Up until September, Federal Reserve Chairman Ben Bernanke effectively sterilized all his financial crisis-fueled monetary injections, either by directly trading Treasury bills for riskier financial securities or by indirectly loaning to financial institutions with money recouped by selling Fed-held Treasuries on the open market. Either way, there was no major impact on the monetary base. As a result, the annual rate of growth of the monetary base remained in the neighborhood of 2 percent through August, with total bank reserves remaining virtually constant.
But after September 17, when the interest on T-bills briefly went negative, Bernanke opened the monetary floodgates In August the monetary base had been $847 billion, with total reserves constituting $72 billion of that. (None of these figures are seasonally adjusted or adjusted for changes in reserve requirements.) A Fed press release on October 22 put the base at $1.149 trillion, a shocking 40 percent jump over the previous year. What has exploded even more is total bank reserves, where the base increase is concentrated. Reserves increased by an astonishing factor of five over the course of just one month, and as of late October were somewhere between $343 and $358 billion.
And that's not all. Federal Reserve Bank credit also doubled to around $1.8 trillion. Although Fed credit once closely mirrored the monetary base, that is true no longer—not since the Fed activated its U.S. Treasury supplementary financing account in the fall. This boosted additional Treasury deposits from zero to approximately $560 billion. The new deposits resulted from what the Treasury calls its Supplementary Financing Program, initiated in September to try to staunch the growing demand for Treasury securities manifested in falling T-bill rates.
Essentially, the Treasury is now issuing extra securities to borrow money from the economy, then loaning the money to the Fed in these special deposits so that Bernanke can re-inject it to make his bailout purchases of various securities, all without increasing the monetary base. In other words, what the infamous bailout act permitted the Treasury to do directly is something it had already started doing indirectly through the Fed to the tune of half a trillion. All in the name of easing a tight Treasury market.
This means that the total bailout is not the $700 billion that Congress appropriated, but at least $1.2 trillion. And that figure doesn't include the Fed's mid-October promise of $540 billion to bail out money market funds, which if not covered by the Fed's sale of other assets, will require either further monetary increases or further Treasury borrowing. Thus we now have the worst of both worlds: a massive bailout financed both by Treasury borrowing (in order to avoid inflation) and a Federal Reserve increase of the monetary base (which heralds future inflation anyway).
Of the $1.2 trillion increase in federal government borrowing, at least half took place within the space of a month. This sudden 25 percent increase in the outstanding national debt qualifies as the most dramatic peacetime experiment in fiscal stimulus the U.S. government has ever implemented. If Keynesian theory were correct, the economy should have been well beyond the reach of any potential recession by the end of October. But how many economists are going to acknowledge this striking empirical refutation of the fiscal policy they hold dear?
This enormous increase in government debt may at least partly explain the sudden stock market collapse after the bailout passed. Government borrowing represents a future tax liability, and expected future taxes affect the value of equities. Some argue that this new borrowing may not increase taxes at all because it merely finances the purchase of earning assets that the government can later resell. While that's certainly possible in the long run, no one knows the true value of those assets in the short run. After all, the market's anxiety about their worth was the justification for the bailout in the first place. So now the government is transferring that uncertainty from private financial institutions to the taxpayers.
Meanwhile, there will be a lag before the broader measures of the money supply feel the effects of the Fed's money bomb. The year-to-year annual growth rate of M1—currency in circulation plus checking accounts—had already risen from 0 percent to over 7 percent as of late October, whereas that of M2 (M1 money plus other types of deposits and most money market funds) is up slightly from 6 to 7 percent. But as centuries of experience has shown, an increasing money supply will inexorably lead to increasing inflation.
Bernanke is betting that he can reverse the process before inflation gets out of hand. But that will require the Fed dumping billions worth of securities it has recently purchased back on the market. It is anybody's guess when Bernanke will judge that the financial system is sound enough for him to do so. All the emergency initiatives of both the Fed and the Treasury since the subprime problem first emerged have not merely proved stellar and consistent failures. As Anna Schwartz, Milton Friedman's esteemed co-author, and other economists have suggested, the thrashing about of Fed and Treasury policy has undoubtedly made the financial situation worse. The prospects do not look promising.
Jeffrey Rogers Hummel is an economics professor at San Jose State University and the author of Emancipating Slaves, Enslaving Free Men: A History of the American Civil War (Open Court).