Friday, February 20, 2009

An Inconvenient Monetary Base?

Recently, a student of mine shared with me a YouTube video of a Glenn Beck (Fox News) piece on... well, that's what I'm not sure about.

You tell me, what's the chart about and what point is Beck trying to make?

If you said that the chart is about our national debt and Beck is making the point that it's immoral to leave such a large national debt as the one he appears to point to in the chart... well, you are wrong. Join the majority of people who watch Beck and, sadly, I think Beck believes this too. However, I do agree with the point Beck is trying to make about the national debt, if only it had anything to do with the debt.

What Glenn Beck actually has in the unlabeled chart is the "Adjusted Monetary Base and Reserves" from the St. Louis Federal Reserve Bank (go here to see the actual chart:

The adjusted monetary base is a measure of the currency in circulation and the cash reserves banks have in an account with the Federal Reserve (both required and excess reserves). In essence, this is the Fed's balance sheet, specifically the Fed's liabilities. In September 2008, this measure began to grow faster than during any other time since the beginning of the Federal Reserve System. There are a couple of reasons for the excessive growth in the monetary base since September 2008. First, the Fed has been adding to the excess reserves of banks by buying distressed bank assets and replacing them with Treasury bills. The Fed then engages in open market operations and buys the Treasury Bills, giving the banks excess cash. Hence, what was not on the Federal Reserves balance sheet before the crisis is now on their balance sheet, some of which is in the form of bank reserves. The idea here is that with these excess reserves (instead of "toxic" assets) and added liquidity, the banks will have the ability and incentive to make new loans.

Second, and I feel the most significant factor in the growth of the monetary base, is that the Fed began to pay interest on the reserves of banks starting in October 2008. Before this time, any bank reserves held by the Fed came at a significant opportunity cost because they did not earn interest. Hence banks only kept their "required" minimum reserves in their account with the Fed. Since the change, banks began putting their excess reserves in their Fed account. Why? Well, to earn interest and because the Fed appears to be a much safer place to put money than in the hands of borrowers in such an uncertain economy. Yes, this policy does seem to go against the idea of getting banks to loan money, but the Fed argues that this measure is important in their ability to manage interest rates in this environment (for the Fed's explanation read:

So think about it. If you are a bank and you had excess reserves before this rule change, you might consider loaning the money out to the public or other banks, albeit cautiously. But now that the Fed is paying interest, and although it's not a great return on excess reserves, given the alternative which is to lend to the public in this economic environment, I think I'd go with the Fed too. Hence, the Fed's balance sheet has soared and the Adjusted Monetary Base has soared and that's what Beck had in his chart as he went up his "An Inconvenient Debt" lift.

What's this all mean? Well, for one, this does not have much to do with the national debt which is what I took away from Beck's video. It means that there is a significant amount of bank reserves waiting for some stability in the economy and when that happens, it would be logical to expect banks to lend to the public. With a significant amount of potential lending, there is a risk of inflation but we are a long way from there and the Fed has tools to control the amount of lending when the time is right.

I know, I know... you question the Fed's ability to control or time anything... that will have to wait for another post.

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