Want to Fix the Fed? Get Rid of It

Inquiring minds have been pondering Volcker's latest statements regarding stagflation, the CPI, regulation of banks, and even the need for an administrator to watch over the Fed.

Let's see where Volcker is right and wrong with his analysis of the current economic situation and what to do about it.

The US economy is not now in the kind of stagflation crisis it had been in, in the late 1970s, former Federal Reserve Board Chairman Paul Volcker told Congress today, but it's not impossible.

'I think there is some resemblance now to inflation in the early 1970s,' he warned the Joint Economic Committee. The economy obviously does not have the full-blown, double-digit inflation crisis that finally appeared, but he said, 'there is an underlying tendency to inflation.'

Volcker also told the committee that the Consumer Price Index may understate the actual rate of inflation. For example, during the real estate boom, the housing component of the CPI rose only slightly. And to consumers, 'when food and energy are running high, not for a couple of months and dropping, but running high for years, it doesn't sound quite right, it doesn't feel quite right.'

My Comment: As for not believing the CPI, virtually no one does. Inquiring minds may wish to consider CPI Numbers For April: Spotlight On Energy fora look at the latest numbers. Furthermore, as Volcker points out, housing was dramatically understated for years. Housing is overstated now. However, Volcker fails to go far enough with this line of thinking.

Other Problems Inherent With The CPI

The CPI cannot measure stock prices or prices falling because of rising productivity. Peak oil is a factor. So is worldwide demand. It's debatable that prices can even be accurately measured or that there is any such thing as a representative basket of goods and services to measure. Most importantly: the CPI is useless in measuring the magnitude of credit bubbles that manifest themselves in other ways besides prices. Finally, the CPI is a lagging indicator.

The final analysis shows that anyone who believes the CPI is (or is even supposed to be) a measure of inflation is making a huge mistake. The solution is to start with a sound definition of inflation and deflation: Inflation is a net increase in money supply and credit. Deflation is the opposite.

Inquiring minds that have not yet done so may wish to read Inflation: What the heck is it? for further discussion.

Volcker did not forecast a recession, rather he talked about a necessary rebalancing of an economy that depended too much on consumption financed with borrowing. 'Somehow that has to change,' he said. 'It's a kind of a rough ride but we have to have it happen to avoid more severe consequences.' And in fact, consumption is declining and exports rising, 'laying the basis for a sustained recovery.'

My Comment: There is clearly a need for rebalancing. However, there is no basis whatsoever for believing a sustained recovery is possible any time soon. The recession is barely a few months old, and some do not even think it has started yet.

More to the point: The jobs picture is miserable, banks are horrendously undercapitalized, and foreclosures are mounting. A Flood of Foreclosures Prove Loan Modification Isn't Working. Bank failures are coming.

In his analysis of the credit crisis, Volcker said the mathematical modelling and financial engineering behind the structured investment products involved are inherently incapable of accounting for the human element of market behaviour.

My Comment: That's easy to agree with. Some of the housing and structured credit models are completely absurd, especially at the rating agencies.

And, having necessitated Fed intervention to rescue the markets and economy as a result, the investment banks which used the financial innovations now need to face the same kind of regulation as commercial banks.

'I believe there is no escape from the conclusion that, faced with the kind of recurrent strains and pressures typical of free financial markets, the new system has failed the test of maintaining reasonable stability and fluidity,' Volcker said.

My Comment: The problem is not lack of regulation. The problem is the Fed itself is distorting the free market. Eliminate the Fed, eliminate fractional reserve lending, and eliminate borrowing money into existence and none of this would have happened, at least to any significant degree.

Asked about the Fed's arranged merger of Bear Stearns by JP Morgan Chase, he said 'I can understand' why the Fed felt it had to act as it did. The more important question, though, is whether better regulation and supervision could have prevented the collapse in the first place.

My Comment: The important question is when do we get rid of the Fed? But first we need people to see that the Fed (and fractional reserve lending) are indeed the big problems.

Faced with the threat of a cascading breakdown of financial markets, the Federal Reserve felt compelled to extend its safety net with long-dormant emergency powers.

'The natural corollary,' to that Volcker said, is that systemically important investment banking institutions should be regulated and supervised along at least the basic lines appropriate for commercial banks they resemble in key respects.'

My Comment: Speaking of corollaries, please consider the Fed Uncertainty Principle corollary #3:

The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab.

Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

By its intervention in the mortgage and other credit markets, the Fed may imply official support for a particular sector of the economy. 'The creators of the Federal Reserve could be rolling over in their graves knowing the Fed is buying mortgages,' he said.

The intervention, in turn raises potential questions about the political independence of the Fed.

My Comment: Volcker is back on track with those statements. The solution to me is easy: Abolish the Fed. Unfortunately, he comes up with a different answer as follows:

Volcker said the Fed should have the lead role in financial regulation, but to take that on, it needs a reorganization with a senior administrator and a stronger staff if it's to fulfill that roll.

Let's see: Now we need a senior administrator to watch over the Fed to watch over the banks and brokers? The Fed itself needs a stronger staff. Who is going to watch over the senior administrator? Congress? How can any of this possibly solve questions about the political independence of the Fed.

Instead of fixing the problem, Volcker proposes still more government partnerships. He never addresses the root problems: 1) Fractional reserve lending fosters credit bubbles and 2) the Fed compounds the problem by micromanaging interest rates.

In my opinion, it's time to stop the madness and abolish the Fed and along with it fractional reserve lending. Sadly, we are moving the opposite direction towards more government intervention, nationalization of banks, nationalization of housing, and more regulation on top of regulation, with increasing power to the organization most responsible for creating the mess we are in.

Comments

[icandoitdon]

good article. i have two comments:

1. it is so ironic that those who credit the fed from "saving" the system from collapse are either too ignorant or too forgetful to understand that it is the fed itself that created the credit bubble. adding insult to injury, congress gives them even more power to regulate...when they wouldn't use the power they had for fear of slowing down the economy.

2. with all due respect to paul volker....a lion among sheep on the federal reserve...he is still a central banker and i wouldn't expect him to sugget limiting the fed's power. but i'd love to hear his private opinion of that #$*(& greenspan.

i agree with the substance of your views. the federal reserve has done more harm to the economy than good and it's power should be severely curtailed...specifical... it's whimsical control over short term interest rates.

[Rhunzzz]

Hmmm. I'm a monetary neophyte here but wouldn't eliminating fractional-reserve lending mean that banks can only lend out money that none of their depositors could call on?? In effect banks would only be able to lend money from fixed/time deposits, not from current or savings accounts, as though the reserve requirement were 100%. That would result not just in a credit crunch, but a credit black hole.

[bearfund]

Rhunzzz, right, eliminating fractional reserve banking would mean banks could lend their equity and time deposits. It would, as you point out, result in MUCH less borrowing. That is exactly what the United States needs not just to recover and improve but to survive - as Volcker himself pointed out. Basically, if a bank isn't willing to lend its own shareholders' money, it shouldn't be willing to lend mine. When a bank borrows from the Fed at trivial interest rates, it devalues the cash I have saved. It is not merely lending my money, as it would if it lent the contents of my deposit account, but actually destroying it through monetary inflation and the loss of purchasing power.

But I'll meet you halfway, because I believe in consistency. The margin rate for lending by banks should be the same as it is for buying stocks: 50%. For every dollar of equity you have, you may lend that equity, and another dollar you've borrowed from me. Not 10. Not 25. Not 50. 1. And the author is right - the Fed should go. It exists to allow consumption to occur before production. If you want to borrow, borrow someone else's savings. And yes, you will pay more. Interest rates might be 10% for short term low risk loans and 25% for longer terms and higher risk. Most individuals should not have any credit at all, certainly not unsecured credit. Mortgages should be for those with superlative credit, and then offered only with LTVs below 70%. But note that since margin requirements would be much higher, there would not be an enormous upward pressure on deposit interest rates, so there would be less disincentive to invest than most people assume. If you can gear up 30x and lend at 7%, it makes a lot of sense to offer depositors 5.5%. But if you can only gear up 2x while lending at 10%, you won't offer your depositors much because you can't usefully deploy very much money. But they can't borrow, so they'll have to save anyway. And once they've saved, they'll have every incentive to consume and/or invest, precisely because you won't pay them much. This, in short, described America before the Fed.

All that's left is to use gold as money again. And at that point, what's the harm?

[CM in MA]

An outstanding article, and good commentary. Thanks, folks, you gave me food for thought today. I appreciate it.

[richjoy]

Disolve the Fed?...Count my vote in the "Nay" column...and it isn't even close!

OK, the Fed isn't perfect...yes, in 20/20 hindsight, Greenspan received more adulation than he should have, and he certainly stuck with low rates too long (and should have used Fed powers to curtail those stupid lending practices).

However, dispite it's faults, we need the Fed to put on the brakes when necessary, and also lubricate our economic machine when needed.

They're still learning. I am not ready to step into the abyss just because they are not yet perfect.

As for Volker, one must wonder...what is his agenda?...Maybe he feels pressure to defend his legacy (for example: might he have been more innovative in addressing inflation than those horrendously high interest rates and awful recession?). Why has he moved from background and near-obscurity and retirement to seeking a microphone at 80-something?

[flow5]

"Sadly, we are moving the opposite direction towards more government intervention, nationalization of banks, nationalization of housing, and more regulation on top of regulation, with increasing power to the organization most responsible for creating the mess we are in." Yes, yes, and yes, - that is an understatement.

[icandoitdon]

those who defend the federal reserve miss the salient point of it's critics, which is this:

the federal reserve has been the big enabler of the credit culture our economy has become beholden to. those who believe this is how it should be are usually beneficiaries of the system, i.e. consumers who don't have a pot to p__s in, retailers and credit card companies who boost their sales and recover the cost of defaults in the form of higher prices for their product/services, mortgage companies who have securitized and sold their loans, ridding themselves of credit risk by shifting it to naieve investors desperately looking for yield because the fed keeps interest rates artificially low...all to feed the credit cycle that keeps this economy going.

anyone who thinks this kind of foundation is healthy for our economy is simply ignorant...i'm sorry. the federal reserve, in flooding the system with cheap credit, has caused the problems of today. instead of facing them squarely and enduring the pain it would cause, which would be significant, it has kicked the can down the road. as a country, we've become good at that, whether in foreign policy, social policy or economic policy.

the federal reserve is a disgrace. so is the congress. so is the executive branch of government. we've met the enemy and he is us.

i took note that fannie mae today announced that they have decided to not raise downpaymet requirements as previously announced...to "help" the housing industry. help it go broke, that is, because it's exactly that type of policy that created the housing/credit crisis. it's more of the same crap from a quasi-federal organization.

[iThinkBig]

Bearfund probably has the best comments of this group and solutions and I disagree with Richjoy that should consider the long-term economic effects of the bottom 97% going broke and if that is good for our GDP or not... I would speculate the path we are on is one of first massive socialism and then depression shortly thereafter.

The mistakes of the Great Depression are being repeated, although I will say Ben Bernanke made the only choice he could have made with Bear Stearns by lowering rates. It's like the Kobi-Murashi Maroo test in Star Trek movie where there is no complete solution for the cadet to save the entire space vessel in the test, it's only lessening degrees of loss of life aboard the ship. I vehemently disagreed with the last .25 point cut but do not think we are yet at the point to follow Volker's solution to inflation by massively raising rates either.

I have repeated many times to many people that going energy independent could be the only real solution to avoiding a depression three to four years from now, but the politics and human nature our nation (most likely just human nature period) tend to have us go over the cliff and be 10 feet to the ground before we open the parachute of American ingenuity and willpower our nation can muster in any emergency. secondary chute to open to avoid some pain I wish it

[icandoitdon]

"going energy independent could be the only real solution to avoiding a depression three to four years from now."

are you kidding? maybe if we all quit driving cars. there is neither the resources nor the technology on the horizon to make this happen in the lifetime of anyone living... never mind three years from now.

[sbenard]

Ditto! May the Fed be dead!