18 Dec 2009

Wenzel Flips?

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A few readers want to know what I think of this provocative post by Robert Wenzel, in which he says Bernanke conned a bunch of us (bold mine):

This is big. It is going to knock for a big loop all those concerned about the inflationary consequences of the soaring monetary base. The Federal Reserve Bank of New York today released a report, “Why Are Banks Holding So Many Excess Reserves?”.

Fed economists Todd Keister and James McAndrews state that while the high level of reserves in the U.S. banking system during the financial crisis reflects the large scale of the Federal Reserve’s policy initiatives, it conveys no information about the effect of these initiatives on bank lending or on the level of economic activity. This is another way of saying what I have been saying right along, watch the money supply, not the monetary base.

Keister and McAndrews explain that the buildup of reserves in the banking system is a by-product of the liquidity facilities and other credit programs introduced by the Federal Reserve in response to the crisis. They also discuss the importance of paying interest on reserves when the level of excess reserves is unusually high. But the key point they make remains that the majority of the newly created reserves end up being held as excess reserves and, therefore, the data on excess reserves provide no useful insight into the lending decisions and other activities of banks. Got that? The trillion dollars sitting as excess reserves has had no impact on the economy, and as the Fed stops it’s emergency facilities, it is going to be drained. The trillion never went into the economy and never will.

If Keister and McAndrews are correct, and I believe they are, then the Fed will have little problem in ending its emergency lending facility activities. The banks by maintaining those funds as excess reserves (for whatever reason, even if it is simply to earn interest) have in reality kept those funds out of the economic system. As the Fed ends its liquidity emergency facilities they will have to pay back the borrowed funds.

The alarmists, who have thus pointed to the surge in the monetary base as a sign of soaring Fed monetary “easing” and who have been shouting about the inflationary consequences, are going to go into cardiac arrest once they see the monetary base crash when the Fed winds down its emergency facilities and the banks use the excess reserves to pay back the facility funds. The super-decline in the monetary base, as was the super-increase in the monetary base, will of course mean nothing relative to the actual money supply, which is where one should have been keeping one’s eyes all along.

In a way Bernanke played a huge shell game on the global financial world. All the so called easing never happened. Let me repeat, what was touted by almost every economist in the world as the extremely loose monetary policy, didn’t happen. The money never entered the system. It was a bluff. Bernanke has set us up for Crash II and few see it coming. I wouldn’t want to play poker against him.

So here are my quick reactions:

(1) I think those Fed economists are wrong. I think we are going to get big-time price inflation, and when we do, people will look back at those who were blowing off a tripling of the monetary base in a little more than a year and think, “Wow, that’s as inconceivable in hindsight as the people who said we weren’t in a housing bubble.” And incidentally, two of the people who said we weren’t in a housing bubble were Fed economists at the height of the boom. How do I know? Because Robert Wenzel told his readers about it.

(2) It’s true that Wenzel was the first guy I saw who was warning that Bernanke had put the brakes on M1 and M2 growth back in March or so. But it was also Wenzel who taught me that the Fed won’t be able to simply reverse its injections of reserves, because the assets it purchased on the way up won’t fetch the same price on the way down. I.e. the Fed can’t simply reverse its actions and “suck the liquidity out of the system,” because it may have seriously overpaid for a bunch of the MBS, Freddie and Fannie debt it added to its balance sheet.

So I don’t view the Wenzel quotation above as a shot against me; if it is, it’s only because of views that I literally learned directly from Wenzel himself.

(3) One final thing: I am going to be really peeved if everything I have been saying turns out true–namely that those excess reserves start finding their way out into the hands of the public (through various mechanisms we have been discussing on this blog), and then when price inflation breaks 10% Wenzel says, “See? M2 is up 28% year-to-date. A lot of economists were flipping out last year because of the huge monetary base, but only EPJ readers knew that the monetary base wasn’t the story, M2 was. You need to read my blog to know what’s up.”

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