Federal Reserve

The Federal Reserve yesterday announced $725 billion in new purchases of Fannie Mae and Freddie Mac securities to hold up housing finance, along with plans to buy $300 billion in Treasury securities. Before this latest program, the Fed was already running the most expansionary modern monetary policy since the Weimar Republic. On top of $2 trillion in guarantees for a broad range of private securities, the Fed has been gunning the monetary base at an extraordinary rate. Consider the following: The Fed normally expands the monetary base, which forms the basis for credit and the overall money supply, by an average of 1 to 2 percent per month. In September and October of last year, they expanded that base by 58 percent; in November and December, they increased it another 50 percent.

The Fed was right to do all this, in a deliberate if desperate attempt to push enough juice into a severely strained and strapped financial system, to enable it to get back on its feet -- or at least to not slip into a coma. It hasn't worked so well yet, because the financial system and economy are sicker than anyone thought. And now we’re caught in a vicious circle: The financial system’s woes pushed the economy off the cliff, which then took most other economies in the world with it, and now the problems of our economy and everyone else's are intensifying the financial system's weaknesses.

And the Treasury is out in the markets every day selling the government's securities, even when the Fed's not buying. And like some titans on Wall Street, they may be making a bad bet with your money. The bet here is that inflation will be nothing to worry about for another decade; and if that's wrong, taxpayers will pay a big price. At issue here is what's called Treasury Inflation Protected Securities, or TIPS, securities which pay those lending to the government a set interest rate, like any other Treasury security, but one figured off a principal amount that adjusts upward every six months to take account of inflation. At the price TIPS are now fetching, the market is betting that inflation will be nothing to worry about for another decade. And the Treasury is backing up that bet by selling TIPS at very low prices.

The market and the Treasury backing it up are almost certainly wrong this time. Here's what may well be happening: When markets heat up or melt down, they have a tendency to assume that their conditions will persist for as far as they can see (or invest). That can explain what's happening in the TIPs market: They’re selling at a rate and return which assume that today’s extraordinary deflation will just keep on going, for years into the future. That's possible -- but it's very, very unlikely. The economy eventually will stop contacting; and when it does, prices will stop going down. In fact, through the booms and busts of the last 50 years, the U.S. inflation rate has consistently averaged about 2.5 percent per year over any extended period.

Moreover, once the economy recovers this time, the extraordinary steps we're taking to bring about that recovery will almost certainly produce strong inflationary pressures. First, we're currently embracing the most expansionary fiscal policy in our history (at least for peacetime), with multi-trillion-dollar deficits -- and necessarily so for an economy contracting at a six to seven percent rate. And on top of that is the Fed’s unprecedented monetary expansion.

Whatever White House or congressional leaders say about education, climate or health care, the economy and the financial system, and only that, will remain the President’s central focus and task for the rest of this year and well into 2010.

Eventually we will succeed -- and when we do, our wildly expansionary (if necessary) fiscal and monetary policies will extract a cost. One principal cost is almost certain to be higher than normal inflation -- and that's when the TIPS issue will bite us. If inflation is much higher five years from now than the TIPS market expects today -- and you can bet on that -- people who bought TIPS when everyone expected very low inflation will end up making a killing as the value of their securities is adjusted way upwards for the higher-than-expected inflation. We estimate that will cost taxpayers as much as $80 billion in additional debt-service costs. Fortunately, there’s an easy answer: The Treasury can buy back the outstanding TIPS and reissue the debt in conventional securities. Current TIPS holders would get the current value of their securities, and taxpayers could save enough to finance an awful lot of college assistance, health care for children, or R&D in climate-friendly fuels and technologies.

At a time when nearly everywhere we turn, it costs us all billions or even trillions of dollars, wouldn't it be satisfying to save some real money -- and without raising anybody’s taxes or cutting anybody’s program?

For more information, see the new study, "The Benefits to U.S. Taxpayers from an Open Market Buyback of Treasury Inflation-Protected Securities," at this site.

On virtually everything economic, the Bush Administration and much of Congress have become the gang that can't shoot straight -- and their stray bullets could take down a good piece of the nation's economic prospects. They have directed hundreds of billions of taxpayer dollars to financial institutions (and soon, auto companies), and they're getting ready to direct several hundred billion more at the overall economy. In all of these instances, a political drive to display the will and capacity for large actions has overwhelmed deliberate thinking about the specific consequences of those actions. The Obama presidency and the country may pay a big price for this scattershot approach.

The latest example of this dangerous development is the ever-expanding size of the long-awaited next stimulus. We're in a deep and serious recession and a major stimulus was certainly needed -- mainly six months ago, when the Bush Administration and Congress provided tax rebates which were largely saved and had little stimulative effect. Now we know how bad the downturn is turning out to be, and Congress and the Administration-in-waiting is preparing another stimulus of a size commensurate with what's already unfolding, once again, as if this were six or eight months ago. A stimulus providing another $200 billion to $300 billion in new federal spending makes sense, mainly as insurance for another shock to the economy. But a $500 billion to $750 billion package like the one now under discussion will miss its target by many months and mainly indicates that the new rule is that anything goes when you win and damn the consequences.

Congress seems intent on responding to this recession as if everything known about how the business cycle works can be ignored, and the consequences could be serious. The Obama team is focused on long-term investments in 21^st century energy and transportation infrastructure, modernizing health care records, expanding training and education, and extending broadband and IT access for poor children. That's all good news for the long-term health of the economy and for the incomes of many households.  The catch is, long-term investments entail not a one-time boost in spending, but continued funding. So when we raise the ante on those investments from $100 billion or so to $300 billion, $400 billion or $500 billion, we're implicitly choosing either to foreswear any other commitments, such as health care, or to embrace another round of dangerously large, structural deficits.

Since the new politics seems to involve never saying no, the likely result of the current course, on top of the extraordinary infusions of credit by the Federal Reserve, is serious inflation once the downturn begins to resolve itself. This pattern is disturbingly similar to the short-sighted and cavalier approach to long-term risks that got the nation into this mess. And it continues to develop alongside the Treasury and Congress' continuing inability to address the rising foreclosures still driving the financial crisis and the credit freeze accelerating the downturn. Yet real responses are within reach: place a moratorium on foreclosures while Fannie Mae and Freddie Mac renegotiate the terms of millions of troubled mortgages and link financial bailout funds to a commitment to use them to extend credit to businesses. If we do that, the economy won't need so much fiscal or monetary stimulus. 

The current approach presents other serious risks. This pattern of fast-rising spending, on top of the bailouts already done and those to come, as well as more tax cuts, could push the U.S. deficit to levels that even the United States will have trouble financing. The Asian and Middle Eastern governments that provide much of our public financing could stop -- either because they'll see inflation coming, too, or because the global downturn and falling oil prices sharply reduce their savings and thus, their ability to lend them to us. The U.S. Treasury will always find the funds it needs, but it may have to pay a lot more to borrow them, which means higher interest rates. So the current approach risks an interest rate spike on top of everything else, which at best would lead to a substandard recovery. With all of its talent and broad public support, the Obama presidency should be able to do a lot better than that.

Congress tried late last week to stall the financial crisis by pledging to spend $700 billion on devalued securities held by financial institutions, and by Monday morning, it was clear that the pledge wasn’t enough to reassure investors or restart lending.

Instead, a classic panic has set in here and around much of the world as public confidence in banks, other financial institutions and the markets themselves has nosedived; at the same time, banks and other financial institutions are wary of loaning money to potential borrowers. This panicked mindset threatens the economy more today than the continuing turmoil in the housing and financial markets. 

We must now recreate baseline confidence before we can repair the continuing damage to our financial and housing markets.  

Financial and broader economic panics thrive on a combination of huge and unexpected setbacks and a serious absence of information. They unfold when people face enormous uncertainty about matters vital to them, such as the value and security of their homes,  retirement accounts and college savings. Panics thrive when people see everyone else, including those with the power and position to manage such weighty matters, struggling with the same uncertainty. 

People feel threatened and powerless to do anything, not because they have no options, but because they have to evaluate or choose among those options, and they worry that more unexpected calamities could overtake whatever course they decide upon. That’s where tens of millions of Americans – and Europeans and Asians as well – have found themselves this week. They don’t understand why the value of their homes and investments has plummeted so suddenly, and they see that those ostensibly in charge of the economy in Washington and on Wall Street have little grip on this as well. The result is that spending and investment are shutting down, dragging the entire economy into what seems very likely to be the worst downturn since the 1930s. 

The remedy to this panic is information, which only the nation’s leaders can generate and demonstrate they understand. For example, the Federal Reserve and the FDIC should have legions of examiners working around the clock to re-audit the conditions of all major financial institutions, starting with commercial banks. The Treasury and Fed could then report to the public on each institution’s financial health and their confidence in its continuing financial health. The largest group would still be judged healthy; another group could be designated as worth watching, with measures to help it move to the first group; those in trouble would be identified with a plan of action to help them recover, if possible. Without this information, most people have been panicking that almost every institution and every investment might well be in serious trouble.  

This program won’t solve the capitalization crisis across financial institutions, much less the crisis gripping housing markets, which itself has driven so much of the current upheaval. But it would staunch the panic as investors, business owners and families come to feel that they finally know where the problems lie and what the government and nation’s business leaders will do to address them.

At the same time, our leaders can finally begin to address seriously the housing and capitalization crises in an economic environment in which businesses and people will be able respond reasonably and predictably.

Coming up from the morning read of the papers it is hard not to feel more than a little worried about the country these days.

We are five years into Iraq, trillions spent, tens of thousands of casualities, the region is more troubled than before and there is no clear and easy end in sight. Warnings about the impact of climate change are growing more urgent, and scary. Oil and gas prices are breaking all sorts of records, and there is no prospect of these price gains being substantially reversed. Global prosperity is driving up commodity and food prices across the world, making the task of moving struggling societies and people into a better place ever more difficult. Important Olympic athletes announce they are skipping the Beijing Olympics due to the dangerous levels of pollution there. More evidence comes to light each week it seems of systemic and almost unthinkable violations of the civil liberties of Americans in the Bush era. The President reaffirms for all the world to see his committment to rip apart the Geneva Conventions. A new and extraordinary Congressional GOP scandal explodes across Washington. The GOP returns to their failed, and racist, efforts to blame the nation's problems on Hispanic immigrants, and a terrible "enforcement-only" bill stumbles closer to passage in the House. The Administation announces they plan on bringing the Columbia Free Trade Agreement to a vote even though it will not pass, will damage the standing of one of our most important allies in Latin America and set back our efforts to rebuild a bi-partisan consensus on global economic policy. The career of a very promising young governor from New York ends spectacularly. The Republican Presidental candidate seems to have been transported into today's election from a bygone era of American politics. The Democrats can't make up their mind on who their next leader will be, and are not even sure how they are going to make up their mind.

Democrats are finding solace in that the nation's anger about the state of our union is being directed, properly, at the Republicans. From today's Post:

"It's no mystery," said Rep. Thomas M. Davis III (R-Va.). "You have a very unhappy electorate, which is no surprise, with oil at $108 a barrel, stocks down a few thousand points, a war in Iraq with no end in sight and a president who is still very, very unpopular. He's just killed the Republican brand."

 

As we've been writing for years now the governing failures of the Bush era have been historic, and have done grave damage to the "American brand." Few believe that in this last year in office this failed President, perhaps the worst in US history, has the capacity to lead and meet even simple challenges. But each passing day the ongoing revelations about the weakening of our financial system suggests we could be facing a crisis of historic porportions, one that will require far-sighted and sure-footed leadership from the President, the Administration and from Congress, from Republican and Democrat alike. A front-page article in the Times today raises serious questions about the Federal Reserves effectiveness in managing the growing crisis so far. And an editorial in the Times today about a speech the President gave on Friday should leave all of us very worried about the capacity of this President to even understand - let alone take appropriate action to deal with - our growing economic and financial challenges.

I am taking the unusual step of posting the whole editorial, for given the gravity of our emerging financial crisis, this excellent essay needs to be read and considered in its entirety:

President Bush admitted on Friday that times are tough. So much for the straight talk.

 

Mr. Bush went on to paint a false picture of the economy. He dismissed virtually every proposal Congress is working on to alleviate the mortgage crisis, sticking to his administration's inadequate ideas. And despite the rush of serious problems - frozen credit markets, millions of impending mortgage defaults, solvency issues at banks, a plunging dollar - he said that a major source of uncertainty today is whether his tax cuts, scheduled to expire in 2010, would be extended.

This was too far afield of reality to be dismissed as simple cheerleading. It points to the pressing need for a coherent plan to steer through what some economists are now predicting could be a severe downturn. Mr. Bush's denial of the economic truth underscores the need for Congress to push forward with solutions to the mortgage crisis - especially bankruptcy reform to help defaulting homeowners. Lawmakers also must prepare to execute, in case it is needed, a government rescue of people whose homes are now worth less than they borrowed to buy them.

Mr. Bush said he was optimistic because the economy's "foundation is solid" as measured by employment, wages, productivity, exports and the federal deficit. He was wrong on every count. On some, he has been wrong for quite a while.

Mr. Bush boasted about 52 consecutive months of job growth during his presidency. What matters is the magnitude of growth, not ticks on a calendar. The economic expansion under Mr. Bush - which it is safe to assume is now over - produced job growth of 4.2 percent. That is the worst performance over a business cycle since the government started keeping track in 1945.

Mr. Bush also talked approvingly of the recent unemployment rate of 4.8 percent. A low rate is good news when it indicates a robust job market. The unemployment rate ticked down last month because hundreds of thousands of people dropped out of the work force altogether. Worse, long-term unemployment, of six months or more, hit 17.5 percent. We'd expect that in the depths of a recession. It is unprecedented at the onset of one.

Mr. Bush was wrong to say wages are rising. On Friday morning, the day he spoke, the government reported that wages failed to outpace inflation in February, for the fifth straight month. Productivity growth has also weakened markedly in the past two years, a harbinger of a lower overall standard of living for Americans.

Exports have surged of late, but largely on the back of a falling dollar. The weaker dollar makes American exports cheaper, but it also pushes up oil prices. Potentially far more serious, a weakening dollar also reduces the Federal Reserve's flexibility to steady the economy.

Finally, Mr. Bush's focus on the size of the federal budget deficit ignores that annual government borrowing comes on top of existing debt. Publicly held federal debt will be up by a stunning 76 percent by the end of his presidency. Paying back the money means less to spend on everything else for a very long time.

The fiscal stimulus passed by Congress, and touted by Mr. Bush on Friday, could juice growth for a quarter or two later this year. But the economy's fundamental weaknesses indicate that Americans are ill-prepared for hard times. That makes the need for clear-eyed policies all the more urgent. We need them from the president, Congress and the contenders for the White House.

Meeting the deep array of daunting challenges the nation faces today will require bold, resolute and visionary leadership from all quarters in the years ahead. My hope is that the President will attempt to do more than prepare for his disgraced retirement in his remaining days in office. And at the very least if he cannot and will not lead, he should do everything he can to get out of the way of those who want to help our great nation clean up the incredible mess he is leaving behind. Democrats may be delighting in the collapse of their opposition but with Congress in their control and the Presidency likely to be in their hands next year, these problems will very soon become theirs to solve.

Sunday night update: The NYTimes lede on its site tells it all: Federal Reserve Acts to Rescue U.S. Financial Markets

For two years we've been wondering out loud if Bush was this century's Hoover. In the past few days I worry that this analogy has become truer than we should all desire.