Tuesday, September 23, 2008

The bailout is NOT inflationary!

The media has been reporting that the bailout will lead to a Germany style hyperinflation. This is completely ridiculous. Below is an example of this type of misunderstanding. It came from Vince Farrell's email to me, earlier today:

"The fear of an inflationary surge from expanding government debt by hundreds of billions of dollars is getting more press than the reverse side of the argument. Private credit has been destroyed, and the financial system is being massively delevered (banks borrow about $10 for every dollar of equity, broker dealers borrow $20 to $30. There are no more big broker dealers and the debt reduction is large.) It looks more like a standoff with the inflationary threat of government debt being checked by the deleveraging of the system."

Here was my response:


The notion that the bailout will be inflationary displays a lack of understanding of monetary policy and how the Fed and Treasury, together, manage bank reserves. Over the past year both total and excess reserves in the system have not grown at all (they’ve actually come down), despite over $1 trillion in lending by the Fed. That’s because the Fed has removed excess reserves through open market operations.

The Fed is obligated to do this in order to maintain the Fed funds rate where it targets it. If excess reserves grow by too large an amount there would be downward pressure on the funds rate, which is something the Fed does not want. Therefore, the Fed has been selling securities from its portfolio (mostly T-Bills) to sop up excess reserves. Thus, no growth in the monetary base and no growth in money supply. (And, no inflation—at least in the monetary sense.)

Recently the Fed’s holdings of T-Bills have fallen to under $8 billion. That is why it asked the Treasury to sell $40 billion of bills in a special auction. The media reported it as the Fed needing more money, but that is erroneous. The sale of these bills was nothing more than a reserve maintenance operation. They were intended to sop up the reserve build tied to the $85 billion loan to AIG.

Even if the Treasury spent all of the $700 billion of the bailout money, it would likely issue an equal amount of Treasuries, meaning that reserves would not grow at all. The public would be exchanging bad debt for good Treasuries, which would result in no increase in bank reserves, the monetary base and, most likely, money supply.

The important thing to remember about money supply is that the vast majority of what we call money (bank credit) is created in the banking system and that comes from demand for loans. (Loans create deposits.) If there is no demand for loans, or if banks are just not making loans, money supply will not grow, regardless of where overnight interest rates are. Moreover, if the government is just replacing one asset with another, that is not in and of itself a reason for money supply to grow.

-Mike Norman

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