The Bazooka That Doesn’t Kill

The chairman of the Federal Reserve and the President of the European Central Bank, arguably the two most powerful men in the world right now, have done what many people had been asking for—fire the monetary bazooka that will supposedly obliterate the four-year economic crisis. In Europe, Mario Draghi announced he would buy unlimited amounts of government debt; in the United States, Ben Bernanke announced an open-ended purchase of mortgage-backed securities. Japan´s central bank followed suit a few days later.

The sad truth is that the bazooka will have the effect of a water pistol in relation to the economic crisis and create new problems later on. The real recovery—as opposed to the immediate euphoria reflected in the stock markets—depends on factors unrelated to what has been announced.

Those who pushed for a big bazooka in recent months seem to live in a different world. Their argument is that central banks were not doing enough. Actually, monetary expansion has been proceeding at a furious pace since the bursting of the bubble. The Federal Reserve has tripled its balance sheet, the ECB has doubled it and the Bank of England has quadrupled it. Europe and Britain are still in recession, while the United States is experiencing an anemic recovery at best.

The theory was that if central banks created all this money banks would lend more to households and businesses. But banks have piled the money onto their reserves. One can see this clearly in the case of the United States, where excess reserves (that is, reserves beyond the legal requirement) amount to almost $1.5 trillion. In the half-century prior to 2008, excess reserves amounted to almost zero.

None of this money has stimulated the credit markets because excess reserves have no relation to the money banks lend. In fact, the bubble was a result of an excess of credit in the economy in a period in which, as noted, there were barely any excess reserves at all.

The United States and Europe are suffering from too much, not too little, credit. In the United States, the total credit owed amounts to about $55 trillion, more than three times the size of the economy. Naturally, right now households are shying away from adding to their outstanding debts, companies are abstaining from investing much and banks are unenthusiastic about lending they way they used to. One can see this in the collapse of the velocity of money in recent years. People, businesses and banks are trying to cure the credit disease before venturing wholeheartedly into creditland again. No monetary bazooka will change this.

One would think a student of the Great Depression such as Bernanke would know this since a similar situation took place back then. In response to the Crash of 1929 and its aftermath, the government printed lots of money. Between 1931 and 1933, the monetary base (the sum of bills and bank reserves) increased by almost 25 percent. The idea was to get banks to lend more money. But people didn´t ask for it and banks didn´t dish it out. The Depression, as we know, lasted more than a decade. Throughout that decade, the banks´ excess reserves grew by a factor of 44 (they went from $150 million to approximately $6.8 billion.) Quite a bazooka. It did not kill or maim the Depression. At best, all that money served no purpose; at worst, it helped prolong the Depression (in conjunction with several other mistaken policies.)

The question today is what will happen with all this inert money once it receives the kiss of life—that is, when people start to ask for new loans, companies to invest and banks to lend at a normalized rate. Unless by then central banks have the guts to withdraw all this artificial money from the system (a political non-starter), we can expect…the mother of all price inflations.

Which is not to say there is no effect yet. The stock markets are disproportionately animated given the current state of the economy, the housing market is already experiencing price hikes and precious metals are becoming more precious by the second.