Recent failures have stripped economists of their immunity from rigorous scrutiny by average citizens. What works and what does not in economics is no longer just a matter of academic debate when forty-four million Americans are on food stamps. Claims by economic theorists about multipliers, rationality, efficiency, correlation and normally distributed risk are not mere abstractions. Such claims have become threats to the well-being of the nation. Signal failures of economics have arisen in Federal Reserve policy, Keynesianism, monetarism and financial economics. Understanding these failures will allow us to comprehend why growth has stalled and currency wars loom.
The Federal Reserve
The U.S. Federal Reserve System is the most powerful central bank in history and the dominant force in the U.S. economy today. The Fed is often described as possessing a dual mandate to provide price stability and to reduce unemployment. The Fed is also expected to act as a lender of last resort in a financial panic and is required to regulate banks, especially those deemed “too big to fail.” In addition, the Fed represents the United States at multilateral central-bank meeting venues such as the G20 and the Bank for International Settlements, and conducts transactions using the Treasury’s gold hoard. The Fed has been given new mandates under the Dodd-Frank reform legislation of 2010 as well. The “dual” mandate is more like a hydra-headed monster.
From its creation in 1913, the most important Fed mandate has been to maintain the purchasing power of the dollar; however, since 1913 the dollar has lost over 95 percent of its value. Put differently, it takes twenty dollars today to buy what one dollar would buy in 1913. Imagine an investment manager losing 95 percent of a client’s money to get a sense of how effectively the Fed has performed its primary task.
The Fed’s track record on dollar price stability should be compared to that of the Roman Republic, whose silver denarius maintained 100 percent of its original purchasing power for over two hundred years, until it began to be debased by the Emperor Augustus in the late first century BC. The gold solidus of the Byzantine Empire had an even more impressive track record, maintaining its purchasing power essentially unchanged for over five hundred years, from the monetary reform of AD 498 until another debasement began in 1030.
Fed defenders point out that while the dollar may have lost 95 percent of its purchasing power, wages have increased by a factor of over twenty, so that increased wages offset the decreased purchasing power. The idea that prices and wages move together without harm is known as money neutrality. This theory, however, ignores the fact that while wages and prices have gone up together, the impact has not been uniform across all sectors. The process produces undeserving winners and losers. Losers are typically those Americans who are prudent savers and those living on pensions whose fixed returns are devalued by inflation. Winners are typically those using leverage as well as those with a better understanding of inflation and the resources to hedge against it with hard assets such as gold, land and fine art. The effect of creating undeserving winners and losers is to distort investment decision making, cause misallocation of capital, create asset bubbles and increase income inequality. Inefficiency and unfairness are the real costs of failing to maintain price stability.
Another mandate of the Fed is to function as a lender of last resort. In the classic formulation of nineteenth-century economic writer Walter Bagehot, this means that in a financial panic, when all bank depositors want their money at once, a central bank should lend money freely to solvent banks against good collateral at a high rate of interest to allow banks to meet their obligations to depositors. This type of lending is typically not construed as a bailout, but rather as a way to convert good assets to cash when there is no other ready market for the assets. Once the panic subsides and confidence is restored, the loans can be repaid to the central bank and the collateral returned to the private banks.
In the depths of the Great Depression, when this lender of last resort function was most needed, the Fed failed utterly. More than ten thousand banks in the United States were either closed or taken over and assets in the banking system dropped almost 30 percent. Money was in such short supply that many Americans resorted to barter, in some cases trading eggs for sugar or coffee. This was the age of the wooden nickel, a homemade token currency that could be used by a local merchant to make change for a customer and then accepted later by other merchants in the vicinity in exchange for goods and services.
The next time the lender of last resort function became as critical as it had been in the Great Depression was the Panic of 2008. The Fed acted in 2008 as if a liquidity crisis had begun, when it was actually a solvency and credit crisis. Short-term lending can help ease a liquidity crisis by acting as a bridge loan, but it cannot cure a solvency crisis, when the collateral is permanently impaired. The solution for a solvency crisis is to shut down or nationalize the insolvent banks using existing emergency powers, move bad assets to government control and reprivatize the new solvent bank in a public stock offering to new shareholders. The new bank is then in a position to make new loans. The benefit of putting the bad assets under government control is that they can be funded at low cost with no capital and no mark-to-market accounting for losses. The stockholders and bondholders of the insolvent bank and the FDIC insurance fund would bear the losses on the bad assets, and the taxpayers would be responsible only for any excess losses.
Once again, the Fed misread the situation. Instead of shutting down insolvent banks, the Fed and the Treasury bailed them out with TARP funds and other gimmicks so that bondholders and bank management could continue to collect interest, profits and bonuses at taxpayer expense. This was consistent with the Fed’s actual mandate dating back to Jekyll Island—to save bankers from themselves. The Fed almost completely ignored Bagehot’s core principles. It did lend freely, as Bagehot recommended, but it took weak collateral, much of which is still lodged on the Fed’s books. The Fed charged almost no interest instead of the high rates typically demanded from borrowers in distress. The Fed also lent to insolvent banks rather than just the solvent ones worth saving. The result for the economy even now is that the bad assets are still in the system, bank lending is highly constrained due to a need to rebuild capital and the economy continues to have great difficulty returning to self-sustaining growth.
When most urgently called upon to perform its lender of last resort functions, the Fed has bungled both times. First in 1929–1933, when it should have provided liquidity and did not. Then again in 2007–2009, when it should have closed insolvent banks but instead provided liquidity. The upshot of these two episodes, curiously, is that the Fed has revealed it knows relatively little about the classic arts of banking.
In 1978, the Humphrey-Hawkins Full Employment Act, signed by President Jimmy Carter, added management of unemployment to the Fed’s mandate. The act was an explicit embrace of Keynesian economics and mandated the Fed and the executive branch to work together in order to achieve full employment, growth, price stability and a balanced budget. The act set a specific numeric goal of 3 percent unemployment by 1983, which was to be maintained thereafter. In fact, unemployment subsequently reached cyclical peaks of 10.4 percent in 1983, 7.8 percent in 1992, 6.3 percent in 2003 and 10.1 percent in 2009. It was unrealistic to expect the Fed to achieve the combined goals of Humphrey-Hawkins all at once, although Fed officials still pay lip service to the idea in congressional testimony. In fact, the Fed has not delivered on its mandate to achieve full employment. As of 2011, full employment as it is conventionally defined is still five years away, according to the Fed’s own estimates.
To these failures of price stability, lender of last resort and unemployment must be added the greatest failure of all: bank regulation. The Financial Crisis Inquiry Commission created by Congress in 2009 to examine the causes of the current financial and economic crisis in the United States heard from more than seven hundred witnesses, examined millions of pages of documents and held extensive hearings in order to reach conclusions about res
ponsibility for the financial crisis that began in 2007. The commission concluded that regulatory failure was a primary cause of the crisis and it laid that failure squarely at the feet of the Fed. The official report reads: We conclude this crisis was avoidable. The crisis was the result of human action and inaction.... The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not.... We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts.... Yet we do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it.... The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup’s excesses in the run-up to the crisis. They did not.... In case after case after case, regulators continued to rate the institutions they oversaw as safe and sound even in the face of mounting troubles.
The report goes on for more than five hundred pages to detail the Fed’s regulatory failures in minute detail. As noted in the excerpt above, all of the Fed’s failures were avoidable.
One last test of Fed competence involves the Fed’s handling of its own balance sheet. The Fed may be a central bank, but it is still a bank with a balance sheet and net worth. A balance sheet has two sides: assets, which are the things owned, and liabilities, which are the things owed to others. Net worth, also called capital, equals the assets minus the liabilities. The Fed’s assets are mostly government securities it buys, and its liabilities are mostly the money it prints to buy them.
As of April 2011, the Fed had a net worth of approximately $60 billion and assets approaching $3 trillion. If the Fed’s assets declined in value by 2 percent, a fairly small event in volatile markets, the 2 percent decline applied to $3 trillion in assets produces a $60 billion loss—enough to wipe out the Fed’s capital. The Fed would then be insolvent. Could this happen? It has happened already, but the Fed does not report it because it is not required to revalue its assets to market value. This situation will come to a head when it comes time to unwind the Fed’s quantitative easing program by selling bonds. The Fed may ignore mark-to-market losses in the short run, but when it sells the bonds, those losses will have to be shown on the books.
The Federal Reserve is well aware of this problem. In 2008, the Fed sent officials to meet with Congress to discuss the possibility of the Fed propping up its balance sheet by issuing its own bonds as the Treasury does now. In 2009, Janet Yellen, then president of the Federal Reserve Bank of San Francisco, went public with this request in a New York speech. Regarding the power to issue the new Fed Bonds, Yellen said, “I would feel happier having it now” and “It would certainly be a nice thing to have.” Yellen seemed eager to get the program under way, and with good reason. The Fed’s lurch toward insolvency was becoming more apparent by the day as it piled more leverage on its capital base. By getting permission from Congress to issue new Fed bonds, the Federal Reserve could unwind quantitative easing without having to sell the existing bonds on its books. Sales of the new Fed bonds would be substitutes for sales of the old Treasury bonds to reduce the money supply. By this substitution, the losses on the old Treasury bonds would stay hidden.
This bond scam was shot down on Capitol Hill, and once it failed, the Fed needed another solution quickly. It was running out of time before QE would need to be reversed. The solution was a deal arrived at between the Treasury and the Fed that did not require approval from Congress.
The Fed earns huge profits every year on the interest received on Treasury bonds the Fed owns. The Fed customarily pays these profits back to the Treasury. In 2010, the Fed and Treasury agreed that the Fed could suspend the repayments indefinitely. The Fed keeps the cash and the amount the Fed would normally pay to the Treasury is set up as a liability account—basically an IOU. This is unprecedented and is a sign of just how desperate the situation has become.
Now as losses on future bond sales arise, the Fed does not reduce capital, as would normally occur. Instead the Fed increases the amount of the IOU to the Treasury. In effect, the Fed is issuing private IOUs to the Treasury and using the cash to avoid appearing insolvent. As long as the Fed can keep issuing these IOUs, its capital will not be wiped out by losses on its bond positions. On paper the Fed’s capital problem is solved, but in reality the Fed is increasing its leverage and parking its losses at the Treasury. Corporate executives who played these kinds of accounting games would be sent to jail. It should not escape notice that the Treasury is a public institution while the Fed is a private institution owned by banks, so this accounting sham is another example of depriving the taxpayers of funds for the benefit of the banks.
The United States now has a system in which the Treasury runs nonsustainable deficits and sells bonds to keep from going broke. The Fed prints money to buy those bonds and incurs losses by owning them. Then the Treasury takes IOUs back from the Fed to keep the Fed from going broke. It is quite the high-wire act, and amazing to behold. The Treasury and the Fed resemble two drunks leaning on each other so neither one falls down. Today, with its 50-to-1 leverage and investment in volatile intermediate-term securities, the Fed looks more like a poorly run hedge fund than a central bank.
Ed Koch, the popular mayor of New York in the 1980s, was famous for walking around the city and asking passersby, in his distinctive New York accent, “How’m I doin’?” as a way to get feedback on his administration. If the Fed were to ask, “How’m I doin’?” the answer would be that since its formation in 1913 it has failed to maintain price stability, failed as a lender of last resort, failed to maintain full employment, failed as a bank regulator and failed to preserve the integrity of its balance sheet. The Fed’s one notable success has been that, under its custody, the Treasury’s gold hoard has increased in value from about $11 billion at the time of the Nixon Shock in 1971 to over $400 billion today. Of course, this increase in the value of gold is just the flip side of the Fed’s demolition of the dollar. On the whole, it is difficult to think of another government agency that has failed more consistently on more of its key missions than the Fed.
Monetarism
Monetarism is an economic theory most closely associated with Milton Friedman, winner of the Nobel Prize in economics in 1976. Its basic tenet is that changes in the money supply are the most important cause of changes in GDP. These GDP changes, when measured in dollars, can be broken into two components: a “real” component, which produces actual gains, and an “inflationary” component, which is illusory. The real plus the inflationary equals the nominal increase, measured in total dollars.
Friedman’s contribution was to show that increasing the money supply in order to increase output would work only up to a certain point; beyond that, any nominal gains would be inflationary and not real. In effect, the Fed could print money to get nominal growth, but there would be a limit to how much real growth could result. Friedman also surmised that the inflationary effects of increasing the money supply might occur with a lag, so that in the short run printing money might increase real GDP but inflation would show up later to offset the initial gains.
Friedman’s idea was encapsulated in an equation known as the quantity theory of money. The variables are M = money supply, V = velocity of money, P = price level and y = real GDP, expressed as:MV = Py
This is stated as: money supply (M) times velocity (V) equals nominal GDP, which can be broken into its components of price changes (P) and real growth (y).
Money supply (M) is controlled by the Fed. The Fed increases money supply by purchasing government bonds with printed money and decreases money supply by selling the bonds for money that then disappears. Velocity (V) is just the measure of how quickly money turns over. If someone spends a dollar and the recipient also spends it, that dollar has a velocity of two bec
ause it was spent twice. If instead the dollar is put in the bank, that dollar has a velocity of zero because it was not spent at all. On the other side of the equation, nominal GDP growth has its real component (y) and its inflation component (P).
For decades one of the most important questions to flow from this equation was, is there a natural limit to the amount that the real economy can expand before inflation takes over? Real growth in the economy is limited by the amount of labor and the productivity of that labor. Population grows in the United States at about 1.5 percent per year. Productivity increases vary, but 2 percent to 2.5 percent per year is a reasonable estimate. The combination of people and productivity means that the U.S. economy can grow about 3.5 percent to 4.0 percent per year in real terms. That is the upper limit on the long-term growth of real output, or y in the equation.
A monetarist attempting to fine-tune Fed monetary policy would say that if y can grow at only 4 percent, then an ideal policy would be one in which money supply grows at 4 percent, velocity is constant and the price level is constant. This would be a world of near maximum real growth and near zero inflation.
If increasing the money supply in modest increments were all there was to it, Fed monetary policy would be the easiest job in the world. In fact, Milton Friedman once suggested that a properly programmed computer could adjust the money supply with no need for a Federal Reserve. Start with a good estimate of the natural real growth rate for the economy, dial up the money supply by the same target rate and watch the economy grow without inflation. It might need a little tweaking for timing lags and changes in the growth estimate due to productivity, but it is all fairly simple as long as the velocity of money is constant.
Currency Wars: The Making of the Next Global Crisis Page 20
