Thursday, March 19, 2009

Is the Federal Reserve Trying to Get a Free Lunch?

Yesterday, the Fed announced that it would buy up to $300 billion of long term U.S. Treasury securities and $750 billions of mortgage-backed securities to push down mortgage and other interest rates. The backdrop to these measures is the U.S. Treasury's plan to borrow around $1.8 trillion to support the stimulus package and other federal spending, which will place upward pressure on interest rates. But, yesterday, the stock market rose, as did the bond market. Things looked rosy.

At least for the moment. The financial markets, however, operate at lightening speed, and doubts about the Treasury's program have already appeared. The problem is that the Fed will, in a nutshell, simply print the money it uses to buy these securities. It's using $1.05 trillion worth of--well, what? Printed money--actually, electronic entries on the banking system's computers; but most "money" today consists of electronic entries. There is no real economic value underlying this printed money. By contrast, if the Fed used tax money collected by the Treasury and loaned to the Fed, it would be using real money. That, however, would likely require tax increases that no one would consider politically acceptable.

The dollar has dropped several percentage points in the last two days against the Euro, Yen and British pound. The currency markets see the dangers of the Fed dropping a bunch of printed money into the financial system. Longer term interest rates, which dropped over 40 basis points yesterday (an astonishing one-day move), are rising today. The stock market is losing a little ground.

The reaction in the currency markets is highly problematic. The largest lenders to the U.S. Treasury today are China and Japan. A drop in the dollar, coupled with a sharp drop interest rates, discourages them from further lending. Printed money presents the danger of inflation that could impose loses on them. Inflation generally is bad to lenders, because they're repaid with less valuable dollars. The relative tranquility in U.S. consumer and producer prices isn't terribly important to China, Japan and other foreign lenders. They aren't trying to buy milk, bread, or gasoline here. What matters to them are the value of the dollar and the interest rates on dollar-denominated investments. The Fed's printing of money may or may not inflate the price of potatoes in Moline. But it is diminishing the value of the dollar in the currency markets while simultaneously pushing interest rates lower. From the standpoint of a foreign lender, that's a double whammy.

What the Fed persists in refusing to understand, notwithstanding mountain ranges of evidence to the contrary, is that easy money policies cause inflation. Since the late 1990s, the inflation has been in the price of assets. First, we had the tech stock bubble. Then, there were the real estate and credit bubbles. Then, there were the bubbles in oil and other commodities. All of these asset inflations ended badly. What reason is there to think that another bubble, this time in U.S. dollar-denominated debt, is a good idea?

The Fed is standing boldly at the roulette wheel, betting that people will treat its printed money as having value. On a micro level, as the average American worker gets another $13 a paycheck, or whatever the amount is, that may happen. But in the financial markets, the big players face big risks and have a broader view of things. They've been burned badly by the recent asset bubbles, and are likely to pause before again playing with fire. If the Fed thinks that they'll believe its printed money has value, then the Fed is looking for a free lunch.

Easy money can fool all of the people some of the time, and some of the people all of the time. But it can't fool all of the people around the globe all of the time. The road to economic recovery will be built by cleaning up the financial system and strengthening the economy's ability to produce valuable goods and services. Easy money has produced false hope and then painful losses, time and time and time again. It's a sign of intelligence to learn from one's mistakes. Perhaps some learning is in order.

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