Recent Federal Reserve activity is unprecedented. For a dramatic visual, go to Greg Mankiw's blog.

Many believed that Ben Bernanke had begun pumping up the money supply as early as the end of last year in response to the financial situation. But in fact, the Fed did not actually open the monetary spigots until a little over a month ago. Up until then, Bernanke effectively sterilized all his monetary injections, either by directly trading Treasuries from the Fed's portfolio for riskier financial securities, or by indirectly loaning to financial institutions with money recouped by selling Fed-held Treasuries on the open market. Either way, there was no major impact on the monetary base. As a result, the annual rate of growth of the monetary base remained in the neighborhood of 2 percent through August 2008, whereas total bank reserves remained virtually constant.

Indeed, one of the problems with the Fed's early response may have been Bernanke's fear of potential inflation, as the RELATIVE prices of oil and other commodities headed upward. He therefore tried to do the impossible: simultaneously avoid inflation by holding the line on monetary growth, while warding off a potential deflationary bank panic by injecting liquidity into selected institutions. The market's confusion over these cross purposes seems to have actually prolonged and deepened financial difficulties. In fact, a desire to achieve both goals simultaneously was a primary motive behind the dreadful Treasury Bailout. At least Bernanke didn't make the mistake of the European Central Bank, which with its rigid inflation targeting, tightened monetary growth in response to rising commodity prices, exacerbating the supply-side shock (and incidentally helping the Euro to remain temporarily strong against the dollar).

But now, all that has changed. After September 17, when the interest on T-bills briefly went negative, Bernanke opened the monetary floodgates. The reversal of commodity prices probably made him more comfortable about doing so. In any case, back in August the monetary base was $847 billion with total reserves constituting $72 billion of that (all figures are not seasonally adjusted and not adjusted for changes in reserve requirements). The Fed's latest H.3 Release (October 22, 2008) puts the base at $1,149 billion, a 40 percent jump over a year ago. What has exploded even more is total bank reserves, where the base increase is concentrated. Reserves have increased by an astonishing factor of about FIVE over the last month, and are now somewhere between $343 and $358 billion.

And that is not all! Federal Reserve Bank Credit (as reported in the weekly H.4.1 release) has doubled in the last month to around $1.8 trillion. Although Federal Reserve Bank Credit used to mirror the monetary base closely, that is true no longer--not since the Fed activated its U.S. Treasury supplementary financing account, which you can find reported in the same release. These are additional Treasury deposits at the Fed, which have gone from zero to approximately $560 billion.

These new deposits result from what the Treasury calls its Supplementary Financing Program, initiated a month ago to try to staunch the growing demand for Treasury securities manifested in falling T-bill rates. What essentially has been going on is that the Treasury is now issuing extra securities to borrow money from the economy, then loaning the money to the Fed in these special deposits so that Bernanke can re-inject it to make his bail out purchases of various securities, all without increasing the base. In other words, what the infamous Bailout Act permitted the Treasury to do directly is something it had already started doing indirectly through the Fed to the tune of half a trillion. And all in the name of easing a tight Treasury market. This partly explains why Treasuries fell in price after the Bailout passed, along with stocks, contrary to what usually happens.

It also means that the total bailout is not the $700 billion that Congress appropriated but at least $1.2 trillion. Nor does this count the Fed's recently promised $540 billion bailout of money market funds, which if not covered by the Fed's sale of other assets, will require either further monetary increases or further Treasury borrowing. Thus we now have the worst of both worlds: a massive bailout financed BOTH by Treasury borrowing, in order to avoid inflationary pressures, and a monetary base increase, heralding future inflation anyway.

There will be a lag before the explosion of the base works its way fully into the broader monetary aggregates. The year-to-year annual growth rate of M1 has already risen from 0 to over 7 percent, whereas that of M2 is up slightly from 6 to 7 percent. Bernanke's plan is undoubtedly to pull liquidity back out before this process heats up. But that will entail dumping around $300 billion of Fed-held securities back on the market (or still more if base expansion continues). Now that the Fed is paying interest on bank deposits at the Fed, it can also induce banks to hold more reserves, dampening the money multiplier. It has already jacked up the interest it pays, not on required reserves, but on excess reserves.

Notice further that when you combine the Treasury's Supplementary Financing Program with the Bailout, you have a $1.2 trillion increase in federal government borrowing, at least half of which has already taken place within the space of a month. This sudden 25 percent increase in the outstanding national debt qualifies as the most dramatic peacetime experiment in fiscal stimulus the U.S. government has ever implemented. If Keynesian theory were correct, we should already be well beyond any potential recession. But how many economists are going to acknowledge this striking empirical refutation of fiscal policy's efficacy?

Indeed, I suspect that this enormous increase in government debt at least partly explains the sudden stock market collapse after the Bailout passed. Government borrowing represents a future tax liability, and expected future taxes affect the value of equities. Some argue that this new borrowing may not increase taxes at all because it merely finances the purchase of earning assets that the government can later resell. While certainly possible in the long run, no one knows the true value of those assets in the short run. After all, the market's anxiety about their worth was the justification for the Bailout in the first place. So now the government transfers that uncertainty from private financial institutions to the general taxpayer. Just in case markets failed to notice, Bernanke--rather than calming them as you might expect the Fed to do--combined forces with Treasury Secretary Henry Paulson and President George W. Bush to scare hell out of the American people in order to ram their ill-advised Bailout through Congress. Is it any wonder that stock prices took a nosedive? In short, current events seem to have not only refuted Keynesian theory but also dramatically demonstrated the validity of the approximate Ricardian Equivalence between government expenditures financed with present taxes and those financed with future taxes.

And as icing on the national debt cake, the Bailout Act, by allowing the Fed to pay interest on bank reserves, has in effect converted that portion of the monetary base into still more Treasury securities. Reserves held as vault cash obviously cannot earn interest, but this change still adds another $325 billion to the growth of federal debt over the last month. Future historians may someday refer to this sad episode as the Bernanke-Paulson Recession, concluding that it was the policies of those two individuals, more than any other factors, that turned what was not even a mild recession into a major economic downturn.

A CORRECTION FOR PERFECTIONISTS (added Oct 27): I realize now that my claim above, in the last paragraph, that interest on reserves increases the national debt by $325 billion is not completely accurate. Here is the reason. Unless it sells goods and services on the market like a private firm, the government has only three ways of financing its expenditures: (1) current taxes, (2) borrowing (i.e., future taxes), or (3) printing money (a.k.a seigniorage). With a central bank, Treasury borrowing is divided between (2) and (3), with the amount borrowed from (that is, monetized by) the Federal Reserve generating seigniorage. Before the Fed paid any interest on reserves, the recent $300 billion increase in the monetary base would have constituted seigniorage. So the future taxes required by the new $1.2 trillion Treasury debt would have been REDUCED by $300 billion. Instead, by simultaneously paying interest on reserves, the Fed completely eliminated this seigniorage deduction, requiring future taxes for the entire sum of $1.2 trillion. Not only that, the Fed began paying interest on reserves the banks were already holding, adding merely about $25 billion (not $325 billion) to the $1.2 trillion. (This may seem complicated enough, but I haven't adjusted for the interest differential between what the Fed pays on reserves and what the Treasury pays on its securities. That differential represents a smidgen of lingering seigniorage that reduces the $25 billion somewhat.) Of course, to the extent that the banks or public convert reserves into currency, Treasury debt will be converted into seigniorage.