I’d like to extend my remarks on Donald Kohn’s recent speech in Nashville, because here we have a top FED official clearly outlining the FED’s recent actions and, to some extent, trying to justify them. His speech makes clear what the FED has done and why it has done it.
The overall picture he paints is clear. The FED has extended massive new credit to new kinds of borrowers. It has also boosted credit enormously to its traditional borrowers.
As I see it, the immediate result is a huge expansion of credit welfare in the American economy. This is an abundance of funding, usually under favorable rates of interest, that the FED has single-handedly created and bestowed upon parties that were being denied such funding by others. This is a massive circumvention and contravention of free capital markets. It is a massive transfer of wealth and buying power, through inflationary means, to parties that have done nothing to deserve it and away from those who are forced to compete with these parties in using dollars. The parties not favored with the FED’s largesse are forced to accept devalued dollars and lower interest rates on their saving.
I will review briefly the FED’s credit welfare programs and the FED rationales for them. That will give me an opportunity to mention what I think will be the long-term results of the FED’s actions,
Begin with the popular investment vehicle, the money market funds. They make short-term loans to borrowers such as business firms, states and municipalities, banks, domestic and foreign governments, and government-sponsored intermediaries like Fannie Mae. The business loans are called commercial paper. Money market funds are relatively safe. Their prices tend to hold at one dollar a share. The funds warn that the price may fall below one dollar and that the investments are not guaranteed.
Kohn relates that:
"Last fall, when a run on money market mutual funds was severely constricting their purchases of commercial paper, an important source of credit to many businesses, we supported the funds, their customers, and their borrowers by making credit available that allowed funds to meet heavy redemption requests and also provided credit directly to borrowers in the commercial paper market."
In this case, the FED provided two streams of credit welfare. It supported the funds, and it supported business firms by buying their commercial paper that the funds were not buying. The people buying money market funds had always exposed themselves to a risk of loss. The business firms borrowing on commercial paper had always exposed themselves to a risk of their funding being interrupted. When the economy moved into a condition where these risks became realities, the FED prevented or mitigated these losses. The FED acted as a kind of insurer providing free insurance after the fact and at no cost to the parties receiving the welfare.
We find this same pattern repeated in the other of the FED’s credit extensions. Kohn has a lengthy list of these recipients of credit welfare:
"…for the first time since the 1930s, we extended credit to nondepository institutions, granting discount window access to primary dealers…
"…we eased the terms on which we lent to depository institutions (our traditional borrowers) quite dramatically.
"We cooperated with foreign central banks through currency swaps to make dollar funding available to banks operating abroad.
"Most recently, in collaboration with the Treasury, we have begun supplying liquidity to purchasers of securitized credit.
"Another aspect of our efforts to affect financial conditions has been the extension of our open market operations to large-scale purchases of agency mortgage-backed securities (MBS), agency debt, and longer-term Treasury debt.
"My remarks will concentrate on actions aimed at broad sectors of the financial markets, not on those aimed at stabilizing individual systemically important institutions, like The Bear Stearns Companies, Inc.; American International Group, Inc., or AIG; and several bank holding companies."
Each credit extension by the FED is credit welfare, and credit welfare is a form of bailout. Each credit extension mitigated losses that, by all rights, should have been visited upon those who assumed those risks.
All of the FED’s new credit creation is inflationary. If a carpenter earns $100 and saves $20, he transfers some buying power to borrowers. His loanable funds reduce his buying power from $100 to $80, while expanding the buying power of others. But since the FED does not work and earn money, it does not transfer its hard-earned assets to others. It creates new buying power via an electronic credit, without in any way having itself worked and created goods and services. Those new funds compete with the loanable funds that the carpenter creates as a transfer of earned buying power. This inflation of loanable funds robs the carpenter in two ways. He receives a lower rate of interest than he otherwise would on his $20 of savings; and he competes with the FED’s recipients to buy the available pool of goods. This raises the prices of those goods. This reduces the value of his $80.
The FED’s credit welfare undermines the foundations of a free society. How? Credit welfare subsidizes favorites, undermines private property, undermines the profit-and-loss system, undermines competition, undermines the dollar, and raises moral hazard.
Kohn admits that the FED chooses favorites:
"…an element of credit allocation is inherent in some of our interventions…we have recognized that the resulting effects can be uneven across markets and lenders."
Borrowers that receive the FED’s credits are subsidized as compared with those who do not. Competitors who do not receive credit welfare are disadvantaged. This undermines competition.
The FED’s ex post insurance changes private property contracts, conferring benefits on some and losses on others. The contracts initially called for various payoffs under various contingencies. The FED changed those payoffs after the fact. This makes hash out of their initial pricing. It introduces uncertainty into future contracting and influences their pricing.
When the FED provides de facto guarantees, even after the fact, it induces the recipients to change their future risk-taking behavior. They are inclined more greatly to ignore the FED-insured risks. They are provided incentives to take on greater risks and leverage. The FED increases moral hazard.
The FED’s credit welfare competes with and thus undermines saving by private savers. Saving is necessary for growth of the capital stock. The net result is an economy whose wealth grows more slowly.
By inflation, Kohn does not mean the money that the FED has already been creating. He means price rises in goods and services. Let us hear Kohn out fully as he addresses the inflation question:
"Will These Policies Lead to a Future Surge in Inflation?
"No, and the key to preventing inflation will be reversing the programs, reducing reserves, and raising interest rates in a timely fashion. Our balance sheet has grown rapidly, the amount of reserves has skyrocketed, and announced plans imply further huge increases in Federal Reserve assets and bank reserves. Nonetheless, the size of our balance sheet will not preclude our raising interest rates when that becomes appropriate for macroeconomic stability."
Kohn and the FED are aware that they must address the reserves they have created:
"However, our newly purchased Treasury securities and MBS will not mature or be repaid for many years; the loans we are making to back the securitization market are for three years, and their nonrecourse feature could leave us with assets thereafter. But we have a number of tools we can use to absorb the resulting reserves and raise interest rates when the time comes. We can sell the Treasury and agency debt either on an outright basis or temporarily through reverse repurchase agreements, and we are developing the capability to do the same with MBS. We are paying interest on excess reserves, which we can use to help provide a floor for the federal funds rate, as it does for other central banks, even if declines in lending or open market operations are not sufficient to bring reserves down to the desired level. Finally, we are working with the Treasury to promote legislation that would further enhance our toolkit for absorbing reserves."
I have the following reactions to his statements. This is guesswork and judgment.
(1) The FED is not going to reverse its credit welfare anytime soon (in the next 1—3 years.) The fact is that it is still expanding its programs. Most of them show little or no signs of decrease. The FED’s clients on welfare want it and are getting hooked on it.
Furthermore, the FED has a history of waiting until a recovery is clearly in view. Furthermore, any recovery may be slow and halting.
(2) With the FED not reversing its credit welfare and expanding it, bank reserves will not be reduced. The banks will have stronger and stronger incentives to make loans as time passes and any sort of recovery occurs, whether a natural one or a money-pumped one. Money supplies will expand. In the long run, those expansions will be accompanied by rising prices. In the short run, the behavior of prices is much less certain. However, my guess is that even in the short run, consumer price rises are more likely to surprise people by their strength than by their weakness.
(3) The FED will downplay any price rises and stay with their policies.
(4) The FED will not raise interest rates on its own accord. If the market raises interest rates, the FED will follow if it has to in order to control its balance sheet. The FED at present is happy to be lowering certain long-run interest rates selectively. As Kohn notes
"…the extremely large volume of purchases now underway does appear to have substantially lowered yields. The decline in yields reflects u2018preferred habitat’ behavior, meaning that there is not perfect arbitrage between the yields on longer-term assets and current and expected short-term interest rates."
The FED cannot raise interest rates vigorously by selling off securities without imposing capital losses on its clients whom it is now trying to induce to buy long-term securities.
(5) Even if a recovery gets underway, the dollar is vulnerable to severe shocks. Any number of possible dollar shocks that are politically-induced can undermine the American economy. Such unexpected events would make hash of the FED’s rosy game plan. The FED itself is walking a narrow and high tightrope. It acts as if the risks it is taking will not transpire.
The American economy historically has been a strong economy with sound foundations. Over time, these have been eroding. The existing set of FED and government policies does nothing to reverse this process of erosion. The FED and the government are furthering the process. The American economy is becoming a higher-risk economy. It is more vulnerable to shocks from any number of sources, ranging from political problems to natural disasters and diseases. The economy is less and less resilient. It has more and more commitments with less and less productive power to back them up. The government remains busy tying the economy up in knots. People are growing more fearful and angry. It is clear that important new directions are needed. It is equally clear that we are not getting them.
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.