Money and Credit Post 2008

Part II of Money and Credit.  See Part I

Bernanke’s Fed upended traditional Fed operating procedures after the 2008 financial crisis.  Bernanke made his academic career as a Great Depression “expert”.  His belief that the GD was a monetary event the Fed could have prevented by flooding the economy with liquidity explains the Fed’s actions in the aftermath of 2008.  Understanding the actual cause of the GD is the defining economic event of the last century and drives everything that has happened in economics over the last 80 years.  The classical explanation for the GD, discovered by Jude Wanniski in his 1978 book, The Way the World Works, explains the continuing errant monetary and fiscal policy that still dominate economics today.  Mankind cannot reach its potential when destructive economic policy retards capital formation, ingenuity, risk, and growth.  Needless chaos and misery continues to afflict the global population from errant economic policy.  Economists default in their errant models to the give-up explanation of secular stagnation.

The significant and defining change to Fed operating procedures was the Economic Stabilization Act of 2008 that became effective on October 6, 2008 and allowed the Fed to pay interest on reserves, IOR.  Prior to IOR, banks held reserves at the required regulatory minimum.  The only exception was during the GD when banks temporarily held excess reserves amid the bank failure crisis.  Required reserves were a cost to banks and thus a minimal fraction of base money.  Therefore, almost all base money was currency in circulation.

Before IOR the Fed had direct control over the supply of base money relative to demand.  The Fed’s creation or removal of base money supply directly affected demand and hence the value of the dollar.  A rise in the price of gold POG above its optimum level immediately transmitted that base money supply exceeded demand.  Similarly, a fall in the POG below its optimum level signaled that base money demand exceeded supply.  This causation held regardless of whether the Fed was operating under gold standard or fiat mechanisms.  The gold signal did not end with the termination of the Bretton Woods international monetary system.

IOR distorted the traditional Fed operating history of base money that had held for 95 years.  With the introduction of IOR, the Fed created non-interest bearing debt which depository banks then loaned back to the Fed for interest payments.  Or another way to put it, the Fed created money out of thin air to pay depository institutions, many of which are U.S. subsidiaries of foreign banks, not to lend.  The previous minimal required reserves exploded into massive amounts of excess reserves along with the value of assets on the Fed’s balance sheet.  

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What is the point, you may ask?  IOR allowed the Fed to enact its liquidity flood without runaway inflation.  In the immediate aftermath of the 2008 crisis, the Fed bailed out banks, corporations, government agencies, Insurance providers, mutual funds, money markets, and other central banks by buying assets or supplying liquidity to everything under the sun with newly created credit and liquidity programs.  The Fed then moved on in subsequent iterations of QE to manipulating interest rates across the yield curve.  The Fed bought selected treasuries and mortgage securities, drove interest rates to the zero bound, and paid banks IOR to sit on the excess liquidity.  Today, $2.24 trillion of base money remains locked out of the economy as excess reserves.   

Result of the Fed Liquidity Flood

The first result of the Fed centrally commanding markets was to prop up financial entities and corporations that should have gone bankrupt.  There is an argument to be made for the Fed acting as lender of last resort in a financial crisis, but the Fed has to balance it against market forces.  Bankruptcy forces capital to its most productive use.  It’s a market cleansing mechanism.  While it is painful in the short run, it is necessary for sustained long-term economic growth.  Capital diverted to insolvent, poorly managed entities comes at the expense of capital that could instead fund new, productive enterprise.  The economy suffers in the long-term.  The entrepreneur spirit that defines America derives from bankruptcy laws that give failure a second chance.  Bankruptcy allows entrepreneurs to start over and attract new capital rather than being permanently burdened with past failure.  The market should determine these risks, not a handful of Fed bureaucrats who emerge from the sheltered confines of academia without any real world experience.

The Fed then set about manipulating the price of interest.  This is Keynesian theory to stimulate aggregate demand.  With Fed manipulated lower interest rates, consumers will refinance their mortgages, reduce credit debt, and splurge with the savings.  Somehow the act of circulating money of declining value without regard to production is the road to economic nirvana.  Or so demand-side theory posits.  Venezuela is demonstrating the real world result.  

Neglected in the demand-side model is that economic growth comes from the producer not the consumer.  The propensity to consume is unlimited and requires no incentive.  Economic policy that incentivizes the producer by lowering barriers to production enables growth.  Stable money and low taxes is the simple, magic policy formula.  No signal is more important to the exchange economy than the price of interest.  By distorting the price of interest, the Fed distorted capital allocation.  Capital flowed to bond issues, stock buybacks, and financialization—the hypertrophy of finance—rather than the productive economy.  This shrunk investment timelines from the future to the present.  M&A activity, powered by access to virtually free money for those connected, became ascendant over IPOs, which dried up and disappeared.  Corporate, established enterprise with access to distorted capital thrived while savers, pensioners, wage earners, and the vast productive class fell further behind.  The inequality gap, that economists and politicians scratch their head in befuddlement over, widened.


The Fed now sits on a $4.44 trillion balance sheet with $2.24 trillion of excess reserves.  It cannot be stated enough that the only purpose of excess reserves is for Fed manipulation of markets through interest rate control and the propping up of entities that were previously insolvent.  Regardless of how excess reserves are categorized—loans to the Fed, credit, money, interest bearing debt, or non-interest bearing debt—they are liabilities of the Fed.  They are base money that the Fed created out of thin air and must remove to achieve normalization.    

There is no firewall between excess reserves and currency in circulation or reserves that back new loans.  Excess reserves become currency in circulation or back loans when demanded.  This is the real danger for future runaway inflation until the Fed normalizes.  Fed regulatory control over depository institutions combined with IOR—it’s free money—has kept excess reserves within the Fed’s indirect control.  The Fed is not tightening with funds rate hikes because the Fed is still rolling over maturing securities and maintaining its balance sheet at $4.4 trillion. As long as this policy remains in effect, funds rate hikes do not tightened.  Funds rate hikes are theater to show that the Fed can still raise the funds rate despite its distorted balance sheet.  The POG today is $185/oz higher than when the Fed began its series of “pretend” tightening funds rate hikes on December 16, 2015.  The only real factor, besides affecting interest rates tied to the funds rate, is that the Fed pays more IOR and increases the level of RRPs required to manipulate the shadow banking industry rate in tandem with the funds rate.  

Despite the widespread economic confusion that seems to reign, this is actually pretty simple stuff.  It is no great mystery.  There is nothing new under the economic sun that has resulted in a new economic paradigm.   Devalued currency, the growth of government, protected classes, and high taxes are the constant cycle of economic decline.  The cycle has existed since the beginning of organized society.  It is an unnecessary cycle that advances in a trial-and-error process.  The ongoing 46 year monetary error from devaluation, money illusion, and central bank manipulation is a regressive, backward step in the cycle.  The world will have to find its way back to stable money to regain a sustained, virtuous economic cycle.  Economics, because it is a behavioral science, requires constant reinvention of the wheel.


  1. George Gilder

    Brilliant lucid exposition of the motives and effects of Fed policy. Thank you, Mike.

    1. Michael Kendall (Post author)

      Thanks George. It’s the scandal of money.


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