Tuesday, May 10, 2011

60 Times (Afterthought 1)

Reviewing my four o'clock, I had too many follow-up thoughts to let it be.

First of all, I wrote:

Base money is created when the Federal Reserve removes debt from the economy.

Until the recent crisis, that was always the case. The U.S. Treasury issues government securities, and somebody in the non-government sector buys them. When the Federal Reserve buys some of those government securities from the non-government sector, it takes debt out of the private economy, and puts money in.

All very nice. After the Fed buys those securities, the government owns them. So when the Treasury makes payments on that debt, the government makes payments to itself. This is basically the same as if that debt did not exist at all: It's "out of the economy."

Some people might use this as an example of the stupidity of government or something equally unpatriotic. I do not. I use it simply as a description of what happens in the world we live in.

But things change. Back in the autumn of 2008 the financial system was collapsing and the Federal Reserve responded with extraordinary measures.

Source: Billy Blog, November 10th, 2010.
The first big event, which shows up in green on Bill Mitchell's graph at right, was a massive increase in "Lending to Financial Institutions". The second big event, if not quite so big, shows up in purple. Mitchell's graph calls it "Liquidity to Key Credit Markets". To me that sounds a whole lot like more lending to financial institutions.

Anyway, both the green and purple emergency-increases gradually tapered off and by mid-2010 the balance sheet of the Federal Reserve had fallen in size, back almost to where it was before the start of the crisis -- except, of course, for that big dark blue cloud sitting ominously above the majestic purple mountain on the graph.

That big dark blue cloud. The graph identifies it as "Fed Agency Debt Mortgage-Backed Securities Purch". To be honest, I don't know exactly what that is. I just have a vague notion. But the key phrase there is "Mortgage-Backed", which means the money that creates income for the holders of those securities comes from people making the mortgage payments.

If that is right, then what the graph shows is a doubling of the size of the Fed's balance sheet, achieved by the purchase of derivatives based on mortgages.

The Federal Reserve created "money from nothing"...
To make a big deal of 'money from nothing' is to get caught up in distraction.
... created "money from nothing" and used it to buy up "toxic assets" in order to reduce "risk" in the financial sector. Myself, I think it had to be done.
That is not to say I think it wise that we let ourselves get into the situation where such a rescue operation becomes necessary.
It had to be done. But look what it did: It took risky assets out of the economy, but left the risky liabilities to fester.

When the Fed buys government securities, the government pays more interest to itself, and there is a net reduction of interest costs. This is not the case when the Fed buys mortgage-backed securities. To get the same advantage, we would have to let the people paying mortgages make payments to themselves. Or just have the Fed forgive all that debt. Or something equivalent, to take that debt out of the economy.

The increase in base money that was used to "Purch" those "Mortgage-Based Securities" was not counterbalanced by removing debt from the economy. If it had removed that debt, if it had removed the risky liabilities, the economy would be in far better shape now than it is. But that did not happen.

So unfortunately: No, it is not true that the only way to create base money is for the Fed to remove debt from the economy.

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