Question:

When the Fed increase the money supply (by buying securities in the open market) what is the source of funds used to pay for the securities purchased? Is there any link with government budget surplus(the gov just have a surplus and pumping it into the economy) or it just print the money from nothing? When the gov can/can not print money ? As I heard that government can not print money just like that, and in the same time money circulating in the economy now is much different than those 20 years ago, so what are the regulation behind printing money? When the American government studying pumping 800 billions into the economy does it make a difference if those funds were borrowed or were previously collected from taxes or just being printed from nothing , the result in all cases stimulating the economy accompanied with some sort of inflation. Where I am wrong ?
Hesham Menshawi, Ernst & Young

Answer:

Jim Haughey: Yes, It does make a difference where the money comes from to fund economic recovery. Borrowed money initially raises credit costs and will eventually raise inflation if it is not spent on something that people voluntarily want to buy. Printed money initially cuts credit rates but is also a long term threat to stable prices if it is not spent on something people voluntarily want to buy. Whether borrowed or printed, additional government spending crowds out private spending. We should worry more about how much the government spends — and what it spends it on — then where the money comes from. Twenty-eight years ago in an even more troubled economy, the government borrowed to finance tax cuts which led to additional private jobs that were sustained because the new employees produced goods or services that people wanted to buy. The government did not have to continue borrowing to support the jobs. Today, the plan is to borrow to finance public jobs and public investments that will not quickly, if ever, produce anything that people voluntarily want to buy. So the jobs will be lost when the two year appropriation is exhausted without additional borrowing.

Some of the money now being spent is being borrowed by the US Treasury Department and various Government housing finance agencies and some is being printed by the Federal Reserve board. The $750 B in bailout money (half now spent) was borrowed by the Treasury from other countries and from the US private market. This has gotten all of the headlines but a much larger amount has been borrowed by the housing finance agencies. This includes Freddie Mac, Fannie Mae and the Federal Housing Administration (FHA) which all originate and buy residential mortgages.

The Federal Reserve Board has also lent far more than a $T. A small share of this was “money on hand” since the FRB earns huge profits from investing interest free deposits that banks must legally keep with the Board and from its check clearing operations. But most of the FRB lending was “new” money that it created by giving borrowers a credit to their account. This is exactly what commercial banks do but the FRB does this without adding to its reserves as commercial banks are required to do.

The huge amount of government borrowing has not raised interest rates because private loan demand contracted substantially in line with much reduced purchases of inventory, capital equipment, homes and motor vehicles. But eventually the government borrowing will force a rapid rise in credit costs when private loan demand revives. Similarly, the printed money has not yet caused a rise in inflation (more money without more items to buy). A rapid rise in inflation will eventually result when panic inventory liquidation stops forcing down prices.

The consequence of the massive increase in government spending will be a somewhat more cushioned recession, an initially faster recovery but beyond 2010 a long period of expensive credit, above average inflation and sluggish economic growth. It could be the 1970’s all over again.

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