Is there any end to the bad economic and financial news? A year ago, we started hearing about trouble in some banks and financial markets, and it seemed that every day thereafter the news became worse. Consumer confidence is down, unemployment is up, large banks keep asking for more help and the federal government seems willing to do outlandish things to prop up the economy and the credit system. What’s next? Is there anything that can be done to help?
More bad news is coming. The trouble is mostly in the commercial real estate market and the result will be unpleasant both financially and in goods markets. A wave of bankruptcies in shopping malls and office space has already started and will gather speed in the near future. My guess is that these events will drive stock prices down, perhaps to a temporary low of the Dow to 4400. We will also see result in a wave of new unemployment, perhaps peaking in the range of 15%. Yes, that means that I feel that the worse not behind us but rather ahead of us.
While the much larger problem is in the commercial real estate market, the residential mortgage market is also in for a tough time. Standard mortgages will continue to weaken, and the so-called “Alt-A” mortgages (those with little or no money down) will begin to generate a steady stream of defaults. Commercial real estate failures will dwarf the residential market, so the collapse of residential mortgages will seem small in comparison.
While I've resisted forecasting a depression, and I'm loath to suggest a currency collapse of the US dollar, I am now solidly in the camp that sees this recession as a fairly deep one, and fairly long lasting. I'm still not ready to jump to the dark side, and while I can't say we are headed into something like a depression or a currency collapse, I now recognize these are distinct possibilities. So what is the best policy to deal with this?
A stimulus package was absolutely required, probably doesn't go far enough, and against all macroeconomic wisdom for the last 75 years, includes tax cuts. To provide maximum stimulus the federal government should have concentrated solely on spending, and they need to get it out there fast. Fiscal policy is the only answer, and the size of the deficit (and subsequent debt) is irrelevant. Because such spending takes time to have an effect, I expect it to take upwards of a year before we see results. If the federal government does not make the stimulus temporary, then we could emerge with a structural (as in persistent) deficit which we lead to another crisis within short order. If they do everything right, this year will still be lousy, the following years will show improvement, and say 5-8 years from now we will need to run a fiscal surplus to pay down the accumulated debt. Again, what they spend it on is not relevant, just that they make the increase temporary.
Of course this spending will generate a very large deficit on the order of $1.5 trillion. Deficits have to be financed, either with increased money supply or new US treasury debt. Given the current environment for private sector borrowing, one would venture to guess that government debt should be able to expand, and at interest rates that are fairly low. It’s unlikely that foreign creditors will rush to sell their US government assets, but this is a global recession, so they aren’t likely to be major creditors either. This means the American private sector (mostly our banks) will have to finance a large portion of this new debt. That should improve our bank’s balance sheets.
Monetary policy is useless, is in uncharted territory, and has no supporting argument in Economics. It is truly bizarre and looks like desperation. We are leveraging our central bank. That's lunacy. The sheer size of the liabilities the FED now guarantees or has directly taken on (something on the order of $7.7 trillion) means a serious decline in any of the supported markets could be very serious. This has the potential to create a cascade effect in the system. Yes, that means a currency collapse. This is of low likelihood, but it is possible.
The outlook improves if the Federal Reserve navigates this period without a major default in markets they are supporting. It can push money into the system as long as the private sector absorbs it. However at some point the FED will need to reverse policy and quickly reduce the excess liquidity. Failure to do this will result in a very serious inflation problem. The short-term outlook is tenuous at best, because it depends critically on whether a FED guaranteed market fails. However, some lag in knowing when the system needs to be drained of excess liquidity will result in inflationary pressure. The long term is impossible to know, as the FED is doing things it should not be doing, and I don't think anyone knows the consequences of that.
Monday, April 6, 2009
Sunday, March 29, 2009
Ultra-aggressive Federal Reserve Policy Risks
Federal Reserve Chairman Ben Bernanke is in a difficult position with regards to monetary policy during the past 6 months. The Fed, under his leadership has taken some very unusual steps during this time, including extraordinary banking support, the use of the FED as a direct lender, and involvement in the demise of some banking institutions. Chairman Bernanke’s decision to permit 60 Minutes to interview him was perhaps among the most unusual and effective choices made in the past six months. It is a good thing to let people know that the FED chairman is a real person with roots in places other than Wall Street.
Still, there are some very serious risks that the FED has taken over the past few months, and while I recognize the situation is quite unusual, I don’t think there is any precedent or macroeconomic theory that would support it. The chief function of a central bank is to manage money supply. It does have the charge to maintain employment as well, but this should be taken as a limiting element to monetary management, not a primary function.
The FED has significantly overstepped its boundaries by directly loaning in non-banking markets. The direct intervention in the commercial paper market might be beyond the normal FED rules, and might have been beneficial in the short term, and given its short term nature possibly an acceptable extension of FED activity. However, the FED’s intervention with non-bank institutions, like AIG, Fannie Mae and Freddie Mac are clearly beyond the FED’s role as a manager of the monetary system. With its announcement on March 18 of $1.2 trillion in new money to support long-term credit markets it is no longer acting as an agency that manages money supply. It is now a heavily leveraged quasi-public player in the credit markets.
So what’s the big deal? Why not cheer the FED’s new role as an active player in macroeconomic policy and the credit system? The most important reason to be concerned is that the US dollar, which is the debt of the FED, has a special place in the world monetary system. During the Great Depression, the US dollar had no such role, and the world monetary system was loosely based on gold reserves (though several countries, notably Great Britain did abandon the standard during the thirties). The more modern fiat money standard appeared in the 1950’s, and co-existed with a gold exchange standard until the early 1970’s. Fiat money is money with no intrinsic value, effectively “trust” money. After the free-floating exchange rates appeared in 1971 countries exchanged their currency on no particular standard for several years. But an interesting thing happened, which was beneficial to the United States. The USA started running ever larger fiscal and trade deficits, which put more and more US dollars on world markets. It became easy for other central banks to hold US dollars as a reserve currency, and the US dollar emerged as the exchange standard. Today, most central banks hold US dollars as their reserve currency, and some countries have even adopted the US dollar as their currency.
The use of the US dollar as a reserve currency alone makes the choices of the FED more critical. Taking risks with the meaning and value of a fiat currency is not a good idea. When the world depends on that fiat currency, it’s downright dangerous. The FED can’t push money into the system without damaging the credibility of its fiat money standard. Money really does not grow on trees, nor can it be created out of thin air. In a fiat standard it must represent what it can buy, and if there is suddenly more money, then each dollar must be worth less, thus buy less than it did before. If confidence in the value of a fiat money declines, we get inflation. If confidence in the entire concept of the fiat money goes away, we get a currency collapse.
With the dramatic actions of the FED in the last few months, there are serious risks of both of these events. The FED is acting like it can create money at will, with no repercussions. It can not. There is a case, in the tradition of J.M. Keynes for an aggressive fiscal policy of deficit spending. But there is no case for an ultra-aggressive monetary policy. The possible damage to the US is one thing, but to play with the world’s monetary systems is irresponsible. The FED needs to unwind its direct involvement in the credit system, and return to its responsibility as the manager of its fiat currency, the US dollar.
Still, there are some very serious risks that the FED has taken over the past few months, and while I recognize the situation is quite unusual, I don’t think there is any precedent or macroeconomic theory that would support it. The chief function of a central bank is to manage money supply. It does have the charge to maintain employment as well, but this should be taken as a limiting element to monetary management, not a primary function.
The FED has significantly overstepped its boundaries by directly loaning in non-banking markets. The direct intervention in the commercial paper market might be beyond the normal FED rules, and might have been beneficial in the short term, and given its short term nature possibly an acceptable extension of FED activity. However, the FED’s intervention with non-bank institutions, like AIG, Fannie Mae and Freddie Mac are clearly beyond the FED’s role as a manager of the monetary system. With its announcement on March 18 of $1.2 trillion in new money to support long-term credit markets it is no longer acting as an agency that manages money supply. It is now a heavily leveraged quasi-public player in the credit markets.
So what’s the big deal? Why not cheer the FED’s new role as an active player in macroeconomic policy and the credit system? The most important reason to be concerned is that the US dollar, which is the debt of the FED, has a special place in the world monetary system. During the Great Depression, the US dollar had no such role, and the world monetary system was loosely based on gold reserves (though several countries, notably Great Britain did abandon the standard during the thirties). The more modern fiat money standard appeared in the 1950’s, and co-existed with a gold exchange standard until the early 1970’s. Fiat money is money with no intrinsic value, effectively “trust” money. After the free-floating exchange rates appeared in 1971 countries exchanged their currency on no particular standard for several years. But an interesting thing happened, which was beneficial to the United States. The USA started running ever larger fiscal and trade deficits, which put more and more US dollars on world markets. It became easy for other central banks to hold US dollars as a reserve currency, and the US dollar emerged as the exchange standard. Today, most central banks hold US dollars as their reserve currency, and some countries have even adopted the US dollar as their currency.
The use of the US dollar as a reserve currency alone makes the choices of the FED more critical. Taking risks with the meaning and value of a fiat currency is not a good idea. When the world depends on that fiat currency, it’s downright dangerous. The FED can’t push money into the system without damaging the credibility of its fiat money standard. Money really does not grow on trees, nor can it be created out of thin air. In a fiat standard it must represent what it can buy, and if there is suddenly more money, then each dollar must be worth less, thus buy less than it did before. If confidence in the value of a fiat money declines, we get inflation. If confidence in the entire concept of the fiat money goes away, we get a currency collapse.
With the dramatic actions of the FED in the last few months, there are serious risks of both of these events. The FED is acting like it can create money at will, with no repercussions. It can not. There is a case, in the tradition of J.M. Keynes for an aggressive fiscal policy of deficit spending. But there is no case for an ultra-aggressive monetary policy. The possible damage to the US is one thing, but to play with the world’s monetary systems is irresponsible. The FED needs to unwind its direct involvement in the credit system, and return to its responsibility as the manager of its fiat currency, the US dollar.
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