A History of the Fed's Political Power
The Power and Independence of the Federal Reserve
Princeton University Press, 2016
xiv + 347 pages
Peter Conti-Brown, a legal historian who teaches at the Wharton School, would sharply dissent from Ron Paul’s wish to End the Fed. He never cites Mises or Rothbard, and the only Austrian work that he mentions, hidden away in an endnote, is Vera Smith’s The Rationale of Central Banking and the Free Banking Alternative. Nevertheless, Austrians will find Conti-Brown’s book of great value. He has, with considerable scholarship, exposed many grave problems with the Fed in a way that strengthens and supports the anti-Fed case.
The paramount concern of Austrian criticism of the Fed has been the vital role of that organization in expanding the money supply. Doing this, as the Austrian theory of the business cycle explains, drives the money rate of interest below the “natural” rate, primarily determined by people’s rate of time preference. This leads to an artificial boom and eventually proves unsustainable, resulting in a depression. Murray Rothbard classically applied this analysis in America’s Great Depression (1963), which emphasized the expansionary monetary policy of the 1920s, pursued by the Fed at the behest of Benjamin Strong, the Governor of the Federal Reserve Bank of New York, in causing the 1929 crash.
Conti-Brown tells us that this view of the Fed’s role in the 1920s was shared by none other than Herbert Hoover, who figures in Rothbard’s book as a principal villain for his futile interventionist efforts to cope with the depression. Hoover “blamed the Fed generally (and the New York Fed in particular) for causing the Great Depression. This orgy [of speculation] was not a consequence of my administrative policies, he wrote, but of the ‘mediocrities’ at the Fed” (p. 24). “Hoover further complained that the Fed (under Benjamin Strong) turned American optimism into ‘the stock-exchange Mississippi Bubble’ ” (p. 283, note 19).
The Fed continued its expansionary course during the 1930s, and here the influence of the banker Marriner Eccles was paramount. Eccles shaped the modern Fed through proposals that Congress enacted in the Banking Act of 1935, which “abolished the Federal Reserve Board created in 1913 and replaced it with the Board of Governors of the Federal Reserve System”(p. 27). Once ensconced in power at the Fed, “Eccles’s clear policy ... was to use all policy instruments at the government’s disposal to do for the economy what consumers could not do: spend their way out of the depression” (p. 32). Eccles greatly admired Franklin Roosevelt and was careful to coordinate his policies with him. “ ‘Coordinate’ may even suggest more separation than Eccles intended: he meant for monetary policy to be administration policy” (p. 32). His ideas resembled those of Keynes, but Eccles had developed them independently. “Though they had never met, the millionaire Mormon from Utah had anticipated the dapper Cambridge don’s worldview” (p. 26). Eccles and Keynes eventually met at Bretton Woods in 1994 but did not like each other.
Conti-Brown, as we will see, views such policies with favor; but he aptly describes the consequences of a monetary expansion that fails: “What looks like economic growth is, in fact, a monetary mirage. It’s not more jobs, goods, and services that we see; it’s just more money. And when more and more money chases the same (or shrinking) number of jobs, goods, and services, the prices of everything go up. These inflationary pressures threaten to undermine the economy’s stability and consumer confidence in the level of prices and wages” (p. 133).
If we turn from the 1930s to the recent past, we find that the Fed has continued on its reckless ways. After the Panic of 2008, Fed Chairman Bernanke assumed extreme power to meddle in the economy. “Invoking emergency lending authority that had been unused for almost eighty years, the Fed picked up its ‘lender-of-last-resort’ function and proceeded to deploy it throughout the economy ... [this] started with the investment banking giant Bear Stearns and in time extended to money market funds, traditional banks, and insurance companies” (pp. 154–55).
The extent of the Fed’s power to intervene is difficult to fathom. “When Bernanke and Secretary of the treasury Henry Paulson approached Congress in the fall of 2008 about the need to inject $85 billion into the insurance giant AIG, [Barney] Frank asked if the Fed had that kind of money. Bernanke responded that he had $800 billion. Frank was stunned. ‘He can make any loan he wants under any terms to any entity or individual in America that he thinks is economically justified’ ” (p. 155).
The Fed under Bernanke did not confine itself to aiding particular firms but aimed at a general monetary expansion. His policy came as no surprise. “In one speech in 2002, Bernanke, then a member of the Fed’s Board of Governors (but not the chair), alluded to a helicopter drop of cash on the general public as a way of getting growth and inflation back to desirable levels. In light of subsequent events, and with that precedent in mind, his critics have sometimes called him ‘Helicopter Ben’ ” (p. 143).
Once he became Chair, Bernanke followed through in a bizarre fashion, in what was called “forward guidance.” This “binds the central bank to a mast of its own in an eff ort to convince participants in the economy that the Fed will honor its policy for a certain period of time. ... [T]he central bank must commit that its monetary policy ‘will in fact be effective if the central bank can credibly promise to be irresponsible, to seek a higher future price level’ ” (p. 143, quoting Paul Krugman).
By no means does this exhaust the material a critic of the Fed can draw from Conti-Brown’s book. He points out that the Fed finances its own activities by issuing money: it is not dependent on Congressional appropriations to keep it going. “That the Fed funds itself largely from the proceeds of its substantial assets, taken together with the nature of the Fed’s ability to create money in pursuit of its monetary policy objectives, means that the Fed’s funding is unique in government. ... [T]he Fed conducts monetary policy by, among other options, creating money with which it can buy government — and more recently, nongovernment securities. These interest-bearing assets generate money that the agency can subsequently use to fund itself ” (p. 207).
If the Fed is an arbitrary and irresponsible agency in the fashion so far described, is there not an excellent case for doing away with it? Conti-Brown does not agree at all. He fears the “devastation of expected deflation” (p. 143) that might ensue were the economy on a strict gold standard and thus largely supports Bernanke’s policies.
Conti-Brown’s focus differs entirely from criticism of monetary expansion. He believes that critics of the Fed are in a grip of a false picture of how it operates, which he calls the Ulysses/ punch bowl view. “Ulysses” refers to the incident in The Odyssey in which Ulysses had himself tied to the mast of a ship so he could hear the sirens’ song; and the “punch bowl” to a comment by Fed Chairman William McChesney Martin that the Fed’s role was to withdraw the punch bowl when the party was getting interesting. “The subjects of the metaphors differ by millennia, but the idea is the same: the partygoers and Ulysses alike want something in the near term that their best selves know is bad for them in the long term. Central bank independence is the solution” (p. 3). Conti-Brown maintains that this view rests on an oversimplified view of how the Fed operates, and that “independence” is not an analytically useful concept in understanding the Fed. He may well be right on both counts; but although he repeats the metaphor interminably, he has not at all made his case that the bulk of criticism of the Fed rests on acceptance of the misleading picture he condemns. To confront criticism of the sort advanced by Ron Paul and Rothbard, Conti-Brown would have to respond to Austrian monetary theory. He instead bypasses monetary theory almost entirely, a great pity owing to his gifts of clear exposition. To do this in a book about the Fed is to offer us Hamlet without the Danish prince.
Are Central Banks Nationalising the Economy?
The FT recently ran an article that states that “leading central banks now own a fifth of their governments’ total debt.”
The figures are staggering.
- Without any recession or crisis, major central banks are purchasing more than $200 billion a month in government and private debt, led by the ECB and the Bank of Japan.
- The Federal Reserve owns more than 14% of the US total public debt.
- The ECB and BOJ balance sheets exceed 35% and 70% of their GDP.
- The Bank of Japan is now a top 10 shareholder in 90% of the Nikkei.
- The ECB owns 9.2% of the European corporate bond market and more than 10% of the main European countries’ total sovereign debt.
- The Bank of England owns between 25% and 30% of the UK’s sovereign debt.
A recent report by Nick Smith, an analyst at CLSA, warns of what he calls ”the nationalization of the secondary market.”
The Bank of Japan, with its ultra-expansionary policy, which only expands its balance sheet, is on course to become the largest shareholder of the Nikkei 225’s largest companies. In fact, the Japanese central bank already accounts for 60% of the ETFs market (Exchange traded funds) in Japan.
What can go wrong? Overall, the central bank not only generates greater imbalances and a poor result in a “zombified” economy as the extremely loose policies perpetuate imbalances, weaken money velocity, and incentivize debt and malinvestment.
Believing that this policy is harmless because “there is no inflation” and unemployment is low is dangerous. The government issues massive amounts of debt and cheap money promotes overcapacity and poor capital allocation. As such, productivity growth collapses, real wages fall and purchasing power of currencies fall, driving the real cost of living up and debt to grow more than real GDP. That is why, as we have shown in previous articles, total debt has soared to 325% of GDP while zombie companies reach crisis-high levels, according to the Bank of International Settlements.
Government-issued liabilities monetized by the central bank are not high-quality assets, they are an IOU that is transferred to the next generations, and it will be repaid in three ways: with massive inflation, with a series of financial crises, or with large unemployment. Currency purchasing power destruction is not a growth policy, it is stealing from future generations. The “placebo” effect of spending today the Net Present Value of those IOUs means that, as GDP, productivity and real disposable income do not improve, at least as much as the debt issued, we are creating a time bomb of economic imbalances that only grows and will explode sometime in the future. The fact that the evident ball of risk is delayed another year does not mean that it does not exist.
The government is not issuing “productive money” just a promise of higher revenues from higher taxes, higher prices or confiscation of wealth in the future. Money supply growth is a loan that government borrows but we, citizens, pay. The payment comes with the destruction of purchasing power and confiscation of wealth via devaluation and inflation. The “wealth effect” of stocks and bonds rising is inexistent for the vast majority of citizens, as more than 90% of average household wealth is in deposits.
In fact, massive monetization of debt is just a way of perpetuating and strengthening the crowding-out effect of the public sector over the private sector. It is a de facto nationalization. Because the central bank does not go “bankrupt,” it just transfers its financial imbalances to private banks, businesses, and families.
The central bank can “print” all the money it wants and the government benefits from it, but the ones that suffer financial repression are the rest. By generating subsequent financial crises through loose monetary policies and always being the main beneficiary of the boom, and the bust, the public sector comes out from these crises more powerful and more indebted, while the private sector suffers the crowding-out effect in crisis times, and the taxation and wealth confiscation effect in expansion times.
No wonder that government spending to GDP is now almost 40% in the OECD and rising, the tax burden is at all-time highs and public debt soars.
Monetization is a perfect system to nationalize the economy passing all the risks of excess spending and imbalances to taxpayers. And it always ends badly. Because two plus two does not equal twenty-two. As we tax the productive to perpetuate and subsidize the unproductive, the impact on purchasing power and wealth destruction is exponential.
To believe that this time will be different and governments will spend all that massive “very expensive free money” wisely is simply delusional. The government has all the incentives to overspend as its goal is to maximize budget and increase bureaucracy as means of power. It also has all the incentives to blame its mistakes on an external enemy. Governments always blame someone else for their mistakes. Who lowers rates from 10% to 1%? Governments and central banks. Who is blamed for taking “excessive risk” when it explodes? You and me. Who increases money supply, demands “credit flow,” and imposes financial repression because “savings are too high”? Governments and central banks. Who is blamed when it explodes? Banks for “reckless lending” and “de-regulation”.
Of course, governments can print all the money they want, what they cannot do is convince you and me that it has a value, that the price and amount of money they impose is real just because the government says so. Hence lower real investment, and lower productivity. Citizens and companies are not crazy for not falling into the trap of low rates and high asset inflation. They are not amnesiac.
It is called financial repression for a reason, and citizens will always try to escape from theft.
What is the “hook” to let us buy into it? Stock markets rise, bonds fall, and we are led to believe that asset inflation is a reflection of economic strength.
Then, when the central bank policy stops working — either from lack of confidence or because it is simply part of the liquidity — and markets fall to their deserved valuations, many will say that it is the fault of “speculators,” not the central speculator.
When it erupts, you can bet your bottom dollar that the consensus will blame markets, hedge funds, lack of regulation and not enough intervention. Perennial intervention mistakes are “solved” with more intervention. Government won on the way up, and wins on the way down. Like a casino, the house always wins.
Meanwhile, the famous structural reforms that had been promised disappear like bad memories.
It is a clever Machiavellian system to end free markets and disproportionately benefit governments through the most unfair of competitions: having unlimited access to money and credit and none of the risks. And passing the bill to everyone else.
If you think it does not work because the government does not do a lot more, you are simply dreaming.
Originally published at DLacalle.com
A Look at Uncertainty in the UK, Post-Election
The results of the UK elections are unquestionably negative for the economy, bad for investment, bad for the pound, and for a swift Brexit resolution.
The UK economy has performed exceptionally well in the past years, even after the Brexit referendum. So well, that international agencies such as the IMF or the OECD had to completely reverse their negative expectations for the economy of a “Yes” vote.
The problem is that we have focused on the positive — the fact that doomsayers were wrong — without analysing the negatives — the impact on potential growth and increase in investments. The Bank of England had to increase its growth estimates for 2017 to 1.7% and 1.3% for 2018. However, the uncertainty of a hung parliament, a weak government unable to negotiate Brexit from a position of strength, and the ongoing weakness of the pound may continue to erode growth potential, gross capital formation, and economic agents’ investment and hiring decisions.
It is extremely unlikely that Brexit will be reversed. It is, however, very likely, that negotiations will be more difficult and longer.
The UK is a very dynamic economy, and its companies have enormous strengths, with a thriving export sector and global multinationals. These will continue to benefit from a weak currency, but internal demand and the large surplus of service exports may suffer from the uncertain process of an even more complex Brexit.
As such, it is likely that we will not see a major impact in the growth prospects of the economy due to the benefits of a global and strong external sector, which benefits more from solid high-margin products and competitive technology than from weak currencies, but internal demand challenges will likely have an impact on consumption, hiring and wages.
It is no surprise, then, that the FTSE will continue to rise. It is fundamentally composed of diversified international companies. The impact of uncertainty may weigh on banks, consumer stocks and those with a large proportion of sales in the UK. However, the FTSE is more impacted by estimates of the global economy and energy-commodity prices. It is an index with almost 30% of sales in foreign currency.
The pound weakness may continue, also because the BoE is unlikely to take any measures to defend the currency.
As for bonds, extended QE means that sovereign bond yields will remain depressed, while solid corporate earnings and good balance sheets will support a more than adequate demand for corporate bonds. A clear indicator in the wake of the UK election this month has been that yields are still contained in all the different indices.
Clearly, investors will have to pay attention to guidance and cash flow generation of companies, but I would imagine that the forthcoming uncertainty will likely have an impact on a potential growth that should be well above EU or US figures, but will not.
Being complacent about average growth and acceptable macro figures cannot disguise the fact that the UK could and should grow well above its comparable economies and that the Bank of England is keeping an uncomfortably aggressive quantitative easing program that will leave it without tools in case of a change of economic cycle that is now more likely than before.
Reprinted with permission of the author. Daniel Lacalle has a PhD in Economics and is author of Escape from the Central Bank Trap, Life In The Financial Markets, and The Energy World Is Flat (Wiley).
Are Central Banks Worthy of Trust?
In vain you tell me that Artificial Government is good, but that I fall out only with the Abuse. The Thing! The Thing itself is the Abuse!"
Our complaint isn't just with "abuse of the system," it is with the system itself! The system is the abuse. Everything else is a symptom, a surface issue.
When BOE Governor Mark Carney spoke on various banking sector abuses at the Banking Standards Board Panel, he misses the entire point. The title of the speech is “Worthy of trust? Law, ethics and culture in banking” and he is concerned that such abuses have produced a "crisis of legitimacy."
"This immense progress has been overshadowed by a crisis of legitimacy. A series of scandals ranging from mis-selling to manipulation have undermined trust in banking, the financial system, and, to some degree, markets themselves."
Bad behaviour went unchecked, proliferated and eventually became the norm.
What can we say? When you place one institution in charge of the entire monetary sector within a given economy, abuses should hardly be a surprise. But rather than questioning the government-granted monopoly, the outlawing of free competition in money and banking, Carney and others of the Bureaucratic persuasion can see only one solution: more regulations and more oversight. He states:
Changes to incentives, new codes and a clearer mapping of responsibilities will all help improve conduct and lay the groundwork for better culture.
We are seeking to raise expectations and norms by using a combination of hard and soft law, with much of the latter developed by the private sector.
They are trying to address various manipulations in the foreign exchange markets, interest rate controversies, and crony business relationships. But how could any of these things be a problem if central banks were not granted exclusive legal control over money and interest rates in the first place? These crony relationships and backroom deals are merely symptomatic of the mandated existence of these monopoly banking institutions.
More laws which aim to stem abuses of the system presuppose that the system itself is ethically pure. Opponents of central banking should not be mere opponents of abuses, but opponents of central banking itself!
Carney characterizes himself as wanting to issue a hard crack down on the "bad apples," but the solution should simply be to eradicate any possibility of these bad apples getting these positions in the first place. How can a bad apple fill a bureaucratic position that does not exist?
Asset-Price Inflation Heating Up with Nothing to Show For It
Richmond Fed president Jeffrey Lacker is allegedly one of the hawks, though that term can’t mean what is used to — not in a world where it takes 8 years to get to .5%–.75% on the Fed Funds Rate target.
Monday, Lacker repeated his position that the Fed is “getting behind the curve.” This puts him sharply at odds with “Dovish” Yellen who in her recent Stanford speech opined the opposite on “getting behind the curve.” Lacker wants a few more minuscule rate increases than Yellen.
What a meaningless disagreement over quarters of a percentage point on a meaningless interest rate. Right under their noses, of course, Fed’s monetary actions over the years have driven financial asset prices skyward, home prices to absurdity, and commodity prices up 40% (even after dropping since 2014). But all they see on the price inflation front is less than 2% on the personal consumption expenditure (PCE) statistic!
But despite all the faux concern over an “overheating economy,” lies the fact that manufacturing sales have largely plateaued since 2012, industrial production has fallen since 2014, and Obama is the first president since Hoover to not have a single year of over 3% GDP growth.
What a time to be alive. Not only has the Fed successfully stagnated the economy, but we are still getting the same tired talk of a push toward interest rate normalization. With a stagnating economy and rising prices, they used to call this stagflation. Now it is dismissed as “the new normal.”
And indeed this has become the new normal, seemingly. But perhaps instead of conducting the same old tired monetarist/Keynesian econometric experiments, the Fed should take a look in the mirror. We certainly can’t expect a growing economy while the world’s central banks actively undermine our vital pool of funding via fiscal and monetary interventionism.