Operation Twisted Logic
Last week the US Federal Reserve delivered no real surprises. Its new policy was expected by the market and those members of the public who still follow the central bank's every move with interest and, I can only assume, in the misguided belief that it has the answer to our problems. As part of "Operation Twist" the Fed will purchase $400 billion of long-dated government bonds and sell an equivalent number of short-dated securities from its extensive portfolio over the coming nine months. The operation is aimed at lowering long-term market rates and flattening the yield curve. In their infinite wisdom, the bureaucrats on the central bank's policy-setting committee decided that here was another set of market prices that required their astute adjustment, or at least gentle guidance.
The Fed has recently acquired quite a taste for correcting market prices. Remember that the goal of the first round of debt monetization — euphemistically called "quantitative easing" — was to free bank balance sheets from the toxic waste accumulated during the boom and thus prevent banks from unloading unwanted mortgage securities in the marketplace at distressed prices, which would not only have burned a considerable hole into their capital but would also have revealed the lack of true demand for these securities. This required the printing by the Fed of a brand new $1 trillion — give or take a few hundred billion — and provided a nice subsidy to the hard-pressed American financial system. The second round of debt monetization — QE2 — was squarely aimed at manipulating the prices of Treasury securities. Treasury yields were simply not in line with what the committee deemed appropriate for the planned recovery and had thus to be massaged to lower levels. Another $600 billion had to be printed for this initiative.
For the benefit of those Americans who were beginning by now to feel that monetary policy in the United States was acquiring a whiff of Weimar Germany, and who were still beholden to the quaint idea that the setting of asset prices and yields, just as any other price, should best be left to the market, Fed chairman Ben Bernanke, in an op-ed in the Washington Post in November 2010, spelled out the advantages of clever price manipulation by the central bank (I know, I know, you readers of the Schlichter files have read this quote already a few times. But it is simply too delicious to miss any opportunity to quote it again):
Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
Well, the virtuous circle has not arrived yet. Defenders of this policy will argue that things would look even worse without it, and that for a while "quantitative easing" boosted equity markets and other risk assets. Hooray for that. Although it has to be said that the idea that we, the public, can easily be cajoled into feeling confident and behaving in more expansionary modes economically via the open manipulation of market prices strikes me as somewhat condescending and hubristic. But we are talking about a state agency here, so we shouldn't be surprised.
The Fed's entire policy program suffers from the same defect that all market interventions suffer from. The moment you stop intervening, the underlying problems come to the surface again. Just look at the short-lived results of QE2. Administrative price setting does not change economic reality, at least not for the better. The interventionist has to keep intervening and do so at an accelerating pace.
Surprisingly few people seem willing to ask what exactly the underlying economic problem is. As long as we avoid that question and simply talk superficially about slow growth, the risk of a "double dip" and the need for "stimulus," I guess the Fed will continue to get away with portraying an image of, at worst, innocent bystander or, at best, a well-meaning and public-service-minded bureaucracy that just keeps trying to fight the recession, diligently exploring all available policy tools. According to this popular view, our economic difficulties seem to have come over us like a bad harvest or an alien invasion. They appear to be entirely exogenous, and the Fed is our friend and partner helping us to get out of this mess.
The reality is different. Like all state bureaucracies, the Fed is in fact struggling with problems that are predominantly of its own making. The Fed is the reason we are in this crisis. Or, more specifically, the present economic crisis is the inevitable consequence of the political decision to adopt a system of unconstrained, constantly expanding fiat money, in which the central bank, in its role as lender of last resort, systematically encourages bank lending and thereby the extension of credit on the basis of money printing rather than true savings. This system came into full bloom only in 1971, when Nixon severed the last link to gold and thus initiated, for the first time in history, a global system of unrestricted fiat-money creation.
Our present problems are excessive levels of debt, now mainly public-sector debt, weak financial institutions, and distorted asset markets. On their present scale these problems would be inconceivable without a system of fully elastic fiat money and persistent periods of artificially low interest rates. Abandoning the gold anchor allowed the Fed, and other central banks, to cheapen credit and encourage borrowing for periods of unprecedented length. Today the Fed is promising us a way out of the crisis by providing monetary-policy accommodation. This is hardly original. The Fed has practically always provided policy accommodation. Policy accommodation was the raison d'être for the Fed. The Fed was founded in 1913 to support the banks' money and credit creation and to avoid credit corrections. Hard and inflexible commodity money has now everywhere been replaced with elastic fiat money under central-bank control so that the level of interest rates and the availability of credit in the economy are no longer constrained by the extent of voluntary saving but can be determined administratively by the central bank for the purpose of extra growth.
When Nixon took the dollar off gold internationally, the monetary base and bank reserves in the United States, that is, the part of the overall money supply that the Fed controls directly, was $69.8 billion. Ten years later it was $147 billion, another ten years later it was $319.7 billion, another ten years later it was $645.1 billion, and last month, exactly 40 years after the dollar was "freed" from gold, it was $2,679.5 billion. Like all interventionists, the Fed has to run ever faster to prevent the laws of economics from catching up with the unintended consequences of its interventions.
"Operation Twist" is another attempt to keep interest rates low and to encourage borrowing when the present crisis is in fact the result of low interest rates and excessive borrowing. The only solution to our problems is to stop printing ever-larger quantities of money and to finally allow the market to set interest rates and to cleanse the economy of its accumulated dislocations.