naked capitalism

This is a short clip and I am sure you’ll enjoy it.

Sadly, I can’t embed it, so you’ll have to click on the link. Watch the segment here.

Reader Hecht pointed out a new piece by Steven Davidoff at the New York Times’ Dealbook, illustrating the lengths to which the Fed will go to defend incumbent bank managements.

The story recounts the sorry conduct of the bank regulator with regard to two small banks, one the $1.1 billion in assets savings & loan First Financial Northwest, the second Cardinal Bankshares, which has a mere $250 million in assets. Both are under supervision of the Fed, neither bank is doing well (First Financial is under “special supervision” as a result of having lost over $90 million in recent years), yet in both cases, true to an apparent long-standing practice, the Fed is siding with the management that is responsible for the banks being in bad shape over activist investors who look to be urging sound measures.

Davidoff recounts the First Financial case in more detail. There, Stilwell Group, which bought 7.9% of the stock, got Fed approval to have its general counsel appointed as a board member. He then made radical suggestions at a first board meeting:

“terminate the director emeritus program,” which Mr. Schneider claimed paid directors as much as $150,000 a year even after their death for doing “nothing.” He also proposed to “remove the directors’ photographs from the executive suite walls” since the photos rewarded poor past performance and the bank was “not a country club or an English manor.”

Finally, as a symbol of First Financial’s newfound austerity, Mr. Schneider [the Stilwell nominee] wanted to “serve only hard candy at the upcoming annual meeting.” He also protested the board’s policy of free iPads for directors.

$150,000 for current, much the less ex, directors of a bank that small is a ridiculous amount of money. Schneider resigned when the board refused to act on his recommendations (note the Times says that Schneider wanted his demands implemented immediately; Schneider counters that the board was unwilling to act. Given the obvious feather-bedding, I suspect Schneider could tell he would be stonewalled).

Stilwell renominated Schneider and sought to have a second director appointed. The Fed intervened, invoking regulations that define 25% ownership of a bank voting shares as “control” and hence subject to Fed approval. But this is ridiculous. Stilwell doesn’t come close to having 25% of the shares, and even if it had won both board seats, it would have only 22% of director votes.

In the case of Cardinal, the activist investor, Schaller Equity Partners, got itself in the Fed’s crosshairs by proposing to place five of six directors (this when it owns 9.8% of the stock). The Fed said if it did that, it would regulate Schaller as a bank holding company, which would make its life miserable. The Fed is pushing hard to neutralize Schaller’s efforts:

Schaller has subsequently dropped the number of its nominees to three to placate the Fed. Even so, the regulator has taken more steps to ensure that Schaller does not have control over these nominees, claiming that even this number of directors could still make Schaller a bank holding company. The directors are now executing passivity agreements that will limit their ability to coordinate activity with Schaller.

This stance, of favoring bad bank managers over reform-minded investors, speaks volumes about the Fed’s priorities. These aren’t complex, difficult to operate banks where management has special know-how. If the dissidents wanted to throw the entire management team out, it would not be hard to replace.

The fact that the Fed so reflexively defends banks against any outside influence, even positive ones, is proof of how the Fed is badly in need of reform. One idea that has been set forth by the Alternative Banking Group of Occupy Wall Street is ending the private ownership of the Fed by banks and barring members of management and boards that the Fed regulates from serving as Fed directors. There are plenty of recently retired financial firm executives who know tradecraft, and the Fed through its supervisory powers can get lots of information about what is happening in markets, rather than relying on the spin of people like Jamie Dimon). The Fed is already a popular target for Congressmen on the right and left ends of the spectrum. If it does not relent from its profoundly pro-bank posture, it may find more changes foisted upon it.

By Philip Pilkington, a writer and journalist based in Dublin, Ireland. You can follow him on Twitter at @pilkingtonphil

Fairytales and nursery rhymes are quite popular among the economists. Economists and economic commentators will couch magical thinking in rational sounding phrases — but that doesn’t stop it from being hokum. Some within the profession attack these juvenile tendencies. Paul Krugman, for example, has often lambasted the idea, fostered by some of his colleagues, that the current crisis is due to a lack of confidence among investors. In a flash of irony he labeled this idea that of the ‘confidence fairy‘.

Of course, Krugman is absolutely right; the idea that a lack of confidence is responsible for the current crisis is a fairytale pure and simple. Our current economic problems are caused by a lack of aggregate demand. Investors are absolutely right to lack confidence at this moment in time because, just like in the 1930s, there is no rational reason to invest more because the population lacks the adequate purchasing power to consume more goods and services. Matias Vernengo over at the excellent Naked Keynesianism blog provides a classic quote from Roosevelt’s Fed chairman Marriner Eccles that summarises the situation well:

Confidence itself is not a cause [of economic depression]. It is the effect of things already in motion. What passed as a ‘lack of confidence’ crisis was really nothing more than an investor’s recognition of the fact that new plant facilities were not needed at the time.

Pretty straightforward point, but powerful nonetheless. And I think Krugman and other ISLM-Keynesians would broadly agree with it. That is, peculiarly, until they start talking about inflation targeting.

Proponents of inflation targeting claim that if the central bank sets a higher inflation target investors will react to this by, well, investing more. Krugman sums it up:

If the Fed were to raise its target for inflation — and if investors believed in the new target — expected inflation over the medium term, say the next 10 years, would be higher… [and] higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea.

Now, is it just me or does it appear that Krugman has just smuggled the confidence fairy in through the backdoor? Read that passage again carefully. The ‘idea’ here is to trick investors into investing by scaring them into thinking that the Fed will allow inflation to rise higher than it currently is.

Really? Come on. Does Krugman really believe investors are this stupid? Does he really think that they make their investment decisions based on what some central banker says is the target rate of inflation? Sure, the commentariat are eating this garbage up — the usually sharp crew over at FT Alphaville provided a glowing account of why the inflation-confidence fairy should be unleashed from its bottle — but when it comes to putting your money where your mouth is, are smart people really going to buy into this idiocy?

Short answer: no. Krugman and others treat investors like children. But investors — real investors who provide funds for new goods and services — are not children. Instead, they will continue to look at the economic fundamentals when making investment decisions. And if there is simply not enough demand for goods and services they will not make investments aimed at creating more goods and services. Duh! It really is quite obvious.

Now, the financial investment community might well react to this hocus pocus — but that is an altogether different thing. This is not because paper-shufflers are stupider than their entrepreneurial and corporate counterparts, but because they are concerned with perceptions and fairytales — it is largely upon these that their business rests. They do react irrationally to news simply because they think that their peers might react irrationally to the same news. The financial community is, in many ways, a hall of mirrors with everyone trying to guess everyone elses’ reaction to announcements and news. But just because the financial community may react to a higher inflation target by no means entails that their money will end up funding goods and services that increase employment in the real economy.

If you actually look at how the financial community reacts to unorthodox announcements by the central bank the reality — as opposed to what abstractions like the ISLM will lead you to believe — is much different. The likely outcome of such an announcement in the present economic environment is obvious given that we now have four years of experience with these sorts of pseudo-policies: financiers will move their funds into so-called ‘inflation hedges’ like gold, silver and other commodities. What’s more, if the central bank manages to scare them sufficiently they may even move their funds out of government bonds and into these ‘hedges’. This will lead to increased upward pressure on the interest rate at which governments borrow which will, in turn, give the austerity brigade even more of a mandate to cut government spending and engage in other sorts of economic vandalism.

Unfortunately, Krugman and others will likely continue to publish their fairytales and recite their bedtime stories. Why? Because, to put it somewhat bluntly, it gives them something to do. It gives them something to talk about that makes them appear as if they have some specialised knowledge that only a select few Very Sophisticated People understand and have access to. It also gives them the assurance that their abstract models actually tell them something — something a priori and mysterious — about the real world that cannot be gleaned by simply observing empirical reality. In short, it gives them a power to fascinate the general public and policymakers and lull them to sleep. But of course this is exactly the same power of fascination that the parent exerts over the child at bedtime by telling them of faraway lands; of witches and of warlocks; of goblins and… of fairies.

Several of my savviest readers wrote expressing disappointment and consternation with the Frontline series on the crisis, “Money, Power, and Wall Street.” The first two parts of the four part series have been released, and it’s probably safe to say that this program is far enough along to be beyond redemption.

It’s a recitation of conventional wisdom, with just enough focus on some of the numerous things the banks and the authorities did wrong so as to make it seem daring for mainstream TV. But anyone who has been on this beat will find the first two segments cringe-making (one advantage I had was that of reading the transcripts, which makes it much easier to parse the construction). Despite the obligatory shots of Occupy Wall Street protestors, displaced homeowners, and stymied officials, much of the story line is remarkably bank-friendly.

The first segment is particularly troubling. It heavily cribs from the Gillian Tett book Fool’s Gold, which to be blunt was not very well received by reviewers. Fool’s Gold discussed the development of the credit default swaps market from the perspective of JP Morgan executives and staffers, with the result that it verged on hagiography. Oh, those great, intrepid, innovative bankers who just wanted to make the world better, and maybe make a buck or two in the process.

The book at least explained that the reason for the creation of the CDS was to solve a rather big problem for JP Morgan, that it was carrying a ton of loan risk and could use a way to lay it off (the broadcast, by contrast, made it sound like this was a market just waiting to happen, as opposed to one JP Morgan, and later its competitors, cultivated).

And no one clearly explains that CDS, as currently used, are certain to produce periodic blowups of undercapitalized guarantors (the monolines and AIG are prototypical). Tett and pretty much everyone in the segment perpetuates the industry PR that CDS are derivatives. A derivative is an instrument whose price “derives” from an actively traded underlying instrument. CDS, by contrast, are the economic equivalent of unregulated insurance contracts. The pernicious feature of CDS is that the CDS protection writers (the guarantors) aren’t regulated for capital adequacy, the way other insurers are. They instead are required to post collateral to reflect the current value of the contract. But that is no guarantee that the CDS protection writer will be able to pay out. When a default or other credit event occurs, the price of the CDS spikes up, and the guarantor may not be able to make good on the new, higher collateral posting. And requiring CDS protection writers to put up enough margin to allow for “jump to default” risk would make the product uneconomical.

But none of this is explained. Tellingly, there are clips of Brooksley Born, but no mention of her failed effort to regulate CDS. It is instead presented as a benign product that JP Morgan understood (did they sponsor this broadcast? Blythe Masters gets a big promo) and no one else did:

MARTIN SMITH: Did top management at JP Morgan understand credit derivatives?

TERRI DUHON: Yes, they did. Absolutely, they did.

MARTIN SMITH: Did they at other banks?

TERRI DUHON: No, not all other banks. Certainly not.

It’s more accurate to say JP Morgan was once burned, twice shy. It took significant losses in the first test of the corporate CDS market, the bankruptcy of Delphi in 2005. That led it to pull its oars in just as the market for asset backed securities CDS was taking off. Fool’s Gold makes a great deal of noise about how JP Morgan couldn’t figure out how other banks were modeling the risks on mortgage-related CDS and presents that as the reason they were largely out of that market. That may be narrowly true, but I wonder if that sort of caution would have reigned had they not had to reassess the adequacy of their risk metrics in the wake of Delphi.

Similarly, the account hews to conventional lines in making Goldman out to be the poster villain in the CDO market, yet merely in passing, has Deutsche Bank CEO Joseph Ackermann admitting to being one of the banks that stuffed Landesbanken like IKB full of toxic debt. Crisis junkies know that Deutsche Bank trader Greg Lippmann was the most aggressive middleman in helping subprime shorts like John Paulson create and sell CDOs designed to fail (and they had their own program, Start, which was a synthetic CDO series just like Goldman’s better known Abacus trades).

Typical of the program’s attention to fine points, it manages to work in a reference to the formal dismantling of Glass Steagall without saying why it was important (answer: it wan’t, but the gutting of the rule over the preceding decade and a half was). There is also some interview material that is flat out wrong on product spreads and CDO structures. The segment provides anecdotes of the crazed subprime lending, but fails to explain how mortgage backed securities and CDOs were linked to lending (or most important, that CDOs came to drive demand for RMBS, which in turn drove demand to the worst loans). Here, Inside Job was vastly better in covering technical material (with one lapse, in confused RMBS and CDOs) and providing data in an accessible manner.

The next segment is even more troubling. It treats the crisis as if it started with the failure of Bear Stearns, when that was the third of four acute phases, and was in full There Was No Alternative mode. It repeated the thesis I believe, but I’ve never seen confirmed, that it was concern over Bear’s CDS exposures that led to the bailout. It also says that Hank Paulson thought Bear was an isolated case, which would explain why the officialdom went into Mission Accomplished mode rather than trying to get to the bottom of the CDS exposures, pronto (We pointed out in March 2008 that Lehman, Merrill, and UBS were next on the list. If we could see that, that meant it was bloomin’ obvious). But it ignores the fact that the Fed first offered a 28 day loan, which it then changed to overnight and the original loan also would have tided Bear over into having access to a new Fed facility. I’m not convinced that Bear would not have made it, and no one has ever explained why the Fed retraded the deal.

Incredibly, this segment also presents the idea that Obama was seriously interested in and campaigning on the economy. Huh? Obama was stumping on the issues of 2006. It also presents other pro-Obama propaganda in the form of the meeting McCain called to discuss the financial implosion-in-progress, which Obama wound up dominating. This has just about zero relevance in explaining the crisis, and strongly suggests that there were multiple agendas in producing this series.

But worse is the Lehman-AIG meltdown. The markets were tanking! The world was about to come to an end! The authorities had to Do Something! No mention of the Fed’s zillions of special facilities (or previous interest rate cuts). Instead we get the TARP, and the story makes much of Congresscritters sounding miffed at being asked to act over a weekend (as opposed to sign off on a soi disant bill that was all of three pages demanding $700 billion while putting the Treasury Secretary above the law). It also fails to mention the Treasury bait and switch, that while the bill did give the Treasury remarkable latitude, it was sold as being used to buy toxic assets (which we said at the time would never work under the parameters Treasury set forth), not a direct bailout to the banks.

We also get the lame excuse for Doing Nothing after Bear (“we lacked the authority”) when the officialdom had no compunction about bringing the banks to heel in October 2008 (note that there are several layers of kabuki here: as we described at the time, Paulson threatened the banks to take the TARP before revealing the terms, and the banks were quietly pleased when they learned how favorable the deal was. So the “forcing” was theater so the ones who wanted to pretend they didn’t need it could keep that story up. But even if this wasn’t a lot of play acting, this threat illustrates the sort of thing regulators have at their disposal but have become timid about using).

DICK KOVACEVICH, Chmn., Wells Fargo, 2005-09: I don’t know how much further we went before I was interrupted by Hank, who said, “Your regulator is sitting right next to me. And if you don’t take this money, on Monday morning, you will be declared capital-deficient.” I was stunned.

Aside: I also wondered if Wells Fargo sponsored this program. There was gratuitous statements by Wells that they were better lenders (not true if you limit it to banks, we’ve commented often on Wells’ sanctimoniousness).

The show defended the false dichotomy of bailout or disaster, when there were other options. Comments like these were throwaways, not taken up in a serious way:

SHEILA BAIR, Chair, FDIC, 2006-11: If the government hadn’t intervened, those counterparties would have taken huge losses, so there was some leverage there. At least tell them, you know, “You’re going to take 10 percent.” That just— that would have helped. But there was just willingness to kind of throw lots of money at the problem. And I don’t— I think we threw more money at the problem than we needed to. Absolutely….

ROBERT REICH, Secretary of Labor, 1993-97: They don’t have to modify any mortgages. They don’t have to put limits on their own salaries or their own compensation or their own bonuses. They don’t have to do anything differently than they were doing before. They don’t even have to agree to major regulatory changes. Basically, they are sitting fat and pretty and happy.

So thus far, we have some populist decorating of a profoundly pro-Establishment account. Yes, the system got really out of control, but whocoulddanode? It just got SOOO complicated no one could understand it, not even those super well paid top Wall Street executives. There isn’t a single mention of ideas like looting, bogus accounting (remember the fictitious Lehman balance sheet, or Merrill’s CDO-hiding Pyxis, or the $40 billion of Citi CDOs that appeared out of nowhere?) or abuses in other areas (like swaps sold to municipalities all over the world, or rapacious privatizations, the auction rate securities blow up, or chain of title abuses). Nah, it’s just a bunch of fundamentally good ideas taken too far. And they really expect you to believe that.

By Pavlina Tcherneva, Assistant Professor of Economics at Franklin and Marshall College, Research Scholar at The Levy Economics Institute, and Senior Research Associate at the Center for Full Employment and Price Stability. Cross posted from New Economic Perspectives

Our mainstream colleagues keep banging their heads against the wall. “Why, oh why wouldn’t Chairman Bernanke do more to rescue the economy?” Today Paul Krugman took on this question again, arguing that Chairman Bernanke should listen to Professor Bernanke who had far more sensible ideas about rescuing an economy from a deflationary environment, as seen in his research on Japan during the 90s.

Krugman revisits a 2000 paper by then professor Bernanke, which many of us have scrutinized before, titled “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” Krugman faults Bernanke for not following his own advice arguing that what he should do instead is 1) change expectations about the future by declaring and sticking to an explicit inflation target and 2) intervene even more aggressively in financial markets through alternative open market operations to deal with the nation’s massive unemployment problem.

Why Bernanke doesn’t do what he prescribed for Japan baffles Krugman who points to one of two explanations. The first was provided by his colleague Larry Ball, who recently claimed that Bernanke has become a victim of “groupthink” and has lost the ability to think for himself. The second is that the power lobby at the Fed and the political bullies in Congress are far too strong for the mild-mannered and soft-spoken Chairman, undermining his ability to act more aggressively.

In 2010, I wrote a paper Bernanke’s Paradox (JPKE version, April 2011) which examines his monetary policy prescriptions for Japan in detail. I have been asking myself the same question: why isn’t Bernanke following his own advice? But the answer I give is that it’s because he cannot, literally. Whatever policy options he believes to be genuinely effective actually depend on Congress and not on him.

The difference is that, unlike Paul Krugman, I actually read Bernanke’s paper from start to finish. See, what Krugman is missing is that Bernanke did not prescribe two policy options to deal with deflations (1. stick to an inflation target and 2. engage in alternative OMOs), but four.

I have discussed these in the paper above and in shorter blogs here and here. Here are the four options Bernanke recommends:

1. Commit to an inflation target and a long-term low interest rate environment;

2. Depreciate the currency through open market purchases of foreign currency;

3. Engage in non-traditional OMOs – including purchases of long term government securities and other private sector liabilities such as non-performing loans, commercial paper, corporate bonds, asset-backed securities and other;

4. Last but not least, finance various fiscal transfers (e.g., tax cuts) to boost consumption demand

Take the time to read Bernanke’s Japan paper and you will find that indeed he did follow this prescription as closely as he could, but he could not do so 100% because the core of the recipe lies in what Bernanke calls the fiscal components of monetary policy. Such fiscal components can be found in the Fed’s actions to depreciate the currency, purchase private sector assets, or finance tax rebates, all of which require an act of Congress or approval of the Treasury for the Fed to execute.

Of the four policy options above, Bernanke clearly prefers the latter – money financed tax cuts. Only the money drops that occur from deficit spending (e.g. via tax rebates) financed by the Fed are able to increase net financial wealth in the private economy, help with faster deleveraging, and hopefully boost aggregate demand.

So much ink has been spilled on Bernanke’s research on Japan and I am still amazed that the mainstream refuses to discuss the importance of these fiscal components in Bernanke’s work. They are the essence of monetary policy effectiveness, as Bernanke understands it.

Fiscal components of monetary policy, of course are a euphemism for fiscal policy proper. The reason why Bernanke calls them “components” of monetary policy and why the mainstream refuses to acknowledge them is because they are still blindly wedded to the idea that monetary policy is omnipotent in rescuing the economy from recessions. Well, it’s time to give up this old notion. How many years of low interest rates, aggressive QE1, QE2, Operations Twists, swaps, and $trillions and $trillions of lending do we need to recognize that these policy actions do not provide proper channels for dealing with the unemployment problem? In fact, in 2000 the Professor thought that:

Nonstandard open market operations with a fiscal component, even if legal, would be correctly viewed as an end run around the authority of the legislature, and so are better left in the realm of theoretical curiosities” (Bernanke 2000, p. 164)

But in the absence of Congressional action to fund aggressive fiscal transfers to the real economy, Bernanke left the ‘realm of theoretical curiosities’ and engaged in as many nontraditional OMOs as he could, some of which were of questionable legality.

Monetary policy just can’t do it alone. Fiscal policy must come to the rescue. Professor Bernanke understood this. Why he prefers tax cuts as opposed to any other type of fiscal policy is a function of his ideological preferences. But the bottom line is this—the way to rescue the economy is through aggressive fiscal stimulus where the Federal Reserve stands ready to finance it. That’s the substance of Professor Bernanke’s message, which has clearly eluded Paul Krugman and Larry Ball.

I titled my paper Bernanke’s Paradox, because I did see a conundrum in Bernanke’s writings, a different conundrum from the one Krugman suggests (that Bernanke seems to believe one thing as an academic but implements another as a policy maker). No, the conundrum is much deeper, much more important than what Krugman identifies.

Bernanke understands well that for monetary policy to be effective, fiscal policy must be aggressive (which the Fed always finances). Without bold Congressional action and a large fiscal stimulus package to boost demand and employment, nominal GDP cannot and will not rise to desired levels, no matter what the Fed does. Bernanke knows that despite his commitment to low interest rates and alternative OMOs, what he really needs is big fiscal components, but those can only come from Congress, not the Fed. Bernanke also knows that the US has infinite ability to finance these fiscal components, that there is no solvency issue and that the policy rate and both ends of the yield curve are under the direct control of the Fed. All of this is clear both from his academic writings and policy actions.

What I find absolutely paradoxical is that, despite all this, he still appears before Congress and makes ominous statements about the unsustainability of the US debts and deficits and their upward pressure on interest rates, failing to distinguish between nations like Greece which do not have their own currency and those like the US and Japan which do.

Having a large and increasing level of government debt relative to national income runs the risk of serious economic consequences. Over the longer term, the current trajectory of federal debt threatens to crowd out private capital formation and thus reduce productivity growth. To the extent that increasing debt is financed by borrowing from abroad, a growing share of our future income would be devoted to interest payments on foreign-held federal debt. High levels of debt also impair the ability of policymakers to respond effectively to future economic shocks and other adverse events.

Even the prospect of unsustainable deficits has costs, including an increased possibility of a sudden fiscal crisis. As we have seen in a number of countries recently, interest rates can soar quickly if investors lose confidence in the ability of a government to manage its fiscal policy. Although historical experience and economic theory do not indicate the exact threshold at which the perceived risks associated with the U.S. public debt would increase markedly, we can be sure that, without corrective action, our fiscal trajectory will move the nation ever closer to that point. (Bernanke, Congressional Testimony, February 2, 2012)

This is the conundrum: either he believes (as indicated by his research of the late 90s and early 2000s) that deficits are sustainable and cause a crowding in effect where the policy rate is under the direct control of the Fed, or he believes that they are not (as in his Congressional testimonies). Bernanke simply cannot argue it both ways. And we know well that in practice the operational reality is the former. In sovereign currency nations as in the US, deficits are infinitely sustainable, do not crowd out, and do not put upward pressure on interest rates.

So yes, I too have been unable to resolve Bernanke’s paradox. How is it possible for someone to hold two completely incongruent intellectual positions? Either he has been intellectually dishonest when appearing before Congress fueling the deficit phobia of policy makers, or he has become intellectually lazy and has not taken the time to rethink the crowding out dogma he has learned in grad school in the face of his later academic work and practical experience, which point all evidence to the contrary.

At the Atlantic Economy Summit in Washington last month, Sheila Bair fielded a question about the just-released results of the latest bank stress tests. The former FDIC chief took pains to point out that they were an improvement over earlier iterations by virtue of keying off a truly dire economic scenario, but then ticked off a number of ways in which they fell short. One was in that they focused solely on credit risk, when historically, adverse interest rate moves have proven very effective in decimating the banking sector. Witness phase one of the savings and loan crisis, in which hasty deregulation and gimmickry in the early 1980s set up the crisis later in the decade, or the derivatives wipeout of 1994, in which an unexpected 25 basis point Fed funds increase created bigger losses than the 1987 crash, or the losses on US bond portfolios in 1997 and 1998, which among other things nearly wiped out Lehman.

The perils of interest rate risk have largely receded from memory since the US has been in a long-term disinflationary trend since 1983. But with rates at zero, we have nowhere to go but up from here.

Chris Whalen, in his latest newsletter, argues that this risk is even nastier than it might appear. One way of mitigating interest rate risk is by holding shorter-dated instruments. The reason is that the more back-weighted your payments are, the more exposure you have to changes in interest rates.

Investors measure this sensitivity via duration. There are somewhat different ways to measure it. One is the weighted average of payments. That gives you a result than under most circumstances is very close to the price sensitivity of a bond to interest rate changes. At “normal” interest rates, a current coupon bond of just under 10 years will have a 10% sensitivity to interest rate changes.

But, as Whalen points out, this all goes haywire when interest rates are super low. So much of the value is in the repayment of principal and so little in the intervening interest payments that it pushes duration out and increases interest rate risk disproportionately. That effect may be further compounded by the fact that banks are desperate for yield and with the yield curve flatish, they are likely to be extending the maturity of their assets.’And of course, anyone holding mortgages will see them extend, since refis will halt and home sales will probably be depressed, since higher interest rates mean more expensive mortgages, which all other things being equal, means lower home prices.

Whalen sets forth his concerns:

For a number of years now, US banks have been loading up on low yielding paper that is a function of the Fed’s efforts to reflate the US economy. Since many Americans are not able to refinance their home mortgage, the Fed’s efforts are not particularly effective, but we are not supposed to talk about housing. Banks and corporations have been able to refinance their debts, lowering interest expenses but also increasing the volatility – that is, the duration — of bonds and related swaps and options.

The trouble with low interest rates is that as coupons fall, the duration on a given bond lengthens exponentially. Whereas the duration on a Fannie Mae 5 or 6 can be measured and managed using traditional interest rate risk management tools, in a low or zero rate environments the effective duration on low or no coupon securities becomes so long and so difficult to manage that hedging becomes problematic.

Keep in mind that most banks today are seeking to maximize net interest margins on an interest rate book where the effective yield is falling. There is little incentive to lend cash or securities to other banks given that rates are zero, so banks simply place their excess cash into government and agency debt that has little cash flow yield and essentially infinite duration risk – risk that cannot be hedged.

“Of course, the banks also own a lot of duration…1.35 trillion of GSE MBS, notes one of the members of our mortgage finance discussion thread. “The Chinese had to sell to someone.” But such levity aside, the fact is that most banks are not even trying to hedge their interest rate books because cash flows on earning assets are so paltry. Thus as and when interest rates do rise, many larger banks that fund themselves in the markets will come under immediate pressure.

Now banks may be able to cover some of this up for a while. They may be able to put these low-yielding assets in a hold to maturity book (as they did in when similarly caught in the 1990s) which will spare them taking mark to market losses. But they’ll still lose money on an ongoing basis if they have assets that yield 3% that they are now funding at 5%.

A reader added another cheery thought via e-mail:

There is also a coming problem for HELOC borrowers – these loans will reset from interest only payments to principal and interest payments in the not too distant future. The HELOC interest only period was typically around 10 years, so that would put the reset dates in 2-3 years for a big chunk of bank portfolio HELOCs. Wells Fargo, in particular, also did a huge amount of convertible HELOCs – in a rising environment, borrowers could convert to fixed rate HELOCs, at the current market rate. This would have the effect of making the par valued variable rate loans convert to below par fixed rate loans for Wells, if rates rise significantly. If it happens at the same time that many of the same loans are also experiencing payment shock due to a conversion to P&I payments, that could get really ugly for Wells with big step ups in both duration and credit risk. Something to look forward to!

Indeed. Of course, if we’ve zombified our economy as well as Japan has, this day of reckoning may be very long in the making. And given the consequences to banks of leaving ZIRP, perennial zombification may be a feature rather than a bug.

By Philip Pilkington, a writer and journalist based in Dublin, Ireland. You can follow him on Twitter at @pilkingtonphil

“Oh no! This is going to get silly!” That’s what I thought when I read the first few lines of Matthew Yglesias’ post on how, in a cashless economy central banks would be able to ‘cure’ recessions. Actually, Yglesias first published this epiphany back in December of last year.

Yglesias claims that in a cashless economy central banks could easily cure recessions. How? Well, they’d simply threaten to debit bank accounts if the Great Unwashed refused to spend or invest their savings. And because people couldn’t take out cash and stash it under the mattress they’d have no choice but to go out and do something with their money before disappears.

This all comes back to the idea of a negative rate of interest that Paul Krugman and other ISLM adherents have been pushing as a way for Ben Bernanke to get his central bank mojo back. If interest rates fall to zero and the economy still doesn’t recover, these people claim, the central bank should try to stoke inflation so that, with their bank balances threatened with erosion, people would spend and invest.

Basically, this is a way for ISLM adherents to save face after saying for years that interest rate policies actually work in a really effective way. For example, in his original article Yglesias wrote the following:

Starting about 40 years ago, it became clear that central banks had the power to end most recessions pretty easily, independent of fiscal stimulus. If your economy is saddled with idle resources—unemployed workers, vacant office spaces, factories that aren’t running all their shifts, trucks cruising down highways half-empty—what you need to do is increase the flow of spending through the economy. You do that by cutting interest rates.

Yeah, that’s a bit of a howler. When recessions occur in a modern economy fiscal stimulus opens up automatically because as unemployment rises and production falls transfer payments increase and tax revenues fall. So, there’s no real evidence that Yglesias’ assertion is in any way true.

Indeed, some argue that monetary policy is not nearly as effective as neoclassical economists think it is. Some argue that it is akin to a shaman’s wand waved in the hope to revive ‘animal spirits’ which, if fiscal stimulus were not forthcoming, would wither and die regardless. This, for example, was clearly Hyman Minsky’s view of the 1974-75 recession; and, if you read his careful study of the government and central bank response (in ‘Stabilizing and Unstable Economy’) you’ll see that he’s probably right.

In addition to this not all recessions are caused by simple hoarding. Keynes was probably wrong when he focused purely on ‘liquidity preference’ as the cause of recessions/depressions. There are also debt deflation dynamics which take hold to ensure that certain segments of society remain underwater and in debt. This is what Richard Koo calls a ‘balance sheet’ recession. Eroding people’s bank accounts won’t do much if some people remain heavily underwater. He argues that in a balance sheet recession, private parties are preoccupied with paying down debt rather than seeking to increase profits (admittedly, we could try to inflate the debt away, but really, how much inflation are we talking about here?).

But let’s not even argue economics here. Yglesias’ plan is so outlandish that I think that we can debunk it with a simple thought experiment. You see, we could actually initiate the plan in a paper currency system. I’ve come up with two ways of doing this – note that there are probably more.

One way to do this would be for the central bank to announce that it was going to start eating into bank accounts, as per Yglesias’ plan. But they could supplement this by saying that all paper currency hereafter returned to the Treasury or central bank, in the form of reserve holdings or tax payments, would be debased by the same amount. Ta-da! Instant inflation. Banks and taxpayers, threatened with a debased currency, would rush to spend and invest.

Or the central bank could announce tomorrow that they were debiting bank accounts a la Yglesias and that there was no point in hoarding paper currency at all because they would shortly be printing new currency that would be debased by the same amount as bank accounts – once this new currency was issued the old currency would be worthless as the Treasury and central bank would not accept it in tax payments or for reserve holdings. So, you’d better return all your notes to your local bank and hold your balances in electronic form ready for debasing, scum!

So, why doesn’t Bernanke do this? Eh… because it’s stupid. First of all, we live in a democracy (shock!) and people, who already generally distrust the central bank, would not like a system that functioned like this. It’s weirdly dystopian and would make people feel completely impotent. And it would call all property rights into question. If your savings aren’t safe from government seizure, what is?

A politician would not have a hard time getting elected on a mandate of ensuring that the central bank doesn’t nakedly expropriate funds that are not working in the public purpose.

Terrifying people into thinking that their savings were going to be seized by the Matrix may do extreme economic damage too. Such actions might scare people in spending to the point of hyperinflation. This is not as remote a possibility as some might think. There is a psychological component to the value of a currency. If a central banker said that he or she is going to start literally stealing your money, people may become distrustful of the currency itself and try to offload their whole bank accounts in order to obtain real goods and assets. Or they might extract their funds for conversion into a new currency and stash it in a foreign bank account that was not threatened with expropriation. The Austrians would no longer look so dumb when they invoked hyperinflation as a real possibility of Big Government intervention.

It’s columns like this that demonstrate how technocratic (and anti-democratic) neoclassical economists actually are. They say they like freedom and all that – but they don’t really. They have a very scientistic view of how economies – which are ultimately just aggregates of real people (not utility-functions, guys!) – actually function. And they, like all technocrats, have an unflinching desire to control people no matter what the cost. But, as we learned in the monetarist experiment under Thatcher, should any foolish politician allow them access to the levers of power, their little fantasy constructions of how Everything works will come crashing down around them as quickly as… well… as quickly as Ben Bernanke could technically expropriate your earnings, peasant!

Yves here. I have a mild quibble with part of the argument below, which is based on a study I find badly constructed. Having lived through the 1970s, I can attest that a certain level of inflation does lead people to spend faster to beat rising prices. But my sense it that effect does not kick in until inflation is perceived to be meaningful, say somewhere over 4-5% a year, and I suspect the effect is backwards looking (ie, consumers base their forecasts not on official projections, but on their own recent experience). The study cited covers only durable goods and only the period from 1984 onward, where inflation levels were markedly lower than in the 1970s. Finally, marketing consultants have pretty much abandoned asking questions (“would you buy X”) as a way to assess demand. It’s just not reliable. But the conclusion in the piece is nevertheless is probably correct, since modern central bankers are so inflation-averse that they would be unlikely to tolerate it getting to anywhere near the level needed to induce anticipatory spending.

By Dan Kervick, who does research in decision theory and analytic metaphysics. Cross posted from New Economic Perspectives

Paul Krugman argues in a recent New York Times column that right-wing critics of Ben Bernanke and his colleagues are trying to bully the Fed into a misguided obsession with inflation, and that “the truth is that we’d be better off if the Fed paid less attention to inflation and more attention to unemployment. Indeed, a bit more inflation would be a good thing, not a bad thing.”

Krugman is absolutely right to lament conservative pundits’ and politicians’ obsessions with inflation when tens of millions of Americans are languishing in unemployment, with all of the personal, social and economic misery and waste that unemployment entails. But his argument, which assumes that the Fed can boost employment by engineering higher inflation, is problematic. He defends the inflationist approach this way:

For one thing, large parts of the private sector continue to be crippled by the overhang of debt accumulated during the bubble years; this debt burden is arguably the main thing holding private spending back and perpetuating the slump. Modest inflation would, however, reduce that overhang — by eroding the real value of that debt — and help promote the private-sector recovery we need. Meanwhile, other parts of the private sector (like much of corporate America) are sitting on large hoards of cash; the prospect of moderate inflation would make letting the cash just sit there less attractive, acting as a spur to investment — again, helping to promote overall recovery.

I believe this is the wrong approach. The Fed’s ability to boost employment is very limited, well-intentioned citations of the Fed’s full employment “mandate” notwithstanding. Rather than looking to central bankers and the banking system to accomplish a task for which they are not really cut out, we should turn our attention back toward fiscal policy as the primary tool for bringing the country up to full employment and keeping it there. And rather than seeking engineered inflation as the mechanism for boosting spending and employment, we should implement the MMT job guarantee proposal to achieve full employment and price stability at the same time.

Krugman’s two main arguments for the beneficial results of inflation are questionable. First, he argues that inflation will help reduce private sector debt overhang. But inflation only reduces debt overhang in a significant way for households who are fortunate enough to see their nominal wages rise along with the general rise in prices. In today’s economy, workers are frequently not so fortunate.

Suppose you work 40 hours a week for $1000 of take home pay, and you have a weekly debt bill of $500 and a weekly consumption bill of $500. So you work 20 hours for debt repayment and 20 hours for consumption. Now let’s suppose prices rise by 5%. Then the same basket of consumption goods you purchased before for $500 now costs you $525. Your debt bill, which is fixed in nominal terms, remains $500 per week.

Suppose also that your employer does not give you a raise, but chooses to take advantage of the inflation by keeping your nominal wages right where they were at $1000 per 40 hours. Then the result will be that you will have to decrease your real consumption by 4.7%. You will continue to work 20 hours for debt repayment and 20 hours for consumption, but now your consumption will be lower in real terms.

This worry about employers’ behavior is a real one. We don’t live in the old days of strong unions and the wage-price spiral that existed when economists like Krugman were cutting their teeth. We live in a permanent buyers’ market for labor characterized by persistently high unemployment and minimal worker bargaining power. As prices rise, many people’s nominal wages stay fixed or lag well behind the price level increase. Real wages go down and ordinary folks feel the sting of higher prices without the benefits on debt relief.

Doubts can also be raised about Krugman’s claim that people respond to inflation by increasing their propensity to spend their income. The idea is that in an inflationary environment, one is losing money just by holding money, so to the degree people expect higher inflation their incentive to spend rather than save increases. But while this behavioral response sounds plausible in theory, it might not be how people actually behave in practice. Instead, people worried about having to pay higher prices in the future and attempting to maintain a stable level of real expenditures over time might cut back on expenditures now to save for the expected higher prices.

A recent paper by Rüdiger Bachmann, Tim O. Berg and Eric R. Sims, based on data from the Michigan Survey of Consumers, makes this argument. The authors find that:

… the impact of inflation expectations on the reported readiness to spend on durable goods is small in absolute value when compared to other variables, such as household income or expected business conditions. Moreover, it appears that higher expected price changes have an adverse impact on the reported readiness to spend. A one percent increase in expected inflation reduces the probability that households have a positive attitude towards spending by 0.15 percentage points. At the zero lower bound this small adverse effect remains, and is, if anything, exacerbated.

In addition to these concerns about the efficacy of Fed-induced inflation as a tool for boosting employment, we should bring in a further consideration about the monetary policy approach to full employment. There is growing appreciation among economists who study the banking system that the Fed’s powers to engineer significantly higher employment are quite limited. The Fed’s influence on our economy is exerted primarily by its governance of the bank lending channel. But the Fed’s role here is primarily to maintain the smooth functioning of the interbank payments system by passively accommodating any increased demand for bank reserves that result from higher bank lending. Banks are not significantly reserve constrained. The lending comes first; and Fed accommodation comes later. The Fed can’t do much to make banks lend when the demand for credit among qualified borrowers just isn’t there. Scott Fullwiler’s recent New Economic Perspectives post on the Fed’s role in the banking system brilliantly outlines this line of analysis.

However, if one is really determined to boost demand, production and employment by pumping money into the economy, the clear preference should be for the fiscal pumps. Congress could pass a law directing the Fed to credit $500 billion to Treasury’s account, and then pass a series of spending bills directing how that money is to be spent. No new taxes; no additional borrowing. Just credit the money and spend it out into the real world. Demand and production are stimulated directly, rather than relying on the Fed-based, supply side approach of indirection and wishful thinking.

The direct fiscal approach might be inflationary, although the inflationary pressure from new money chasing goods and services in the market should be offset by the expanded volume of goods and services made available to meet the increased demand. But if there is inflation, at least ordinary people would be receiving the higher nominal income they need to cope with it.

Central bank induced inflation is sometimes supported by economists as a strategy for reducing the real wages of workers, in the hope that we then get higher employment by lowering the real cost of hiring people. Yes, there are some people who still believe America’s workers are overpaid! In a recent post, Scott Sumner approvingly quotes Tyler Cowan, who has argued both against public sector hiring and for lower real wages. Cowan said, “the greater the number of protected service sector jobs in an economy, the more likely those citizens will oppose inflation. Inflation brings the potential to lower real wages, possibly for good.” Sumner then argued that Cowan’s considerations are a strong argument for favoring monetary policy over fiscal stimulus.

But working people have already suffered enough. It is absurd to support lower real wages for working people as a tool for getting to lower unemployment. The real incomes of workers have been falling for years, while the ratio of CEO to worker pay in America is now in the hundreds, and massive amounts of the nation’s productive wealth are skimmed off the top of our economy by a bloated and wasteful financial sector in the American plutonomy. If there is another approach to full employment – one that does not place the burden of assisting unemployed workers on the backs of employed workers who are struggling themselves – we should take it.

The MMT approach to full employment is a federal job guarantee program that will stand ready to offer a job to anyone both willing and able to take it. Descriptions of the job guarantee program and the economic theories supporting it can be found in the writings of many MMT authors. One classic source is Warren Mosler’s article “Full Employment and Price Stability.” And two useful recent discussions of the MMT approach to employment and price stability, by Pavlina Tcherneva and William Mitchell, can be found here and here.

The job guarantee and other fiscal policy initiatives can only be carried out by politicians, not by central bankers. The exaggerated attention that pundits continue to devote to the Fed and monetary policy helps run interference for failing politicians, who are only too eager to continue to shirk their duties; to pass the buck to the convenient scapegoats at the Fed; and to promote the myths of monetary policy fixes for major economic challenges that require political courage and political solutions. The obsession with the Fed, and the public delusions of vast untapped central bank powers that these obsessions propagate, are a massive social distraction. There is no central bank shortcut to the goal of full employment. We need more politics and more action by Congress and the President, not more financial technocracy. It’s good to hold the feet of the powerful to the fire. But right now the wrong feet are being roasted.

By Dan Kervick, who does research in decision theory and analytic metaphysics. Cross posted from New Economic Perspectives

The recent exchange on the nature of banking among Paul Krugman, Scott Fullwiler, Steve Keen and others has been feisty and instructive. But some readers might be left wondering whether the whole exercise is too wonky by half. The anatomical details of banking systems might be juicy and interesting for the academics who like to dissect those systems and dig deep into their entrails. But how significant are the details for practical questions of public policy? They are in fact very significant.

The functional details of institutions matter, and without understanding how the banking system actually works it is impossible to distinguish causes from effects in our attempts to guide that system toward the service of the public good. Conventional textbook models of banking and monetary systems are responsible for widespread commitment to the money multiplier and loanable funds models of the relationship between central bank reserves and the volume of bank lending. Relying on these models, some prominent economists and pundits have been telling us throughout our recent economic crisis that we can address the problems of a stagnating economy and persistently high unemployment with the reserve management tools of monetary policy alone.

Even worse, some monetary policy hyper-enthusiasts seem to view the Fed has having vast powers to manage the nation’s overall spending level and adjust the nation’s money supply up and down though mysterious and occult mechanisms that extend well beyond the grubby plumbing of the credit system. The Wizard of Fed, it seems, can control the economic minds of Americans though imperious pronouncements on his expectations for the future. Hundreds of millions of Americans, one is led to believe, pay close attention to the Beloved Leader and await his determinative dicta, and then adjust their own behavior accordingly. L’État, c’est Ben. The nation’s central banker is the glass of financial fashion and the caller of the economic tune.

Incongruously, this picture of an America enthralled under a slavish devotion to the oracular sayings of Chairman Ben is often brought forth as an instance of the “rational expectations” approach in economics. Allegedly, the lemming-like congruence of expectations precipitates its own self-generating rationality. Since we all know that we have all tacitly agreed to enslave ourselves to the nation’s central banker, when we then proceed to conform to the general goose-stepping we are behaving quite rationally.

Now I ask you: speak to several of your neighbors tonight and ask them who Ben Bernanke is and what he does, and then consider whether this precious conceit of the court theorists of the financierati has the slightest grounding in empirical reality. I have no doubt that this picture describes the attitudes of some relatively small number people. My guess is that most of the people in question watch CNBC and Bloomberg all day, and manically shuffle their money hither and thither in the asset markets as the tipsters tip and the news items roll in. But down on Main Street where the real economy lives, and where people are too busy working all day – or at least trying to get work – to spend time playing games in the markets? Does the average citizen’s step either quicken or slacken to the cadences called by the Fed chairman? Does the average consumer go to the store looking for a washing machine or an iPad on the Fed’s say-so? It’s doubtful.

This inordinate faith in and reverence for the power of the central bank and the Central Banker has had a profound effect on national policy over the past several decades. The US Congress has assigned to the Fed the “mandate” to achieve full employment, and many now routinely excoriate the Fed for failing to fulfill that mandate. And yet, while there may be more the Fed can do, there is little evidence that the Fed actually has any substantial degree of control over demand and employment in the real economy, at least in a circumstance in which interest rates have fallen as low as they can go. In fact, as various adventures in conventional and unconventional monetary policy have continued to fail, the evidence mounts that faith in monetary policy is misplaced, official mandates notwithstanding. We might as well assign to the Air Force a mandate to deliver pink ponies to every child in America. Just as there is no reason to think that Air Force brass and fighter pilots are particularly well-prepared for satisfying the equine needs of America’s eager tots, it seems increasingly clear that the Fed is not the agency of government best suited to parachuting real jobs down across America.

The problem in America is not bankers who won’t lend. Corporations are already sitting on record-setting amounts of profits and cash, but production and hiring are not booming. The problem is that ordinary people at the foundation of our economy, the people whose desires for goods and services drive the production that employs our resources, are lacking income. They do not want more credit and more debt. They want more income.

Yet it’s not as though we don’t know how to promote economic production, deliver income and boost unemployment when the private sector fails to deliver as much of these social goods as we need. As a monetarily sovereign country, the US government can finance an expansion in spending that does not require either new taxes or burdensome debts left to posterity. What people want the Fed to do – somehow push new, spendable monetary assets into the real economy – the political branches of the government can do better, and in a much more direct and effective way. What is called for is a renewed commitment to fiscal policy, not more exercises in conventional and unconventional central bank policy. We need to return fiscal policy to the front and center of our national discussion of economic policy.

Fiscal policy and the political branches of government are needed to do what the central bank can’t, and to restore our sick economy to health. But there is another reason that we need to rediscover the power and capabilities of fiscal policy. The incessant debates about the virtues of monetary policy tend to encourage people to take an excessively technocratic and abstract view of our nation’s economic policy needs, and to reduce those needs to the rubric of “macroeconomic stabilization.” But our nation doesn’t just need jobs in general; we have specific national needs for specific kinds of work. We don’t just need more production and spending in general; we need to produce and buy specific kinds of things to advance urgent public purposes. The macroeconomist sometimes views spending on a bridge or a school as spending in the abstract; spending that is justified by the mere fact that we need more spending of some kind. But the citizen sees these actions mainly as spending on a bridge or a school – something we do mainly to buy something we need. That’s why monetary policy is a lame substitute for engaged fiscal policy in a democracy. A central bank can, at best, only concern itself with the public purpose of managing the flow of money and credit in general; but the public has very specific purposes in mind.

We are faced with imposing national problems of social decay, public underinvestment, incoherent and feckless national purpose and unconscionable underemployment of people and resources. These are problems that can’t be fixed by Fed money management and expectations setting, and many of them are challenges of national scope that manifestly exceed what we can expect from the hurly-burly and hustle of private sector entrepreneurialism. Solving these problems is going to take an activist national government, and a politically engaged and committed public, directing serious resources toward unmet public purposes. We’re way beyond the point where the only macroeconomic policy we need from the national government is the limited kind of “stabilization” that can be provided by the Fed. Our country is broken and our future prosperity is in deep jeopardy. We need to define large goals, set challenging tasks and get to work. It is time to get people to stop looking to the Fed to do the jobs that can only be accomplished effectively by the American people acting with purpose through their legislative representatives. There is no pure monetary policy cure for what ails us.

One prominent current enthusiast for monetary policy is Scott Sumner, who uses his blog The Money Illusion to promote an approach to monetary policy called “market monetarism”. The core policy recommendation of market monetarism is that the Fed should target the aggregate level of dollar spending in the country, and maintain a stable rate of increase in that level, which includes engineering catch-up spending in subsequent years if spending in prior years false short. Sumner has no doubt at all that the Fed could hit this target if it truly sets its mind to it.

Sumner recently launched a blistering attack on a new paper by J. Bradford DeLong and Lawrence Summers. DeLong and Summers argue in that paper that “discretionary fiscal policy where there is room to pursue it has a major role to play in the context of severe downturns that take place in the aftermath of financial crises.” But Sumner is having none of it. Here is part of his tirade:

So let’s start over. The Fed is unwilling to provide enough monetary stimulus. OK, now what is the point of this paper? Is this to train our future econ PhD students? Are we trying to teach them the optimal policy regime? Obviously not. The optimal regime relies on monetary policy to steer the nominal economy, and fiscal policy to fix other problems. So we are going to defend the model how? A blueprint for failed states? For banana republics? Fair enough, but ask yourself the following question: In a failed state, which is more incompetent branch of government; the central bank or the legislature?

Yes, the Fed is bad. But Congress is downright ugly. Deep down most economists are technocrats. They see the central bank as being the best and the brightest, the guys who are above politics, who will “do the right thing.” And how do economists view our Congress? The terms ’stupid’ and ‘incompetent’ don’t even come close to describing the disdain. So are we supposed to change our textbooks in such a way that the fiscal multiplier is no longer zero under an inflation targeting regime (as the new Keynesians had taught us for several decades?) And on what basis? Because the Fed might be so incompetent that we need Congress to rescue the economy? In what world does that policy regime actually work? If you have a culture that has its act together, such as Sweden or Australia, the central bank will do the right thing. If not, then all hope is lost.

I find Sumner’s assault on fiscal policy and Congressional action to be both economically misguided and politically disturbing.

First, it is hard to understand the practical difference between “steering the nominal economy” and “fixing other problems”. The economy consists in the production and exchange of things of value, and one can measure those values in various ways. One way is to measure goods and services by their current market values as expressed in dollars. But economists have also devised various methods of abstracting away from the fluctuating current dollar as a measurement standard, so as to get at some more stable measure of value that allows for meaningful comparisons across times and places. They thus distinguish between nominal and real measures of value. But while one can distinguish analytically between nominal and real measures of economic activity, there is no such thing as the “nominal economy” that can be separated out for the “other things” and steered independently of those other things. It’s all the same economy, whether its values are measured in nominal terms or real terms.

Perhaps what Sumner has in mind is not dollars as a nominal measure of value, but as a medium of exchange. We live in a monetary economy, and dollars are one of the things that are produced and exchanged in that economy. So the proposal might be that it should be left to the central bank to steer the part of the economy involved in the production and exchange of dollars, and leave it to fiscal policy to steer the part of the economy in which other things are produced and exchanged. But the fact is that almost every transaction that takes place in the United States takes place in dollars. The dollar economy is the real economy, and the real economy is the dollar economy. The economic system which consists of both money and the things money buys is an organic whole of integrated human activity. There is no plausible way of regulating or managing one without regulating or managing the other.

Nor is there a real-world way of institutionally separating the macroeconomic stabilization functions of government from public investment and redistributive operations of government. It’s all part of the same job.

But what is really disturbing about Sumner’s attitude is his haughty and unembarrassed contempt for democratic processes. Sumner actually believes the US should be seen as a failed state and banana republic if it fails to devolve responsibility for it economic fate onto the shoulders of an unelected, elite-governed and autocratic central bank, and away from its stupid and incompetent elected representatives. But my guess is that most Americans, schooled in reverence for democratic traditions and citizen responsibility of self-government, would view things from quite the opposite perspective.

Members of Congress might be corrupt, bungling and in some cases outright incompetent – and these three traits make their sorry presence felt in some eras more than others. But as democratic citizens we know where our obligation lies in such circumstances: Throw the bums out, get a better Congress and then hold their feet to the fire to serve the public interest. If we simply pack it in instead, neglect our obligations, and dispose of our democratic institutions when they are not functioning properly, and then hand everything over to cadres of arrogant and aloof technocrats with minimal democratic accountability, we will have lost more than a few jobs.

Lately, in their zeal to defend to powers of the central bank, we have been getting some truly radical, and frankly dangerous, calls from central bank enthusiasts to allow the Fed to appropriate to itself all sorts of broad spending powers that every American schoolchild has learned are the prerogative of the United States Congress and the people who elect them. And sure, if we allow the central bank to become a second, unelected Congress that can conduct a second channel of fiscal policy by crediting bank accounts and buying things, without any direct democratic accountability or debate over its spending decisions, then it can no doubt have the same kind of macroeconomic impact that an unleashed Congress and Treasury could have. But if we do cross that Rubicon and go down that authoritarian road, turning the Fed into some kind of neo-Soviet Stroibank empowered to spend and command real national resources outside the normal democratic process at the behest of a technocratic elite, we will probably never get our democracy back.

People frequently rail against the pork barrel spending and earmarks that result from the legislative process. But the pork barrels don’t worry me nearly as much as handing our economy over to another generation of theory-addled elitists like Alan Greenspan. As part of the democratic process, representatives come from all over the country to look for the resources to deliver the things their constituents want and need. They wrangle and haggle. And yes, in the process they land a few “bridges to nowhere.” But most of what they get are bridges to somewhere. The people in New Hampshire might not like the way the people in Georgia use their share of our national resources, and the people in Georgia might feel the same way about the people in Oregon. But the end result is that things get built; people are hired; public goods are created; national and local needs are met; things get done.

My sense is that Americans are dead tired of a corrupt and aimless government that can’t or won’t do anything important anymore; that works energetically to deliver resources to its masters in the plutocracy, but then holds up its hands and says “Sorry, out of money!” when suggestions for the pursuit of major public purposes are advanced. It doesn’t have to be this way. America hasn’t always had a Congress full of can’t-do seat-warmers, small thinkers and penny pinchers determined to castrate the national government and let bankers and CEOs run the world. There have been times in our history when we have actually managed to organize our vast resources to accomplish important things and invest public resources in our future.

We have an election this year. I suggest we use it to ditch the empty suits, the plutocratic shills and the small minds, and fill their spots with people ready to act.

Edward Harrison here.

We seem to be moving forward with this discussion on monetary policy, banking, and reserves. Things seemed to be veering wildly off track but I have seen a huge number of good comments in the last 24 hours. Now, John Carney does a good job of summarising some of the initial forays in this back and forth that started between Steve Keen and Paul Krugman but that has since branched out. I am going to try my hand at framing the discussion here in order to weed out a lot of the extraneous stuff. Where there are mistakes, I will fix them accordingly as they are pointed out. I think this is pretty important, so please pay attention to this one.

The comments from the last post I wrote and from a follow on post by Tom Hickey at Mike Norman’s blog got at the heart of the debate and so I will try to characterise what was said.

Framing

We have been living in a world predominated by floating exchange rates and currency non-convertibility for forty years now. Nevertheless, most of economics world seems to take a fixed exchange rate, Bretton Woods, or gold standard view of money and banking. In that world, as Warren Mosler quipped, bank lending is reserve constrained with the interest rate an endogenous variable via bank competition for reserves.

I put it this way in December [emphasis added]:

In the old gold convertible system, the central bank had to jack up rates to prevent an outflow of gold. Interest rates were the release valve. But in those old days, only by adjusting the gold peg i.e. depreciating the currency, could countries under attack get away with low rates once the vigilantes were on to them. That’s what happened during the Great Depression. Once the conversion was broken, the currency depreciated and depression lessened immediately.

Today the release valve is always the currency because there is no gold tether. So the currency gives way, not interest rates.

-Bond vigilantes and the currency relief valve

What this in effect means for the domestic banking system is that in a nonconvertible floating exchange rate system, lending is not reserve constrained as banks can create reserves by making a loan that creates a deposit. Any one institution can always borrow reserves from other banks or from the Fed itself if it finds itself short of reserves (See this BIS paper from 2010 for further discussion).

The US government, as monopoly issuer of its own sovereign currency, has given the Fed monopoly power in the market for base money. The Fed then exercises this monopoly power by targeting the overnight rate for money, the fed funds rate. That is to say, the Fed targets a rate or a price, not a quantity. Almost all modern central banks of today operate with explicit interest rate targets, allowing the overnight rate to fluctuate within a range. Any monopolist can only control either price or quantity, not both. Now, central banks could target something else like reserves to transmit monetary policy into the economy; and they have done in the past. The Fed targeted reserves from 1979-1982. What the Fed found was that it had only a controlling influence on base money because targeting the monetary base meant volatility in interest rates (see this 2004 ECB paper for further discussion). But, more importantly, because bank loans create deposits that actually need reserves to maintain the integrity of the payments system, the Fed is forced to supply them according to its legal mandate.

In short, reserves are about helping set interest rates, not about pyramiding money on a reserve base.

Under present institutional arrangements, the Fed Funds rate is dependent on the Fed’s supplying the required amount of reserves at any given reserve ratio to keep the interest rate at its target or within its target band.  The Fed can’t target a rate unless it supplies banks with all the reserves that the banks need to make loans at that rate. This means that central banks must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints. Failure to supply the reserves means failure to hit the interest rate target. So in practice, if a banking system as a whole is at the reserve limit, central banks always increase the level of reserves desired by the system in order to maintain the interest rate. Not doing so means at once that the Fed cannot hit its target or that transactions fail as the payments system breaks down.

In sum: In a nonconvertible. floating exchange rate system, the amount of credit in the system is determined by the risk-reward calculations of banks in granting loans and the demand for those loans. Banks are not reserve constrained. They are capital constrained. Financial institutions grant credit based on the capital they have to deal with losses associated with that activity.

I don’t think anything I wrote is particularly controversial for those with banking and money as their primary economic discipline or area of study. But if you read textbooks like the one I got in business school by Glenn Hubbard, you find sentences like "The monetary base sometimes is called high-powered money because a given amount of base allows creation of a multiple amount of money" (p. 420, Money, the Financial System and the Economy, Hubbard, 1995). This suggests that the banks in fact are pyramiding credit/money creation on the back of reserves when this is not the case. I checked my intro college economics textbook by Baumol and Blinder from 1985 and it’s exactly the same kind of stuff. The reality is that banks are not reserve-constrained because the Fed must supply reserves to back loans already granted. Only if and when the Fed decides to raise the fed funds rate to curtail credit growth will reserves be constrained. And they will be demand-constrained, not supply-constrained.

Central Bank Flexibility – tactics, strategy, and policy

Given that framing above, the question everyone is asking is whether any of that matters over the long-term. Here’s how I explained Nick Rowe’s objection to the concept of endogenous money:

I think the real difference between what Nick Rowe is saying and what people like Scott Fullwiler and Steve Keen are saying is that Nick believes over the medium-term, central bank interest rate policy is endogenous. What I think Nick means is that Scott Fullwiler’s view is reasonably clear and straightforward in his view that central monetary policy is exogenous but that it only matters over a short-term time horizon because central bank interest rate policy adjusts endogenously over the medium-term to commercial bank and other economic variables such that it is really endogenous rather than exogenous.

Further, I think Nick Rowe is saying that it creates an expectation of central bank interest rate policy merely by announcing its target rate and the market moves to accommodate that target, knowing the central bank is the monopoly supplier of reserves. In that sense the central bank has control. But what he seems to suggest is that the central bank policy rate cannot be determined independent of macroeconomic variables (like inflation specifically) and that central bank may be forced to change policy based on these, making it possible to treat the central bank policy rate as medium-term endogenous.

Nick Rowe says my view of his previous commentary is fairly accurate. Scott Fullwiler doesn’t like the terms short- and medium-term. He would rather see us talk about Fed tactics, strategy and policy.

Scott frames it this way (with minor edits for readability):

1. Tactics – can the central bank directly target reserve balances, monetary base, etc?
2. Strategy – what sort of rules/discretion balance does the central bank follow in adjusting the target it has set tactically. How often? How big of an adjustment each time? By what criteria?
3. Policy – How does the macro economy work and what role can or should the central bank play in stabilizing it?

Scott goes on to say that:

The debate between Krugman/Keen once it got to issues related to the money multiplier and loanable funds was about tactics–can banks individually or collectively create loans without regard to deposits or reserve balances? This is closely linked to an understanding of what banks are/do and hence Krugman’s view that they didn’t need to be included since inserting them didn’t change how one should view the money multiplier or loanable funds models. This is where I jumped in, because Krugman in my view was completely wrong on these points.

But Krugman’s reply to me, and Rowe’s post, brought in strategy and policy–”the central bank must change the interest rate target by adjusting to events and expectations” which is about how the central bank should adjust its target (strategy) within the context of how the macroeconomy works and interacts with monetary policy (policy)…

The MMT view is that we need to understand how the tactics work to inform our strategy and even our understanding of how the economy works. Krugman tried to suggest understanding the tactics is irrelevant to these two. This is a very significant distinction between the approaches.

Further, in MMT, we keep these three (tactics, strategy, policy) separate when we discuss them. Neoclassicals generally don’t–so, when I say the central bank must set an interest rate target (tactics) but can move that target wherever it wants (the possibilities for strategy), Nick says no the cb must set a target that responds to the economy and thus must be endogenous (strategy in the context of view of macroeconomy). We end up talking past each other as I have not invoked yet at all how central banks “should” set strategy with regard to how the macroeconomy works. While we will disagree on the latter, in our view jumping to that without clarifying and setting a common language for tactics and strategy complicates the discussion unnecessarily.

This is progress.

Translation: we agree on the basics here but semantically there are differences. 

• MMT’ers believe the central bank, as monopoly supplier of reserves has monopoly power and therefore full discretion to act as an exogenous actor.
• Nick Rowe says a central bank must set a target that responds iteratively to the economic variables like inflation and thus must be endogenous as a overarching strategy in the context of a macroeconomy).

I think that’s where we stand.

My Conclusions

• We have been living in a world of floating exchange rates and currency non-convertibility but the economics world very often – and wrongly – takes a Bretton Woods view of money and banking.
• The Bretton Woods world is one in which bank lending is reserve constrained with the interest rate an endogenous variable via bank competition for reserves.
• In a nonconvertible floating exchange rate system, lending is not reserve constrained (over the short-term) as banks can create reserves by making a loan that creates a deposit. Any one institution can always borrow reserves from other banks or from the Fed itself if it finds itself short of reserves. If a banking system as a whole is at the reserve limit, central banks always increase the level of reserves desired by the system in order to maintain the interest rate.
• But questions remain about what a central bank can target and to what effect and as to the discretion a central bank has in adjusting any target it has set "tactically". Some say that over the long-term a central bank must respond iteratively to macro economic variables. Others believe the central bank has full discretion to set policy as an exogenous actor.
• My question is whether the above suggests banks MUST be including in any realistic economic model for it to have predictive power even in more extreme economic circumstances like the ones that existed during the great credit bubble. The Great Financial Crisis would suggest yes. yet, many in the economics field resist this notion. Hopefully, we can get more answers on this question as a result of this post.

By Scott Fullwiler, Associate Professor of Economics and James A. Leach Chair in Banking and Monetary Economics at Wartburg College. Cross posted from New Economic Perspectives

The debate between Paul Krugman and my friend Steve Keen regarding how banks work (see here, here, here, and here) has caused me to revisit an old quote. Back in the 1990s I would use Krugman’s book, Peddling Prosperity (1995), in my intermediate macroeconomics courses since it provides a good overview of what were then contemporary debates in macroeconomic theory as well as Krugman’s criticisms of various popular views on macroeconomic policy issues from that era. One passage near the very end of the book has always remained in the back of my mind; in it, Krugman critiques a popular view that was and still is highly influential regarding productivity and trade policy. He writes:

So, if you hear someone say something along the lines of ‘America needs higher productivity so that it can compete in today’s global economy,’ never mind who he is or how plausible he sounds. He might as well be wearing a flashing neon sign that reads: ‘I DON’T KNOW WHAT I’M TALKING ABOUT.’ (p. 280; emphasis in original)

In his latest post in this debate (which Keen replied to here), Krugman demonstrates that he has a very good grasp of banking as it is presented in a traditional money and banking textbook. Unfortunately for him, though, there’s virtually nothing in that description of banking that is actually correct. Instead of a persuasive defense of his own views on banking, his post is in essence his own flashing neon sign where he provides undisputable evidence that “I don’t know what I’m talking about.”

Moving right into Krugman’s post, he writes:

There are vehement denials of the proposition that banks’ lending is limited by their deposits, or that the monetary base plays any important role; banks, we’re told, hold hardly any reserves (which is true), so the Fed’s creation or destruction of reserves has no effect. This is all wrong, and if you think about how the people in your story are assumed to behave — as opposed to getting bogged down in abstract algebra — it should be obvious that it’s all wrong.

Yes, I will argue here that banks either individually or in the aggregate are not limited by their deposits and the monetary base doesn’t constrain bank lending, but my argument as well as that of the endogenous money crowd in general (MMT, horizontalists, circuitistes, etc.) has nothing to do with whether or not banks “hold hardly any reserves.”

He continues:

First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand. I hope this isn’t controversial, although given what usually happens when we discuss banks, I assume that even this proposition will spur outrage.

In fact it is wrong, and in fact that is not controversial. Let’s start with a basic bank and its customer and do T-accounts for both. The bank creates a loan and a deposit “out of thin air,” and the customer has now a new liability (the loan) and an asset (the deposit) as shown in Figure 1.

As is well known, and by the logic of double-entry accounting, the bank does make a loan out of thin air—no prior deposits or reserves necessary. But this isn’t really the point Krugman wants to make, so let’s just move on. Krugman continues:

But the usual claim runs like this: sure, this is true of any individual bank, but the money banks lend just ends up being deposited in other banks, so there is no actual balance-sheet constraint on bank lending, and no reserve constraint worth mentioning either. That sounds more like it — but it’s also all wrong.

Actually, that’s not the argument I would make whatsoever. Neither would any person who understands endogenous money, horizontalism, the circuit, etc. The number of banks involved has nothing to do at all with the argument. Our argument is valid if we consider only 1 or 1 million banks. So, again, let’s keep going.

Krugman: “Yes, a loan normally gets deposited in another bank”

Actually, a loan doesn’t get deposited in another bank—a deposit gets deposited in another bank. The loan is a bank’s asset, and a deposit is a bank’s liability. Here we see the very beginnings of the importance of remaining clear on accounting if one wants to truly understand what “loans create deposits” means. If we assume, as per Krugman’s example, that Customer 1 takes the proceeds of the loan and deposits them in, say, Bank B, then we have Figure 2 below:

This is a bit more complicated than Krugman made it sound, isn’t it? Let’s walk through this slowly.

Customer 1 withdraws the deposit from Bank A, which is the “-Deposit” on Bank A’s liability/equity side, and the “-Deposit @ Bank A” on Customer 1’s asset side. Customer 1 then makes a deposit in Bank B, which is the “+Deposit @ Bank B” on Customer 1’s asset side and the “+Deposit” on Bank B’s liability.

But how does the deposit get from Bank A to Bank B? Let’s assume it’s done by electronic transfer here (that is, Customer 1 instructs Bank A to transfer the funds from the account at Bank A to the account at Bank B) since Krugman wants to discuss currency withdrawals below. Note that as far as the banks are concerned, this is the equivalent to Customer 1 spending the proceeds of the loan and the recipient of the spending being another customer that banks at Bank B—that is, in either case the deposit simply moves from Bank A to Bank B.

Now, let’s also assume that Bank A had no reserve balances on hand when it made the loan. How does it transfer reserve balances to Bank B? As it turns out, the Fed provides an overdraft for any payment sent in which a bank’s account goes below zero—that is, the payment is never rejected when it occurs on the Fed’s books. The Fed does this as part of its legal obligation to promote stability in the payments system (more on this in a minute). The rub is that the Fed requires Bank A to clear this overdraft by the end of the day, which Bank A will most likely do in the money markets (such as the federal funds market, often via pre-established lines of credit). So, on the liability/equity side for Bank A, we end with “+Borrowings” in the money market to clear the overdraft.

Note underneath Bank A’s balance sheet I’ve shown the totals or net changes to its balance sheet overall, which is simply a loan created offset by borrowings in the money markets on the liability/equity side. So, the loan was made without Bank A ever needing to meet reserve requirements, without needing reserve balances before making the loan, and without needing any deposits. Can Bank A just continue to make loans forever this way without ever needing any of these? The key here is to understand the business model of banking—which is to earn more on assets than is paid on liabilities, and to hold as little capital (equity) as possible (since that’s generally more expensive than assets). The most profitable way to do this is to make loans (that are paid back, obviously, so credit analysis is an important part of this) that are offset by deposits, since deposits are the cheapest liability; borrowings in money markets would be more expensive, generally. So, Bank A, if it is not able to acquire deposits is not operationally constrained in making the loan, but it will find that this loan is less profitable than if it could acquire deposits to replace the borrowings.

If Bank A wants a more profitable loan but is not able to acquire deposits, it can raise the rate charged to Customer 1 and thereby preserve its spread, which can result in Customer 1 taking his/her business elsewhere. But it can still make the loan. In other words, it is not deposits or reserve balances that constrain lending, but rather a bank’s own choice to lend given the perceived profitability of a loan—which can be affected by the ability to obtain deposits after the loan is made—and also given a perceived creditworthy borrower (someone has to want to borrow, after all, if a loan is going to be made) and sufficient capital (since regulators will want the bank to hold equity against the loan).

A digression is in order here on the central bank and the payments system. According to the Fed’s data in 2011 payments settled using Fedwire (the Fed’s main settlement system) averaged $2.6 trillion per business day, or about 17% of annual GDP each day. A significant percentage of these payments are themselves settled a still larger dollar volume of transactions on private netting payments systems. And the US is not unique in this regard, as I explained here (see Table 1), in other countries payments settled on the central bank’s books each business day routinely average between a low of about 10% and a high of over 30% of annual nominal GDP. As the monopoly supplier of reserve balances (since the aggregate quantity can only change via changes to its balance sheet), it is the central bank’s obligation to ensure the stability of the national payments system. All central bank’s therefore provide reserve balances to their banking systems on demand at a price of the central bank’s central bank’s choosing.

Note that it cannot be any other way. If the central bank attempted to constrain directly the quantity of reserve balances, this would cause banks to bid up interbank market rates above the central bank’s target until the central bank intervened. That is, central banks accommodate banks’ demand for reserve balances at the given target rate because that’s what it means to set an interest rate target. More fundamentally, given the obligation to the payments system, it can do no other but set an interest rate target, at least in terms of a direct operating target.

What does this mean for our present context? It means simply that there is no quantity constraint on the quantity of reserve balances the central bank will supply, and thus there is no reserve constraint on a bank or on the banking system’s ability to create loans. Central banks stand ready to provide reserve balances at some price always. They can adjust this price up or down if they are concerned about the expansion of credit or monetary aggregates, and this increase in price can be passed onto borrowers who may then not want to borrow. But this means that the manner in which a central bank can exert control over credit expansion is indirectly through its interest rate target, not through direct control over the quantity of reserve balances.

Returning to Krugman, he then writes:

— but the recipient of the loan can and sometimes does quickly withdraw the funds, not as a check, but in currency.

Actually, withdrawing funds—spending them, in other words—via check or electronic transfer is far and away more common than withdrawing via currency. When I took out a mortgage to buy a house, I didn’t withdraw the funds in cash (duh!), and neither does anyone else. When I buy a plane ticket with my credit card (which is a loan, by the way, that creates a deposit—do you think Citibank has to look to see if it has sufficient reserve balances before approving your loan to buy those clothes at Nordstrom?), the funds are disbursed via reserve balances, not currency. Again, these absolutely dwarf any currency withdrawals of funds created by a loan—it’s not even close.

And currency is in limited supply — with the limit set by Fed decisions.

This statement is simply mindboggling. It’s so wrong I don’t know where to begin. The Fed NEVER limits the supply of currency. Never. Ever. To do otherwise would be to violate its mandate in the Federal Reserve Act to provide for an elastic currency and maintain stability of the payments system.

To play along, withdrawing the funds created by the loan as currency would look like this:

Here, instead of the transfer to Bank B, Customer 1 withdraws in the form of currency, which depletes Bank A’s vault cash. Let’s assume that this leaves Bank A holding less vault cash than it desires to hold. In that case, Bank A purchases more vault cash from the Fed. If we further assume that Bank A did not have the reserve balances to settle this transaction with the Fed, as in the previous example, it receives an overdraft from the Fed that it clears in the money markets. The net change to Bank A’s balance sheet is then the same as in Figure 2—a loan offset by borrowings. Again, no prior reserve balances required, whereas the Fed also supplied currency to replenish vault cash on demand. (Yes, a bank does need to have sufficient vault cash on hand to meet the withdrawal in the first place, but it is common for them to place restrictions on withdrawals to avoid running out—such as when your ATM only allows you to withdraw $200/day.) As in Figure 2, the bank’s decision to make this loan would be based on the profitability of the loan, not any quantity constraints related to the monetary base.

And the same goes for the aggregate—there is no constraint on banks’ abilities to obtain currency from the Fed. For instance, consider what a director of the Fed’s payments system operations said about currency in Congressional Testimony in 2006:

One of our key responsibilities is to ensure that enough currency and coin is available to meet the public’s needs. In that role, the twelve regional Federal Reserve Banks provide wholesale currency and coin services to more than 9,500 of the nearly 18,000 banks, savings and loans, and credit unions in the United States. The depository institutions that choose not to receive cash services directly from the Reserve Banks obtain them through correspondent banks. The depository institutions, in turn, provide cash services to the general public. Each year, the Federal Reserve Board determines the need for new currency, which it purchases from the Department of the Treasury’s Bureau of Engraving and Printing (BEP) at approximately the cost of production.

Note that she did not say anything about limiting the supply, or the Fed setting the supply. Two times she specifically said—as I emphasized via italics—that currency in circulation is based on the public’s needs, not any target set by the Fed. Consider also what the New York Fed says about how the quantity of currency in circulation is determined:

Depository institutions buy currency from Federal Reserve Banks when they need it to meet customer demand, and they deposit cash at the Fed when they have more than they need to meet customer demand.

As with reserve balances, the Fed could attempt to target the quantity of currency in circulation indirectly—that is, changes in the federal funds rate target might be able to influence how much currency the public wants to hold. But (a) there is strong evidence that currency demand is almost completely unrelated to the Fed’s target rate, and (b) this would mean that it was the fed funds rate target constraining bank lending, not currency or any sort of quantity constraint.

(As an aside, not also the the New York Fed made clear that because the quantity of currency in circulation is based on the public’s demand, the Fed also does not have the ability to oversupply currency. In that case, banks just sell the currency back to the Fed in exchange for reserve balances—which as above don’t enable more/less lending than otherwise. Similarly, if the public were somehow holding more currency than it desired, it could simply deposit these in a bank as a deposit, savings account, CD, money market fund, etc—which banks would then return to the Fed. In other words, because there are (in fact, numerous) opportunities to convert currency into highly liquid (in some cases just as liquid as currency) stores of value that also take the currency out of circulation, there is no such thing as a “hot potato effect” for currency (or deposits either, since they too can be converted into savings, money market funds, CDs, etc.) The Fed can’t supply any more or any less currency than the public wants to hold. Helicopter drops are fiscal operations, not monetary operations.)

Krugman summarizes:

So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates — even if banks hold no reserves.

As above, the quantity of reserve balances the bank is holding has nothing to do with it. Krugman is correct that there is no automatic process that will enable a bank or the banking system overall to keep deposits equal to the amounts of their loans created, but as I’ve explained that represents a potential reduction in the profitability of the loan, not a quantity constraint on a bank’s or the banking system’s abilities to create loans out of thin air. The only relevant quantity constraint on creating a loan is capital—assuming capital requirements are strictly enforced—not reserve balances, not reserve requirements, not deposits, not the monetary base, etc. The latter can only affect the loan decision by influencing the profitability of the loan—a price effect of monetary policy, at best—and similarly the borrower’s decision can be affected by the fed funds rate set by the Fed (and the rate the bank charges as a markup over this), which is another price effect. The reason for this is that a central bank defends the payments system every day, every hour, every minute, at some price. This is the essence or fundamental truth of central banking, and anyone who fails to grasp it doesn’t understand central bank operations.

So how much currency does the public choose to hold, as opposed to stashing funds in bank deposits? Well, that’s an economic decision, which responds to things like income, prices, interest rates, etc.. In other words, we’re firmly back in the domain of ordinary economics, in which decisions get made at the margin and all that. Banks are important, but they don’t take us into an alternative economic universe.

Strange that he would say “stashing funds in deposits” since deposits settle a greater dollar volume of spending than currency does. At any rate, Krugman wants to argue that banks aren’t important since they can’t “do” anything more than occurs in a model without banks. Again, that’s not even close to true. As above, banks create loans without regard to the quantity of reserve balances they are holding; they obtain any reserve balances needed at the federal funds rate or roughly equal to it. Their ability to replace withdrawals with other deposits merely affects the profitability of lending, not the ability to do so. Consider, for instance Canada, which has no reserve requirements and where the central bank is so good at forecasting banks’ demand for reserve balances (due to how the interbank market functions there) that banks actually desire to hold no reserve balances overnight—reserve balances only exist on an intraday basis. What if the Canadian public decided also to stop using currency? (There was in fact a good deal of research on this possibility related to the so-called e-money revolution back in the late 1990s and early 2000s.) This would mean the monetary base was zero. Would this stop banks from lending? No. Now, add reserve requirements to this—which we’ve already shown above do not constrain banks—and a desire to hold currency by the public—which we’ve explained is met on demand by the central bank. Nothing’s changed. The size of the monetary base is a result or an outcome, not a cause.

Instead, Krugman argues that these at least in the aggregate do constrain banks’ abilities to lend, as in the traditional money multiplier model or the loanable funds view. But in fact a world with banks is quite different if the size of the monetary base doesn’t matter, ever. On the way up, this is particularly so in a world in which the largest banks can exist on ever smaller margins between their lending rates and rates paid on liabilities (given scale and also increasing revenues from non-interest sources), while also providing the revolving fund of financing for institutions investing in the money markets. As such, banks can provide the financing for an asset price bubble while the monetary base responds in kind, rather than vice versa; on the way down, as the desire for bank credit relative to income slows, increasing reserve balances or currency don’t necessitate spending. And those paying back debt simply destroy bank deposits (since the repayment results in a debit to the payor’s deposits and a debit to the bank’s loan); there is no transfer from those repaying debt to lenders (and it wouldn’t work that way anyway—debt repayment is out of income for the debtor, but the transfer is a portfolio shift for the owner of the debt, not income aside from the interest payment).

Concluding his post, Krugman writes,

Now, under current conditions — that is, in a liquidity trap — the monetary base is indeed irrelevant at the margin, because people are indifferent between zero interest public liabilities of all kinds. That’s why there are no immediate policy differences between some of the monetary heterodoxies and what IS-LMists like me are saying. But that’s not the way things normally are.

Krugman wants to reiterate that the size of the monetary base matters, unless we are in a so-called liquidity trap, as he thinks we are in now. His own definition of the liquidity trap is when reserve balances earn the same as t-bills, as they generally do now (within a few basis points). Under those conditions he wants to argue that the monetary base can be as large as the Fed wants it to be and it won’t be inflationary and it won’t encourage more lending. What he fails to understand is that it is only when the Fed sets its target rate equal to the rate paid on reserve balances (which will mean t-bills earn roughly the same as reserve balances—Krugman’s liquidity trap) that the Fed can actually target the quantity of reserve balances and by extension the monetary base. And even then, it must be sure to provide at least as many reserve balances as banks desire at the target rate to achieve its target rate in the first place. The key point here is that “under normal circumstances” the monetary base’s size would be determined endogenously based on the public’s demand for currency and banks’ demand for reserve balances at the Fed’s target rate; the Fed or any other central bank can only control the size of the monetary base directly by creating “liquidity trap” conditions that set interest on reserve balances equal to interest on t-bills.

In short (!), the money multiplier model is wrong because it has the causation backwards—banks create loans based on the demand by borrowers, perceived profitability, and capital they are holding. The quantity of currency held or in circulation and quantity of reserve balances held or in circulation at the time of the decision to create the loan have nothing to do with it. If there are reserve requirements, then the quantity of reserve balances may increase as lending may increase reserve requirements and the central bank will have to raise the quantity of reserve balances circulating to achieve its target. Similarly, if credit creation raises the public’s demand for currency, then the central bank will have to increase currency in circulation, as well. It also means that the loanable funds model is wrong. Banks are not constrained by deposits whatsoever, but the quantity of deposits they can raise after making a loan to replace a withdrawal will affect the profitability of the loan. Again, the constraint is a price constraint, not a quantity constraint.

And, for Krugman and others like him that want to defend the money multiplier, loanable funds, or any other perspective that suggests banks individually or in the aggregate are constrained by currency, deposits, or reserves in lending, well . . . . here’s your (flashing neon) sign.

By Michael Hudson, a research professor of Economics at University of Missouri, Kansas City and a research associate at the Levy Economics Institute of Bard College

An interview with Michael Hudson published on the Russian website Terra America (TA).

What is the place of the Federal Reserve System in the American financial and economic structure?

Prior to the Federal Reserve’s founding in 1913, U.S. monetary policy was conducted by the Treasury. Like the Fed, it had district sub-treasuries that performed nearly all the financial functions that the Fed later took over: providing credit to move the crops in autumn, managing government debt, and so forth.

But after the severe 1907 financial crisis, a National Monetary Commission was reformed. Under the then-Republican administration, it recognized a need for more active government intervention to prevent future financial crises. It also recognized the desirability of moving away from the Anglo-Dutch-American system of “merchant banking” based on short-term lending against collateral in place, or for shipping of goods already produced. The National Monetary Commission’s longest volumes were on the great German industrial banks, and Republican policy aimed at bringing banking into the industrial era, to provide long-term funding after the model of German and other Central European banks.

However, the leading bankers sought to use the crisis as an opportunity to grab power for Wall Street, away from the Treasury. In this sense, the Fed was founded in large part to take monetary control away from Washington’s elected officials and appointees, and privatize the supply of money and credit.

So its place in the U.S. financial and economic structure is to allocate credit, primarily to serve Wall Street financial interests. That explains the insistence on the financial class here and abroad in insisting on an “independent” central bank. It means that instead of serving the public interest, it serves the interests of the banking class. The hoped-for transformation of commercial banking into long-term industrial banking was not achieved.

Can we imagine the global economic system without Federal Reserve today? If yes/no, why?

As David Kinley’s book for the National Monetary Commission pointed out a century ago, nearly all the financial functions performed by the Fed already were performed by the national Treasury. In more recent times, Milton Friedman and his University of Chicago colleagues suggested that the entire Fed could be reduced to a single desk inside the Treasury. The “Chicago Plan” of the 1930s urged Treasury control, as does Congressman Dennis Kucinich’s current bank reform.

There is no inherent need for a monetary agency to exist outside of the national government, except to serve the interests of the financial class as distinct from those of government, industry and labor. And the banking sector’s business plan is to load down real estate, labor, industry and the government with as much interest-bearing debt as possible.

Some people in the US (especially supporters of the congressman Ron Paul) believe that the Federal Reserve is the reason of serious problems within the American financial system. Do you agree with this claim?

The Fed is a reason for serious problems, but not the only reason. Unfortunately, Ron Paul’s proposal opposes paper credit itself, whether issued by the Fed or the Treasury. He wants to return to the gold standard and clash government spending – in effect, to create an economy without government. So what he actually advocates is not only the end of the Fed, but the end of a functioning credit and tax system. The idea is otherworldly and has no possible chance of being enacted, because it would cause a vast debt default as a result of plunging prices, incomes and employment.

Contrary to most of European central banks the Federal Reserve is quite autonomous and has some private aspects. Doesn’t it give too much power to this financial structure? Or maybe this power is part of the checks and balances within the American political system? If yes, what is its precise role and place?

The Federal Reserve is private in name only. Its heads are appointed by Washington, but Wall Street has veto power over it (as it has over the appointment of major Treasury and other regulatory agency officials). So the problem is not that the Fed is technically owned by its stockholders, but that Wall Street has gained overpowering control over government itself.

The financial sector has sought to dismantle checks and balances, making it protect Wall Street even as financial interests diverge from the promoting of economic growth and rising living standards.

What is the priority for the Fed leadership: solving national American problems or serving the interests of the global system?

The Fed is officially supposed to perform two functions: First, to promote “price stability.” This means in practice, fight against wage inflation and preserve sufficient unemployment so that wages will not increase. The “prices” that are supposed to stabilize are the price of labor (wages) and commodity prices.

Meanwhile, the Fed seeks to inflate asset prices, above all real estate prices. Under Alan Greenspan, the aim of the Bubble Economy was to inflate housing prices by enough so that homeowners could borrow the interest to pay the bankers each year, and even enough to spend on consumer goods that their stagnant wage levels were not sufficient to buy. The result was to vastly increase the volume of debt – and debt service became a rising element of prices throughout the economy. Debt-leveraged housing prices ended up absorbing about 40 percent of typical family budgets, and a rising share of corporate income as well, leaving less for spending on current production of consumer goods and capital goods.

The second function the Fed was supposed to perform was to promote full employment. Mr. Greenspan made it clear that he believes that this is incompatible with the ideal of price stability. He pointed out before Congress that the virtue of loading down homeowners, college students and others with debt was that they were afraid to go on strike or even complain about working conditions or seek higher wages, for fear of being fired and missing a mortgage payment or credit-card payment. Going on strike or losing as job would threaten them with loss of a home, and an immediate increase in the credit-card interest rates and penalties that they had to pay. So the Fed became the leading administrator in Wall Street’s war against labor.

Under Mr. Greenspan’s tenure and that of his successor, Ben Bernanke, the Fed has overseen the greatest shift of wealth n American history since the Robber Barons.

Finally, the Fed has taken over the functions of government by threatening to close down the economy if the government does not bail out the banks at taxpayer expense, and protect the wealthy 1% against losing money.

How different were the three last Fed chairmen? Who was the most successful?

Paul Volker came from the Chase Manhattan Bank. In the late 1970s he coped with the U.S. balance-of-payments deficit (stemming mainly from overseas military spending) and consequent the inflationary pressures by raising interest rates to 20%, thereby plunging stock market and real estate prices.

His successor, Alan Greenspan, was a Wall Street lobbyist and a follower of Ayn Rand. Diametrically opposite from Paul Volcker, he pressed to deregulate the economy and sponsored the financial bubble to pump enough credit (debt) into the economy to enable debtors to pay the banks the interest that was mounting up. As a bank lobbyist in control of the banking system, he “freed” the bank from government control – and promoted the greatest debt bubble in U.S. history.

Ben Bernanke was an academic, not a banker but sufficiently brainwashed in neoliberal, pro-Wall Street ideology to be trusted by the banks to flood the economy with credit in an attempt to re-inflate the bubble economy so as to pull real estate prices out of negative equity – thereby saving the banks from their bad loans. Instead of writing down debts, the Fed made sure that no bank would lose, or even be prosecuted for the financial fraud that has risen to epic proportions over the past decade. My UMKC colleague Prof. Bill Black calls this phenomenon “criminogenic.” So in effect, Mr. Bernanke is as much a bank lobbyist as Mr. Greenspan.

In this sense, both Mr. Greenspan and Mr. Bernanke were successful in steering U.S. financial policy to benefit Wall Street by loading down the economy with debt, and then using public credit to bail out the banks and pass the losses onto taxpayers. But this “success” is leaving the U.S. economy debt-ridden and uncompetitive internationally, because its industrial producers face such heavy debt charges that they are priced out of world markets for most products except for military arms, agriculture and high-technology monopoly goods and patented motion pictures and entertainment.

The existence of the Federal Reserve: does it match with the ideas of the classical liberalism? How liberal is this institution?

The Federal Reserve is antithetical to the classical liberal aim of using financial and tax policy to minimize the economy’s cost of production. From the Physiocrats and Adam Smith through Ricardo, John Stuart Mill and the Reform Era, the aim was to minimize land rent (by either taxing it away or nationalizing the land), monopoly rent (by price regulation or by keeping natural monopolies in the public domain) and interest or other financial charges that were payments for special privilege.

Acting on behalf of the banks, the Fed has sponsored the un-taxing of real estate and monopolies, as these have become the major bank customers. And by deregulating Wall Street, the Fed has underwritten the overgrowth of unproductive credit – credit extended not to finance industrial capital formation, but simply to speculate and to transfer ownership of assets already in existence.

The guiding philosophy of the Fed is to inflate prices of assets in order to expand the market for real estate loans (which account for some 80 percent of bank loans in the United States), corporate takeover loans and speculative “casino capitalist” loans for foreign-currency and interest-rate arbitrage.

As Winston Churchill pointed out, history is written by the victors. The big end of finance, having won decisively in the global financial crisis, is in the process of rewriting history to suit its liking. The cover story in the current Atlantic by Roger Lowenstein on Ben Bernanke, titled simply, “The Hero,” is a classic example of this type of revisionist history.

I don’t know what has happened to Lowenstein. His book on the collapse of hedge fund Long Term Capital Management, When Genius Failed, is a terrific piece of reporting. People I know who were on the inside of the LTCM rescue negotiations give his account high marks. But he has increasingly fallen into the role of scrivener for powerful interests, when his previous standards of writing and his knowledge of the finance beat says he must, on some level, know what he is doing.

The Fed couldn’t have gotten better PR if it had paid for it. Lowenstein’s account has just enough muted criticism of Bernanke (he was slow to see the severity of the crisis, his critics on the left may have a point in saying he hasn’t been aggressive enough in trying to reflate the economy) to mask its hagiography.

And this sort of spin-meistering is effective. Not only did people at the Atlantic economy conference, which coincided with the release of the piece, take up the “Bernanke did a great job in the crisis” mantra (they seemed to appreciate a piece that reinforced inside-the-Beltway conventional wisdom) but the cover, with a beatific picture of Bernanke and “THE HERO” blazed across his chest, will be seen by lots of people walking by newsstands and have an impact well beyond those who read the piece. As further proof of its faux-objectivity, the title inside the magazine is “The Villain,” to highlight the way (as Lowenstein positions the piece) Bernanke is being unfairly pilloried.

I’ll turn to the major arguments shortly, but one of the things that was particularly annoying was the way it repeatedly gilded a rotting cabbage. These are devices that most readers would miss, by virtue of not reading carefully enough to recognize their construction, or not knowing the terrain well enough to discern how Lowenstein skews his account. Here are a few of numerous examples:

Lowenstein offers a key parenthetical, in discussing quantitative easing:

…we have no way of knowing whether the economy’s improvement would have been less robust, and how much so, without Bernanke’s efforts

This is a twofer: it paints a tepid, technical recovery as “robust” and gives Bernanke meaningful credit for it.

Lowenstein mentions the nervous collapse of Montagu Norman, the governor of the Bank of England during the Great Depression, as proof of how tough it is to be a central banker during a crisis. Um, Montagu had a long history of mental instability and had had a breakdown in 1912. His psychological fragility is described at length in Liaquat Ahamed’s book Lords of Finance.

Lowenstein depicts Bernanke as an apt student of economic history, when his account shows the Fed chair is either intellectually dishonest or has issues with reading comprehension:

As we began to discuss his policies, the Fed chief urged me to pick up a copy of Lombard Street, a seminal book on central banking written by Walter Bagehot, the 19th-century British essayist. “It’s beautiful,” Bernanke said of the book—obviously appreciating that Bagehot had urged central bankers to take vigorous action to forestall panics.

Huh? Most people who know anything of Bagehot can recite his famous Bagehot rule: Lend freely, against good collateral, at penalty rates. You can cherry pick Bagehot to emphasize the “lend freely” bit, and one can argue that a central bank has the power to make any collateral into “good seeming” collateral by dint of throwing enough money at it. But the message of this paragraph is that Bernanke is a faithful student of well-established principles of central banking. In fact, Bernanke has thrown central ingredients of the formula out the window: the rescue is to be only of solvent but illiquid institutions, and then it has to be sufficiently painful as to deter them from coming back any time soon.

Lowenstein takes dictation in reporting one vignette from Bloomberg’s long-running fight over Fed transparency. Keep in mind that the piece depicts Bernanke as engaged in a sincere effort to make the Fed more open, when the Fed has fought Bloomberg’s FOIAs tooth and nail and even when compelled to cooperate by court rulings, has often engaged in redactions that appear unjustifiable. This is only footprint of this long-running row in the article:

Soon after my visit, he [Bernanke] released a letter he had written to Senate leaders refuting, point by point, a spate of articles that had characterized a Fed lending program as “secret” (the names of the borrowers were secret, but not the existence of the program or its size), and that had reported the total of Fed loans and bailouts as $7.7 trillion, a wild exaggeration.

Whoa! This is what actually went down, as we reported at the time:

It’s telling that the Fed was dumb enough to try upping the ante in its ongoing fight with Bloomberg News over the central bank’s refusal to disclose many critical details about its emergency lending programs during the crisis. Any poker player will tell you you don’t raise with a weak hand when the other side is pretty certain to call your bluff…

Bernanke sent a letter that is pissy by the standards of Fed discourse…

First, it tries the sneaky device of complaining about all the bad press it is getting, and alludes in passing to the latest Bloomberg report (“one last week”). So are we dealing with the general or the specific? The attachment to the letter, which makes a series of specific claims of where the coverage allegedly was off beam, was rebutted with great speed and vigor by Bloomberg. So trying to have it both ways (attacking Bloomberg but trying to depict it as part of general critic wrongheadedness) backfired.

But what is even more striking is the tone and substance of the letter: overreaching words like “egregious,” the patently false claims that there is nothing new in the latest (and by implication, earlier) Bloomberg stories, that the disclosure issues are settled. If there was no new information given to Bloomberg, then why did the Fed fight so hard to prevent the release of information? The Fed has never been cooperative. Even with the Congressional Oversight Panel, the so called Sanders report coming out of Audit the Fed (and remember, the Fed succeeded in lobbying to narrow the scope of Audit the Fed), a new GAO report, the latest Bloomberg FOIA still pried loose more information. The Fed is clearly not interested in transparency, but keeps trying to claims that everything that anyone would want to know is public, and there really is nothing here to discuss any more.

There’s a lot more here on how misleading the Fed letter was; we suggest you read the post in full.

Right on the heels of this no-name swipe at Bloomberg, Lowenstein starts the next paragraph with: “Bernanke is bothered by attacks that seem to be little more than smears…” which in context, suggests that a pitched battle with a preeminent financial media organization about transparency and accountability is a smear. Nicely played.

Ironically, the Fed chief appears to have revealed what his true aims were in increasing Fed disclosure (which despite his claims otherwise, came in response to demands from Congress, the media, and critics):

According to Greg Mankiw, formerly President George W. Bush’s top economist and now an adviser to Mitt Romney, Bernanke earnestly believes in the democratic process; he thinks disclosure will lead to a more responsible electorate.

“A more responsible electorate”? “Responsible” in the sense of accepting the need for austerity? (The Fed has come out firmly in favor of budget cuts, in particular of social programs). “Responsible” in the sense of accepting the central bank’s propaganda recognizing the wisdom of the Fed’s policy choices?

The use of “responsible” telegraphs that Bernanke sees the electorate as irresponsible, which puts lie to his pretenses of being responsive to democratically determined outcomes. Bernanke is interested in listening to voters only after they have been re-educated by the Fed.

Now let’s get to the thrust of the argument, that Bernanke did a great job in the crisis and its aftermath, and that critics, save maybe Paul Krugman, are ignorant populists (Krugman is presumably an educated populist). This thesis conveniently sidesteps the fact that Bernanke is at best a doctor who unnecessarily amputated both legs of the economy and is now being applauded for attaching badly fitting prosthetics to the stumps. And there are numerous experts who have criticized the Bernanke Fed, ranging from Steven Roach, Chris Whalen, former central banker Willem Buiter, as well as former Fed staffers and financial markets professionals of the non-goldbug variety.

Another central banker, Andrew Haldane of the Bank of England, has done some rough estimates of the cost of the crisis to the global economy, and the low end of his range is one times global GDP. That is such a large number that if you were to try to make the biggest banks to pay for it over 20 years, the first year charge would exceed their market value. Haldane has pointed out in other articles that big bank shareholders and executives who have equity linked pay are in the position of option-holders: they have capped downside (the authorities will ride in to the rescue) and unlimited upside. And the more volatile the performance of the underlying instrument (bank stocks) the more an option is worth. Bankers not only have powerful incentives to take risks, even worse, they are in a position to generate systemic risk, and that’s the best course of action for them. Yet last week, after another round of stress test theater, the Fed gave all but a few banks permission to pay out dividends and buy back stock rather than bolster their equity bases, even as the mortgage settlement is based on the premise that the banks are still too fragile to pay for the damage they’ve done.

Lowenstein argues, in keeping with other Bernanke defenders, that the crisis was Greenspan’s doing rather than Bernanke’s. It isn’t that cut and dried. Bernanke, as a notable monetary scholar, gave intellectual legitimacy to Greenspan’s unprecedentedly long period of low interest rates in the dot-bomb era that many argue stoked the credit bubble. Bernanke’s famous 2002 speech on deflation, which Lowenstein refers to, was a defense of Greenspan’s overreaction to the stock market bust. The unwinding of that bubble, unlike our current one, did not represent a threat to the financial system, since the speculation was not fueled by borrowing.

Bernanke was vocal proponent of the “no bubble to see here” view when he took the helm of the Fed, and argued the runup in household debt was benign, since consumer balance sheets were in good shape. But that of course was based on unsustainable home prices.

There is much that Lowenstein ignores in his piece, and that’s because it is necessary to paint such a flattering picture of Bernanke. First is the Fed’s record during the crisis. Lowenstein depicts it as a success, when you can conclude that only by dint of applying a very liberal grade scale. The only missteps he mentions are the “75 is the new 25,” the central bank’s panicked rate cuts when it realized the crisis was more severe than it thought, and the AIG bailout.

But that only scratches the surface. I’m not certain that Bear Stearns should have died. The Fed was originally going to give it a 28 day loan which some believed would allow Bear to find more capital or persuade the markets it was being unfairly stigmatized. And the Fed also created an unprecedented facility to lend to primary dealers. Had Bear gotten the loan it was originally promised, it would also have gotten access to the new program, which might have enabled it to survive. No explanation has ever been given of why the Fed changed its mind and reneged on its a 28 day loan promise, extending instead an overnight loan to carry it through to a weekend subsidized sale to JP Morgan.

But if you assume the Fed was right, Lehman was simply a bigger version of Bear, and Merrill and UBS were also known to be at risk. And most observers assumed the reason Bear was bailed out what its credit default swaps exposures, which had the potential to turn a Bear failure into a bigger mess. Yet, as we recounted at some length at time, Bernanke, Paulson and Geithner went into Mission Accomplished mode after the Bear rescue. Instead of seeing the Bear implosion as a wake up call, and mounting a full bore effort to diagnose the health of the major players, or get a grip on CDS exposures, the Fed and SEC notched up supervision only a smidge. The Fed sent a grand total of two people to Lehman, for instance. By contrast, the FDIC had to send 160 bank examiners to get a handle on a single (admittedly large) loan portfolio when Citi was on the ropes in the early 1990s.

And Lehman was a self-inflicted wound. Bernanke, Paulson, and Geithner had only one plan, and that was a private sector rescue. They didn’t even look at what the alternative might entail; they hadn’t even talked to Harvey Miller, the dean of the bankruptcy bar who had been retained by Lehman. They were utterly flat footed when the negotiations failed. Miller has stressed that the lack of any prep (including the use of a thin form bankruptcy filing) made outcomes much worse than they needed to be.

In an interview, Bernanke cut short Lowenstein on AIG, and there’s good reason why. Its original bailout was the only one I approved of; it did adhere to the Bagehot rule by applying a high rate of interest and securing the loan with all of AIG’s assets. But one also has to note that the very fact that the Fed figured out a way to make massive emergency loans to AIG undermines its “we had no legal authority” defense of the Lehman debacle. (The other excuse has been that Lehman didn’t have enough good collateral, but time has proven that to be true with AIG, plus Bloomberg-forced disclosures revealed that some of the other emergence lending, such as that to Morgan Stanley, also had dubious backing).

But the authorities not only lent AIG more money, they kept improving the terms, and allowed its intransigent new CEO Robert Benmosche to defy the original plan, which was to dismember AIG, which would have been a very effective way pour discourager les autres. That in turn resulted from the Fed’s failure to require the board to resign as one of the conditions of the rescue.

And this is all before we get to the Fed’s two-facedness about contracts. It insists contracts have to be observed strictly when they favor bankers, such as the credit default swaps contracts AIG had written, or pay agreements with bank executives and major producers that would have been worthless ex taxpayer support and Fed intervention. But it has no problem with banks running roughshod over agreements with homeowners and investors. As recounted here and elsewhere, the mortgage settlement incorporates, among other things, that wrongful foreclosures at a rate of up to 1% (which equates to 33,000 homes since 2008) is acceptable servicing and the Fed and other regulators will give it a free pass. Similarly, the Fed has joined in a effort to reverse the long-established creditor hierarchy, allowing banks to modify first liens owned by investors (and count this use of other peoples’ money towards the settlement of their own misdeeds) without wiping out second mortgages they own, as would be required contractually.

The second major theme of the piece is that Bernanke is a fine economist and ideally suited to steer the central bank now. To the extent that Bernanke is held in high regard, it says more about the state of orthodox economics than it does about his expertise. Anna Schwartz, who with Milton Friedman authored the influential Monetary History of the United States, upbraided Bernanke for his handling of the crisis, stressing that he failed to recognize that it was a solvency crisis, not a liquidity crisis (needless to say, that issue is absent in Lowenstein’s account).

Bernanke is also a firm believer in the discredited “loanable funds” view, that if you make put money on sale by making interest rates low and credit readily available, businesses will take advantage of it and borrow and invest. But that’s just silly. The cost of money is a secondary consideration in investing. The primary one is: will there be enough buyers for your output and will they pay what you need to charge to make the project work? And we can see that in the result of the Fed’s operations. As Richard Koo points out in his latest research report, the Fed has increased bank reserves by over 320% since Lehman, yet the money supply has increased only 25%.

The worst is that the Lowenstein article is long enough and consistently wrong-headed enough that there is much more I could add to this shredding, but in the interest of not taxing reader patience, I’ll stop here. I’m afraid we are due for a steady diet of this sort of thing. And even though we can’t stop it, we can let the people putting out this sort of disinformation and our colleagues know that we aren’t fooled.

We were more than a little surprised to read a Bloomberg story on March 10, which reported that the Federal Reserve was giving banks a hard time over its latest stress tests, particularly on the possible losses on consumer debt if the economy were to take a dive. The story indicated that if the Fed held tough, major banks would be restricted in making dividends and buying stock. This seemed to be quite a volte face from the Fed’s previous “give banks everything they ask for and then some” posture. But some Fed defenders argued, no really, once the banks were out of confidence crisis land, the regulators always planned to get tougher with them about building up their capital bases.

If today’s Bloomberg story is accurate, whatever resolve the central bank had was awfully short lived:

Wells Fargo & Co. (WFC) and Citigroup Inc. (C) may join banks unleashing more than $9 billion in dividend increases and share buybacks if they get passing grades this week on the Federal Reserve’s annual stress test.

Thirteen of the 19 largest U.S. lenders may say they’ll pay out $3.79 billion in extra dividends this year and buy $5.52 billion of additional shares, according to estimates of six analysts compiled by Bloomberg. That’s 30 percent more than they spent last year. San Francisco-based Wells Fargo probably will offer the biggest difference at a combined $4.16 billion, followed by Citigroup with $2.92 billion.

Now narrowly speaking, the two stories do not contradict each other. The later, cheerleading story, reflects analysts’ expectations, not any new information from the Fed. The earlier piece also noted that Mr. Market would be disappointed if the big banks (ex Bank of America) were restricted in their use of funds.

Now if we really believe that the Fed might have concerns about the solidity of bank balance sheets, which would be consistent with their super low interest rate largesse, why might they back off? Political scientist and leading expert in money in politics Tom Ferguson points out that any Republican presidential nominee, including Romney, is certain to be tougher on the Fed that Obama would be. He argues if the Fed proves to be generous to the banks, its motivation is likely to include the idea that the banks will start being more generous to Obama (and Bernanke) since the Fed continues to watch their backs.

The Fed has released its methodology for evaluating the banks (hat tip reader Deontos). It describes a much more adverse scenario than was included in the 2009 stress tests:

…a deep recession in the United States, significant declines in asset prices and increases in risk premia, and a slowdown in global economic activity… real GDP is assumed to contract sharply through late 2012, with the unemployment rate reaching a peak of just over 13 percent in mid-2013. The scenario assumes that U.S. equity prices fall by 50 percent from their Q3 2011 values through late 2012 and that U.S. house prices fall by more than 20 percent through the end of 2013. Foreign real GDP growth is also assumed to contract, with growth slowdowns in Europe and Asia in 2012.

Sounds like Lehman lite, and the more dire scenario is based, as the report indicates later, on concerns about the Eurozone. The Fed stresses that this is a scenario and not a forecast.

This in fact is pretty grim, and I would have trouble believing that the Fed could justify anything other than having the banks build up more in the way of capital buffers. As we’ve discussed repeatedly, the four biggest banks have residential mortgage second liens that based on the most recent data are valued at $369 billion. My understanding is that they are marked at between 80% and 90% of face value (JP Morgan may have written them down a bit more) when second lien paper is trading in the secondary market at 30 cents on the dollar. If you assume an average of 85% of face and it needs to be 30%, that $369 billion is really $130 billion, meaning you’d have a nearly $240 billion hit. And that’s just a realistic current mark, not taking into consideration the extra damage occurring in the new stress scenario.

In other words, if any of the big four banks are allowed to pay dividends or buy back stock this year, you should regard it as a bit of electioneering by the Fed. The banks have a long way to go before they are healthy, and the central bank knows even as it pretends not to know that for public relations purposes.

By Matt Stoller, the former Senior Policy Advisor to Rep. Alan Grayson and a fellow at the Roosevelt Institute. You can reach him at stoller (at) gmail.com or follow him on Twitter at @matthewstoller. Cross posted from New Deal 2.0.

Sometimes finance executives let slip the way they really feel: that they hold the world in the palm of their hands.

It’s not often that the people in charge admit what is really going on: a global game for political dominance. I just saw an interview with Wall Street superlawyer Rodgin (“Rodge”) Cohen of Sullivan & Cromwell, the secret force behind (among other things) the expanded emergency lending power of the Federal Reserve through section 13(3). You know, that’s the law allowing the Fed to lend unlimited sums based on whatever it wants to lend, a section amended in 1991 at Cohen’s behest. He was involved in “more than 17 deals” during the crisis in 2008, including the bankruptcy of Lehman Brothers, the $85 billion AIG bailout deal, and the takeover of Fannie Mae by the federal government. He is, as Bill Black said, the fixer of Wall Street. Here’s his quote, at minute 3:39 of this Bloomberg interview:

Hopefully we will not see the major financial institutions in this country disappear because if we do we will also see a loss of ability to influence events not only financially but also politically throughout the world.

That’s pretty clear. It reminds me of this quote from an anonymous military officer while he was touring JP Morgan’s trading floor (emphasis added):

JPMorgan Chase yesterday hosted about 30 active duty military officers (across all branches and agencies) from the Marine Corps War College in Quantico, Va. The officers met with senior executives, toured the trading floor and participated in a trading simulation. They discussed recruitment, operations management, strategic communications and the economy. Aside from employees thanking them for their service as they passed by, they also received a standing ovation on the trading floor. Said one officer after a senior JPM exec thanked him for his service: “We promise to keep you safe if you keep this country strong.”

There are always conspiracy theories out there about a global linkage between large financial institutions and American empire. They don’t, however, usually come from the people running the place.