In the blame game of what caused our financial meltdown following a massive credit bubble, we’ve all heard it was the bankers, the rating agencies, the mortgage brokers, the individuals whose eyes were bigger than their bank accounts, Fannie Mae and Freddie Mac and of course, deregulation. The point being missed in this discussion is that all these influences were just symptoms of the actual disease. The disease was artificially cheap money created by the Federal Reserve. One of the real tragedies of what our economy has experienced is the lack of understanding for what the true genesis of the credit bubble and bust was. Thus, the blame is not being pointed at the real culprit, the Federal Reserve, and scrutiny is unfortunately not taking place to nearly the extent it should. Without this, a true fix and repair of our economy cannot occur. A doctor that misdiagnoses the disease cannot then cure it. Many participants were reckless but the true enabler was easy money engineered by the Fed.
Typical monetary policy works very simply. To spur growth, lower the fed funds rate to encourage borrowing. Lowering rates even more and the more borrowing takes place as long as lenders are willing and capable to meet the demand. This brings us back to 2001 as the stock market bubble was in the process of popping, the US economy was entering recession and 9/11 froze business activity. The Greenspan led Fed with Bernanke in the background cut rates in 2001 alone from 6.5% to 1.75% which was then followed with a 1% rate from mid ’03 to mid ’04. Another catalyst for the 1% rate that stayed there was the fear and Fed’s bad forecast of deflation just as one of the greatest bull market in commodities was getting under way. With artificially cheap rates, the extraordinary demand for yield ensued as pension funds had to meet 7-9% rate of return hurdles, insurance companies wanted yield for the premiums they took in, savers were discouraged from saving and took more risk for more yield and international banks thought they were buying US Treasuries in disguise. More risk and more leverage were the only ways of achieving rates of return to meet obligations.
With a massive pool of credit supply searching for yield, enter home buyers and banks and mortgage brokers and paper subsequently created to further feed this that was blessed as risk free by the rating agencies. A housing boom ignites. The US consumer goes on a spending binge, fuels growth in all those countries that sell to them (mostly China), that money gets recycled into the US Treasury market and a self fulfilling credit party follows with Greenspan, Bernanke and the Fed playing the part of bartender.
The bust of course follows and the Fed deals with the consequences of the aftermath with the exact policy that caused the problem but this time, not just with cheap money but with even cheaper money. Why give a drunk more alcohol to cure the hangover and encourage more borrowing and spending?
So here we are now, the Fed talking about more money printing because of their fears of deflation and slack growth. They fear deflation just as the CRB raw industrials commodity index, which includes most major commodities except energy, is at an all time record high. Also, since the gold standard ended in 1971, the CPI price level has risen 447% and as of the last reading in Sept, is just .8% off its record high in July ’08. It’s like oil going from $20 to $110 and then dropping to $109.23. Is that deflation? They want inflation just as the American consumer can barely afford the current cost of living. When demand is slack, why does the Fed want to raise the cost of living and make things more expensive? Doesn’t the law of supply and demand call for lower prices when demand is low? Wal-Mart says many of their customers are literally living paycheck to paycheck and the Fed seems hell bent in making it worse for the average consumer in order to bail out borrowers who can pay back their debts with inflated money. In terms of actual economic stimulus, all cheap money has done has encouraged refinancing which just kicks the can down the road when our economy desperately needs to reduce debt. For many who have to and want to de-lever, who cares what the cost of money is. With respect to the economic cycle, recessions are good as they cleanse, they clear, they de-lever. If only they let the early 2000’s recession run its full course without monetary distortion I wouldn’t be writing this piece.
The monetary policy act of setting the short term cost of money (the fed funds rate) and embarking on quantitative easing is price fixing on a grand scale, Soviet Union central planning style. Leaving that decision to ten voting members sitting around a mahogany table in Washington, DC is the true error of our economic ways. The Federal Reserve’s policy of setting what they think is the right rate is the true weapon of mass financial destruction. It has led and continues to lead to a massive misallocation of capital, a terrible debasement of the US dollar where capital is literally fleeing the country and hiding in gold out of self defense and a hidden inflation that is not captured in their preferred view of the world, the CPI. The US dollar has lost more than 90% of its purchasing power since the Federal Reserve was created in 1913, case in point.
The Fed’s dual mandate of maximum employment and price stability must be altered to eliminate the former. Price fixing short term interest rates to manipulate human behavior to achieve some level of economic activity is a grand experiment that has failed miserably and the US economy will never be on firm footing without the market based setting of interest rates throughout the entire yield curve that can quickly adjust to changing behaviors and demand for credit. A free market supply, demand dynamic and pricing discovery mechanism for the cost of money would lead to sounder lending decisions and the more prudent allocation of credit and capital throughout our economy. A stable currency and sound money would hopefully then follow as the Fed’s printing press wouldn’t be given another reason to print more money than the economy demands.
The Fed’s monetary policy particularly over the past 10 years must be scrutinized and exposed for the mess that it has left. Unfortunately Bernanke and Greenspan have disabused themselves of any responsibility for what they have wrought upon us. They don’t see that cutting rates from 6.5% to 1% back to 5.25% and now to basically to zero, followed by quantitative easing is a problem with policy. Bernanke particularly thinks it was the lack of regulation that resulted in the credit bubble. In other words, he thinks it wasn’t easy money that created the excessive demand for credit that led to massive leverage that was the problem; it was the lack of oversight by bureaucrats in Washington, DC. I strongly disagree.