Last week, the Federal Reserve announced that it would buy a little more than $1 trillion of Treasury bonds as a means to revive the economy. This is such a challenge to the conventional wisdom that many people -- even those who ought to know better -- have made it sound as if there is something nefarious going on. For example, the usually very sober Edmund Andrews, a NYT business columnist, described the Fed's policy as "a tactic that amounts to creating vast new sums of money out of thin air" and "using its authority to create new money at will." Yes, it is. On the other hand, that's always the essence of money creation. The current situation is dire, and the Fed is responding (finally) in an appropriate way. Here, I'll briefly explain the process and then discuss the merits of the Fed's move.
The Fed is the central bank of the United States. (It is called the Federal Reserve rather than the Bank of the United States because of political opposition to centralized planning.) When it wants to change the money supply, it either buys or sells government bonds. Even though the Fed is a federal agency, for accounting purposes it is not a part of the government that issues bonds. If the Treasury (not the Fed) needs to borrow money, it issues bonds that private individuals, businesses, state and local governments, and foreign governments buy from the Treasury. Doing so leaves the money supply unchanged, because the Treasury borrows dollars from someone else and spends those same dollars on, say, park rangers' salaries. When the Fed buys Treasury bonds, however, it does so by using its authority to create new money. It sends a check (backed by itself) to Treasury, which uses the new funds to finance its deficit. When the Fed sells back some of the bonds that it has previously purchased, that decreases the money supply by pulling dollars out of circulation.
Usually, the Fed makes its bond buying and selling decisions as part of a strategy to influence interest rates. Lately, however, the economy has been in such terrible shape that the interest rate most responsive to Fed policy is essentially zero and cannot go any lower. The Fed understands that the economy needs more spending, so it is buying bonds -- creating new money out of thin air -- in the hope that people will spend the money on goods and services. Again, this is not some kind of conspiracy. Every modern economy works this way, with central banks creating new money all the time.
Based on conversations I've had recently with non-economists, one of the things that people seem to have absorbed from their long-ago Econ 101 class is that money creation must be inflationary. This has intuitive appeal, because otherwise why would we not just print money at will? The fact is, however, that the connection between increased money supply and increased inflation is anything but certain. Two other variables (beyond money supply and prices) are involved: how many times each dollar is spent and re-spent on new goods and services ("velocity") and how many goods and services are being created.
Consider the latter: If someone shows up at a store with an extra $100 and the store does not have an extra $100 worth of merchandise, then the store owner will raise prices. If, on the other hand, the store owner has unsold merchandise sitting on shelves, they'll be glad to sell those goods without raising prices. In other words, in a weak economy it is highly unlikely that new spending will tempt suppliers to increase prices. (The velocity of money has been the topic of countless dissertations and research articles. Suffice it to say that velocity does not act in a way that guarantees a direct link from money creation to inflation.)
Could the Fed's injection of new money lead to inflation later? Sure. If the economy recovers, at some point there will be upward pressure on prices. If we reach that happy place, though, the Fed can then drain money out of the economy (by selling Treasury bonds), which is the appropriate monetary policy to fight inflation.
The new question that people are raising about the Fed's money creation activities is whether the Chinese government will be angry. Because it holds a large amount of U.S. Treasury bonds, the Chinese government has an interest in the value of those assets. If U.S. policy would undermine the long-term value of holding assets denominated in U.S. dollars, that would be bad for China's finances. The Chinese government should be worried, then, if either (1) the U.S. is about to engage in inflationary policy, or (2) the U.S. will be less likely to pay its debts in the future. With the biggest concern currently being whether we're going to slip from recession into depression and deflation, the first concern is simply not credible.
Just as importantly, a strong U.S. economy is better able to support its debt payments than is a weak U.S. economy. (If you have lent someone money, you'd be reasonably worried if the borrower lost her job.) China has a strong interest in the U.S. coming out of its severe contraction, which means that -- far from being angry with us for adopting an expansionary monetary policy -- they should be happy that we are trying to speed up our recovery (which would, coincidentally, revive U.S. demand for China's exports).
It is understandable that people mistakenly equate "printing money" with inflation. Thankfully, however, it is not that simple. The Fed's policy is counter-intuitive, perhaps, but it makes sense for the U.S. government and its creditors.
-- Posted by Neil H. Buchanan