Following Weidmann, Lacker Takes a Stand

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“As background for our monetary policy decisionmaking, we at the Federal Reserve have spent a good deal of effort attempting to understand the reasons why the economic recovery has not been stronger. Studies of previous financial crises provide one helpful place to start. This literature has found that severe financial crises--particularly those associated with housing booms and busts--have often been associated with many years of subsequent weak performance. While this result allows for many interpretations, one possibility is that financial crises, or the deep recessions that typically accompany them, may reduce an economy's potential growth rate, at least for a time. The accumulating evidence does appear consistent with the financial crisis and the associated recession having reduced the potential growth rate of our economy somewhat during the past few years.” Chairman Ben Bernanke, “The Economic Recovery and Economic Policy,” November 20, 2012

It is inaccurate to blame the 2008/09 financial crisis for the lagging U.S. recovery. Poor post-Bubble economic performance instead relates directly to previous boom-time excesses. And there should be little debate that loose Federal Reserve policies played prominently throughout the mortgage finance Bubble period. A system doesn't almost double total outstanding mortgage Credit in about six years without unleashing major distortions in the allocation of resources and spending/investing patterns throughout the real economy. And surely no one can argue that four years of zero rates and massive federal deficit spending have fostered sound resource allocation and significant economic wealth-creating investment.

Post-Bubble backdrops create a real mess in terms of policymaking. And, inevitably, the bigger the Bubble the more profound the messiness. We’ve been witnessing this dynamic play out around the world. Simplistically, when the pie is perceived to be shrinking, reaching political consensus becomes a constant battle. When previous policies and associated environments are viewed as having unjustly and inequitably distributed wealth, there will undoubtedly be a powerful backlash. Political and social forces will gather - determined to make amends.

With an underlying focus on redistribution, post-Bubble democracies will struggle promoting and implementing sound growth policies. And as we’ve witnessed at home and abroad, emboldened central bankers have been keen to exploit political impotence. Meanwhile, an already troubled backdrop is only compounded by the general confusion (along with a bevy of flawed theories) as to the causes of post-Bubble stagnation.

Here in the U.S., we’ve had an election and now our elected officials will be tasked with managing an increasingly problematic fiscal predicament. If voters are not satisfied, they’ll return to voting booths in two and four years. And while attention is these days fixated on the “fiscal cliff” drama, our unelected central bankers seem determined to push their grand experiment even further into uncharted waters. The dangers associated with discretionary monetary policy remain a prominent theme of my Macro Credit Theory. As recognized generations ago, too much discretion virtually ensures that errors in monetary policy will be compounded by only bigger mistakes.

President of the San Francisco Federal Reserve Bank John Williams has recently voiced support for increasing the Fed’s monthly quantitative easing (QE) operation to $85bn beginning in January, fully offsetting the expiration of the Fed’s “operation twist” (buy bonds, sell T-bills) support operation. Furthermore, comments this week from chairman Bernanke seemed to lend support to those on the committee (including ultra-doves Yellen and Evans) calling for more definitive numerical targets (i.e. unemployment rate) to drive policy decisions.

Employment growth has lagged badly during this recovery specifically because of deep Credit Bubble-associated structural economic maladjustment. It would be most regrettable to use the current elevated unemployment rate as justification for augmenting monetary looseness that is today clearly promoting government finance Bubble excess and maladjustment. Amazingly, after all these years the Fed somehow remains blind to the Bubbles it inflates.

You either believe in sound money and Credit or you don’t. As such, the Bundesbank has been fighting a lonely battle. And I’ll give another hat tip to its distinguished President for his determination to keep fighting the good fight.

Friday from Bloomberg (Scott Hamilton and Stefan Riecher): “European Central Bank Governing Council member Jens Weidmann said the bank’s crisis-fighting measures may encourage governments to delay tackling the root causes of the problem and make the situation worse. It is certainly true that if the house is burning, putting out the fire has to be the most pressing concern,’ Weidmann… said… ‘But we have to also make sure that with all the fire fighting and new fire insurance that we’re handing out, we’re not unwittingly preparing the ground for the next fire.’ Weidmann, an outspoken critic of the ECB’s planned bond-purchase program, cited the central bank’s 1 trillion euros ($1.29 TN) of three-year loans to banks as an example of the risks inherent in its crisis-fighting measures. While those loans averted a credit crunch, they were used by banks to buy government bonds, increasing the risks on their balance sheets and potentially exacerbating the debt crisis, he said. ‘The crisis has blurred the boundaries between monetary policy and fiscal policy… The impression that you can escape this with temporary easy policies, through monetary policies, just aggravates the problems we face in the future. Monetary policy is seen by politicians as an easy way out. It is not a panacea.”

November 19 – Dow Jones (Tom Fairless and Todd Buell): “Crisis-stricken euro zone states may do better by pushing through tough budget cuts early rather than seeking to stretch them out over a longer period, the head of Germany's central bank said… ‘It is sometimes better to have a hard cut at the beginning’ which leads to visible success, than to have a long process that seems never to end, said Jens Weidmann, President of Germany's Bundesbank and a member of the European Central Bank's governing council… Asked about the social costs of austerity in Greece and Spain, Mr. Weidmann said ‘one thing is clear. The adjustments in those countries cannot be avoided.’ The developments that took place prior to the crisis ‘and which led to the crisis can’t simply continue,’ he said.”

November 23 – MarketNews International: “Exiting from accommodative monetary policy will become more difficult over time… Weidmann said Friday. …Weidmann acknowledged that these were ‘not normal times’ but warned it is ‘important to keep in mind the long-term consequences of what we are doing.’ ‘The balance of risks and benefits will shift over time and it is getting more and more difficult to exit,’ Weidmann said, arguing that central bank actions continue to ‘distort’ markets… Weidmann… reiterated that monetary policy should not be ‘overburdened’ in the current crisis and warned that central bank interventions risked delaying government reforms.  ‘Monetary policy is seen by many politicians as the easy way out…’ While it ‘buys you time,’ it might ‘lead to behaviour where you just sit and wait,’ he warned. Weidmann said the ‘experience so far is not very comforting in this buy time that is not being used.’”

Typically well said by Mr. Weidmann, with his “sound money” framework as pertinent here in the U.S. as it is in Europe. Much closer to home, I strongly commend Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, for this week taking a strong stand against the course of Federal Reserve policymaking. In his speech, “Perspectives on Monetary and Credit Policy,” at the Shadow Open Market Symposium in New York, Mr. Lacker took exception with various aspects of the Fed’s current policy approach, including the proposal for basing monetary stimulus on the unemployment rate. “Crisp numerical thresholds may work well in the classroom models used to illustrate policy principles, but one or two economic statistics do not always capture the rich array of policy-relevant information about the state of the economy.”

Mr. Lacker also delved into the important issue of Credit policy: “When the Fed expands reserves by buying private assets, it extends public sector credit to private borrowers. To the extent that purchases of private claims have any effect, they do so by distorting the relative cost of credit among different borrowers. Such differential effects are unlikely to be beneficial, on net, unless borrowers in the favored sector would otherwise face artificially high rates. I think it’s difficult to make this case for agency MBS, a sector that historically has benefited from heavy subsidies, which arguably contributed to dangerously high homeowner leverage. So I do not see the rationale for reducing the interest rates paid by conforming home mortgage borrowers relative to those paid by, say, small-business borrowers. Moreover, purchasing agency MBS encourages the continuation of a housing finance model based heavily on government-sponsored enterprises, at a time when the housing sector would be better served by a new model that relies less on government credit subsidies… An immediate consequence of a central bank’s independence is the capacity to use its balance sheet to direct the flow of credit toward particular market segments, circumventing the constitutional checks and balances that would otherwise apply to such fiscal initiatives.”

The decision to promote rapid mortgage Credit growth as an integral aspect of its post-tech Bubble (“mopping up”) monetary stimulus was arguably the greatest policy blunder in the history of the Federal Reserve system. Recent comments from Dr. Bernanke and other Fed officials make it clear that they are today more determined than ever to promote mortgage Credit growth in a desperate attempt to resuscitate a private-sector Credit boom. Not only does such a move again go beyond our central bank’s mandate, it indicates that critical lessons with respect to the dangers of loose money/Credit and government market intervention remain unlearned.

And, courageously, Mr. Lacker comes with a quite sound proposal: “If the Federal Reserve cannot limit credit policy of its own accord, legislation may be the best option. And the restraint of credit policy would not be complete unless limits on reserve bank lending are complemented by limits on the Fed’s ability to buy private sector assets.”

This is absolutely correct: Some basic rules of the game would go a long way toward containing the ongoing damages associated with profligate discretionary monetary management. This runaway experiment must be reined in; there has to be a return to trusted central banking principles. The Fed should be limited to government debt purchases, and there must be clear limitations on the size of its balance sheet. And I would argue that until there is a return to a sound monetary doctrine there will remain this pall of uncertainty overhanging the economy.

Interminable “fiscal cliff” and European infighting are not the only games in town. I hope others will bravely support Mr. Lacker in what could prove a fascinating – and critically important - battle brewing at the Federal Reserve.

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About Douglas Noland