Is The Fed Corrupt or Out of Control?

The Federal Reserve System is an extremely controversial and largely misunderstood institution. Senators on both the right (Ron Paul) and the left (Bernie Sanders) are highly critical of The Fed.   I’ve shied away from commenting on The Fed because it’s  a pretty complex subject. Every time I think there’s a point to be made, I find it requires explaining some other point, which leads to yet another, and on and on.  It’s always seemed too daunting.  I could never figure out where to start.  But a reader asked last week for my thoughts about The Fed audit, so I’ll make an effort:

What’s the meaning of the audit of the Federal Reserve Bank that has just been completed? I am hearing from friends that the revelation of loans made to banks by the Fed is evidence that they “are out of control” and doing something corrupt or dishonest. I find that hard to believe.

At the risk that I’ll have a few “I’ll explain this later” points in this post, let’s talk about The Fed and whether it’s corrupt.  Let’s start with the results of the audit of The Fed which were released in July 2011 in response to a Congressional bill requiring a one-time public audit of The Fed..  The Raw Story summarizes the report for us and also has an embedded copy of the audit results for those interested:

The U.S. Federal Reserve gave out $16.1 trillion in emergency loans to U.S. and foreign financial institutions between Dec. 1, 2007 and July 21, 2010, according to figures produced by the government’s first-ever audit of the central bank.

Last year, the gross domestic product of the entire U.S. economy was $14.5 trillion.

Of the $16.1 trillion loaned out, $3.08 trillion went to financial institutions in the U.K., Germany, Switzerland, France and Belgium, the Government Accountability Office’s (GAO) analysis shows.

Additionally, asset swap arrangements were opened with banks in the U.K., Canada, Brazil, Japan, South Korea, Norway, Mexico, Singapore and Switzerland. Twelve of those arrangements are still ongoing, having been extended through August 2012.

Out of all borrowers, Citigroup received the most financial assistance from the Fed, at $2.5 trillion. Morgan Stanley came in second with $2.04 trillion, followed by Merrill Lynch at $1.9 trillion and Bank of America at $1.3 trillion.

The audit also found that the Fed mostly outsourced its lending operations to the very financial institutions which sparked the crisis to begin with, and that they delegated contracts largely on a no-bid basis. The GAO report recommends new policies that would eliminate such conflicts of interest, and suggests that in the future the Fed should keep better records of their emergency decision-making process.

The Fed agreed to “strongly consider” the recommendations, but as it is not a government-run institution it cannot be forced to do so by lawmakers. The seven-member board of governors and the Fed chairman are, however, appointed by the President of the United States and confirmed by the Senate.

The audit was conducted on a one-time basis, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed last year. Fed officials had strongly discouraged lawmakers from ordering the audit, claiming it may serve to undermine confidence in the monetary system.

The big news, judging by both Ron Paul’s and Bernie Sanders’ reactions is the three-fold fact that The Fed provided loans (or their equivalent in asset swaps) to large banks and governments to the tune of $14.5 trillion “in secret”.  The first concern is the size of the actions. The second concern seems to be that some of these banks and governments were foreign. And the third is that the loans were secret. I think the conflicts of interest and poor decision making processes are bigger issues uncovered by the audit. But I’ll get to that later in this post.

Before we can conclude The Fed is “out of control” or corrupt we need to look at what The Fed is supposed to do.  The Fed, being the central bank for the U.S., is responsible for:

  • maintaining the health of the U.S. banking and financial system and institutions.  It does this by regulation of those institutions and by being lender of last resort in a crisis.
  • conducting monetary policy. Legally, The Fed has a “dual mandate” on monetary policy. It is supposed to:
  1. maintain price stability (in other words, avoid inflation or deflation)
  2. maintain full employment

The critics from the right tend to be followers of Austrian economics (Ron Paul) or far-conservative and libertarian. These are the ones most likely to claim The Fed is “out of control”.  What they generally mean (a typical example is here) is they think The Fed has created too much money and is debasing the currency.  There’s very little The Fed can do that would satisfy most of these people other than to shut down and ask the government to return to a gold standard.  Their concerns about the $14 trillion in loans being inflationary and “newly printed money” reveal deep misunderstandings about the nature of money (a post yet to be written), the functioning of the financial system, and even the nature of inflation.  They make a big deal of the size of the loans by comparing them to real GDP.  That’s apples to oranges.  To figure out if the $14 trillion in loans was large, it should be compared to the total balance sheet of the banking system, not GDP.   Yes, the loans The Fed made were of record amount, but so was the crisis. The Fed has a duty to act as lender of last resort in a financial crisis.  It did that. And it largely avoided the scale of disaster that occurred in 1929-1933 when The Fed failed to act as lender of last resort and was complicit in creating The Great Depression, snuffing out thousands of banks in the U.S. and depositors’ savings with it.  So if “out of control” means The Fed is wildly “printing money”, creating inflation, and debasing the currency, then, no, The Fed is not out of control.

A second charge that both the right and left have leveled is that The Fed shouldn’t have made loans to foreign banks and governments.  In a pure-thought fantasy world of theoretical political economy, I suppose The Fed would be a nationalist institution.  Certainly we expect the central bank of any other nation to be dominated by solely by protecting their own nation’s interests. (in the case of the Eurozone, it would be a great improvement if the ECB gave a hoot about even it’s own).  But reality has to intrude.  The U.S. dollar is the world’s reserve currency. We wanted it that way. More than half of all U.S. money is outside the U.S.  The world’s trading and financial systems depend on the dollar. Given the scale and scope of the crisis in 2008, The Fed had little practical alternative to making loans to some large foreign banks and even some nations.  Nobody else could do it.  The alternatives were too nasty.  Should it be regular practice? No. Should it be encouraged? No. Should we second guess the middle of the crisis when nobody else was stepping up?  Probably not.  Should we think about how to handle it better in the future so we don’t have to rely on The Fed?  Yes.  Have we thought about it and changed? No.  So the second charge of being “out of control” as evidenced by making foreign loans doesn’t really hold up.

The third charge, the question of “secrecy” in the loans is more difficult.  On the one side, it is unseemly for The Fed to be able to make large loans on favorable terms to banks, loans that save those banks’ managers from failure, without any sunshine or transparency.  It makes fertile ground for corruption.  On the other hand, banking is a confidence game. Publicizing loans to banks, even when part of the normal course of affairs, can be misinterpreted by the public, fund managers, or other banks.  It alone could spark a run on a bank. The run then creates the very crisis the loan was intended to avert, turning temporary liquidity crisis into permanent bank failure.

Some fear of the secrecy of these loans is driven by a misunderstanding of what The Fed loans and where it comes from.  Again, this arises from common misunderstandings of what money really is or where it comes from.  Many fear the “money” The Fed lends is money that had to come from somewhere (they suspect taxpayers) or diverted from some other useful purpose.  Not so.  The Fed doesn’t actually lend “money” in the sense that you and I have “money” to spend.  The Fed creates new bank reserves out of thin air.  It’s not spending money and it’s not scarce. The Fed can as easily remove these reserves later in the future.

So, is The Fed “out of control”?  I don’t think so in the way that many critics make the accusation.  Just because I don’t think The Fed is some “out of control money printing machine” doesn’t mean I think The Fed is innocent or doesn’t need to be changed.  The audit revealed other issues regarding decision-making and transparency that I find much more troubling.  They reveal that The Fed has fallen into a kind of “group think” that doesn’t serve the nation well.  I think The Fed is both misguided and poorly structured.  But I’ll deal with that in tomorrow’s post.

The Fed is a Rorschach test.

The Misunderstood National Debt

A colleague asked for my thoughts on this article/column by Michael Manning in the State News, the Michigan State student newspaper, so I thought I’d post it for all.

Basically Mr. Manning reaches the right conclusions with a correct, but weak case. In looking at the issue of the size of the U.S. national debt and the panicked concerns many politicians are now expressing about the “urgent need to cut the deficit”, he concludes:

Republicans have decided to use this opportunity to further their party’s political agenda, feeding off of the public’s misunderstanding of national debt.

Although the debt is growing at an alarming rate, it does not mean the end of times or the end of American economic dominance. Public debt largely is misunderstood and used as a tool to scare everyday Americans.

He’s right. The debt is not the end of times nor will it end American economic prosperity (other policies may do that!).  And he’s absolutely right that public debt is largely misunderstood.

But the arguments for why it’s not a crisis and how it’s misunderstood are even stronger than he argues.  Essentially, Manning argues that most all of the debt is owed to “ourselves”, meaning either American citizens, American corporations/banks, or other units of government (Social Security program, The Federal Reserve, etc). That’s all true, but there are bigger reasons why the national debt doesn’t really matter.

He quotes Glenn Beck and then responds:

In the words of Glenn Beck, “China, some day, will want their payment, America. They will demand payment and they will receive their payment.

And if we can’t pay, they will do what any other bank would do, emotionlessly take the collateral that they now own. That will be our oil reserves, our land, our resources, our rare minerals, our coal, whatever it is.”

How much stake do these Chinese bankers actually have in America? They own a mere 7.5 percent, or about $1 trillion dollars of the national debt.

Yes, China only holds a small amount of the debt. But that’s not really why they won’t “repossess the collateral”.  The reason China won’t foreclose on the U.S. more complex. First, Glenn Beck is absolutely ignorant.  There is not “collateral” on government debt.  The only security for the loan is the “full faith of the U.S. government”.  In other words, if the U.S. didn’t want to pay, or if it wanted to payoff with new bonds, or if it wanted to payoff with newly created “money”, that’s their privilege. The lender knows that at the beginning.  There is no international court of claims where one country can foreclose on another for a bad debt.  What happens when a nation defaults on it’s debt?  Basically the lenders (usually banks in other countries) get really upset. They stamp their feet. They call serious meetings. Serious communiques are issued.  Foreign ministers get “concerned”.  Then they re-write the debt and the lenders take a loss. Nothing else.  Because it can’t!  The idea of China “emotionlessly” claiming our “oil reserves, land, our resources,” etc. is absurd.  How does Mr. Beck propose this happens?  China just pulls a couple ships up to Texas, kicks everybody out and tows the state of Texas home to China?  Or maybe China just moves in, digs up our coal and ships it home while everybody in West Virginia stands around? Or does Mr. Beck believe China will invade and forcibly take over (a nation with enough nuclear weapons to make dust of all us many times)?  It’s ludicrous.  I repeat.  The government is NOT like a household, and that means there’s no analogy between holders of US debt and a car loan or mortgage you took from the bank.

But the national debt is more misunderstood than just this false household analogy.  Indeed, it’s even misunderstood by many economists.  The issue has to do with money. The U.S. government, being (1) a sovereign nation that creates it’s own money . that (2) borrows in it’s own currency and (3) has a fiat currency with floating exchange rate, means the government (federal) cannot go broke or ever not be able to pay back bonds and interest when they are due.  This is because the government creates and is the source of the underlying “base money”.  It can always create more money to pay the bonds when due.  Now I know many folks, including many economists who haven’t updated their understanding of the monetary system since the 1971, will say “but, but, but that’s printing money and that creates inflation.”.  No it isn’t. And no it doesn’t.  The government doesn’t pay it’s bills or payoff bonds with “money”.  They send checks drawn on The Federal Reserve Bank.  Those checks are accepted by your local bank when you deposit them. When your local bank gives the check to The Fed, The Fed provides the bank with bank reserves.  Bank reserves are not money.  Bank reserves do not circulate. And, since 1971 at least, bank reserves do not limit or really influence how much money is in circulation.  How much your local bank loans out creates money.  And The Fed creates reserves to match what’s needed. (for a more in-depth explanations, see Bill Mitchell’s blog BillyBlog or the UMKC Economic Perspectives or this blog and search on “MMT”).

Now some, including many economists, claim that creating new bank reserves is inflationary.  But this is based entirely on an outdated theory called the quantity theory of money which hasn’t proven useful, accurate, or valid for over 40 years, largely because it’s based on having a gold standard or fixed exchange rates (both of which Nixon abolished).  Inflation happens when the nominal economy grows too fast and the central bank controls that through interest rates, not quantities of bank reserves or money.  I realize that some of this may sound counter to what folks may find in a lot of econ 101 textbooks, but that’s because the textbooks really haven’t been updated to reflect modern monetary theory or modern central banking operations in the way they work since the end of fixed exchange rates and gold standard.  In economics we have a problem with zombie ideas refusing to die.

Finally, there’s another very important reason the Chinese or anybody else that holds U.S. debt in large amounts don’t have a problem with the size of our debt.  That’s because the “debt” itself, the bonds, really shouldn’t be thought of as “debt”.  Government debt is really more like “paper money that pays interest”.  Again this is sovereign national debt – see above conditions.  If you are a state government or a nation like Greece or Ireland that foolishly gave away control of their currency to some foreign central bank, it’s different.  That debt is really debt.  But national, sovereign, floating exchange rate, government “debt”, the kind the U.S., Japan, Australia, U.K., Canada, and a host of other nations have isn’t really “debt”.  It’s a form of interest-paying risk-free cash.  It’s used by pension funds, banks, and investors as a risk-free asset. Indeed, at one point in the previous decade when Australia was actually paying down it’s debt and not issuing new bonds, the banking community persuaded the government to borrow anyway just so the bonds would exist.

So, Mr. Manning is correct, but he’s even more correct than he argued.  The national debt is misunderstood. And a false crisis is being created in order to push an alternative agenda.

The Fed Has NOT Been Printing Money

A common refrain among the “cut, cut, cut” chicken littles and the hard-money crowd is that “the Fed has turned the printing presses lose printing money”.  These folks should really join us in the 21st century.  That’s not how it works and that’s not what The Fed has been doing.  Quantitative Easing, as well as The Fed bailouts of the big banks 2-3 years ago, did not involve “printing money”.  It involved creating bank reserves that are NOT loaned out and therefore do not create new “money” or M1.  James Hamilton explains:

Money and reserves

I wanted to offer some clarification on stories about all the money that the Federal Reserve is supposedly printing. It depends, I guess, on your definition of “money.” And your definition of “printing.”

When people talk about “printing money,” your first thought might be that they’re referring to green pieces of paper with pictures of dead presidents on them. The graph below plots the growth rate for currency in circulation over the last decade. I’ve calculated the growth rate over 2-year rather than 1-year intervals to smooth a little the impact of the abrupt downturn in money growth in 2008. Another reason to use 2-year rates is that when we’re thinking about money growth rates as a potential inflation indicator, both economic theory and the empirical evidence suggest that it’s better to average growth rates over longer intervals.

Currency in circulation has increased by 5.2% per year over the last two years, a bit below the average for the last decade. If you took a very simple-minded monetarist view of inflation (inflation = money growth minus real output growth), and expected (as many observers do) better than 3% real GDP growth for the next two years, you’d conclude that recent money growth rates are consistent with extremely low rates of inflation.

Two year growth rate (quoted at annual percentage rate) of currency in circulation. Data source: FRED.
currency_feb_11.gif

But if the Fed didn’t print any money as part of QE2 and earlier asset purchases, how did it pay for the stuff it bought? The answer is that the Fed simply credited the accounts that banks that are members of the Federal Reserve System hold with the Fed. These electronic credits, or reserve balances, are what has exploded since 2008. The blue area in the graph below is the total currency in circulation, whose growth we have just seen has been pretty modest. The maroon area represents reserves.

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