Thursday, December 26, 2013

100 Years Ago

John Phelan

100 years ago last week [..] the Federal Reserve system was born.

The Fed was born out of the Panic of 1907. The collapse of the Knickerbocker Trust Company triggered a run on banks across the United States which was only stemmed by the deliberately high profile intervention of famed financier JP Morgan. He assembled and led a consortium of leading financiers to put their own money into the system.

The lesson widely drawn from the Panic was that institutions with long term assets but short term liabilities, the very business of banking, suffered inherent liquidity risk. Reasoning that next time there might not be a Morgan around to act as backstop, Congress called for an institutional lender of last resort which would tide over solvent but illiquid banks, following Walter Bagehot’s advice to “lend freely at a high rate, on good collateral”. Thus, the Federal Reserve Act sought to “provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes”.

A century on, “for other purposes” means the Fed’s modern mandate for macroeconomic management. With the discrediting of Keynesian fiscal policy in the late 1970s and its replacement by a belief in the efficacy of monetary policy in smoothing fluctuations in GDP, the chairman of the Federal Reserve and his lieutenants came to be hailed as ‘Maestros’ with the power to ‘save the world’.

William McChesney Martin, Fed Chairman from 1951 to 1970, is quoted as saying that the Fed’s job is “to take away the punch bowl just as the party gets going”. His successor Alan Greenspan (1987-2006) took a rather different view. Greenspan didn’t believe it possible to discern the punch induced drunkenness of unsustainable bubbles from the usual high spirits of sound economic growth. All you could do was watch the broader inflation figures and dig out the monetary mop and bucket to clean up the aftermath. The policy outcome was that no monetary action was taken to reign in asset price rises while every fall was combated with vast infusions of liquidity which inflated the next bubble. This one way bet became known as the ‘Greenspan put’.

In a speech before the New York Chapter of the National Association for Business Economics in 2002 Greenspan’s successor, Ben Bernanke, endorsed this stance. And, when the subprime mortgage market crashed and blew holes in banks’ balance sheets in 2007-2009 the Fed pumped in liquidity. To paraphrase Bagehot, it certainly lent freely, but at token rates and against toilet paper.

At a stretch this could be seen as in keeping with the Fed’s original mandate. Also, given Bernanke’s academic work studying Milton Friedman’s interpretation of the Great Depression, it had some theory behind it. But the heirs to the Committee to Save the World were expected not just to save financial institutions but boost the rest of the economy too. However, the Fed was not designed to do that and has little theoretical idea of how to accomplish it. So it went to work on the long end of the yield curve with Quantitative Easing which amounted to ‘print and hope’.

As a result of this fresh infusion of liquidity, currently running at about $85 billion a month, stock markets, one of the new bubbles along with government bonds and emerging markets, have nearly doubled since 2009 while the ‘real’ economy has limped up by 2%. This situation is perverse. On August 15th, reports that British retail sales had risen unexpectedly sharply and that American unemployment had fallen to a six year low, which in the mainstream-macro discourse that dominates economic debate are considered positive indicators, sent the FTSE 100, the Dow Jones Industrial Average, the S&P 500, the DAX 30, and the CAC 40 tumbling. Markets, hooked on the punch of cheap liquidity, were terrified by the prospect that an improving economy might see the punch bowl removed, or ‘tapered’. The Telegraph headline said it all; “Strong data sparks market sell-off on fears stimulus is over”.

The reverse happened a day later. When the results of a US consumer confidence survey came in “far worse than expected” stock markets rallied and now the Telegraph headline read “Wall Street edges higher on disappointing data”. Stock markets are supposed to be driven by the expectations of the profitability (or not) of the stocks being traded, not the pursuit of speculative gains caused by the monetary manipulations of central bankers. We now appear to be in a position where the interests of financial markets are precisely at odds with the interests of the rest of the economy; where the good news for us is bad news for them and bad news for us is good news for them.

The one way bet of the Greenspan Put maintained, so far, by Ben Bernanke, has created a market of monetary-punch-drunk liquidityholics. On its 100th birthday the Federal Reserve has the tricky task of sneaking the punch bowl out of the party, a task it seems they’ll struggle to manage without starting a riot. They may have printed themselves into a corner.