Thursday, November 4, 2010

Here Comes the Spaghetti! The Fed's $850 Billion Bet.

The headline reads that the Federal Reserve is going to engage in a new round of quantitative easing. The Fed is going to purchase an additional $600 billion in U. S. Treasury securities over the next eight months, or $75 billion per month, in order to get the economy growing again.

The information that did not make the headlines is that over the same time period, roughly $250 billion will run off of the Fed’s Mortgage-backed securities portfolio. This $250 billion in Mortgage-backed securities will be replaced by the Fed with $250 billion in U. S. Treasury securities.

The world investment community sees a Washington, D. C. is disarray. The Fed is going crazy. (But, this is not the first time that Bernanke has shown panic. See “The Bailout Plan: Did Bernanke Panic”, And, the additional federal deficit is projected to be at least $15 trillion over the next ten years.

What we are seeing, in my mind, is the culmination of a half century or more of governmental economic policy that has had the wrong focus. This began with the Employment Act of 1946. Full employment became a goal of the United States government and the Federal Reserve was charged with the task of contributing to the achievement of this goal.

Right now, the Fed believes that there will be little or no stimulus programs coming from the federal government, especially with the changes in the makeup of Congress resulting from this week’s election. Thus, the Fed seems to believe that it must carry the full burden of reducing unemployment.

We have reached this state of desperation over a long period of time. The background of this environment is presented in the book by Raghuram Rajan called “Fault Lines” which just won the Financial Times award for the best business book of the year. (See my review of this book: The next five paragraphs contain material from this review.

Rajan states that “Almost every financial crisis has political roots.” Beginning from this premise, he discusses the foundation of the economic policies of the United States. The root of the government’s economic policies, he contends, is the concern over “the growing inequality of income” in the United States, a disparity that can lead to political unrest.

Politicians, however, have not responded to this problem by focusing on the longer run solutions to inequality connected with education and opportunity, but has instead focused on short run solutions because of the nature of the American political process.

Rajan argues that these politicians have responded to the discontent this divergence in incomes creates in the electorate with two short run panaceas: first, the effort to achieve high levels of employment through the monetary and fiscal policies of the government. This resulted in the Employment Act of 1946 and the Humphrey-Hawkins Full Employment Act of 1978. The second is the effort to help as many individuals as possible own their own homes.

Thus the government has created policies that underwrite efforts to attain high levels of economic growth and employment and will provide downside protection against economic contractions and unemployment. Likewise, it will underwrite the supportive credit inflation of the private sector and will “save” financial institutions experiencing trouble on the downside.

Home ownership has become the default policy of government in the inequality debate because efforts to directly combat income inequality in the United States, Rajan contends, have been exiled from political debate. Supporting home ownership for as many people as possible and in as many ways as possible has been substituted. As a consequence, the number of programs, institutions, and incentives advocated for home ownership has grown to the point where they dominate most economic and social policies of the United States government. Credit creation is the vehicle of choice for the achievement of homeownership and prancing from “bubble to bubble” has become the essence of the fiscal and monetary policy that supports this effort.

The problem is that these policies don’t work over the longer run. In fact, the efforts to achieve success in these areas over time may do more to help the wealthy and educated at the expense of the less-wealthy and the less-educated.

In the fifty years that the efforts Rajan describes have been incorporated into the economic policy of the federal government, the United States has actually seen the inequality of incomes become even more skewed toward the higher end of the income spectrum.

And, it appears that most of the efforts of the Obama administration to protect and better the position of the less-wealthy and the less-educated have done exactly the opposite of what the administration intended!

For example, look at this article by Shahien Nasiripour in Huffington Post this morning, “Federal Reserve Rains Money on Corporate America—but Main Street Left High and Dry”. (

So, who has benefitted from the policy of the Federal Reserve? The big banks. Big corporations. Emerging nations. (More and more of these countries are thinking of imposing controls on money flows to stem the flood of dollars coming across their borders), China. India. Brazil.

You don’t see on this list smaller banks, smaller businesses, middle class Americans, and so on.

And, who is capable of positioning themselves to take advantage of these federal monetary and fiscal policies? The wealthy and the educated…not the less wealthy or the less-educated.

Just a case in point: as the credit inflation of the 1960s and 1970s built up, the wealthy began to build portfolios of assets that served as inflation hedges. Houses, of course, were one of these assets.

In fact, housing became the piggy bank of many, many Americans during this time. But, since the prices of housing never went down during this period of credit inflation it appeared that one way to help the less-well-to-do in the society was to help them get a “piece of the bank.” The subprime loan was one of the last vehicles to get people into the piggy bank. I mean, how could they miss with housing prices rising 10% to 12% year-after-year. And, the Fed would never let these people down for long.

And, what about unemployment? Unemployment may actually be made worse by too much credit inflation. Trying to put people back into the jobs they have recently lost through credit inflation may only make the employment situation worse as under-employment grows, as it has over the past fifty years, and as capacity utilization declines, as it has over the past fifty years.

I really can see little or no good coming from this “quantitative easing”. However, I can imagine a lot of bad things happening. The plunge that is now taking place in the value of the dollar leads me to believe that a lot of other people believe the same thing.

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