What Would You Do?

Here’s a post that was inspired by an excellent article on the Federal Reserve by Eric Parnell, published Friday on Seeking Alpha. And in particular, a question that was asked in comments that followed the article. The questioner suggested that we shouldn’t be too fast to criticize Ben Bernanke and asked: “What would you do?” To be fair, he also agreed with Bernanke’s critics, but “What would you do?” still hung out there seeking an answer.

I’ll begin my answer with some thoughts on the latest QE and the Fed’s belief in the portfolio balance channel – their jargon for buying so much of a few assets that you push up the price of every asset. If you’re anything like me, your instinctive word association for portfolio balance channel is hypocrisy. It wasn’t long ago that the Fed wanted us to understand that it wasn’t their role to manipulate asset prices. And market bubbles? Nothing they can do, not their job. Fast forward to today and the stated policy is to manipulate asset prices. I expect flip-flops like this from politicians, but not central bankers and esteemed academics.

Now there are many issues raised by the Fed’s new approach, including the economic influence that’s been concentrated in a single unelected official (as discussed by Parnell) and the wisdom of the decision to socialize our nation’s capital markets. But the sheer hypocrisy suggests that we should look at the incentives and psychology that may be involved. (Okay, I never need a reason to look at incentives and psychology other than the fact that they explain all decisions, but this is a prime example.)

As for the flip-flop, it’s easy to find a logical explanation. The banks want QE. Influential political and economic leaders want QE. Therefore, the path of least resistance is to give them QE. On the other hand, market manipulation to prick the Internet and housing bubbles would have been widely unpopular. Therefore, policymakers rejected the idea that they should manipulate markets and prick bubbles. No one likes to be unpopular.

More generally, QE seems to me to be explained by Bernanke (and his colleagues) being unable to sit still. This is natural behavior when you have to continually justify decisions. It’s not easy to explain to Congress, the media or public why you’re doing nothing but waiting for past policies to work. It won’t be long before people portray you as weak and indecisive and tell you to “Get to work, Mr. Chairman.” But once you start implementing new policies, especially if they’re in a direction that’s expedient for everyone in the short-term, then those criticisms go away. They’re replaced by adjectives like bold and proactive. And who doesn’t want to be known as bold and proactive?

But wait, you may say, QE is part of a blueprint that Bernanke developed long before accepting the chairmanship. After all, he came into his post with a reputation as one of our foremost experts on deflationary busts. And yes, he’s applying the methods he studied. But we’re no longer in the type of environment that motivated his studies. Recent inflation rates are roughly the same as the average inflation of the past ten or twenty years. They certainly don’t suggest a deflationary bust. In other words, the playbook today is virtually the same one that Bernanke drafted while studying the Great Depression and other deflations, but since prices aren’t falling he simply scribbled out “Stopping Deflation” from the front cover. Once again, this leads me to view current policies as an inability to sit still. To use a variation on a popular saying: If you hire a man who designed a hammer, then everything looks like a nail.

Turning back the clock

Now that you know my perspective, I’ll get back to the question: “What would you do?” The main reason for my post is to argue that we wouldn’t do too badly to reconstruct the FOMC of thirty years ago. Not to bring back monetary targeting, which didn’t work especially well, but because Chairman Volcker managed one particular accomplishment that’s mostly forgotten. We remember that he crushed inflation, and he deserves a boatload of credit for that. But his behind-the-scenes work to reign in the deficit was almost as important. Government debt threatened to spiral out of control in the early Reagan years, just as it is once again today. And Volcker was instrumental in browbeating Congress and the Administration to correct their fiscal errors. He essentially told the key players (while publicly denying it): No deficit reduction, no changes in monetary policy.

Consider these accounts from William Greider’s Secrets of the Temple, which is arguably the most thoroughly researched history of Volcker’s Fed:

Reagan’s OMB Director David Stockman: “Volcker was telling everyone, ‘If you give us some relief on the deficits, it will take some pressure off … Our hands are tied unless you give us some relief on the fiscal side.”

Influential Congressman and Reagan tax cut champion Jack Kemp: “Monetary policy is deliberately being kept unnecessarily tight and the economic expansion held hostage to a tax increase … Mr. Volcker would offer a quid pro quo of monetary ease and lower interest rates in return for a fiscal policy of higher taxes which is more to his liking.”

It seems quaint today to think that we had a Fed Chairman who turned the tables and put the government on the defensive for its financial irresponsibility. But that’s exactly what we need. Our biggest problem these days isn’t the sluggish economy that Bernanke’s fighting with every half-baked tactic the Fed’s economic machinery can produce. Our biggest problem is the debt. We have no choice but to live with the sluggish economy – it’s a natural outcome of the boom/bust in the private credit markets. On the other hand, there’s still time to fix the debt. But if it isn’t fixed, then we’re headed for something much worse than 2008/09. And it won’t be fixed as long as the Fed’s extreme stimulus continues.

In today’s political calculus – which is a long way from the old days when fiscal discipline was rule #1 – deficits don’t matter anymore as long as they can be funded for a pittance. And Fed policies are intended to reduce funding costs to exactly that – a pittance. Therefore, there’s no incentive for politicians to take serious action on the debt. Kyle Bass said it clearly recently, noting that when he challenges congressional leaders on their poor fiscal habits, they tell him to look at the 10 year.

In other words, the Fed’s asleep at the wheel for the second time in a decade. Bernanke doesn’t recognize that our soaring government debt is setting us up for the next bust, just as he didn’t see the dangers in the private credit boom. Nor does he recognize that the Fed’s policies are a major part of the problem, just as the Fed actively abetted the private credit boom. As Yogi Berra would say: it’s déjà vu all over again.

Identifying the next crisis

So, “what would I do?” Borrowing Jeremy Grantham’s description of current Fed policy, I’d stop “beating a donkey (a 1% growing economy) for not being a horse (a 3% growing economy).” The clean-up from the last crisis should have been the main priority four years ago and possibly for another year or so thereafter. But it’s time to think about the next crisis, which won’t be a replica of the last one. It’ll be based on the next set of imbalances, and our unsustainable fiscal position is fast becoming the largest one.

Unfortunately, the Fed’s current leadership isn’t likely to spot the next potential crisis. For all Bernanke’s expertise on deflationary busts, it’s obviously concentrated on the clean-up, not recognizing the environment that precedes a bust. And there’s nothing to suggest that he’ll act to forestall a potential government debt crisis. But thirty years ago, we had a Fed Chairman who did exactly that. On the argument that central bankers should be judged by what happens long after they’ve left office, Volcker stands out for his willingness to trade off a painful recession in 1981-82 for 25 years of Great Moderation. We should bring back Volcker (or a surrogate who thinks the same way) and add the Fed’s voice and leverage to the push for fiscal reform.

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