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Warren Mosler is currently the Present of Valance Co, Inc. located in St. Croix in the US Virgin Islands, where he resides. In 1982, Mosler was a founder of Illinois Income Investors that evolved into the III investment companies. Over the years, he pioneered numerous investment strategies that... More
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Mosler Economics
  • Assessing the Fed under Chairman Bernanke
    "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."
    Keynes, Chapter 12, The General Theory of Employment, Interest, and Money

    The Fed has failed, but failed conventionally, and is therefore being praised for what it has done.  

    The Fed has a stated goal of "maximum employment, stable prices, and moderate long term interest rates"  (Both the Federal Act 1913 and as amended in 1977).

    It has not sustained full employment.  And up until the recent collapse of aggregate demand, the Fed assumed it had the tools to sustain the demand necessary for full employment.  In fact, longer term Federal Reserve economic forecasts have always assumed unemployment would be low and inflation low two years in the future, as those forecasts also assumed 'appropriate monetary policy' would be applied.  

    The Fed has applied all the conventional tools, including aggressive interest rate cuts, aggressive lending to its member banks, and extended aggressive lending to other financial markets.  Only after these actions failed to show the desired recovery in aggregate demand did the Fed continue with 'uncoventional' but well known monetary policies.  These included expanding the securities member banks could use for collateral, expanding its portfolio by purchasing securities in the marketplace, and lending unsecured to foreign central banks through its swap arrangements.

    While these measures, and a few others, largely restored 'market functioning' early in 2009, unemployment has continued to increase, while inflation continues to press on the low end of the Fed's tolerance range.  Indeed, with rates at 0% and their portfolio seemingly too large for comfort, they consider the risks of deflation much more severe than the risks of an inflation that they have to date been unable to achieve.

    The Fed has been applauded for staving off what might have been a depression by taking these aggressive conventional actions, and for their further aggressiveness in then going beyond that to do everything they could to reverse a dangerously widening output gap.  

    The alternative was to succeed unconventionally with the proposals I have been putting forth for well over a year.  These include:

    1.  The Fed should have always been lending to its member banks in the fed funds market (unsecured interbank lending) in unlimited quantities at its target fed funds rate.  This is unconventional in the US, but not in many other nations that have 'collars' where the Central Bank simply announces a rate at which it will borrow, and a slightly higher rate at which it will lend.  

    Instead of lending unsecured, the Fed demands collateral from its member banks.  When the interbank markets ceased to function, the Fed only gradually began to expand the collateral it would accept from its banks.  Eventually the list of collateral expanded sufficiently so that Fed lending was, functionally, roughly similar to where it would have been if it were lending unsecured, and market functioning returned.

    What the Fed and the administration failed to appreciate was that demanding collateral from loans to member banks was redundant.  The FDIC was already examining banks continuously to make sure all of their assets were deemed 'legal' and 'appropriate' and properly risk weighted and well capitalized.  It is also obligated to take over any bank not in compliance.  The FDIC must do this because it insures the bank deposits that potentially fund the entire banking system.  Lending to member banks by the Fed in no way changes the asset structure of the banks, and so in no way increases the risk to government as a whole.  If anything, unsecured lending by the Fed alleviates risk, as unsecured Fed lending eliminates the possibility of a liquidity crisis.

    2.   The Fed has assumed and continued to assume lower interest rates add to aggregate demand.  There are, however, reasons to believe this is currently not the case.  

    First, in a 2004 Fed paper by Bernanke, Sacks, and Reinhart, the authors state that lower interest rates reduce income to the non government sectors through what they call the 'fiscal channel.'  As the Fed cuts rates, the Treasury pays less interest, thereby reducing the income and savings of financial assets of the non government sectors.  They add that a tax cut or Federal spending increase can offset this effect.  Yet it was never spelled out to Congress that a fiscal adjustment was potentially in order to offset this loss of aggregate demand from interest rate cuts.

    Second, while lowering the fed funds rate immediately cut interest rates for savers, it was also clear rates for borrowers were coming down far less, if at all.  And, in many cases, borrowing rates rose due to credit issues.  This resulted in expanded net interest margins for banks, which are now approaching an unheard of 5%.  Funds taken away from savers due to lower interest rates reduces aggregate demand, borrowers aren't gaining and may be losing as well, and the additional interest earned by lenders is going to restore lost capital and is not contributing to aggregate demand.  So this shift of income from savers to banks (leveraged lenders) is reducing aggregate demand as it reduces personal income and shifts those funds to banks who don't spend any of it.

    3.  The Fed is perpetuating the myth that its monetary policy will work with a lag to support aggregate demand, when it has no specific channels it can point to, or any empirical evidence that this is the case.  This is particularly true of what's called 'quantitative easing.'  Recent surveys show market participants and politicians believe the Fed is engaged in 'money printing,' and they expect the size of the Fed's portfolio and the resulting excess reserve positions of the banks to somehow, with an unknown lag, translate into a dramatic 'monetary expansion' and inflation.  Therefore, during this severe recession where unemployment has continued to be far higher than desired, market participants and politicians are focused instead on what the Fed's 'exit strategy' might be.  The the fear of that presumed event has clearly taken precedence over the current economic and social disaster.  A second 'fiscal stimulus' is not even a consideration, unless the economy gets substantially worse.  Published papers from the NY Fed, however, clearly show how 'quantitative easing' should not be expected to have any effect on inflation.  The reports state that in no case is the banking system reserve constrained when lending, so the quantity of reserves has no effect on lending or the economy.        

    4.  The Fed is perpetuating the myth that the Federal Government has 'run out of money,' to use the words of President Obama.  In May, testifying before Congress, when asked where the money the Fed gives the banks comes from, Chairman Bernanke gave the correct answer- the banks have accounts at the Fed much like the rest of us have bank accounts, and the Fed gives them money simply by changing numbers in their bank accounts.  What the Chairman explained was there is no such thing as the government 'running out of money.'  But the government's personal banker, the Federal Reserve, as decided not publicly correct the misunderstanding that the government is running out of money, and thereby reduced the likelihood of a fiscal response to end the current recession. 

    There are also additional measures the Fed should immediately enact, such banning member banks from using LIBOR in any of their contracts.  LIBOR is controlled by a foreign entity and it is counter productive to allow that to continue.  In fact, it was the use of LIBOR that prompted the Fed to advance the unlimited dollar swap lines to the world's foreign central banks- a highly risky and questionable maneuver- and there is no reason US banks can't index their rates to the fed funds rate which is under Fed control.

    There is also no reason I can determine, when the criteria is public purpose, to let banks transact in any secondary markets.  As a point of logic, all legal bank assets can be held in portfolio to maturity in the normal course of business, and all funding, both short term and long term can be obtained through insured deposits, supplemented by loans from the Fed on an as needed basis.  This would greatly simply the banking model, and go a long way to ease regulatory burdens.  Excessive regulatory needs are a major reason for regulatory failures.  Banking can be easily restructured in many ways for more compliance with less regulation.

    There are more, but I believe the point has been made.  I conclude by giving the Fed and Chairman Bernanke a grade of A for quickly and aggressively applying conventional actions such as interest rate cuts, numerous programs for accepting additional collateral, enacting swap lines to offset the negative effects of LIBOR dependent domestic interest rates, and creative support of secondary markets.  I give them a C- for failure to educate the markets, politicians, and the media on monetary operations.  And I give them an F for failure to recognize the currently unconventional actions they could have taken to avoid the liquidity crisis, and for failure inform Congress as to the necessity of sustaining aggregate demand through fiscal adjustments.
    Sep 01 08:03 am | Link | Comment!
  • The Fed and the Interest Income Channel
    The following is a little quoted section from the widely read 2004 Fed paper on 'unconventional monetary policy.'  It discusses how interest rates work through the fiscal channel to reduce interest income.  
     
    This means the Fed should be fully aware that any presumed benefits of lower interest rates can be offset by the reduction of interest payments by the Treasury unless the federal deficit is increased.
     
     
    Comments in CAPS below:
    ______________________...
    Monetary Policy Alternatives at the Zero Bound:
    An Empirical Assessment
    Ben S. Bernanke, Vincent R. Reinhart, and Brian P. Sack
    2004-48
     
     
    "A second possible channel for quantitative easing to influence the economy is the
    fiscal channel. This channel relies on the observation that sufficiently large monetary
    injections will materially relieve the government’s budget constraint, permitting tax
    reductions or increases in government spending without increasing public holdings of
    government debt (Bernanke, 2003; Auerbach and Obstfeld, 2004).
     
    IN OTHER WORDS, THE LOWER RATES FROM THE FED AND BUILDING THE FED'S BALANCE SHEET 
    REDUCE FEDERAL INTEREST PAYMENTS TO THE NON GOVERNMENT SECTORS.
     
    THIS REDUCED FEDERAL SPENDING IS A CONTRACTIONARY BIAS THAT CAN BE OFFSET BY 
    TAX CUTS AND/OR GOVT. SPENDING INCREASES.
     
    ...Thus, it seems reasonable to expect that the fiscal channel of quantitative
    easing would work if pursued sufficiently aggressively."
    ______________________...
     
     
    This analysis can be take further.  Over the last two years the Fed funds rate has been cut by about 5%, with savers losing about that much in money market funds and other short term holdings, as well as accepting lower yields on longer term holdings that matured.
     
    Additionally, with the Fed's balance sheet  at about $2 trillion and assuming an average coupon of 3%, the Fed is removing an additional $60 billion per year of interest income from the non government sectors.
     
    And while some borrowers have saved some interest expense, many have not as net interest margins for the banking system widened to perhaps something over 4%, and those operating profits are replenishing bank reserves and not adding to aggregate demand.
     
    As a consequence, the Fed's cutting of rates may have removed perhaps $200 billion per year in net interest income from the non government sectors.  And while the somewhat lower rates may help some borrowers, it looks to me like the cut in interest income is a much larger factor, as banks shy away from borrowers whose income is declining.
     
    Interest Income
     
    (chart on the interest income component of personal income, which is one of the net recipients of interest income. Others include the foreign and corporate sectors.)
     
    Therefore, over the last two years Fed rate cuts look to me like they've probably been restrictive, and not accommodating as is universally presumed.
     
    And that means the automatic stabilizers have to work that much harder creating unemployment and cutting tax revenues to get the deficit high enough to effect a turnaround.
     
    It also means that as long as the Fed keeps the fed funds rate near 0 we will be able to enjoy a deficit that much higher than otherwise.  (Lower taxes for a given level of public spending are a good thing in humble opinion!)
     
    Additionally zero interest rates are deflationary through the cost channel.  Much of US business uses 'mark up' pricing and with a lower cost of funds their costs of production for both investment and consumption are that much lower, resulting in lower prices than otherwise.  Lower costs and lower demand tend to result in lower prices. 
     
    However, with the current aversion to federal deficits of our political leaders and the economic mainstream, the recovery is at risk if they support policy that both reduces the federal deficit and keeps rates low.
     
    See:  " Zero is the Natural Rate of Interest" (1996) at www.moslereconomics.com under 'mandatory readings'.
    May 14 09:39 am | Link | Comment!
  • Macroeconomic Review

    May 8th, 2009

    In mid 2006, I had written that the Fed’s financial obligations ratios suggested that the federal deficit had gotten too small to sustain the kind of growth we’d been seeing, and that aggregate demand would moderate until the economy got weak enough to get the federal deficit to probably about 5% of GDP as had been the case in most previous cycles.

    And, at the same time, rising crude prices due to monopoly pricing power would drive up CPI.

    I had also thought the Fed would keep rates steady or increase them as inflation expectations rose, and that the higher interest rates would further drive up CPI and support incomes through the interest income channel as the non government sectors are large (equal to the size of the outstanding Treasury securities) net savers.

    GDP growth did start declining and CPI did start climbing, as did inflation expectations. However I was wrong about the Fed’s reaction as they cut rates long before CPI peaked.  Ironically for the Fed, events seemed to support that notion I have long suggested that rate cuts are in fact deflationary, working through the 'cost channel' as well as the 'income channel' as the rate cuts removed interest income from the non government sector and contributed to the decline in aggregate demand.  The $170 billion Q2 08 fiscal package more than offset that, however, and real GDP remained positive for the first half of 08.

    The end of that fiscal package coincided with what I termed the 'Great Mike Masters Inventory Liquidation' which was even more severe than I had imagined, lasting to year end, and driving down GDP in the process.  

    By year end the rapid increase in unemployment and the decline in tax revenues combined to increase the federal deficit to over 5% of GDP, boosting the $US net financial equity of the monetary system by that same amount (federal deficits add directly to non government savings of financial assets) and slowing the decline of personal income to the point of ending the inventory liquidation by the end of q4 and reversing the decline in the rate GDP some time during Q1.

    Q2 GDP is currently looking to be somewhere near flat and maybe positive as the proactive fiscal measures begin to kick in, and with international inventories starting from extremely low levels.

    My proposals for fiscal policy, once the inventory liquidation was in progress, included the payroll tax holiday (the Treasury would make all payments for employees and employers), $300 billion of revenue sharing for the states on a per capita basis, and funding a job for anyone willing and able to work that included health care.  This would have eliminated the need for unemployment to rise and GDP to fall as the means of restoring the federal budget deficit to level necessary to sustain output and employment.  And all with the caveat that energy prices would resume their climb as soon as stability was restored if there was not a credible plan in place to immediately cut US domestic crude oil consumption.

    Rather than something like my 'bottom up' approach to restoring aggregate demand and restoring the ability to make mortgage and car payments, our government instead took a 'top down' approach, with both the Treasury and the Fed buying only financial assets- a policy that does nothing for aggregate demand, and only prolongs the agony of waiting for the automatic stabilizers work to restore aggregate demand through the most ugly process of rising unemployment and falling tax revenues.  

    The Obamaboom is now underway due to the ‘automatic stabilizers’ described above, and the additional fiscal adjustments that began in April.  Unfortunately, because there was no fiscal response, we got here that ugly way, via rising unemployment and falling taxable incomes- a real and tragic cost.  Sadly, those real losses are water under the bridge, never to be 'recovered.'  

    And, unfortunately, our crude consumption has dropped only modestly and is already increasing as GDP stabilizes, even at current levels of unemployment.  As a consequence, crude prices are headed north again, and will support headline and eventually core CPI through the cost structure, as cost push ‘inflation’ resumes after pausing for last year's massive inventory liquidation.  While off of last year’s highs, food prices are now rising from levels that are about double those of a few years ago and crude prices nearly triple earlier levels.

    The US fiscal expansion is also likely to drive imports, with rising crude prices increasing the US import bill as well.  This keeps a lid on domestic employment, and as unemployment remains high and real wages stagnate, increases in real consumption and wealth due to productivity increases and (some) employment gains necessarily flow to the ‘top’ in what could be the largest upward flow of real wealth we've ever experienced.  It also means US dollars will be ‘easier to get’ overseas which puts downward pressure on the USD.  The Fed and Administration are prone to look at this as a ‘good thing’ as they view increased ‘competitiveness... that drives increased exports ‘necessary’ to ‘balance the trade account.’  

    For the real economy, however, rising prices of imports while nominal wages are contained decreases real standards of living as workers use up their take home pay on food and energy, exporting a greater share of their output rather than consuming it.  This is what happens with an administration that doesn’t understand that exports are real costs and imports real benefits.

    The Fed will soon be looking at sub trend GDP, unacceptably high unemployment, a falling dollar, rising headline CPI and rising inflation expectations.  And while recent history says they will keep rates low as long as they perceive an continuing output gap, they are also keenly aware of severe mainstream criticisms of the former chairman for keeping rates too low too long.  And I do expect the mainstream to define away a large chunk of the output gap by raising the 'natural rate of unemployment' as CPI and inflation expectations escalate.  Meanwhile, the administration will see the same data and be hesitant to blame the Fed for inflation, for fear of triggering higher interest rates.

    Ironically, this disturbing scenario is, historically, a near ideal environment for nominal equity prices, so the administration may soon be presiding over a period of increasing wealth in the financial sectors, the senior management level, and in the investor classes in general, while pondering what to do about unemployment in the face of rising inflation and what is perceived as a too high budget deficit.  This makes the major risk to equity valuations the potential political responses rather than the fundamental economic forces.  These could include higher corporate (as well as personal) taxes on both earnings and dividends, and excess profits taxes should energy prices move back towards last year's highs.  The recent attack on the $190 billion of 'corporate loopholes' may be indicative of where the administration is looking regarding the presumed need for tax revenues.

    May 10 09:55 am | Link | Comment!
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