Ben Bernanke began his press conference with a touching tribute to the unemployed. Oh, how he cares! And so deeply! His description of the problem was accurate enough. But then out came the smoke and mirrors.
Bernanke said that to remedy the unemployment problem, he will continue the Fed’s program of asset purchases. Specifically, the Fed will continue to buy and hold mortgage-backed securities (yes, they are still sloshing around the banking system) and Treasury securities — $40 billion-plus per month. Plus, he will keep the federal funds rates at near zero.
The great change, he said, is the intense focus on the policy objective of unemployment. The committee sees no inflation threat, so it might as well turn its attention to the labor markets. The Fed loves the unemployed, you see, and wants to help them.
But here’s the disconnect. What the devil does buying bad debt from zombie banks have to do with getting people jobs? The relationship between assets purchases and policy goals is murky at best.
“I need a job, so I hope the Fed buys more bad mortgage debt” — said no unemployed person ever.
Yes, I know about ancient Keynesian theories. There is tradeoff between unemployment and inflation. But those theories have not really explained much at all for the last 40 years. In fact, they blew up in the 1970s with the emergence of “stagflation.” An affliction where unemployment remains high even as inflation roars ahead.
You might be able to explain Bernanke’s outlook through the normal intuition. Low rates spur growth. Growth leads to new businesses. New businesses hire new people. Problem solved.
But the problem here is that the last five years have provided scant evidence that low and even zero interest rates have actually spurred economic growth. You can point to some measure of improvement in the data. But the cause-and-effect relationship between higher growth rates to zero interest rate policy is… less than persuasive.
And here is where we get to what has long bugged me and others about the Fed’s policies since 2008. These guys are not idiots. They read the same economic reports we do. The history is surely somewhat as plain to them as it is to us. The policy is not working as it should. Bernanke has conceded as much.
Why, then, does the Fed persist in this policy?
This is where you need to look beneath the surface to find the answer. What is the purpose of the central bank? Looking back historically, the central bank has served one primary purpose and one second purpose that is the source of its power. It is there to keep the banking industry solvent, providing liquidity when necessary and papering over the errors that are revealed in the course of economic crises. And secondarily, it is there to provide a market for government debt when governments get in trouble.
There is a quid pro quo here. Governments are willing to back the banking cartel with legal status provided the banking cartel serves government when it is needed. Government is more willing to enter into such a deal with banks, rather than the salt or shoe industry, because, well, banks are where the money is. Government needs that stuff because they typically want more money than taxpayers are willing to cough up.
That’s all you need to know to understand why the Fed is willing to create some $85 billion each month to buy more mortgage-backed securities and more Treasury debt.
The banking industry is still holding the stinking bag of you-know-what that was first exposed in 2007. The mess is still there. The banks are in continuing need of shoring up their balance sheets. Offloading bad assets on the Fed and writing them off the books is the best path from here to there. That the Fed is still doing this after all these years provides us an indication of just how bad the crisis really was and just how vulnerable the banking system was and is to finding itself completely insolvent.
As for the government’s needs right now, say no more. Our rulers have created a horrible mess of astronomical and unpayable debt, and even rating agencies are taking note. There is the fiscal cliff. There are the unfunded liabilities. There is the unsustainable empire. There is the utter impossibility of a rational political solution to this problem. Thus does the Fed come to the rescue, guaranteeing a market for government debt and helping its friends in the bond-selling business at the same time.
Now let’s consider the effects. Zero interest rates policies amount to a complete perversion of market signalling. The effect on savers like you and me has been disastrous. Average people in the past depended on the banking system to park their money for eons, but now only chumps do that.
But there is another angle here too. The banks can no longer rely on loan markets to be the main source of their profitability. Since 2008, the main activity of the industry has completely changed in response to zero interest rate policies. In what we might describe as a “lending cliff” the commercial banking sector has slowed lending, dramatically at first, and then crawling backing more recently and seeming to plateau at a much lower rate of expansion than the historical average.
This represents a change in the way banks work and the way money has traditionally been created in a fractional-reserve lending system. Picking up the slack have been nonbank lending institutions, which are in a boom stage of development right now. The lending standards in the nonbank sector, stung by 2008, are more strict than in traditional banking. They maintain a level of soundness that banks never have. And they sure as heck don’t go along with the zero interest policy, as you well know if you have taken out a loan from a nonbank source in recent years.
The banks themselves have always been the creative engine of new paper money to flood the system. If banks are creeping away from loans markets, effectively outsourcing them to the nonbank sector, this trigger mechanism is no longer in place. This is why there is a gigantic disconnect between Bernanke’s claim to have a “highly accommodative” policy stance and the monetary reality on the ground.
Close observers have noted this trend for many years. The Fed doesn’t seem to have the level of direct control over money creation that it once had. Here is a chart of “Money of Zero Maturity” that chronicles percentage change from a year ago.
Most notable is that you see a dramatic rise in the early part of the 2008 crisis and then a precipitous fall once the crisis was in full swing. Pumping efforts showed some promise in 2009 but faltered. The subsequent plunge continued through 2010, the very time frame in which the Fed claimed to be pulling out all the stops to flood the economy with money.
What’s up with this? If the Fed is creating massive amounts of money, why are we not seeing it appear very dramatically in money aggregates, and why isn’t this feeding the markets in the conventional way?
To ask the question a different way, even if price inflation is higher than the government admits, why have we not yet seen signs of Weimar Germany or Zimbabwe? The clue comes from looking at the reserve balances at Federal Reserve banks themselves, where the commercial banking sector is actually parking its new-found fake wealth.
They are doing this because the Fed has made it possible for the banks to earn interest from their deposits. Leaving money in the vaults make a lot more sense than trying to navigate Dodd-Frank regulations and risk violating Basel III capital requirements.
Putting all of this together, we can see that what Bernanke has done is fundamentally change the function of banks and the role of the Federal Reserve. In seeking to save the banks, he has essentially nationalized them, disabling their lending function relative to the past and turning the Fed from being a clearinghouse to being a gigantic holding tank for newly created money, the purpose of which is to pretty up the balance sheets and shore up confidence in a bankrupt system. This is why he can stand up there at press conferences and so confidently claim that inflation represents no great threat right now.
To be sure, Bernanke’s policies are not harmless. They represent a massive distribution of wealth from the productive sector to the banking system and the financial sector, solely for the purpose of keeping the Fed’s clients solvent.
Another danger comes from the many creative ways that banks have learned to make money in the age of Bernanke by playing recklessly in the derivatives market, holding on to infinitely guaranteed demand deposits, and manipulating every marginal opportunity for speculative trading that comes along.
This could be the banking bomb that will blow up in the years to come. But this explosion is going to take a new and unpredictable form from any that has come before. A bubble pops first at the weakest part of the balloon. Where that is precisely is known through experience.
The end of banking as we’ve known it is probably good news, and, in bringing this about, Bernanke has probably done the world a favor. Finding the right path forward is the great challenge that every holder of dollars will face in the years ahead.
Sincerely,
Jeffrey Tucker
