Federal Reserve | timiacono.com - Part 55

Paper Money, Economists, and Hubris

I don’t recall how this WSJ op-ed came to my attention again the other day, but, since it did, it seemed worth sharing the paragraphs below. Originally appearing on August 15th last year – on the 40-year anniversary of Nixon closing the gold window – it reminds us of what a swell job economists continue to do for us non-economists in the world.

Most of today’s macroeconomists see surprisingly little wrong with the present system of fully elastic money. This is surprising for two reasons: First, there is the universally dismal historical record of paper money systems. Second, paper money systems are inherently incompatible with capitalism. In a state paper money system, the banking system is de-facto cartelized and the banks’ funding conditions and certain interest rates are determined administratively by a state agency—the central bank. The constant expansion of bank reserves constitutes an ongoing subsidy to the banks, which encourages further money creation through fractional-reserve banking. Credit growth in such an economy is no longer driven by the extent of saving in the economy but the result of central bank policy and the banks’ willingness to expand their balance sheets.

The belief among mainstream economists and central bankers today is obviously that they fully understand and can correctly anticipate the consequences of their monetary manipulations. The effects of money injections appear to them to be simply stronger growth and higher inflation, both neatly captured by the set of macro-statistics that modern economists follow so slavishly. All that central banks have to do, then, is target the right balance between the two. A display of such intellectual hubris was given by Federal Reserve Chairman Ben Bernanke when he explained the Fed’s policy of quantitative easing to the U.S. public in an op-ed last November. Extolling the advantages of artificially depressed interest rates and propped up asset prices courtesy of the Fed, Bernanke promised that, “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.”

This brings to mind the ongoing brouhaha between econo-bloggers and St. Louis Fed President James Bullard who, over the last week, has been taken to task for saying a lot of things that most non-economists would view as simple common sense, for example, that the housing bubble created a lot of artificial demand in the economy in the last decade and attempting to restore aggregate demand to that level through money printing is dangerous.

A New Perspective on the Fed’s Balance Sheet

Following the long-term look at the federal government’s public debt in this item from a short time ago comes this long-term view of the Federal Reserve’s balance sheet compliments of the recently stumbled upon Gresham’s Law blog.

Note that the graphic is interactive in its original form at Gresham’s Law and additional charts are provided that go into great detail regarding what the central bank was doing, money-printing-wise, over 10 year periods beginning in 1915. But, the most important point is made in the right-most portion of the graphic above where even a log-scale chart would indicate an astounding increase in Fed largess.

A Different Perspective on U.S. Debt

After stumbling upon the U.S. Government Debt website and fiddling with their charting tools a bit, a chart that I’ve never seen before appeared – a very long-term picture of public U.S. debt relative to GDP going back to 1792. Back in the old days, the only time the nation would rack up debt was when they were at war and then they’d pay it down

All that changed not long after the last vestiges of a gold standard were abandoned in the 1970s and it’s been a three-decade long climb up debt mountain ever since. Moreover, since the graphic above includes only public debt, the picture is significantly worse when including intergovernmental liabilities such as social security (see comment below).

Fateful Words from Ben Bernanke?

I didn’t watch Fed Chief Ben Bernanke’s appearance before the Senate Budget Committee yesterday, but there was an interesting exchange with Sen. Pat Toomey (R-PA) recounted in this Wall Street Journal story($) on the subject of the central bank creating market distortions that they may not be able to counter if and when sentiment changes.

At issue is the Fed’s continuing policy of bond-buying. While the central bank has stopped expanding its balance sheet with new asset purchases, it is engaged in a plan to sell short-dated Treasury bonds and replace them with a like amount of long-dated government debt. The result? Ten-year Treasury borrowing rates are around historic lows, and with them, mortgage rates.

For Bernanke, this is by design, not accident. He told Toomey a significant aim of the Fed is to gobble up enough risk-free Treasury debt so that investors are forced into riskier investments that will in principle generate better levels of growth.

“We don’t want to go too far,” Bernanke told the committee. He said the Fed was “very attentive” to signs that its stimulus was in the process of generating imbalances, and added the central bank had “greatly expanded” its surveillance of financial markets, in a bid not too be caught off guard.

“The effects of Fed policy, independent of all the other factors, on Treasury rates [are] modest,” Bernanke said. The bigger problem is investor confidence in future government borrowing. “Rates will rise eventually, and if investors were to lose confidence in U.S. federal fiscal policy, there is nothing the Fed can do to stop those rates from rising”.

If memory serves, it was Ken Rogoff (of This Time is Different fame) who observed that, throughout history, there is virtually no warning for when the bond market turns on a nation’s sovereign debt (so much for the Fed’s “attentiveness”) and, when combined with Bernanke’s warning above that there’s little they’ll be able to do under those circumstances, this sets the stage for one monster U.S. sovereign credit crisis somewhere down the road.

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