Over the last year, especially since the Bear Stearns closing in March 2008, the Federal Reserve has done extreme damage to the parts of its own balance sheet that affect the money supply. Particularly at fault are the Fed’s Board of Governors and the Federal Reserve Bank of New York, which have dictated the terms of all the bailout efforts, as well as those regional Reserve Banks that follow their monetary policy leads.  

One wonders what might provoke dissident Reserve Bank presidents into open rebellion if the affronts to sound policy prescriptions of the past year do not suffice. The inspiration for reasonable rebellion has accelerated in the past four weeks, with the Treasury’s $700 billion bailout bill (politely called the “Emergency Economic Stabilization Act of 2008”), combined with massive helicopter drops of Federal Reserve liquidity into various financial capitals of the world.

The Federal Reserve now has offered unlimited liquidity to European and Japanese central banks, an action of questionable wisdom and legality. Foreign exchange swap lines such as these should be approved by the entire Federal Open Market Committee, not just the Fed’s Board and the New York Reserve Bank.

Since mid-September 2008, the Federal Reserve has followed a policy that will cause a doubling of the size of the Fed’s balance sheet by year-end 2008. This means a gross and potentially dangerous expansion of money and credit in both the foreign and domestic markets.

One particular method chosen for this expansion is discount window lending aimed at specific institutions instead of open-market operations where the Fed does not know in advance who will receive the injected liquidity. This makes it unlikely in the extreme that the Fed could reverse the policy course and require even a partial return of the increased supply of reserves if the overall economic outlook improved and the Fed wished to tighten monetary policy.  If one lends Wall Street $1 trillion, is it realistic to expect Wall Street to be able to return the money?