Has recent Federal Reserve policy been a failure?
In September, the Fed announced its intention to purchase $40 billion in mortgage-backed securities each month. This new round of quantitative easing, called QE3, is designed to stimulate an economy that continues to sputter.
A system of fiat money, where money is backed by nothing other than the willingness of people to accept it, makes quantitative easing possible. After the 2008 collapse, the Fed embarked on two rounds of quantitative easing, QE1 and QE2, which have not significantly improved the economy.
If QE1 and QE2 didnt work, why try again? Where did all the new money go?
To answer these questions, we need to distinguish between the money supply and the monetary base. The money supply includes checking account balances and cash held by the public.
In contrast, the monetary base is what the Fed can directly affect. Its biggest component is commercial bank reserves. When the Fed buys bonds, the immediate effect is to increase bank reserves. Whether checking account balances will expand depends on whether commercial banks use their new reserves to make loans. If banks dont make loans, then a rapidly growing monetary base will do little to stimulate spending.
Ironically, in October 2008, the Fed announced a new policy of paying interest to commercial banks for holding excess reserves a policy that discourages lending and contradicts the Feds stated goal of providing economic stimulus.
From September 2008 through the present, the monetary base increased from $949 billion to $2.6 trillion, an annual growth rate of 29 percent. Since banks have been holding lots of excess reserves, the money supply has increased at a much lower rate.
Should commercial banks start aggressively making new loans, the now-gigantic monetary base provides ample fuel for an explosion in the money supply and future inflation. The Fed maintains that it is monitoring this risk; should signs of inflation emerge, it will promptly reverse course and pull bank reserves from the system.
Critics of the Fed argue that vacillating policies create uncertainty and ultimately do more harm than good. Looking back on a dismal pattern of boom-and-bust cycles during the Feds 100 years, the historical record validates this view. The Fed and other central banks worldwide are now engaged in quantitative easing, leading to growing inflation fears and a chorus of voices arguing for a return to a gold standard.
Ultimately, free people should be allowed to determine what they want to use as money. If central banks abuse their money-creation privilege, the market will look for substitutes for fiat money. A return to gold is one possibility, but improvements in technology open up others. Now, changes in ownership of an economys real productive capital can be instantaneous. Index funds and exchange-traded funds allow for individuals to easily own a share of an economys capital stock, and one can visualize a future world where ownership shares are traded for consumption goods directly, eradicating any need for government-created fiat money.
Nobody knows precisely how a free economy will evolve to most efficiently exchange and value goods and services. However, as central banks rapidly manufacture money out of thin air, the push for workable market alternatives to fiat currency will assuredly accelerate.
Dwayne Barney, Finance professor at Boise State University and co-author of Capital as Money. capitalasmoney.com