Wall Street pundits are quick to criticize the Federal Reserve for being either too “tight” or too “easy.” These terms refer to a Fed system that attempts to increase or decrease the money supply — by manipulating the federal funds interest rate — in order to influence the economy and inflation. In terms of the economy, the Fed believes it can sway the growth of consumer purchasing power — due to borrowing — in order to spend. Lower interest rates are thought to encourage both borrowing and credit expansion.
Now that the Fed has cut the target funds rate from 5.25 to 3 percent — a reaction to fears of an economic slowdown — the critics are out in force. The Fed, they say, has reverted to the easy-money days of the post-Y2K slowdown, when the stage was first set for the mortgage-market meltdown. They also say current Fed policy is inflationary, and to make their point they dust-off a decades-old analogy: Rather than merely tinkering with his various policy levers, they say the Fed chairman is out flying his helicopter, dumping bales of dollars on the economy.
There’s a big problem with this analogy, however. The Fed chair, be it Alan Greenspan prior to 2006 or Ben Bernanke today, has never been granted a pilot’s license.
Economists point to the monetary base as the source of the Fed’s power to increase or decrease the money supply. The monetary base has two components: currency in circulation (i.e., money in peoples’ pockets) and adjusted bank reserves. Thus, if the Fed chair were dropping dollars from on high, the act would be reflected in the statistics. There either would be a rapid expansion in adjusted bank reserves or an increase in currency in circulation.
And yet, today, neither is the case.
The following chart indicates that while the Bernanke Fed has been lowering the funds rate, the monetary base as per bank reserves has been contracting:
Fed data also show that the currency component of the monetary base has been shrinking while rates have been coming down:
These statistics disprove the helicopter dollar-drop theory. They also offer little evidence that lower interest rates, or “easy” money, produce higher net spending. For every dollar borrowed in a lower-interest-rate environment, one dollar is saved. Thus, while lower interest rates may help borrowers spend, they reduce the spending of savers. Only to the extent that the propensity of these two groups to spend is different are interest rates expected to change demand.
All this is not to say that a dollar-dropping helicopter doesn’t exist. In certainly does, and standing at the ready are its pilot and co-pilot: the president and Congress.
When the U.S. gets in trouble, the government writes the checks. And when those checks are circulated the proverbial helicopter goes airborne and opens its dollar-dumping doors. Sometimes this is a good thing. Our pilot and co-pilot are to be commended for the several hundred billion they have thus far dropped on the Iraq and Afghanistan wars, and the $50 billion they marked for a targeted drop on the Gulf Coast regions devastated by Katrina and Rita.
There is, of course, the swing from a $200 billion surplus under Bill Clinton to a $500 billion deficit under George W. Bush. Either the government helicopter has been extra busy in recent years or Bush traded in for a bigger one. To be fair and accurate, however, increased government spending did contribute to rising output and productivity, and helped keep the economy growing for the balance of the Bush years. Inflation, it’s important to note, remained reasonably low in this time, while financial markets achieved record highs.
You may agree or disagree with the purpose of much of the Bush administration spending, and that’s fine. One pending helicopter dollar-drop that has drawn my rebuke is the Keynesian demand-side tax-rebate plan agreed upon by the president and Congress. It is designed to put “money in people’s pockets,” and that it will. But it will also produce larger deficits for no good reason. If you really want to stimulate greater economic activity, the supply-side is the best way to go: Lower tax rates across the board. Bush and Congress got this right in 2003. They blew it in 2008.
While your rebate checks are being written, however, at least you now have the answer to the ubiquitous helicopter mystery: Fiscal policy is the “culprit,” and the Fed is just along for the ride.