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.