classical economics
for analysis,  forecasting
and policy design

No More Power for Fed

By Wayne Jett
© April 3, 2008

    As much as President George W. Bush is committed to the well-being and security of Americans, his economic policy has become perfectly suited to no one except Wall Street (those Franklin Roosevelt pejoratively called “organized money”). With all the talk of emulating Reaganomics, this Republican administration has come closer to the late Nelson Rockefeller’s view of financial matters.
    That is a shocking turn of events for a president who owes his second term largely to his decision at year-end 2002 to abandon conservative Keynesian advice that designed the demand-padding 2001 tax cut plan. Instead, he turned to the crisp, clear 2003 cuts in marginal tax rates that allowed capital growth and propelled his political success in 2004. Nevertheless, it seems, this was not an economics lesson well learned.
    After the 2003 tax cuts, the Federal Reserve allowed a stable dollar and a relatively normal yield curve for a brief period. In June, 2004, the Fed began its ill-advised series of funds rate hikes that continued for two years, slowing growth and reducing demand for dollars, while continuing to inject liquidity by buying Treasury securities. By mid-2005, this two-pronged attack on the dollar produced results. The dollar’s purchasing power in gold dropped from $350/oz in 2003 to $735/oz in May, 2006, when Henry M. Paulson Jr. was nominated by President Bush as his third secretary of the treasury.
The Death of Dollar Credibility
     Not to be outdone by his predecessor John W. Snow, Paulson continued espousing the “strong dollar” policy mantra around the world as the Fed’s devaluation of the dollar proceeded past $1,000/oz in 2008. President Bush was drawn into repeating Treasury’s “strong dollar” position even as the ECB injected $500 billion in euros trying to stay within sight of the dollar’s drop. This is ignominious performance of economic policy and of economic advisers.
    Both Snow and Paulson stood aside as the Federal Reserve countermanded faster accumulation of private capital permitted by the 2003 tax cuts, draining capital from production into above-market bank credit costs. As the yield curve inverted two years ago, business customers of banks, not to mention consumers, were denied credit at market rates. Small business necessarily liquidated credit capital, losing capability to maintain existing production, much less to expand and hire.
Small Business Bled, Big Business Fed
    That was not the fate of big business, however. While squeezing small business with high bank credit rates, cloaking its actions in inflation-fighting rhetoric, the Federal Reserve continued injecting liquidity through 2006. Since the liquidity could not flow to small business, it flowed to the long end of the yield curve, enabling larger borrowers to finance at low rates through commercial paper and bonds. Fed chairman Greenspan may have been dismayed that long rates did not rise with short rates, as they would when inflation is expected, but his “conundrum” was caused by policy shoving liquidity at big business, Wall Street and Stamford’s hedge funds, while small business was denied capital.
    Firms awash in credit adjusted accordingly and leveraged to extremes, taking on extraordinary amounts of risk. At September 30, 2007, NYSE member firms had average liabilities-to-capital ratio of 34 to 1. Hedge funds leverage 40 to 1 or higher which, of course, magnifies upside and downside moves. LBO firms had their heyday in taking public firms private. When the Federal Reserve stopped injecting new liquidity in 2007, debtors and investors began to feel the pain of bad credit decisions. Sub-prime home mortgage loans got the lions share of media attention and blame for poor credit quality, but most sub-prime loans were better collateralized and better performing than risks taken on by, say, prime brokers and investment bankers like Bear Stearns.
Bad Policy Must Be Short Term
    As the markets detected and punished poor judgment in credit transactions, by August, 2007, fear and suspicion of credit permeated even commercial paper. Until then, FOMC members had heard nothing from golfing companions to arouse concern about denial of credit to small business. Big business’ pain, on the other hand, evoked immediate action. FOMC injected additional temporary liquidity, and then began hacking away at the artificially high overnight funds rate in September, 2007. Still, after six months of funds rate cutting, the yield curve remained inverted and bank credit costs to small business unreasonably high. With no small business growth to absorb liquidity and no room for FOMC to drain liquidity without precipitating bankruptcies among financial institutions, the dollar plummeted to historic depths at gold prices above $1,000/oz.    
    In March, 2008, the Federal Reserve indemnified J. P. Morgan Chase against loss arising from $30 billion in debt instruments on Bear Stearns’ balance sheet to facilitate merger of the two entities, but the nature of those financial instruments is unknown in any detail. Since Morgan Chase was Bear Stearns’ primary financier of the $30 billion in investments, Morgan Chase is the primary beneficiary of the Fed’s “flexibility” in granting its indemnification. The Fed’s aid to Morgan Chase is reminiscent of Franklin Roosevelt’s assist to the Rockefellers when they took control of Chase Bank, then the nation’s largest, in 1933.
    The Federal Reserve’s current dilemma – its currency near collapse unless liquidity is drained, and private financial institutions near collapse if liquidity is denied – is emblematic of the Fed’s trademark stop-and-go liquidity valve. During 1996 to 2001, FOMC provided no liquidity to accommodate robust growth. The dollar soared to $252/oz in 1999, destroying profits with reduced prices, and caused U. S. equity markets to crash in 2000-2002. Since 2004, FOMC’s deliberate weakening of the dollar above $1,000/oz represents a devaluation of 75% in the international reserve currency within a span of four years.
Federal Reserve as “Market Stability Regulator”
    In the context of this abysmal performance by the Federal Reserve in its primary function – managing the national currency – it comes to pass that this failed organization is recommended to assume even greater power in U. S. financial markets. Secretary of the treasury Henry Paulson recommends that the Fed be given power as the “market stability regulator” to take “corrective actions when necessary in the interests of overall financial market stability.” The Fed would be authorized to collect information from financial institutions and to disclose (or refrain from disclosing) information to the public.
    The Federal Reserve is a private entity owned and managed by the bankers of Wall Street. Treasury secretary Paulson is the former CEO of Goldman Sachs, pre-eminent investment bank and power on Wall Street. Paulson and Goldman Sachs are said to have played pivotal roles in promoting the Fed’s facilitation of the Bear Stearns takeover. The Fed being so compliant, of course, more power to the Fed is entirely consistent with Wall Street wishes.
    The Federal Reserve’s devaluation of the dollar must serve Wall Street interests or the central bank would not be in such favor. However, devaluation does not serve main street business or ordinary Americans well. The twin scourges of inflation and deflation have ravaged the country since 1971. The last thing Americans want or need is additional doses of abstract, obtuse cover stories from the Fed for Wall Street’s financial escapades. The Federal Reserve should be ordered to stabilize the dollar’s value relative to gold, and its authority should be limited strictly to that purpose. ~