Can the Fed create money?

I’ve been arguing recently like others that QE2 isn’t really creating new banking money. Yesterday Ben Bernanke was interviewed and said the following (video skip to 19:00 mark) (h/t Pragmatic Capitalist):

What the purchases do… is… if you think of the Fed’s balance sheet, when we buy securities, on the asset side of the balance sheet, we get the Treasury securities, or in the previous episode, mortgage-backed securities. On the liability side of the balance sheet, to balance that, we create reserves in the banking system. Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed. Now the question is what happens the economy starts to grow quickly and it’s time to pull back the monetary policy accommodation. There are several tools that we have…: [he goes on to describe the use of short-term interest rate on reserves].

I generally agree with Ben Bernanke but with a small distinction: while QE isn’t creating money, it’s artificially maintaining an illusion that there is money, than there would otherwise be. Specifically, it’s forcing savers to invest in places that we would not otherwise invest because they are not really increasing real wealth productivity.

I view banks not as creator of money, but as intermediaries that lend credit to money so it becomes more easily acceptable: they liquify money rather than create it. The only reason we need banks is that we do not have an alternative decentralized infrastructure to efficiently liquify money created by the private or public sector. Efficiency here is measured in how low discounting cost of liquifying money is.

As Hyman Minsky said, “creating money is easy, the hard part is getting it accepted”. In other words, a private party – say a private business like a farm – can create money simply by issuing vouchers for their products/services, as is the case when a farm issues vouchers as part of a Community Supported Agriculture program. They don’t need anyone to create these vouchers, they only need confidence they can do good on their promise. The problem is that these vouchers are not easily acceptable because the cost of evaluating the ability of the farm to do good on their promise, and actually deliver the goods/services is high. Banks merely reduce that cost buy swapping these vouchers with assets that are more creditworthy, specifically claims on their own balance sheet. These claims are more easily accepted because 1) there are claims on a diversified portfolio of assets 2) because regulated banks promise to convert these claims in Federal reserve notes on demand.

The past 10 years have provided great empirical evidence that banks and the Fed are not necessary to create money: the shadow banking system created a ton of money by taking promises from the private sector, liquifying them by turning them into tradable assets via mortgage-backed securities, assigning good rating to them, so they would become acceptable in transactions, effectively turning them into money. These should have evaporated.

What the Fed is merely doing is artificially propping up the value of these debt-based assets to levels that they would otherwise not have. But they are not creating new money, they are just trying to keep the level of money in the economy at least constant or increasing.

Of course, this isn’t without issues. The main problem I see is that these actions are distorting capital allocation decisions. They give incentives for capital holders to allocate capital to assets that they would otherwise not invest in.

Real money should only be created when wealth productivity increases: for instance a farmer becomes more efficient and sustainable at growing healthy food that naturally heals people. Conversely, it should be destroyed when we realize that the wealth productivity increase were fake, for instance a farmer using petrochemicals to artificially prop up production of food that’s causing cancers and destroying land.

What can you and I do?

If you are a short-term speculator, it is important to understand that you can’t fight the Fed. You have to go with their illusion-making but be extremely aware that “debts that can’t be paid, won’t”, which means that at some point, the illusion will drop, likely in a dramatic way.

It’s better to be an investor, which means focusing on investments that represent real wealth for you, your family and your community. These are different for each of us, but to me they start with healthy food, safe housing, access to health and energy, and building relationships with other likeminded “investors” in your neighborhood and in the world. For instance, consider investing in a local farmer, equipping your house with solar or wind energy or investing in a sustainable energy cooperative, learning to share resources, organize and co-create with your neighbors. I would also recommend investments in companies dedicated to true increased wealth productivity: efficient/sustainable farming like aquaponics, robotics, renewable energy, sharing and trust networks, biotechnologies. In the short-term, while shady assets are propped by, your returns may be disappointing, but when the illusion disappears, you will find yourself in a much better position.

Also, if you are a software developer, an angel investor or venture capitalist, you need to invest your talent and capital in the Open Banking infrastructure i.e. the infrastructure that will facilitate the creation of liquid money within and across communities with similar values. This is critical to lessen the power of the Fed to artificially prop up assets that most of us pay for, but which create no tangible value to us.

[This is not an investment advice]