The Federal Reserve dominated the news the week after Thanksgiving, and its actions were consistently misunderstood. At the beginning of the week, the news was details, forced from the Fed by Bloomberg News, about some $7.7 trillion in short-term emergency lending in 2008-2010. Nearly all news reports over-represented the magnitude of this lending.
By midweek, the news was an agreement among the Fed, the European Central Bank and the central banks of four other countries to facilitate trades of dollars among themselves. One headline called it an “attempt to save the world.” But this time financial markets also misread the news, and stocks rose sharply.
The common element to both stories was that members of the media, as well as the general public, don’t really understand how central banks work or what they can and cannot accomplish.
After the first news, readers emailed asking where exactly the Fed got the $700-plus billion that it had actually lent out at the height of the financial crisis.
The answer is that it got the money exactly the same way it will get the dollars that it will “swap” with other central banks to reduce growing liquidity problems in Europe. It created the money out of thin air.
This is precisely why we have central banks, to increase or decrease the money supply as needed and to act as a lender of last resort in times of crisis. It is what the framers had in mind in 1913 when they wrote the Federal Reserve Act’s preamble stating the new institution was “to provide for an elastic currency.”
Commercial banks are required to keep “reserves,” legally stipulated fractions of their deposits, at the Fed. When the Fed makes a loan to a bank, it merely increases the recorded total in that bank’s reserve account. The bank can then draw down that new amount by presenting checks for payment.
I won’t take the time here for a more detailed explanation of how central banks create and destroy money. Some details are important, however. While the Fed can create new bank reserves, and hence new money, by making direct loans to commercial banks or to other central banks, this does not have to mean an identical net increase in the overall money supply. As it makes such loans, it can simultaneously act to decrease the money supply in other ways.
When Lehman Brothers and AIG went broke in fall 2008, the Fed increased its lending to banks by $556 billion, going from $169 billion on Sept. 10, 2008, to $725 billion on Nov. 12. Yet the money supply only increased by $230 billion.
Similarly, although Fed lending has since dropped by $678 billion from that 2008 peak, the money supply has continued to grow and is now $1.6 trillion larger than it was then. So emergency loans to banks are only one way the Fed controls the overall money supply.
Similarly, dollars that the Fed swaps for foreign currency will be created out of thin air. But whether this increases the total money supply depends on what other actions the Fed takes.
There is much commentary to the effect that the Fed is stepping in to bail out the European banking system, putting the U.S. economy and the U.S. Treasury at risk. Neither is really true.
Swaps between central banks have been a routine practice for decades. They are always closed out eventually, with no instances of default. If the Fed lends $100 billion to the ECB in exchange for euros, then at some point in the future, the ECB will return the dollars and we will return the euros. And at that point, both central banks probably will just destroy that money in the same way they created it.
Any lending to commercial banks in Europe will come from that continent’s central banks. They will bear the entire risk of any loss. But the Fed will get its dollars back.
The most serious misunderstanding is that of financial markets, which apparently viewed what is a fairly minor administrative change, as some magic new intervention that will solve Europe’s fiscal problems. In fact, all it can do is alleviate short-term problems of European banks that need to meet obligations in dollars rather than euros.
Central banks can provide liquidity in times of crisis, when normal flows of cash seize up. But they cannot fix insolvency. And it is insolvency that is the fundamental problem in Europe.
Ironically, some of the immediate scramble for dollars is to pay off U.S.-based money market funds that, as recently as two months ago, were providing a third of European banks’ short-term financing and are now running for the door. My retirement fund probably is involved, and yours, too.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at ed@edlotterman.com.
