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Home > Blogs > Anthony Harrington > Debunking ideas that the US Fed is out of control

Debunking ideas that the US Fed is out of control

Fractional reserve banking | Debunking ideas that the US Fed is out of control Anthony Harrington

One of the many memorable lines in Casablanca, right up there with Lauran Bacall’s “You do know how to whistle, don’t you? You just put your lips together and blow,” is the policeman’s exclamation: “I’m shocked, shocked to learn that there is gambling going on,” just as his winnings are slipped into his pocket. Northern Trust’s chief economist, Paul Kasriel chose the latter quote as the headline to a recent blog, “I’m shocked, shocked the QE2 is Akin to Printing Money and Public Debt Monetization!”

In this blog he attempts manfully to demonstrate to an unheeding world that all the panic over the Fed’s second round of quantitative easing (QE2) is somewhat misplaced since, well, banking systems have always created credit out of thin air. It is simply part of the nature of fractional reserve banking.

For those for whom fractional reserve banking is an unfamiliar term, relax; it describes something with which we are all very familiar – namely the fact that banks hold only a fraction of their customers’ deposits against potential withdrawals and use the rest to lend out. This has the effect of multiplying the amount of money in circulation well beyond that actually issued by the country’s central bank. Note the point here. First the Fed, or the central bank in question creates money out of thin air and lends it to the banks. Next, the banks use this “seed money” as the basis for attracting depositors (by paying them interest) and as an earnings instrument through their lending activity. 

As Kasriel puts it, “… when there is an increase in the sum of Federal Reserve credit and commercial banking system credit, credit is created out of thin air, which is akin to 'printing money'." Some entity’s debt is always being monetized in this process, by definition. He offers the reader a chart which shows the history of Fed “money printing”/ “debt monetization” starting in 1953 and culminating in 2009. Surprisingly, 2009 is the only year over this whole period in which the Fed’s monetization activities actually contracted.

“In the 12 months ended October 2010, the fastest three month annualized growth in monetization was a paltry 1.1%,” he points out. That is scarcely up there with the Weimar Republic or Zimbabwe in the money printing stakes. If the Fed implements its $600 billion quantitative easing programme, which there is little reason to doubt, then provided that commercial banking system credit were to remain unchanged between the end of October 2010 and the end of June 2011, which is when QE2 is scheduled to end, Kasriel points out that total debt monetization over the period would amount to 5.2%, or an annualized rate of 5.6% over the June 2010 level. Again, this is hardly hyperinflation territory.

What does this add up to? “Assuming that the commercial banking system does not create any net new credit between now and the end of June 2011, (which seems a reasonable assumption given that US companies are not exactly snapping bankers’ hands off to get credit – most of them are still deleveraging like crazy) the magnitude of the credit creation being contemplated by the Fed is not extraordinary in a historical context,” he says. 

This message is an important counterweight to the prophets of doom, who see each phase of QE2 as another milestone on a very short road to super inflation.

Further reading on quantitative easing, QE2, and inflation:




Tags: asset price bubbles , banking , capital adequacy , central banks , financial crisis , fiscal stimulus , GDP growth , global imbalances , QE2 , regulation , sovereign debt
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