Barataria: The Black Magic of the Federal Reserve

The actions of the Federal Reserve have an air of dark wizardry about them – they are mysterious, powerful, and use forces that appear to be a kind of magic.  The most powerful incantation is the often-muttered “Quantitative Easing”, a spell that has moved from the dark recesses of economics into the popular press.  What it means, in the end, is that the Fed literally conjures money from thin air and gives it to the US government to go out and spur some kind of economic growth.  Though this handy li’l charm is now being openly discussed the reasons why it has become so useful have not.

You want to see a magic act?  This is one helluva trick.  It’s showtime at the Fed.

The term “Quantitative Easing” is a term that is designed to obfuscate and deflect from the start.  It came to us from Japan circa 2001, a time when interest rates with the central Bank of Japan were at zero and the economy was still flat and busted.  “Quantitative” refers to a set amount of money, and “Easing” means relaxation of credit that is tight despite the low interest rates.  It differs from the usual policy in that it isn’t a broad policy but a fixed amount of cash.

Quantitative Easing is used when the economy is in a period of deflation or a serious risk of it.  Money, as we know it, is nothing more than “The full faith and credit of the Federal Reserve”, which is to say a bunch of something that can grow and contract along with the economy.  It’s simply a matter of faith and nothing more, subject to the laws of supply and demand.  If there is too much of this “money” floating around it is worth less and goods and services start to require more of it – prices rise and we call it “inflation”.  If there’s too little “money” around people want more of it and prices fall in the same way.

Deflation may sound like a good thing, but it’s far worse.  That’s why it requires dark arts like Quantitative Easing to take it on.  I’ll leave the explanation to Ben Bernanke, then a Federal Reserve Governor (and not yet Chairman) on 21 November 2002:

With inflation rates now quite low in the United States, however, some have expressed concern that we may soon face a new problem–the danger of deflation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation–a decline in consumer prices of about 1 percent per year–has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors. While it is difficult to sort out cause from effect, the consensus view is that deflation has been an important negative factor in the Japanese slump.

This is an important speech for several reasons.  For one, it dates concerns about deflation – the hallmark of a Depression – as early as 2002.  Another reason is that it sets out the terms of Quantitative Easing and when it is a critical tool for a central bank.  Lastly, this is the speech that earned Ben Bernanke the nickname “Helicopter Ben” for bringing up the ultimate way to stimulate the economy – dropping freshly printed money out of a helicopter:

A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman’s famous “helicopter drop” of money.

Not only does it make for a fun nickname, it’s a much better image than that of a dark wizard waving a wand with the strange moniker “Quantitative Easing”.

The Federal Reserve has, so far, purchased about $2 trillion in US government bonds using money that it more-or-less simply created on its own balance sheets out of thin air.  That money went forth and is supposed to be doing great things for the economy.  They will likely give us another round of Quantitative Easing, aka “QE2”, estimated to be about $1 trillion more, in the next few weeks.  The stock market is up on the joyous news that the Fed will do whatever it takes – even if some of us think it should be down on the grim reality that this is a tacit acknowledgment that we are in a lingering Depression, not a “Great Recession”.

Quantitative Easing is a simple yet powerful kind of magic.  It’s worth getting to know because it shoves big and arcane ideas like “economy” and “money” into an interesting new perspective.  It’s all about management, not something tangible and fixed.  When the principles given this charge have the allure of being dark wizards we live in less of a democratic republic and more of a strange pagan theocracy.  The more we know about the managers of our economic fate, the better.  It’s not that dark or that magic after all – at least not any more than we make it so by not paying attention.

This post was written by  Erik Hare and originally published on  Barataria. Follow him on Twitter:@wabbitoid.

Comments (4)

  1. Submitted by Bert Perry on 10/18/2010 - 08:11 am.

    Well, yes, deflation is a bad thing if….you’re a debtor, or one who depends for his livelihood on doing business with debtors.

    On the other hand, if you aren’t……sorry, we’ve gotten into this position, economically speaking, via Keynesian nonsense, and I’m going to have to suggest that the way out is to back out from that nonsense. The question is not whether it ought to be done, but rather how quickly it ought to be done.

  2. Submitted by Dan Landherr on 10/18/2010 - 02:31 pm.

    Robert Reich’s blogpost on Saturday 10/16 expresses his opinion that quantitative easing will likely just inflate another stock market bubble. Even the Fed says unless an across the board tax cut gets this money to people in the bottom 80% of income there will be little economic benefit because it will not stimulate consumption.

  3. Submitted by Erik Hare on 10/18/2010 - 03:24 pm.

    “All money is a matter of belief.”

    – Adam Smith (in “Wealth of Nations”)

    Having said that, our belief is being sorely tested lately. Dan, I agree with you – the Fed, to the extent they are agreeing amongst themselves on anything, is indeed trying to organize something just like what Bernanke called a “helicopter drop” back in 2002:

    “A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.”

    Hardcore stuff. Is anyone really going to tell me that this isn’t a Managed Depression?

  4. Submitted by Richard Schulze on 10/19/2010 - 06:28 am.

    Keynesians wish us to spend more, drive up debt, and then inflate it away. This taxes debt and property holders at the expense of the over-borrowed. The alternative is to allow the over-borrowed to declare bankruptcy, and write off bad debts, at the expense of bank shareholders (or the government if you’re Ireland). The Keynesians argue that theirs is the better alternative because the greater liquidity generated will jump-start the economy. In a purely macroeconomic sense, I’m sure that’s what the models say, but it continues the cycles of the last 30 years, where whenever the stock market plunges, shareholders are bailed out, whenever counter parties are threatened, banks are bailed out, etc.

    It is time to draw a line in the sand. If you borrow too much and you lose your gamble (whatever it may be), then you lose. The problem of one-sided bets extends well beyond financiers. We have to start allowing gamblers to lose when it is their time to lose, or there will only be more gamblers at the table whenever the next game starts. So balance the budget, and let people go bust. There will be pain either way, but we just might solve some underlying problems if we broke the cycle of bailouts.

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