Wednesday, July 21, 2010

A "Conservative" Calls for More Debt Monetization

In Setting the Table for Fiscal Restraint, Vincent Reinhart of the American Enterprise Institute (and a former high Fed official and the husband of Carmen Reinhart, co-author of the book on financial crises with Ken Rogoff), argues that:

The next available weapon in the Fed’s arsenal is the direct purchase of securities. . .

Lower market interest rates from renewed Fed purchases would encourage households and firms to spend.

This view is of a similar philosophic view as George W. Bush's that he violated free market principles in order to save the free market. Though what he was really saving was Wall Street as we know it/as he likes it.

Dr. Reinhart should know better. The Fed has pushed on the proverbial string. To mix a metaphor, it would be better off un-digging the hole it has dug rather than digging some more.

Does not Dr. Reinhart know that for every borrower, there is a lender who will suffer from lower interest income?

If the Fed prints money to buy bonds, temporarily the market for bonds may push higher in price/lower in yield, thus depressing income interest to new lenders. However, the proper signal from debt monetization by the central bank throughout history is that more newly-created money always means relatively higher prices. Certainly it is true that the prior, pre-Fed gold standard era tendency of prices to fall after a rise means that one may not see prices rise as the quantity of money rises. Absent that rise in money supply, instead prices would have fallen. Those falling prices would benefit buyers and hurt producers. So it is true that anti-deflationary money-printing exists; but that new money is never simply burned. It sticks around and then creates rapid price rises in the next up-cycle for the economy.

If the Fed were to create new money and go out and buy a million automobiles over the course of one year at a cost of $30 B, the price of autos would rise. If auto manufacturers were unaware that the Fed was the buyer, they would overexpand production and be surprised the next year when demand fell by the same million units. If the Fed had no use for the autos, they would just sit around somewhere and society would be the worse for the misallocated resources.

If the auto manufacturers were aware this was a one-time Fed boondoggle, they would simply raise their prices while the extra demand for autos was in force. So there would be no benefit, just wasted auto production.

What is true for autos is true for bonds. If the Fed has special knowledge that long bonds or other securities are drastically undervalued, of course it can make a profitable investment for itself by purchasing such securities, collecting interest and then selling them back to the market when their price has risen to reflect their fair value.

That is unlikely, however! The Fed's friends on the Street can price securities just fine. So all we are talking about is more bond manipulation. Now why would the Fed want to manipulate bond prices?

The Fed purchases securities through the Federal Reserve Bank of New York. The FRBNY is a privately owned institution. While its decisions are influenced by the Federal Open Market Committee, the FRBNY pays 6% yearly dividends to its stockholders. From the Fed website:

The twelve regional Federal Reserve Banks, which were established by Congress as the operating arms of the nation's central banking system, are organized much like private corporations--possibly leading to some confusion about "ownership." For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.

I do not know how a dividend-paying organization is a non-profit. Perhaps the point is that no additional funds are retained after dividends. My understanding is that FRBNY is required to remit profits to the Treasury. I am also unclear whether the 6% dividend yield is off of a base value from the formation of the FRBNY almost a century ago or whether it is 6% of "market value".

In any case, my point here is that FRBNY is owned by its constituent banks. It bailed out said banks in 2008-9 via the AIG conduit and numerous other maneuvers; more precisely, it bailed out the shareholders and bondholders of said bank holding companies. What it did and continued to do by implementing a zero short-term interest rate policy is penalize savers specifically so that the bank owners of the Fed could borrow at next to nothing and then lend either to the government for a guaranteed spread profit or to ordinary borrowers at very attractive spreads.

Dr. Reinhart's proposal would benefit whoever would be selling securities to FRBNY. Those entities would receive the newly-created cash. If the sellers are banks and mutual funds, they would in turn continue the daisy chain and pay themselves the salaries to which they are accustomed and continue the illusion of a healthy economy by buying up other financial assets with the newly-created funds.

Gradually, this new money would make its way into the real economy and force prices higher.

The Reinhart recommendation would be a toxic variation of "trickle-down" economics. At least when what was pejoratively called trickle-down was practiced in the Reagan era (and subsequently), the rewards actually went to high earners via lower tax rates. Since this is America, there's actually nothing inherently wrong with working hard and making a lot of money. When tax simplification occurred in Reagan's second term (TRA of 1986), in a true bipartisan manner it was sponsored by Democrat Richard Gephardt in the House and Democrat Bill Bradley in the Senate.

What's been going on lately has been much more like crony capitalism. The rewards have been and are going disproportionately to those who helped create all the malinvestments in housing and junk bonds that are plaguing the productive parts of the economy today.

My preference is that Big Finance justify itself with no more handouts. In fact, it's time for it to give back to society. But in the age of the Bushbama Continuity of putting Big Finance first, that's asking too much, it would appear.

If Dr. Reinhart's proposals represent mainstream Republican thinking, as the AEI often does, then that is evidence that Team GOP has learned nothing from the past decade. If his thinking reflects the thinking of the powers now in charge in D. C., then the economic hole the country is in is going to get deeper.

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