Monday, December 31, 2012

William Cohen: Fed policy more of a problem than fiscal cliff

In his Washington Post editorial, William Cohen looks at the Fed's monetary policies and concludes that they are more of a problem for the economy than the fiscal cliff.

Regular readers know that these policies are the result of the pursuit of the Japanese Model for handling a bank solvency led financial crisis.  Under the Japanese Model, bank book capital levels and banker bonuses are protected at all cost.

One of the ways to protect bank book capital levels and banker bonuses is to drop a bank's cost of funding to zero.  Since bank make money on the difference between what they charge to lend out their funds and what they pay for their funds, zero interest rate policies maximize their income.

This income is then divided.  First, it goes to pay banker bonuses.  Second, it goes to "build" bank book capital levels.  Third, it goes to pay dividends to shareholders.  Lastly, it goes to absorbing some of the losses still being hidden on and off the bank's balance sheet.

Maximizing bank income comes at a huge cost to the real economy.  Specifically, when the bank's cost of funds drops to zero, so too does the income earned by savers on their money.  Lost income that savers attempt to offset by cutting back on current consumption.

Savers cut back on current consumption rather than chase yield because they learned in the run-up to the financial crisis that this results in the loss of principal.  Savers have adopted Mark Twain's investment philosophy:  they are more concerned about the return "of" their money, than the return "on" their money.

The reduction in current consumption creates recessionary pressure on the real economy so long as zero interest rate and quantitative easing policies are being pursued (just look at Japan which has experience 2+ decades of economic slump).

In the short term, Washington lawmakers are understandably preoccupied with trying to avoid the “fiscal cliff.
But the decisions that are likely to affect the economy’s long-term health are happening not on Capitol Hill or at the White House, but at the Federal Reserve — specifically, Chairman Ben Bernanke’s policy of continuing to drive down long-term interest rates until unemployment hits 6.5 percent. 
This tactic, called quantitative easing, could remain in place for years. But is it helping the middle-class Americans who need it most? 
Unfortunately, the answer is no. 
Quantitative easing not only hurts older Americans on fixed incomes and those who have dutifully saved for retirement, it also frustrates younger people who can’t afford to take advantage of historically low mortgage interest rates
Mainly, Bernanke’s quantitative easing helps Wall Street’s banks and traders, a dynamic that could be setting us up for another financial crisis as investors again seek out higher-yielding, lower-quality investments that Wall Street is only too happy to provide....
The bad news is that the Bernanke policy is a most unwelcome tax on savers and the millions of older Americans who live on fixed incomes.... Savers and fixed-income investors are getting very little reward for their prudence and might be struggling financially, because as Bernanke forces interest rates lower, the amount their savings yield on a monthly basis dwindles, too.... 
So who benefits from the low interest rates on checking and savings accounts? The big, consumer-oriented banks such as Bank of America, Wells Fargo, JPMorgan Chase and Citigroup, all of which were bailed out by the federal government four years ago....  
Who else benefits from Bernanke’s creativity? A similar crew: Wall Street’s bankers and traders. The Fed’s policy means their profits and bonuses are higher than they would be otherwise. The bankers benefit because, with interest rates so low, they can reap huge fees by underwriting the explosion of corporate debt that their clients are eager to issue....  
Traders, meanwhile, know that Bernanke will be there to buy their Treasury securities or mortgage-backed securities — to the tune of that $85 billion a month. They can make a killing buying the securities in the market, for their clients or themselves, sure that when they are ready to sell, the Fed will buy them at the market price, which, thanks to the Fed chief, has been rising steadily....

For all the well-deserved plaudits Bernanke has gotten for being creative and for doing something while economic indecision reigns in the rest of Washington, his policies are badly hurting savers, benefitting Wall Street greatly and only marginally helping those people lucky enough to be able to get or refinance a mortgage. Worse, he may be the cause of another financial crisis long before we have fully recovered from the last one. 
No less a legendary bond authority than Bill Gross, the founder and co-chief investment officer of the investment firm Pimco, made a similar argument recently
The time is long overdue to take the morphine drip out of the debt markets’ arm and let interest rates be based on genuine supply and demand, not propped up because of a creative Fed policy. Otherwise, this is not going to end well.
And the only way to end the morphine drip is to adopt the Swedish Model and make the banks absorb the losses on the excess debt in the financial system.

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