Monday, January 7, 2013

Is the Fed doing enough, too much or not enough to aid recovery

The Wall Street Journal carried an article on the American Economic Association's annual meeting that in celebrating the 100th anniversary of the Fed's creation asked:  is the Fed doing enough, too much or not enough to aid recovery.

Regular readers know that under the guidelines for central banks established by the father of modern central banking, Walter Bagehot, the Fed is doing too much.

For example, Mr. Bagehot said that as a lender of last resort, the central bank is suppose to lend freely at high rates of interest against good collateral.  Since the beginning of the financial crisis, the Fed and the other central banks have lent freely at low rates of interest against collateral of marginal value.

For example, Mr. Bagehot said that interest rates should never be below 2% as rates below 2% change savers' behavior.  When making this comment about the change in behavior, he was well aware of Mark Twain's observation about being concerned about the return of his capital rather than the return on his capital.  Since the beginning of the financial crisis, the Fed and other central banks have pursued zero interest rate and quantitative easing policies.

Anna Schwartz, Milton Friedman's co-author and an authority on the Great Depression, also argued that the Fed is doing too much because it does not understand that we are facing a bank solvency led financial crisis.

As she said,

"This was [his] claim to be worthy of running the Fed," she says. He was "familiar with history. He knew what had been done." But perhaps this is actually Mr. Bernanke's biggest problem. Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."
Bottom line:  the Fed is doing too much because it is pursuing policies for a liquidity crisis when we are faced with a bank solvency crisis.

From the WSJ,

On the 100th anniversary of the central bank's creation, economists remain divided over whether the Fed's decisions to slash interest rates to nearly zero and buy trillions of dollars in bonds will fuel inflation or fall short of reigniting growth.
Your humble blogger, who does not have an economics PhD, is already on record saying that we will continue to face a Japan-style economic slump until such time as the losses on the excess debt in the financial system are recognized.

I said this in early 2008 before the Fed engaged in zero interest rate and quantitative easing policies.

To date, economic performance has confirmed my prediction.
For much of its history, the Fed has acted too timidly when faced with difficult circumstances, University of California, Berkeley economists Christina Romer and David Romer argued in a paper presented at the conference. 
They argued that the Fed didn't do all that it could have done to foster growth until the fall of 2012. But they praised the Fed for its recent moves. 
During the Great Depression, officials doubted monetary policy's ability to overcome the forces that had wrecked the economy. Later, in the 1970s, officials thought high inflation could not be surmounted at a reasonable public cost. 
"An unduly pessimistic view of what monetary policy can accomplish has been a more important source of policy errors and poor outcomes over the history of the Federal Reserve" than overconfidence, the Romers said.
Having worked at the Fed, I would be the first to tell you that there are economic outcomes that monetary policy can accomplish.

Addressing bank solvency is not one of them.
For others, the Fed has already done too much. 
Carnegie Mellon economist Allan Meltzer warned that the Fed's bond-buying programs, often called quantitative easing, may be fueling a farmland price bubble. He worried that the actions also risk driving up inflation, and they have left the central bank as essentially the only significant player in the mortgage market. And when long-term rates eventually start to rise, the government will face an explosion in currently low borrowing costs that will further complicate efforts to rein in deficits, he warned. 
"It is impossible to minimize the size of the economic problem that faces us in the future," the chronicler of central-bank history said at a panel.
Maybe I missed something, but Fed policies also made it the only significant player in the market for US Treasuries.  Zero interest rate policies, quantitative easing and Operation Twist are designed to push rates on treasuries below where other investors will want to buy them.
Former Fed Vice Chairman Donald Kohn, now a Brookings Institution scholar, cautioned that ahead of the financial crisis, "not only didn't we see it coming," but once the trouble started, central bankers "had trouble" understanding what was happening, he said in a panel.
Your humble blogger was one of the handful of individuals who saw the financial crisis coming.  All modesty aside, I didn't have trouble understanding what was happening.

More importantly, I tried to explain to several Fed Governors, including Mr. Kohn, what was happening at the time it was happening.  This included predicting which policies would or wouldn't be effective (please see early posts on this blog for some examples).

What I discovered in these conversations were individuals who were captured by group think.  They had and still have a model for how the financial system and real economy is suppose to work and they dismiss any suggestion that their model is wrong.

In fact, the power of group think has them so wed to their models that they have repeatedly lashed out at consumers for not behaving in the way the economic models say they should behave.
The Fed has "only limited guidance" from history about how to navigate the economy with radically new tools of monetary policy.
Actually, history as represented by Walter Bagehot and Anna Schwartz provided plenty of guidance.  Fed policymakers chose to ignore this guidance to the detriment of the real economy and social programs.
More than five years after the onset of the financial crisis, scholars inside and outside government are struggling to rewrite textbook understandings of how the economy works and how unconventional monetary policies have affected markets and the economy. 
All modesty aside again, your humble blogger has rewritten the textbook understandings of how the economy works on this blog.  Please read the posts on the FDR Framework, the Queen's Question and how a modern banking system is designed to allow banks with low or negative book capital levels to continue operating because of the combination of deposit insurance and access to central bank funding.
"The whole policy evaluation inevitably is difficult," said Michael Joyce, an adviser at the Bank of England, "given the unknown counterfactuals, uncertain transmission mechanisms and [the fact that] we don't have many historical examples."
The historical examples we do have suggests that the whole policy would be evaluated negatively.

Mr. Bagehot set his guidelines for central banks as a result of his experience with the frequent financial crises that occurred in the 1800s.

Anna Schwartz made her observation that the Fed was pursuing the wrong policies based on her experience with the Great Depression.  She understood that we are dealing with a bank solvency led financial crisis and not a liquidity crisis.

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