The Fed: Still In A "Hole"!

There are articles all over the place discussing the possibilities for what Fed Chairman Ben Bernanke is going to say at his late August speech at the Federal Reserve Conference in Jackson Hole, Wyoming.  Last year, of course, Bernanke announced QE2.  And, for the next ten months we lived QE2. 

The question is…what is Bernanke going to spring on us this year?

Listen to this…”what is Bernanke going to spring on us this year?”

Ben Bernanke is considered to be one of the most creative economists in the world.  He has basically improvised his way through the last three years or so in a way few others could.

But, this is the central bank we are talking about.  Historically, central banks have been the promoter of stability.  Central Banks have been predictable.  Central banks have attempted to reduce uncertainty.

And, maybe this is a clue to the situation we face in the world today.  Maybe things are not what they once were.  Maybe central banking must change…must create a new “business” model”.

Central banking after World War II was different than it was before the 1930s.  Benjamin Strong, President of the Federal Reserve Bank of New York, Montagu Norman of the Bank of England, Emile Moreau of the Banque de France and Hjalmar Schacht of the Reichsbank were what central banking was all about during the 1920s and early 1930s.

But, the world was on the gold standard back then, international capital flows were restricted, and the world was moving from economies based on agriculture to economies based on industrial manufacturing.  “Country” banking, Fed Districts, and the Fed’s discount window dominated central banking in the country.  

The world after World War I was different from the world after World War II and the central bank had to develop a new model. 

Post-World War II, the responsibilities of the central bank changed and grew.  The objectives of central banks also changed.  Whereas the primary responsibility of central banks before this time had been to be the “lender of last resort” to the banking industry, it now took on new responsibilities.  First, under the influence of Keynesian thinking, central banks became responsible for achieving high levels of employment.  Then, after the work of Milton Friedman and the Monetarists, the Fed added price stability as another goal of monetary policy.  Thus, the Fed entered the manufacturing era with three goals, being a lender of last resort, achieving low unemployment, and keeping inflation under control.

Then things changed during this time period.  The global economy became a reality and capital became mobile throughout the world, the gold standard collapsed, and fixed exchange rates gave way to floating exchange rates.  The manufacturing economy gave way to the information age.  Large domestically orientated banks became global behemoths and financial innovation (allowed by the advances in information technology) came to dominate the financial scene. 

Toward the end of the twentieth century, the environment shifted.  Money easily flowed where it wanted to.  We had the high tech bubble of the 1990s and the explosion of securitization.  We saw countries brought to their knees by the international capital markets.  France was certainly the most noticed instance of this but the United States also felt the “end of the stick” and this led Treasury Secretary Robert Rubin to convince President Bill Clinton to get the budget under control.  The fiscal policy of the Clinton administration “bailed out” Alan Greenspan for the time as Fed Chair constantly waited for the substantial increase in productivity to come from the advances in information technology. 

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The 2000-2001 recession came followed by Greenspan’s fear of a further deep recession which resulted in a lengthy period in which the target Federal Funds rate was kept at 1.00 percent for an “extended period of time.”  The housing bubble resulted accompanied by a bubble in the stock market.  It seems that in the new financial environment, funds could flow effortlessly around the world and create bubbles where ever the opportunity arose.

Chairman Bernanke came along and Bernanke, an “inflation hawk”, raised interest rates and kept a lid on the banking system until the “crash” came.  The Fed kept the “punch bowl” away from the economy for too long. 

This story is leading up to this point.  Bernanke’s effort at “inflation targeting”, which over stayed its welcome, was the last effort to conduct monetary policy under the “old”, post-World War II monetary regime.  Everything since that time has been improvisation and innovation.

This puts us right where we are today.  There is no current model of central bank operations that can explain what the Fed…and the European Central Bank…and the Bank of England…and so forth…are doing…or will do. 

We are in a new age…the information age.  It became apparent over the past ten years that money…credit…finance…was just a subset of information.  Money, credit, and finance, are really nothing more than 0s and 1s that can be “sliced and diced” anyway one can want.  And, a buyer can be found for these “sliced and diced” pieces of information. 

The large banks and other large financial institutions understand this.  So do many of the manufacturing giants of the past 60 years or so.  General Electric was at one time earning three-quarters of its profits from…its finance wing.  And, what about GMAC and General Motors?  And, the list goes on. 

We have gotten to the point where a huge proportion of the economy is represented by the finance industry…both in terms of income and in terms of employment. 

The manufacturing age is fading.  Yes, we still need manufacturing, but we also still need agriculture.  The world moves on.  Where is employment going to be in the coming years and what kind of training are these workers going to require.  The problem in the United States seems to be a misfit between where the jobs are and how the workforce is trained. But, we are talking about banking and about the Federal Reserve and about monetary policy. 

To me it is evident that things have changed in the financial industry.  Over sixty percent of the commercial banking industry in terms of assets are in the hands of twenty five banks, and most of the activities of these banks are nowhere near what the activities of commercial banks were fifty years ago.  And, most of this difference can be related to the advances in information technology.

And, my prediction for the next five years…you will hardly know what banking is in five years.

Where does that leave Mr. Bernanke and the Fed?  My guess here is that the Fed is going to have to go through changes in its “business model” just as most other institutions are doing.  The conduct of monetary policy in the future will be different than it is now, just as the conduct of monetary policy in the last half of the twentieth century was different from that in the first half. 

I don’t know how monetary policy is going to be conducted in the next decade or so, but my guess is that it will be different.  The Fed is in a “hole” and must find its way out of the “hole” and not dig the “hole” its in any deeper.