Free Markets, Free People

Maybe I’m just an alarmist

In the Financial Times today, Martin Wolf comes out swinging (free registration required) against those who are afraid the Fed’s Quantitative Easing programs carry a danger of sparking serious inflation.

The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending. Why is such privatisation of a public function right and proper, but action by the central bank, to meet pressing public need, a road to catastrophe? When banks will not lend and the broad money supply is barely growing, that is just what it should be doing (see chart).

The hysterics then add that it is impossible to shrink the Fed’s balance sheet fast enough to prevent excessive monetary expansion. That is also nonsense. If the economy took off, nothing would be easier. Indeed, the Fed explained precisely what it would do in its monetary report to Congress last July. If the worst came to the worst, it could just raise reserve requirements. Since many of its critics believe in 100 per cent reserve banking, why should they object to a move in that direction?

Now turn to the argument that the Fed is deliberately weakening the dollar. Any moderately aware person knows that the Fed’s mandate does not include the external value of the dollar. Those governments that have piled up an extra $6,800bn in foreign reserves since January 2000, much of it in dollars, are consenting adults. Not only did no one ask China, the foremost example, to add the huge sum of $2,400bn to its reserves, but many strongly asked it not to do so.

Everything he says is correct, but that’s not really any help, because the implications are pretty severe, even if he’s completely right.

First, let’s assume the Fed can, via repos or changes in reserve requirements, sterilize the increase in the money supply. The problem then becomes when does the Fed do this sterilization. let’s go back to 1981-1982.  When the Fed was looking at monetary aggregates in the wake of the 1981 recession, they saw the money supply growing far faster than their target. At the time, the Fed’s primary tool was securities sales and purchases to control the rate of growth in the money supply directly, while letting the markets set interest rates. (Today, the fed primarily uses changes in the Discount Rate and Federal Funds target rate to run monetary policy.)

When the Fed saw those big increases in money supply, they immediately moved to sterilize the increases, to keep inflation in check.  Sadly, the lack of velocity in the money supply, i.e., its actual rate of use in transactions, was near zero. as a result, the Fed’s tightening threw the economy into another recession, with unemployment rising to 11%. The policy may have been correct, but the timing was wrong.

So, what guarantee do we have that the Fed will perform sterilization at precisely the right time? If they move too early, the economy shuts down, a la 1982.  Too late, and inflation takes off. Then the Fed would really have to tighten, which would probably result in another recession to wring out the extra inflation.

The trouble with the Fed is that monetary policy moves take 6-18 months to fully percolate through the economy. And they make these decisions based on economic data gathered in previous months. It’s like driving down the street by looking only at the rear-view mirror.

That makes proper timing by the Fed…hard.

Perhaps the Fed will operate as if run by infinitely wise solons, who know precisely when to sterilize their quantitative easing, either through repo operations, or raising the banks’ reserve requirements appropriately.

If it doesn’t, however, we’re looking at either another steep recession, or a bout of serious inflation, follwed by another serious recession to tame the inflation.

Oh, and even if the Fed is that good, it doesn’t address the problem of how the Chinese will react to any increased currency risk they face by holding dollar-denominated securities if the value of the dollar falls in the FOREX. As Mr. Wolf admits, the Fed’s mandate has nothing to do with the foreign exchange value of the dollar.  So, maybe, the Chinese will decide to sell as much of their holdings in Treasuries as they can.  That implies a serious decline in treasury prices, and a concommittant rise in bond yields, i.e., interest rates. Aaaand, we’re back to a possibility of a steep recession again Especially if they do it while the Fed is already in the middle of money supply sterilization operations.

So, I guess the question is, “How much to you trust in the ability of the Federal Reserve to do exactly the right thing, at exactly the right time?” And, “How much do you trust the Chinese to go along with all this?”

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8 Responses to Maybe I’m just an alarmist

  • Based on their track record since 1929, zero confidence. Critics of military action always point out that there is no such thing as a surgical strike. The same applies to the Federal Reserve. There are no dials to twist or valves to adjust. Because of the time delay,  the scalpel of Fed policy has the effect of a meat axe.
    Pushing on a string has long been a phrase used to describe Fed actions when demand for money is low. And yet they persist. Banks aren’t lending for two reasons. First, because they can lend money to the Fed at a low but safe rate and use the gain to repair their balance sheets. A riskless trade akin to  passbook savings. Second, where is the demand from the customers? The customers are going the same thing; repairing their balance sheets, de-leveraging. I think the latest Fed actions are in accord with the Le Petomane Principle (We’ve gotta do something to save our phoney baloney jobs.)
    I do disagree on one point. I think it was the recession of 1982 that finally killed the great inflation of the 1970s.

  • The DOW priced in gold:
    Now keep in mind this is from about a year ago.  Gold is now around $1400/ounce and the Fed just promised to monetize another $600 billion in debt.

  • I am not as wise as Beardboy Bernanke, or TurboTax Geithner, but I know a bad policy when I see it.

    My prediction;  Pain!

  • There is another way to look at this … which is probably worst.
    The Federal Reserve is buying a boatload of federal securities, which is pretty much what China did.
    Is no one concerned that, just like the possibility with China, that the Federal Reserve is gaining a stranglehold on the U.S. federal government with the possibility of being able to crash a regional or national market just before an election ?
    All those bad things Obama has been saying about Wall Street, will probably apply to the Fed before long.

    • Not the same thing. China bought the securities because it has large quantities of dollars earned through foreign exchange. As Milton Freidman eloquently pointed out many years ago, “They give us stuff, we give them green pieces of paper that can only be spent in the United States.”
      Despite what some may say, the Fed can’t act like the Hunt Brothers trying to corner the silver market. Any market small enough to be crushed is too inconsequential to matter to international trade. See the financial crashes of the Asian Tigers circa 1995. The consequences of crashing any market large enough to matter are rather dire. That’s not to say that the Fed hasn’t acted in the past to save our own domestic international banks. See the Brady Plan et al.
      What I see is a bunch of allegedly smart people desperately trying to undo 30 years of poor decision making.

      • I’m not so sure.
        If I believed in conspiracies, I would believe that the whole financial crisis was an attempt to make “the Democrat” President by reminding everybody that Bush was so bad by “having a little financial panic,” which got completely out of control.
        I see no reason to believe, at least in my wildest dreams, that it couldn’t happen again.

  • Mr. T would let Jesus win, but Jesus would win no matter what. Mr. T. is a Christian.