Fed’s Magic Money exit plan to create 35-year drag on economy

Unlike most of our economic policy decision agencies, the Federal Reserve has a real balance sheet — one that is a reasonably accurate reflection of the central bank’s financial position at a specific point in time.

The Fed’s current (July 26) balance sheet shows total assets of $4.465 trillion. That is a lot of money. Ten years ago, its balance sheet showed total assets of $0.915 trillion. Why did it grow so much and so fast? There’s a simple answer: “Magic Money” and distressed assets.

One of the economic policies adopted in response to the financial collapse of 2008-2009 was the creation of Magic Money. It worked like this: To get the economy rolling again, Congress would authorize the government to spend money it didn’t have. The Treasury Department would finance the deficit spending by issuing bonds to cover it. Then the Fed would purchase the bonds and hold them in its portfolio of assets, essentially taking them off the market. Everybody was happy, and the economy slowly recovered — instead of dragging us down into another 1930s-like Great Depression.

There’s nothing really magic about magic money, except that it resembles a parallel universe theory of finance that allowed Congress to spend money it didn’t have and park its debt in a universe that didn’t have to face a financial market’s reality check.

The Congress that was face to face with the Great Recession was not the first legislative body in our history to confront disaster. The Continental Congress faced a similar financial crisis during the Revolutionary War. The army was on the brink of collapse. In desperate need of food, ammunition and clothing, it was being held together by respect for its general, George Washington. But even that respect, which was formidable, could not stand up forever against bitter cold and soul-draining hunger.

The Congress, though, had no money. So, the choice came down to giving up the Revolution — and probably being hanged by a vengeful king — or spending money it didn’t have. And since there was no central bank like the Federal Reserve to help by covering their deficit, they took the only remaining option and printed up the new money they needed, keeping the army, and the Revolution, alive.

Magic Money didn’t solve the other half of the Fed’s problem, though. The Wall Street collapse had left the nation’s banks in a sorry state, unable to finance an economic recovery. The Fed decided to purchase the banks’ distressed assets — their mortgage-backed securities. There was essentially no market for these securities at the time, and they exerted a drag on the commercial banks’ financial health. Selling them to the Fed cleaned up the member banks’ balance sheets and give them a fresh start.

Indirectly, the Fed’s purchases, by creating member bank reserves, injected liquidity into the system, which allowed the banks to make loans and kept the economy’s wheels from locking up.

Recently, the Fed announced that it would begin winding down its balance sheet, probably starting in December of this year. The question for us is whether we should prepare a cake that says “Fond farewell, from a grateful nation” “or “Close the door on your way out.”

Any honest evaluation of the Fed’s two-part program should bear in mind the “you had to be there” guideline. As the financial crisis deepened, our central bank faced a problem that was as grave in its own way as that faced by the Continental Congress. Our founding fathers decided to save the Revolution and accept the cost of debasing the currency. At least they would be dealing with that cost as an independent nation, not a vassal of a distant king.

In a similar way, facing financial abyss, our current Federal Reserve chose to risk its credibility — and that of the nation’s — by holding Treasury debt and mortgage-backed debt securities in its pocket … with the idea of releasing them, gradually, to the open market when the economy had recovered and could absorb them.

So far, the magic money and the distressed assets programs seem to have worked. The fears of magic money’s early critics — that it would encourage Congress to spend money it didn’t have — seem justified, though. There’s still nearly $2.5 trillion of the program’s Treasury securities on the Fed’s books along with the $1.77 trillion in mortgage-backed securities.

The Fed’s exit plan calls for selling off the assets of both programs gradually at first, at $10 billion a month. The problem is that the $10 billion a month creates a $120 billion drag on the economy every year … for the next 35 years.

Was it worth it? Undoubtedly. But the farewell cake will be a modest one.

James McCusker is a Bothell economist, educator and consultant.

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