 money eventually comes back out of the banks and financial institutions, where it currently is sitting (doing nothing, since Banks are not lending it out), and enters the real economy, then what do you think will happen? Inflation gone wild.
What is the Authority for QE1 and QE2?
The $2 Trillion dollars created out of thin air and entered into the accounts of US and Foreign financial institutions, was created on the sole unchecked authority of Ben Bernanke. Not the President of the United States. Not Angela Merkel. Not David Cameron. And helicopter Ben did this on his own nickel, so to speak. No one could or can stop him. Note that the amount of money was bigger than the infamous $865 Bilion Obama-Pelosi-Reid Stimulus Package of 2009, and bigger than the $700 Billion Bush TARP.
Now do you believe Ron Paul is right to be concerned about the out of control, unbridled, all powerful Federal Reserve?
Where Did the Dollars For QE1 and QE2 Come From?
As was stated above, the increase in the Fed Balance Sheet due to QE1 and QE2 was $2 Trillion dollars. That is the amount of increase in the Fed balance sheet that occurred as a result of QE1 and QE2, as shown in the second figure above. Where did this money come from? Not from the US Taxpayer. Not from borrowing. The sad but true answer is that this money came out of thin air, from the fingertips of Ben Bernanke on a computer keyboard. This money is not backed by gold, it is not backed by anything, really. Oh yes, it is backed by the full faith and credit of the United States, its people who are alive today, and all future generations of Americans.
Impact of QE1 and QE2 on Money Supply – Currency In Circulation
At the same time as the Fed infused money out of thin air into the accounts of financial institutions in the US and worldwide, the United States Treasury was also busy printing money. The dollar amount of currency in circulation is shown as a chart versus time, in the bottom figure above. In January of 2008 there was $800 Billion dollars in circulation. By March of 2012 this amount had increased by about 37.5%, to $1.1 Trillion dollars. Why is this important?
The answer to this question is: inflation. In other words, if there are 37.5% more dollars in circulation, with no additional backing by gold or other tangible reserves, why then it means that the dollars have become devalued by 37.5%. Inflation.
When Will the Inflation Begin?
But, you say: Wait a minute, we have not seen anything close to 37.5% inflation from January 2008 until today, March of 2012. Why is that?
The answer is that the additional currency is not in the real economy. It is not in the hands of people who are working or spending. The currency is sitting in the coffers of the financial institution the world over, and governments the world over. Well, that’s great, you say, we are saved from inflation, right?
Wrong. At such time as the economy eventually recovers, and lending conditions improve, and interest rates rise, well at that time the money will come out of the coffers, and will begin to flood into the real economy, and that is when inflation will start to hit, and that is when inflation could get really really large, like up to 37.5%.
“What is To Be Done?”
What is to be done? The long term answer is to gradually normalize interest rates. But a permanent fix would be as follows:
1. Fire Ben Bernanke
2. Make the Fed accountable to elected officials, or failing that, kill the Fed.