Let There Be Light

The consumptive U.S. dollar experienced a brief new high last week. Creeping devaluation had resulted in an exchange rate where one had to pay $1.50 to buy one euro. Had it not been for Ben Bernanke’s comments, the dollar might have continued strengthening last week. The Fed chief took one look at the exchange rate and announced something would be done. But the effect of that announcement had only a brief effect on the dollar because the Fed’s interest rate policy itself is the real cause of the dollar’s decline.

More money in circulation

Just a few hours prior to these cautionary words, Bernanke declared his intention to continue with the Fed’s zero-interest rate policy for the foreseeable future saying they would keep interest rates at “exceptionally low levels for an extended period.” Naturally, this resulted in a rush to sell dollars, which in turn caused several currencies to fall and resulted in Bernanke’s new warning mentioned at the beginning of this article.

The Fed has been pursuing a de facto zero-interest rate policy since December 2008, an unprecedented run in U.S. economic history. The “cheap money” is supposed to stimulate lending during the crisis, and that, in turn, is supposed to result in increased investment and consumption. But simultaneous with the flood of dollars, there is a rising danger of an uncontrollable and precipitous nosedive for the dollar on international currency markets. Besides that, there is also the long-term danger that the current deflationary tendencies may evolve into full-blown inflation.

Historically, the Fed has been making new money out of thin air in absolutely breathtaking dimensions since September 2008. Thus, the monetary basis termed “MO” has increased by some $910 billion since then. “MO” is the term used to describe all the currency in circulation as well as the minimum reserves held by all merchant banks and the Federal Reserve combined. Even during the period of stagnation in the 1970s, the MO never grew faster than at a 15 percent annual rate. These days, it’s exploding at a rate of 100 percent based on a yearly comparison.

This inundation of money has yet to stimulate lending in credit markets. Lending volume at the beginning of September was some $126.4 billion below the same period a year previously. This also represents another historic collapse unprecedented in the statistics. At the peak of the debt-financed real estate boom of 2006-2007, the debt figure temporarily grew by more than $800 billion over a one-year period. The reason for the slowdown is the “spread,” or the difference between the prime rate and the market interest rate in the United States. While banks are able to loan money at zero interest, the interest rate charged to businesses and consumers has hardly fallen at all.

So the question remains, what happened to all that “Fed-created” money? First off, much of it flowed into U.S. government bonds; America is buying up its own debt. The program ran until October 2008 and accounts for some $300 billion. In addition, the Fed also bought up vast quantities of bad Mortgage-Backed Securities (MBS) from troubled banks. MBS, in the meantime, have become the Fed’s biggest “asset” along with other government securities. The Fed’s total assets ballooned from slightly under $1 trillion to over $2 trillion in just one year and the “value” of the MBS, according to media reports, rose proudly to $920 billion. And a new program has been announced to buy up agency debt for an additional $200 billion.

Questionable “assets”

These programs are paid for with money the Fed itself has created. Following the biblical example of “Let there be light!” (“Fiat lux!”), we now have the term “Fiat money” for the money thus created by the Federal Reserve. The world’s leading currency appears to have taken on the idolatrous characteristic of being able to create itself – and therefore its value – from absolutely nothing. The only reason that a dramatic inflationary wave hasn’t followed is that this deluge of money is currently driving an inflation of asset prices.

This miraculous financial mismanagement is responsible for the current stock market boom. The banks, now freed from their toxic investment burden, weren’t moved to increase lending in the midst of a recession. That would run contrary to their internal business logic of primarily exchanging worthless mortgage securities for potentially toxic loans. Instead, the deluge of money is inflating the latest bubble in stock markets and so-called carry trades as explained recently by the Washington Post: “Who is taking out loans these days? By and large, it’s neither private households nor small businesses that traditionally don’t like to take on debt during times of crisis. It’s the hedge funds and other investors who use borrowed money to buy stocks, corporate bonds and other capital goods, thereby inflating their values beyond what is economically justifiable. The Federal Reserve provided them with freshly printed cash that enables them to engage in a new round of gambling in the global financial casino.”