“The Fed Does What Washington Dares Not”

Sydney M. Williams

Thought of the Day

“The Fed Does What Washington Dares Not”

September 17, 2012

To avoid being seen as partisan, the Federal Reserve traditionally has taken no decisive action in the last several weeks of a Presidential election. Mr. Bernanke tossed custom aside when, on Thursday, he pushed through what the Financial Times termed “a stunningly aggressive set of measures.” The Fed said they will be purchasing $40 billion of mortgage securities a month. The plan is open-ended, with the focus on jobs rather than controlling inflation. The reason that the Fed has had to go on the offense is because the President and Congress have failed in their responsibility to enact a pro-growth fiscal policy.

Even the New York Times acknowledges that the new stimulus “reflects the disappointing condition of the American economy.” Later in the article, and in keeping with their bias, they quote the master of blunt partisanship, Senator Chuck Schumer: “The Fed is fulfilling its obligation to take action to address unemployment. Now Congressional Republicans need to fulfill theirs.” There was no mention that during 2009 & 2010 Democrats controlled both Houses of Congress and the White House – yet did nothing for the economy. There was no mention that the President’s 2012 budget, back in May, was defeated 414 – 0 in the Republican dominated House and failed in the Democratic controlled Senate 99 – 0. Does Mr. Schumer think the electorate stupid? What has the President done to aid a flailing economy? And, while fiscal matters are the domain of Congress not the President, is it not the responsibility of the executive to propose legislation? Isn’t the President supposed to lead? While Mr. Obama is quick to pass on blame onto others, he is equally agile at accepting credit when it comes his way, as we saw with the killing of Osama bin Laden.

These questions are critical, for they show an absence of leadership and a failure to assume responsibility. (Mr. Truman’s sign, “The Buck Stops Here,” must have been removed.) We have an economy that has seen average incomes decline over four years and a net job loss over the same time. The federal deficit now exceeds $16 trillion. Unemployment consistently has been above 8% for forty-two months, the longest stretch since the Great Depression. U.S. employment, as a percent of the population, at 45% is the lowest in thirty years. Median household income, according to the U.S. Census, has fallen for four years in a row. The President and his surrogates brag about the number of jobs created since he has been President, but he doesn’t say anything about the number of jobs lost, nor does he explain that 1.5 million people enter the workforce each year, so must be absorbed. The stated unemployment is as low as it is because millions of people have given up the search for jobs. That is why workforce participation rates are more important in understanding what a desperately poor job this President has done in terms of employment and the economy. And, it explains why the Fed has been the only game in town.

The New York Times on Saturday suggested that the fault lies with Republicans for failing to support stimulative programs, hiring teachers, rebuilding schools and otherwise creating jobs. The Times apparently doesn’t understand that it is only the private sector, through the taxes they pay, that can build schools and provide for additional teachers. With no sense of irony, an editorial in the same paper suggested that one of the benefits of low interest rates is that they encourage stock investments – and “from there [to] consumer spending.” That’s a form of trickle down economics that not even Republicans could recommend.

There is only one way out of the maze in which we find ourselves, and that is more rapid economic growth, which is difficult given some of the secular changes to our economy, but which only the private sector can provide. Government can provide a safety net, but it is not an engine for growth. The Federal Reserve has attempted to encourage growth, but they cannot do it alone. QE1, which began on November 25, 2008, was necessary in my opinion to stave off what could have been a cataclysmic credit collapse. It worked. By the time Mr. Obama took the oath of President, the effects were being felt. The TED spread, for example, had declined 300 basis points. The benefits of QE2 and Operation Twist are less clear cut. One can argue that they helped the housing market, but they also caused asset prices, like food and energy and financial assets, to increase, which helped the wealthy at the expense of the poor. Of course, they also had the negative consequence of greatly reducing the income of seniors living on fixed income securities and annuities.

The decision by the Fed to go with QE3 is likely to generate more speculation in commodity prices and may help housing by keeping mortgage rates low, but it will do little to encourage banks to increase lending and, of course, does nothing to prevent the fiscal cliff facing us at the end of this calendar year. Businesses, faced with uncertainty, are unlikely to increase hiring. Additionally, the Fed’s decision increases the difficulties of an eventual unwind. Over the past four years, the Fed’s balance sheet has increased three-fold, from $800 billion to about $2.5 trillion. With freshly printed dollars the Fed has been buying Treasuries and mortgage securities, with most of the interest they receive being rebated back to the Treasury. The effect is two fold. First, the annual deficit is understated because it does not include most of the interest costs on bonds bought by the Fed, and second, interests rates are lower than they would have been had markets been acting freely, as the Fed has been the single largest buyer of Treasuries. With QE3, that trend will persist. Price fixing, whether it is on cabbages, gold or interest rates has never been a panacea.

Mr. Bernanke is counting on two things happening – one, that the economy picks up strongly with little or no inflation, and second that his eventual unwinding of the portfolio will not cause interest rates to spike so rapidly that they kill the recovery he hopes to engineer. It is a risky strategy, and one taken solely because the Administration and Congress have ignored their responsibility. If it does not work, expect the Dollar to depreciate substantially and inflation to become a major concern. In any event, the Dollar will likely continue to weaken and food and energy inflation will probably continue to rise.

We do not have a liquidity problem. Banks have excess reserves estimated to be $1.5 trillion. Corporations have approximately $2 trillion on their balance sheets. What we have is an absence of confidence. Ideally, at a time of unusually low interest rates, borrowers try to extend maturities. A handful of companies have sold 100-year bonds. In April, the University of Pennsylvania sold $300 million of 100-year bonds with a yield of 4.7%. The UK has been toying with same idea. But the U.S. cannot do so, because the Fed, in its commitment to keep long rates low, has been buying almost all the Treasury’s thirty-year issuance, along with mortgage securities. There are no other buyers at current yields. In fact, the Fed has been funding the Obama Administration’s spending which has proved so ineffectual in terms of economic results. We have backed ourselves into a very risky position.

The only way out of this maze is through dramatically reforming fiscal policy, so that it encourages investment, and convinces businesses that government is there to help, not hinder, growth. Government can provide guidance and act as a referee. It is when they act as a participant that they do harm. The first steps should be to streamline regulation, simplify the tax code, encourage more free trade agreements and return government programs to zero-based budgeting.

The tax code should be simplified and flattened. The President should propose, and Congress should implement on a graduated basis, eliminating all significant deductions and credits. The federal income tax should be broadened, so that every worker pays some amount, no matter how small. Such action would lessen dependency by causing every working American to have a stake in his or her government. Higher tax revenues will be a consequence of the simplification. Higher tax rates alone will not, as history has shown time and again, yield higher revenues.

Regulation has become too big a constraint on entrepreneurs. It has discouraged start-ups and hiring. For example, instead of thousands of pages of bank regulation, it would be far simpler to simply to require banks to reduce leverage based on asset size (including off balance sheet items.) The bigger the bank, the less leverage they should be able to deploy. The “too big to fail” risk has risen exponentially in the last four years. We could not afford another 2008, yet the prospect of such an event lingers. Voters, politicians and regulators should understand that, in a competitive environment, complexity is a friend of the wealthy individual and the large corporation. Simplicity is friend to the small and less wealthy.

Trade should be encouraged. Debasing the Dollar, as the Fed’s actions will ultimately do, raises the risk of a return to the “beggar thy neighbor” policies of the Depression. Both Mr. Romney and Mr. Obama’s attacks on China do not help. To the extent they provoke a trade war with China, they put at risk thousand of U.S. workers who are employed either on the design phase of many Chinese manufactured products, or in their distribution. Additionally, a reduction in Chinese imports will cause an unnecessary rise in consumer prices for millions of Americans.

Virtually all budgeting in Washington (and in State Capitals) today assumes that the “baseline” is automatically approved, and it is only the increase that is subject to being cut or increased. The practice, in my opinion, is highly deceptive. A return to zero-based budgeting should be required of all government departments.

While the likelihood of events unfolding as I would like them is slim to nil, any directional shift toward these ends would be welcome. The effect would be to raise the level of confidence. The biggest hurdle for the economy is that neither consumers nor business trust the future. Providing a sense that government is on the side of economic growth, and that simplified rules and regulation will have some level of permanence, will allow businesses to invest, not only in infrastructure but in people. And it would provide individuals the confidence to invest for the future. The Fed cannot accomplish this alone, as recent history suggests. Investor’s should not be fooled by rising financial markets as a forecast of economic events. Markets are simply responding to the Fed’s encouraging the purchase of riskier assets. Success will be seen in employment and economic numbers. Thus far those numbers portend a bleak future. An expanding economy will produce the revenues politicians are seeking. But it is only the private sector that can lead us out of the darkness.