The Fed keeps on making the same mistakes
The Federal Reserve Act was signed into law by President Wilson on December 23 1913. Its purposes were “To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”
How has America’s old lady acquitted herself in her first 100 years?
Forrest Capie, the latest historian of the first Old Lady – of Threadneedle Street – concludes his monumental study by paraphrasing the Book of Common Prayer:
“The Old Lady left undone those things that she ought to have done and did those things that she ought not to have done.” Naughty thing!
Can one say the same of her transatlantic sister? To judge by three books that have landed on my desk in the first month of her anniversary year, it seems that the answer is Yes.
Blinder’s bond bomb
Alan Blinder bends over backwards to be kind to the Fed. The Fed helped to save the world from a total meltdown. The crisis could have been worse. Blinder is anxious to dispel what he sees as misunderstandings about the role the Fed played. Previously unimaginable actions were taken – and they worked. They were needed, though they did result in a huge increase in moral hazard. Well, he is a former vice-chairman of the Fed.
Interestingly, Blinder has no time for the view that large global forces were major culprits. No, the problem started in the US and was “pushed” abroad. The financial industry exported its complex, opaque and “hideously overrated investment products”.
Yet even Blinder does not let the Fed off the hook. The biggest cause of the crisis was what he calls the bond bubble. Where did the bond bubble come from? Blinder is blunt:
“That story, I’m afraid, does start with the federal reserve’s monetary policy” (p 45, his italics).
Prompted by fear of deflation, in 2003 it pushed its overnight interest rate all the way down to 1% – the lowest since 1954 – sparking the now notorious “search for yield”.
And where was the Fed as supervisor (one key original purpose in the act of 1913, see above)? Fast asleep:
“Under the Fed’s unwatchful eye, banks proliferated (sic) the SIVs (special investment vehicles)…..”
OK, the other regulators were “just as asleep (sic) at the wheel as the Fed” – Not quite. Sheila Bair at the FDIC was trying to wake everybody else up.
“One of the great tragedies of the financial crisis is that bank regulators could have slammed the door on some of the more outrageous underwriting practices but didn’t. ” (page 58).
Blinder describes how agonisingly slow the federal open market committee (FOMC) was to recognise the severity of the crisis in 2007 – a view confirmed by the recent release of transcripts of their meetings in that year. But at least “the Fed was way ahead of the ECB” – a claim that will raise eyebrows in Frankfurt and Paris…where Jean-Claude Trichet, then president, now lives: the ECB has prided itself on being the first major central bank to inject large amounts of liquidity into the markets.
This is indeed a testing time for central bank solidarity. The wall is crumbling. Humpty-Dumpty has had a great fall….
At that stage in the crisis, where was the Secretary of the US Treasury Hank Paulson? According to Blinder, he was nowhere to be seen – not at the bridge of the good ship America, not anywhere. He was a “missing person”. Everybody had assumed that the former chief honcho of Goldman Sachs had his finger on the pulse of the markets – says Blinder: “or so we thought”.
The so-called Asian savings glut, much beloved by Blinder’s Princeton colleague Ben Bernanke and Mervyn King, “China” and its trade surplus do not even rate a mention.
On financial reform, Blinder sides with Bernanke against Mervyn King’s view that keeping banks small enough to fail is the way forward and endorses the “resolution” approach being followed officially.
This is an all-American account of the crisis. The rest of the world is boring.
By contrast, the other two books focus on the global effects of the Fed’s monetary policies. Both see Fed policies – not just in this crisis but over many decades – as destabilising for the world as well as for the US.
McKinnon bemoans Fed’s insularity
Ron McKinnon sees eye to eye with Blinder on two big things: first, the Asian savings glut and China’s payment surplus are NOT causes of the great financial crisis; China is a stabilising force in the world economy. Its stable exchange rate with the dollar should form the basis of a refreshed world dollar standard; and second, ultra-low interest rates in the 2000s triggered financial instability. But he sees all this through an international perspective.
For McKinnon, the US dollar is the indispensable hub of the world’s trade and exchange arrangements. For 70 years it has been the key currency used for clearing international payments among banks, including interventions by governments to influence exchange rates. It is the dominant currency for invoicing trade in primary commodities and in official reserves. Despite being repeatedly assaulted by its own Dad, it has shown enormous resilience.
“A weak and falling dollar led to worldwide price inflations of the 1970s and contributed to the disastrous asset bubbles and global credit crisis after 2000 – including the global credit crunch of 2008-09”.
Devaluing the dollar is worse than useless as a remedy for trade imbalances:
“Correcting international trade imbalances must start with countries changing domestic absorption, that is, aggregate spending, relative to income”
“No additional or “supporting” exchange rate changes are necessary. They make matters worse.
“Unfortunately, the expectation of renminbi appreciation invites massive hot money inflow…making the problem of domestic monetary control much more difficult” (p 129)
If emerging markets were to do what the US says it wants – stop intervening, and let their currencies appreciate – it would trigger a drastic credit crunch in the United States. Flexible exchange rates do NOT offer a way out of “the dollar standard trap”.
The dollar standard has relaxed the constraints on US borrowing so that US households and the government feel they do not need to save. This speeds de-industrialisation in the US.
But if the dollar standard is so “unloved” and has destabilised the US and world economy, how come it survives?
McKinnon’s answer is that it is indispensable – hated, dysfunctional but horribly necessary.
If Ron is right, the world economy will continue to be hobbled by a bad international monetary system. There is no cure in sight because the US has shown it will not follow the rules of the road that Ron outlines. It will not make the dollar standard work better either for itself or the world, and nobody can force it to.
But eventually, as is the way of the world, markets will find a replacement.
No-holds-barred onslaught from Brendan Brown
The most unbuttoned, impudent attack comes from Dr Brendan Brown, a City economist and author of many scholarly books on monetary history and the euro.
The title says it all: “The Global Curse of the Federal Reserve”. But make no mistake. This book is far from being just a populist muck-raking rant. Brendan Brown combines impressive economic credentials – a master’s degree from Chicago and a Phd from the LSE – with an encyclopaedic knowledge of monetary history. Debates on the Fed’s legislation in 1913 are as immediate to him as the latest twist in the battle between hawks and doves on the FOMC.
The founders of the Fed never intended it to attempt to manage the economy. Monetary activism has been a disaster, causing bubbles, booms and busts from the 90 years following the 1920s. Yet the Fed grows more powerful with each crisis. Why? Brendan does not speculate, but one natural interpretation from a public choice perspective is that if crises are in the institutional self-interest of the Fed, it will be blind to them. If Bill White and people who agree with him are right, a central bank can “lean against the wind” and, if it gets its timing right, control the build-up of a bubble. But maybe there is a reason they don’t do that.
According to Brendan, repeated bouts of “irrational exuberance” have three key conditions – the pegging of forward guidance on interest rates below the neutral rate, investor fatigue from a long period of yield-starvation and growing worries about the emergence of inflation in the future from prolonged spell of low rates.
Quantitative easing then spreads the effects of growing irrational exuberance to the world through the dollar area – he is close to McKinnon here. It was this mechanism that forced the Bundebank in 1970s to unpeg from the dollar and start the process towards EMU.
Brendan thinks the Fed’s onslaughts in effect destroyed the dollar area – onslaughts on Europe, Japan and now China have caused it to disintegrate.
Both Bernanke and Greenspan followed what Brendan calls the Blinder doctrine – ignore asset bubbles as they are forming but deal with them forcefully when they burst. “Clean, don’t lean”.
Like Mckinnon he identifies deflation-phobia as a culprit. In a healthy economy, the inflation rate and price level should fluctuate to be consistent with maintenance of economic stability.
The only thing that will rescue the world is a return to strict monetary orthodoxy founded on a rule for a regular increase in the monetary base – a return to strict targeting of narrow money. Immediately, the dollar would be king again. “No longer would international investors fear erosion of their dollar assets”.
So he ends up, like McKinnon, hoping for a rehabilitation of the dollar standard.
But there is no real hope here, is there? Not, a least, if he is right is asserting that on the basis of the historical record the Fed’s religion is not stable prices but “constant, never-ending, worldwide inflation”.
The Fed is at the same game again even as we speak: pumping up yet another bond bubble.
“After the Music Stopped: the Financial Crisis, the Response and the Work Ahead”, Alan S Blinder, The Penguin Press, 2013.
“The Unloved Dollar Standard: From Bretton Woods to the Rise of China”, Ronald I McKinnon, Oxford, 2013.
“The Global Curse of the Federal Reserve: How Investors can Survive and Profit from Monetary Chaos”, Brendan Brown, Palgrave Macmillan, 2013.