What is Going on with the Fed? No, Not Anything Like What it Seems

6.5% unemployment or bust; until then, the money spigot is open wide. This was the gist of the Fed’s world-headline-grabbing announcement this week.

Less noticed was that, as the FT reported on the same day, “The US Federal Reserve is carrying out its first ever system-wide stress test of bank liquidity…”  Translation: The Fed will be pushing bank reserve requirements significantly higher.

In other words, in the past week the Fed hurled, in succession, loose-money and tight-money hardballs — the first with a big public windup, the other almost slipped by — at the batter that is our economy. But, then, it’s a combination this pitcher has been throwing for four years now.

Not long  ago I highlighted here at Ricochet economist Steve Hanke’s contrarian analysis of U.S. monetary policy. Hanke points out that even as the volume of “state” money (as he calls high-powered money or, roughly, M1) has ballooned the last four years, “bank” money (his term for lending in various forms) has stagnated under pressure from national and international regulators.  With bank money making up 85% of today’s money supply (down from 93.5% in 2008), total monetary growth has languished at 7.5% below trend.

But why such rapid fire policy change ups? Elsewhere, I’ve argued that the Fed has been, and still is, muddling through two crises:

Four years ago, Fed Chairman Benjamin Bernanke and his colleagues were presented with two crises. The first was the collapse of the housing bubble. Brought on by the demands of congressional Democrats led by Rep. Barney Frank and then-Sen. Chris Dodd that banks become extensions of federal social policy, the housing bubble swept away tremendous volumes of bank capital when it burst. It wasn’t that this bank or that bank was too big to fail, but that a vast number of banks were suddenly capital deficient and endangered. By creating large volumes of “state” money while restricting the expansion of “bank” money, the Fed has spent the last four years, in effect, recapitalizing the American banking system.

In its current phase, the second crisis also began in 2008—the crisis in government debt and unaddressed entitlement liabilities. The media is full of talk about the fiscal cliff. Will we go over it? Will we not? But if you are sitting at the Fed (and working closely, as Bernanke has throughout his tenure, with the Secretary of the Treasury), you have to assume that, whatever the outcome of the current White House-Congress negotiations, the government’s unprecedented volume of borrowing will continue indefinitely. 

So, now, assume you are Chairman Bernanke.You ask yourself, “How do we finance all those deficits?” You answer, “What if we at the Fed print lots of ‘state’ money and buy the debt ourselves?” But then you think, “If we do that, how do we protect the nation from late ’70s-early ’80-style runaway inflation?” Then you think, “Bingo, we’ll clamp down on ‘bank’ money?”

How simple. Two crises, one solution. 

Here is how the Fed’s words and actions of the last couple of days add up. Mr. Bernanke sees both crises continuing indefinitely. Announcing that lowering unemployment is the goal buys him time with his most worrisome Hill and White House critics but doesn’t necessarily mean that “state” and “bank” money policies will move measurably relative to one another.

Bank capital will continue to build. The government will continue to be funded. Growth will continue to crawl.

So in assessing the Fed, our standard should not be, have they come up with great policy, or even particularly good policy?  It should be, have they come up with the best bad policy under the circumstances?  

  1. raycon and lindacon

    The bet Bernanke is making is that there will be no collapse in confidence in the dollar as the world reserve currency.  If that happens, and our ability to sustain international commerce because the world deems US money promises as little more than those of Nicaragua or Greece, then we are sunk.

  2. liberal jim

    Your post is an illustration of what is and has been wrong.  The “housing bubble” as you choose to call it was just one more manifestation of the bi-partisan malfeasance that has grip DC for the past four decades.  I note that you a Republican cast the blame on to Frank/Dodd.   

    There may be differences in degree between Obama/Bush and Democrats/Republicans but there is little that fundamentally separate them ethically or morally.  The idea that monetary policy should or could ameliorate the ills of corrupt fiscal policy  is fiction.  

    The ruling elites have been using tax payer funds and credit to buy votes for the past four decades and they have been cheered on by their respective fans, such as yourself, in the media.  That is the fundamental problem.  

    You are writing about a pine tree in a forest that is burning down and you and your fellow “journalist”  stood buy while the fire was being started and said nothing.  

  3. King Banaian
    C

    Clark, I did see this but did not remark on it because it changes very little. If banks hold 2 trillion in excess reserves and the Fed decides to raise reserve requirements, it does nothing to the money multiplier. Its real effect would be to reduce interest payments from the FED to the banks but, since interest margins are up, that’s not so big a deal either.Also, aren’t these new tests and requirements new for foreign banks only? I don’t see anything new on this front for domestic banks.

  4. Clark Judge
    C

    King:  The review will apply to the 19 US banks covered by Basel, as well as to Basel-included non-US banks with operations here.  In addition, with regional banks being brought under Basel, I would not be surprised if now or later, it were extended to at least some regionals.  I did not mentioned in the posting, but perhaps you have seen the talk from various quarters of the government that reserve standards as currently measured are inadequate and that a much more stringent liquidity standard should be adopted.  In any event, I am suggesting that the review continues and extends the policies and pressures that have contributed to the run-up in reserves and that, I am suggesting, will push them up further.

    Liberal Jim: You read a lot into my posting, including attributing to me opinions I don’t have.  Maybe you should calm down.  Then we can discuss.

  5. King Banaian
    C

    Ah, we’re talking about different things.  I thought you were saying something about required reserves, you are in fact talking about capital requirements.  Yes, there are the Fed’s own CCAR test and now a second stress test created by Dodd-Frank.  That’s a regulatory piece that DF creates.  So there is hope that the Congress will fend off any extension of this, as I don’t think DF allows the Fed power to extend on their own.  What do you think?

  6. BlueAnt
    Clark Judge:  

    But if you are sitting at the Fed (and working closely, as Bernanke has throughout his tenure, with the Secretary of the Treasury), you have to assume that, whatever the outcome of the current White House-Congress negotiations, the government’s unprecedented volume of borrowing will continue indefinitely. 

    In a sane world, this realization would either invalidate the study of structured finance and macroeconomics… or else crash the value of US government bonds.

    So in assessing the Fed, our standard should not be, have they come up with great policy, or even particularly good policy?  It should be, have they come up with the best bad policy under the circumstances? 

    I’m curious to see the alternate universe where the Fed’s mandate does not include managing unemployment.

    I am not a fan of Bernanke’s actions over the last 5 years, but I have to admit they make sense from his point of view.  The problem is they require him to assume the status quo can go on indefinitely… which is, historically speaking, the least safe assumption one can make.

  7. Clark Judge
    C

    King:  Sorry for the confusion.  Yes, now we’re on the same page.  Re. Congress fending off any extension, I wish I could be optimist about the legislative branch’s understanding, will or ability. But Hill Democrats as a group are economically illiterate, particularly on matters of banking and finance (either public or private).  Though broadly free market, many, perhaps most, congressional Republicans have little more comprehension of financial issues than the Ds.  Only dimly grasping the stakes, they can be intimidated into going along with very bad ideas —  particularly when a populist wave gets going.  Sarbanes-Oxley is a case in point.  Meanwhile the Obama White House is ready to use regulation in place of, even in defiance of, legislation, comfortable that its allies can block congressional intervention. Besides, all along it has been the Fed’s policy partner (or maybe it’s the other way around).  The intransigence of Tea Party members helps put the breaks on fiscal issues.  But they tend to see banking questions not in terms of  maintaining monetary aggregates but of croneyism toward a special interest.  I hope you’re right, but I can see how things could go badly.

  8. Indaba

    Quietly inflating the currency is great politics because it is not noticeable, except for Canadian manufacturers selling into the US and they do not get to vote.

  9. ParisParamus

    It’s a tangent to this post, but to go to 6.5% with the current economic landscape is essentially at least a decade away. Think of unemployment as a pyramid. For every downward tick (vertical axis) the set of job seekers expands (horizontal axis). Maybe not the Fed’s fault but we are screwed. Indefinitely.

  10. King Banaian
    C
    BlueAnt

    In a sane world, this realization would either invalidate the study of structured finance and macroeconomics… or else crash the value of US government bonds. …

    I’m curious to see the alternate universe where the Fed’s mandate doesnotinclude managing unemployment.

    Bernanke wrote a paper like that himself in 1997 (ungated version), and concluded there was no difference.  That’s an accepted position from many economists, but with the caveat that all the tests were run in a low-inflation world: Single mandates for price stability have only really taken hold since 1990, in a period of mild inflation worldwide.