Has the Fed Painted Itself Into a Corner?

A couple of articles in the Wall Street Journal, reporting on a conference at the Boston Fed, indicates that some people at the Fed may recognize that the central bank has boxed itself in more than a tad.

The first is on the question of whether the Fed is in a liquidity trap. A lot of people, based on the experience of Japan, argued that resolving and restructuring bad loans was a necessary to avoid a protracted economic malaise after a severe financial crisis. But the Fed has consistently clung to the myth that the financial meltdown of 2007-2008 was a liquidity, not a solvency crisis. So rather than throw its weight behind real financial reform and cleaning up bank balance sheets (which would require admitting the obvious, that its policies prior to the crisis were badly flawed), it instead has treated liquidity as the solution to any and every problem.

Some commentators were concerned when the Fed lowered policy rates below 2%, but there we so many other experiments implemented during the acute phases that this particular shift has been pretty much overlooked. But overly low rates leaves the Fed nowhere to go if demand continues to be slack, as it is now.

Note that the remarks by Chicago Fed president John Evans still hew to conventional forms: the Fed needs to create inflation expectations, and needs to be prepared to overshoot.

This seems to ignore some pretty basic considerations. First, the US is suffering from a great deal of unemployment and excess productive capacity. The idea that inflation fears are going to lead to a resumption of spending (ie anticipatory spending because the value of money will fall in the future) isn’t terribly convincing. Labor didn’t have much bargaining power before the crisis, and it has much less now. Some might content the Fed is already doing a more than adequate job of feeding commodities inflation (although record wheat prices are driven by largely by fundamentals).

From the Wall Street Journal, “Fed’s Evans: U.S. in ‘Bona Fide Liquidity Trap'”:

The Federal Reserve may have to let inflation overshoot levels consistent with price stability as part of a broader attempt to help stimulate the economy, a U.S. central bank official said Saturday.

“The U.S. economy is best described as being in a bona fide liquidity trap,” and given the challenges now faced by the nation, “much more policy accommodation is appropriate today,” Federal Reserve Bank of Chicago President Charles Evans said….

Mr. Evans said that such a regime, which he called price-level targeting, “would be a helpful complement to our current and prospective strategies in the U.S. There are quite a number of academic studies of liquidity-trap crises that find either price-level targeting or temporary above-average inflation to be nearly optimal policies.”…

Mr. Evans said that when a central bank “is missing both components of its dual mandate by a large margin, there is justification for targeting a higher price-level path in an effective, disciplined and limited fashion.”…

Mr. Evans gave a nod toward the delicate nature of the Fed’s relationship with the inflation outlook, saying “clearly communicating an expected path for prices would help guide the public’s understanding of the Fed’s intentions while we carry a large balance sheet and promise continued low interest rates for an extended period.”

Yves here. Note the Fed’s with markets-centric view of the world. The Fed may be able to convince investors it is going to do whatever it takes to generate inflation. That will at a minimum lead to a steeper yield curve, which will help banks rebuild their balance sheets on the sly. But the deflationary forces at work are powerful, and it isn’t clear that all the Fed’s chatting up its sincere intent to create inflation is going to move the needle as much as it hopes in the real economy.

The second sighting is more amusing. The Fed is starting to think forward to the date when it has to realize losses on all that stuff it bought during the crisis and still has on its balance sheet. Losses were baked in from the beginning, yet people at the central bank appear, weirdly, to be focusing on that issue only now.

The Fed was quite deliberately forcing the prices of credit markets instruments up via massive and sometimes rather indiscriminate purchases. It wants to unwind those positions only when it is ready to soak up liquidity, in other words, when there is meaningful inflation. But higher interest rates mean high bond yields mean lower bond prices, which mean portfolio losses.

The Fed is going to find itself in the same position as the PBoC on its dollar foreign exchange reserves. Both central banks made those purchases to pursue specific policy goals, and the monies spent were guaranteed to produce losses if and when unwound. Both institutions have allowed themselves to have these expenditures depicted as investments, which open them up to criticism (I’m not saying I am fan of either central bank’s intervention; I’m merely focusing on the political problem each faces).

Note this problem is acknowledged in a backwards fashion: the Fed should stoke up reserves now in anticipation of future losses. From the Real Time Economics blog:

A senior Federal Reserve economist says the Fed should be setting aside more of its immense profits as a safeguard against future potential losses.

“The Fed is earning and turning over to the Treasury an enormous amount,” James McAndews, co-head of research at the Federal Reserve Bank of New York, said….

However the Fed could easily one day turn losses. Say, for instance, inflation starts rising and the Fed needs to sell some of its immense portfolio of bonds to push interest rates up in order to counter inflation. It could lose money on the bonds it sells. It also pays interest to banks for reserves that they keep with the Fed. If interest rates move higher, the Fed’s interest outlays on these reserve could rise too.

Some Fed officials say they aren’t worried about this … Big losses wouldn’t be the same catastrophe for the Fed that they are for commercial banks. That’s because unlike commercial banks, the Fed can print its own money. It doesn’t have to worry about running short of funds the way commercial banks do…

Still, some economists counter that the Fed could use a bigger buffer against potential losses, if for no other reason to avoid bad appearances in the future. Its total capital, at $57 billion, is just 1.1% of total assets. If it runs through all of its capital, that wouldn’t look very good for the central bank, even though it can print all of the money it wants.

Marvin Goodfriend, an economist at Carnegie Mellon’s Tepper School of Business, noted another complication at the Boston Fed panel. Say the Fed has to push up the interest rate it pays on bank reserves to fight inflation and at the same time it is running big losses because its older bonds don’t pay much interest. It could be in the unusual position of printing money to cover its costs at the same time that it is trying to tame inflation.

Mr.Goodfriend the Fed should get a capital transfer from the U.S. Treasury. Laurence Meyer, of Macroeconomic Advisers, shot back, “absolutely not.” Mr. McAndrews said retaining more of its present profits would be a “good risk management approach,” which would ensure it has a bigger buffer for a rainy day in the future.

Yves again. This presentation is more than a tad disingenuous. First, the Fed can’t print on an unlimited basis. Even the oft unfairly pilloried Modern Monetary Theory types are quick to point out that the constraint on central bank money-creation is inflation. So big enough balance sheet losses would generate unacceptable levels of inflation, and would necessitate a recapitalization of the Fed by the Treasury, aka a bailout.

Willem Buiter, a former central banker and now chief economist of Citigroup, was as usual was years ahead of the Fed on this one, and saw the risk of the Fed needing a recapitalization as a result of its creation of an alphabet soup of rescue facilities. He was a fierce critic of these programs as an abuse of normal budgetary processes, as well as for their implication for central bank independence:

I consider this use of the Federal Reserve as an active (quasi-) fiscal player to be extremely dangerous and highly undesirable from the point of view of the health of the democratic system of government in the US.

There are two reasons for this. First, it undermines the independence of the Fed and turns it into an off-budget and off-balance sheet special purpose vehicle of the US Treasury. Second, it undermines the accountability of the Executive branch of the US Federal government for the use of public resources – taxpayers’ money.

As for the Fed’s independence (whatever independence remains), first, even if the central bank prices the private securities it purchases appropriately (that is, there is no ex ante implicit quasi-fiscal subsidy involved), it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

As regards democratic accountability for the use of public funds, even if the central bank has sufficient capital to weather the capital losses it suffers on its holdings of private securities, the central bank should never put itself into the position of becoming an active quasi-fiscal player or a debt collector. The ex post transfers or subsidies involved in writing down or writing off private assets are (quasi-)fiscal actions that ought to be decided by and accounted for by the fiscal authorities. The central bank can act as a fiscal agent for the government. It should not act as a fiscal principal, outside the normal accountability framework.

As usual, Buiter’s concerns are spot on, yet the Fed remains in denial about the fix it has gotten itself into. It’s remarkable that the crisis has had so little impact on its thinking.

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  1. F. Beard

    …it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Willem Buiter

    Then slap leverage restrictions on the banks at the same time. Mightn’t that work? Or is reducing the ability of the banks to leverage literally unthinkable to a central banker these days?

    Also if the Fed doesn’t print then where is the US Treasury going to get money to bailout the Fed? Raise taxes? The very idea infuriates me unless it is just massive claw-back of banker bonuses.

    1. JeffC

      “if the Fed doesn’t print then where is the US Treasury going to get money to bailout the Fed? Raise taxes?”

      To my engineer way of looking at this, there is less to a Fed recapitalization than there might seem to be. I suspect all that has to happen is that The US Treasury and the Fed exchange pieces of paper: the Fed gives the Treasury equity shares in exchange for Treasury bonds. Issuing the bonds costs nothing. No interest will even be paid on them in the net, because the Fed returns net profits to the Treasury every year. So the whole deal is a swap of IOU’s that in the net means nothing whatever really. It just keeps the books balanced in a formal sense.

      (To anyone who knows central-bank finance: please do clarify or correct.)

  2. killben

    Is it best to “End the Fed”?

    Why have such a trouble creator setting policies.

    Have they done anything useful after all their policies are the cause of all the upheavals!

    Except for making Ben Bernanke the most powerful man in the world these guys are not really offering any solutions. Infact they seem to be compounding the problems constantly with their interventions and skewing the markets. Also they are not able to regulate well .. else we will not be in this mess

    So tell me why have Fed around? Let us get rid of them while we can.

    They are become more of a centralised policy agency which sets interest rates, GDP etc. based on what is good for Banks and not based on what is good for America

  3. JWL

    Note that the remarks by Chicago Fed president John Evans still hew to conventional forms: the Fed needs to create inflation expectations, and needs to be prepared to overshoot.

    Not that this stopped them before, but how much of an unconventional response can the Fed legally implement? Monetary policy just doesn’t seem like the best tool for dealing with current problems, but it’s the only hammer the Fed has.

  4. yoganmahew

    The problem is not a liquidity trap. The problem is a policy trap. The Fed lowered rates to zero. Then it suppressed long-term interest rates with QE. It effectively said “there will be no inflation, guaranteed”, but the only solution for the Fed is to generate inflation, in part to stave off the bugbear of deflation, but also to write down the value of existing debt holdings. Now it wants the market to think that there is going to be inflation to raise inflation expectations.

    Mr. Krugman and others are proposing pocket-bazooka policies to generate inflation expectations. Either they are credible and there really will be inflation or they are not credible and there will not be inflation. At the moment, the market believes they are not credible (probably; it is hard to tell from long-term rates!). Should the market switch to believing they are credible, it will not be possible to jaw the genie back into the bottle with a “just kidding”. Either we will have no inflation or we will have lots of inflation, there doesn’t appear to be a middle ground from the current position.

    The Fed has said “we won’t raise interest rates until inflation and economic activity has normalised”. It is stuck at zero. It is suppressing the forward indicator that would show inflation expectations, so I’m not sure how it can decide when it should raise rates. If it leaves it to looking at employment levels, it will repeat the Greenspan Great Mistake and leave interest rates too low, too long.

    In any case, it appears that interest rates, once they have reached zero, cannot rise without an external shock. The problem now is that many, many positions have been taken out that are only justified by free money. Small margin leveraged trades are inherently unstable. The entire liquidity system has been turned into LTCM – liquidity is only being provided because of this small margin leverage.

    The solution? Well, it is too late for it really. Interest rates should be pegged to the long-term cost of money, not the short-term. While Mr. Volcker might have been correct to target short-term rates to kill inflation, an excessive focus on the short-term is a very unstable position. So say long-term rates are around 5%. Peg them at that. Adjust money supply using QE or QT (Quantative Tightening) both through long-term purchase and sale of assets and through long-term repo/reverse repo operations.

    How we get back to the position where this is possible is difficult to say.

    Long live Benoit Mandelbrot RIP…

    1. nanute

      I think there is some validity to your argument of targeting interest rates to the long term cost of money. However,demand for borrowing is almost anemic at current rates. What is making the cost of borrowing more expensive going to achieve? I think a direct cash infusion to taxpayers would be reasonable approach. Bypass the lenders, and see if consumers will spend it or save it.

  5. hermanas

    If monies keep going to the top 1%, where’s the inflation supposed to come from? They tried the free money with the mortgage bust. When will they get it; we need good paying secure jobs to feel secure.

  6. Nathanael

    Moderate inflation could be safely, and convincingly created if the top 1/3 of 1% — the people, mostly criminals, raking in over a million dollars a year — had their mostly-ill-gotten gains expropriated
    (by high taxes) and returned to the average American.

    It’s class warfare, and the very upper class are winning. The only way to fix the economy for everyone else is to make them lose. (That will incidentally be pretty good for them too, as they’ll have decent public services and profitable industrial businesses again, but only a few of them seem to care about that.)

    1. Rodger Mitchell

      There is no mechanism by which increasing taxes on any segment — rich or poor — will benefit the poor. Taxes remove money from the economy, which always hurts the poor more than the rich.

      For an understanding of the American economy, one first must understand Monetary Sovereignty. Without that understanding, all comments are meaningless.

      Rodger Malcolm Mitchell

      1. RueTheDay

        “Taxes remove money from the economy”

        Taxes do not remove money from the economy.

        It doesn’t matter what framework is being used to perform the analysis either.

        In the context of a traditional framework, the government spends the money it taxes, this money does not disappear from the face of the earth.

        In the context of an MMT framework, the government is not revenue constrained in its spending, and assuming it sets spending at the level required to maintain full employment, tax levels are irrelevant.

        It’s this sort of muddle-headed analysis and internal inconsistency that turns so many people off from the MMT position.

        In my opinion, the MMT folks get a lot of stuff right, but they’d be better off jettisoning the chartalist influence and sticking to the endogenous money side of the house.

        1. FlimFlamMan

          At the risk of descending into “did not… did too”, taxes do remove money from the economy, it’s just that government spending ‘puts it back’. More accurately: government spending compensates for the removal. So what really removes money from the economy – or adds it – is the difference between taxes and spending. If government spending is at a lower level than taxation in a given period then the difference – the government sector surplus – is removed from the economy.

          “In the context of an MMT framework, the government is not revenue constrained in its spending, and assuming it sets spending at the level required to maintain full employment, tax levels are irrelevant.”

          First part is right; second part is wrong – and I guarantee you didn’t hear it from anyone who understands MMT, since MMT makes it clear that the relationship between taxes and spending is vital.

          Imagine an economy where government spending is supporting full employment, and the tax level is at whatever it is at. If that tax level were irrelevant we could increase it without effect. Increasing it will remove money from the economy though, reducing demand. If the government is supporting full employment via a Job Guarantee then the demand drop and subsequent output drop will be compensated for by the JG, and that will happen automatically, but it will involve an increase in government spending. If full employment is being supported by conventional public sector employment there will be no automatic spending reaction to the demand/output drop, and unemployment will increase. Either way you have an effect.

          Equally, if that tax level were irrelevant we could reduce it without effect, but if we do reduce it the private sector will have more money at its disposal, and will be able to spend more, boosting demand. If the economy has spare capacity to respond to the demand growth then output will increase, perhaps with a transfer of workers from the JG to the private sector. If the economy has no spare capacity then inflation will increase. Either way you have an effect.

      2. soulmatic09

        If taxes remove money from the economy, can you explain the wonderful economic performance of the Bush years?

        Likewise, can you explain the 8 year Clinton-era depression?

        1. Rodger Mitchell


          You asked where tax revenues go, and I assume you are asking about federal tax revenues. Upon receipt, they are destroyed as credits on the federal government’s balance sheets. They have no function as money. They merely are an accounting record.

          By contrast, state and local tax revenues actually go into state and local bank accounts — a completely different process. This is the system most people think the federal government uses, simply because they do not understand the difference between a monetarily sovereign nation (http://rodgermmitchell.wordpress.com/2010/08/13/monetarily-sovereign-the-key-to-understanding-economics/ ) and an entity that is not monetarily sovereign.

          The federal government does not pay bills from any form of income. States and local governments (and you and me) do.

          Rodger Malcolm Mitchell

      3. traderjoe

        Rodger works (and wrote a book) under the delusion that the Fed and US Treasury are the same institution, and does not acknowledge the Fed and the banks as being the creators of money in our economy. He believes the US Treasury spends money into existence, and that we currently live in an MMT paradigm. He does not accept the private ownership of the Fed, that the FRN is the currency of our realm, and that the UST must borrow FRN’s before spending them. [I too would prefer an MMT world over the current system, but don’t believe we actually live in an MMT world.]

        From Modern Money Mechanics – printed by the Federal Reserve:
        “Who Creates Money?
        Changes in the quantity of money may originate with actions of the Federal Reserve System (the central bank), depository institutions (principally commercial banks), or the public. The major control, however, rests with the central bank.
        The actual process of money creation takes place primarily in banks.”

        “What they [banks] do when they make loans is to accept promissory notes in exchange for credits to the borrowers’ transaction accounts. Loans (assets) and deposits (liabilities) both rise by [the amount of the “loan”].”

  7. Rodger Mitchell

    The whole “liquidity trap” argument is based on the false belief that low interest rates are stimulative. There is no post-gold-standard (1971) relationship between interest rates and GDP growth. Why? See: Interest vs. GDP

    Rodger Malcolm Mitchell

  8. RueTheDay

    Couple of points:

    1. I don’t see QEn being particularly effective as long as the financial institutions that transmit monetary policy actions to the economy remain broken. It’s like trying to put more gasoline into the fuel tank of a car with a broken fuel pump.

    2. I don’t get the concern over “losses” the Fed is going to take. The Fed taking a paper loss doesn’t hurt anything. Yes, the Fed will have to “print”. Yes, this can be inflationary. However, this has to be considered in the context of an overall deflationary environment. Imagine what would happen if the defaulting debt remained on the books of private banks – massive deflation. Also, consider that A) the majority of debt the Fed purchased is not going to default and B) to the extent that it does default, the Fed has a claim to the underlying collateral which can be sold by the Fed (and in turn will have the same effect as any open market sale, pulling money out of the system).

  9. joebhed

    Sorry, Yves, this ain’t about the conundrum of the Fed’s failed policies, nor of the illiquidity of the banking system to fund the national economy..
    This is plain vanilla insolvency of the monetary system.
    The system of money we are using in this country and the world since Bretton Woods I has run its course, and we flounder around for scapegoats and ideological policy cover.
    So, to be clear, we have allowed the capital-marketeers to profit by ruining our system of providing the circulating medium of our national economies – as a debt to themselves.
    The problem is that the capital marketers own the national economies, and I don’t expect yourself or your readers to call them out because it will be easier to Austerianize ourselves for a generation, or two if necessary, than to take back the money systems that all national economies OWN, as a result of their sovereignty.
    We are at the point where we should recognizing the truth that Nobel Prize winner Frederick Soddy stated after his two-year study of why the money-system was incapable of providing prosperity even when any nation had surplus labor, resources and productive capacity.
    “It’s a confidence trick”.
    It is the debt-money system we call fractional-reserve banking where ALL money is created as a debt, and therefore all money IS a debt, that is broke, broken and insolvent.
    Very fortunately, a way out exists, if we ever find the spine to take back the national economy from the “financializers”.

    Prof. Kaoru Yamaguchi, who Dr. Steve Keen says has the most sophisticated systems-dynamics based macro-economic model he has ever seen by far, has modeled a switch to debt-free money issuance and found it can solve the main problems of our insolvent monetary system.
    At the recent American Monetary Institute conference in Chicago, Dr. Yamaguchi presented a paper entitled: “On the Liquidation of Government Debt Under a Debt-Free Money System – Modeling the American Monetary Act”.
    Dr. Yamaguchi’s paper is available here:
    An interview where he discusses the results of his work is available here:
    It’s not the Fed that has painted itself into a corner here. It is the very real fact that what Soddy found before he wrote his book on “The Role of Money” is the truth. The confidence trick of debt money has run its course.
    There are no adjustments, no policies and no tools left in the toolbox.
    We need a new monetary system. And one is available to do the job.
    The Money System Common

    1. F. Beard

      And some people still can’t understand why the gold price is where it is, and headed higher. Bam_Man

      Gold is a barbaric form of money and a tool of the usury cartel. It requires government privilege to compete. Gary North, for instance, wants to require the collection of taxes in gold. That would be a huge boon to gold holders at the expense of saner forms of private money. If we go backwards to a government gold standard then yes, people will achieve a windfall by owning gold. But that does not mean that gold is an intrinsically good form of money. In fact, a true free market in money creation would crush it and fractional reserve lending too.

      So. If we move forward gold will be crushed but if we move backwards then gold will be exalted. If we go too far back then copper-coated lead in a brass casing might be a better investment.

      I guess one should diversify but I won’t dirty my hands with gold.

    2. hermanas

      Sorry fellas, I didn’t read down this far beore I went back above to note the next inflating bubble is gold or blood.

      1. F. Beard

        beore I went back above to note the next inflating bubble is gold or blood. hermanas

        “Bubbles, bubbles
        toil and troubles”

        It is really sad the human race has not yet figured out how to do money properly.

        Actually the solution is simple if not obvious:

        Let government money be legal tender for government debts only and let private monies only be good for private debts.

        1. traderjoe

          I agree with the idea of “competing” monies. I do not believe government, or any other private or public institution, should have a monopoly on money creation. The only check on power is competition and the availability of alternatives…

  10. Diogenes

    Yves, you quote William Buiter as saying:

    it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk.

    I need some help with the logic here.

    It seems to me probable (based on what I have read) that a very large portion of the non-Treasury (e.g., MBS) securities that the Fed has already purchased were acquired at prices well above “fair market value” (whatever they might have been). As a result, even if you ignore the risk of further price depreciation in a rising interest rate environment, it seems likely that it has been a foregone conclusion from day one that the Fed was going to end up taking a big loss on these “investments”.

    I take this to mean that if the Fed committed an inflationary act, it was the decision to overpay the banks with real (albeit freshly minted) cash to acquire these securities in the first place (rather than have the banks underwater assets written down by taking the banks through bankruptcy).

    Assuming a large number of the assets that the Fed currently holds and which it is likely still to acquire simply default, as I expect they will, how does printing cash to replace those defaulted securities have any impact on the economy unless the Fed then uses it to buy still more securities? And if they don’t print more money, other than from an accounting perspective, what are the real world implications of writing down the Fed’s balance sheet from $2.5 trillion to $1.0 trillion?

  11. jimmy james

    Recapitalization of the Fed is a red herring. The only reason it would ever need to be done is to save face, because FRNs are not redeemable for anything. The capital ratio could be 0.0% and it wouldn’t matter.

    1. traderjoe

      Agreed. How could the Treasury ‘bail out’ the Fed, since the only the Fed can create the FRN?

  12. JGould

    The Fed is creatively trying to get out of paying for 30+ years of constant price inflation. They don’t understand the economic maxim that there are no free lunches and you absolutely can’t get something for nothing. We are coming down the backside of the biggest credit bubble in history…it is time to take our medicine.

    1. Ed Seedhouse

      “They don’t understand the economic maxim that there are no free lunches and you absolutely can’t get something for nothing. ”

      Maxims aren’t necessarily true. This one is particularly bad, because it’s almost entirely wrong. All money is in fact created out of “nothing” as is all “wealth”.

      Physically, the standard model holds that actually “something” is being created out of “nothing” continuously, and is the cause of the “forces” that we feel in everyday life.

      Tell me, where do inches come from?

      1. JGould

        most money is lent into existence by banks, ergo a debt is created with the new “money”…these debts have consequences and in my humble opinion repudiation is the most capitalist alternative available

        “capitalism without failure is like Christianity without hell.”

  13. Eric L. Prentis

    Bernanke’s QE2 is shear insanity, fraught with countless negative consequences: 1) it will cause bad inflation i.e., on commodities, food and energy—when oil reaches $100 a barrel the US is back into a worse recession—with unemployment starting at 9.6%!—and will do nothing to stop deflation in real estate; 2) trying to inflate our way out of debt will cause our foreign lenders to cut us off; 3) the US dollar will crash causing a currency trade war; 4) the dollar carry trade will be terrible for the US economy because all this money goes overseas and not help here; 5) monetizing a country’s debt has never once worked in history, ever!; 6) trying to end quantitative easing is impossible, without causing a huge financial crash; and 7) the Fed has never done anything like this before and does not know what it is doing. The list of unknowable unintended consequences is perhaps, endless. Due to QE2, the Fed owns the next depression.

  14. Cedric Regula

    Buiter is the only one that seems to know what the Fed is doing to us. We need to quarantine the Fed and have it designated a National Insane Asylum. No one leaves. Since we will still need a central bank in a modern world, I suggest we go in halves with the ECB.

    Whether the Fed is curing liquidity or solvency crisis, that would be better understood if we would rename the buck to the “Mulligan”. You can exchange your toxic illiquid long term debt for Mulligans, if you belong to the club, of course.

    I guess I also need to explain to the idiots that when you do QE by printing money to buy long term debt, you have put massive amounts of money out there already by doing that. It’s not inflationary because it went to excess reserves, velocity dropped way down, money multiplier went way down, we are in a liquidity trap, or whatever is your favorite way of explaining that situation.

    The next problem is that you can’t get back all the liquidity whenever you may need to because of portfolio mark-to-market loss and any loss of principal due to defaults.

    The same does apply to commercial banks, so when the time comes that the Fed is worried about their balance sheet imploding due to rising inflation and/or interest rates, that will certainly happen to the banking system.

    And imagine what happens to market long term rates when the market realizes the Fed is either monetizing their balance sheet, or is faced with going to the treasury who is going to the market to borrow money???? In Mulligans? Much of it from foreigners or Wall Street? (whom certainly know a crook when they see one)

  15. Allen C

    As AEP states – “The overwhelming fact of the global currency system is that America needs a much weaker dollar to bring its economy back into kilter and avoid slow ruin.”

    So why all of the BS? The President and Treasury handled the last two devaluations (’30s and ’70s). Why should the Fed drive the next? They certainly aren’t fooling China.

    And when are we going to address the issue that ZIRP and devaluation is a transfer of money from savers to debtors? How many times do we have to repeat unfortunate history before we learn? Good Grief…

    1. Cedric Regula

      The dollar is not overvalued against the euro, yen, or any other developed country currency.(unless we continue to indiscriminately destroy it, of course)

      The Yuan is undervalued against everything else.

      So the way to solve that is different than massive devaluation against everything, which will no doubt result in sky high oil, and there is evidence that oil above $90 is a tipping point which increases recession risk in the US.

      Our policy makers are criminally negligent.

      That seemed like such a silly thing to type. Everyone knows that already.

      1. Allen C

        The US has run a persistent trade deficit for decades and has the largest, negative NIIP. The Euro is a mish mash of countries with differing financial characteristics. Japan has run a persistent trade surplus for decades and has a large, positive NIIP.

        1. Cedric Regula

          When Japan did run a surplus, the yen was 120/$. It’s closer to 80/$ now. The dollar doesn’t need to go lower than that against the yen.

          The euro is 1.40 again, post postponed crisis, and Germany is the major exporter. The population is $90M, and developed countries get to compete with porsche, bimmer, mercedes and VW pricing. Some of this gets built in US and Mexican factories. We can handle the pricing.

          I guess there are French airplanes, wine, and Italian cars and clothing. But I haven’t heard US manufacturers screaming about them either.

  16. Rodger Mitchell

    Most people want more U.S. exporting, because importing “takes American jobs.”

    Most people want less federal deficit spending because the federal deficits are “unsustainable” and “cause inflation.”

    What most people don’t understand is that exporting is functionally identical with deficit spending (Both add money to the U.S. economy. See: http://rodgermmitchell.wordpress.com/2010/10/15/do-you-know-what-you-want-deficits-vs-exports-vs-stronger-dollar-vs-inflation/) And no federal debt is unsustainable, because the government has the unlimited ability to pay any debts.

    So if you want more exporting and less deficit spending, you have economic bipolar disorder.

    Rodger Malcolm Mitchell

  17. PascalB

    1) They are trying to create wealth effects with their QE to boost stock market prices so that confidence returns.

    2) They want inflation for pricing power of firms and increasing inflation expectations to decrease the real wage, which would help in some segments of the labor market.

    3) The QE should also bomb the USD (absent global panic), which will be followed by equivalent monetary stimulus in the BRIC group, which will boost global demand, hence US exports, all else equal.

    The question is not wether all this is good – it’s not. The reality is that this seems to be the lesser of all potential evils…

  18. fjf

    If interest rates move higher, the Fed’s interest outlays on these reserve could rise too.
    . . .
    Big losses wouldn’t be the same catastrophe for the Fed that they are for commercial banks. That’s because unlike commercial banks, the Fed can print its own money.
    Future Scenario: Interest rates rise and so the Fed prints more money and/or sells its holdings at a loss to suppress rates. It seems that the Fed is then trapped in that its only recourse is to print which in turn stokes inflationary fears and hence rising interest rates. This only exacerbates the underlying problem and the outcome is uncontrolled hyper-inflation as the Fed’s only policy response is between printing or destroying its own balance sheet.
    What am I missing here?

    1. Cedric Regula

      It will happen to the banking system first for the same reasons, and the Fed will print to save the banks and its own balance sheet.

      So we will get a credit collapse in parallel with wild Fed money printing. What fun. We can only imagine how the rest of the details will work out.

  19. Hugh

    The Fed is populated by idiots. It’s like watching a house on fire. Most of us would want to get as much water on it as fast as we could. The response of the people at the Fed would be to expand the water works. Even if you could expand the water supply to infinity and do it in a timely fashion, it doesn’t mean a thing if it doesn’t go where it’s needed.

    Perhaps the prime reason we are so screwed and depression is all but inevitable is that when we look to the policymakers who might avert the coming disaster there is no one to be seen but fools, liars, and thieves.

  20. halbhh

    “…should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk….”

    Off the top of my head, this idea seems immediately wrong.

    If their is a lot of defaulting, it will be in a situation of deep economic weakness, in which inflation will hardly be strong to begin with.

    2nd, as the Fed wishes to withdraw excess money from the economy (by selling Treasuries), it can do so to whatever extent it wishes, and can even innovate as needed, etc., etc.

    In other words, the idea that Fed nominal losses on paper would lead is inflation isn’t mathematically realistic.

      1. halbhh

        yeah, it’s a possibility. Of course it won’t be due to fed paper losses, but rather to the purchases years before. In the case of large paper losses at the Fed, inflation will be lower than in the case of no or small losses, of course.

  21. gerold k.b. weber

    Marriner Eccles (as quoted in Robert Reich’s ‘Aftershock’):
    ‘A mass production has to be accompagnied by mass consumption, mass consumption, in turn, implies a distribution of wealth – not of existing wealth, but of wealth as it is currently produced – to provide men with buying power equal to the amount of good and services offered by the nation’s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-1930 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.’

    Suggestion: If the Fed believes it must ease a bit, Mr. Bernanke should start his helicopter and distribute an equal dollar amount to every American, large enough to close the output gap and achieve his target inflation rate. Hence Eccles’ trickle-up poker game could go ahead for some time, and we might get a fair solution with a lot of bang for the buck.

    In another world, Ben could convince Obama to design a fiscal stimulation program with that effect.

    1. nanute

      I basically made this same argument yesterday in the comments. Not as explicit, but the same idea. Bypassing the financial sector and going directly to the depressed, unemployed and employed workers with a cash infusion might, I stress might, create enough demand to warrant new investment and hiring by the private sector. All the money spent to date, with the exception of a small portion of the stimulus, was targeted towards those that already have a too large share of the money/wealth. I suspect that the major financial institutions are irreparably damaged, and continuing down the road of trying to save them is compounding the problem. The sooner one cuts their losses the quicker recovery can take place. I’m not advocating for a “let them fail” approach. It’s time to put the big boys in receivership, sell off the “assets” and make the creditors pay for their bad investments.

    2. halbhh

      Excellent quote. Reich has been stellar at clearly drawing the picture of our broad economic situation. Too bad he isn’t as ubiquitous as David Brooks. He’d make a great replacement for Brooks on PBS, etc.

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