Tag Archives: Monetary policy

“Giving up on the Fed”

Posted on January 26, 2010 by | 3 comments

By Warren Mosler

We’re getting closer to the point discussed a few weeks ago about markets giving up on the Fed.

At the time the 10 year was maybe 3.75-3.80, gold had gone about 1,200, the dollar was near the lows, crude was back over 80, stocks were up, all based on the belief the Fed had the power to ‘reflate’ and was ‘printing money’ through trillions of ‘quantitative easing’ which was, sooner or later, hyper inflationary, along with 0 interest rates and ‘record deficits’ which would drive up interest rates, risk default and a sudden breakdown of the $US, all contributing to the same inflationary collapse.

Now that the bets have been placed, and none of that is happening, it’s all starting to erode. Crude is back below 75 (the Saudis’ actual target/range?), gold is selling off, the dollar is edging higher, the 10 year just traded at 3.57, stocks are selling off, etc.

The next step is for first markets and then policy makers to realize the Fed has no tools to inflate. That 0 rates and qe don’t cut it. Nor are deficits large enough to reflate. Bernanke was asked by Time magazine late last year if he had any tools left. He said yes. When asked what they were, he had no specific answer. Well, if he does have more tools, with 10% unemployment and weak prices and a dual mandate for full employment and price stability, what’s he waiting for?

Should market psychology turn to the notion that the Fed has no tools to inflate, and we have a Congress dead set against larger deficits, it can all get very ugly very quickly in the race to the exit from the inflation plays (including steepeners) currently on the books.

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Will Bernanke Be Reappointed? Does It Matter?

Posted on January 25, 2010 by | 6 comments

By L. Randall Wray

There is a lot of speculation over the reappointment of Ben Bernanke to continue to head the Fed, with the Obama Administration pushing hard. Of course, Wall Street is also calling in its favors. It looks like a done deal. The Administration has probably got the 60 votes required in the Senate to remove the hold, and the 51 votes needed for confirmation.

Does it matter? Well, on one level, this is a reward for incompetence—something that is never a good idea. Chairman Bernanke never saw “it” (the great financial crisis) coming, and indeed, actively promoted practices that made the crisis inevitable. However, on that score he is not nearly as guilty as his predecessor—Greenspan–who ruled monetary policy from 1987 to 2005. Poor Bernanke was left to clean up the mess, while Greenspan got to retire to great acclaim (that did not last long!). As the crisis unfolded, Bernanke had to learn on the job. While he was supposedly a student of the Great Depression and thus should have known what to do, in truth, he had always misunderstood the crisis of the 1930s. Hence, he has taken many half-steps and made many mis-steps over the past three years that made matters worse. Yet, if we look at where the Fed stands now, it has finally got to the position it should have immediately taken. It has satisfied the liquidity desires of the private financial system by expanding its own balance sheet to $2 trillion, and it is paying interest on reserves (reducing the “tax” on banks and simplifying interest rate targeting procedure). It took some time, but Bernanke finally figured out how to deal with the crisis. The liquidity crisis is over (at least for now). Banks are still insolvent—but that is a matter mostly for the FDIC, not for the Fed.

Here are my fears should Bernanke be reappointed.

1. He does not understand that “unwinding” the Fed’s balance sheet is nothing to be concerned about. As I have written previously, this will occur naturally as banks pay-off their loans that the Fed extended in the crisis, and as banks repurchase the assets they sold to the Fed to obtain reserves. However, Bernanke still seems to believe in the discredited “deposit multiplier” and believes the Fed will have to take action to drain reserves (“reverse the quantitative easing”) to prevent excess reserves from fueling inflation. This is nonsense. Banks do not lend reserves and existence of excess reserves does not make them more willing to lend. The Fed does not need to do anything more than to accommodate banks—no concerted action is required. Still, even in the worst case, the Fed will not be able to create a huge mess. Since it operates with an overnight interest rate target, if it tries to remove reserves that the banks want to hold, it will drive rates above the target—so will have to add back the reserves. This could create some uncertainty but it is not likely to generate any crisis.

2. Bernanke might appear to be a “born again” regulator, but that is highly doubtful. The Fed will never take regulation seriously because it is captured by Wall Street. So the important thing is to ensure that the Fed does not become the “super duper systemic regulator” that many are now proposing. This job needs to go to the FDIC, which has in the past actually done some regulating.

3. A win for Bernanke might energize the forces that want to keep Timmy Geithner and Larry Summers in their jobs. In truth, it is far more important to remove Timmy and Larry (and to remove Robert Rubin from his position as advisor to the administration). I have not seen any evidence that Bernanke has been corrupted by Wall Street. Unfortunately, the same cannot be said of Geithner and Summers—where apparent conflicts of interest abound, and questionable decisions have been taken that favor Wall Street institutions. And the Treasury is far more important than the Fed. If we are going to reregulate financial institutions (as Obama now seems inclined to do), we have got to have real regulators at the Treasury. Neither Timmy nor Larry has ever indicated any interest in “interfering” with Wall Street. Indeed, Geithner seems to have been leaking to the press his dissatisfaction with Obama’s recent proposals. Perhaps he is already angling for his Wall Street rewards—seeking a well-compensated position in a financial institution should he be fired.

To be clear, I would prefer to replace Bernanke with someone who actually understands monetary policy and who advocates regulation and supervision of financial institutions. Unfortunately, that looks unlikely. We need to turn our attention to Rubin, Geithner and Summers. Obama does not need any action by Congress to rid himself of these anchors that are dragging down his administration, as well as the Democratic party.

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Helicopter Drops Are FISCAL Operations

Posted on January 7, 2010 by | 24 comments

By Scott Fullwiler

Given all the chatter in the blogosphere about “Helicopter Ben” Bernanke, it’s probably time to look more carefully at the actual accounting behind so-called “helicopter drops of money,” made famous years ago by Milton Friedman. As most everyone knows, the idea behind a hypothetical helicopter drop is that the central bank would essentially drop currency from a helicopter in an effort to stimulate aggregate spending. One could modernize the story and presume that the central bank credits X number of dollars to the bank (deposit) accounts of all (or even some) individuals. And while traditionally it’s been presumed that it would be the Fed that would be dropping money from the helicopter(s), it could just as easily be action taken by the Treasury – e.g. by requiring the Treasury to take an overdraft on its account at the central bank via mandate from Congress and the President.

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Let The Mea Culpas Begin, Part 2

Posted on January 6, 2010 by | 10 comments

BERNANKE’S APOLOGY FALLS FLAT
By L. Randall Wray

As discussed in Part 1 (see here), some of the policymakers responsible for this calamity have started to apologize. On January 3 Chairman Bernanke admitted that rather than using rate hikes back in 2004 to deflate the housing bubble, the Fed should have used “[s]tronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management” (see here).

There appear to be at least three reasons for Bernanke’s admission that the Fed did not do its job. First, and most obviously, Bernanke is up for reappointment (his term expires January 31)—and he will not sail through. The public is mad as hell, and politicians will have to put him through the wringer or face voter’s wrath in the next election. So Bernanke will have to appear contrite, and will apologize for his misdeeds many more times while Congress makes him sweat it out.

Second, Congress is actually considering whether it should strip the Fed of all regulatory and supervisory authority, given its miserable performance over the past decade—during which the Fed has consistently demonstrated that it has neither the competence nor the will to restrain Wall Street’s bankers. Since Greenspan took over the helm, the Fed has never seen a financial instrument or practice that it did not like—no matter how predatory or dangerous it was. Adjustable rate mortgages with teaser rates that would reset to levels guaranteed to produce defaults? Greenspan praised them (see here). Liar loans? Bring them on! NINJA loans (no income, no job, no assets)? No problem! Credit default swaps that let one gamble on the death of assets, firms, and countries? Prohibit government from regulating them! So Bernanke has to grovel and beg Congress to let the Fed retain at least some of its authority.

Third, many commentators blame the Fed for the crisis, arguing that it kept interest rates too low for too long, fueling the real estate bubble. Bernanke argues “When historical relationships are taken into account, it is difficult to ascribe the house price bubble either to monetary policy or to the broader macroeconomic environment”. If he can convince Congress that the problem was lack of oversight and regulation he can shift at least some of the blame to Treasury and Congress—since it was Treasury Secretary Rubin, and his protégé Summers, as well as Barney Frank, Christopher Dodd, and many others (significantly, Democrats who will now decide the Fed’s fate) who pushed through the deregulation bills in 1999 and 2000. He figures that if the Fed now supports re-regulation, he will be forgiven and the Democrats will be too embarrassed to admit their own misdeeds. (Significantly, Dodd has announced his retirement, in recognition of the role he played in creating the crisis. Another mea culpa on the way?)

While I do believe the Fed should be stripped of all such authority, I am sympathetic to his argument about monetary policy. Low interest rates do not cause bubbles. The Fed kept interest rates low after the NASDAQ crash because it feared deflation in the face of significant downward pressures on wages and prices globally (see here). The belief was that low interest rates would keep borrowing costs low for firms and households, helping to promote spending and recovery. In truth, spending is not very interest sensitive and the economy stumbled along in a “jobless recovery” in spite of the low rates. What was actually needed was a fiscal stimulus (if anything, low rates are counterproductive because they reduce government interest spending on its debt—as Japan’s experience taught us over the past couple of decades—but that is a point for another blog).

Still, the Fed was following conventional wisdom, and only began to gradually raise rates when job growth picked up in 2004. Over the following years, the Fed kept raising rates, and economic growth improved. (So much for conventional wisdom!) The worst excesses in real estate markets began only after the Fed had started raising rates, and lending standards continued their downward spiral the higher the Fed pushed its target interest rate. In other words, contrary to what many are arguing, the Fed DID raise rates but this had no impact in real estate markets.

Why not? Two main reasons. First, recall that Greenspan had promoted adjustable rate mortgages with teasers. No matter how high the Fed pushed rates, lenders could offer “option rate” deals in which borrowers would pay a rate of 1 or 2 percent for two to three years, after which there would be a huge reset. Lenders ensured the borrowers that there was no reason to worry about resets, since they would refinance into another option rate mortgage before the reset. That is the beauty of ARMs—they virtually eliminate the impact of monetary policy on real estate.

Second, and this was the key, house prices would only go up. At the time of refinance, the borrower would have far more equity in the home, thus obtain a better mortgage. Further, the borrower could flip the house and walk away with cash. While I will not go into this now, public policy actually encouraged homeowners to look at their houses as assets, rather than as homes (see here) (And now that many are walking away from underwater mortgages—treating houses as assets that became bad deals—policy makers and banksters are shocked, shocked!, that borrowers are treating their homes as nothing but bad assets.)

In truth, when speculation comes to dominate an asset class, there is no interest rate hike that can kill a bubble. If one expects asset prices to rise by 20%, 30%, or more per year, an interest rate of 10% will not dampen enthusiasm. To kill the housing boom, the Fed would have had to engage in a Volcker-like double-digit rate hike (in the early 1980s, he raised short-term interest rates above 20%). There was no political will in Washington (either at the Fed or the White House) for such drastic measures. Nor was there any reason to do this. Bernanke is quite correct: the Fed could have and should have killed the real estate boom with much less pain by directly clamping down on lenders, prohibiting the dangerous practices that were rampant.

Is there any reason to believe that Bernanke is the right Chairman, or that the Fed is the right institution, to lead the effort to re-regulate and re-supervise the financial sector? Quite simply, no.

The Bernanke-led Fed still does not understand monetary operations, as indicated by its recently announced plan to unwind its balance sheet. Over the course of the crisis, the Fed invented new procedures such as auctions through which it provided reserves. Throughout, it always was focused on quantities, rather than prices, using quantitative constraints on the size of the auctions. Further, Bernanke continually promoted “quantitative easing”, reflecting the view that quantities are what matter. Now, the Fed has begun to worry about the size of its balance sheet—and also the size of reserve holdings of the banking system (the other side of the balance sheet coin, because the Fed buys assets by issuing reserves). Still following the thoroughly discredited theory of Milton Friedman, too many bank reserves are supposed to promote too much lending which then causes too much spending and hence inflation. Thus, Bernanke and many outside the Fed fret about how the Fed can reduce outstanding reserves to prevent incipient inflation. The Fed proposes to create new bonds it will sell to reverse the “quantitative easing”.

Actually, the Fed’s tool is price, not quantity, of reserves. When the crisis hit, the Fed should have opened its discount window to lend reserves without limit, to all comers, and without collateral. That is how you stop a run. The Fed’s dallying and dillying about worsened the liquidity crisis, but it eventually provided the reserves that the financial institutions wanted to hold and its balance sheet eventually grew to $2 trillion. Banks are still worried about counterparty risk and possible runs, so they remain willing to hold massive amounts of reserves. When they decide risks have declined, they will begin to reduce reserve holdings. This will not require any special practices by the Fed. Banks will repay their loans from the Fed, using reserves. This automatically reduces reserves and the size of the Fed’s balance sheet. They will offer undesired reserves in the overnight, fed funds market. Since many banks will be trying to unload reserves at the same time, this will put downward pressure on the fed funds rate. The Fed will then offer to sell assets it is holding to mop up the excess reserves (banks will use reserves to buy assets the Fed offers). This will also reduce reserves and the size of the Fed’s balance sheet. All of this will happen automatically, following the same procedures the Fed has always followed. All it needs to do is to watch the fed funds rate, and when it falls below target the Fed will drain reserves to relieve the downward pressure on overnight rates.

Quantitative easing was a misguided notion, and reversal of quantitative easing is similarly misguided. It simply indicates that Bernanke still does not understand how the Fed operates. In truth, formulating and implementing monetary policy is extremely simple and can be reduced to the following:

1. Offer to lend reserves at the discount window at 50 basis points to all qualifying institutions;

2. Pay 25 basis points on reserve holdings;

3. Perform par clearing of checks between banks, and for the Treasury.

Surely President Obama can find a chair who can do that.

The Fed’s relationship with banks is too cozy to make it a good regulator. It is, after all, owned by private banks. The Fed’s district banks are often run by bankers, and district Fed presidents take turns sitting on the policy-making FOMC. There is a particularly incestuous relationship between the NYFed and Wall Street banks—with Timmy Geithner as a prime example of the dangers posed (“I’ve never been a regulator” proclaimed the former head of the NYFed). It does not have the proper culture to closely supervise financial institutions. Its top body, the Board of Governors, are political appointees often with no experience in regulation (many are academic economists, typically mainstream and with a free market orientation). While the FDIC was also mostly asleep at the wheel over the past decade, it does have the proper culture and experience to take over responsibility for regulating and supervising the financial sector. With some management changes, and hiring of a team of criminologists tasked to pursue fraud, the FDIC is the right institution for this job.

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Fixing the Small Banks

Posted on January 1, 2010 by | 3 comments

By Warren Mosler*

Fixing the Small Banks

The Obama administration has been preaching the importance of fixing the small banks and getting them lending again. This will review what I see as the critical issue and how to fix it.

First, the answer:

1. The Fed should loan fed funds (unsecured) in unlimited quantities to all member banks.

2. The regulators should then drop all requirements that a % of bank funding be ‘retail’ deposits.

Yes, it is that simple. This simple, easly to implement ‘fix’ will immediately work to restore small bank lending from the bottom up by removing unnecessary costs imposed by current government policy.

The current problem with small banks is their too high marginal cost of funds. The only reason the Fed hasn’t expressed an interest in ‘opening the spigot’ and supplying unlimited funding at its target interest rate to any member bank to bring down this elevated cost of funds has to be a lack of understanding of our banking system.

Currently the true marginal cost of funds to small banks is probably at least 2% over the fed funds rate. This is keeping their minimum lending rates at least that much higher, which also works to exclude borrowers who need that much more income to service their borrowings, all else equal.

The primary reason for the high cost of funds is the requirement for ‘retail deposits’ that causes the banks to compete for a finite amount of available deposits in this ‘category.’ While, operationally, loans create deposits, and there are always exactly enough deposits to fund all loans, there are some leakages. These include cash in circulation, the fact that some banks, particularly large, money center banks, have excess retail deposits, and a few other ‘operating factors.’ This causes small banks to bid up the price of retail deposits in the broker CD markets and raise the cost of funds for all of them, with any bank considered even remotely ‘weak’ paying even higher rates, even though its deposits are fully FDIC insured. Additionally, small banks are driven to open expensive branches that can add over 1% to a bank’s true marginal cost of funds, to attempt to attract retail deposits. So by driving small banks to compete for a limited and difficult to access source of funding the regulators have effectively raised the cost of funds for small banks.

It should be clear my solution would immediately lower the marginal cost of funds for small banks. I’ll now attempt to address the usual host of objections to my proposal.

There are always two fundamentals to keep in mind when contemplating banking with a non convertible currency and floating exchange rate:

1. The liability side of banking is not the place for market discipline.

2. The Fed and monetary policy in general is about prices (interest rates) and not quantities.

Disciplining banks on the liability side has been tried repeatedly and always and necessarily fails. First, it’s fundamentally impractical to the point of ridiculous to expect anyone looking to open a checking account or savings account, for example, to be responsible for analyzing the finances of competing banks for solvency, when even Wall Street analysts can’t reliably do this. The US leaned this the hard way when the banking system was closed in 1934, reopening with Federal deposit insurance for bank deposits for the sole purpose of removing this responsibility from the market place. Regulation and supervision on the asset side then became the imperative. And while we have seen periodic failures due to lax regulation and supervision of the asset side of the US banking system, and it’s a work in progress, the alternative of using the liability side of banking for market discipline exposes the real economy to far more disruptions and far more destructive systemic risk.

Those who understand reserve accounting and monetary operations, including those directly involved in monetary operations at the world’s central banks, have known for decades that in banking, causation runs from loans to deposits, with reserve requirements, if any, being merely a ‘residual overdraft’ at the central bank and not a control variable. This includes Professor Charles Goodhart at the Bank of England, who has written extensively on this subject for roughly half a century, endlessly debating the ‘monetarist’ academic economists who spew gold standard and fixed exchange rate rhetoric, and who are unaware of how monetary operations are altered when there is no legal convertibility of a currency. Recall the ‘500 billion euro day’ back in 2008 when the ECB added that many euro in reserves to its banking system, and a week later the monetarists pouring over the data ‘couldn’t find it.’ The fact that they even looked was evidence enough they had no actual knowledge of reserve accounting and monetary operations. And, more recently, the notion that ‘quantitative easing’ makes any difference at all apart from changes in interest rates (it’s always about price and not quantity) reinforces the point that there is very little understanding of monetary operations and reserve accounting. While Professor Goodhart did declare quantitative easing in the UK a ‘success’ he did so on the basis of how it restored ‘confidence,’ making it clear that there was no actual monetary channel of causation from excess reserves to lending. Banks do not ‘lend out’ reserves. Loans create their own deposits. Total reserves are not diminished by lending. This is operational and accounting fact, and not theory or philosophy.

What this means in relation to my proposal of unlimited lending by the Fed to small banks at its target rate, is that any lending by the Fed will not alter anything regarding lending and the ‘real economy’ in any other regard, apart from the resulting term structure of interests per se. (Also, and not that it matters in any event, total lending by the Fed won’t exceed funds ‘hoarded’ by some banks along with the usual operating factors that routinely ‘drain’ reserves.)

In other words, the notion that this policy will somehow result in some inflationary monetarist type expansion is entirely inapplicable with a non convertible currency and floating exchange rate policy.

The other common concern is the risk to the Fed of lending unsecured to its member banks. However, there is none, if you look at government from the macro level. All bank assets are already regulated and supervised, and the banks are continually subjected to solvency tests. This means government has already deemed to the banks ‘safe to lend to.’ Furthermore, functionally, the fact that banks can indeed fund themselves in unlimited size with FDIC insured deposits means the government already lends to banks in unlimited quantities, protecting itself by regulating and supervising the assets, including asset quality, capital requirements, etc. Therefore, the Fed asking for collateral from its member banks is entirely redundant, as well as disruptive and a cause of increased rates to borrowers.

Conclusion: If the Obama administration had the knowledge, they would immediately move to implement my proposals to support small banking.

*First published on Moslereconomics.com

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“Fixing the Economy”

Posted on December 31, 2009 by | 7 comments

By Warren Mosler*

I was asked by a reporter to state how I’d fix the economy in 500 words and replied:

Fixing the Economy

1. A full ‘payroll tax holiday’ where the US Treasury makes all FICA payments for us (15.3%). This will restore ’spending power’ allowing households to make their mortgage payments, which ‘fixes the banks’ from the ‘bottom up.’ It also helps keep prices down as competitive pressures will cause many businesses to lower prices due to the tax savings even as sales increase.

2. A $500 per capita Federal distribution to all the States to sustain employment in essential services, service debt, and reduce the need for State tax hikes. This can be repeated at perhaps 6 month intervals until GDP surpasses previous high levels at which point state revenues that depend on GDP are restored.

3. A Federally funded $8/hr job for anyone willing and able to work that includes healthcare. The economy will improve rapidly with my first two proposals and the private sector far more readily hires people already working vs people idle and unemployed.
In 2001 Argentina, population 34 million, implemented this proposal, putting to work 2 million people who had never held a ‘real’ job. Within 2 years 750,000 were employed by the private sector.

4. Returning banking to public purpose. The following are disruptive and do not serve no public purpose:

a. No secondary market transactions
b. No proprietary trading
c. No lending vs financial assets
d. No business activities beyond approved lending and providing banking accounts and related services.
e. No contracting in LIBOR, only fed funds.
f.  No subsidiaries of any kind.
g. No offshore lending.
h. No contracting in credit default insurance.

5. Federal Reserve- The liability side of banking is not the place for market discipline. The Fed should lend in the fed funds market to all member banks to ensure permanent liquidity. Demanding collateral from banks is disruptive and redundant, as the FDIC already regulates and supervises all bank assets.

6. The Treasury should issue nothing longer than 3 month bills. Longer term securities serve to keep long term rates higher than otherwise.

7. FDIC

a. Remove the $250,000 cap on deposit insurance. Liquidity is no longer an issue when fed funds are available from the Fed.
b. Don’t tax the good banks for losses by bad banks. All that does is raise interest rates.

8. The Treasury should directly fund the housing agencies to eliminate hedging needs and directly target mortgage rates at desired levels.

9. Homeowners being foreclosed should have the option to stay in their homes at fair market rents with ownership going to the government at the lower of the mortgage balance or fair market value of the home.

10. Remove the ’self imposed constraints’ that are disruptive to operations and serve no public purpose.

a. Treasury debt ceiling- Congress already voted for the spending and taxes
b. Allow Treasury ‘overdrafts’ at the Fed. This is left over from the gold standard days and is currently inapplicable.

11. Federal taxes function to regulate aggregate demand, not to raise revenue per se, and therefore should be increased only to cool down an overheating economy, and not to ‘pay for’ anything.

*First published on Moslereconomics.com

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Fed Offers New CD; Chairman Bernanke is still confused

Posted on December 30, 2009 by | 7 comments

By L. Randall Wray

As reported in the NYT yesterday, the Fed has decided to offer banks an interest-paying CD. So far, so good. However, the argument offered by the Fed to justify this “innovation” is that it needs to start mopping up reserves in order to prevent inflation:

The Federal Reserve on Monday proposed allowing banks to park their reserves at the central bank, a move aimed at weaning the economy off extraordinary infusions of cash and curbing inflation. The Fed would create the equivalent of a certificate of deposit that pays interest to banks for keeping some of their reserves — which are currently estimated at more than $1 trillion — for up to one year. That would help offset some of the $2.2 trillion the central bank has fanned out into the economy during the financial crisis. It also would allow the Fed to quickly entice banks to take more money out of circulation in case inflation emerged as a serious threat in the near future. The proposal was the latest sign the Fed is intensifying its efforts to scale back the vast amounts of money it pumped into the economy at the height of the crisis.

This blog has published a number of pieces explaining why there is no need to worry about the trillions of dollars of reserves and cash created by the Fed to deal with the run to liquidity set-off by this crisis (see here and here). As and when banks decide they do not want to hold reserves, they will retire their loans at the discount window and will begin to purchase higher-earning assets. As this pushes up asset prices (reducing interest rates), the Fed will begin to unwind its balance sheet—selling the assets it purchased during the crisis. Retiring discount window loans plus purchases of assets from the Fed will eliminate undesired reserve holdings. It is all automatic and nothing to worry about or to plan for. And it will not set off a round of inflation. The old “money multiplier” view according to which excess reserves cause banks to lend, which induces spending, which causes inflation, was abandoned by all serious monetary theorists long ago. Chairman Bernanke ought to abandon it, too.

However, there is nothing wrong with offering longer-maturity CDs to replace overnight reserve deposits held by banks at the Fed. Banks are content to hold deposits at the Fed—safe assets that earn a little interest. They are hoping to play the yield curve to get some positive earnings in order to rebuild capital. If they can issue liabilities at an even lower interest rate so that earnings on deposits at the Fed cover interest and other costs of financing their positions in assets, this strategy might work. That is what they did in the early 1990s, allowing banks that were insolvent to work their way back to profitability. The Fed could even lend to banks at 25 basis points (0.25% interest) so that they could buy the CDs, then pay them, say, 100 or 200 basis points (1% or 2% interest) on their longer maturity CDs. The net interest earned could tide them over until it becomes appropriate for them to resume lending to households and firms.

Finally, note that these new CDs are equivalent to Treasuries: government debt that pays interest. However, no one has castigated the Fed for proposing to bankrupt our grandchildren by running up debt. Apparently, this is because economists and policymakers recognize that the Fed is just substituting one kind of liability (reserves) for another kind of liability (CDs). But that is exactly what a sale of a Treasury bond does: it substitutes one government liability (Fed reserves) for another government liability (Treasury bonds). Operationally, it all amounts to the same thing. Once this is recognized, the Treasury can stop issuing debt, we can all stop worrying about our grandchildren, and our nation can get on with ramping up fiscal policy to get out of this economic crisis.

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A New Maestro?

Posted on December 25, 2009 by | 8 comments

By L. Randall Wray

Ok, the media is a poor judge of the performance of the Chairman of the Board of Governors. It seems like only yesterday that it anointed “maestro” status to Chairman Greenspan, right before all hell broke loose and he had to admit that his whole approach to financial markets had been dangerously wrong-headed. Now Chairman Bernanke is awarded with a magazine’s choice as “man of the year”—purportedly for saving capitalism as we know it. More importantly, the Senate is trying to decide whether he deserves reappointment. Usually these votes are little more than a rubber-stamping. Yet, something seems amiss this time around as the Senate Banking Committee voted 16 to 7 for approval—with significant opposition to reappointment. To some extent this is probably a vote of no-confidence for the Administration’s approach to dealing with the financial mess created by three decades of complete mismanagement of the banking system by a succession of Fed and Treasury officials. And, in truth, it would make more sense to fire Timmy Geithner and Larry Summers—who have done far more harm to the economy than has Ben Bernanke.

Let us suppose for a moment that Bernanke had done everything exactly right. Would he deserve accolades? In truth, the job of a Fed Chairman is pretty darn simple. So far as monetary management goes, he has one tool—the overnight interest rate target that is set in meetings of the Federal Open Market Committee. The Chairman has tremendous influence at these meetings, as we know from the transcripts that are released with a 5 year lag. While tremendous significance is believed to surround changes to the Fed’s target rate, in truth the overnight rate has little influence over the economy. As conventional thinking goes, the Fed raises rates in an inflation and lowers them in a recession. When the crisis hit, the Fed should have lowered rates, and did so. By itself, this should have had no impact; and by all accounts it had no impact. Should anyone receive man of the year designation for doing something that any Fed Chairman would have done, and which everyone agrees has virtually no impact?

Better to replace the FOMC with a rule that the overnight rate will be kept at zero from now on, a directive that the NYFed would implement. That would provide a lot more stability to the financial sector—and would go some way toward J.M. Keynes’s “euthanasia of the functionless rentier class”. But that is a story for another day.

In a crisis, the other thing the Fed does is to “provide liquidity”—that is, it lends reserves to prevent bank runs. This has been widely accepted policy since the 1840s and there is no central bank anywhere in the world that would not act as a lender of last resort in the sort of situation Bernanke faced. In fact, Bernanke was a bit slow to the gate on this, and never seemed to fully understand what he was doing. While he should have lent reserves without limit, to all comers, and against any kind of collateral, he played around with a variety of limited auctions, let a major financial institution fail due to lack of access to the Fed’s lending, and demanded good collateral for far too long. If anything, the Fed’s slow learning curve contributed to the crisis. Man of the year? I think not.

Finally, the Fed is supposed to be a regulator of financial institutions—through the thick and thin of the business cycle. Let us suppose a counterfactual: what if Bernanke had been a competent regulator from the time of his appointment? In truth, he consistently and persistently opposed any regulation that might have prevented this crisis, but in that he only followed his predecessor. And most of the damage had been done, with Greenspan at the helm since 1987 and with most of the important deregulation already accomplished by 2000. Clearly Bernanke deserves a grade of D- as a regulator (Timmy proudly earned an F when he testified before Congress that in all his years at the helm of the NY Fed he had never acted as a regulator!). So, he is certainly no worse than a Rubin or a Paulson and by 2005 when he was appointed he would not have had sufficient time or influence to overcome all the damage that had already been done. But a Man of the Year might have at least sounded a warning—rather than continually claiming even through summer 2007 that all was fine and dandy.

Bernanke will win reappointment. He has probably learned a bit as a result of this crisis so he will be a better head in his second term than he was in his first. Much is made of his scholarship that focused on the Great Depression. It is indeed a great advance over the work of Milton Friedman, who claimed the Fed caused the crisis by reducing the money supply. Bernanke also blamed the Fed for the initiation of the crisis, but the prolonged depression resulted because of the failure of financial institutions—which disrupted the relation between banks and their customers. When the bank of a farmer or entrepreneur failed, they were unable to borrow to finance operations—which collapsed production and employment. This is probably why Bernanke wants to prop up Wall Street institutions at all costs, to get “credit flowing again”. What he does not understand is that Wall Street banking has evolved—these are not lenders. They are speculators that serve no useful public purpose. If Bernanke were ever to figure that out, and would start to close down these predators, then he might deserve to be called Maestro.

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Posted in L. Randall Wray, Monetary policy, Uncategorized

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Why Bernanke Must Go

Posted on December 20, 2009 by | 7 comments

By Marshall Auerback

There are any number of reasons why Ben Bernanke should not be reconfirmed, notwithstanding the vote in his favor by the Senate committee last week.

1. Let’s start by using some criteria laid out by Bernanke himself. When first nominated as chairman of the Federal Reserve, Mr. Bernanke promised a greater degree of transparency than his predecessor, but has completely stonewalled anybody seeking to obtain clarification of the events surrounding the credit crisis and more specifically, the role of the Federal Reserve. Any information disclosed would have facilitated a proper assessment of Bernanke’s job performance (which is probably one of the reasons the Fed chairman doesn’t want it released) and, more importantly, would have created a foundation for useful forensic work to prevent recurrences going forward.

Understanding what the decision-making was prior to and during the crisis is key to evaluating Bernanke’s performance and to improving performance in general. Post mortems are standard in sports and medicine. Why not here? And, more importantly, why does Bernanke continue to oppose it? Even the Swiss National Bank has provided a higher level of disclosure and transparency on the banking crisis to its public than has hitherto been agreed by the Bernanke Fed.

2. The Fed chairman claims unique expertise on the grounds of his scholarship of the Great Depression. Few have actually challenged him on the basis of these academic credentials, yet Bernanke holds these out as if they are manifest proof of his appropriateness for the position as head of the Federal Reserve. Ironically, even though Bernanke drew heavily on the work of both Milton Friedman and Anna Schwartz for his own scholarship of the period, Ms Schwartz herself has been enormously critical of the Fed’s conduct both pre-crisis and in seeing providing liquidity as the primary solution. She also warned explicitly against drawing comparisons between the gold standard era Depression and now. Additionally, Bernanke’s reading of the Depression (which is pretty conventional, that the Fed blew it by not providing more liquidity) ascribed little significance to fiscal policy, which has led Bernanke toward wrongheaded “solutions” such as “quantitative easing” and an alphabet soup of lending facilities, none of which did anything to enhance aggregate demand. Consistent with that, the Fed chairman been on the wrong side of fiscal policy, urging the Congress to balance the budget, at least longer term, which suggests that he learned nothing of the fiscal successes of the New Deal.
3. Bernanke’s consistent advocacy of “quantitative easing” perpetuates the silly notion that the Fed has had something to do with the economic “recovery” (a line which Time Magazine had readily embraced in its selection of the Fed Chairman as “Person of the Year”). He has ascribed little importance to the existence of the automatic stabilizers and indeed has persistently fed the misguided notion that the Federal government had limited fiscal resources.

The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment. But as Bill Mitchell as pointed out, quantitative easing merely involves the central bank buying longer dated higher yielding bonds in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts: “[QE] is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates.” In the real world, the creation of a loan and (concurrently) a deposit by a bank are in no way constrained by the quantity of reserves. Instead, the terms set by the central bank for acquiring reserves (which then also affects the rates banks borrow at in money markets) affect a bank’s profit margin on a newly created loan. Thus, expanding its balance sheet can create a potential short position in reserves, and thus the profitability of newly created loans, not the bank’s ability to create the loan.
Banks, then, lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. Even the BIS recognizes this. Unfortunately our Federal Reserve chairman either does not know this (in which case his ignorance disqualifies him for another term in office) or he deliberately misrepresents the actual benefits of QE (duplicity being another good ground for disqualification for a 2nd term). The current incoherence of our economic policy making could diminish if we had a Fed chairman who understood the importance of fiscal policy, rather than one who downplays its significance. Which leads to point 4 below.

4. The Fed chairman continues to demonstrate a tremendous conceptual confusion at the heart of the current crisis, particularly in regard to the banking sector. He actively supported TARP on the grounds that repairing the banks balance sheets would somehow “unblock” credit flows and thereby enhance economic activity. The whole notion of repairing bank balance sheet is a lie and misdirection. The balance sheets we should want to see repaired are household balance sheets. Banks have failed us profoundly. We want them reorganized, not repaired. This will never happen as long as this apologist for Wall Street remains head of the Fed. A world in which the banks are all fixed but households are still broken is worse than what we have right now. Too-big-to-fail banks restored to health are too-big-to-fail banks restored to power. The idea that fixing legacy banks is prerequisite to fixing the broad economy is a lie perpetrated by, amongst others, the Federal Reserve Chairman.
For all of these reasons, Bernanke must go.

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Posted in Marshall Auerback, Monetary policy, Uncategorized

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What If the Government Just Prints Money?

Posted on November 22, 2009 by | 46 comments

By Scott Fullwiler

As Congress gets set in the near future to consider raising the debt ceiling yet again, my fellow blogger L. Randall Wray creatively suggests not raising the debt ceiling but instead having the Treasury continue spending as it always does: by simply crediting bank accounts. As he puts it:

The anti-deficit mania in Washington is getting crazier by the day. So here is what I propose: let’s support Senator Bayh’s proposal to “just say no” to raising the debt ceiling. Once the federal debt reaches $12.1 trillion, the Treasury would be prohibited from selling any more bonds. Treasury would continue to spend by crediting bank accounts of recipients, and reserve accounts of their banks. Banks would offer excess reserves in overnight markets, but would find no takers—hence would have to be content holding reserves and earning whatever rate the Fed wants to pay. But as Chairman Bernanke told Congress, this is no problem because the Fed spends simply by crediting bank accounts.
This would allow Senator Bayh and other deficit warriors to stop worrying about Treasury debt and move on to something important like the loss of millions of jobs.

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