The Federal Reserve and Quantitative Easing

John Lindauer is a macroeconomics PhD who now owns and operates a number of businesses.  We asked him about the Federal Reserve’s plan for another round of quantitative easing and his answers were not what we expected .

Lindauer thinks the writers and pundits discussing the Fed’s plan have by and large merely repeated the somewhat naive conventional wisdom about the FOMC – that the  Federal Reserve mainly operates via changing  interest rates.

Firstly, he says, the Fed doesn’t change our economy’s interest rates - because it can’t. The only rate the Fed sets is the overnight rate between banks and a knowledgeable banker will have a hard time not laughing if you tell him the Fed thinks  he will change his loan rates or make more business or consumer loans just because he can or can’t borrow the money to do so for 24 hours. Secondly, and more importantly, most businesses are motivated by the availability of credit rather than its interest rate cost.  And today in America money is tight – its virtually impossible for a small or medium sized business to obtain financing today no matter how good their credit or sound their business.

Today the banks do not have money to loan despite the Fed’s so-called “quantitative easing”.  Yes, the FOMC is increasing bank liquidity. But simultaneously other offices of the FED and the FDIC are encouraging the  banks, under very real threats of closure, to hold the  additional liquidity as tier one capital. So what on balance is the Fed actually doing to increase the loanable funds needed to fund increased business and consumer spending and end the recession -  virtually nothing.

And another note for another story: pouring money into the banks which are short of loanable funds does not somehow mean there will be inflation in the future even if the Fed initially provides too much. That’s another conventional wisdom. In fact, just as the FOMC can pour liquidity into banks within hours when there are not enough customers for our businesses such that a recession occurs, so it can remove it in hours if spending begins to look excessive so that inflation will occur.

The Federal Reserve’s job is to see that  there is enough money in circulation, not too little to cause a recession nor too much to cause inflation. It has failed because the President has mostly appointed Federal Reserve governors who are not macroeconomists with real  world experience. The naive decisons they are making are comparable to the decisions we would get from the Supreme Court if the president appointed dentists and chiropracters as justices because they had experience being sued.

The reality is that an economy such as ours has grown enormously since the Fed  was formed almost a 100 years ago.  So our economy quite naturally requires more and more money for its ever  growing volune of transactions. The Fed provides that additional money by buying bonds from the Treasury so the federal government can spend the created money and so inject it into the growing economy where it is needed to enable the increasing amount of transactions. In other countries the provision of additional money for growing levels of  transactions comes as “coinage” wherein the a part of national spending is funded by the newly created money their economies need in circulation.

So in reality our national debt has two main sources: some of the debt was created over the past 100 years to create the additional money our growing economy required.  The rest of the debt was created to fund federal spending in excess of the amount generated by taxes and the creation of the needed additional money.  Bottom  line: Our debt is nowhere  near as great as the alarmists claim – the Fed has about trillion in assets in phantom debt it acquired over the years by standing in for  the federal government to provide a normal expansion of the money supply.  That suggests our national debt is overstated relative to other countries, such as the euro block,  wherein none of their debt is related  to many years of normally expanding their money supply.

And if you want  to be controversal, it even suggests the federal government could reasonably levy a one-time tax on the Fed to take and cancel the trillion or so of ”unearned” debt the Fed created for “coinage” purposes.

Of course Lindauer’s thoughts differ from the  conventional  wisdom - He actually spent  years studying macroeconomics and then teaching and writing and testifying at congressional hearings about macroeconomics before he began owning and operating businesses and really understood how prices and jobs are created.

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