Wouldn’t that be a good way to jump start the economy?
Sheila Baer, chairman of the Federal Deposit Insurance Corp. during the Crash of 2008, was a lonely voice of sanity at that time. In 2012, she wrote an article for the Washington Post poking fun at the Fed for what it had been doing. It was entitled “ Fix Inequality With $10 Million Loans For Everyone.”
Why not, she said, expand the Fed’s current welfare system for banks, financial firms, and wealthy investors to everyone else? Why not, in short, create sufficient new money to lend every US household $10mm at zero interest rates?
You might object: how will we pay the money back? But don’t worry. You won’t spend this money. You will just invest it.
If you invest it in ten year US bonds today, you will earn $300,000 a year, which should be enough to pay down your other debts and get you spending again. If you want to be adventurous, you can invest in foreign bonds paying much more than 3%. Some of these bonds would pay you more than $1mm in interest per year.
You won’t be the only one to benefit. All the spending will create new jobs. In a stroke, unemployment will no longer be a problem. And the government will be able to say good bye to deficits, because there will be a gusher of new tax money coming in.
Sheila Baer remained tongue-in-cheek in her article. But lest someone think it is actually a good idea, let’s briefly review what is wrong with this happy picture. If the Fed did loan each household $10mm of newly created money, everyone’s income would soar, and so would consumer demand. But the supply of goods and services would remain the same, or perhaps even collapse because many people would decide to retire and enjoy their new wealth.
With demand for goods and services soaring and supply shrinking, the prices of everything we need would soar too. Before long, we would find that our fabulous new incomes wouldn’t buy any more than our old ones did.
Unfortunately creating new money doesn’t create new wealth. It is like pouring water into a bowl of milk and pretending that you have more milk.
OK, you might say, if this is true, why hasn’t the Fed already created runaway inflation? Hasn’t it created trillions of new dollars since the Crash?
Here is the answer. If the Fed had lend millions directly to consumers, or perhaps just dropped new dollar bills from airplanes ( a variant on an idea mentioned by retiring Fed chairman Ben Bernanke), inflation would be inescapable.
But the Fed didn’t do that. Instead, it made its money available to financial institutions and indirectly to the government. The financial institutions devised numerous imaginative ways to make money on the new money, but very little of it got into the hands of middle class consumers, the people who can most directly drive up consumer prices. Reported inflation has actually fallen, to a low 1% in the US, and only .8% in Europe.
Are these inflation figures reliable? Inflation certainly does not feel this low to most people. And, in all probability, it isn’t.
Shortly after Social Security and other government payments were linked to inflation, government statisticians began changing the way inflation is calculated. You won’t be too surprised to learn that much of the re-engineering, which reduced reported inflation, was done by the always clever Clinton administration.
Business economist John Williams ( shadowstats.com) estimates that if we calculated inflation the same way we did in 1980, it would be running at around 9% today.
Based on this, are we on the verge of even more consumer price inflation? Is that where all the Fed’s new money creation will lead us? Perhaps, but not necessarily.
When the Fed creates masses of new money, it initially flows to Wall Street, but from there its path is unpredictable.
To the degree that it does reach the average consumer, as we have noted, it will produce consumer price inflation. To the degree that it reaches rich people, it will drive up the prices of what rich people buy. We see this today when a single townhouse in Manhattan is listed for over $100 million dollars. To the degree that it flows into the stock market, it will raise stock prices. If enough flows in this direction, it will create an asset bubble, only to be followed by a crash, which will in turn bring recession and unemployment.
Wherever the new money flows, it may increase demand in the short run, only to reduce it in the long run. This is because the new money created by the Fed is not just given away. It is made available to banks to lend, which means that it enters the economy as debt. A little debt, especially if spent or invested wisely, may help an economy. But too much will strangle it.
As consumers, businesses, and governments become weighed down with more and more debt from the past, especially debt that was spent unwisely, the interest and principal payments become increasingly burdensome. Dollars that might have been spent on new investments with the potential to create new jobs and new income are instead siphoned off to pay for past mistakes. We end up with a zombie economy, still breathing, but just barely.
Historically we can measure how many dollars of economic growth we get from each new dollar of debt. At the moment, it seems to be negative. In other words, more new debt makes it worse, not better.
Despite this plain evidence, the Fed continues to try to persuade consumers and businesses to increase their borrowing and spending and also underwrites government borrowing and spending. It holds interest rates very low, which for now keeps the debt house of cards from tumbling down.
Will the Fed’s feckless money creation end in inflation or depression? It could go either way. Insofar as it stokes demand, it could lead to inflation. Insofar as it increases an already too heavy debt burden, it could lead instead to recession, joblessness, and depression. Or it could lead first to the one and then to the other.
It could also lead to a third possibility: stagflation. In this scenario, consumer prices advance even while unemployment increases. We had this in the 1970’s. If we measured inflation as we did in the 1970’s, it would be apparent that we already have it today.
The new Fed chairman Janet Yellen says that 2014 will finally bring us back to blue skies, with economic growth picking up. She also believes, relying on government figures, that unemployment is currently 6.8% and falling.
What this overlooks is that reported unemployment is falling because more and more people are giving up and dropping out of the labor force. As John Williams points out, the unemployment number, calculated as it once was, would be rising, not falling, and over 20%, similar to what we had in the Great Depression.