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Source link: http://archive.mises.org/13457/can-the-fed-successfully-exit/

Can the Fed Successfully Exit?

August 3, 2010 by

With banks entering insolvency every week, the Fed is in no position to start unwinding any of its balance-sheet policies. Until the Fed deems the sector stable, entrepreneurs will be forced to guess as to what price inflation lies ahead. FULL ARTICLE by David Howden


michael August 3, 2010 at 8:48 am

If the Fed were to start unloading inventory the practical effect would be to force interest rates up. You can’t dump such a large quantity of bonds onto the market without saturating it. After that you have to sweeten the pot.

What’s next? First, the cost of doing business suddenly becomes more expensive. And second, federal expenditures go up. Interest payments on the Debt exceeded $400 billion for each of the years 2006, 2007 and 2008– when interest rates were only slightly higher than they are today. What happens when interest rates double, and interest becomes our number one expense? We really need the Fed, to soak up excess supply of Treasury offerings and keep this line item from exploding in our hands.

So it’s probably a good thing no persons of the Austrian persuasion are on the Federal Reserve Board. They might sink the ship.

Joshua August 3, 2010 at 9:21 am

“So it’s probably a good thing no persons of the Austrian persuasion are on the Federal Reserve Board. They might sink the ship.”

It’s also a good thing there are no devout Quakers in the military. They might lose the war on terrorism!! :P

mpolzkill August 3, 2010 at 9:22 am

After his stunning success here:


Michael is charting new waters. Maybe Michael’s right and he is just the kind of man to pilot the SS Titanic as far as she’ll go. Maybe we *do* need to listen to him as he constantly tells us to make for the life rafts.

Scott D August 3, 2010 at 9:30 am

Oh, look, it’s Michael. Oh, and hello to you too, Mr. Strawman.

You might try actually reading the article before you comment next time, eh? Your response to the article’s message of “Wow, the Fed has really dug itself deep in the mud and it’s gonna be painful to get out, no matter what it does” is, “Damn, that’s a really stupid policy prescription, you dumbass Austrians.”

Keep this up, Michael, and people might start thinking you are a troll…

michael August 3, 2010 at 1:13 pm

You’re right about this, Scott. It was a dumb thing for the Fed to act as pawnbroker, paying full price for damaged goods and then even kicking in some interest. The market value on those dogs was zero at the time. The Fed should have offered to buy them outright at a very steep discount. But they didn’t want to own the loans. That would have meant they’d have to service them. So the loans got serviced instead by third parties with no direct interest in devising workouts. It was the worst of all solutions to the problem.

I could have said that. Instead, you’re right, I set up my soapbox to ask where we should go from here. Any ideas?

Scott D August 3, 2010 at 2:12 pm

“Any ideas?”

Admittedly, no, I do not know what the best plan is going forward. Short-term gains might be had only at the expense of long-term costs, and long term stability might be won only at the cost of great pain in the short term. It hardly helps us to point out that Austrian economics would have counseled against the interventions that stimulated the bubble in the first place, and would not have supported the bailouts of the housing and banking industries.

I do believe that noticeable inflation will be the result of whatever the Fed does. It has to happen. The Fed basically created a lot of money that was far in excess of the (then) value of the toxic assets. I just hope it doesn’t hit us too hard and at the wrong time. The economy has been knocked around enough as it is.

michael August 4, 2010 at 6:19 am

Thanks for engaging, Scott. I ask the question because I don’t think it’s sufficient to point out what we think has gone wrong in the past. We also have to be prescriptive in our outlook. Otherwise it’s all academic.

The Fed should certainly be dribbling out its assets onto the bond markets at a rate that may depress interest rates but not completely drown that market, as a brake on threatened price inflation whenever it threatens. But I suspect they already know that. Under their guidance, more enlightened than it was back in the 1970s, they seem to have found something of a Final Solution to the problem of price inflation. Check the CPI index if you don’t agree.

That’s why investors are buying long-term Treasuries at such low rates, I think. They believe the federal medicine has a lengthy track record of working in our favor.

A lot of second thoughts have attended our old (1980s) thinking about inducing painfully severe structural adjustments. Unless you have moderate inflation (above 10%) there’s really no need for anything drastic. And my first impressions of the Austrian approach are that everyone here is panicky, and thinks we have to dismantle the entire public sector immediately to avoid imminent collapse. Putting such a plan into action would cause untold hardship (what it really is is an induced depression) and there’s really no need.

If we continue bumping along like we’ve become accustomed to over the last half-lifetime, the outlook would seem to be for continuing mild inflation, in the 2-4% range, going into the foreseeable future. It will be interrupted periodically by surges above 5%, which will be taken down in a matter of several months.

We need to keep government expansion and federal spending within bounds, but that’s very hard to do. Increasingly, state revenues are way down, and the states have all become dependent on federal largesse. (Well, maybe not all. Alaska and Wyoming are both doing very well as our own home-grown Venezuelas, awash in a sea of oil and gas money.) Without federal funds the states will corrode very badly from within… that is, unless they take the unthinkable step of increasing state taxes.

And we’ve yet to get a handle on our greatest fiscal issue, health care costs. We’ve let private industry lead the way in dictating legislation to Washington, with the predictable result that health care is already beyond unaffordable. We need to somehow return to a self-sustaining model.

And on the other side of the coin, we absolutely have to return tax rates to the levels they were during the late 1990s. It’s insane to believe we can turn the corner without revenues coming in. That means corporate taxes too.

No doubt you have prescriptive ideas of your own. I think that’s the focus we have to maintain, so we all don’t just waft off into the theoretical clouds.

Lance August 10, 2010 at 3:18 pm

Micheal –

I completely understand what you are trying in to say in your arguement. The likelyhood of a high inflation rate is’nt very likely and the idea of a dramatic recession does spring the thought of unheard of hardships, but please you need to think through things.

From the Austrian perspective, it’s not necessarily that we support completely economic catastrophy, but we attack the root cause of the problems at hand. From instant, in one of your arguments, of course cutting off the federal funding in states will cause hardship because the dependancy among states but that’s like continuing the supple of a drug addict so he doesn’t go into withdraw. If the states can’t support themselves, than obviously there is a much bigger that needs to be resolved, and federally funding doesn’t not help.

As far as the inflation rate, what would happen to the price of apples if 2 major players in the apple industry went out of business and had to liquidate their assets? In order to liquid all of their assets, they would have to sell their apple supply below the industry average dropping the market equilibirum price – Deflation. You would think if 1000s of companies went out of business in the past 2 years there would be a noticiable rate of deflation over a long period of time, but is there? There is anything but. The real inflation rate is inflation + the deflation that should have occured (of course, that is unmeasurable, but it’s not deniable). Inflation in the up coming future is a unprediactable number, but I can promise it will be much higher than the current average of around 3-4%. Even though, only small amounts of cash are being made into bonds currently, you still have to take into account the money multipler and how it works in the economy.

The Anti-Gnostic August 3, 2010 at 9:23 am

The ship sinks regardless. Artificially low interest rates give rise to additional malinvestments that will be liquidated in their turn.

mpolzkill August 3, 2010 at 9:28 am

No, no, TAG, Michael KNOWS all (haha) and this great student of the “Austrian school” has got that covered. The government doesn’t tell people how to invest:


Daniel Hewitt August 3, 2010 at 10:07 am

The revenue from the mortage payments (or whatever else is backing the assets) will flow to the Fed for whatever period of time that they are on the Fed’s balance sheet. I think(?) that this would act as a liquidity drain during that period, and could offset some of the inflation. Is this effect negligable when determining the upper and lower bound of the inflation?

The Anti-Gnostic August 3, 2010 at 10:46 am

I would say negligible, as a significant portion of the underlying loans are in default at this point. It is really a strange time. Right now we’re in the 1970′s again, with economic stagnation and rising prices in all the most inconvenient areas for the middle class (groceries, medical care, insurance premiums, education). But unlike the 1970′s, we’ve got insane low interest rates and everybody too afraid of His Obamaness’s next 2,000 page law to spend or loan their cash. Banks can’t do it; their balance sheets are in tatters, so they sit on it or lend it to the government. Some money seeps out regardless via deficit spending by governments at all levels.

How long can governments keep borrowing money at nominal/negative rates of interest? Governments will continue to pile on taxes and regs and businesses will just sit and sit on their cash because there’s too much uncertainty. So deflation persists until creditors can no longer keep ahead of the government’s money-printing. Then government bonds start being deeply discounted and people start abandoning cash for hard assets. Inflation, and probably hyperinflation. I’d love to be proved wrong.

michael August 4, 2010 at 11:53 am

I agree with you, Anti-G. The private credit markets have mostly frozen so solidly that they won’t free up any of those trillions they’re sitting on. So if there’s any lending or spending to be done, it’s up to the government to get the ball rolling.

What Washington should do is reverse what turned out to be a bad trend, and ask for all their money back. Then they could give it back to the Fed, retiring a heap of debt. And whenever a bank went into default, put it into bankruptcy court, appoint trustees and let them take over.

Let the system proceed.

J. Murray August 3, 2010 at 12:06 pm

One problem, calling it a balance sheet means there is actually an asset to back up all the liabilities. The Fed’s sheets don’t balance. It’s an elephant playing on a see-saw by himself. The Fed sheets are just a pile of liabilities with nothing to back them up with.

Shay August 3, 2010 at 10:46 am

So basically, the question is whether the Fed printed up 1.1 trillion and bought empty boxes, or bought boxes with 1.1 trillion worth of stuff in them, which it can sell at some later point for 1.1 trillion and destroy the proceeds of, thus balancing all the money it printed.

Ohhh Henry August 3, 2010 at 10:52 am

Evidently they have not bought 1.1T worth of assets, because they have enacted things like HAMP in an effort to keep people in homes that they still can’t afford.

The truth is that millions of irrationally exuberant people bought houses they couldn’t afford, using “creative” mortgage products, and then borrowed against the inflated value of these houses so they could live the good life. They rolled craps and now need to accept the consequences. These worthless government programs have cost taxpayers $100 billion and just postponed the ultimate bottom for housing.

At this rate, it seems unlikely that they will get their 1.1T back.

The Rev August 3, 2010 at 11:01 am

What if, instead of trying to soak up the excess reserves, you let the banks keep the money and raise reserve rates substantially instead? Wouldn’t this make the banking system more stable while simultaneously giving the Fed more leeway (by reducing the inflationary effects of credit expansion that would come with printing money) to pay off the national debt?

The Rev

J. Murray August 3, 2010 at 12:13 pm

It’s still a statist policy. How about abolishing the Fed and returning to a free banking system where we, the depositer, decides what risk we want and what money to use? That would completely get around the entire mess.

Instead of trying to fix the symptoms, get rid of the problem. The problem is a central bank. They’ve never worked in the 500 years of history of their existence, the Fed is no different.

michael August 5, 2010 at 11:33 am

“Instead of trying to fix the symptoms, get rid of the problem. The problem is a central bank. They’ve never worked in the 500 years of history of their existence, the Fed is no different.”

J Murray: The eighty year period between Andy Jackson’s dismantling the Second National Bank and the establishment of the Fed didn’t work any better. In fact recurrent depressions were probably deeper and more sharply defined than they were either before or after. The one thing the Fed does best is act as a shock absorber against economic concussions.

mpolzkill August 5, 2010 at 11:42 am

In fact, much worse times for war makers, except for the period in the 1860s when they were able to fool with the money.

Now switch over to that front for a second and then forget it and switch back again, Michael.

Eric August 3, 2010 at 12:22 pm

I was wondering that myself. But what happens to all the small banks that didn’t get any of the bailout money? Wouldn’t that suddenly raise their reserve requirements without having any extra reserves. Knowing these crazies, maybe they’d have a 2 tier reserve system, one for bailees and one for others.

But it’s really fascinating to me that the FED bought all these bad loans and then became so afraid of their actions that they decided to essentially bribe the banks into not touching all the (new) money that they were given for the bad assets. This tells me that somewhere in the FED someone actually does understand what creating all that money out of thin air does.

But in their public speeches, especially before congress when Ron Paul is questioning them, they sure do speak a bunch of economic techno-babble and never ever admit that what they do is the sole cause of price inflation. They still pretend to be the world’s inflation fighter. It’s also interesting that we have to use hyphenated terms (price-inflation, money-inflation) to get around their Orwellian new-speak that changed the “official” meaning of the non-hyphenated term inflation so we wouldn’t have the words to describe their actions. Straight out of 1984.

michael August 5, 2010 at 11:56 am

“This tells me that somewhere in the FED someone actually does understand what creating all that money out of thin air does. But in their public speeches, especially before congress when Ron Paul is questioning them, they sure do speak a bunch of economic techno-babble and never ever admit that what they do is the sole cause of price inflation. They still pretend to be the world’s inflation fighter. It’s also interesting that we have to use hyphenated terms (price-inflation, money-inflation) to get around their Orwellian new-speak that changed the “official” meaning of the non-hyphenated term inflation so we wouldn’t have the words to describe their actions. Straight out of 1984.”

Hi Eric. I think I’m the one who introduced the term “price inflation” here. It’s because I wanted to avoid confusion, and distinguish between the usual sense of the word inflation (a rise in the prices of things and services) and the Austrian definition: any increase in the money supply.

The two are linked, of course. But far from identical. Price inflation occurs because producers and/or retailers think they can get away with raising prices. And they do so primarily when there is an abundance of money (or credit) in consumers’ pockets. (That’s why the Fed used to have as a priority the prevention of full employment. Too many people making money, and everyone wants to raise their prices to get in on the action.)

In this current round, we had an increase in the money supply but no (price) inflation). In fact we had price deflation. How come?

The money all stayed in the bank vaults. Out on the streets there’s been a serious money shortage. So the supply of “walking around” money actually contracted.

That’s why I like making the distinction when commenting here.

I’d also like to comment on this: “They still pretend to be the world’s inflation fighter.”

They’ve been doing a first rate job, actually. It’s actions on the part of the Fed that brought down the double-digit mess of the late 1970s and has kept inflation in line since. We live in a world where Fed policy is to keep inflation within the 2-4% annual range. And it has succeeded, with mostly very short intervals when it was over or below.

They don’t like what they have to do to achieve zero inflation, because it has a dampening effect on business. Zero-inflation policies keep us in a perpetual state of mild recession. So they like the sweet spot, 2-4%. And whenever the rate hits five they take prompt action to bring it back down. To me, it seems optimal.

Look at their track record. I think you have reason to be impressed with their performance:

I also think the CPI is fairly weighted. See what you think:

Jonathan Finegold Catalán August 3, 2010 at 12:52 pm

The Rev,

Assuming that is a policy the Federal Reserve accepts and commits to, it still stands that all that liquidity will at some point be invested as the economy stabilizes. In other words, I would argue that as economic growth resumed, these reserve requirements would slowly go down, and as such so would interest rates.

It is notable that when money is invested in higher-orders of production the general price level rises only marginally. Outside of the industries directly affected by the boom (the housing market, for example), prices did not rise astronomically. As such, there is really no warning sign for the Federal Reserve on whether or not their monetary policy is truly inflationary. This is doubly as true when you consider that they do not recognize intertemporal disequilibrium as a problem, and so their indicators rely completely on price inflation.

Wildberry August 3, 2010 at 1:42 pm

Raising reserve requirements might only “capture” the liquidity, perhaps without the Fed being required to pay interest. But the assets would remain on the Fed’s books.

Jonathan, you seem to suggest that if these reserves were invested primarily in high-order production, the cost reduction of greater production efficiency would tend to lower prices and keep price-inflation in check. This appears somewhat related to the “infrastructure” argument for building long-lived assets like bridges and reforestation, etc., as a form of stimulus. Although the efficiencies of such investment are indirect, do you think that would have the same effect?

What would prevent the Fed from just making the “assets” disappear? Since the liquidity was created out of “thin air”, couldn’t these assets be made to disappear also? I really don’t see many limitations on the slight-of-hand that can be worked on the Fed’s balance sheet.

What happens if housing prices cannot be stabilized at their currently inflated prices? Obviously even at the currently slightly discounted prices, there is great uncertainty as to their current market value. If this value were to take another dive through price deflation, even if mostly limited to housing, these assets would become worthless or much more so than they are today.

Personally, I think the move is a government-sanctioned devaluation. Government and union workers could be covered with an instant wage adjustment, and everyone else would fend for themselves, and presto, instant serfdom.

michael August 3, 2010 at 2:06 pm

Jonathan: “..there is really no warning sign for the Federal Reserve on whether or not their monetary policy is truly inflationary. This is doubly as true when you consider that they do not recognize intertemporal disequilibrium as a problem, and so their indicators rely completely on price inflation.”

If we approach the problem constructively we should try to find some indicator that tells us when the Fed’s actions are going into the redline. And this latest bout of injecting funds, where they bought up so much bad debt and flooded the credit market with undeserved cash, didn’t trigger any price inflation of importance. After a brief flirtation into the fives, in mid-2008, the CPI rebounded into negative range for a while. And prices haven’t gone up appreciably since.

Compare this occasion with 1989-1991, when the CPI went above 4.5% for thirty consecutive months! And there was no compensating deflationary event that followed.

I’m not offering any opinion, just asking the question. I know you must have studied this. What was the Fed doing wrong then that they did right this last time?

Jonathan Finegold Catalán August 3, 2010 at 2:09 pm

The liquidity trap.

michael August 5, 2010 at 12:08 pm

I’m trying to comprehend your comment, which seems kind of terse. You’re saying that we had a 2-1/2 year period of inflation back in 1989-91 that threatened to become serious, and that it subsided because of Fed actions? Or because it didn’t?

And during the current condition we’ve had a recession that’s taken an entirely different course because…?

Please use more words to spell this out. You’re as cryptic as an Alan Greenspan, or the Delphic Oracle.

mpolzkill August 5, 2010 at 12:23 pm

And you’re as gaseous as Bob Wills.

Guard August 3, 2010 at 8:12 pm

I really appreciate this understandable explanation of what’s going on. Thanks!

flow5 August 4, 2010 at 8:46 pm

The much bandied about “exit strategy” will in the end, be a non-event. Besides, the “trading desk” is swiftly adept, at superfluous adjustments.

The FED has only one achievable mandate – stable prices. But price stability has been unattainable under Burns, Miller, Volcker, Greenspan and now Bernanke.

Why? Because the liquidity preference curve is a false doctrine. A “liquidity preference” curve is presumed to exist which represents the supply of money. In this system, interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity. All of this has little or nothing to do with the real world, a world in which interest is paid on checking accounts, and now excess reserves.

Anyone on the FED’s technical staff that believes the money supply can be managed by any attempt to control the cost of credit, should lose both their job and their pension.

Christopher August 5, 2010 at 11:20 am
Steve Price August 6, 2010 at 4:31 pm

I’m missing something in the argument. What exactly is the linkage between the Fed liquidating bad assets and upward price pressure? It would seem to be that the Fed’s loss is just an out and out loss that will presumably lead to higher long term debt for the country and possibly a crowding out effect on the interest rate, lowering growth and demand, not increasing it. Is it that this debt will make our currency decline abroad? Thanks.

mgorsky October 20, 2010 at 3:22 pm

When I read the August 2009 Congressional Oversight Panel’s Report on the “Continuing Risk With Troubled Assets under the TARP,” I noted the following: “In publicly-available data reviewed by the panel, the 19 tress-tested [bank holding companies] have reported: $657.5 billion in Level 3 [poorest quality] assets. . . . [and] $8.9 trillion in credit default sub-investment grade exposure.”The above figures should be read along with the following statement found in the report: “Based on information submitted by the BHCs, bank supervisors predict that this change [that the assets be marked to market] alone could result in approximately $900 billion in [troubled] assets being brought back onto the balance sheets of these institutions [beginning in 2010].”Now i read that the the Federal Reserve bought, and continues to but large chunks of the toxic mortgages, thus removing them, at least temporarily from the BHCs’ balance sheets . However one looks at the situation, the toxic assets have not been neutralized and can, as the COP Report stated, come back to haunt the economy in case of a double dip recession. That is, the precipitating factor for the economic meltdown: the failure of liquidity in the securitized instruments (CDO, MBS, CDO2′s and 3′s, ABCP and so on} which was supposed to have been purchased and made liquid, were not, with TARP monies going to buy preferred shares in BHC’s receiving monies to refloat their capital.Unbenknownst to me the Feds were active in buying up the toxic assets. Yet, as the article shows, they are still illiquid and still ready to wreak havoc in the economy if there is a double dip. Where did I go wrong?

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