Monday, May 25, 2009

Central Banking's Last Hurrah?

The current system of central banking, which has been in place for approximately the last century, is on the cusp of establishing its worth, or spectacularly failing. Central banks, in the U.S. and elsewhere, usually succeed in stabilizing the financial system during moderate downturns. But they have never successfully rescued an economy from a severe downturn. The Great Depression ended only because of the enormous boost in government spending required by World War II. Severe downturns in the Third World, which have been common in the postwar era, have usually been resolved with the assistance of external sources of funding such as the IMF and aid from First World nations. The one severe downturn in the U.S. in the postwar era before our current times was the stagnation of the 1970s. The weight of opinion today is that the Federal Reserve did a poor job in the 1970s, allowing inflation to skyrocket while the economy stagnated. Only after a new Chairman, Paul Volcker, was installed did the Fed bite the bullet and do the right thing, quelling inflation even though the cost was a severe recession in 1981-82. It helped that the price of oil fell to $10 a barrel by the mid-1980s, with gasoline sometimes available for less than $1 a gallon.

Because the U.S. was by far the largest economy in the world in the 1970s, there was no external source of funding or aid to help pull it out of the 1970s downturn. The nation had to work its way out of the mess, slowly and painfully. Even though Chairman Volcker, in the end, saved the day, U.S. central banking deserves a C- for its performance that decade. Of course, that's better than the F it deserves for its performance in the 1930s.

As in the 1970s, today there is no external source of funding or aid that can help the U.S. Indeed, the IMF is seeking more capital from the United States and other industrialized nations to help stabilize Eastern Europe and other small nations experiencing major downturns. So America, and the Federal Reserve, will have to go it alone.

The Fed's principal tactic has been to print money. There are an ever increasing number of alphabet soup programs through which the Fed has operated its printing press: TALF, TAF, TSLF, AMLF, PDCF, loans to the FDIC, purchases of U.S. Treasury securities, etc., etc. But when you get past the technical details, these programs consist of dispensing "money" that the Fed creates simply by making appropriate computer entries in the banking system's records. The Fed's printing press has increasingly become the source of credit in the U.S. for individuals, businesses, and the federal government.

All this liquidity is having an impact. The economy seems to be declining less quickly, oil (and gasoline) prices are rising briskly, stock values have bounced up, and the dollar is shrinking. As was the case for the last decade, Fed easy money policies are triggering asset inflation. It happened in the 1990s, when Alan Greenspan's mistaken belief in a paradigm shift rationalized low interest rates that bubbled up tech stock prices, followed by a collapse from which the stock market has yet to recover. It happened in the 2001-2005 era, when easy money created the now notorious real estate boom and bust, with which we still struggle. It happened again in 2007-08, when Fed easy money intended to prop up the banking industry and real estate market instead caused a bubble in oil prices that broke the back of America's auto companies. (Think about it: if oil prices in 2008 had stayed around $60 a barrel and gas around $2.50 a gallon, American car companies would be having a tough time today but wouldn't be in or on the verge of bankruptcy.) Now, with the economy headed for 10% unemployment and the worst drop in GDP since the 1930s, the Fed is running the printing press day and night, and some asset values are starting to bubble again. One doesn't like to think of the central bank as a one trick dog, but . . .

If all this works, Ben Bernanke and his colleagues will be heroes. But no government program that consists primarily of printing money has ever before salvaged a sinking economy. In World War II, the massive military budget was funded by borrowing (recall the war bond drives) and tax hikes. To prevent inflation, there were price controls and strict rationing of civilian access to food, fuel and various other essentials. No new cars were made for the civilian market from the beginning of 1942 until the end of the war. The nation paid its way to victory and economic recovery; it didn't debase its currency. While it's true that massive government spending did pull the U.S. out of the Great Depression, the nation did so with real money.

Right wingers who stockpile food, water and ammo foam at the mouth about fiat money (i.e., paper money issued by a government) and the temptation of debasement it poses to governments. Most of the time, their concerns are misplaced because central banks learned from the experiences of 1920s Germany, 20th Century Latin America, and various other economic disasters that printing money provides only false, short lived hope. The Fed hopes that its flood of liquidity will stimulate the economy, and intends to withdraw the liquidity soon thereafter to prevent inflation and panic. But withdrawal of the liquidity could cause the economy to turn downward again, a la 1937-38, when FDR's administration did something comparable.

The Fed is on a road no central bank has successfully driven down, and the way is foggy. Congress is no help because its sound bite-driven histrionics preclude further government stimulus programs (which would have to be funded mostly by borrowing because Americans no longer believe in paying their way). There is a chance that the Fed could pull this off. The hard part will be withdrawing the liquidity as the economy rebounds. Some pain would be inevitable and the ensuing political outcry might sway the central bank to give the wino a few more bucks.

If the Fed fails, central banking as we know it will have to change. The Fed's poor oversight of the risk levels taken by the banking industry allowed the current crisis to develop. If the Fed can allow a disaster to arise and then not fix it, the Fed has to change. Its ability to print money would have to be substantially limited. We'll need much stricter risk management for the banking system, similar to the Canadian system. Perhaps the derivatives market will have to be separated from the core banking system and made the province of parties having an underlying economic need for the contracts, trading with counterparties that aren't affiliated with banks. These measures will probably reduce America's potential for growth. But they would also reduce America's potential for losses. With the stock market having attained no net gains for the last ten or eleven years (longer if one takes account of inflation), and numerous 401(k) accounts now devastated, reducing the potential for loss would be no small achievement.

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