Monday, November 10, 2008

The Fed and irrational fear

The Federal Reserve (Fed) is refusing to identify the recipients of almost $2 trillion of emergency loans from American taxpayers or the troubled assets the central bank is accepting as collateral.  Ted Forstmann, senior partner of Forstmann Little & Co. in New York said “It's your money; it's not the Federal Reserve's money,” “Of course there should be transparency.”
The Fed is transparent in that it is subject to the oversight of Congress.  Periodically Congress reviews the Fed’s activities and can alter its responsibilities by statute.  The intent of Congress in shaping the Federal Reserve Act was to keep politics out of monetary policy.  Legislation requires that the Federal Reserve reports annually on its activities to the Speaker of the House of Representatives, and twice annually on its plans for monetary policy to the banking committees of Congress. 
The recently failed Franklin Bank which is based in Houston, described their founder Lewis Ranieri in a securities filing last year as "the father of the securitized mortgage market," during the 1980’s.  Today, we are in the midst of experiencing the consequences of the failure of a party that got way out of control.  The party was brought on by the geeks bearing formulas.  Their party gave us the credit default swap, mortgage backed securities and other structured investments that have pushed the global banking system into crisis.  One of the greatest of Federal Reserve chairmen, William McChesney Martin, once said that the job of the Fed is “to take away the punch bowl just as the party gets going.”  Washington Irving wrote about the Mississippi Bubble in his paper “Crayon Papers” from 1719 that common sense told him that eventually, the “short but brilliant” phenomenon of irrational exuberance bursts and is most often replaced by irrational fear. What was a sure thing yields to uncertainty; uncertainty undermines decision making; and the confident decision making that is needed to sustain the economy retreats into a defensive crouch. Counterparties come to be viewed with suspicion. No business appears worthy of financing. Cash is hoarded. The economy, starved of the lifeblood of capital, staggers and begins to weaken.

Now that the economy has weakened again the Fed has stretched out the terms with which we lend to bankers; accepted new forms of collateral; broadened access to our lending window to securities dealers and one particular insurance company—AIG—whose failure was deemed by the Federal Reserve Board to present a risk to the financial system; opened a window for financing commercial paper; backstopped money market mutual funds; and, recognizing that we are inextricably interwoven with a global economy, established swap lines to help meet the dollar-funding needs of 14 central banks, ranging from the European Central Bank and the Bank of England to the Banco de México and the Singapore Monetary Authority, the total of which now aggregates to hundreds of billions of dollars. The Fed's staff and policymakers have provided substantial intellectual input into activities of other regulators, such as the FDIC and the Treasury, as they develop innovative means and modes of recapitalizing the banking system, dealing with the mortgage crisis and restoring economic growth.

You can see the size and breadth of the Fed’s efforts to counter the collapse of the credit mechanism in its balance sheet. At the beginning of this year, the assets on the books of the Fed totaled $960 billion. Today the Fed's assets exceed $1.9 trillion. I would not be surprised to see them aggregate to $3 trillion—roughly 20 percent of GDP—by the time we ring in the New Year. The composition of the Fed's holdings has shifted considerably. Previously, almost 100 percent of its holdings were in the form of core holdings of U.S. Treasuries; today, less than a third are. The remainder consists of claims deriving from our new facilities.

The fourth President of the United States James Madison once said, “The circulation of confidence is better than the circulation of money.”  Madison led the unsuccessful attempt to block Hamilton's proposed Bank of the United States, arguing the new Constitution did not explicitly allow the federal government to form a bank.  While President in 1815, he supported the creation of the second National Bank.  James Madison also said, "Union of religious sentiments begets a surprising confidence."  


Brian Gill said...

Hi Jason,

The sanctity of the Fed's political independence extends only to monetary policy. When the Fed starts deciding which companies are worthy of taxpayer money, they are/should be subject to normal political constraints.

The beauty of open market operations is that the Fed cannot make the "who" decision. If it wants to affect the macroeconomy, it can inject or remove cash, but how the new money supply is allocated amongst economic players is entirely dependent on those players themselves, and not political determinations.

And for me, just as those open market operations are beautiful, the array of new 'bailout economics' (the easing of collateral requirements, diversification to riskier assets, etc. that you mentioned) paint a much cloudier and uncertain picture.

Keep up the good work!

Jake Miller said...

Perhaps the Fed has begun to politicize itself. A central bank that controls the money supply needs to be insulated politically. A central bank that starts engaging in other activities is painting a target on its back. Is it possible to buy up other types of securities to save a few banks and comment on congressional fiscal policy while remaining independent? I don't know. I just don't want Speaker Pelosi dictating monetary policy.

Jim Campbell said...

Thanks Jason, I didn't know that. I didn't know a lot of stuff till I started getting into it. Would it have been possible to have loaned the banks money with the caveat, loan it or loose it with in a specific time? That seems to be the world on the street that the banks aren't loaning the money.

On Tue, Nov 11, 2008 at 7:18 AM, Jason wrote:

Jason has left a new comment on your post "FED REFUSES TO IDENTIFY $2,000,000,000,000.00 BANK...":

The Fed is transparent in that it is subject to the oversight of Congress. Is twice a year not fast enough? The intent of Congress in shaping the Federal Reserve Act was to keep politics out of monetary policy. Legislation requires that the Federal Reserve reports annually on its activities to the Speaker of the House of Representatives.

Tim C. said...

Two answer your question, No, twice a year is not fast enough. Particularly considering the pace at which they are changing the rules of the game.

The simple and obvious problem we face in this "brave new world" that is being constructed under the banner of the 'economic crisis', is that the Fed in partnership with the Treasury has stepped far outside of the role dictated to them by law.

The purse strings that guard the taxpayers' money was relegated solely to the Congress by the Constitution, yet even prior to the passage of the "Economic Rescue Package", which gave sweeping new powers to the Treasury as well as the Fed and almost completely re-defined the way our economic system is structured, the Fed was spending hundreds of billions of taxpayer dollars to repair a breach caused by its own lack of "party crashing" if you will.

Considering the fact that the Fed is now printing money at a rate never seen before in this country (ultimately destroying our Dollar in the process) merely to meet the demands caused by overwhelming incompetence and/or mind-blowing neglect, those who have created this mess through greed, Congress included, yet still reap the benefits of Trillions of dollars in taxpayer bailout money should absolutely be forced to account for every penny.

We are a far cry away from familiar waters in respect to monetary and fiscal policies at this point and the American people are being forced to mortgage the future of their Nation in an unprecedented way. As such, I think common sense not to mention common courtesy strongly suggests that equally unprecedented transparency and accountability to those footing the bill is in order
and Constitutional constraints should be further applied, not ignored.

gregory d. said...

Thanks for the brief, but concise history of the Federal Reserve. As for the current Fed chair, Bernanke, isn't he an expert on the Great Depression, sworn not to make the same mistakes? I think he views the damage of a steep and long recession to be much worse than the upfront cost of avoiding such a serious downturn. It will be even more difficult for the Fed come January as the economy continues its downward spiral and the strengthened Democratic majority intensifies the hunt for scapegoats.
(As for brian gill's comment; isn't it a small commission within the Treasury that decides which banks to save?) Very good piece - you should be proud. SplendidMarbles

Jayhawk said...

It seems to me that when the Fed reports that it has lent $2 trillion of taxpayer money and states that it will not disclose to whom that money was lent, that transparency is hardly a term that can be applied. Either they should not be disclosing at all that the money was lent, or they should be disclosing the recipients. Doing it this way not only invites distrust, it utterly demands it.

The idea that they cannot disclose because if I know my bank is borrowing from the Fed I am somehow going to freak out and think the money in my bank is unsafe is just plain wierd.