Originally published on January 20, 2012

Hello readers of the IIEP blog!  Since this is my first time posting here, let me briefly introduce myself.  I am an associate professor of economics and international affairs here at The George Washington University and an affiliate of the Institute for International Economic Policy (IIEP).  My specialty is empirical macroeconomics.  This means I get surprisingly excited about the new data we get from recessions – yes, someone has to be happy about recessions and that job falls to me. To be clear, recessions themselves don’t actually make me happy.  I definitely did not enjoy the last one here in the US and I don’t wish a recession on anyone.  However, the data we get from recessions, data that may help us to make better forecasts and policy decisions so that we can avoid recessions in the future, bring a certain twinkle to my eye.

One of my roles here is that I am IIEP’s resident Fed watcher.  Beyond actually being able to see the Federal Reserve building through the windows of the Institute, I regularly Google “Federal Reserve” and see what people at the Federal Reserve are up to and what the press and others are saying about the Fed.  After the excitement of the past few years I have recently reduced the frequency of my searches, having grown a bit weary of the Fed’s repeated forecasts of sluggish growth and promises of low interest rates until at least the middle of 2013. Yesterday, however, I thought to poke around a bit and found that in the flurry of academic activity at the end of the year I missed a major controversy.  Although the traditional comment period may have passed, I feel the need to blog about it – which brings me to my first IIEP blog post:

In my search for recent posts about the Fed I was drawn in by the clever title of the Daily Show’s “America’s Next TARP Model.” I enjoyed the part about the kitten known as Professor Butterscotch that was just about to get tenure – because he was an actual professor.  However, I did not enjoy the fundamental misunderstanding of the actions of the Federal Reserve evidenced in the piece.  In particular, under the video on the Daily Show’s website is the following caption:

“A Bloomberg report reveals that the U.S. government loaned banks $7.7 trillion in secret bailout funds at no interest and then borrowed the money back at interest.”

The first misunderstanding in this caption is that it was not the U.S. government who loaned these funds to banks.  Instead, it was the Federal Reserve, the US government-chartered central bank.  This is important because the Fed is charged with serving as the lender of last resort – and that’s the role it played when it lent money through the discount window to struggling banks in the height of the financial crisis.  On the rest of the misunderstandings, let me quote John Williams, President and Chief Executive Office of the Federal Reserve Bank of San Francisco from the FRBSF Economic Letter I happened to read yesterday as well:

“Now there are many myths associated with these emergency programs. I would like to take this opportunity to dispel some of them. First, these programs were not “secret.” The fact is that all of these programs were publicly announced and reported on regularly. Indeed, the amounts lent in each program were shown on Fed financial documents made public every week. The only thing that wasn’t disclosed at the time was the names of specific borrowers and the amounts lent to them. Second, this lending did not put taxpayer money at significant risk. All of the lending was backed by good collateral and the vast majority of it has been fully repaid. Indeed, these emergency lending programs alone generated an estimated $20 billion in interest income. That income, like all the net income the Fed generates after its expenses, went to the U.S. Treasury. Third, borrowers did not get below-market interest rates. Many of our programs charged penalty rates so that borrowers would want to go back to the private markets as soon as they opened up again. Fourth, the Fed is audited. Our financial books are subject to a stringent reporting process and regularly reviewed by Congress (see Board of Governors 2011).”

Let me emphasize what I think is the point John Stewart and others have been missing:  the net income from the lending programs went to the Treasury.  This means that yes, the banks made profits, but so did the U.S. government – on money created out of thin air!  This is where it really matters that it was the Fed that did the initial lending.  The Fed has the power, given to it by Congress, to create new money.  Lending the new money to banks, even if the banks turn around and lend it to the government, keeps the interest rate lower than it otherwise would be.  In particular the interest rate was lowered for government borrowing.  So, rather than costing the taxpayer money, the lending by the Fed lowered the interest the government had to pay and also prevented financial collapse.  This sounds to me like a win-win.

Why don’t we just let the government print the money so they can have it directly without having to sell bonds or even collect taxes?  We’ve seen what happens when countries do that – they no longer only print money based on the needs of the economy.  Instead, they end up printing money whenever there’s a bill they have to pay.  Eventually the increase in the supply of money devalues the currency.  It makes a lot of sense to have the power to print money in the hands of people whose reputations rely on keeping inflation low and who have to return the profits to the government.  This way the government, and therefore the taxpayers, gets the benefit of the printing of the new money while also maintaining a hopefully more stable value of the currency.

It is possible that in some other blog post I may criticize the Fed – I do not always agree with their actions or policies, and keeping interest rates so low for so long scares me.  But serving as the lender of last resort to prevent an economic catastrophe is exactly what Congress created the Fed to do, and I believe that’s what they did with their emergency lending programs.  And, they did it with little risk to the taxpayer.