Fedopus

The US Federal Reserve used to be like an elephant. It had one trunk and with that one trunk it could accomplish a lot. Of course, it couldn’t play the viola but then again who really wants an elephant sitting in an orchestra pit? Now the Fed is more like an octopus – not to be confused with Pussy Riot – with a bunch of arms. Despite having eight arms markets are not convinced this is any more useful than one trunk.

This post is all about monetary policy, moral hazard, and emasculation. The idea for this came from my reading an incredible book called In Fed We Trust by David Wessel. Wessel documents with painstaking and interesting detail the progression of the Fed’s powers between 2007 and today. I knew all that was going on in a general sense but to read the unfolding story it really floors you. It also gives us some insight into the motivations, ambitions, and personalities of the key players – Greenspan, Paulson, Bernanke, Geithner, and others.

There is a lot in the book and I highly recommend it but I try here to extract a few ideas. This is always dangerous and I rely on my faithful followers to let me know if I have misread the author. One key takeaway for me is that Fed Chairman Bernanke did not want to repeat the mistakes the Fed made in the Great Depression. Bernanke believes strongly that the Fed should play the lender of last resort role. Most people would not fault him for this. Whether it was the original Bear-Stearns  or AIG bailouts or the lack of one for Lehman, the over-riding principle was to calm the markets and provide enough liquidity and financial support to prevent financial spillovers from institution to institution.  It is possible that it would have been okay to let any one of these financial giants fail. But it was Bernanke’s decision that the fallout from each failure could bring down the whole system.

Along these lines one might say that the Fed was providing liquidity or general financial support. Another way is to say it was supplying confidence – confidence that one’s money and one’s financial assets would have some value in the coming day.  The broader environment found a federal government that was incapable of either discerning the problems or acting on them and it soon became the province of the Fed to be central bank, legislative branch, and executive branch.  Since the Fed is not elected or representative in any real sense, a concern is whether or not it should have acquired all these functions of government. Perhaps next year it will replace the Supreme Court. Why not? It is doing everything else.

You retort – Larry there you go again. Put down the JD and think rationally. And I would retort, read Wessel and tell me that the Fed has not taken over everything from greeting the diners to washing the dishes.  When I teach macro or monetary economics I have a lecture about the tools of the Fed. In the past I joked that the Fed was like a one-armed juggler – having one arm and trying to keep three balls in the air – output, inflation, and employment (and maybe more). When you have only one arm it is hard to do all that. That one tool used to be its ability to inject or withdraw money from the system via the discount window or open market operations. We say the Fed increases its balance sheet when it prints up money and uses it to buy outstanding government bills. It cannot buy these government securities directly from the government but it can legally enter into financial markets and buy them from existing holders. Stick money in the system when it needs more. Take money out of the system when the economy needs less. That’s pretty simple stuff.

So what has changed? Much of what has changed is called quantitative easing. With QE the Fed is no longer concerned with this process of adding money into the banking system. With QE the Fed is bordering on financial and fiscal policy by buying up very specific assets. It isn’t trying to liquefy the economy. Recent statements by the European Central Bank show it is planning to do the same – buying Spanish and Italian bonds which injects money into the system and then use other tools to withdraw the money or liquidity that would be added. Thus the ECB would be involved in a fiscal action – helping Spain and Italy – while neutralizing any impacts on the supply of money in Europe.

The Fed and the ECB are trying to resolve problems in specific sectors of the economy. One day the Fed buys distressed mortgages if mortgage companies are having problems. Another day they help out money market funds. A couple days later they pump money into a specific bank or other financial company or insurance company that is not able to meet its obligations. On another day they buy equities of an automobile company to protect auto workers’ jobs and pensions.  On Sunday if the till is short a few bucks they chip into the plate at the First Buddhist Temple of Bloomington. Okay, I jest on that one. But joke or not – the Fed has established a precedent – if Congress cannot act then the Fed will come to the rescue of any financially significant company or institution. We don’t need to go through that nasty process of making laws to solve economic problems. We just phone up the FED and explain that the world as we know it will crumble if the Fed does not buy shares in our local Childcare Center.

I think I am shouting. Plunk Plunk. I just freshened my JD with a couple of ice cubes. Ah that’s better. Now where was I?

One trunk or an octopus? Is this good or bad? Let’s start with the good part. It took the Fed a year or so after the housing crisis unfolded but when they did catch on to the full risks, they jumped in with both feet (or eight arms). They decided that doing nothing or just using traditional tools was not enough to stop a global catastrophe. One can disagree with their assessment or not but they did act and at least so far we had no worse than a long global recession. In the US the recession lasted only two years though the recovery has been slow and painful. But my point is that we will never fully know what might have happened if the Fed had stuck to its one tool policy. Inasmuch let’s give the Fed a gold star.

What can be wrong about this approach? Where do the future problems lie?

First and foremost is the issue of moral hazard. Moral hazard exists when an unintended result has an adverse moral effect that undermines your original intent. You pay your baby sitter a very high hourly rate so that she will take care of your darling little perfect child. You pay so much that the sitter sneaks out of the house and goes to a local bar and drinks Soju until five minutes before you get home. In the case of the Fed it is no accident that as soon as the word got out that the Fed was helping out, the line of despondent banking CEOs in front of the Fed door was longer than the queue at the unemployment office. It’s like handicap parking stickers. There are so many people claiming to be handicapped today that people with serious disabilities can’t find a place to park. The moral hazard the Fed created suggests that in the future, whenever things start to go downhill it will go downhill that much faster because claimants will compete to be first in line for a handout. All they have to do is make the case that they are systematically important and the Fed will look like it just saw Vlad the Impaler and start handing out money like the Mayor of Chicago at a Mafia convention.

The second worrisome future factor is that the basis of any current Fed success is exactly what limits its future success. What made the Fed successful is that the public believed the situation was dire and that the Fed’s intervention would work. As 2008 and 2009 unfolded there was much unknown and much to fear. The Fed really calmed the markets. But in 2012 or 2013 the situation is much different. For one thing much more is now known. For another we are not sure that the Fed has the secret combination. Thus – what do we learn when we hear that the Fed is about to make another major policy move to support the economy or some part of the economy? It tells us two things. First it tells us that things are much worse than we previously thought. Second, it may have a very negative impact on expectations and confidence. This more or less guarantees that the Fed policy will have little to no effect and raises the risk that our lack of confidence will show up in less employment, more selling of assets that reduce prices of houses stocks, and bonds, and a pimple outbreak among the under-40 set.

Third, the problem with these interventions is that they do not address the sources of our problems. Recall that the housing and stock market bubbles that kicked off this mess were born of TOO MUCH spending and borrowing. Notice that the Fed’s actions generally support MORE spending and borrowing. It is okay to give drug addicts methadone as they deal with withdrawal challenges. But at some point you have to move from that stage to one where no drugs are taken. The longer you stretch out the first stage the more you prevent or retard the eventual remedy. So far the Fed is still so worried about a financial collapse that it is not willing to get us off the drugs.  Notice that we have been in this phase for five years. When will the Fed start backing away from this phase? They were a whole year or more late in defining the crisis in 2009. What if they are a year late in knowing the worst is over? Once you become an all-powerful octopus for too long is it possible to become a humble elephant again? Only time will tell. Only then will we get on to the business of treating the problems that cause our economic malaise.