Federal Reserve Changes Its Business Model

The American culture does not begrudge neighbors their success; the achievements of someone else take nothing away from me. In that spirit, we rejoice in developing countries rising up out of poverty, satisfied their good luck will make for a safer more prosperous world.

Philadelphia Federal Reserve

Rising international prosperity does, however, change matters in several disruptive ways. Developing countries first become producers. subject to the risks of inflation because then they have more money than they know how to spend. The wiser ones know inflation and huge internal income disparities often lead to revolutions, so they sterilize their money by exporting it. The history of coups and dictatorships shows what happens if a developing country doesn't export its inflation. Conversely, our recent dot-com and sunbelt real estate bubbles show what happens if inflation gets exported to us. Eventually, of course, developing countries both produce and consume. Never mind denouncing the rubbish they decide to consume; its only problem for us lies in using up the world's resources faster. Once more, the developing countries export inflation to us in the form of commodity inflation. If we are not careful, we will have a commodity bubble on our hands; when any bubble bursts, a sharp recession can quickly follow, and after that some other kind of bubble.

With luck, these disruptions consequent to a neighbor's prosperity can be overcome by improvements in productivity. One huge productivity windfall for America is the astonishing thirty-year improvement in longevity we have experienced; in time, we will surely devise occupations for retirees more productive than mere vacationing. Such occupations are likely to grow out of electronic productivity which can use home sites as work sites.

So in short, America must readjust and one systematic readjustment has just surfaced at the Federal Reserve. The flood of money from China and the Persian Gulf sought an outlet in our economy, adopting the device of shifting American credit sources from banks to Wall Street ("securitization"). Cheap money once derived from bank deposits in local banks; it now travels through the "carry" trade and other channels for foreign surpluses to get to Wall Street investment banks. Through securitization (turning loans into stock), Wall Street was able to make home mortgages directly, with only token involvement of local banks. So long as Wall Street can continue to find new sources of cheap money, this upheaval of finance is likely to be permanent because it is desired by both sides. Access to cheaper loans and access to safer investment harmonize the needs of the haves and the have-nots. In every participant's eyes, it's cheaper and more efficient. But it threatens the old banking system, and since the Fed's control of the currency is based on its control over the banks, it threatens the Federal Reserve. That's the real driving force behind the Fed seeking control of non-traditional credit sources.

On March 16, 2008 things came to a head with the impending collapse of Bear Stearns, a Wall Street investment bank heavily involved in Credit Derivatives. There are rumors the rescue plan implemented over a weekend had actually been devised and perfected long before then. Many imperfections will undoubtedly surface with experience, but at least the plan had likely been explored as thoroughly as logic without direct experience ever allows.

The Federal Reserve Act was passed by Congress in 1913, and most observers believe the Fed's inexperience in 1932 repeatedly made matters worse in that greatest of all bank panics. The new plan therefore had to step around the limitations imposed by Congress in the past, the political pressures generated by an impending presidential election, and the powerful resistance from private industries whose future was affected. The adroitness with which such a complex matter was handled over a weekend will surely become legendary. Probably because of existing legal roadblocks, three "lending facilities" were created, but a single device was at the heart of it. Instead of lending money, the Federal Reserve offered to swap securities with these new non-bank managers of retail credit. The investment banks held massive security for loans which could not be sold in paralyzed markets. Wall Street in a word had plenty of wealth, but could not turn it into money fast enough to pay its bills. So sidestepping the legal constraints, instead of giving Investment firms money as a lender of last resort, the Federal Reserve swapped Treasury Bills for the "frozen" assets held as security for mortgage loans. The securities had been "caught in a loan" as the expression goes. There isn't much difference between Treasury bills and cash, or between exchanging bonds and selling them. But the new approach could be quickly and legally accomplished, and once done, the Federal Reserve was the master of investment banks. It became effectively their lender of last resort. Regulations will ensue, hearings will be held and laws passed, but the Fed has regained control of the money supply.

There was moral hazard in this; the presence of a lifeguard tempts swimmers into deeper water. It was somewhat inflationary in the midst of an inflation threat. No doubt the Federal Reserve regards these negatives as prices worth paying, and they probably are. The decisive remaining issue is not whether the initial shape of this transformation is exactly correct; it surely isn't. Just as was true in 1932, what will matter will be whether with this altered stance the Fed will adjust quickly and appropriately to future difficulties. And whether politicians will even permit it to do the right thing, assuming anybody then knows what the right thing might be.

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