What Is Going on with the Fed? No, Not Anything Like What it Seems

6.5% unemployment or bust; until then, the money spigot is open wide. This was the gist of the Fed’s world-headline-grabbing announcement this week.

Less noticed was that, as the FT reported on the same day, “The US Federal Reserve is carrying out its first ever system-wide stress test of bank liquidity…” Translation: The Fed will be pushing bank reserve requirements significantly higher.

In other words, in the past week the Fed hurled, in succession, loose-money and tight-money hardballs — the first with a big public windup, the other almost slipped by — at the batter that is our economy. But, then, it’s a combination this pitcher has been throwing for four years now.

Not long ago I highlighted here at Ricochet economist Steve Hanke’s contrarian analysis of U.S. monetary policy. Hanke points out that even as the volume of “state” money (as he calls high-powered money or, roughly, M1) has ballooned the last four years, “bank” money (his term for lending in various forms) has stagnated under pressure from national and international regulators. With bank money making up 85% of today’s money supply (down from 93.5% in 2008), total monetary growth has languished at 7.5% below trend.

But why such rapid fire policy change ups? Elsewhere, I’ve argued that the Fed has been, and still is, muddling through two crises:

Four years ago, Fed Chairman Benjamin Bernanke and his colleagues were presented with two crises. The first was the collapse of the housing bubble. Brought on by the demands of congressional Democrats led by Rep. Barney Frank and then-Sen. Chris Dodd that banks become extensions of federal social policy, the housing bubble swept away tremendous volumes of bank capital when it burst. It wasn’t that this bank or that bank was too big to fail, but that a vast number of banks were suddenly capital deficient and endangered. By creating large volumes of “state” money while restricting the expansion of “bank” money, the Fed has spent the last four years, in effect, recapitalizing the American banking system.

In its current phase, the second crisis also began in 2008—the crisis in government debt and unaddressed entitlement liabilities. The media is full of talk about the fiscal cliff. Will we go over it? Will we not? But if you are sitting at the Fed (and working closely, as Bernanke has throughout his tenure, with the Secretary of the Treasury), you have to assume that, whatever the outcome of the current White House-Congress negotiations, the government’s unprecedented volume of borrowing will continue indefinitely. 

So, now, assume you are Chairman Bernanke.You ask yourself, “How do we finance all those deficits?” You answer, “What if we at the Fed print lots of ‘state’ money and buy the debt ourselves?” But then you think, “If we do that, how do we protect the nation from late ’70s-early ’80-style runaway inflation?” Then you think, “Bingo, we’ll clamp down on ‘bank’ money?”

How simple. Two crises, one solution. 

Here is how the Fed’s words and actions of the last couple of days add up. Mr. Bernanke sees both crises continuing indefinitely. Announcing that lowering unemployment is the goal buys him time with his most worrisome Hill and White House critics but doesn’t necessarily mean that “state” and “bank” money policies will move measurably relative to one another.

Bank capital will continue to build. The government will continue to be funded. Growth will continue to crawl.

So in assessing the Fed, our standard should not be, have they come up with great policy, or even particularly good policy? It should be, have they come up with the best bad policy under the circumstances?