Assigning The Blame

Assigning The Blame

By Martin Hutchinson March 23, 2009 | 23 March 2009

The Federal Open Market Committee (FOMC) meeting on March 17-18, if it achieved nothing else, made one thing abundantly clear: even after all the damage that has been caused to the global economy, the Federal Reserve neither accepts responsibility for its misdeeds, nor has any intention of modifying its errant behavior. A private sector institution that behaved in this way would be bust— unless it too found a way of wheedling endless billions out of the unfortunate taxpayers. In monetary policy as in most human activities, there is an urgent need for accountability.

Only two years ago, Fed Chairman Ben Bernanke was proclaiming a "Great Moderation" by which 'improved' monetary management capability by the Fed and other central banks had caused a permanent decrease in the volatility of the global economy, with inflation remaining low while growth continued at a steady pace. The only disturbing factor was a mysterious "savings glut" in Asia, which was causing "balance of payments imbalances" and might conceivably prevent the capital markets from accommodating ad infinitum the worthy consumerism of the U.S. public.

As we now know, this analysis was unadulterated hogwash. Far from producing a "Great Moderation," the Fed's excessively lax monetary policy over the last decade has produced the most dangerous global recession since the Great Depression. Far from being the world's chief problem, the Asian "savings glut" was the result of uncontrolled U.S. money printing and balance of payments deficits— and that glut may now be the principal factor allowing the world to escape the current troubles without repeating the experience of the 1930s.

So where's Bernanke's apology? Or, better still, resignation? Why are we still being forced to listen to his endless predictions of deflation, something that has completely failed to appear [[as in "money deflation"; we've had more than enough "asset deflation"! : normxxx]], either in 2002 when he first predicted it or in the last few months, during which core inflation has remained resolutely positive with a tendency to accelerate? Where is the legislation threatening to tax his income at 90%, in retaliation for his role in causing this disaster? Where is the investigation of his finances by the New York state Attorney General? Where even is the beautifully modulated denunciation by President Obama?

The lack of political blowback from the Fed's mistakes is perhaps unsurprising, but it is also dangerous. The policy-setting FOMC meeting March 18 voted to compound the Fed's errors of over-enthusiastic money creation by buying $750 billion more credit card and mortgage debt, $100 billion more of debt of the odious and superfluous Fannie Mae and Freddie Mac, and $300 billion of Treasury bonds. With broad money supply increasing at an annual rate of more than 15% even before this latest extravaganza, all hope of monetary moderation has been lost.

The late Fed Chairman William McChesney Martin famously defined the Fed's job as "taking away the punchbowl just as the party gets going." Under Alan Greenspan and still more under Bernanke, the Fed "spiked" the monetary punch, thus producing a very unpleasant hangover. It now proposes to treat that hangover by injecting absolute alcohol directly into the economy's veins.

The Fannie Mae/Freddie Mac purchases compound an old error; they limit the scope of the private sector in the mortgage market. That's the mistake that led to securitization's takeover of that market, a development that can now be seen to have raised mortgage costs and destabilized housing [[but while forcing long-term and mortgage interest rates artificially low, so I very much doubt that last: normxxx]]. The other new debt purchases, apart from the effect of their huge size on monetary expansion, will artificially revive the securitization market, providing subsidized competition to the banking sector. Since the principal economic need in this difficult time is for the banking sector to earn profits sufficient to fund its past mistakes, these purchases are economically counterproductive.

However, the most dangerous part of the FOMC's new aggression is its purchase of Treasury bonds. Already, the Obama administration is promising to run budget deficits of more than 10% of Gross Domestic Product, far beyond any seen in previous U.S. peacetime history. The Fed now proposes to monetize those deficits, reducing their political cost to the crazed public spenders, but greatly increasing the danger of spiraling inflation.

Funding excessive budget deficits through the central bank was a favorite tactic of Weimar Germany (until the roof fell in late in 1923), various Argentine governments and banana republics everywhere. It is one of the most effective ways known to destroy the economy, since to the normal "crowding out" effect of excessive state borrowing it adds the wealth-destroying effect of surplus money creation. In Third World countries whose monetary system has been competently designed by Western bureaucrats under aid grants, it is illegal.

The FOMC's action was initially popular with the markets, and with market-oriented commentators. "Grownups in Washington won't let the circus over ill-gotten corporate bonuses distract them from saving this economy," wrote CBS MarketWatch. In reality, what remains of the U.S. private sector appears well on the way to saving itself. Retail sales were up in January and February, the upward slope in unemployment claims is becoming less steep and economic statistic after statistic comes in significantly better than the forecasts, now adjusted to doom and pessimism.

The main unknown is the true condition of the banking system, but here the main need is to avoid further government meddling, whether by providing ludicrously expensive bailouts of bad loans the banks are taking care of themselves, or by imposing randomly punitive taxes on the unfortunate [[but scarcely innocent: normxxx]] bankers. It seems increasingly likely that even Bank of America is working its way out of its problem, with only Citigroup and the egregiously awful AIG being true basket cases likely to need yet further infusions of taxpayer money. The healthier banks such as Wells Fargo and US Bancorp have taken to hurling insults at the Treasury Department and the Fed, an excellent sign that they are well on the way to recovery!

Once the economy has touched bottom, around the middle of this year, the private sector's problems will be well on the way to being solved, and we will only have to deal with the disasters perpetrated by the public sector in response. Unfortunately, those disasters seem likely to be far more economically damaging than the original problem. The Congressional Budget Office believes that U.S. public debt will increase by over $7 trillion in the next decade, with the deficit remaining in the $700 billion to $800 billion range throughout.

There is no equivalent body auditing monetary policy, but the inflation statistics themselves will soon tell the tale of money supply growth run riot. It is thus likely that for several years we will be forced to continue dealing with the multilayered economic crisis for which Bernanke and his predecessor Greenspan bear so much of the responsibility. Bernanke's term ends next January, and it is to be hoped that President Obama does not reappoint him, though on current form I hold out little hope that his successor will be much of an improvement.

In any case, the incentives at the Fed are all wrong. While theoretically the Fed chairman should wish to make the private economy as strong as possible through prolonged non-inflationary growth, in practice most of his day-to-day contacts are in the public sector, and his only report of significance is to the economic illiterates of Congress. There is a better way.

When the great and wise Alexander Hamilton set up the Bank of the United States, he set it up as a private sector institution. The Bank of England was also fully private until the post-war Labor government started nationalizing everything that wasn't nailed down. Technically, parts of the Fed are also private— the 12 Federal Reserve banks are owned by the banking system— but its incentives are entirely public-sector and in many cases counterproductive.

There are thus two possibilities. One would be make the Fed truly independent of government, and provide a remuneration system whereby members of the FOMC were properly incentivized to get it right. The Fed's statutes must be written so that maintenance of sound money is the Fed's preeminent goal, not shared with politicized matters such as the maintenance of full employment.

A contract could be drafted providing a suitably long-term remuneration incentive, geared to inflation, economic growth and money supply growth, for the Fed chairman and for all members of the FOMC while in office. To the extent factors deviated from their target range (for example, the excessive increase in M3 money supply from 1995), remuneration would be reduced, with the reduction becoming more pronounced as the deviation was prolonged.

The other possibility would be to design, de novo, a purely private sector central bank, with the board of directors consisting of senior bankers. In pre-1946 London, this worked well because the bankers with high IQs tended to work for medium sized institutions. In the Wall Street of 2007, that would not have worked— as the late unlamented Treasury Secretary Hank Paulson showed, there are altogether too many confluences of interest between a Goldman Sachs and the Treasury or the Fed.

However, if the behemoths are reined in [[ie, heavily regulated!?!: normxxx]] because of being "too big to fail" and the brains migrate to medium sized advisory institutions, then those institutions would be ideally suited both to provide governance over the central bank and to provide its top officials. In either case, the separation between the Fed and the governmental apparatus must be sharply increased. Such a position, however, will be attainable only when the media, the public and at least some of the politicians have grasped one overriding truth: the current unpleasantness is far more the fault of the Fed than of Wall Street, which simply responded to the perverse incentives provided by monetary mismanagement. [[Yes, but they didn't have to do it quite so enthusiastically! : normxxx]]

The Bears Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

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Normxxx    
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