How the Fed Is Being Too Clever

by: David Merkel posted on: August 04, 2008    

In the midst of a loosening cycle, the Fed keeps the monetary base flat.  This is not normal.  Instead, they use their high-quality balance sheet to bail out the liquidity problems of banks, broker-dealers, and maybe others, all while not expanding high powered money.  This is not normal, either.  After all, the Fed wants to heal the providers of badly underwritten credit (and increased their efforts last week, also here, here, and here), but they don’t want any liquidity to spill over into the general economy, because it might spark a wage-price spiral.

Consider the efforts of the Treasury toward Fannie (FNM), Freddie (FRE), the banks, and the housing market generally.  Yes, they are trying to avoid systemic risk, and that’s important.  But where is the support from the Fed and Treasury over unemployment, which is beginning to grow currently.  I’m not just talking about more unemployment, but about less compensation growth for labor in total.  Their focus is away from that, and looking at stabilizing a financial structure.  That’s good for all of us, but a disproportionate amount of the benefits goes to enterprises that made bad loans.  My rules of bailouts say that you must make bailouts painful to management teams and shareholders, while protecting senior debt, and thus preventing systemics risk.  That is not what is going on here.

I’m no great fan of central banking; I believe it makes our economy more stable in the short run, but intensifies crises when they take place (In my opinion, we never would have had the Great Depression if we had not created the Federal Reserve).  Life under a true gold standard has real panics, but they are sharp and short.

At present, we are setting the stage for an increase in unionization.  I am no fan of unions, but who can blame workers from seeking more bargaining power when they have had it rough for a long while?

My summary is that the policies of the Bernanke Fed are too clever.  Restrain wage/price inflation while bailing out banks and broker-dealers, Fannie, Freddie, etc.  But goods inflation keeps running ahead, and the oversupply of houses keeps forcing prices lower.  The actions of the Fed and Treasury protect the financial system for now, but at what eventual cost?  It might have been better for the Bernanke Fed to have been more traditional, and have stimulated the general economy, while letting the Treasury protect individual financial institutions in trouble.

I don’t think this will end well, but perhaps a recession like 1973-74  will clear the decks.  The Fed has to see that its main roles are price inflation and unemployment, with systemic risk third.  Any other way of prioritizing Fed action will lead to greater controversy in the long run.

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This article has 6 comments:

  •  
    Ops did it
    again
    Aug 04 10:49 AM
    So this guys are bankers or economist. Why are you so surprise that they care only about saving the financial companies and their officers?
  •  
    iThinkBig
    Aug 04 12:00 PM
    My Website
    Congress creates policy and leans hard on Treasury and the Fed. Changes are in order thought process, subsequent policy:

    1) Deficits do matter
    2) No, the USA can no long be the world's policemen
    3) No, we can no longer support 20 million illegal aliens at $35k a year each in entitlements while the law abiding middle class is destroyed. Entitlements for votes is an old game that begain with FDR. It has reached critical mass as non-sustainable (45% of all Americans on some sort of government subsidy, yet 50% of our population pay 97% of the taxes).
    4) The Great Moderation worked for a few politicos and guys at the top in terms of wealth creation. The model has failed as Freidman economic model failed.
    5) The USA must invest in energy, higher ed, telecommunications, roads. Everything that creates more permanent skilled jobs and has a lasting positive economic effect, in other words no more malinvestment into dishonest operators.
    6) Good leadership in Washington. Don't expect to see much of this on this election cycle, probably 2012.
  •  
    JasonC
    Aug 04 01:06 PM
    The article writer should make up his mind. Either the Fed is recklessly expanding or it isn't. Since he knows it isn't, and is thereby departing from his "I hate the Fed, everything is the gubmint's fault" libertarian ideological schtick, he doesn't know what to think and flails around.

    He claims there would be no great depression without the Fed. This is clear nonsense. At the height of the depression it was not anything in the US drowning the world, it was the utter collapse of world trade and of European relations generally. Nobody ever paid for WW I until the crash. It was all kicked down the road and papered over with slogans and American loans. When Europe crashed, the US got stuck with the tab for the entire first world war.

    Then the gold standard made it worse. The Fed contracted the money supply by 30% during the depression, because it was bound by law to do so whenever gold left the US banking system. Which it did in droves, for Europe, as everyone there cashed out all their balances in a panic. It was insane, but the insanity was doctrinaire gold standard - any country losing gold was supposed to contract its money supply. That the reason the US was losing gold was we still paid our debts even after everyone else in the world had defaulted on their larger obligations to us, goes unmentioned.

    If you want to know what really happened in the great depression, read Charles Kindleberger. Especially hair raising is the Creditanstalt crisis in Austria. The largest bank in Austria after it absorbed all the lesser fry as their failed, it had about 60% of all deposits there. Unable to meet foreign withdrawals of gold as it became clear the losing powers of WW I could not repay their commercial debts and reparations simultaneously in depression conditions, it cast about for an international loan to get it through a run.

    Then it gets fun. American private bankers, British public ones, and French public ones, all agreed to a rescue loan. The day before it was to go into effect, the French raised a political condition - Austria must renounce its free trade agreement with Germany. The Austrian government refused the condition. The next day it lost a vote of confidence in parliament, and fell.

    So, Austria had no operating banking system, no loan, and no government. The run exploded and the Creditanstalt failed. Germany went next within a month, and the Pound was devalued by 33% soon thereafter. This spread a new wave of deflation over the US as the currency shot up 40% in value against its trading partners. At the same time, panicking bankers withdrew every credit that still paid in gold - meaning France and Belgium and the Scandanavian countries were all paid back in full, while nobody who owed us anything paid a dime. The gold standard then mechanically contracted the US money supply by 30%.

    Enough, men were mad and did not know how the system operated. But pretending it all would have been fine without them dang gubmints is ignoring the fact of WW I and the nonsense finance that followed it. And the reckless "chicken" diplomacy that followed the collapse of that nonsense finance.

    The Fed isn't going to contract the money supply 30% to "undo" past private sector inflation created by reckless banks. It isn't going to deliberately deprive the country of a banking system as some grand morality play - that would only end in men slaughtering each other anyway. Flip ideologues have no idea of the serious traffic they are playing in with this stuff.
  •  
    JasonC
    Aug 04 01:10 PM
    iThinkBig - the problem isn't what we invest in particularly, but the fact that we don't save to begin with. That is the cause of the trade deficit and with it the weaker dollar etc.

    We are also patsies in modern world trade. China and Russia get dollars for goods and oil, but never pay a cent for software they simply steal. Arabs and Europeans benefit greatly from the freedom of the seas we provide, then castigate us as power-mad cowboys because they don't like the manners we show as we provide it. Without the USN, they'd all be broke. But none of our leaders will play hardball, and nobody else's is remotely just or sensible.

    It will end in a smash, and we will do just fine in said smash. Others will not.
  •  
    flow5
    Aug 05 10:37 AM
    Just ask economists Richard Anderson & Robert Rasche, (the U.S. leading authorities on the monetary base) -- Is the monetary base "binding"? And it will be answered that high powered money is no longer a base for the expansion of money & credit.

    The effect of tying open market policy to a fed Funds rate is to supply additional, and excessive, commercial bank money & credit creation - when loan demand increases.
  •  
    Whidbey.
    Aug 05 09:06 PM
    The Fed is of two or three minds, and it can not concentration on inflation, or employment, or anything else for very long with Congress busy spending and reallocating the dole. The facts are, the US monetary policy is a myth, we are simply unable to do much with inflation or employment so long as the recessionary forces prevail. We much pick an objective and pursue it with some concentration. I suspect that strengthening the dollar will be most productive in the long run. Short run nothing helps much.
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