On the Brink of Inflationary Disaster

Robert P. Murphy
Mises Institute
Aug. 25, 2011

Ever since Ben Bernanke began his massive infusions of money into the financial system, many analysts (including me) have been worried about the severe weakening of the dollar if and when the fractional-reserve-banking system magnified the initial injections severalfold.

Although the trend could reverse, data from the past two months suggest that the inflationary big one may be upon us.

Keeping the Genie in the Bottle

To understand the potential problem, we need to review some basic facts. Back in the fall of 2008, when Lehman collapsed and the entire financial system appeared in jeopardy, the Fed began bailing out investment banks through massive asset purchases and extraordinary lending operations. These activities rescued the major banks that would otherwise have gone bankrupt, by taking bad assets off their books (at inflated prices) and by propping up the new "market" price of the assets remaining on their books.

When the Fed buys an asset, it writes a check on itself. This action creates new electronic reserves in the banking system. For example, if the Fed buys $10 million in mortgage-backed securities from Joe Smith, then Smith will deposit the check in his own checking account. His bank will credit Joe Smith's checking balance by $10 million, but at the same time the bank's account with the Fed itself will rise by $10 million too.

At any time, regulations insist that commercial banks in the United States keep a minimum amount of reserves set aside in order to "back up" the demand deposits (think of checking accounts) of their customers. For example, if a commercial bank's customers think they have a total of $1 billion in their checking accounts, then the Fed's regulations force the commercial bank to keep (roughly) $100 million set aside in reserves. These reserves can consist of green pieces of paper stored in the commercial bank's vaults, or the reserves can be electronic entries showing how much the bank itself has on deposit with the Federal Reserve.

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