The Fed's Money Printing and Quantitative Easing

I've heard a lot of complaints over the spending bills, bailouts, etc. from the recent Tea Parties and most of it I agree with.  However, I disagree with the popular idea of Tea Party participants

that the Federal Reserve's Quantitative Easing policy is the problem - hardly so.  Quantitative Easing, or "Printing Money" in simplistic terms, is doing two things for the economy that investors and businessmen LOVE.  Just like a tax cut, QE reduces the interest rate, and thereby distributes wealth from the powerful banks and investment institutions to the businessmen and entrepreneurs.  Or should I put it differently as diverting wealth from the powerful banks and investment institutions and into the businesses they own. Lower interest thereby reduces the expenses on businesses and consumers.  It also reduces inflation - in the short term - by keeping prices moderated (businesses don't feel the need to increase prices when their expenses have been reduced), but at the same time stems deflation - which is absolutely the end all of economic disasters. 

You may wonder how QE policy can put the spending power in the hands of businesses rather than banks.  Steve will know the answer to this one.  Businesses and businessmen look at the interest rate as an opportunity cost standard for whether a business should simply earn interest on a bond investment, or whether they should make a capital investment and wait for a future return.  By reducing the interest rate (called "Printing Money"), the opportunity cost of capital investment is reduced, and the incentive to invest in a bond for future interest payments is reduced.  Therefore businesses would rather spend money upgrading.  It also has to do with present value of money.  By reducing the interest rate to zero as the Fed has done, the future value of money in nominal terms will be the same as the present value.  This is based on the equation Pv=S(1+r)N Where Pv is present value, S is the principle amount invested, n is the time in years, and r is the current interest rate.

Here's an example.  The value of 10,000 dollars in three years at a 5% interest rate is:

=10000((1+.05)^3)

=11600

So in 3 years at a 5% interest rate, the value of 10,000 is 11600.  So if your expected ROI on a 3 year investment is less than 11600, you should just put it in a bond at 5% and forget investing in capital.  Also, this means that if 10,000 is worth 11600 in 3 years, it will theoretically take 11,600 to buy something that was worth 10,000 in today's current money value.  But if the interest rate is closer to zero as it is now, 10,000 today is still 10,000 tomorrow, both in quantity and money value.  This theoretically gives enormous incentive for investment in capital goods.  And capital goods are the core drivers of our economy.

So this easing policy is much like a tax cut, but from the Fed rather than the government.  However, the government should also be reducing taxes and expenditures while the Fed does this over the long term.  Short term it may make sense for the government to spend more, since they can get cheaper bonds.  The problem is the government already had enormous debt BEFORE the crisis.  So spending any money they don't have is dangerous.

The only caveat to Quantitative Easing is that you have to be very good at judging when inflation is back to normal from zero, or when GDP is positive from negative.  If you don't time it right, inflation will be more than normal.  This is based on the Fed's money calculation MV=PQ.  Increases in GDP raise the PQ side, and therefore to remain proportional, the Fed needs to increase the money site proportionally.  V is a constant velocity of money, and P for prices in the economy normally should stay the same to avoid inflation.  However, if GDP (prices or quantity) are decreasing, the fed can theoretically increase MV to force an increase in PQ.  It is leaving the large amount of money on the table for too long that increases P too much, causing inflation.

Also, one has to take into account Gregory Mankiw's new theorem (Mankiw is a conservative economist at Harvard) that inflation is only a problem if it outpaces average raises in wages.  Think of this:  Businesses normally don't give raises based on performance.  They have bonuses and promotions for that.  Most raises are usually "in line" with or a bit above the interest rate.  This means from year to year, the average worker maintains the same buying power, while GDP increases the quantity of selection as more and better products and services enter the market.  This means that you have more to purchase tomorrow or next year with the same purchasing power (because the quantity of dollars available to you increased through a raise). 

Currently, raises (if your company hasn't suspended them yet) are still outpacing inflation, which is somewhere near zero, or even slightly negative.  Even if you got no raise, it is still in line with inflation since it is at zero. Once the economy recovers, most companies will give raises that are larger than normal to "make up" for the previous suspension, while hopefully the inflation rate stays below or around 4%, which will maintain a slight increase in purchasing power that we have been used to since Reagan. 

Maintaining a 4% or lower inflation is the trick the Fed has to ensure.

Check out Mankiw's blog: http://gregmankiw.blogspot.com/ or this other blog by James Hamilton http://www.econbrowser.com/archives/2009/03/quantitative_ea_1.html

Now I want your dissertations and dissentions!

Tijs Limburg
Chairman and CTO of DMX - Digital Media eXceleron, Inc.
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Bailouts - History Lesson

That's a good question, Eric. 

I'll try to explain it as best that I can and from what I have learned in my business studies.

The Federal Reserve is chartered by congress to under the Federal Reserve Act of 1913.  That act was supported by a key Senator, then the Republican Senate leader, Nelson Aldrich.  He was first opposed to a Central bank (Alexander Hamilton was the first to propose a Central Bank over a hundred years before), but as he studied the central banks in Europe, he was convinced that this would be the answer to most of the problems the US currency system had faced previously; albeit on one condition.  That the bank be private, with the only government representation being on the Board of Governors, as the Board of Governors is appointed by the US President.  However, the President cannot fire a boardmember (only the board can do that with a vote), and the boardmembers are not beholden to anyone in the government, because they serve longer terms than those who appoint them.  They can act for themselves, just as a charter gives a corporate board of directors the ability to conduct business as the board sees fit.  Both charters are fundamentally similar.

Even the stocks of the Federal Reserve are owned by the banks operating within a region of the system, and not the government.  (There are 12 regions within the Fed system)  Each Federal Reserve Bank is independently incorporated and has a 9-member board of directors, 6 of which are nominated by the member banks and 3 which are nominated by the Board of Governors.

The purpose of the Fed is to provide adequate currency, prevent bank runs, to monitor banks, and to manage "paper" (bonds, loans, mortgages, etc.).  Its powers have expanded since being formed to balance interests of private banks and the government (which it can do because it is not 'government'), to provide financial services to deposit banks and the government, and to maintain and strengthen the US economy and financial system, among others.

The Fed also is the only organization, as chartered by congress, that can order Reserve Notes to be printed from the Treasury.  In that regard as well, the US currency is not subject only to the government, but the people's control.  The Federal Reserve Note, issued by Federal Reserve Banks replaced the once used United States Notes which were issued by the US Treasury. The government has to do much of it's financial transactions through the Fed's banking window.  Because of this, the value of the currency is based only on the credit of the government, and the combined assets of the US economy.

Coins, on the other hand, are direct issue from the government, because they are directly obliged to the US Treasury.

To answer your question "If all the "government" (President and Congress) can do is advise and request things of the Federal Reserve but their decisions are their own, what stops the Fed from running things as they see fit?", the short answer is that the Fed does in fact run things as they see fit, and many times have gone in the face of both the government and wall street.   In most cases, history has shown that the Fed's decision in those cases was probably one of the best ways to go about the problem. 

However, recently it seems that some of the Fed Governors have neglected their duties.  Here is a quote from their US Code on the Fed's responsibility in preventing asset bubbles (like the ones we have seen recently):

"Each Federal reserve bank shall keep itself informed of the general character and amount of the loans and investments of its member banks with a view to ascertaining whether undue use is being made of bank credit for the speculative carrying of or trading in securities, real estate, or commodities, or for any other purpose inconsistent with the maintenance of sound credit conditions; and, in determining whether to grant or refuse advances, rediscounts, or other credit accommodations, the Federal reserve bank shall give consideration to such information. The chairman of the Federal reserve bank shall report to the Board of Governors of the Federal Reserve System any such undue use of bank credit by any member bank, together with his recommendation. Whenever, in the judgment of the Board of Governors of the Federal Reserve System, any member bank is making such undue use of bank credit, the Board may, in its discretion, after reasonable notice and an opportunity for a hearing, suspend such bank from the use of the credit facilities of the Federal Reserve System"

Twice in the last 15 years, and under two Chairmen and two US Presidents we have seen bubbles in assets like the ones described in the US code.  Yet, it seems that the Fed has been reluctant to step in and make adjustments in the last decade.  I'm not sure what has happened since the enormous, and somewhat secret, failure of Long Term Capital Management in 1998, but it seems that the Fed has been very hesitant to stem in and take control - beyond adjusting interest rates.  Had the Fed not acted in bailing out LTC in 1998, a suprize economic collapse would have occurred, because of the unexpected breakdown in their trading algorithm would have caused worldwide losses at least in the hundreds of billions of dollars.  (As a side note, the study which led to the algorithm they used had won the Nobel Prize in economics a year earlier).  However, my opinion is that the Fed is now reluctant to step in because the LTC fiasco has made larger firms believe that a Fed bailout is inevitable if they fail, so they can now take on more risks, and the Fed doesn't want to appear like they are catering to that idea.

To be clear, taxpayers don't foot any of the Fed's bills such as bailouts until the full aftermath of the firm being bailed out has been accounted for.  Most of the time, those huge bailout numbers are not as large when they hit the Fed's balance sheet because the companies are broken apart while under Fed protection and either sold, such as the case with Bear Stearns being sold to JPMorganChase in a weekend by the Fed's backing.  Only when the losses of the company are so large that the liquidation or sale of company businesses and assets doesn't match up does the Fed debit money form it's tax-backed accounts.

That being said, I will answer the second part of your question.  Jim Cramer is a great example of how to get the Fed's, especially the Chairman's, attention that their policies are not in line with the market pressures.  Complain.  He complained to media, threw a fit (which is now infamous) on live TV, and taught people how to "trade against the Fed", so to speak.  Because the Fed is run by Capitalists, and not institutionalists and beaureaucrats, they monitor and take heed to market pressures.  If you don't like the Fed policy, bet against them.  Stockpile money, cause a credit crunch, stop consuming, stop trading or short sell stocks, bonds or mortgages which will drive down the prices (while potentially making you money in a bear market), decrease the value of the currency or start buying other currencies or commodities like gold, move your money from stocks to bonds, or across the seas to other markets, stop hireing at your business, etc.  All of these things will cause the Fed to rethink their tactics.  And as always, complain. 

To sum up the idea that the Central banks around the world listen to the mass of complaints, the Central Bank in Europe told the press yesterday that they had heard too much complaining.  They told the papers and the media that all of the complaints were based on fears that the media was purpetrating and creating, and asked that the media stop with the doomsday reports because people were getting overly scared about issues and speculations they shouldn't be so concerned about and that were not substantiated or true.

Hope that answers the question to some degree.

Tijs

On Wed, Sep 17, 2008 at 6:56 PM, Eric Limburg <dmx311@gmail.com> wrote:

Question:

You said,

"We also need to remember that the Fed is not technically an arm of the government.  They are a private institution that is not controlled by Congress or the President, but We the People.  If we have an issue with the way things are being run at the Fed, then we as a people need to step in and fix it."

If the Fed (or Federal Reserve/Central Bank) is a private, third party, institution not controlled by Congress or the President, how do We the People fix what they are doing? If all the "government" (President and Congress) can do is advise and request things of the Federal Reserve but their decisions are their own, what stops the Fed from running things as they see fit. I probably need an economics lesson, but it sure seems strange that our fiscal system is run by a third party, non-elected, committee. Who's responsible for all this madness. Everyone is blaming the government, but the ones making the decisions are independent of the government. But then we as tax payers are the one with the bill? Sounds like an insurance claim nightmare. Help me out here those of economic minds...

---

From: Tijs Limburg <tijis311@gmail.com>
Sent: Wednesday, September 17, 2008 1:04 PM
To: Limburg, Garth <Garth.Limburg@slcgov.com>; Eric Limburg <dmx311@gmail.com>; Nevin Limburg <Nevin.Limburg@wvc-ut.gov>; Brendon Charles <bcharles22@gmail.com>; Dupaix Steven <steve.dupaix@thomson.net>; Lizzie Dupaix <dyzylyzy@gmail.com>; Ronald Hess <rjoehess@gmail.com>
Subject: Bailouts - History Lesson

I agree with most of this article.  However, there is a slight flaw in Andrew's logic which I have pointed out to him.  The article would lead you to believe that Fed bailouts are something new.  In fact they are not.  Bailouts from the "Central Bank" could be argued to be the underlying premise of the Fed in the first place. 

Before the Fed was formed, the closest thing the US had to a central bank was J.P. Morgan bank.  Mr. Morgan used his extensive financial arm and prowess on more than one occasion to bail out both the govenrment in 1895, and to stop the panic of 1907, among others.  He even advocated the idea of a central bank, which Congress eventually followed.  So in essence, J.P. Morgan could be looked at as the first 'Fed Chairman', who bailed out failing systems long before.  Some have said Morgan advocated a central bank because he proved it was absolutely necessary in dire situations to have a central financial power that could step in at the right time and offer money, buy stocks, or create mergers.  They also think that Morgan was tired of having this responsibility upon himself, as he was trying to run a banking business, not a regulatory agency of the treasury. 

We also need to remember that the Fed is not technically an arm of the government.  They are a private institution that is not controlled by Congress or the President, but We the People.  If we have an issue with the way things are being run at the Fed, then we as a people need to step in and fix it. 

While I don't think that every large failing company should be bailed out, and I am in a bit of disagreeance with helping AIG stay up, I don't think the bailouts we have seen so far are that dissimilar to tactics Morgan used over a century ago to save the US financial system from crisis.

But the article is worth a read.  Hopefully our regoinal banking system is firm enough that any widespread effects to not find their way to Salt Lake as quickly.  Either way, keep an eye on the performance of the bank you go to.  We may see a lot of small banks go under.  In 1992, before the big turnaround we have seen in the last 15 years, 800 small or regoinal banks failed.  We may see the same thing again.

http://blogs.moneycentral.msn.com/topstocks/archive/2008/09/16/the-fed-is-not-our-sugardaddy.aspx?CommentPosted=true#commentmessage


--
Tijs Limburg
Chairman and CTO of DMX - Digital Media eXceleron, Inc.
Get eXcited!
www.dmxed.com

Blogs:
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http://getoutofthedark.blogspot.com/

The "Don't Tread on Me" Flag: The First Navy Jack is enjoying renewed popularity these days thanks to an order from the Secretary of the Navy that directs all U.S. Navy ships to fly the First Navy Jack for the duration of the War on Terrorism.

--

Tijs Limburg
Chairman and CTO of DMX - Digital Media eXceleron, Inc.
Get eXcited!
www.dmxed.com

Blogs:
http://phystrings.blogspot.com/
http://getoutofthedark.blogspot.com/

The "Don't Tread on Me" Flag: The First Navy Jack is enjoying renewed popularity these days thanks to an order from the Secretary of the Navy that directs all U.S. Navy ships to fly the First Navy Jack for the duration of the War on Terrorism.

--
Tijs Limburg
Chairman and CTO of DMX - Digital Media eXceleron, Inc.
Get eXcited!
www.dmxed.com

Blogs:
http://phystrings.blogspot.com/
http://getoutofthedark.blogspot.com/

The "Don't Tread on Me" Flag: The First Navy Jack is enjoying renewed popularity these days thanks to an order from the Secretary of the Navy that directs all U.S. Navy ships to fly the First Navy Jack for the duration of the War on Terrorism.

Ron Paul - A Disaster for America

Ron Paul's Ideas Illogical

It was when I first heard of Ron Paul rejecting the idea of international trade and wanting to block trucks coming north from Mexico from entering the country, which is now allowed, that I wondered why he would attempt to run for president.

I then heard him say that the Federal Reserve was unconstitutional, unnecessary, and the cause for the "worthless" dollar.  I say worthless because his statistic of the dollar being worth 4 cents for every 1920s dollar would make everyone think just that.

However, consider this.  We have all heard our grandparents tell of a bottle of coke costing $0.05 in 1920.  This is confirmed by most recorded accounts. (see http://www.foodtimeline.org/foodfaq5.html#cocacola)  

Sounds pretty cheap, eh?  Especially compared to the price of a similar bottle of Coke at $1 today.  However, further analysis proves sightly different.  Many analysts estimate the average wage in 1920 to have been somewhere around $30 a month.  So lets estimate that to $1 a day in 1920s dollars.  To buy a Coke, it took 5% of your gross daily income.  

In today's terms, let's use the minimum wage of $5.85 in today's dollars to compare to the daily wage of $1.  Working a full time job at minimum wage, you would earn $46.8 gross.  (It should also be noted that many workers in 1920 probably worked longer than 8 hours a day.)  So in those terms, the cost of a $1 Coke of today takes just over 2% of your daily gross income to buy.  In effect, the cost of a Coke today is 238% less than it was previously.

Which would you rather have?  A Coke for $0.05 costing 5% of your daily wage, or a $1 Coke costing 2%?

Another argument that Ron Paul brings to his campaign is the idea of doing away with the Federal Reserve.  Such a move would be ridiculous.  Since its formation in the post 1929 crash era, the Federal Reserve has insured that we have not suffered  a depression as the one experienced at that time.  This is even more important considering the 1987 Crash -Of which this current month is the 20th anniversary. 

The 1987 Crash was the worst in US history.  The Dow fell a whopping 23% in one day, out-shadowing the 1929 Crash.  However, the Federal Reserve was in large part responsible for keeping the economy from going into a depression.  In fact, if you were to have bought shares after the 1987 crash, you would likely be up ten fold today -A much different result than in 1929, when by July of 1932, the Dow had lost 89%, and did not close above the peak level in 1929 until nearly 25 years later in 1954.

How can someone who is running for president justify his stance on dissolving institutions such as the Federal Reserve?  And more disturbingly, how can even 1% of the Republican voters be following him? (according to the latest Fox News poll.)

I think the economy will develop into a very important issue for 2008.  I just hope that the rest of the 99% of voters, republican or democrat, will be more informed of the workings of economics.