Friday, April 18, 2008

The Imperial Fed: Does It Have Enough Power?

by Thomas Humphrey and Richard H. Timberlake Jr.

This article appeared on on April 14, 2008.


The Federal Reserve System (the Fed) is the steward of the monetary system. Originally, Congress limited its mission to supplement the operations of the gold standard by lending to needy but solvent banks that were suffering a liquidity problem. In fulfilling this function, it was labeled a Lender of Last Resort (LLR). Through the decades since 1913, however, Congress has endowed it with all the additional powers to do by positive human control what the gold standard did spontaneously on the basis of well-understood rules. It is not only a LLR but also a Monopoly Money Supplier (MMS).

In today's world, the Fed has virtually complete control over the quantity (or stock) of money that appears in the U.S. monetary system. Much of the 'rest of the world' voluntarily uses these Fed dollars in preference to their own or other moneys. Whatever the Fed does as domestic monetary policy, therefore, resounds throughout most of the trading world.

Thomas Humphrey is the former vice president of the Federal Reserve Bank of Richmond and the author of Money, Banking, and Inflation. Richard Timberlake is professor emeritus of economics at the University of Georgia, an adjunct scholar of the Cato Institute, and the author of Monetary Policy in the United States.

More by Richard H. Timberlake Jr.

Much of the time the Fed's supreme money-creating power is overshadowed by the fact that when the Federal Open Market Committee (FOMC) buys or sells government securities in the open market, changes in short-term interest rates accompany its policies. However, the interest rate response is an ephemeral artifact of the money-creating process, and does not reflect the Fed's fundamental function—that is, control of the quantity of money. Short-term changes of the Federal Funds target rate have simply become code words for what the FOMC is doing to the stock of money: "Lowering rates" means they are aiming to make more money available, and "raising rates" means they are trying to tighten up the quantity of money.

While the creation of money—the Midas Touch—is awesome, it is not itself productive of real goods and services. The Fed cannot make a ball-point pen, nor scrub anyone's kitchen floor. However, by controlling the quantity of money, it can guarantee stability in the value of the money unit, and thereby allow the multitude of markets that make up the rest of economic society work to their best advantage.

The new Fed policy, headed by Ben Bernanke, is to provide assistance to specific firms, such as Bear Stearns, in the investment banking industry. The argument is that Bear Stearns is the nucleus of a vast network of credit interrelationships that are vital to financial markets, whose failure would bring chaos to the entire financial market system. It is a continuation of the "too big to fail" notion used in the Continental Illinois bail-out two decades ago.

This contention is very much unproven. It surely was not the primary cause of the Great Contraction of 1929-1933. Today, if Bear Stearns were to go into receivership, its creditors, in cooperation with other market players, would recapitalize it, scaling down the value of its assets until they were in equilibrium with other market values. The firm's real resources would still be in place; they simply would be reorganized and revalued.

In the Bear Stearns case, the Fed provided some of its own stock of already monetized Treasury securities to an insolvent and bankrupt firm taking the firm's now-junk bonds in exchange. In so doing, it conducted a rescue operation of an individual private enterprise rather than providing liquidity to markets in general. Thus far, the Fed has simply exchanged securities dollar-for-dollar with Bear Stearns. It has not yet monetized any of the inferior Bear Stearns securities it is holding.

Under the current institutional framework, the Fed constantly buys U.S. government securities at market prices to provide gradual increases in the stock of money. In plain words, it monetizes outstanding government securities—or anything else it buys—simply by paying for them with checks against its assets. Its new assets that cover the checks are the securities (or junk bonds) it has just purchased! By means of such open-market operations, it creates $25-plus billion per year, or about $50 million per week. This revenue is a seigniorage tax that is credited to the U.S. Treasury. Fed checks to pay for the securities are the monetary fetuses that gestate into living dollars of one kind or another.

This continuous provision of dollars to U.S. and world markets, if managed properly, prevents money itself—as Milton Friedman observed--from becoming a part of the problem. Financial and all other markets then self-correct random disequilibria that occur by directing the dollars to where it is most needed. Indeed, such adjustments have been and are taking place constantly and much more quickly than the Fed or any other agency could direct them.

Encouraging, or even allowing, the Fed to monetize private securities to offset a "crisis," opens the door to the most dreadful of possibilities—monetization of the federal government's vast unfunded liabilities that hang over the economy, an ongoing problem that must be treated in just a few years. That is: If the Fed can monetize Bear Stearns securities to prevent a "crisis," what is to prevent it from monetizing the U.S. Treasury's outstanding debt—as it is doing constantly on a small scale anyway–-when Social Security and Medicare costs overwhelm the federal budget? The Fed has always—ALWAYS—been subservient to the Treasury. So when some future Executive with his agreeable Congress must fund burgeoning Social Security payments, and pressures the Fed to keep interest rates "low" so that the Treasury can market new securities to pay Social Security benefits, what will a pliant FOMC reply if it has the precedent of Bear Stearns in 2008? Will it say, "No, Mr. President; we cannot buy any more securities right now. That would cause inflation, and violate our pledge to keep the dollar stable?" Or will the FOMC, many of whose members may have been appointed by the incumbent executive, dutifully increase its purchases of government securities thereby inflating money prices six to nine months later? Virtually no one would understand what was happening in the latter case; few laymen know how the monetary machinery works or that it works with a lag. But everyone, especially congressmen and media people, can see interest rates rising in the here and now. The hyperinflation that would result from such monetization procedures could rival the German Reichsbank inflation of 1923.

Current policy has encouraged the creation and viability of the Fed as a central bank. It is an institution of human design with one exclusive power: It controls the stock of money, and thereby the value of the dollar. It operates outside of any market influences. At the same time, however, markets of all shapes and sizes control the manufacture of goods, services, and capital. These markets work spontaneously under well-understood rules, but without human manipulation, to direct resources into their most economical channels. For the government to upset this stable arrangement by sanctioning its monetary agency to intervene in private securities markets is not only destabilizing, it also provides a dangerous precedent that may lead to all kinds of future monetary catastrophes. If Congress nevertheless thinks that private security markets need bailing out, it must acknowledge that it alone bears ultimate responsibility for putting the taxpayer at risk. Burdening the taxpayer is a fiscal, not a monetary, responsibility, one that this constitutional republic assigns to Congress, not to the Fed.

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