Photo Credit: eflon || All in all, you’re just another brick in the wall…
In some ways, the Federal Reserve is the whipping boy of Congress. Congress can’t decide on anything significant, so the Fed fills in the blanks, and keeps things moving, even if it creates humongous asset bubbles in the process.
That is what we are facing today. Overvalued stocks, housing, corporate bonds, private equity, and more. Inflation in goods and services may be transitory, but asset inflation is a constant. Whether by QE or rate policy, the Fed tries to end the possibility of recessions by making financing cheap, and blowing asset bubbles in the process.
What of the future? The Fed will be dragged kicking and screaming to tightening. It will follow the stupid Alan Greenspan highway of 25 basis points per meeting. It will be all too predictable, which has little to no impact until it is too late, creating pro-cyclical economic policy, something the Fed specializes in.
The Fed will be surprised (again) to see that the long end of the yield curve does not respond to their efforts. Are they stupid? Yes. the yield curve hasn’t worked in the classical way for over 20 years. In an overindebted economy, long rates are sluggish. Can the Fed abandon the dead orthodoxy of neoclassical economics to embrace the reality of overindebted economics?
I doubt it. I asked two Fed governors three years ago when the Fed would abandon the failed Neoclassical economics. They looked like dead sheep for a moment, before they gave some lame defenses of the theory that can’t account for financial markets or marketing.
What I expect is that the Fed will tighten the Fed funds rate to 1.5% or so, the long end sinking, and then something blows up, and they return to the prior policy of 0% rates, and QE… failed policies that inflate asset bubbles and increase inequality.
We’re in a “doom loop” where there is no way to purge this system of its errors. We would be better off under a gold standard, with stricter regulation of banks. Would we have a recession? Yes, but eventually the economy would grow again organically, without the pollution of stimulus.
That said, the Federal Reserve is not the main problem. The main problem is American culture that will not tolerate severe recessions. We need recessions to liquidate bad debts that hinder the economy from growing rapidly in the future.
We need to accept the boom-bust cycle, and not look to the government or central bank to moderate matters. Bank regulation is another matter, as loose regulation of banks led to extreme booms and busts, particularly between 1870-1913, and 2004-2008.
Conclusion
The Fed will tighten and fail, returning us to the same morass that we are in now. Financial repression via the Fed will continue to create inequality with no smoking gun. Stupid people will finger other causes, when the real cause is the Federal Reserve. We need to eliminate the Federal Reserve, and cause Congress and the Executive Branch to take responsibility for their failed policies.
PS — there could be a currency panic, but I doubt it. Too many countries want to export to the US.
David, thank you. Your conclusion is this: “We need to eliminate the Federal Reserve, and cause Congress and the Executive Branch to take responsibility for their failed policies.” Since that most likely will NOT happen, what is your advice for a guy like me, the small individual investor who is 10-15 years away from retirement? How do I position myself financially?
The globalization of the economy has dropped the bottom out of the labor market for at least a couple of reasons: 1. globalization of capital- the factories are not in the US, 2. globalization of labor (immigrants and factories/workers in other countries). This is the biggest reason for the inequalities.
The central bank behavior also contributes (none of this happens without being impacted by the other variables).
I keep waiting for the Volcker moment. I expect something to break, as you said. IF! that happens, there might have to be a Volcker moment (where they do something drastic- default on a debt or reduce future welfare/social and defense budgets).
OR- we could be like Japan- mediocre performance because of a forever debt burden. I am not sure if that can happen, however, because I believe that the US enables Japan’s financial situations.
Either way, the future looks like it’s a bit punk for my kids’ generation.
Thanks for the post.
I can think of no worse solution than to expect that Congress and the Executive branch would somehow rise to the occasion and act responsibly in the face of recession, inflation or rising debt levels. Congress and the Executive branch have failed for many years (if they ever did) to act responsibly when it comes to fiscal matters, and instead have exported these problems to the Fed to somehow be managed by means of monetary tools alone. Having said that, I suspect the Fed has arguably done at least a fair job of the tasks that have been delegated to it, although you correctly note that they have spectacularly failed at key moments.
What to do? My opinions are probably no better than anyone else’s, but what I wouldn’t do is fantasize about returning to a real or some sort of quasi gold standard. We’ve tried that experiment and it didn’t work, and I have little hope that we could somehow make it work now. Also, accepting boom/bust cycles also doesn’t sound very attractive as, inevitably, its the large portion of our population with few capital assets and no real ability to borrow who are hurt the most when the economy goes bust.
What does appear to be a common theme in much of this discussion is the appetite for and ease with which new debt can be created. I would like to get the Fed out of the bond buying business as soon as possible, but I would also like to see greater restrictions placed on the creation and sale of private and public debt. A change in our tax code to restrict or eliminate debt interest deductions would help, but the likelihood of Congress taking up such a challenge seems slim to none at all.
I share a growing sense that the economic principles that we so carefully studied in school seem to be less relevant in today’s economy. If so, I can only hope that younger and bolder economists will somehow manage to chart out and explain what has changed and, more importantly, how we manage going forward.
Folks hoping for a Volker moment in terms of Federal Reserve Policy will probably be waiting a long time. When Paul Volker raised interest rates to combat inflation the US federal government debt as a percentage of the economy was at least 1/4 the size it is now. Therefore the US budget could afford to pay for higher interest costs. Now higher interest rates will cause serious budget problems.
In any case now we are in an environment where money creation in the economy does not depend on interest rates since it is the Fed that is creating the money via QE. Private banks will only create money when interest rate spreads make in profitable to do so. The Fed can create as much money as it likes while keeping interest rates low. Inflation will be high but if they can fool the public into believing they are not responsible for it, they will be able to continue their QE policies. The net effect will be a combination on inflation and lower returns on capital invested in the financial markets. Basically we are monetizing fiscal deficits at this point – savers and investors are being taxed.
Kolya- if you read the post carefully, you will note that it doesn’t talk about raising rates. It talks about some kind of default. That’s the type of Volcker moment that would be effective now- with such high debt.
Gold standard- Prof Friedman recommended a basket of commodities to back a currency. I would envision some large number, e.g. more than a hundred such. It could be managed like the S&P 500 then- as commodities got more or less valuable (due to commercial/technical advances), they could be rolled in and out of the basket. Easy enough on paper, anyway.
The WSJ described the choice of Powell vs Baird as a choice between tweedle-dum and tweedle-dee. They were being diplomatic.
The problem in Washington DC, including the Fed but not just the Fed, is that the smartest people in society don’t want to be caught driving past DC never mind working there. The District (both parties) is a collection of half-wits and quarter-wits, many of whom are openly corrupt.
We’ve had half a dozen elections for President, alleged leader of the free world, that were really a contest between tweedle-dum and tweedle-dee. And yet people still think that things will improve if we get “the other guy” out of office. Replacing tweedle-dum with tweedle-dee accomplishes nothing since they are both incompetent.
Instead of arguing about dimpled zits and hanging chads, we should have been asking why we can’t attract better candidates in both parties?
The answer is that anyone who gets elected has to work with career criminals (the federal bureaucracy) while answering inane questions from the click corps (aka the media). Making good decisions, or God forbid representing the 50 states outside the district of corruption, isn’t part of the selection criteria.
Powell’s job is to print pesos and zimbabwe dollars to fund all the batsh!t crazy nonsense that incompetent politicians can ram down our throats. More corrupt bureaucrats and more corrupt agencies backseat driving every single minute of every day.
The USA will not improve unless and until the federal bureaucracy is right sized. At least 60% of federal bureaucrats need to be fired, and their positions eliminated. Yes, that means members of Congress will have smaller staffs — that would be a good thing. They would have to focus on a small number of meaningful bills instead of trying to be all things to all people.
The Fed is a disaster for the citizens of the USA, but it represents its Washington DC constituency very well. And that’s the problem.
Respectfully, David, your conclusion “We need to eliminate the Federal Reserve, and cause Congress and the Executive Branch to take responsibility for their failed policies” is effectively voided by your second sentence that states “Congress can’t decide on anything significant.” While I sympathize with many of your observations regarding the Fed’s actions, your recommendation smacks of Recep Tayyip Erdo?an’s politicization of the Turkish Central Bank. Independence from any government’s current Presidential/Congressional/Prime Minister/Parliament extremely short-term/misguided perspective is more important. Independent central banks, however flawed, are better than the purely politically driven alternatives.
Hi David, I love your grasp on the economic landscape (albeit a depressing one). Two questions: wouldn’t eliminating the federal reserve throw global markets into panic? And, what does the current mess mean for those international markets? My advisor http://www.morebo.co.za does a great job here in South Africa but we are at the whim of the international scene.