Historic days lie ahead, and not because the occupant of the Oval Office will soon be of an atypical color.
The United States, throughout its early history, has been the only major trading nation to carefully avoid extensive government involvement in economics and finance. We went for more than 100 years without even a central bank (meaning, an official lender of last resort). And when the need for the Federal Reserve finally became undeniable in the wake of the Panic of 1907, its architects conceived it in secret meetings, and with a quasi-private structure, because they knew even then that Congress would never go for another attempt to establish a “Bank of the United States.”
During the New Deal, the role of the Federal Reserve was expanded to include regulatory control over the US banking system. In 1951, the Fed finally established its full independence from the US Treasury (in the sense that they could refuse to monetize issues of public debt), and entered the modern period of its history.
But in keeping with the American tradition of relatively light control over financial matters, the Fed’s objectives have always been primarily to maintain confidence in the value of the dollar, and to ensure the integrity of the interbank payments system.
They have long held a balance sheet consisting almost entirely of risk-free US Treasury securities. At times, like any lender of last resort, they have made funds available to their correspondent banks, but generally for the shortest possible terms, at relatively high “penalty” interest rates, and requiring collateral of the very highest quality.
In short, the Fed has never been a risk-taking entity. To take risk (and, equivalently, to intermediate credit) has always been the function of the private sector.
Twelve months ago, the Fed held a balance sheet of about $800 billion, and held reserves (also known as “Fed Funds”) for banks of about $40 billion. These balances comprise the monetary base of the United States, and they have been relatively stable now for quite a few years.
Today, the Fed’s balance sheet appears to be about $2.2 trillion, nearly three times as big as it was, as recently as last summer. The size of bank reserves, depending how you count, has balloned to about $600 billion.
And most hair-raising of all, the composition of the Fed’s balance sheet (including such unusual entities as “Maiden Lane,” the quasi-hedge fund that holds the erstwhile assets of Bear Stearns) has shifted from all Treasury securities, to a wide range of risk-bearing instruments, including mortgage-backed securities.
While the country’s attention was fixed on Treasury Secretary Paulson’s $700 billion stabilization fund (the TARP), Fed officials were quietly laboring under the radar to fundamentally transform the character of the US (and indeed the world’s) financial system.
The Bernanke Doctrine
Have you noticed one particular sentiment that is always expressed by policymakers and pundits as regards this financial crisis? They’re always talking about taking bold, decisive actions, as large as possible and as soon as possible.
I call this the Bernanke Doctrine. Fed Chairman Ben Bernanke is a leading expert on the Great Depression, particularly of the specific channels through which a series of bank failures boiled over into the economy and caused widespread unemployment and reduced industrial output. He’s also one of the people who paid close attention to how the Japanese mishandled their real-estate deflation in the Nineties.
His conclusion, broadly, has been that authorities must act quickly and massively at the onset of any financial crisis, in order to prevent… well, things like the Depression and Japan’s Lost Decade.
The economic policy community has taken this doctrine to heart. So we’re hearing about a trillion-dollar fiscal stimulus for the economy, ideally to be enacted on the “incredibly historic” day that we get a new President of the United States.
But look at where we are with the Fed. Throughout the financial crisis that began in August 2007, they’ve done everything possible to prevent shortages of liquidity, which could cause bank failures to tear through the world like dominoes.
So far, so good. No one who is close to finance and capital markets has any doubt that the world came very close, on multiple occasions, to total disaster. The warnings about what could happen if the TARP were not passed were not phony in the slightest.
But the end result of the Bernanke Doctrine has been to leave us with a financial system that’s frozen in amber. With very few exceptions, essentially no one is creating private credit (lending money) without an explicit or implicit guarantee, either from the Fed or from the Treasury.
And this is true not only in the United States. The financial system of the whole world is now on life support. This is truly historic and unprecedented, and full of unforeseen consequences that will take years to unfold.
And now we’re talking about federalizing the economy as well as the financial system. To propose a fiscal stimulus of the size being discussed, is to shift to a world in which most new economic activity is government-directed.
There are essentially no incentives for private actors to take any risk any more. In the financial sphere, the Fed and the Treasury are assuming or guaranteeing nearly all market and credit risk. In business, no one yet knows which industries and which companies will be blessed by the government under the New New Deal, so everyone is in wait-and-see mode.
So what happens from here?
Well, it turns out that a great deal of the ability of Americans to consume goods and services has been imported from other countries. For quite a few years now (arguably since early in the Clinton Administration), global capital flows have strongly benefited the US. Broadly, that’s because global investors have demanded far lower returns on capital invested here, than they have demanded from capital invested in other countries.
Why that? Combination of things. Partly liquidity, partly the desire for a safe haven in times of stress, partly a sense that Americans understand finance better than other people do, partly our emphasis on market freedom, and partly inertia.
This in fact is the part of the story that will soon be tested. We’re now moving into a period in which nearly all of the factors that have led global investors to prefer placing capital in the US, are reversing.
We started the year with five major Wall Street investment banks, some in business for over a century. Today, there are none left. None. So much for Americans being better at risk-management than other people. And so much for free markets and light regulation.
And in terms of the economy, investors are now being asked to take on faith that Obama’s stimulus package will actually produce lasting benefits. But this is the same Obama who has been scrambling in search of “shovel-ready” projects, and actually proposing tax cuts, because he can’t think of ways to spend money any faster. Does this make you confident that these people will spend the stimulus wisely? It shouldn’t.
And then we still have massive expansions in entitlement spending ahead, all of which will be government-directed. The demographic time bomb that will soon cause Medicare and Medicaid spending to balloon is still ticking. That’s all money that will have to come from somewhere. (Social Security isn’t really a problem, because it’s transfer payments rather than actual displacement of alternative economic activity.)
So for all these reasons, we’ve arrived at an historic moment when Americans will face huge growth in public-sector spending. And this moment has come faster than anyone expected, as America’s Historic, Transformational President isn’t even official yet.
There’s a strong case to be made now, with the global economy weak everywhere, that it’s a good investment for the world to fund a US fiscal stimulus. But will this continue to be true two years, five years, and ten years from now?
For the answer to that question, keep a close watch on the US Treasury yield curve. The Treasury has been issuing unbelievable amounts of new debt, and in a range of new configurations, in recent days. That’s the proximate reason why prices for Treasury debt have fallen so far, so fast. (The 30-year bond was priced to yield 2.50% early last week. Today it’s back over 3%. In bond-land, that’s a huge move in such a short time.)
What economic policymakers must do, is the following:
We must make it very clear, right now, including specific timetables and mechanisms, exactly how the coming trillion-dollar deficits will be repaid to the world’s investors.
And we must make it very clear, right now, including specific timetables and mechanisms, exactly how the Treasury will fund the expanding range of public liabilities in the future.
It’s going to be credible to tell the investors who fund our deficits, that we must stimulate the US (and thus the global) economy this year, because of the emergency. But only if we show them exactly how we’re going to roll back the emergency borrowing and spending and get back to normal. How shall we do all of that, and how can we return to a more productive US economy? That’s another post in itself.
But think what will happen if we don’t provide credible answers to those questions. Well, ask yourself how you’d react if someone wanted you to lend him a huge amount of money today, but you know he’ll be back for a whole lot more later.
You’d demand a far higher rate of interest and protective covenants, wouldn’t you?
Yes, you would. Keep a close eye on the middle and long-end of the Treasury yield curve as we go through this stimulus debate over the next few weeks.