Friday, April 19, 2013

Is the Federal Reserve insane? No. It only has one tool and it uses it to try to solve all problems.

In a must read Bloomberg editorial, Matthew Klein asks if the Federal Reserve is insane because its response to every economic problem it to try to solve it with a bigger economic bubble.

I would not argue that the economists who run the Fed are insane.  I would say they are a product of their training.  In the course of studying for their PhDs, they have learned a particular way of looking at the world.

It is this rigidity in thinking and the desire to defend the PhD theses that resulted that prevents them from implementing alternative responses to solving an economic problem.

My case in point would be our current financial crisis.  It is well known that we are dealing with a bank solvency led financial crisis.  Yet, the Fed continues to treat it as if it were a bank liquidity crisis.

Your humble blogger is not the first to make this observation that the Fed is treating a bank solvency problem as a liquidity problem.

The loudest voice on this was Anna Schwartz, Milton Friedman's co-author and an authority on the Great Depression and monetary policy before Ben Bernanke began his studies.  In a Wall Street Journal interview, she debunked the Fed's response, which is a reflection of what Mr. Bernanke argued should have been done at the time of the Great Depression, to our current crisis.

Ms. Schwartz made the case for bringing transparency to all the opaque corners of the financial system, including banks and structured finance securities.

The Fed, as Mr. Klein observes, is not interested in bringing transparency to all the opaque corners of the financial system.  Instead, the Fed is only interested in implementing what Mr. Klein describes as the Fed bubbles only policy:

Back in the 2000s, however, most people just wanted to get out of the funk associated with the aftermath of the tech boom. 
There was also a widespread belief that bubbles aren't dangerous as long as the central bank is around to "clean up" the mess when they burst. This view was best articulated by Ben Bernanke in 1999. 
As a result, many monetary policymakers were untroubled by the prospect of creating a new bubble to replace the old one. 
Transcripts of the Fed's internal meetings make it clear that this was their conscious plan. 
On March 16, 2004, Donald Kohn, a longtime Fed staffer who later became the Fed's vice chairman, said that the credit bubble was "deliberate and a desirable effect of the stance of policy." 
According to Kohn, the Fed's strategy was: "boost asset prices in order to stimulate demand." 
That appeared to work for a short time, but it ended badly. We're still struggling to emerge from the wreckage despite, yet again, incredibly low real interest rates and very large government budget deficits. 
Clearly, cleaning up after bubbles is harder than it's made out to be. 
One might think that the Fed has learned something from this experience.  A recent speech from Nayarana Kocherlakota, the president of the Minneapolis Federal Reserve Bank, suggests otherwise. 
He said that the Fed "will only be able to achieve its congressionally mandated objectives by following policies that result in signs of financial market instability." 
In other words, he wants to repeat the exact same formula that Donald Kohn endorsed in the 2000s.
Please note that there is nothing in the Fed's blow bubbles strategy that directly addresses bank insolvency.  So what are the chances it will be successful in ending a bank solvency led financial crisis?

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