The Fed's response to the Financial Crisis of 2008 has been controversial for some. Some bloggers and commentators have derided Ben Bernanke by referring to him as Helicopter Ben (based on a speech that he gave in 2002 in which he mentioned dropping money from a helicopter in response to a significant threat of a deflationary spiral). Critics cite the work of Milton Friedman to make the case that the Fed should not have increased the money supply significantly in response to the crisis. Are the critics correct?
Where did Ben Bernanke get the idea of "dropping money from a helicopter"?
In September 2008, the financial system began to grind to a halt. Evidence of this could be found in many places including sudden and dramatic withdrawals from money market mutual funds and a freeze in bank lending, including banks not willing to lend funds to one another (i.e., the federal funds market froze). Given that banks and people shied away from such conservative, low risk activities, it was a clear signal that we were facing the most dramatic financial crisis since the 1930s. Left unchecked, most macroeconomists recognized that we were heading to a depression. Knowing this, the Fed took extraordinary actions in order to stabilize the financial system. Sounds melodramatic? Let's take a look at some of the evidence.
Rapid Surge in Excess Reserves
As seen below, banks normally hold a very low level of excess reserves. You may note the blip up in response to the events of 9/11. The last time bank holdings of excess reserves increased significantly was in the early 1930s. However, the increase in Fall 2008 was higher and quicker than during the onset of the Great Depression.
Lender of Last Resort
During the early 1930s, the Fed was criticized for not carrying out its role as lender of last resort. No less than Nobel Prize winner Milton Friedman cited the Fed's passivity as a major reason that a severe recession turned into the Great Depression. This time, banks were able to borrow from the Fed (as intended), particularly during the worst part of the crisis. As can be seen in the chart below, borrowing declined rapidly following the depths of the crisis and returned to near zero by 2012.
The Fed's Balance Sheet (Monetary Base)
Many critics of the Fed have complained that the Fed increased the money supply significantly, which would cause high inflation. However, it wasn't the money supply that increased, but the Fed's balance sheet, what economists call the monetary base. The monetary base consists of currency plus bank reserves, so as banks increased their excess reserves, the monetary base increased as well. Is this inflationary? Not as long as the bulk of it is held as excess reserves. Money that is not being used cannot result in inflation. That said, when financial and economic conditions change and banks choose to hold fewer excess reserves, this "money" will flow into the economy. The Fed will need to withdraw the excess funds in order to prevent a surge in inflation.
Money Multiplier
Economists use a concept known as the money multiplier to measure how changes in the monetary base become changes in the money supply (note the money supply includes currency plus deposits). You'll note the dramatic decline in the money multiplier that took place in Fall 2008. When was the last time it fell so much and so fast? No, not during the Great Depression. It took 2 years for it to fall 30% during the Depression. This time, it took a few months to fall nearly 50%. If one takes the monetary base and multiplies it by the money multiplier, you obtain the money supply:
money supply = monetary base x money multiplier
Thus, if the money multiplier declines by 50%, the Fed needs to double the monetary base in order to keep the money supply from changing.
And here's a chart of the M2 money multiplier (also declined by about 50% in a short period of time and is now down almost 2/3 from its peak at the start of the crisis).
Money Supply
As seen below, the dramatic increase in the monetary base did not result in a rapid increase in the money supply. In fact, by late 2009/early 2010, the growth in the money supply was slowing considerably. If the Fed had not increased the monetary base as much as it did, the US would have experienced a dramatic decline in the money supply. When was the last time the money supply experienced a significant decline? Yes, during the Great Depression. Most economists consider the significant decline in the money supply as the primary cause of the Great Depression (based on the work of Milton Friedman). The lesson learned was not to let the money supply shrink. Surprisingly, some commentators tried to cite Milton Friedman in criticizing the Fed's response to the financial crisis. However, Friedman's work provided the basis for the Fed's response (in terms of increasing the monetary base significantly). In the summer of 2011, the money supply began to increase more quickly? Why? The primary reason was investors seeking the safety of assets included in the money supply, particularly checking accounts, as global risk aversion rose significantly. In recent years, the growth of the M2 money supply has tended to be about 6-7%, which is similar to its historical average.
So the money supply has not increased that quickly (money supply = monetary base x money multiplier).
Here's a nice explanation showing why Fed policy is unlikely to cause high inflation.