As no doubt you have heard, the FED's Balance Sheet has grown since the beginning of the financial crisis. Here is how it looked before the crisis compared to how it looks now. I have simplified the accounting jargon to make it easy to understand. (In Billions)
You can see that the FED now owns substantially less US Treasury securities than it did before the crisis. You can also see that it owns substantially more junk mortgages and other assorted junk financial IOU's than it did previously. You might be interested to know the identity of the Banks from whom the FED purchased these low quality "assets". The FED is silent regarding this, but we can assume the FED purchased them from its banking buddies (at a nice premium to FMV), including Citibank, Bank of America, Goldman Sachs, etc. The purchases at a premium were obviously done to save those banks from impending insolvency doom. In other words, the FED has moved the devalued assets to its books to avoid markdowns required by accounting standards. The FED's books are not audited.
You might also be wondering where the FED got the money to buy these assets. Here is how it works. The FED created money by making loans and made accounting entries like this on its books:
Debit Junk Mortgages (Asset) $xxx Billion
Credit Deposit in an account for a bank (Liability) $xxx Billion
This accounting entry on the FED's books created $xxx Billion in credit out of thin air and apparently increased the monetary base. However, do not be concerned, this is how all bank loans work. The bank makes a loan to a borrower (asset) and creates, from nowhere, money in a customer's account (liability). Banks do NOT lend customer deposits. Customer deposits provide liquidity for banks to service their customers, not money to make loans.
So, what happened on the bank's books? Very simply, the bank made the following entry:
Debit Bank account at the FED (Asset) $xxx Billion
Credit Junk Mortgages (Asset) $xxx Billion
In other words, the bank replaced a non-performing asset whose value was in jeopardy with a performing asset whose value is stable. The "Bank account at the FED" is earning interest and the bank cannot withdraw the funds except under certain conditions. It is likely the FED can force the bank to take its bad loans back.
Commentators would have you believe that somehow the above set of accounting entries is "printing money" and the country faces hyperinflation and soaring interest rates as a result of massive increases in the money supply. These commentators apparently fell asleep in their Principles of Accounting class.
The only immediate result of the FED's loan was to put the bank back in the same position as it was before the bad mortgage went bad. The transaction did not provide any direct stimulus to the overall economy. All it did was to save the bank from insolvency. The only potential "benefit" was that the bank is still around to make new loans and create more money out of thin air, provided they can find any qualified borrowers. It is silly to argue that hyperinflation is around the corner because the FED has expanded its balance sheet...so far.
Wikipedia says "Quantitative Easing" is:
"In practical terms, the central bank purchases financial assets, including treasuries and corporate bonds, from financial institutions (such as banks) using money it has created ex nihilo (out of nothing). This process is called open market operations. The creation of this new money is supposed to seed the increase in the overall money supply through deposit multiplication by encouraging lending by these institutions and reducing the cost of borrowing, thereby stimulating the economy. However, there is a risk that banks will still refuse to lend despite the increase in their deposits, and in a worst case scenario, possibly lead to hyperinflation."
The FED finds money to buy assets in 2 ways (other than earnings).
1) Order Federal Reserve Notes from the US Mint.
2) Make a loan to a borrower (asset) and create a deposit (liability)
You can see from the Balance Sheets above that the FED has increased it Federal Reserve Notes (currency) liability by $89 billion. These dollars are probably being used in foreign exchange activities with foreign central banks. This is not going to cause hyperinflation in the USA. According to some estimates, 75% of all currency are in circulation outside the USA anyway. That leaves only $200+ billion in cash in the country. So far, the FED is not printing currency, or depositing money directly into citizens' bank accounts. When, and if, the FED decides to actually "helicopter drop" a couple trillion dollars into the bank accounts of regular citizens, the hyperinflation folks might actually have an argument in their favor.
We also hear a lot of blather about the FED buying $300 Billion of US Treasuries. As you can see from the Balance Sheets above, the FED owns $220 Billion less in UST's than it did, so what is the big deal about raising its holdings to what they were before. The FED can make a loan to a bank, but it can't make a bank make a loan to people if no one wants to borrow. So, as the "quantitative easing" definition above states so clearly, the FED can buy all the UST's it wants and it may not stimulate anything.
So far, the FED's direct actions have been to rescue banks with the hope they will create lots of new loans to people who can pay them back (or not). Lending stimulates the economy, but unfortunately, bank loans are just a little hard to come by these days. Since the only way NEW money enters the US economy is through bank loans, it is a little difficult to have hyperinflation absent massive bank lending or FED currency printing. And also know this the only way money in the economy can be freed from an interest charge to a bank is for the borrower to fail to repay the loan. Once created, money never goes out of existence. Once the bank writes off loan, the money is emancipated from the clutches of the banks and the borrower is no longer a debt peon.
Deflation will remain the name of the game until the FED changes course and starts making deposits directly into the bank accounts of all US Citizens in the bottom 95% who are current on their Income Tax filings. There are only 2 possible solutions to solve the financial downturn. Number one is to let the debt pyramid implode and thus redistribute relative wealth from lenders to debtors. Number two is to redistribute the wealth to debtors, the bottom 95%, by creating new money and depositing it directly into their personal checking accounts so that the debtors can keep paying their lenders.
Either answer is mathematically the same. Number two is probably better because it would get 95% of the people all excited to go shopping for plastic crap from China and finally, remodel the guest bathroom.
In Part 2, we will discuss where the money comes from to buy the US Treasury Securities that fund the so-called National Debt and in the process we will discuss whether deficit spending can stimulate the economy and/or cause hyperinflation.
G. Allen Fischer CPA