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Commentary: Strong Medicine for Ailing Economy
Op-ed - Terry Coxon
As Washington struggles to resolve the economic crisis, it is worth examining the policies of former Federal Reserve Chairman Alan Greenspan and Ben Bernanke and building and maintain bank reserves and how they affect the overall economy.
Greenspanol
The first remedy for falling markets and a weak economy is the creation of new reserves for the banking system. The Federal Reserve does this trick by buying Treasury securities in the open market and crediting the purchase price to an account that the seller’s bank maintains at one of the twelve Federal Reserve Banks. Those new reserves are then available to the bank to invest, to lend, or to use to satisfy a withdrawal by its customer. But even in the case of a withdrawal, unless the customer wants $50 bills, the new reserves simply move to a different bank.
The creation of new reserves has been part of the Federal Reserve’s emergency medical kit since 1913, when the institution was created. But until 1971, when the gold standard was put to rest, the Fed was constrained to use reserve creation sparingly. Even after 1971, although reserve creation was sometimes extravagant, the government tended to use it in a confused fashion, in combination with other remedies, such as changes in tax rates or in banking regulations. Then came Alan Greenspan. He saw clearly how powerful reserve creation could be all by itself, and he was the first to rely on it as the only remedy needed, hence the name Greenspanol.
So where has all the bailout money – the Fed’s credit auction facility and the billions for Bear Stearns and AIG and others -- been coming from?
Bernanox
Through its nearly continuous creation of new reserves since 1913, the Federal Reserve accumulated a huge pile of Treasury securities -- as of August 2007, more than $800 billion worth. Until recently all the emergency measures you’ve been reading about involved drawing on that hoard. The Fed would lend T-bills, for example, to a bank in exchange for the bank’s IOU secured by junk bonds. Even when the Fed handed cash to the rescued institution, with its other hand it was selling Treasury securities in the open market to reabsorb the cash. Swapping T-bills for junk is an entirely new remedy. It is Mr. Bernanke’s invention and so is fairly named Bernanox.
What Will Happen
But this doesn’t make banks willing to lend. It doesn’t revive their appetite for risk taking. It doesn’t halt the decline in housing prices that every day turns more mortgages into defaulted loans. At some point soon, the recession will force the Federal Reserve to resort to the old-time medicine and start creating new reserves in earnest.
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