[R-G] [BillTottenWeblog] How to Reverse a Deflation

[Bill Totten]

Helicopter Ben Needs to Drop Some Money on Main Street

by Ellen Brown

webofdebt.com (September 08 2010)


The Fed is proposing another round of "quantitative easing",
although the first round failed to reverse deflation. It failed
because the money went into the coffers of banks, which failed to
lend it on. To reverse deflation, the money needs to be funneled
directly to state and local economies.

In 2002, in a speech that earned him the nickname "Helicopter Ben",
then-Fed Governor Bernanke famously said that the government could
easily reverse a deflation, just by printing money and dropping it
from helicopters. "The US government has a technology, called a
printing press (or, today, its electronic equivalent)", he said,
"that allows it to produce as many US dollars as it wishes at
essentially no cost". Later in the speech he discussed "a
money-financed tax cut", which he said was "essentially equivalent
to Milton Friedman's famous 'helicopter drop' of money". You could
cure a deflation, said Professor Friedman, simply by dropping money
from helicopters.

It seems logical enough. If there is insufficient money in the
money supply (deflation), the solution is to put more money into
it. But if deflation is so easy to fix, then why has the Fed's
massive attempts to date failed to do the job? At the Federal
Reserve's Jackson Hole summit on August 27, Chairman Bernanke said
he would fight deflation with his whole arsenal, including
"quantitative easing" (QE) - purchasing longterm securities with
money created on a computer. Yet since 2008, the Fed has added more
than $1.2 trillion to "base money" {1} doing just that, and the
economy is still in a serious deflationary spiral. In the first
quarter of this year, the money supply actually shrank {2} at a
record annual rate of 9.6%.

Cullen Roche at The Pragmatic Capitalist {3} has an answer to that
puzzle. He says that as currently practiced, quantitative easing
(QE) is not really a money drop. It is just an asset swap:

    The Fed doesn't actually 'print' anything when it initiates its
QE policy. The Fed simply electronically swaps an asset with the
private sector. In most cases it swaps deposits with an interest
bearing asset.


The Fed just swaps Federal Reserve Notes (dollar bills) for other
assets (promissory notes or debt) that can quickly be turned into
money. The Fed is merely trading one form of liquidity for another,
without raising the overall water level in the pool.

The mechanics of how QE works were revealed in a remarkable segment
on National Public Radio {4} on August 26, describing how a team of
Fed employees bought $1.25 trillion in mortgage bonds beginning in
late 2008. According to NPR:

    The Fed was able to spend so much money so quickly because it
has a unique power: It can create money out of thin air, whenever
it decides to do so. So ... the mortgage team would decide to buy a
bond, they'd push a button on the computer - 'and voila, money is
created'.

    The thing about bonds, of course, is that people pay them back.
So that $1.25 trillion in mortgage bonds will shrink over time, as
they get repaid. Earlier this month, the Fed announced that it will
use the proceeds from the mortgage bonds to buy Treasury bonds -
essentially keeping all that newly created money in circulation.
The decision was a sign that the Fed thinks the economy still needs
to be propped up with extraordinary measures.

    "Extraordinary measures" was a reference to Section 13(3) of
the Federal Reserve Act, which allows the Fed in "unusual and
exigent circumstances" to buy "notes, drafts and bills of
exchange" (debt instruments) from "any individual, partnership or
corporation" satisfying its requirements. The Fed was supposedly
engaging in these extraordinary measures to "reflate" the money
supply and get credit flowing again. Yet the money supply continued
to shrink. The problem, as Roche explains, is that the dollars were
merely being swapped for other highly liquid assets on bank balance
sheets. That this sort of asset swap will not pump up a collapsed
money supply has been shown not only by the Fed's failed
experiments over the last two years but by two decades of failed QE
policy {5} in Japan, an economy which remains in the deflationary
doldrums. To reverse deflation, it seems, QE needs to be directed
somewhere else besides the balance sheets of private banks. What we
need is the sort of helicopter drop described by Bernanke in 2002 -
one over the towns and cities of the real economy.


There is another interesting lesson suggested by two decades of
failed QE: it might actually be possible for the government to
"print" its way out of debt, without triggering the dreaded
hyperinflation long warned of by pundits. Swapping dollars for debt
hasn't inflated the circulating money supply to date because
federal debt securities already serve as forms of "money" in the
economy.

The Textbook Money Multiplier Model
... And Why It Is Obsolete

Beginning with some definitions, "quantitative easing" {6} is
explained in Wikipedia like this:

    A central bank ... first credit[s] its own account with money
it has created ex nihilo ('out of nothing'). It then purchases
financial assets, including government bonds, mortgage-backed
securities and corporate bonds, from banks and other financial
institutions in a process referred to as open market operations.
The purchases, by way of account deposits, give banks the excess
reserves required for them to create new money, and thus a hopeful
stimulation of the economy, by the process of deposit
multiplication {7} from increased lending in the fractional reserve
banking system.

    "Deposit multiplication" is the textbook explanation for how
credit expands as it circulates through the economy. In the
textbook model, banks must retain "reserves" equal to ten percetn
of outstanding deposits (including deposits created as loans). With
a ten percent reserve requirement, a $100 deposit can support a $90
loan, which gets deposited in another bank, where it becomes an $81
loan, and so forth, until a $100 deposit becomes $1,000 in
credit-money.


The theory is that increasing the banks' reserves will stimulate
this process, but both the Federal Reserve and the Bank for
International Settlements (BIS) now concede that the process has
not been working in the textbook way. (The BIS is "the central
bankers' central bank" in Basel, Switzerland.) The futile effort to
push more money into bloated bank reserve accounts has been
compared to adding more apples to shelves that are already
overstocked with apples. Adding more reserves to a banking system
that already has more reserves than it can use has no net effect on
the money supply.

The failure of QE either to increase bank lending or to inflate the
money supply was confirmed in a March 24 paper by Federal Reserve
Vice Chairman Donald L Kohn {8}, who wrote:

    The huge quantity of bank reserves that were created [by
quantitative easing] has been seen largely as a byproduct of the
purchases [of debt instruments] that would be unlikely to have a
significant independent effect on financial markets and the
economy. This view is not consistent with the simple models in many
textbooks or the monetarist tradition in monetary policy, which
emphasizes a line of causation from reserves to the money supply to
economic activity and inflation.


The textbook model is obsolete because banks don't make lending
decisions based on how many reserves they have. They can always get
the reserves they need. If customers don't walk in the door with
new deposits, the bank can borrow deposits from other banks,
something they can now do at the very low Fed funds rate of .2%
(1/5th of one percent). And if those deposits are not available,
the Federal Reserve itself will supply the reserves. This was
confirmed in a BIS working paper called "Unconventional Monetary
Policies: An Appraisal", which observed {9}:

    The level of reserves hardly figures in banks' lending
decisions. The amount of credit outstanding is determined by banks'
willingness to supply loans, based on perceived risk-return
trade-offs, and by the demand for those loans ...

    The aggregate availability of bank reserves does not constrain
the expansion [of credit] directly. The reason is simple: ... in
order to avoid extreme volatility in the interest rate, central
banks supply reserves as demanded by the system. From this
perspective, a reserve requirement, depending on its remuneration,
affects the cost ... of loans, but does not constrain credit
expansion quantitatively ... An expansion of reserves in excess of
any requirement does not give banks more resources to expand
lending. It only changes the composition of liquid assets of the
banking system. Given the very high substitutability between bank
reserves and other government assets held for liquidity purposes,
the impact can be marginal at best.


Again, one form of liquidity is just substituted for another,
without changing the overall level in the pool.

If bank reserves do not constrain bank lending, what does?
According to the BIS paper, "the main ... constraint on the
expansion of credit is minimum capital requirements". These capital
requirements, known as "Basel I" and "Basel II", were imposed by
the BIS itself. It is interesting that the BIS knows that the main
constraints on bank lending are its own capital requirements, yet
it is talking about raising them {10}, in an economic climate in
which lending is already seriously impaired. Either the BIS is
talking out of both sides of its mouth, or its writers don't read
each other.

A Solution to the Federal Debt Crisis?

Another interesting aside arising from all this is the suggestion
that the government could actually print its way out of debt - it
could print dollars and buy back its bonds - without creating
inflation. As Roche observes:

    [Quantitative easing] in time of a balance sheet recession is
not actually inflationary at all. With the government merely
swapping assets they are not actually 'printing' any new money. In
fact, the government is now essentially stealing interest bearing
assets from the private sector and replacing them with deposits ...
This policy response would in fact be deflationary - not
inflationary.


Roche concludes, "the inflationistas have been wrong and the USA
defaultistas have been horribly wrong". The "inflationistas" are
the pundits screaming that QE will end in hyperinflation, and the
"defaultistas" are those insisting that the US must eventually
default on its debt. Representing both camps, for example, is
Richard Russell {11}, who writes:

    In my opinion, the US MUST default on its debt. There are two
ways to default. One is simply to renege on the debt ... The other
way to default on the debt is to inflate it away. I'm absolutely
convinced that this is the path that the US will take. If the US
inflates enough, then over time (many years) the devalued dollar
will tend to reduce the power of the debts.


The failed QE experiments in Japan and the US suggest, however,
that there is a third alternative. Printing dollars to pay the debt
(referred to by Russell as "inflating the debt away") might
actually eliminate the debt without creating inflation. This is
because federal bonds and Federal Reserve Notes are interchangeable
forms of liquidity. Government securities trade around the world
just as if they were money. A $100 bond represents a claim on $100
worth of goods and services, just as a $100 bill does. The
difference, as Thomas Edison said nearly a century ago, is merely
that "the bond lets money brokers collect twice the amount of the
bond and an additional twenty percent, whereas the currency pays
nobody but those who contribute directly in some useful way ...
Both are promises to pay, but one promise fattens the usurers and
the other helps the people".

The Fed's earlier attempts at QE involved swapping $1.25 trillion
in mortgaged-backed securities (MBS) for dollars created on a
computer screen. As noted in the NPR segment, many of those
securities have come due and have gotten paid off, putting cash in
the Fed's till. The Fed now proposes to use this money to buy
long-term Treasury debt rather than MBS. That means the Fed will,
in effect, be buying the government's debt with dollars created on
a computer screen. The privately-owned Federal Reserve is not
actually an arm of the federal government, but if it were, the
government would thus be printing its way out of debt - just as
Helicopter Ben proposed in 2002. Recall that he said, "the US
government has a technology, called a printing press" - the US
government, not the central bank that has done all the QE to date.

Running the government's printing presses to pay its bills has not
seriously been tried since the Civil War, when President Lincoln
saved the North from a crippling war debt at usurious interest
rates by printing Greenbacks (US Notes) {12}. Other countries,
however, have tested and proven this model more recently. They
include Germany, which pulled itself out of a massive financial
collapse in the early 1930s by printing a form of currency called
"MEFO bills"; and Australia, New Zealand and Canada, all of which
successfully funded public works in the first half of the twentieth
century simply by advancing the credit of the nation. China,
Malaysia, Guernsey, Jersey, India, Argentina and other countries
have also revived their economies at critical times by this means.
The US government could do this too. It could print dollars (or
type them into electronic bank accounts) and spend the money on the
sorts of local public projects that would put people back to work
and get the economy rolling again.

How to Reverse a Deflation:
Do a Helicopter Drop on the States

The government could pay its bills by issuing Greenbacks as Lincoln
did, but it probably won't, given the current deadlock in Congress.
Today only the Federal Reserve Chairman seems to be in a position
to act unilaterally, without asking anyone's permission. Chairman
Bernanke could execute his own plan and generate the credit needed
to get the economy churning again, by aiming his "quantitative
easing" tool at the states. After all, if Wall Street (which got us
into this mess) can borrow at 0.2%, underwritten by the Fed as
"lender of last resort", then state and local governments should be
able to as well. Chairman Bernanke could credit the Fed's account
with money created ex nihilo (out of nothing) and swap it for state
and municipal bonds at the Fed funds rate.

A "state" might not qualify as an "individual, partnership or
corporation" under Section 13(3) of the Federal Reserve Act, but a
state-owned bank would. Bruce Cahan {14}, an attorney and social
entrepreneur in Silicon Valley, California, proposes that the Fed
could diversify its role by buying long-term bonds in existing or
newly-chartered state-owned banks. These banks, which would have a
mandate to serve state and local communities, would more quickly
and accountably lend for in-state purposes than private banks do
now. They could be required to use accepted transparency accounting
standards to trace how the proceeds of their loans flowed into the
economy. Local needs would thus determine how best to jumpstart and
keep alive businesses and households that the "too big to fail"
megabanks no longer want to fund on fair credit terms. Adding a
state-owned bank would also bring competition to regional banking
markets such as that of the San Francisco Bay area, which are now
dominated by out-of-state megabanks. By funding state-owned banks,
the Fed could inject "liquidity" where it is most needed, in local
markets where workers are hired and real goods and services are
sold.

Links:

{1} http://research.stlouisfed.org/fred2/series/BASE

{2}
http://www.telegraph.co.uk/finance/economics/7769126/US-money-supply-plunges-at-1930s-pace-as-Obama-eyes-fresh-stimulus.html

{3}
http://pragcap.com/quantitative-easing-the-greatest-monetary-non-event

{4}
http://www.npr.org/blogs/money/2010/08/26/129451895/how-to-spend-1-25-trillion

{5}
http://pragcap.com/quantitative-easing-the-greatest-monetary-non-event

{6}
http://pragcap.com/quantitative-easing-the-greatest-monetary-non-event

{7}
http://en.wikipedia.org/wiki/Fractional-reserve_banking#Money_creation

{8}
http://www.federalreserve.gov/newsevents/speech/kohn20100324a.htm

{9} http://www.bis.org/publ/work292.pdf?noframes=1

{10}
http://www.risk.net/risk-magazine/news/1503162/basel-committee-prepares-raise-capital-requirements-stressed-var-test

{11}
http://crescat.net/745/richard-russell-predicts-money-printing-by-the-fed-to-address-the-u-s-%E2%80%99s-growing-debt-position/

{12} http://www.webofdebt.com/articles/lincoln_obama.php

{13} http://www.webofdebt.com/articles/energy-costs.php

{14} http://cyberlaw.stanford.edu/node/6523

_____

Ellen Brown is an attorney and the author of eleven books. In Web
of Debt (2007), her latest book, she shows how the Federal Reserve
and "the money trust" have usurped the power to create money from
the people themselves, and how we the people can get it back. Her
websites are webofdebt.com, ellenbrown.com, and public-banking.com.

http://www.webofdebt.com/articles/bernankes_helicopters.php


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