Money makes the world go ‘round, as the old saying goes. And central banks make money. The US central bank, the Federal Reserve, oversees the money creation process. That is a major power in its own right. But, thanks to its response to COVID-19, the Fed has become even more important. It is currently planning $2.3 trillion in asset purchases to soften the pandemic’s economic blow. Understanding what this means for economics and politics is crucial for all citizens.
Sometimes people say the Fed “turns to the printing press” to create money. Technically, that is incorrect. The actual printing presses are owned and operated by the Treasury. And, when the Fed wants to increase the money supply, it rarely turns to them. Instead, it creates money by adding electronic balances to the accounts of depository institutions that hold funds at the Fed.
You can think of the Fed as a “bankers’ bank.” Member banks of the Federal Reserve System hold reserves at the Fed. To expand the money supply, the Fed electronically increases the size of banks’ reserves. This shows up as an asset on banks’ balance sheets and a liability on the Fed’s. But the Fed doesn’t go around crediting and debiting accounts willy nilly. Instead, it credits (debits) accounts when it buys (sells) financial assets, typically government bonds, in transactions known as “open market operations.”
Or rather, it used to be. Since the 2007-8 financial crisis, things have changed quite a bit. As a result, the Fed’s focus has shifted from managing the money supply to directing the allocation of credit.
During the financial crisis, the Fed experimented with balance sheet policy. It took risky assets off financial institutions’ books and replaced it with cash. It also made a wide array of emergency loans.
Following the economic turmoil created by COVID-19, the Fed has gone even deeper into balance sheet policy, including some never-before tried programs: direct lending to small- and medium-sized businesses, as well as state and local governments.
While effective at stabilizing markets in the short run, the Fed’s policies have dangerous costs in the long run. First, the Fed’s policies almost certainly reallocate credit. If a business gets a loan from the Fed that it could not have gotten elsewhere, the Fed has redistributed purchasing power. And since purchasing power is used to acquire goods and services, the Fed has effectively altered the pattern of economic activity.
Reallocating credit is far afield of the Fed’s traditional mission. The Fed used to be focused on liquidity: helping markets by ensuring an adequate supply of money. Now it seems the Fed is no longer content to be a referee. It wants to be a player in the game.
The second cost is political. Much of the Fed’s post-coronavirus activities were authorized by Congress when it passed the CARES Act in March. But the legality of the Fed’s new activities offer little consolation. Congress is using the Fed to avoid democratic oversight of its usual taxation and budgeting decisions. If Congress wants to bail out a business or make an emergency loan, it should do so itself. Instead, it is trying to rope the Fed into becoming its fiscal policy agent. That undermines the Fed’s independence and, by diverting attention from its traditional role, makes the Fed less effective at conducting monetary policy.
Politically and economically, COVID-19 has pushed us into novel territory. We will be wrestling with the consequences of the virus for years to come. The change in the Fed’s mandate is not something we can afford to ignore. Its new policies come with significant economic and political costs. If we do not come to grips with them, the Fed might not be able to help much when the next crisis hits.