Overview

The Federal Reserve was well aware of the severe inflationary dangers when it directly created almost a trillion dollars as part of its separate bailout of Wall Street. If this cash - which exists in highly liquid form right now - escapes into general circulation, the result could be immediate and major inflation that would devastate the value of the dollar and all of our savings. Therefore, even as it created the trillion dollars, the Fed set up a series of barriers to contain the new cash and ultimately return it to the void from whence it came, lest the new cash break out and wreak monetary havoc.

While described in detail in Federal Reserve Chairman Ben Bernanke's own speeches, the creation of the new money, the barriers to contain it, and the strategy for destroying it are understood by very few in the media or on the web. Yet, the significance is profound and there are powerful, game-changing implications for the economy, the housing market, the inflation / deflation debate and the very fundamentals of long-term and retirement investing.

In this article we will illuminate what looks on paper to be a brilliant economic strategy, and then cut through the theory to get to the real world bottom line for all of us: you and I stand to lose everything if an ambitious but profoundly dangerous strategy goes awry, while the bonuses and future rewards continue to go straight to those whose short-sighted greed created this mess in the first place.

The Horse Has Already Left The Stable

As covered in my recent article, "Creating A Trillion From Thin Air", the problem is not just one of growing future inflationary pressures - but that one of the most inflationary events in US monetary history has already happened: In 2008 and 2009 the Federal Reserve directly created more new money out of nothingness than total physical currency created in the previous 230 years.

As also explained in that article, what the Fed did with most of this money was buy close to a trillion dollars of securities, at 100 cents on the dollar, meaning that it quite deliberately overpaid, and covered what the banks' losses would have been if they had sold into a free market. The largest source of funds for this massive market manipulation for the benefit of banking insiders, came through the Fed's creating $819 billion in "excess reserve balances" and giving those balances to the banks in exchange for the troubled investments. "Excess reserve balances" is an obscure term, but what it translates to is freely spendable cash.

Dividing $819 billion in newly created excess reserve balances by 111 million American households shows that the Federal Reserve created new cash equal to about $7,400 per household. When we move beyond excess reserve balances to total Federal Reserve balance sheet growth of $1.3 trillion, that works out to $12,000 per household. With no economic growth, taxes or assets to support the new cash.

The horse is already out of the stable.

What If The Cash Escapes?

The danger with paying cash - which is effectively what excess reserves are, freely expendable cash - is that the banks can do whatever they want with these excess reserves. For instance, banks are free to do what banks are supposed to do, which is to go out and make loans. So if the banks took $1 trillion, for round numbers, and then went out and made $1 trillion worth of loans, that money would go out into the economy. And much of that money would come right back into the banks in terms of increased bank balances at that bank and other lending institutions - who'll then take those balances and lend them out again.

This Econ 101 concept is known as the multiplier effect. If this were to happen with this trillion dollars, then all of a sudden, instead of having $1 trillion in brand-new money in the economy, we might have an additional $4 or $5 trillion running around in the economy. So instead of $12,000 per household, now we would be looking at something more like $50,000 or more per household potentially going through the economy.

This is a potentially colossal inflationary event. Now, keep in mind that this danger is not theoretical - this is the situation as it exists right now. That freely expendable cash has already been created and is on the bank's balance sheets right now. The salient question is whether this existing inflationary event, this creation of money out of thin air that has already occurred, can be contained and unwound as intended, or whether it will break free into general price levels.

Creating The Corral

As covered in the Ben Bernanke's speech (linked below), "The Federal Reserve Balance Sheet: An Update", the Federal Reserve is keenly aware of this danger, and was so even as the cash was created. (The "Exit Strategy" section is of particular interest.) Therefore, even as $1 trillion was created out of the nothingness to buy the banks out of the trouble they had gotten themselves into, so was the containment strategy.

http://www.federalreserve.gov/newsevents/speech/bernanke20091008a.htm

It used to be that the Federal Reserve did not pay interest on the reserve balances that banks were required to maintain at the Fed. This was for good reason, as the purpose of the banks is to lend money. If the Fed was paying an attractive rate of interest on reserve balances, the banks would not have the incentive to lend. So the Fed did not pay banks any interest on reserve balances, and "excess reserve balances" were a miniscule item on the Federal Reserve balance sheet.

Times have changed, however. Now we have almost $1 trillion in excess cash that was needed for the private bailout of the banks, but which the Federal Reserve badly does not want to get out into general circulation because of the potentially severe inflationary consequences. Thus, by act of Congress, the Federal Reserve rules were changed so that for the first time the Fed pays interest on excess balances.

(This ties into a long-time theme in my writing that deflationist theorists just don't seem to understand. Symbolic money such as the post-1933 US dollar is governed by a set of rules, and when a government gets its back against the wall - it just changes the rules. This has happened again and again throughout global and US history, with the Fed's new ability to pay interest on reserve balances being only the most recent example. Deflation theory assumes that governments are hand-cuffed by the rules governing money - but they aren't, for the rules are simply whatever the government says they are. Unfortunately, those same rules are also the only really protection any of us have for the ongoing value of our money.)

If you read Bernanke's lengthy description of his exit strategy from "quantitative easing", it looks like he's actually fairly proud of how clever he has been in handling this situation. The investments that the Federal Reserve purchased are loans. The theory is the loans will pay off over time and the money will flow back into the Fed at which time it essentially disappears back into the void from whence it came. Money is a liability for the Fed, and as each dollar of loan is repaid, the money is removed from the system, and the Fed's assets and liabilities ratchet down together, as the supply of money diminishes. Or if the markets get strong enough the securities can be sold back to the banking institutions or other investors, and the cash can be pulled out of the system and the money supply in the same way.

If that doesn't quite work out, the Federal Reserve can pay the banks to keep their money out of the overall system and thereby contain the inflationary danger. As Bernanke very explicitly says, he's quite confident of his ability to manage this through the use of a variety of available tools. One of them is the new ability to pay interest on excess reserves. Because the Fed has the ability to pay whatever interest-rate is required, and it has essentially no credit risk (at least from the banks perspective), then logically the Fed should always be able to pay enough so that the banks would never take their money out of these excess reserves.

The Reverse Repo Lasso

Even if that money did somehow slip out of the Fed's internal accounts (if the horse jumps the corral fence), Bernanke describes a multi-tier Fed strategy for throwing a lasso around the neck of the money, and pulling it back out of circulation. One central strategy is through entering into what are known as reverse repurchase agreements. The jargon may be intimidating, but the essence is not that difficult. The Fed wants to take the bank's cash temporarily out of circulation, so it sells securities to the banks, which the banks pay for by giving up their cash. Simultaneously, the Fed agrees to buy the securities back on a specific date at a higher price in the near future (often overnight), meaning the Fed returns the bank's original cash plus a little more cash. (The investments that are bought and sold are almost irrelevant other than being acceptable collateral.)

The locked in difference between purchase price and resale price effectively becomes an attractive rate of interest on their money for the bank, so they send their free cash to the Federal Reserve. Again, as the Fed can offer essentially no credit risk and an ability to pay a higher rate than anyone else, they are confident that they can completely contain the cash at will without it getting out of the system and setting off general inflation.

However, this creates a very ironic situation in terms of the difference between what is being presented to the world through the media, what's being presented to Congress and what is actually happening here. What the public is being told is that the banks aren't doing their part, that they are supposed to be going out there and making loans, but they are reluctant to do so. This is a common story that is found in the media.

But when we look at Bernanke's own words, what's really happening here is the Fed is going to a great deal of trouble and has elaborate strategies on multiple levels in place to make darn sure that the banks don't take anywhere close to the full amount of this new cash created for them and actually lend it out, because of the potentially disastrous inflationary consequences that the Fed is very well aware of.

Using Infinite Money To Control Infinite Money

Now let's step back from the cleverness of the Federal Reserve chairman and consider what's really happening here. A huge sum of money, over a trillion dollars (total Fed balance sheet growth) was created quite literally out of the nothingness with no assets or taxes. It's just pure monetary creation, and it was distributed in such a way as to yield the maximum benefit for some very well connected political insiders, the executives of the banking industry. But we don't have to worry about the inflationary consequences, as the money can theoretically be contained indefinitely by the Fed paying the banks a higher rate of interest than anyone else. This high interest rate can be either directly on the excess balances or through the reverse repos and other methods the Fed can use to pull money out of circulation.

What is the source of the Federal Reserve's perfect credit and its ability to pay higher interest rates than anyone else in the market which, in the Fed's opinion, makes it certain that this cash will be contained? The source is the direct creation of money. Because the Fed can directly create money, it can pay however much interest as it takes.

When it comes to "reverse repurchase agreements" and similar arrangements, which are Bernanke's ultimate source of confidence that he can put the monetary creation genie back in the bottle at will, what do they really come down to? The Federal Reserve drains money from banks by making the banks deals that are too attractive to refuse, through giving them back even more money at the end of the short term contract. Each round of reverse repos that is used to contain excess money, ends up leading to still more money out there in a matter of days, that then needs to be contained in the next slightly larger round. Repeat, repeat and repeat as needed - for there are no limits.

The theory is that a potentially infinite sum of money can be created and passed to politically connected insiders, but the damage can be contained through the creation of infinite money to pay them off, to keep them from actually spending the money that was given to them. In my opinion, this is a crazy strategy for preserving the value of our money -- but it is our current reality.

The Fatal Flaw

There is good news and bad news about how this strategy has performed in practice. The good news is that the first round from the fall of 2008 actually worked. The original investments were commercial paper and emergency loans to banking institutions, each of which are quite short term in nature. The commercial paper has paid off. The great majority of the bank loans have already been repaid.

But there is troubling news as well. According to the theory behind the original plan - as each loan payment came in, the money should have been extinguished, and a proportionate amount of excess reserve balances forced back into general circulation where the need to invest could potentially stimulate the economy. By the end of 2009, the excess reserve balances should have been gone and the Federal Reserve balance sheet should be back down to about $800 to $900 billion, with the "liabilities" consisting almost entirely of physical currency. The desperate measures successfully taken in the fall of 2008 should already be a historical footnote, being discussed only in graduate student seminars over the coming decades.

However, in the real world - the excess reserves are still there, and the new Federal Reserve is still almost triple the size of the old Federal Reserve. Because the fatal flaw in the plan is that the real world isn't about economic equations, but rather people. The Federal Reserve is run by people with quite human motivations, who are subject to the temptations of power and hubris.

Money is power, and a trillion dollars is a great deal of raw power for the small group of un-elected economists who run the Federal Reserve. Each board member knows that the trillion dollars shouldn't be there, because of the threat to the value of the currency they are supposed to maintain. But they got the money and they got it scot-free. More money than an entire year's individual income taxes for a nation (as recently as 2004), and they don't have to answer to Congress on how they spend it. The Federal courts are uninterested, the press has no idea what's going on, and neither does 99% of the public. In other words, the members of the Federal Reserve board find themselves with an awesome amount of power that is essentially extraconstitutional, without the usual checks, balances or semblance of accountability.

So naturally, the members of the Federal Reserve Board are exercising that power, and the bad news is that they entirely spent the newly created money as it came back to them. (Who does hand power on that scale back?) This second round is however far more ambitious - and far more dangerous - than the original very temporary intervention into short term and relatively high quality investments.

The Federal Reserve decided to intervene on a massive scale and essentially create an artificial market for mortgages. The goal was to prop up the United States housing market through offering below market mortgage rates. The method used was radical - use money created out of thin air to finance essentially 100% of home purchases for an entire nation. The risk is that if the intervention fails, then housing and mortgage rates find their natural levels regardless of government intervention, but meanwhile the value of everyone's savings has been destroyed in the attempt. Leading to tens of millions of impoverished retirees, among the other economic casualties. Getting a grasp on what is really going on with this extraordinary but almost unreported gamble is the subject of our next article.

The Societal Bottom Line

Let's review. In their shortsighted greed and hubris, in their pursuit of extraordinary personal wealth, a small group of exceptionally wealthy and politically well-connected bankers took enormous and obvious risks that nearly destroyed the global financial system. In response, two separate bailouts took place. One was the congressional sideshow that gathered all the media attention, and the other was the real deal, with over $12,000 per household in money created and another $150,000 per household committed to be created if necessary.

The $12,000 per household was paid in cash, freely spendable cash. Cash that could take a big chunk out of the value of the US dollar if it got out into general circulation, both directly and via the "multiplier effect". So the Fed began paying off the bankers not to spend the massive amount of cash that had been created and given to them under highly favorable terms.

One could liken this situation to that of a loaded revolver (a six-shooter to continue the horse and corral theme). In essence, the Federal Reserve dealt with those mischievous risk-takers at the banks who had nearly destroyed the financial world by handing to them a loaded revolver that was pressed against the heads of all the nation's savers, investors and retirees. A revolver that could destroy most of the value of your personal savings. Then the Fed said "Please don't pull the trigger! We will create however much money is needed and pay it into your personal bonus pools, just so you won't pull the trigger on that revolver we just handed to you."

This is essential to understand, because what does paying higher rates than the banks could otherwise get on excess balances and reverse repos really mean? It means higher profits and bonuses. Ultimately, the Fed's official inflation containment strategy is to always be able to offer banks a better deal than any private investment alternative. A better deal means the bank taking in more income, which means the banking executives involved get bigger bonuses. The source of funding for this ability to always pay more than the private markets is the ability to directly create a limitless amount of money. At this point it is a very low interest rate, but the rate can go as high as needed, when inflationary pressures build.

This may sound outrageous, but all it really does is demonstrate the true nature of the Federal Reserve. It is owned by the banks. It is run by the banks. As we are seeing demonstrated right now, its job in times of crisis is to manage the money supply for the benefit of the banks, regardless of the harm inflicted on the rest of the nation.

Taking Personal Action

What is the bottom line when it comes to conventional investing? Live a productive life, consume less than you produce, save the difference and trust. Trust the Federal Reserve, trust the Federal Government and trust Wall Street. Invest steadily but blindly in an indexed, buy-and-hold strategy and we are assured that not only will the value of our money be retained but we will all participate in a massive creation of wealth. So long as we trust. Things haven't quite worked out that way so far but we're told to keep the faith when it comes to the mainstream financial media.

There is an alternative. Which is to say that we don't trust the Federal Reserve, or the Federal Government, or Wall Street. Because we've seen what they're doing. We see who they are really working for.

If we don't trust, then we need to find a different path than conventional strategies. You need to try some entirely different strategies, and the path to those strategies is education. The first step down that educational path is to come to understand what the Federal Reserve and Wall Street already know quite well, even if the general public does not. Inflation does not destroy wealth for a nation as a whole. Inflation redistributes wealth within a nation. And if we have a massive round of inflation what may very well happen is that most of the country does indeed lose most of its wealth - but it's crucial to understand that wealth is not destroyed. Instead, the wealth is redistributed to a smaller group within the country.

Do you know how that works? Think you should?

Read widely. Find new sources. Explore new concepts. Challenge your assumptions and beliefs. The world is not a fair place, and strategies that appear to be safely in the mainstream might only bring victim status.

Would you like to find practical solutions to the issues raised in this article? Find out how to position yourself to benefit from insider bailouts and reckless monetary creation? Do you want to know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation - the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? These are among the many topics covered in the free "Turning Inflation Into Wealth" Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at DanielAmerman.com or InflationIntoWealth.com.