Tag Archives: Federal Reserve

Janet Yellen vs Larry Summers

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There is an informative article in the May 12, 2016 issue of Bloomberg Businessweek, “How to Pull the World Economy out of Its Rut.”  Recall that Janet Yellen succeeded Ben Bernanke as Chair of the Federal Reserve in January 2014. The other candidate for the post was Larry Summers.
Capture6They have rather different views about the role of a central bank:

  • Janet Yellen insists that economic conditions are returning to normal, even if slowly. She is neutral about the slow growth, secular stagnation hypothesis and using fiscal stimulus to overcome it.
  • Larry Summers argues that world growth is stuck in a rut because there is a chronic shortage of demand for goods and services. Growing inequality puts a bigger share of the world’s income in the hands of rich people who spend less. The new economy is asset-lite (Uber and Airbnb prosper by exploiting existing assets) and so needs less investment. Software doesn’t require the construction of new factories. He thinks that central bankers should spend more time and effort trying to influence fiscal policy. For example, more government spending on infrastructure, global warming and improving education. Also changing the tax code to put more money in the hands of lower- and middle-income families who would spend it.

I think that they are both partly right and partly wrong.

  • Janet Yellen is correct in believing that the Fed should stick to monetary policy. But she is too cautious in raising interest rates back to more normal levels. There will be some (stock market) pain in accomplishing this but it needs to be pushed faster regardless.
  • Larry Summers is correct in calling for action on the fiscal front. But his suggestions for how to do this are mostly off base because they will lead to massive new debt which must be avoided.

So what is the proper course to get out of our economic rut? It is what I’ve been saying over and over again but I’ll repeat it for good measure in my next post!  Stay tuned!

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The Financial Crisis III. How Do We Sort Out What Happened?

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The Financial Crisis in 2008 was one of the most disruptive events in U.S. history.  It is crucial that we understand what caused it so that we can recover from it more fully and avoid a recurrence.  My favorite books about the crisis are: The Financial Crisis and the Free Market Cure by John Allison, President of the CATO Institute and former CEO of the large financial services company, BB&T;  Bull By the Horns by Sheila Bair, Chair of the FDIC from 2006-2011; and Hidden in Plain Sight by Peter Wallison, an economics policy scholar at AEI and former member of the FCIC.
CaptureNot surprisingly, these three very well informed individuals have somewhat different points of view.
Mr. Wallison says that the government’s affordable housing policies caused the financial crisis by essentially requiring the GSEs Fannie Mae and Freddie Mac to acquire increasingly large numbers of subprime mortgages.  The financial power of the GSEs forced private lenders to lower their own lending standards in order to compete (this last assertion is in dispute). When the resulting housing bubble burst, large numbers of subprime mortgages defaulted causing huge losses for both GSEs and private financial institutions alike.
Ms. Bair says that “the subprime lending abuses could have been avoided if the Federal Reserve Board had simply used the authority it had since 1994 under the Home Ownership Equity Protection Act to promulgate mortgage lending standards across the board.”  In March 2007 she testified strongly in favor of the Fed issuing an anti-predatory lending regulation under HOEPA and was rebuffed by the Fed.  As FDIC Chair she constantly urged, largely without success, that other federal agencies use their regulatory powers to curtail the abuses of private lenders.
Mr. Allison agrees with Mr. Wallison that “the whole origination market relaxed its standards to compete with Freddie and Fannie.”  However he goes on to say that “the investment banks (including Bear Stearns and Lehman Brothers) magnified the misallocation of credit to the housing market.  They created a series of financial innovations (CDOs, derivatives, etc.) that leveraged an already overleveraged product. … Investment bankers unquestionably made irrational decisions based on pragmatic, short-term thinking. … Those who made these mistakes should have been fired and their companies allowed to fail.”
Can these disparate points of view be melded into a coherent framework for the financial crisis which suggests a way forward from where we are today?  I will attempt to do this in my next post.

How Likely Is Financial Collapse?

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The financial crisis of 2008 was the biggest shock to our financial system since the Great Depression of the 1930s.  It caused a deep recession from which we are still recovering.  To aid the recovery the Federal Reserve launched an unprecedented expansion of the money supply, referred to as quantitative easing, as well as keeping short term interest rates near zero. As explained by James Rickards, a portfolio manager at West Shore Group, in his new book, “The Death of Money, the coming collapse of the international monetary system,” such a severe recession would normally have caused a corrective period of deflation.  Quantitative easing has warded off deflation and, so far, without igniting inflation.
CaptureWe are now in a catch-22 situation.  Congress could and should adopt several policy changes to speed up the recovery as I described several days ago in “The Federal Reserve Cannot Revive the Economy by Itself.”  But, if and when the economy does start growing faster, it will require great skill by the Fed to exit from its current policies without harm.  If it contracts the money supply too quickly, it risks a sharp rise in interest rates.  If it contracts the money supply too slowly, it risks a sharp rise in inflation. Mr. Rickards doubts that the Fed will be able to accomplish this fine tuning without another major crisis.  Here are his Seven Signs of what to look for:

  • The price of gold ($1300 per ounce today). A rapid rise to $2500 will anticipate inflation. A rapid decrease to $800 signals severe deflation.
  • Gold’s continued acquisition by Central Banks. Large purchases by China, for example, will announce inflation.
  • IMF governance reforms, e.g. towards more voting power for China, will be an inflation warning.
  • The failure of regulatory reform, i.e. reinstatement of Glass-Steagall in addition to the Volcker Rule, will increase the chances of systemic failure.
  • System crashes, resulting from high-speed, highly automated, high volume trading. An increasing tempo of such events will cause disequilibrium which could close markets.
  • The end of QE, could give deflation a second wind and lead to a new round of QE.
  • A Chinese collapse (predicted by Rickards), will lead first to deflation and then inflation.

We all hope that the Federal Reserve can steer clear of a new, and much deeper, financial crisis.  But it doesn’t hurt to have guideposts and Mr. Rickards knows what he’s talking about.

The Federal Reserve Cannot Revive the Economy by Itself

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The Great Recession caused by the financial crisis ended in June 2009.  In the intervening five years the U.S. economy has grown at the anemic annual rate of 2.2%.  In an attempt to speed up growth the Fed has injected $4 trillion into the economy and kept short term interest rates near zero during this time period.  Fed Chair Janet Yellen recently gave her semiannual report to Congress and, according to the American Enterprise Institute’s John Makin, “Fed Chair Yellen puts on a brave face.”  She said that “If economy performance is disappointing, then the future path of interest rates likely would be more accommodative than currently anticipated.”
CaptureCapture1Mr. Makin adds that “Eventually the realization will dawn that the only way to get the economy moving again is to work on the supply side.  Specifically, that means undertaking measures to boost investment and produce a rising capital stock which will boost labor productivity, hiring, and GDP growth without inflation.” He suggests that three measures to boost capital spending are:

  • Enactment of accelerated depreciation provisions and investment tax credits.
  • A sharp reduction in the corporate tax rate from 35 to 15 percent to induce corporations to repatriate the $1.59 trillion in accumulated profits being held abroad.
  • A concerted White House-led effort to set a clear, less burdensome path for healthcare and other regulatory measures as a means to reduce investment dampening uncertainty.

I would add a fourth measure:

  • An across the board lowering of individual tax rates (offset by closing loopholes and deductions which primarily benefit the wealthy) in order to boost personal consumption which has been highly depressed due to stagnant wage growth and high unemployment.

In other words there are clear and straightforward measures which our national leaders can take to speed up the economy.  ‘If there is a will, there’s a way’ and incumbents should be held responsible for inaction come the elections in November!

Get Out While the Getting Is Good!

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David Malpass, president of Encima Global LLC, has an op-ed in yesterday’s Wall Street Journal, “The Economy Is Showing Signs of Life”, pointing out that business loans, auto sales and hourly earnings are up.  Mr. Malpass says that “The sequester is a bad way to set spending priorities, but it reduces the risk of future tax increases, contributing to the upturn in consumer and business confidence. … The good news is that an end to the latest version of the Fed’s quantitative easing would create space for more growth in private credit and a shift back toward market, not government allocation of credit. …Because America’s private economy is the world’s biggest net creditor and capital allocator, the United States will be the biggest beneficiary of a return to market based interest rates, with vast potential in efficiency, intellectual property and the capacity to innovate.”
Federal Reserve Chairman, Ben Bernanke, is given much credit for the fact that the Great Recession did not turn into another depression.  But now, four years after the end of the recession, we have the twin problems of a slow growth economy, which keeps the unemployment rate much too high, and the potential for huge inflation caused by the vast increase in the money supply.  Mr. Malpass makes an excellent argument that the economy has recovered enough so that further quantitative easing will now retard future growth.  It clearly also increases the chance of runaway inflation.
Current artificially low interest rates also disguise the future damage now being created by huge federal deficit spending.  When interest rates go back up, as they inevitably will, interest payments on our rapidly increasing national debt will also increase dramatically, and force far greater cuts in federal spending than are currently being caused by the sequester.
In other words, to speed up economic growth, curtail the risk of future inflation and to put more pressure on Congress to control federal spending, the Federal Reserve should begin to exit from quantitative easing in the very near future!