Who Screwed Up the 1970s?

The standard narrative of the stagflation of the 1970s is the one that the right has advanced. The left has no countervailing narrative. In that of the right, the economic doldrums of the ’70s can be squarely hung round the neck of liberals: in the simplified version, because of the welfare state, no further explanation required; in the more complicated one, the inability to choose between the guns of Vietnam or the butter of the Great Society, of Keynesian fine tuning and oil shocks resulting from liberal pussyfooting around in foreign policy. The hero of this narrative is Ronald Reagan who unwound twenty years of leftist regulation and redistribution, unleashing the U.S. economy to do what it does best.

As a liberal, this is the narrative against which I must justify my policy preferences, but more basically, I think it just simplifies a much more complex story. As an example, when Reason, a right-of-center libertarian publication, decides to hold a colloquium on the renewed threat of stagflation, which president do they put on the cover as the personification of the memory of the inflation of the 1970s? Gerald R. Ford:

Reason Magazine, October 2009, President Gerald Ford as the poster-boy for inflation

Poor Gerald Ford: an honorable man whose best association is Chevy Chase spoofs from Saturday Night Live of him tumbling down the airstairs.

It should be recalled that Reagan’s first run for the presidency consisted of his failed challenge to incumbent Ford for the 1976 Republican nomination, and that the real bête-noire of the Ford-Kissinger foreign policy was not the Democrats or the left, but the anti-détente, anti-arms control neoconservatives and elements of the right who found their political figurehead after Barry Goldwater in Ronald Reagan. It should also be recalled that the policy maker credited with the defeat of the inflation of the 1970s is then Federal Reserve Chairman Paul Volcker, a Carter appointee, rather dishonorably shown the door for his efforts by President Reagan in favor of Alan Greenspan.

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A Co-President?

Federal Reserve Chairman Ben Bernanke and President George W. Bush

At the constitutional convention in summer of 1789 the founding fathers struggled to find an amenable compromise between those desiring a vigorous executive and those concerned about despotic overreach. One proposal to limit the executive was that instead of concentrating power in a single person, create a miniature division of powers by having a triumvirate of co-presidents.

Events of the past few weeks have been instructive. It would appear that the Federal Reserve Act of 1913 delivered us a co-presidency in a sub-constitutional manner. It would appear that they each have their own portfolio: one is commander and diplomat in chief and the other is the captain of the macro-economy. With his 20 year term, substantial independence, control over interest rates, lending capability, 800 billion in capital and a regulatory mandate over the banking system, the Federal Reserve Chairman has a vast array of powers, while not on par with the official executive, impressive nonetheless.

It’s also worth noting that, like the official President, the Federal Reserve Chairman accrues perhaps the better part of his powers through reputation, as a focal point of attention and the judicious use of his own particular bully pulpit.

This has some potentially troubling implications, depending on where you fall on the democratic spectrum. In this regard, Will Wilkinson has some interesting ruminations on what he calls “the structure of the de facto American constitution” (“What’s an Incrementalist Market Liberal to Think?,” 19 September 2008; the previous post, “The Benign Rule of Ben Bernanke and the Ideal of Democratic Equality, 18 September 2008, along the same lines is also good too).

It’s also worth noting — something that has become apparent throughout the Bush years — that many of the constraints on the presidency are not official, but adhered to only out of tradition. When the situation warrants — or ambition allows — the executive is capable of blowing through its traditional restraint, erupting into a ferocious activism. When this happens in the realm of foreign policy everyone loves it. Nothing gets people excited like a little kicking of foreigner ass. When it happens in the domestic or economic realm, people aren’t so enthusiastic, as Congressional telephone lines, recently clogged with populist anti-high finance carping, will attest.

Federal Reserve Balance Sheet

Amid news that the Federal Reserve is establishing this multi-billion dollar line of credit, extended that many billion in overnight repurchase agreements, contributed $30 billion to the J.P. Morgan buyout of Bear Stearns and spending $83 billion for the purchase of A.I.G., the question lingering in the back of my mind is how is the balance sheet of the Federal Reserve looking right about now. The Federal Reserve doesn’t have unlimited resources at it’s disposal. It has about $800 billion in assets which only buys it a limited amount of credibility. It’s not all that much relative to the scale of modern financial flows.

Anyway, wonder and The Wall Street Journal will deliver (Blackstone, Brian, “U.S. Moves to Bolster Fed Balance Sheet,” 18 September 2008, p. A3 [subscription required]):

Federal Reserve assets, The Wall Street Journal, 18 September 2008

The Treasury, responding to worries that the Federal Reserve could be running out of financial ammunition to deal with the credit crisis, moved to reload the Fed’s gun with $100 billion worth of bullets.

The central bank’s bailouts of Bear Stearns and American International Group Inc., as well as lending programs created in the past year, are putting the Fed’s once-mighty balance sheet at risk. Financial markets have begun to fear that if nothing is done, the Fed might have trouble putting out fires in the future.

The Fed held close to $800 billion in Treasury securities a year ago. By last week, that had dwindled to just under $480 billion. The amount drops to less than $200 billion if the $200 billion pledged to the Term Securities Lending Facility — a Fed lending program created in March for investment banks — and the full $85 billion line to AIG are accounted for, Fed watchers say.

“The tally is so low that it is becoming imperative for the Fed to take actions to enlarge its balance sheet,” said Tony Crescenzi, a strategist at Miller Tabak in New York.

When the Fed lends money to a financial institution, it usually sells an asset such as Treasurys separately in the market and absorbs the cash created by the loan. The goal is to keep a proper level of money flowing through the financial system. If the Fed were to run too low on Treasurys to conduct these operations, it could lose its ability to drain money from the banking system and control inflation.

On Wednesday, the Treasury announced a temporary program to bolster the Fed’s balance sheet and sold $40 billion in 35-day Treasury bills. It announced later in the day that it would hold two additional auctions of Treasury bills on Thursday totaling $60 billion. In effect, Treasury is auctioning off more securities than are needed to fund the federal government, and carrying out the draining function in place of the Fed. The cash from the Treasury’s sales is parked at the Fed.

Of course the government has infinite money, but it comes at a cost. As long as the Fed coffers are topped off, Chairman Bernanke is his own man. But already Federal Reserve assets are approaching levels where he will increasingly be at the behest of Treasury Secretary Paulson and House Financial Services Committee Chairman Barney Frank.

Not So Fast on the Moral Hazard

Last week American International Group requested assistance in the amount of $40 billion from the Federal Reserve. This was rejected only to have A.I.G. come back with a second request, this time for $75 billion. Over the weekend the Federal Reserve and the Treasury decided to let Lehman Brothers fail. On Monday and today the editorial pages were full of adulation about the reinstantiation of the rule of moral hazard. “If Lehman is able to liquidate without a panic … the benefits would include the reassertion of ‘moral hazard’ on Wall Street.” (“Wall Street Reckoning,” The Wall Street Journal, 15 September 2008, p. A22) “It was a brave decision. By abandoning Lehman Brothers, a 158-year-old piece of Wall Street furniture, and refusing to remove their hands from their pockets when Merrill Lynch came calling, Hank Paulson, US Treasury secretary, and Tim Geithner, governor of the Federal Reserve Bank of New York, had one of the busiest weekends of dispassion on record.” (Persaud, Avinash, “Lehman Had to Fall to Save the Financial System,” Financial Times, 16 September 2008, p. 13).

But then on midday Monday, New York state started waiving insurance regulations to allow A.I.G. to make a complex set of financial transfers to try to gather up enough collateral to cover it’s debts at a downgraded credit rating. At midday today when it started to look like a private bailout package being negotiated between J.P. Morgan and Goldman Sachs was faltering, the Federal Reserve stepped in to assist in the negotiations. Then it appeared that the Federal Reserve would be playing a key role in the package, but Fed spokesman was declining comment. Now, late this evening the Federal Reserve is announcing that it’s not going to be facilitating a private loan to, but outright buying a controlling interest in A.I.G. (de la Merced, Michael J. and Eric Dash, “Fed Readies A.I.G. Loan of $85 Billion for an 80% Stake,” The New York Times, 16 September 2008):

In an extraordinary turn, the Federal Reserve was close to a deal Tuesday night to take a nearly 80 percent stake in the troubled giant insurance company, the American International Group, in exchange for an $85 billion loan, according to people briefed on the negotiations.

In return, the Fed will receive warrants, which give it an ownership stake. All of A.I.G.’s assets will be pledged to secure the loan, these people said.

The Fed’s action was disclosed after Treasury Secretary Henry M. Paulson and Ben S. Bernanke, president of the Federal Reserve, went to Capitol Hill on Tuesday evening to meet with House and Senate leaders. Mr. Paulson called the Senate majority leader, Harry Reid, Democrat of Nevada, about 5 p.m. and asked for a meeting in the Senate leader’s office, which began about 6:30 p.m.

The Federal Reserve and Goldman Sachs and JPMorgan Chase had been trying to arrange a $75 billion loan for A.I.G. to stave off the financial crisis caused by complex debt securities and credit default swaps. The Federal Reserve stepped in after it became clear Tuesday afternoon that the banking consortium would not be able to complete the deal.

Extraordinary indeed! It would seem that the Federal Reserve and the Treasury aren’t so bullish on moral hazard after all.

The Committee to Save the World, Ten Years On

The Committee to Save the World, Time Magazine, 15 February 1999

It’s mostly consigned to the past, but it increasingly seems to me that the Asian financial crisis of 1997-98 and the attendant reaction of U.S. economic policy makers was the watershed economic event of the present era. The economic handlers of the time, most outstandingly Alan Greenspan, Robert Rubin and Lawrence Summers came as close to the rank of heros as economic policy makers are allowed (“the committee to save the world” in Time Magazine’s famous formulation). During the period 2 July 1997 through 23 September 1998 — the floating of the Thai baht to the deal to bail out Long Term Capitol Management — the Federal Reserve held rates steady at 5.5 percent, then in September, October and November made a succession of impressively restrained off-committee 25 basis point rate cuts. The firebreak held and the U.S. economy got another 24 months of economic growth, crossing the line to become the longest uninterrupted economic expansion in U.S. history in February of 2000. On such a basis is the formidable reputation of Alan Greenspan built.

But the unenunciated strategy of Greenspan, et. al. during this period was to stave off the spreading crisis by converting the vast and voracious American body of consumers into the buyer of last resort for the world. The countries in crisis would be propped up through IMF aid packages, but also through the newly enhanced competitiveness of their goods on the U.S. market. This was accomplished through the aforementioned interest rate cuts, but also at Treasury through the strong dollar policy.

U.S. trade deficit, 1991-2005

Source: Wikipedia; U.S. Census Bureau, Foreign Trade Division

The broadest mechanism by which interest rates work is through home mortgages. As interest rates decline they set off a wave of home loan refinancing, liberating spending previously sunk into housing costs. That combined with the (psychological) wealth effect of the stock market and a historic credit binge came together in the person of the American consumer to pull the world back from the brink. A glance at the above graph of the trade deficit shows that 1997 was the inflection point.

In so far as the way that the U.S. opted to combat the global spread of the anticipated “Asian contagion” was to transform the U.S. consumer into the buyer of last resort through loose credit, the collapse of the housing market bubble is the continuation of, or the knock-on effects of the Asian financial crisis of 1997-98. It could only be postponed, not avoided; transformed, not stopped. Old wine in new bottles.

It was fairly apparent to most observers during the late 1990s and 2000s that the Federal Reserve was struggling to stave off a crisis and did the best that it could, but was merely kicking the can down the road. There was plenty of commentary at the time that the Fed was merely letting pressure off one bubble by inflating another. And inside the Fed they were fully aware that this was what they were doing, but they had to deal with the crisis at hand and figured that they would cross the bridge of the iatrogenic consequences of their policies when they came to them.

In this sense the ultimate cause of the present economic crisis is a structural imbalance in the world economy that has a tendency to generate crises. One portion of the world, the developing, produces without consuming and as a result experiences a glut of savings. The other, the U.S., consumes by borrowing the surplus savings of that other portion of the world. Witness the current account deficit of the United States with China and the strategic fallout thereof. The problem is political-economic in nature and the ultimate solution lies in the realm of politics, not behind the scenes financial wizardry.

The Federal Reserve and Mortgage Backed Securities II

So it turns out that what was unusual about the Friday open market operations of Federal Reserve was even more narrowly technical still. The Federal Reserve always accepts mortgage backed securities as collateral, but usually issues loans backed by this sort of collateral at a less favorable rate. What was unusual on Friday was that the Federal Reserve issues all loans at the most favorable rate, no matter the collateral.

Kevin Drum passes along an e-mail from Stephen Spear, a professor of economics at Carnegie Mellon University, in which the Professor relates a conversation with a Federal Reserve colleague about the operation (“Friday’s Liquidity Event,” Political Animal, The Washington Monthly, 12 August 2007):

Here’s what I’ve been told by a colleague at the Fed:

First a minor point: Most of the open market operations that the Fed does (including Friday’s) are short-term collateralized loans and not outright purchases of securities. Friday’s loans were all overnight (well, over the weekend, actually, maturing on Monday). So the Fed is technically not buying anything; it’s been making short-term loans of cash against collateral.

The Fed accepts three categories of collateral for these loans. One is Treasury securities, another is other government agency securities, and the third is mortgage-backed securities that are federally guaranteed. Because they are federally guaranteed, the mortgage-backed securities the Fed accepts are (obviously) the very best.

Typically the interest rate on these short-term loans varies slightly depending on the type of collateral offered by the borrower. Treasuries get the lowest rate; mortgage-backed securities the highest. (The details of the last 25 OMOs, including the rates for each type of security, are available here.)

What was unusual about Friday (other than the size of the operation) is that the Fed announced it would lend against all three types of collateral at the same rate.

To quote my Fed colleague on this: “I’m not sure why we did this. I think the idea was that given the size of the operation we did not want to risk disrupting the Treasuries markets, but there may have been other motivations. The expectation was that borrowers would primarily use mortgage-backed securities, since these have the lowest opportunity cost to the borrower.”

On the web page above, you will see that for Friday’s operations, under collateral type it just says “mortgage-backed.” What this means is that mortgage-backed securities or any better securities were allowed as collateral — in other words, all three types were acceptable. Apparently, the media misinterpreted this as saying that the Fed was only accepting mortgage-backed securities, which led to the headlines about the Fed buying these things up.

So, the bottom line is that the Fed’s actions on Friday were unusual, but not tremendously so. It did three OMOs instead of the usual one. The quantity of reserves lent out was larger than normal, and the way collateral was handled was slightly unusual. But the general operating procedure, including the type of collateral accepted, was completely standard. It would seem that the media is trying to make the story a lot more sensational than it truly is.

Given the extraordinary amounts of money here along with tweaks to the usual policy, obviously the Federal Reserve sees a problem requiring extra-ordinary measures, but obviously not the panic initially reported by the press.

The Federal Reserve Does Not Buy Mortgage-Backed Securities

When I saw the following story in the New York Times on Friday (Peters, Jeremy W. and Wayne Arnold, “Stocks Are Volatile After Global Sell-Off,” 10 August 2007) I fucking freaked:

The E.C.B. injected another 61 billion euros ($84 billion) into the banking system, after providing 95 billion euros the day before. The Federal Reserve today added $19 billion to the system through the purchase of mortgage-backed securities, then another $19 billion in three-day repurchase agreements. The Fed added $24 billion on Thursday.

It’s not the amounts of money that are unusual. Yes, this indicates a fairly aggressive attempt to preserve liquidity in financial markets and it is definitely earning the headlines it is getting in The Financial Times and The Wall Street Journal. But that the Federal Reserve might engage in the direct purchase of $19 billion worth of mortgage-backed securities would indicate a real problem and the adoption of extraordinary, panic measures on the part of the Federal Reserve. On Friday I was thinking how I might reinvest my 401k into gold doubloons.

Thankfully, on Saturday Dean Baker pointed out (“The Fed Does Not Buy Mortgage-Backed Securities!!!!!!,” Beat the Press, 11 August 2007) that this was just incompetence on the part of the economic reporting at The New York Times and The Washington Post (who also reported the story). That what really happed was that the Federal Reserve made a more routine loan through the discount window and accepted the $19 billion in mortgage-backed securities as collateral for the loan.

While you’re there, his post (“Tell The Post: The Problem Isn’t Subprime,” Press, 11 August 2007) pointing out that the cause of our current financial woes is not the subrime market (dirty, irresponsible poor people) is a useful reminder. The real problem is the bursting of the housing bubble more generally. The subprime market is just the first place it’s really being felt.