By David J. Merkel, CFA of Alephblog.com
(Reprint from January 2011) I agree with Daniel Indiviglio about half of the time; I think he is a bright guy, but I disagree with him over certain principles. He recently wrote a piece called Why We Need the Fed. I am here this evening to take the opposite side of the argument.
We need to divide the argument, because there are two things being argued about:
- What do we use as a currency? Should currency have intrinsic value (privately determined), or is it just a social convention, a forcible notional unit of account (legal tender)? If it is notional, should we let a bunch of largely unaccountable bureaucrats manipulate its value, ostensibly for our good, but more often for the ends that the bureaucrats prize?
- How do we regulate banks? Credit policy is more important than monetary policy. How does a free society rein in the ability of financial companies from making financial promises that average people don’t realize that they can’t keep.
The second question is more important, because that is what drives our credit booms and busts.
If banks did not engage in maturity transformation, borrowing short and lending long, we would have almost no banking crises. Crises happen because there is a run on liquidity. Banks rupture when they don’t have liquidity to pay depositors or repo lines. Banks that are matched have the short-term assets to liquidate to repay exiting lenders/depositors.
The thing is, we have rarely regulated our banks well in US history, whether we have a central bank or not, and whether our currency is backed or not. We allow for too much leverage, and too much asset-liability mismatch.
I can hear a banking executive say, “But if you do that, we won’t be able to earn decent returns. Our ROEs will be in the single digits.” To which I would say, “Yes, in the short run, until enough excess capacity in banking exits, and your ROE gets into the low single digits because pricing power improves. This would parallel what happened to the life insurance business when it improved its risk management.”
Indiviglio cites four core functions of the Fed, from the Fed website:
1. Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rate
2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers
3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
4. Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system
Let me take them out of order. On point 2, the Fed played a leading role in the various banking regulators not doing their jobs during the booms in the 1920s, late 80s, and 2000-2007. As I argued in my piece Who Dares Oppose a Boom?, the incentives are wrong unless regulators are willing to be tough as nails, and stand in the way of a wave of liquidity-driven seeming-prosperity. And in times of moral laxity, like the 20s and the last 30 years, regulators go with the flow.
On point 3, the Fed added to systemic risk again and again 1984-2007 by always loosening rates to defuse the unwinding of some area of overleverage. This gave the markets a sense of complacency, such that in the last wave of speculation, almost everything was overlevered. The name for this was the “Greenspan Put;” if the Fed is always willing to provide more liquidity to financial players after a crisis, guess what? The financial players will take advantage of that.
If I had the power to change the mandate of the Fed, I would change its mandate to restraining leverage in the economy.
Ignore price inflation and labor unemployment — there is little evidence that the Fed has much direct influence there. Faster growth happens when leverage is low; more disasters happen when leverage is very high, like in the 20s and today. Debt-based systems are inherently inflexible; equity based systems deal with volatility better, and force managers to seek out organic growth opportunities, as opposed to financial engineering.
Thus on point 1, because the Fed allowed a borrowing bubble to build up twice, in the 20s and today, they ended up poisoning labor employment, because in a period of debt deflation, few companies want to hire on net. We would have been better off if the Fed had allowed prior minor crises (LDCs, Continental Illinois, Commercial Real Estate, RMBS, Mexico, 97 Asian Panic, LTCM, Tech Bubble) to break ugly, so that bad investments would be liquidated, and capital released to more profitable ventures. Then the crises would not have grown, and there would have been sufficient fear in the markets to restrain undue speculation.
The bust phase of the credit cycle has to be given the opportunity to do its work, and deliver losses to speculators without the Fed interfering. If so, there will be less of a tendency to make money through speculation, and more made through organic growth.
Finally, on point 4, you don’t need the Fed to provide those services. The Treasury could do it itself, or, as in much of US history, it could contract with a private commercial bank to do it for them. That’s not all that important of a reason for the Fed to exist anyway.
If Not the Fed, Then Whom?
Commodity standards have problems, but so does fiat money. And the problems are two-sided. Why should we favor debtors over savers, or vice-versa? If we view it this way, there is no answer, it only becomes a question of what do we favor as policy? Hard money and savers, or easy money and debtors? Is it just a class war thing, because the wealthy have assets and the poor don’t?
Yes it is partly that, but the poor don’t benefit from instability, and instability flows from high overall debt levels, which stem from easy money. My view is that everyone benefits in the long run from hard money, whether we have a currency board, a tight central bank following a Wicksellian mandate, or yes, a commodity standard.
The nice thing about any of the prior three, is that the currency becomes inelastic, a store of value, allowing for rational calculations by businessmen, allowing the economy to grow more rapidly in the long run, so long as we don’t let bank credit get out of control.
I agree with Indiviglio here — toughen bank regulation. Whether we have a central bank or not is a lesser matter, but the current Fed has blown it royally, and is no example for what we should have for monetary policy.
For more on the Fed visit the Learn Bonds list of 30 free resources for following the Fed.