Understanding Bernanke

July 2, 2008

If skyrocketing food and oil prices point to inflation on the rise, then why has the Fed risked even more inflation by lowering interest rates so much since last Fall? That’s a popular question these days. And one that’s hard to answer without knowing how the Fed works.

The trick to understanding the Fed is to have a basic understanding of inflation itself.

Generally speaking, inflation is considered to be an increase in the price of goods and services over time. One cause of higher prices is an increase in the supply of money relative to the amount stuff money can buy.

Say, for instance, the government decided to give every American citizen a million dollars tomorrow. Everyone would race to spend their windfall and prices would move upward as a result. No one would be any wealthier in terms of the AMOUNT of goods they were able to purchase. People would just have to pay higher prices for the same stuff they buy every day.

More money => higher prices = inflation.

So more money causes inflation. But what is money and where does it come from?

Defining “money” is tricky. The government has multiple definitions, all of which are considered inadequate by some. One way to conceptualize money is to think of it as anything that can be used to buy goods and services. Cash is money. So are the deposits in your checking account, which can be spent via checks and/or debit cards.

Now consider that the source of the money in your wallet or in your checking account may be more than simply your weekly paycheck. The source may be a line of credit. The bank can give you cash to spend today (via a home equity loan, a student loan, etc.) so long as you agree to pay it back in the future.

Banks literally create money this way. Say you deposit $1000 in the bank with your next paycheck. The bank is required to keep only 10% in reserve and is free to lend the remaining 90%. That means the bank can lend $900 of your money to someone else. And what happens to that $900? It will likely end up as a deposit in the borrower’s bank account. His bank, required to keep only 10% in reserve, may lend $810 to another borrower. The process continues until no more money is available to lend. In this way, your $1,000 deposit in the bank is turned into $10,000 of total money in the economy. (For those interested, additional reading here and here)

U.S. GDP is driven almost exclusively by the “spending” of households, businesses and the government. And much of that spending is driven by whatever supply of money is created by banks. If banks supply the economy with too much money, the result is inflation. The housing bubble of the last five years is a perfect example. Banks supplied too much money to buy homes, and rapid house price inflation was the result.

Why would banks choose to supply more or less money? The biggest reason is whether they can lend money profitably. A bank’s revenues are driven by the interest rate they charge borrowers, 7% on a mortgage for instance. A bank’s costs are driven by the interest rate that they pay depositors, 2-3% these days. If the interest rate paid to depositors declines relative to the interest rate received from borrowers, then the bank makes more money and will be encouraged to lend more.

Summing up: a growing money supply is responsible for inflation, banks increase the supply of money based on the profitability of lending, which is largely driven by the interest rates they pay depositors. Therefore, he who determines interest rates has immense power to inflate or deflate the economy.

“He” is Ben Bernanke, the Chairman of the Federal Reserve Board of Governors.

If you’ve understood all of the above, you may have arrived at the question that is perplexing the Fed’s critics: why in God’s name is Ben Bernanke lowering interest rates, encouraging banks to feed more money into the system, when inflation (as seen in food and oil prices) seems to be accelerating?

Well, a big reason is that, when thrown in reverse, the money supply cycle detailed above ends up destroying money far more quickly than it was ever created. Recall the math: with a reserve requirement of 10%, banks need $1000 on hand for every $10,000 in loans created. If the bank loses $1000 (because a subprime borrower defaults on his mortgage, for instance), then the bank has to take $10,000 out of circulation.

This is the fundamental problem facing the American economy right now. Borrowers are defaulting on all sorts of debts at increasing rates. Home loans. Student loans. Auto loans. Credit cards. And, as the WSJ is reporting today, construction loans.

With all these bad debts collecting on bank balance sheets, one would think banks would be in no position to inflate the economy with more lending. Paul Kasriel, Chief Economist at Northern Trust, has published multiple reports over the last week demonstrating this fact.

Most interesting was chart 1 to the right, published in his report two days ago. That sudden and rapid decline seen all the way to the right shows: “the sharpest 13-week contraction in bank credit” since data were first available in 1973. Banks simply don’t have the capital on hand to avail “themselves of the cheap credit the Fed is offering to fund them at.”

This is what it means to be in a “credit crunch.” Banks have suffered hundreds of billions in losses, forcing them to pull credit out of the economy. Every time you read an article about banks cutting credit lines, exiting lending businesses, or eliminating mortgage products it represents more bank credit drying up.

Sure enough, as shown in this second chart that Paul published last week, the decline in bank credit corresponds to declining growth in the money supply:

As noted above, the amount of money in the economy available for spending is one of the chief determinants of economic growth. To the extent that money is rapidly drained from the system, through a credit crunch for instance, then the economy can experience a painful deflationary spiral that leads to recession (or depression). Bernanke is one of America’s foremost scholars of the Great Depression and is thus acutely aware of the economic risks posed by a rapidly deteriorating credit environment.

This is why Bernanke has lowered rates aggressively since last Fall despite inflationary pressures from rising oil and food prices. As he stated multiple times, he believed the risks of recession “outweighed” the risks of inflation.

Unfortunately, lower interest rates may do little to cushion the blow of the credit crunch. Despite cheap funding offered by the Fed, bank credit is declining rapidly.

And just because the domestic money supply is under pressure doesn’t mean that the global money supply can’t expand. Bernanke’s low interest rates encourage foreigners to sell their dollar holdings, putting them into circulation. See, for instance, the rapid flow of capital out of dollars and into Chinese Yuan. This is putting immense downward pressure on the value of the dollar, increasing prices for commodities priced in dollars.

The bottom line is that Bernanke inherited a VERY sick economy from Alan Greenspan, whose low interest rate policies earlier this decade encouraged a cycle of excessive, imprudent lending that led to the economic hangover we’re suffering today.

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