Fed Gives Congress Room to Shirk Resposibility

Fed Gives Cover to Bumbling Congress
By helping to prevent a depression after the financial crisis, the Federal Reserve gave the Republican-controlled Congress cover to shirk its duties.
Bloomberg, February 26, 2015

One of my favorite thought experiments is the careful-what-you-wish-for scenario. I was reminded of its utility during Federal Reserve chief Janet Yellen’s Congressional testimony the other day.

Consider the critique of the Fed by some members of Congress. As the New York Times described it, the three-hour hearing was “testy” as “Republicans on the House Financial Services Committee accused Janet L. Yellen, chairwoman of the Fed, of using her office to advance liberal policy goals.”

I find it rather surprising that the Fed’s mandated goals of containing inflation (check!) and reducing unemployment (check!) are deemed liberal. That is how topsy-turvy the partisan world of Washington has become during the past decade.

“You’ve already made monetary policy a partisan political exercise,” declared Representative Scott Garrett, a New Jersey Republican, in a partisan political response to Yellen’s House testimony yesterday.

The upside-down worldview that statement reflects seems to be lost on the Congressman. It’s an exercise in massive projection. No wonder Congress’s approval ratings keep breaking all sorts of record lows.

I suspect the contingent in Congress that wants to audit the Fed really hasn’t thought through its goals. As we shall see below, the Fed bashers might not be happy with the results.

Regular readers know I am none too keen on making predictions. Instead, I like to look at probabilities. These war-gaming scenarios look at possible outcomes. It is more of an intellectual exercise than a way to manage money. We use it to help reduce potential surprises, and explore ideas that are not yet mainstream.

One caveat: I don’t work in a think tank or get paid to engage in the indulgences of the student philosopher; rather, I am the chief investment officer of an asset-management firm. It isn’t my job to critique or give advice to the Fed, but instead to figure out what impact Fed actionsmight have on investable assets.

Back to Congress and the Fed: The U.S. government response to the Great Recession was different from what we normally experience after a major slump. Typically, the policy is to attack weak demand with a combination of fiscal and monetary stimulus. This has been true around the world for both ordinary balance-sheet recessions, as well as the deeper, more painful credit crises, like the one we experienced six years ago.

Several things were very different following this credit crisis from, say, the Crash of 1929. As Milton Friedman so cogently observed, “The Great Depression in the United States was . . . enormously intensified and made far worse than it would have been by bad monetary policy.”

Friedman was referring to the lack of a muscular response by the Fed, which had only been in existence 16 years and had no experience dealing with a systemic financial crisis.

But while the Fed’s monetary policy this time was very aggressive, the government failed to provide a similarly strong fiscal response. The fiscal stimulus package of 2009 was far too small, mostly consisting of temporary measures such as extended unemployment benefits and temporary tax cuts. Less than a third of it was devoted to longer-term, spending that lays the foundation for durable future growth. The response was mediocre — and so was the recovery.

Rather than step up  government stimulus to mute the impact of the Great Recession, Congress was an irresponsible drag on the economy. Compare this do next-to-nothing Congress with the sort of affirmative response after other financial crises.

Before you run off yelling about deficits, let’s recognize that the worship of fiscal discipline is mostly lip service paid by whichever party is out of the White House. The Democrats did it to Ronald Reagan and George W. Bush, the Republicans did it to Bill Clinton (who actually turned deficits into surpluses) and Barack Obama. And historically, Republican administrations have spent more and taxed less since World War II, creating much larger deficits than Democrats. This is why I look at the austerity/deficit reduction posturing as a con.

Which leads me back to today’s thought experiment.

What might have happened if the Fed actually did what the Tea Party conservatives wanted? Let’s imagine in October 2008 that the Trouble Asset Relief Program legislation was amended to include congressional oversight and require approval of Fed action. The result might have been a very constrained Fed response, if any at all. What would have happened, for example, if the Fed were barred from cutting interest rates to zero and ordered by Congress not to reduce them below 4 percent on the theory that doing so would give unjustified aid to underwater homeowners? Or let’s suppose there was no quantitative easing, no liquidity injections or none of the various credit facilities established to free up money flow.

It is plausible, indeed probable, that the economy would have gotten much, much worse than it did. The odds are there would have been even more layoffs, as companies lacking for access to short-term credit to cover payroll had no choice but to shed employees. Unemployment would have gone up even more. Mortgage rates would not have gone as low as they did, providing relief to strained homeowners, and leading to many more residential foreclosures. This would have caused more bank failures, as the real-estate losses depleted the capital of sick banks. Imagine what would have happened to the stock markets. What little confidence there was would have been shattered.  A full-blown depression on a par with the 1930s would have been a very real possibility.

And so we see a great irony here: the Fed has provided economic cover for Congress to behave badly and engage in childish posturing rather than doing the people’s business.

All of this is lost on the current crop of Congressional leaders.

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I originally published this atBloomberg, February 26, 2015. All of my Bloomberg columns can be found here and here.