Bernanke's Gamble

Most Americans have heard of the Federal Reserve (often referred to as "the Fed"). And most Americans probably know that the Fed can influence interest rates. But I suspect that many people are unaware of the Fed's most awesome power: The Federal Reserve can create U.S. dollars without the consent of even one democratically elected official. Recently, Ben Bernanke has created an astounding number of U.S. dollars. In fact, the monetary base (the sum of U.S. dollars in circulation plus banks' deposits at the Federal Reserve) has nearly doubled since the economic crisis began. In layman's terms, the Federal Reserve DOUBLED the amount of money out there. Earlier this week, the Fed announced that it would create another 1 trillion dollars and use that money to buy U.S. Treasuries, mortgage bonds and agency bonds. It seems that within a few months, the monetary base will have at least tripled. If the T.A.L.F. becomes a 1 trillion dollar program, as Geithner has suggested, the monetary base might just quadruple.

Printing money is risky business. Many countries that have tried to print their way out of economic trouble have suffered economic collapse. So far, Bernanke has managed to get away with it. The sharp economic contraction has counteracted the inflationary effects of the greatly expanded monetary base. And the global perception that the U.S. dollar is safe has helped to keep the dollar strong vs. other currencies. However, there are signs of weakness. Since Bernanke announced that he would create another 1 trillion dollars on Wednesday, the U.S. dollar has taken a bit of a beating in foreign exchange markets and commodity prices are higher.

Bernanke argues that if inflation becomes a problem, he can reduce the monetary base. This is true. When the Federal Reserve creates and then disburses money, it acquires financial securities (like mortgage bonds and U.S. Treasury bonds) in exchange. The Fed also makes short term collateralized loans to banks. Bernanke believes that it will be a straightforward affair to sell these securities and to terminate loans to banks if the dollar begins to weaken. When the Fed sells those securities or terminates the loans, it will get its greenbacks back. And the monetary base will shrink again.

Bernanke is counting on the theory that if the economy improves and lending increases, it will be easy to unwind the Fed's expansive new programs. However, another scenario is possible. The economy could begin to improve while a group of healthy financial institutions could help increase the use of credit in the country. But at the same time, the deficit could continue to run at a record high. Meanwhile, a group of unhealthy financial institutions might continue to depend on Fed lending. If that happens, it would be quite problematic for the Fed to reduce the monetary base because yields on treasury bonds and mortgage bonds would probably be much higher than they are today. (The yields on treasuries and mortgages usually increase during economic expansions and when governments need to borrow a lot of money. And when yields increase, the prices of bonds go down.) The Fed would have to sell the Treasuries and mortgage bonds for less than it paid. So it would be impossible for Bernanke to sell the assets and get back all the money he printed. And terminating the bank loans to unhealthy banks could bankrupt those institutions, meaning the Fed would be repaid with collateral as opposed to cash. Then the Fed would need to sell even more securities at a discount in order to reduce the monetary base. But it would not be able to get all the money back if it were selling them for less than it paid. Yet another scary prospect is that political factions try to influence Fed decisions, which seems increasingly likely given recent behavior by Congress. Anything is possible there.

The point here is not that Bernanke has made a mistake by increasing the monetary base. Rather, there is a strong case for increasing the monetary base during severe economic contractions. However, the methods Bernanke is using to accomplish monetary expansion involve more risk than he would have us believe. A more realistic assessment of the risks involved might lead to a safer course of action by the Fed. For instance, Bernanke could focus his purchases on securities with shorter maturities, which have less risk. He could also require banks to post higher quality collateral on their loans. Hopefully, Bernanke is correct and the U.S. Dollar is not at risk. But it is unsettling to hear him gloss over the risks as minimal.

To learn what Bernanke has to say on this matter, follow the link below. The sections titled "The Federal Reserve's Policies and its Balance Sheet" and "Credit Risk and Transparency" focus on the issues discussed above.

Bernanke discusses the risks of recent Fed actions