The following is excerpted from a commentary originally posted at www.speculative-investor.com on 23rd September 2012.

We've speculated in TSI commentaries that unwavering devotion to bad economic theory (a type of stupidity) is the most likely reason for the Fed's introduction of a new inflation program at this time. There are other plausible explanations, but in general terms it boils down to this: the Fed is either stupid, or evil, or stupid and evil. There is no fourth possibility that makes any sense. It is either evil enough to inflate the currency in an effort to help banks (or the re-election chances of Obama*) even though it knows that doing so will harm the overall economy; or it is stupid enough to believe that the economy can be helped by creating money out of nothing and distorting the price signals upon which an efficient market relies; or it is evil enough and stupid enough to believe that it can transfer wealth to the banks and simultaneously create a net benefit for the overall economy. We'll go with evil and stupid. The timing of the new policy was probably determined by the deteriorating employment situation, but the Fed may well be trying to kill multiple birds with a single stone. In any case, regardless of the reasoning behind the Fed's latest policy move, the Fed exists primarily to enable growth in the government and secondarily to enable growth in the banking industry. Growth in government is enabled because a government with a captive central bank will never run short of money, irrespective of how big its deficits become and how far into debt it goes. Growth in the banking industry is enabled because the central bank's unlimited power to create new bank reserves means that banks need never run short of reserves, irrespective of how reckless they are in their lending and borrowing.

It is clear from the following chart that the Fed has succeeded in its primary objective. The chart shows spending by the US federal government as a percentage of GDP from 1880 through to 2012. In 1880 the federal government spent about 3% of GDP. In 1913, the year the Federal Reserve came into existence, the federal government also spent about 3% of GDP. In other words, as a percentage of GDP there was no growth in the US federal government during the 33 years prior to the inauguration of the Federal Reserve. An ultra-long-term upward trend then began. Ignoring the war-related spikes during the late-1910s and the first half of the 1940s, there has been steady growth in the US federal government from 1913 through to the present. Currently, US federal government spending equates to about 24% of GDP. This means that since the birth of the Federal Reserve the cumulative increase in the size of the US federal government is about 700% greater than the cumulative increase in US GDP.

Chart Source: www.usgovernmentspending.com

Would a Republican victory in this year's US Presidential election reverse the upward trend in the size of the federal government? If history is a guide, the answer is no. In fact, over the past thirty years the size of the US federal government, as indicated by federal government spending as a percentage of GDP, increased by more during Republican administrations than during Democratic administrations. The Republicans often talk a good game (they pay lip service to smaller government), but in practice they are usually just as bad as or worse than their Democratic counterparts. One of the main reasons is that the Republicans are generally in favour of boosting the amount of money spent on the military. An increase in military spending is always politically easy to accomplish because most Americans are proud of their armed forces, but of the main areas of US government spending the most unproductive is the military. We are certainly not in favour of government spending on public works programs in an effort to create jobs, but it would be much better for the government to spend money building a bridge in the US than blowing up a bridge in the Middle East.

So, a Romney-Ryan victory in November would probably change the composition of the federal budget, but believing that it would result in a smaller government is an example of the triumph of hope over experience. Regardless of who wins in November, it's a good bet that the US federal government will be a bigger part of the economy four years from now than it is today. And as always, the government growth will be enabled by the Federal Reserve.

The extent of the Fed's success in achieving its secondary objective (enabling growth in the banking industry) is less easy to establish. This is because the big banks periodically go way too far and blow themselves up. The Fed then bails them out, either immediately and directly via the injection of new money or gradually and indirectly by manipulating the yield curve and altering regulations, but the periodic blow-ups mean that there hasn't been a consistent ultra-long-term upward trend in the banking industry relative to the overall economy. The US financial sector's performance has been lumpy, although it has still managed to grow from about 3.5% of GDP at the introduction of the Fed to about 8% of GDP today.

The bottom line is that we can speculate about why the Fed introduced a new inflation program at this particular time, but in the grand scheme of things it doesn't matter. A specific policy move by the Fed will generally be a reaction to recent economic data and short-term considerations, but the Fed doesn't exist for the purpose of fine-tuning the economy (although the current Fed chairman and governors may well be politically naive enough and economically illiterate enough to believe that it does). It is a tool that facilitates the growth of the government and the banking industry.

*In last week's Interim Update we outlined our reasons for thinking that the Fed did not act with the aim of boosting Obama's re-election chances. We also said that in the unlikely event that it did act for this reason, the move could backfire. An informal Facebook survey conducted by the Federal Reserve Bank of San Francisco underlines the possibility that the Fed's move could hinder rather than help the Obama campaign. As noted in a WSJ blog entry on 17th September, the Facebook survey indicated an overwhelmingly negative public response to QE3.

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