In testimony before the committee on financial services of the US House of
Representatives in Washington, DC, on February 10, 2010, regarding the "Federal
Reserve's Exit Strategy" from the extraordinary lending and monetary policies
that it implemented to combat the financial crisis and support economic
activity, Federal Reserve chairman Ben S Bernanke said the Fed's response to
the crisis and the recession can be divided into two parts.
First, the financial system during the past two-and-a-half years experienced
periods of intense panic and dysfunction, during
which private short-term funding became difficult or impossible to obtain for
many borrowers, even those with good credit standing in normal times. The
pulling back of private liquidity at times threatened the stability of major
financial institutions and markets and severely disrupted normal channels of
credit.
Yet Bernanke skirted over the fact that for several large institutions, the
liquidity crunch was inseparable from an insolvency problem. What these
distressed institutions needed was more than a liquidity tie over; they
required an injection of capital.
In response, performing its role as liquidity provider of last resort, the
Federal Reserve developed a number of programs to provide supposedly
well-secured, mostly short-term credit directly to the financial system. These
programs, which Bernanke alleged rather simplistically as imposing no cost on
the taxpayer, were a critical part of the government's efforts to stabilize the
financial system and restart the flow of credit.
As noted in Part 2 of this series, the tax exemption granted to distressed
institutions had cost the Internal Revenue Service tax revenue in amounts that
exceeded the estimated positive returns from disposing of distressed assets the
Treasury had acquired. Yet, the true cost of Fed intervention to the integrity
of the market system cannot be fully evaluated until the unintended
consequences surface years later. Free-market capitalism may well be history
after government intervention in this crisis, as the Fed exit strategy may
never be completely carried out or Fed direct intervention will be expected in
all future crises.
What Bernanke did not say in his testimony was that these programs were not
macro monetary measures addressed at the overall capitalist financial market
system, but direct micro intervention into selected wayward distressed
financial firms deemed to big to fail. The approach has set a pattern of
fearlessness among gigantic financial institutions. Yet the net result of the
government approach to the banking crisis is to impose on the market an
oligarchy of a small number of large surviving banks.
The Fed was providing more than liquidity to the financial system. It took over
toxic assets from distressed banks and bank-holding companies which had
ventured into the non-bank financial sector and the shadow banking sector. The
Fed acted as the white knight to save a market failure in the entire global
debt securitization arena. It took on the role of protector of miscreants from
market disciplinary penalties, straying from its official mandate as protector
of the faith on financial market fundamentalism.
Economist Randall Wray wrote in the website of Roosevelt Institute's New Deal
2.0 Project:
But in those areas in which the government believes
markets do work, there should never be any intervention to subvert market
forces that want to punish miscreants. Treasury secretaries [Robert] Rubin,
[Henry] Paulson, and [Timothy] Geithner's repeated claim that we cannot allow
market forces to operate on the downside is logically nonsensical. Markets
cannot work if downside risks are removed. In any area in which the downside is
going to be socialized, the upside MUST also be socialized - that is, removed
from the market. If the market is to work on the upside, it must be allowed to
operate also on the downside.
What about systemic risk? Yes, if government had allowed markets to operate as
Bear [Stearns] and Lehman [Brothers] went down, all of the big financial
institutions would also have been brought down. As Bernanke now apparently
realizes, that would have been a good thing. The market would have accomplished
what Bernanke now professes to desire: resolving the problem of "too big to
fail". We would have been left only with smallish institutions - those not too
big to fail. And as [Roger] Lowenstein forcefully argues, those big financial
institutions do very little that is desirable from a public purpose
perspective. Whatever good they do accomplish can just as easily be done by
small institutions or directly by government where the market fails.
After all, this ain't rocket science. It is just finance: determine who is
credit-worthy, provide a loan financed by issuing insured deposits, and then
hold the loan to maturity. If the underwriting is poor, the institution will
fail and the government will protect only the insured depositors. No individual
institution will have an incentive to grow quickly (rapid growth is almost
always associated with reducing underwriting standards, and fraud) since once
it reaches a one percent share of deposits its access to more insured and cheap
deposits is cut-off. Small institutions would not have to compete against the
large "systemically dangerous" institutions that now enjoy a huge advantage
because even their uninsured liabilities are thought to have the Treasury
standing behind them. With a level playing field, even "average skill and
average good fortune will be enough", as J M Keynes put it.
Bernanke
asserted that as financial conditions have improved, the Fed has substantially
phased out these lending programs. What Bernanke failed to tell congress was
that while the phasing out in this case meant only that the transfer of
troubled debt from the private sector into the public sector had been a
one-time measure that was not expected to be repeated with more Fed funds, the
return of the troubled debt from the public sector back to the private sector
remains on an open schedule. No matter how carefully the Fed intends to carry
out this return of liabilities from the public sector to the private sector, it
will unavoidably cause a head wind for the seriously impaired economy.
Bernanke said the second part of the Fed's response, after reducing the
short-term interest rate target nearly to zero, involved the Federal Open
Market Committee (FOMC) providing additional monetary policy stimulus through
large-scale purchases of Treasury and government sponsored enterprise
securities.
Bernanke claimed correctly that these asset purchases had the additional effect
of substantially increasing the reserves that depository institutions hold with
the Federal Reserve Banks, and had helped lower interest rates and spreads in
the mortgage market and other key credit markets. But his claim that thereby
these purchases promoted economic growth is subject to debate and not supported
by actual data. What Bernanke did not acknowledge was that the effect of Fed
purchases of government debt instruments had not alleviated the rise of
unemployment or foreclosures, much less promoted economic growth.
While admitting that at present the US economy continues to require the support
of highly accommodative monetary policies, Bernanke warned congress that at
some point the Fed will need to tighten financial conditions by raising
short-term interest rates and reducing the quantity of bank reserves
outstanding.
"We have spent considerable effort in developing the tools we will need to
remove policy accommodation, and we are fully confident that at the appropriate
time we will be able to do so effectively," he said. He only glossed over the
details on these tools and gave no indication on when the appropriate time
might be. The fact remains the Fed's tool box is very limited as monetary
policy is generally understood as a very blunt instrument for affecting
economic trends.
Yet the market is keenly aware that the date of a Fed exit from the financial
markets may well be followed by the date for a double dip in a nervous market
that would add more weight to the already impaired economy. Meanwhile, the
exchange value of the dollar is kept up only by other currencies falling faster
as the result of looming sovereign debt crises worldwide, not by the strength
of the dollar's purchasing power.
The Fed's liquidity programs
Bernanke told congress that with the onset of the crisis in the late summer and
autumn of 2007, the Fed aimed tactically to ensure that sound financial
institutions had sufficient access to short-term credit to remain sufficiently
liquid and able to lend to creditworthy customers, even as private sources of
liquidity began to dry up.
Yet what the Fed actually did was to ensure the survival of unsound
institutions on the verge of insolvency that were deemed too big to fail. The
funds that went to these institutions failed to reach even the dwindling number
of creditworthy borrowers. Instead of lending more, much of the bailout money
was used by recipient financial institutions for de-leveraging to shrink their
liabilities.
Bernanke said that to improve the access of banks to backup liquidity, the Fed
reduced the spread of the target federal funds rate over the discount rate -
the rate at which the Fed lends to depository institutions through its discount
window - from 100 basis points to 25 basis points, and extended the maximum
maturity of discount window loans, which had generally been limited to
overnight, to 90 days. A basis point is 0.01 percentage point.
Many banks, however, were evidently concerned that if they borrowed from the
discount window they would be perceived in the market as weak, and consequently
might come under further pressure from creditors.
To address this so-called stigma problem, the Fed created a new discount window
program, the Term Auction Facility (TAF). Under the TAF, the Fed regularly
auctioned large blocks of credit to depository institutions. For many reasons,
including the competitive format of the auctions and the fact that practically
all institutions were in distress, albeit at different degrees, the TAF has not
suffered the stigma of conventional discount window lending and has proved
effective for injecting liquidity into the financial system. Another possible
reason that the TAF did not suffer from stigma was that auctions were not
settled for several days, which signaled to the market that auction
participants did not face an imminent shortage of funds. On the other hand, it
showed that serious market failure could still emerge in a matter of days, a
possibility that Bernanke did not mention.
Liquidity pressures in financial markets were not limited to the United States,
and intense strains in the global dollar funding markets began to spill over
back on US markets. In response, the Fed had to enter into temporary currency
swap agreements with major foreign central banks. Under these agreements, the
Fed provided dollars to foreign central banks in exchange for an equally valued
quantity of foreign currency. The foreign central banks, in turn, lent the
dollars to banks in their own national jurisdictions.
The currency swaps helped reduce stresses in global dollar funding markets,
which in turn helped to stabilize US markets. Bernanke said, importantly, the
swaps were structured so that the Fed bore no foreign exchange risk or credit
risk due to dollar hegemony. In particular, foreign central banks, not the Fed,
bore the credit risk associated with the foreign central banks'
dollar-denominated loans to financial institutions in their respective
financial system. Left unspoken was that in protecting the Fed from exchange
rate risks, the Fed in effect neutralized the equilibrium function of the
exchange markets by manipulating the global supply of dollars.
Thus it is ironic that some US politicians, unversed in monetary economics and
urged on by economist-turned-propagandist Paul Krugman, accused China of
manipulating the exchange value of its currency by keeping its peg to the
dollar. When one currency is pegged by policy to another over a long period,
the manipulator can only be the issuer of the currency to which the peg has
been set for a decade.
The only way to maintain stability in the exchange rate market is for the US
Treasury, supported by the Fed, to give weight to the slogan that a strong
dollar is in the US national interest. Unfortunately, the strong dollar slogan
will remain an empty one for a long time to come, as the prospect of US
economic policy giving the dollar strong support is highly unlikely. On the
positive side, the Obama administration is at least soft-peddling the
irrational push toward a destructive trade war with China over the yuan
exchange rate issue. A trade war is the last thing the impaired US economy
needs at this precarious juncture.
As the financial crisis spread, the continuing pullback of private funding
contributed to illiquid and even chaotic conditions in wholesale financial
markets and prompted runs on various types of financial institutions, including
primary dealers and money market mutual funds. To arrest these runs and help
stabilize the broader financial system, the Fed had to invoke a seldom-used
emergency lending authority under Section 13 (3) of the 1932 Federal Reserve
Act (as amended by the Banking Act of 1935 and the FDIC Improvement Act of
1991), not used since the Great Depression, to provide short-term backup
funding to select non-depository institutions through a number of temporary
facilities.
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