The Federal Reserve under Fire, Part Two
President Eisenhower, in the face of the relatively mild recession of 1958, resisted the harangue of Republicans in Congress to cut taxes and, in so doing, was able to oversee a government that had several years of balanced budgets. He argued that the huge tax cuts of 1954 had been enough in the way of fiscal stimulus, and he was proud to point out that the majority of the money from that round of tax cuts had gone to people of more modest means. The fiscal discipline he imposed as chief executive officer of the United States would prove exceptional, particularly in light of the howl from his own Republican Party as it obsessively paraded its pandering wares for the low-taxes crowd of that day.
President Kennedy, fully infused of a more enlightened Keynesian advisory slate, and with the excuse of having inherited from Eisenhower a sluggish economy, actually appealed to Congress for legislation to cut taxes. At the same time, he was laying out plans to take the country onto the entrance ramp of a long, wide highway of massive growth of government. His vision was dutifully and honorably fulfilled by his successor, President Johnson, who knew full well, as did his ill-fated predecessor, that a completely compliant Federal Reserve stood ready to monetize what would become a spiral of expenditures far beyond the means of even the United States, especially in the face of inadequate tax revenues. The Great Society (Johnson's follow-on to Kennedy's New Frontier) and the Vietnam War (Johnson's high-octane version of Kennedy's advisory actions in southeast Asia) would together become, first, the engine of fiscal policy permanently masked as economic stimulus; second, the wedge by which the public sector would become permanently entrenched as an integral and significant part of the American economy; and, third, a means by which monetary and fiscal policy distinctions could be better and more systematically blurred on a nearly permanent basis.
Duties and Tools of the Federal Reserve
In principle, the Federal Reserve has three functions, the first two of which it has carried out with what has arguably been a considerable degree of clarity and strength. The Fed regulates and supervises banks; the Fed provides banking services for banks (as a competitor with private financial institutions that offer the same); and the Fed conducts monetary policy.
Regulation and Supervision: The seven Governors, appointed by the President with the advice and consent of the Senate, of the Federal Reserve Board construct bank regulations. Sometimes, as with many federal agencies, these rules rise to the level of regulatory law; in other circumstances, the regulations are interpretations of federal laws enacted by Congress. The application and enforcement of these regulations created by the Board of Governors is the responsibility of the 12 Reserve (or "District") Banks, each overseeing the banks in its own geographical region. Application and enforcement is carried out through bank audits, dissemination of information, and other activities. In summary, regulation is carried out by the central Board of Governors, and supervision is carried out by the Reserve Banks.
Banker's Bank: Just like any other business enterprise, a bank needs a place to deposit its money and get other important financial services. The Federal Reserve offers the entire range of such services a bank might need, but the Fed operates as only one possible financial institution banks may use for such purposes. Certain private, commercial institutions offer the same services, and the Fed's participation in this market is generally to ensure a degree of competition and encourage innovation.
Monetary Policy: Technically speaking, the Federal Reserve has three tools by which it can conduct monetary policy. One is the "required reserve ratio," the fraction of demand deposits a bank must keep on hand to satisfy claims on its customers' checking accounts. The level at which this required reserve ratio is set has the consequence of determining the factor by which new money entering the system will multiply as the result of loans and deposits. A higher required reserve ratio will slow down the multiplier effect; a lower required reserve ratio will increase the multiplier effect. As a tool of monetary policy, this required reserve ratio is blunt in the sense that relatively small changes in it can have fairly dramatic effects on how fast the money supply grows; as such, the ratio is set primarily for its function of imposing upon member banks a minimum amount of money that will be in the vault for customers and for those bearing checks from customers. In times when people have worries about the banking system and their money, the Fed might set the required reserve ratio higher than in times when people are quite confident about the economy and its banking system.
The second tool of monetary policy is the "discount rate," which is the interest rate at which the Federal Reserve, itself, would lend money to member banks. The Board of Governors sets the discount rate about eight times a year, moving it up and down, or leaving it alone, to signal broader Fed policy intentions. Typically, banks would prefer not to step up to the so-called "discount window" for a loan because they can borrow from each other in the "Federal Funds market," even though the "Federal Funds rate" (or "Fed Funds rate," for short) is higher. The Federal Reserve sets the discount rate (logically, because it is the lender at the discount window), but it cannot "set" the Fed Funds rate because this rate is driven by the supply of and demand for lendable funds in the banking system.
The Federal Reserve does set a target for the Federal Funds rate, and it tries to move the actual rate toward the target rate by the third of the three tools of monetary policy, the so-called "open market operations" (OMOs), which are executed by the Domestic Trading Desk at the Reserve Bank of New York (the "Empire" bank). These OMOs are carried out every day, and they are the activity of the Federal Reserve in the financial markets that powerfully affects the supply of money in the banking system. Policy expressed through the open market operations is set in meetings of the Federal Open Market Committee (FOMC), on which the seven Governors are voting members, as well as the presidents of four Reserve Banks on a two-year, rotating basis, and the president of the New York Reserve Bank on a permanent basis. The FOMC makes decisions about how much liquidity the banking system should have at a given time, and the directives to add liquidity to or drain liquidity from the system are transmitted to the Desk in New York for execution by traders who then enter the open market for Treasury securities and offer to buy them from or sell them to member banks. If the Desk is a net buyer, that causes demand for Treasuries to increase, which drives their prices up (which pushes their yields down), and the result is that banks receive money from the Fed for the Treasuries they sell to it, induced as the banks are to sell some of their Treasuries because they can fetch the rising prices of them. On the other hand, if the Desk is a net seller of Treasury securities, that causes the supply of those Treasuries to increase in the open market, thus driving their prices down (which pushes their yields up), and the result is that banks surrender money in exchange for the Treasuries they are buying, induced as they are to buy some Treasuries because the falling prices are making them more attractive investments.
In the case where the Desk is a net buyer of Treasuries from member banks, money is flowing into the banking system as the Desk pays the banks for the assets it has purchased, so the cash is being deposited in Federal Funds market in the names of the banks the Desk is paying. This makes the Fed Funds rate drop because the supply of lendable funds is rising, meaning the system has more cash money to lend. In the case where the Desk is a net seller of Treasuries to member banks, money is flowing out of the banking system (and into the vault or shredder at the Fed), making the Fed Funds rate rise because the supply of lendable funds is decreasing, meaning the banking system has less cash money to lend, since it spent money buying those Treasury securities the Desk was offering. The result of these open market operations is that the liquidity of member banks' asset portfolios is altered: when the Fed is pursuing expansionary monetary policy, the asset portfolios of member banks is becoming more liquid (tilted toward more cash that can be lent), causing interest rates banks charge for loans to drop; when the Fed is pursuing contractionary monetary policy, the asset portfolios of member banks is becoming less liquid (tilted more toward Treasuries, which cannot be used for lending), causing interest rates banks charge for loans to rise.
The Purpose of Monetary Policy: Theory and Reality
Ideally, in carrying out its duties to conduct monetary policy, the Fed has one and only one goal: maintain the stability of the aggregate price level. That means the Federal Reserve, in managing the money supply, is charged with preventing inflations and deflations, especially those that would persist long enough to embed expectations of future continuations of price increases or decreases into wage levels, interest rates, and prices for goods and services. To that singular goal of maintaining stability of the aggregate price level, the Fed would oversee a growth rate of the money supply that matchedand did not go above or belowthe real growth rate of the economy. In other words, sound monetary policy would be to the exclusive and singular end of ensuring that the money available to the American economy was just enough, no more and no less, to provide the cash the economy needed for its transactions. This would mean that the money, itself, was completely neutral with respect to effect and did not, because of an over- or under-supply of it, distort growth, expectations, aggregate demand, or aggregate supply.
Unfortunately, monetary policy can affect the short-term real growth rate of an economy, and the neo-Keynesians have not been afraid to use this as a tool of intervention in the business cycle, particularly to the end of stimulating the economy, whether or not the economy needed any stimulus. President Kennedy's Fed was certainly not the first to understand that excessive growth of the money supply can create a short-run stimulative effect, and the Federal Reserve came in the neo-Keynesian era to embrace an expansive understanding of the goal of monetary policy (and, by implication, of the authority of the Fed) that included "assisting" the economy in times of economic hardship. The worst part for the Fed of abandoning a more parsimonious goal of controlling the aggregate price level was that, once it had become an instrument of fiscal policyindeed, of social and public policiesits Board of Governors found itself less and less able to stop the integration of the Fed into the machinery by which the U.S. Treasury funded government operations.
The Federal Reserve of the Nixon years continued this abandonment of the mission of the central bank, which arguably culminated when the Board, under the chairmanship of Arthur Burns, monetized the price shock of the OPEC oil embargo of 1973. As excess money was already spreading through the American economy, causing general and escalating inflation, the solution proffered by Nixon and the federal legislature of the time was to impose wage and price controls, which are essentially the legislative version of curing inflation by putting a cork into the wound of a person bleeding profusely from a gunshot to the abdomen. With the Fed pumping money into the system to keep aggregate demand strong, inflation accelerated; far worse, however, expectations that the inflation would continue and accelerate started to set in.
For Nixon's successor in office, Gerald Ford, that meant keeping the money printing presses rolling to forestall the gathering and inevitable storm of a recession that would be caused in part by interest rates rising because of the expected inflation premium in them starting to embed and grow. Ford's solution, facile as it was, had as its hallmark a public campaign to "Whip Inflation Now," as if it would be by some decision of the economy's consumers, workers, and merchants that inflation would abate and expectations of it would vanish.
It was then left to President Carter to do what had to be done. At first, he approached the problem much as Ford had done, putting the burden on the economy's participants to deal with the matter. He dubbed his campaign the "Moral Equivalent of War," which has the unfortunate but telling acronym "MEOW." Carter was not, however, a stupid man by any means, and he did understand what had to be done. In 1979, he appointed Paul Volker as Chairman of the Federal Reserve Board and gave him the charge to do what was necessary: crush the money supply, which would send real interest rates (the actual price of money) through the roof because the expected inflation premium already in those rates was sky-high, and draining liquidity from the banking system would put those interest rates into nose-bleed territory. Sure enough, Volker's Fed sent the U.S. economy into a brutal recession, in part because the peanut farmer from Georgia understood that the pain of austerity was the prelude to rebirth of an American economy able to carry on in the last two decades of the 20th Century. By the end of Carter's one term in office, he was overseeing budget deficits that were minuscule, even in inflation-adjusted dollars, compared to what his successor, Ronald Reagan, was about to allow, encourage, and use to the purpose of inappropriately projecting American military and financial power.
At first, Volker's attack on the money supply did nothing to dampen expected inflation, and this was because no one actually believed the Fed really was Hell-bent on killing inflation; after all, Presidents had for years been promising to deal with it, and yet it had just kept getting progressively worse. The price spiral of something close to hyper-inflation began to abate only after just about everyone became convinced that old "Tall Paul" Volker did not care how badly the economy suffered under constrained liquidity. Finally, as President Carter was swiftly vanishing into history as some kind of pariah to economic pundits and short-sighted historians, expected inflation premiums began to disappear from interest rates, from wage and salary demands, and from prices of goods and services. The falling interest rates, in and of themselves, began to breathe life into what had been a moribund economy.
Ronald Reagan rode into office in 1980 on the strength of what had been done by his immediate successor, and the Gipper was able to stride to the podium in his first address as President to gravely announce, "We're in an economic mess," affording him the populist high ground for his tax cuts to be passed by Congress, attended as they would be in the years that followed by rising budget deficits and a return to neo-Keynesian policies heavy on the interlocking relationship between industry and government, but with a Republican twist of no "countervailing force" (as economist John Kenneth Galbraith called it) of powerful unions to ensure the rights and wages of workers in the final plunge toward the 21st Century.
Government unable to resist the whine of greedy, pandering Republicans for tax cuts coupled with big government spending on government/industry projects: this is the legacy of Republicans from Richard Nixon forward. Government unable to resist the equally tiresome whine of greedy, pandering Democrats calling for a government war solution to everything from poverty to communism in southeast Asia coupled with big spending on government/industry projects: this is the legacy of Jack Kennedy and Lyndon Johnson, but the legacy ended there: both Carter and Clinton oversaw controlled government spending and tax rates that brought in sufficient revenues to meet government expenditures; and Bill Clinton actually oversaw budget surpluses in his last years in office, notwithstanding the still-noisy bleatings of historical revisionists trying to find some shred of equivalence between President William Jefferson Clinton, who reined over the longest peacetime expansion in modern U.S. history, and President George W. Bush, Jr., who collaborated with his Republican-led Congresses to initiate, prosecute, and consummate the recklessly irresponsible fiscal policies of the period from 2001 to the end of 2006 that have finally brought the American economy to the brink of deep recession.
Morning in America, Nightfall of Empire
Jack Kennedy was no Dwight Eisenhower, who stood firm against tax cuts, industrial policy, and monetization of government excess. For that matter, no Republican since Ike Eisenhower has been an Ike Eisenhower. The idealized versions of everything from Jack Kennedy and "Camelot" to Ronald Reagan and "Morning in America" are the fine stuff of American mythology, but the blindness to realities and complexities of the economic leadership these men provided the American people clouded a firm understanding of the long-term consequence of short-term policy actions they and their ilk pursued, particularly those policy actions funded by expansionary monetary policy actions by the Federal Reserve as it persistently strayed into management of the economy. This blindness to consequences is still happening: most Americans have not the slightest clue as to what has caused this nation to now stand at the precipice of an economic chasm of severe recession attended by high inflation. Quick fixes of massive infusions of liquidity are not going to work, and neither are fawning tax rebates; yet, these are the solutions being pursued right now by the United States government. Both the wildly excessive infusions of money and the too-late-to-matter tax cuts will make the problems worse and the subsequent, reparative fiscal and monetary policy actions extraordinarily more painful.
The current Fed Chairman, Ben Bernanke, is no Paul Volker; and George W. Bush is no Jimmy Carter, who stood firm against the economic mess that nearly two decades of decadent use of the Fed had finally produced as the lasting legacy of both Democrats and Republicans who could not keep their whims of Empire and its glory from infecting prudent central bank policy. The United States has now, in seven short years, returned to the brink of the brutal combination of recession and inflation happening at the same time, a mix for which the cure of sustained, contractionary monetary policy will hurt the American people like Hell and politically damage the President who has the courage to put into place a Federal Reserve Board of Governors with the will to administer the near-lethal regimen.
The American people of today will soon have to deal, as the people of Mr. Carter's time did, with the awful and painful solution to the reckless malfeasance and incompetence that will have been the legacy of irresponsible leadership. George W. Bush might be able to depart the White House before the full force of disaster of his economic recklessness becomes apparent to the American people, but even that is not assured: already, many believe that the U.S. is in a recession, even though the majority of Americans have yet to feel much pain other than high fuel prices and the discomfort of getting scared by stories of other people losing their homes in foreclosure. In truth, the American people have not yet even begun to feel a real recession.
But they will. They'll get their paltry tax rebate checks, and when they go out and blow that Fed-printed (and foreign-lent) money to make themselves feel better in their own households, they will see the economic equivalent of tossing tens of millions of lit matches onto a smoldering sea of gasoline that is the excess liquidity by which this Federal Reserve has been keeping the U.S. economy alive even as Mr. Bush and his Congress were digging its grave over the past seven years.
When the economic downturn actually does hit, the American people will scream bloody murder, and they will want the head of the President who is in office when the word "stagflation" comes into vogue, once again. George W. Bush might not be as lucky as, say, John F. Kennedy, the latter having been long in his tomb before the consequences of neo-Keynesian policies he started and his successors continued led to the last round of debilitating stagflation.
For those who reminisce fondly about Jack Kennedy, the good news is this: President Kennedy is a footnote in history; as such, all manner of greatness can be ascribed to him that is nothing more than the expression of fantastic minds imagining a better time than now. President Bush, on the other hand, will suffer the unfortunate advantage of being not a footnote in history, but instead the very definition of the trajectory of the 21st Century for this nation. Kennedy and Bush are, however, of a kind in that the repair of their errant policies will be in the hands of a successor. The United States was most fortunate that several stood to the task in the wake of Kennedy and his otherwise failed successors.
For the President who will succeed George W. Bush, history will allow no breathing room to govern and leave office without facing either the fury of economic disaster or the wrath of an American people who cannot imagine that they must, as part of their citizenship, pay for the failure a prior leader who finally became apparent for the incompetent, dense, prevaricating war-monger that he had always been.
The time of reckoning is soon; but as bad as the economy may get, the worst part is this: not one of the candidates running for President of the United States in 2008 is a Dwight Eisenhower, a Jimmy Carter, or even a Bill Clinton; to that extent, then, the American people will get what they deserve.
Unfortunately for the next President, that same American people will surely want someone other than themselves to blame for the insufferable outrage of inevitable consequences.
The Dark Wraith welcomes readers to the comedic tragedy of Empire in its final act.
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