Gary North

October 24, 2008

I have never seen anything like this. The adjusted monetary base over the last eight weeks has risen at 341% per annum. The increase in the monetary base is $300 billion

This indicates panic at the Federal Reserve. The financial system is coming unglued.

The monetary base is high-powered money. For every dollar injected here, the money supply can rise by at least 10 to one. A 10% reserve requirement is imposed on large urban banks, i.e., a 10-to-1 multiplication factor. This is the fractional reserve banking process. This is from the Federal Reserve's site.

The recession is pushing down the price of commodities. So far, the new money has gone to banks and financial institutions. They are not lending to businesses. They regard businesses as too risky. This is getting a lot of press.

These articles never mention the obvious: the banks can lend at any time. They make no money if they don't. They can buy Treasury debt. Central banks do. So can commercial banks. This explains why Treasury rates have not increased, despite the increase in the Federal debt.

The Federal government spends every dime it borrows. This money will flow into the economy by way of Washington. This money will not be lent to private businesses. It will not re-capitalize the country. How can it? It is not saved capital. It is fiat money.

If the banks are not lending at all, the monetary base sits there, ready to be used by the banks. At the first sign of economic recovery, they will start making loans. The money multiplication process will take over.

If this expansion of the monetary base does not stop, it will create mass inflation when the banks begin to lend (assuming they aren't lending to the government now).

To stop it later, the FED can sell assets to shrink the monetary base. Which assets? Toxic waste loans? Who is going to buy them? Who wants toxic waste assets in the any stage of the recovery? It can sell Treasury debt, but only until it runs out. It has a little over $450 billion remaining.

If the banks will not lend at all, then the FED is "pushing on a string." But why won't they lend? They are legally allowed to. Why borrow in the federal funds market if you have legal reserves? Yet banks are borrowing in this market. They borrow because they have no reserves remaining.

Banks can buy Treasury debt, which is liquid. The debt pays some interest. Something is better than nothing. Not to buy Treasury debt is to throw money away. Banks do not throw money away. Banks buy Treasury debt; the government spends it. Businesses seeking loans find that they must pay higher interest, because the Treasury gets the money. So, the government's share of the economy grows. This reduces productivity. An economy in a recession needs productivity to get out of the recession.

The fractional reserve process takes over. The money supply grows. We can see this happening now. Here are the latest M1 statistics. You can see that the figure is headed straight up after years of being flat.

Alert anyone you think should see this. Email this page. People can monitor these statistics free of charge on my site. Go to Federal Reserve Charts and Yield Curve, which are in the Free Materials section of my site.