The Frightening Reserve

The Federal Reserve is our nation’s central bank.  It, unlike other central banks of the world, is a body independent from our government (although its board members and chairman are appointed by the President and ratified by Congress).  With its establishment in 1913 it has a mandate to promote price stability, full employment, low interest rates; as well as regulate the commercial banking sector.

Their tools take the form of monetary policy actions, not fiscal policy actions.  In other words, they can influence interest rates and the money supply.  But they can’t spend and raise revenue through issuing debt or levying taxes.  Only Congress and the President through the Treasury can perform those latter.

The Fed’s most commonly used tool has been traditionally influencing higher (“tightening”) or lower (“easing”) the interest rate banks pay to borrow funds.  Raising those rates chills bank lending activity, if the Fed fears that the economy may overheat and cause inflation.  Lowering those rates tends to spur lending activity, if it has slowed from fear of recession.

That’s worked pretty well for most of the past century.  Until recently.  Commencing in 2007, when it became abundantly clear that we were heading into a severe and unprecedented credit crunch, the Fed began lowering rates toward an unheard of (just pretend Japan doesn't exist) zero percent.  It has since held rates near zero for almost four years now, and yesterday indicated that it will continue to do so until at least mid-2015.

In essence, the Fed has indicated that it will keep the cost of borrowing funds for banks free, for the better part of a decade.  Most easing cycles of the post-World War II period lasted for a handful of months to maybe a year-and-a-half.  Typically, our current unprecedented level and duration of low interest rates would have caused the economy, and likely inflation, to explode long before four or seven years had passed.

But that hasn’t happened.  Growth is weak.  Jobs are recovering at the worst rate since the Great Depression.  And broader indications of consumer inflation indicate that it has been hovering in a very benign zone of ~1.5-2.5%.

The reason that hasn’t happened is because we are suffering the deflationary effects of a depression - what the Fed is trying to avert.  The cost of stuff we buy might not have declined yet by virtue of the Fed's monetary stimulus to-date, but deflation nonetheless is finding ways into the system in the form of declines in wages, for instance.

A depression is different than your typical recession.  Recessions are caused by the natural ebb and flow of the business cycle.  Depressions are protracted and deeper than typical recessions, caused by a long period of society-wide debt pay down after an over-expansion of easy credit and leverage.

They simply take a real long time to work out.  And there isn’t much anyone can do about it.  But the Fed keeps trying, as the lack of any political fortitude has neutered any further fiscal action.  On top of years-long zero interest rates, the Fed has also been making outright purchases of securities in the market place.  This is their so-called “quantitative easing” (“QE”).

So what does that do?  In essence, it places cash directly in the hands of financial institutions.  In their conventional easing process of lowering short-term interest rates, the Fed literally purchases treasury securities with very short maturities from banks and other financial institutions.  The Fed is bigger than that market (as it has unlimited purchasing power, ultimately backed by the Treasury that can print money), so its actions influence market interest rates lower.

But once it pushes rates to zero as it has, that policy becomes ineffective – the so called “liquidity trap”.  So that’s when they resort to the unconventional QE.  With QE operations, the Fed purchases treasuries with longer dated maturities for cash.  This is more potentially inflationary than their conventional method of easing for a couple reasons.

Firstly, in their conventional method, they don’t really buy those very short term securities for cash.  They purchase them in exchange for a “reserve credit” that the bank can put on its balance sheet.  Think of it as a casino chip - it has value to the casino (to the Fed, that requires banks to keep a certain amount of funds relative to deposits), but no value outside of the casino.

Until the bank actually "cashes in" that credit and uses it to make a loan to someone that wants one, the Fed has not issued cash into the money supply.  And in case you haven't noticed, banks haven't been exactly tripping over themselves to make loans nowadays.

QE is different.  It is a direct purchase for cash of securities by the Fed, with money (at this point) literally printed out of thin air by the Treasury.  It immediately and directly expands the money supply.  And since it is purchasing securities that don’t mature for years – where in conventional easing they typically purchased securities that mature in days – it effectively expands that money supply for years longer than standard easing might.

Further, the Fed isn’t just buying treasuries (notes issued by the Federal government to borrow money).  But let’s just look at that for a second.  Through QE, the Fed is borrowing money printed out of thin air from the Treasury… to buy notes issued by the Treasury to borrow money.  In other words, through the Fed (as independent as it may be) our government is lending money too itself and in that process just printing money to keep the whole nation from collapsing into a deflationary spiral.  Nice.

So they’re not just buying treasuries, as I said.  They are also buying mortgage-related securities.  Remember those things?  That caused the financial crisis?  The Fed’s buying them because no one else wants to.

Which brings me to my point.  I have maintained for three or four years now that the financial crisis never really ended; that the crisis has just moved to different quarters; that the threat and risks are still with us, just manifested in a different manner.

Today, those risks of using excessive leverage to invest heavily in risky assets are being moved off of the private sector’s balance sheets and onto the Fed’s balance sheet (as well the Federal government's as weak economic activity increases its debts from lack of adequate revenue collection).  Pre-crisis, say late-2006, the Fed’s balance sheet was roughly $900 billion of assets and liabilities (the Fed typically maintains a “matched book”, where assets equal liabilities).

At year-end 2006, the Fed’s liabilities were mostly our checkable deposits, $779 billion (a good chunk of the money supply).  Their assets were mostly treasury securities, $741 billion.

Moving forward to today (latest report is through 31 March 2012), the Fed’s balance sheet is over triple what it was – now $2.9 trillion.  It’s never been expanded anywhere near this size before in its century-long history.  Their liabilities are now about $1.1 trillion of our deposits, and now $1.5 trillion in member bank reserve credits.

So with about $2 trillion of quantified Fed activity geared toward stimulating the economy, they have increased our deposits by a mere ~$300 billion.  In essence, ~15% effectiveness, if you will.

The rest of that “stimulus” – the $1.5 trillion of reserve credits (which was a scant $19 billion in 2006) – sits on bank balance sheets across the land not being lent.  Even though those funds for lending come free for the banks.

Which is why the Fed moved on to QE.  If the banks won’t use the funds to expand the money supply, the Fed will just eliminate that “middle man” and do it directly themselves by purchasing securities outright.  So now they own $1.7 trillion treasuries (up from $741 billion) and… nearly $1 trillion in mortgage-related securities issued by… the now since failed and nationalized Fannie Mae and Freddie Mac.  Because no one else wants to touch that stuff.

So when our Fed embarks on an experiment, never before attempted to this scale, and triples the size of its balance sheet, taking on $1 trillion of instruments no one else wants (that they owned $0 of in 2006 and before because they weren't allowed to), it might cause one to regard with concern the financial health of our central bank.

And yesterday, because all this activity has produced paltry results at best, the Fed announced that they are further going to buy another $40 billion of that stuff, each month, going forward into oblivion.  With money that we are creating out of thin air.

The crisis is still here.  But instead of destroying home prices, Countrywide, Fannie Mae, Freddie Mac, AIG, Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual, Wachovia, IndyMac, GM, Chrysler and the European PIIGS… now it merely threatens to destroy our central bank, the dollar and with that our full faith and credit.

Oh yeah.  And then we have that "fiscal cliff" coming up in a few months too.  That's a whole 'nother story.

 Have a nice weekend.

The Clear Choice

Well, both the Republican and Democrat conventions are finally out of the way.  A lot of people made a lot of speeches about how the choice is really so clear.  And they would be correct.  They would have us believe that one side screwed everything up; and the other side, the other.  And again, they would be correct.

This is, they tell us so emphatically, our clear choice.  What we have to choose from.

I believe that it is merely the illusion of choice, when the only effective options we have are between the same two parties that have at the very least presided over, but really are to me complicit in the affairs that have led us to our current dilemma.  Our "choices" are for one of two parties that have together shared complete control over this great nation since the early 1800s – making it effectively a bifurcated single-party state since.

And they spend too much money.  Both of them.  At least since I’ve been alive.  In my view, Republicans want to spend a lot of money on certain things by generally borrowing.  Democrats want to spend a lot of money on certain other things by generally taxing us instead.  And they would use these funds to effectively purchase votes from their constituents to tilt power between the two.

Both also spend a heck of a lot of time contrasting themselves with the other party.  But they are the same people.  And their rhetoric is growing more extreme, because we live in more difficult times.  Their respective party die-hard constituents absorb this rhetoric.  Through this, those constituents themselves grow more extreme, forcing politicians to follow that self-reinforcing spiral to our current intransigence.  (Only to pretend, as best they can, to be moderate for a small time between primaries and general election day to sop up the middle that hasn’t drunk their Kool-Aid.  Every damn cycle.)

It’s growing more difficult to be a politician in America nowadays.  (Smallest-violin-in-the-world-time.)  That’s because there is no longer any fat left to carve off and feed back to us in exchange for our vote.  This sociopolitical Ponzi Scheme is becoming starkly more apparent as our tide of wealth recedes – where there is less of our own treasure to take from, and promise back, to us.

There’s no more fat because, unlike before, budgets are actually going to have to become reconciled.  As our gross Federal debt has now topped $16 trillion – over that danger zone of greater than 100% of GDP.  And yet we still burn through over $1 trillion each year.  They let deficits run away because they are afraid for their own personal political careers, and as credit markets have given us a pass for now.  Which is hyperbolic foolishness – borderline treason, in my view.  (But let's just refer to it as gross negligence.)

When in 1933 FDR first rolled up his sleeves and got busy trying to right the effects of the Great Depression, he started with Federal debt to normal GDP (pre-collapse) at about 25%.  Budgets were about 3% of GDP.  The top marginal personal income tax rate was 25%; 1.5% for average incomes.

In other words, he had all the latitude in the world to harness the economic might of a young, industrializing and great economy, even despite its catastrophic collapse.  We don’t have that now.  We can’t spend our way out of this one.  There’s nothing left to spend.

I watch MSNBC plugs with Rachel Maddow, Ed Schultz or Chris Matthews for instance (no offense to them, they’re just reading the script handed to them for those bits, I hope) where they extol the virtue of Depression Era spending and public works as the way today.  It makes me chuckle (otherwise I’d be crying).

Spending on public works is not only the way.  It is necessary in a now clearly flagging infrastructure and faltering education system.  Public funding has incubated many of the most powerful private industries that helped make America, America.  I absolutely so agree with them.  But what I guess they don’t get is (and pardon the crude metaphor), parasites die to if they leech an unhealthy host to death.

The point is, increasing taxation on a healthily growing economy is all totally fine, if we can’t cut spending.  Tax rates are clearly much higher than when FDR started out in 1933.  And they can also clearly go higher.  But they would dangerously sap an already ailing economy, as spending cuts would – thus our rock and hard place.

Budgets are now 25% of GDP, not 3%.  Debt to GDP is now in the zone of when we were maxing out for World War II-time production.  We don’t have any more spending latitude so long as the economy is weak.

And not for nothing, when FDR was done, by say 1939 before the war started for us, tax rates were tripled to 79% for the highest incomes; 4% for average incomes.  Debt doubled to 50% of GDP.  The budget had tripled to 10% of GDP.  All that Keynesian effort… and unemployment was still 19%.  That’s certainly better than 1933’s 25%.  But we started in 1929 at 3% unemployment.  (For reference, I believe that “underemployment” was 28% by 1939, 38% in 1933 and 5% in 1929.)

The only obvious solution for right-sizing our debts and budgets, will have to come from all quarters – as the now two-year-long disregarded, bipartisan-composed Simpson Bowles Plan advocates.

Unfortunately for the politicians, the real work will have to involve doing things we don’t like.  Cutting popular plans we spend on.  Raising taxes (for all) to pay for what we can.  And politicians don’t like that pitch.  (Although personally, I think it’s coming right after this election, no matter who wins.  It’s either that or a credit/currency crisis in about two years.)   So they embrace the extreme.  They pander to their respective party’s fundamentalist core – blaming the other party for our nation’s woes and hoping that gets them re-elected.

In my view, the economy is weak and the necessary amount of jobs are absent, simply because the nation and world has lost confidence in the leadership of the greatest nation on Earth – the only one that has truly led the world in modern times - geopolitically and economically.  Now it can't even lead itself.  No wonder the world continues so adrift, four or five years now past the financial crisis.

The choice really is rather quite clear.  Our leaders must do the responsible thing – not the personally self-preserving thing like they continue to.  If our nation and the world see that, then we’re back in the game.  Like gangbusters.

Until then, we all just stand here, jaws agape, staring at our would-be elected officials blather on at us about how clear the choice is.

So yes, we do see how clear the choice is.  We only wish you did too.