A Volcker rule for the Fed
By Hossein Askari and Noureddine Krichene
Since United States Federal Reserve chairman Ben Bernanke started talking about
a Fed exit strategy to unwind its intrusive role in the ongoing financial
crisis, he has been expanding the Fed’s balance sheet through a number of
schemes.
These include an outright monetization of the US fiscal deficits, pushing the
Fed’s holding of government securities from US$474 billion in February 2009 to
$777 billion in February 2010; increasing its holdings of long-term mortgage
backed securities (MBS) from $6 billion in February 2009 to $1,025 billion in
February 2010; and the purchase of federal agency securities rising from $24
billion in February 2009 to $166 billion in 2010.
By buying MBS, Bernanke has acquired the assets that have
ruined the US financial system, and in the process he has bailed out the banks
and transferred the credit risk to the Fed’s balance sheet. As a result, a
large number of congressmen have demanded that the accounts of the Fed be
audited. Bernanke and his supporters considered that such audit would undermine
Fed’s independence, although the extent of its future losses from such
purchases remains unknown.
Bernanke has himself called his policy aggressive or unorthodox. He realized
that pushing the federal funds rate to near zero bound had failed to
reinvigorate lending. Consequently, he decided to buy the toxic MBS of banks
that had impaired bank balance sheets, so that they might resume their lending.
Through such a monumental MBS purchase program, Bernanke wanted to prevent a
downward adjustment in housing prices and at the same time enable banks to
clean their balance sheets and acquire the needed liquidity to resume their
lending.
Many leading banks have announced record profits in spite of a faltering
economy and their direct bailout by the government. Yes, this has made banks
very profitable, as they were able to unload assets at values that may have
exceeded market values. But always remember, there is no free lunch. This has
all been on the backs of the American taxpayer.
Bernanke’s policies can be best characterized as distortionary. During
2002-2004, he was a party to forcing interest rates to the lowest levels in the
post-war period. Consequently, unchecked monetary expansion led to the worst
economic and financial crisis of the post-war period. The fiscal cost of the
crisis has been translated into record fiscal deficits of about 10-13% of gross
domestic product (GDP) in 2009-2010; unemployment rose to 10%; and real incomes
of workers and pensioners fell significantly.
Bernanke simply blamed the crisis on regulators, and through his unprecedented
bank bailouts and purchases of MBS, he made the large banks profitable in spite
of the fact that the same banks would have simply disappeared without
government bailouts.
The direct purchase of toxic assets has distorted market mechanisms and has
made insolvent banks become highly profitable, pushing up the price of their
traded shares. A central bank is not supposed to buy toxic assets from banks
and keep them on its balance sheet. A central bank buys only short-term
government issues or rediscounts prime paper for short periods. Through its
monetization of bank losses, the central bank inflicts a quasi-fiscal cost on
the government, undermines banking legislation and social equity principles,
distorts the market mechanism, increases moral hazard, and prevents an orderly
resolution to unwind the impaired assets of banks.
Bernanke’s reasoning has been that monetary policy with near-zero interest rate
was too restrictive during a financial crisis. He has adopted the position that
such unorthodox monetary policy could be aggressively pursued as long as
inflation was not pronounced. At that time, Bernanke would start tightening
monetary policy. If he plans to fight inflation, why should he create it in the
first place? And which inflation would Bernanke fight anyway? That is the big
dilemma.
Bernanke has always considered core inflation as the relevant measure, that is,
a measure excluding food, energy, and asset prices. In his recent testimony to
the US Congress on February 24, 2010, Bernanke maintained "that inflation will
be subdued for some time. ... In addition, according to most measures,
longer-term inflation expectations have remained relatively stable".
Hence, according to Bernanke, inflation was subdued even though during 2009 gas
prices rose by 55% and most food prices rose by over 25%. In every testimony
during his tenure as chairman of the Fed, Bernanke has always believed that
inflation was subdued. It would seem that he was not aware of the damage caused
by inflation to the economy.
Housing price inflation, although irrelevant for Bernanke’s Fed, has pushed
housing prices, property taxes, and rents far beyond average incomes. The
outcome was mortgage defaults, foreclosures, banking collapse, bailouts, and
the Bernanke purchase of $1,025 billion of toxic MBS. Still more uncertainties
loom ahead as implications of forgotten housing inflation are still unfolding.
Similarly, Bernanke ignored energy and food price inflation.
Although the Fed could instantaneously, or electronically, buy over $1 trillion
of MBS, banks are not as "instantaneous" as the Fed. They could not
instantaneously push through the economy the money for their MBS sales.
Would-be borrowers could not get this money as instantaneously as the Fed
wished; and the economy could not grow as instantaneously as Bernanke wanted.
Instead, banks had accumulated $1.2 trillion of excess reserves at the Fed in
February 2010 compared with less than $2 billion prior to September 2008.
With the credit-to-GDP ratio at 350%, a meltdown of subprime loans, the
corporate default rate at its highest, and the number of problem banks
exceeding 700, it would be hard to see how banks could inject instantaneously
and profitably huge amounts of liquidity into the economy. If these excess
reserves were released to the economy, they would have created financial
disorder.
Fortunately, banks discovered, albeit belatedly and at a high cost, that they
were not in business to shovel free and instantaneous money created by the Fed
to consumers. They had learned a lesson. During 2002-2007, their financial
position deteriorated significantly, and some reputable long-established banks
even disappeared altogether. So the Fed decided to circumvent banks and
directly buy consumer loans from finance companies. Hence, besides transferring
mortgage risk to the Fed’s balance sheet, the Fed added the risk of subprime
consumer loans to the Fed’s balance sheet.
The Fed's actions in August 2007 to re-inflate the economy and inject massive
liquidity merely further damaged the economy. While the likes of economist
Joseph Stiglitz and investor George Soros have attributed the financial crisis
to the Fed's distortionary policies in 2001-2004, Bernanke has continued to
deny any responsibility.
In August 2007, the Fed should have recognized the consequences of its past
mistakes, which allowed unchecked credit expansion, the free fall of the US
dollar, and virulent housing speculation. It should have accepted the view that
housing and asset bubbles could not burst without unavoidable consequences for
the banking system and the economy. The Fed could have instead followed a
restrictive monetary stance allowing interest rates to be market-determined,
housing prices to adjust, and banks to assess risks.
Such a policy would have avoided the commodity inflation that followed August
2007. The economy might not have experienced such a deep recession; and the
recession could have been less protracted as prices would have adjusted faster,
real supply would have been enhanced, and with monetary stability and greater
impact on real supply, the economy could have made a faster recovery. The US
economy has been, and is in need of more savings and investment, and not more
consumption.
The Fed's monetary mismanagement during the past decade has undone two-decade
of economic prosperity and has spread financial disorder not only in the US,
but also in Europe and even further afield. It has pushed US public debt to
almost $15 trillion, penalizing future generations. While it is a fact that a
central bank can create money instantaneously and at zero cost, the long-term
effects of this are invariably ruinous. Bernanke's announcement on February 24,
2010, that interest rates will be kept at near-zero rate for a long period
again boosted markets. Free money from the Fed will continue to sustain
speculation in equities, commodities, and currencies and redistribute free
wealth to financial institutions such hedge funds, equity funds and banks, or
Wall Street, at the expense of workers, or main street.
It may still take some time for the Fed to realize that near-zero interest
rates can only prolong distortions in the economy and may not be conducive to
economic growth and employment creation. As in the recent past, it may only set
the foundation for another financial crisis. The Fed appears to have lost
control of monetary policy and has little choice at this juncture except to
keep interest rates depressed and print money without limit to avoid further
pressure on fiscal deficits emanating from higher interest rates. With US debt
expanding to $15 trillion, a substantial rise in interest rates can only
exacerbate fiscal deficits.
Caught between President Barack Obama's unorthodox fiscal expansion and
Bernanke's unorthodox monetary policy, the US economy may yet be stalled in a
period of prolonged stagnation and inflation. There are uncertainties on how
the US will cope with record fiscal deficits - through inflationary tax or
through higher tax rates. Either alternative would impede economic growth.
Moreover, distortions from unorthodox monetary policies could damage savings,
capital accumulation, and economic growth. Fiscal and monetary expansion has
created excessive demand, as reflected by external current account deficits and
high inflation in essential commodities. Producers are hardly motivated to
expand real supply when the cost of storing commodities and obtaining working
capital becomes negligible; they have the ability to maximize their profits
through higher prices. They will curtail real supplies and hike prices.
They know that higher prices will always be accommodated by the central bank
through greater monetary injection. Consumers, facing constantly higher prices
for subsistence products such as energy and food, will reduce their real food
intake and forgo spending on non-essentials. Such cuts in real spending will
depress many sectors for which demand is highly income elastic.
Despite Bernanke's views that inflation has been subdued, American consumers
have suffered dramatic cuts in essential products due to a manifold increase in
food prices, and the number of people that receive food relief (in the form of
Food Stamps) soared to nearly 40 million in 2009. The combination of rising
prices, falling real supplies, and falling real demand will keep the economy in
a prolonged period of stagflation until the government decides to restrain
monetary policy.
In sum, near zero interest rates may make loans unusually cheap; however, they
have pushed gold prices past $1,100 an ounce, oil prices beyond $80 per barrel,
and food prices up and up. In contrast, relatively stable monetary policy kept
oil prices at $18 a barrel and gold prices at $260 an ounce for about two
decades.
Social unrest has started in Europe with strikes taking place in a number of
countries. Workers have realized that they have lost significant purchasing
power and cannot put the same amount of food on the table for their children.
If social unrest and labor strikes spread in the US, as in the 1970s, then
unemployment could become unmanageable and recovery could be disrupted even
further.
In the late 1970s and early 1980s, then Federal Reserve chairman Paul Volcker
was able to restore long-term monetary stability that brought two-decades of
economic growth. Volcker has recently proposed regulation to prevent
proprietary trading by banking institutions as a way to enhance credit
intermediation by banks. In other words, banks would have to hold their assets
in the form of loans and bonds and not in form of equities or commodities.
It appears that a rule that restores orthodox and safe money policy by the Fed
would help financial stability and economic growth far better than a rule that
restricts the composition of banks' portfolios. With near-zero interest rates,
banks are more enticed into speculation in commodities and equities. In an
environment characterized by overleveraged corporations, households, and
governments, high rates of default, and rates of interest rate that are kept
artificially low by the central bank, banks have little opportunity for safe
and profitable lending. They seek profits in trading activities in order to
remain in business.
In short, it would appear that the Fed may need a modified Volker rule even
more than the commercial banks.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist with a PhD from UCLA.
(Copyright 2010 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
sales, syndication and
republishing.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
