As we’ve discussed before at the BC, the housing bubble (which triggered the overall financial crisis) was caused by decades of government policies directed at increasing the rate of home ownership. These policies - pursued with gusto by both Republicans and Democrats [Ed.: isn’t bipartisan good? Not when it’s bipartisan stupidity] - had the effect of greatly loosening lending standards. IOW: government encouraged, and then abetted, then forced, easy mortgage money.
I won’t retell the whole story here on what happened next, but wide swaths of the credit market just about shut down. Interbank lending, commercial paper, commercial lending, real estate lending, corporate bond market, municipal bond market, credit derivatives, everything - everything, that is, except for United States Treasuries, backed by the full faith and credit (i.e. the taxing authority) of the Federal Government.
This shutdown of the short-term credit market was the real financial crisis, the true danger to the economy. Short-term credit is the blood supply of the economy. Blood cells are not the “coolest” cells in the body - everyone swoons over the smooth muscle cells and (of course) the sperm and ova. But you can live without muscle, sperm, and ova; you can’t live without blood. The same thing is true of short-term debt and the US economy: no debt, no economy.
So something had to be done. Problem is, like all panics, it was far from clear at the time what had happened, why, and what to do about it. But one thing was certain: we needed to get debt flowing again.
Into the breach stepped the Federal Reserve Bank. It injected staggering quantities of liquidity into the system in an attempt to restart lending. The patient was bleeding (to continue the analogy), and while we didn’t know where the wound was, we knew that blood pressure was dropping and unless we started giving him lots of blood his body would begin to shut down.
The Fed set up, on the fly, huge new programs to absorb illiquid assets into its balance sheet. It bought residential mortgages (prime and subprime), commercial paper, and money market assets, lent money to banks, non-bank financial companies, and even non-financial companies, all in an attempt to bring the short-term credit markets back to life by giving banks liquidity secured by just about any asset. Treasury “helped” by putting capital into banks, and the FDIC helped by raising insurance limits; but the heavy lifting was done by the Fed. Its balance sheet ballooned to over $2T in a matter of weeks, and it held its breath.
Slowly, the system started to work again. Banks started lending to each other; commercial paper markets reopened; mortgages started being underwritten again (although with much tighter standards); etc. We’ve gradually been seeing money come back into the market. The thaw is real.
Essentially, the Fed went “all-in” with liquidity. It was a huge gamble, but it looks like it is paying off. In fact, some of these Fed programs are beginning to shrink - total Fed assets actually fell by $130B in April, and more than $60B of that was a drop in commercial paper alone.
Now, however, the initial game - restart short-term credit markets - is evolving into a new game: keep Treasury rates low during the next year so that the ARM resets don’t bring the system back to its knees. This is a big reason, IMHO, why the Fed has jumped into the long-bond market; it has pushed short rates as far as the can go, so it needs to push long rates down to keep the overall yield curve low and affordable for ARM resetters.
This is a much bigger gamble, and it’s too early to tell if it will pay off.
In summary, as we’ve discussed before, the Fed, with the tight OODA loop of monetary policy, stepped in to try to fix the immediate problem.
But fiscal policy is another matter. The Obama Administration, almost from the moment it occupied the White House, set about increasing government spending in an attempt to “stimulate” the economy. But fiscal policy is much different than monetary policy.
A lot of folks might think, “Well, the Fed injected $1.2T into the economy, and President+Congress injected $800B, so the Fed is a bigger stimulator.” But this misses a key difference. The Fed, when it lends to banks and takes collateral, does not really “inject” anything into the economy. It simply swaps one asset (say, a mortgage) for another asset (cash). The “stimulative” effect only comes when the bank finds someone who will borrow the cash (which, in turn, is usually secured by assets).
The Fed’s actions are also, therefore, easy to reverse. Right now, banks are happy to borrow at 0% against illiquid (but paying) mortgages. They can turn around and lend out at 5% or more, and make good money. But if the Fed raises the interest rate it charges, say to 4%, the banks will pay off those loans, and most of that liquidity will get sucked back out of the economy. And it will happen fast (although hopefully not as fast as it was added).
Fiscal policy, on the other hand, is a transfer of money (not an exchange of assets) from one group to another. The government collects taxes (or prints money) and spends it. Once the spending commitment is made, it’s almost impossible to reverse. It also takes a lot longer to have an impact; as an example, the vast majority of “stimulus” funds will not be spent this year. IOW: big, slow OODA loop.
—
So what’s coming? A showdown between Congress and the Fed.
The Fed is an independent entity. It is a network of 12 Regional Federal Reserve banks. The Presidents of these Regional Fed banks are chosen by an independent board of directors. Each Regional Fed bank is owned by member banks, but the board is controlled by non-bankers (6 non-bankers, 3 bankers).
This means that the control of the Fed banks is in the hands of private citizens, and not Congress. Each President works for their respective board, which hires and fires them.
Some folks complain about this arrangement, but it has saved our bacon, IMHO. This independence has allowed the Fed to act without having to go to Congress or the White House for permission. This keeps its OODA loop tight, and helps shelter it from partisan political fights. Its independence has also allowed the US dollar to be the world’s reserve currency.
But here’s things get sticky. The Obama Administration is proposing the most dramatic expansion of Federal spending in history. Trillions of dollars will be added to the Federal Debt during the next 3-4 years, and if they pass healthcare reform, it will get even worse. In addition, by increasing marginal tax rates, economic growth will slow, and growth is the only way we can eventually pay off the debt we have accumulated.
So here’s the scenario. In the next 12 months we will see all of these factors come together:
1. Dramatic expansion of government spending.
2. Falling tax receipts due to recession and increased marginal tax rates.
3. A projected $10T increase in Federal Debt.
4. Continued unsustainable structural deficit from entitlement programs.
5. Stabilized of financial markets.
6. More “green shoots” of growth creating early signs of inflation.
All of these factors will lead the Fed to conclude that interest rates must be increased, to drain excess liquidity out of the financial system. Unless rates get raised, there will be huge inflationary pressure. The party will be starting, and it will be time to take away the punchbowl.
However, there is one more fact that will come into play:
7. Unemployment will still be high.
This means that Congress and the President will NOT want interest rates to increase, lest the young “recovery” be hurt.
The result will be a showdown, and it will determine whether the dollar will continue to be the world’s reserve currency, and the US the largest financial services provider in the world.
In the coming weeks, you will start to see calls for Congressional influence or approval of the Fed Presidents. To set this up, there will be an increasing drumbeat from folks like Frank and Dodd as well as the Obama Administration (yes, Insty, the country’s in the best of hands) railing against the Fed, and blaming them for every little hiccup or setback, while taking credit for anything good. This will all be part of an effort to undermine the Fed, and position it for a Congressional takeover.
And when the takeover attempt is made, that will be the moment of truth, the time at which we will determine whether the housing bubble bursting will trigger just a really nasty recession, or the next Great Depression.
If Congress gets control of the Fed, the game will be over. Everyone in the world will know that the US is going to inflate its way out of its problems so that it doesn’t have to confront its lack of fiscal discipline. Bond prices will plummet, the dollar will collapse, and the economy will go back into the ICU. Inflation will punish the working man, while the investor class will be fine (inflation can be a good thing for equities and real estate).
If the Fed maintains its independence, interest rates will rise and Democrats will have to face the music and give up on most of their expansionist dreams. If they continue to spend, rates will continue to rise and we’ll get stagflation just in time for the 2010 elections. And they’ll get hammered, just like in 1980.
So Congress can tax and spend responsibly, or they can take over the Fed. Guess which they’d prefer.
From such a crisis of a nation comes the test of a generation.
I have to say that I have a difficult time finding a hole I can poke in Mr. Linbeck’s facts or logic. Therefore, I think his prediction of the coming conflict is totally foreseeable. At this point, I think that the Congress and President would lose such a showdown. However, I thought that the country would never elect a president as liberal as Barack Obama, so what do I know?
I’d be interested to hear anyone else’s take on this.
