Monday, September 9, 2013

Booms and Busts Due to Federal Reserve

The Federal Reserve Act, passed in 1913, created the Federal Reserve; a quasi-governmental entity whose chairman is appointed by the President and approved by the Congress.  They work with the US Treasury to regulate the banking industry and provide credit to the banking system.  The Federal Reserve was created, in part, to be a lender of last resort in an attempt to stabilize the banking system that had fairly frequent banking panics (bank runs) in the late 1800s and early in the 1900s.  The panics caused economic downturns.

A part of law creating the Federal Reserve gave them the duty or mandate to maintain price stability and maintain full employment.  But you probably can see right away that these are conflicting mandates.  This is called a 'dual mandate.'

As a result of this dual mandate, the "Fed" has erred on the side of inflation.  This body has been responsible for the 23 fold increase in prices in it's 100 years of existence.  That's 2,300% of price inflation!  It sounds astronomic but it amounts to an average 3.2% inflation per annum--which is not a huge number.  But the 2300% number is a good example of power (or curse) of compounding.  Once the Fed. Reserve was founded in 1913,  prices went up 110% from 1913 to 1921 alone!  Maybe Congress should have eliminated this body in 1921 since it was already failing miserably?

Now The 'Fed' Has Taken On a 3rd Mandate: Levitate Asset Prices


Chairman Bernanke has taken the Federal Reserve into a whole new regime compared to his predecessors.  He's taken the creation of excess credit to a whole new level with zero interest rates and monetizing of the Federal deficits through "money printing."  The process of 'money printing' puts large amounts of 'excess reserves' into the banking system.  Those reserves could be used by the banks to extend loans to customers. Since the excess reserve levels are so large, there is fear that this could dramatically increase credit outstanding.  And if that rate of credit creation exceeds the growth of the economy, then prices will rise.

But in the past few decades, we've seen that excess credit creation is more correlated with rising asset prices like housing, land, and equities (stock market) rather than being reflected in the official inflation indices such as the CPI.  I wrote a blog called Government Scrubs Away True Inflation Rate that talks about revising the official inflation indexes to reflect inflation in key assets.

Have a look at the effects of the highly experimental policies of the Fed in recent years. They have even taken pride that QE has lifted asset prices. This is nearly insane as there is inevitably a reversal of these policies and a reversal of the effects of that policy.


 

Bubbles and Busts Thanks to the Federal Reserve


Take a look at the recent 20 year history of bubbles and busts created by the Federal Reserve.  Yeah, it sounds academic to talk about bursting bubbles, but the aftermath of the housing bubble has led to 5 years of slow economic growth and massive underemployment that could have easily turned into the Great Depression II.  The housing bubble, a credit-fueled asset price inflation,  is also due to government incentives over many decades, ie., no capital gains on house sales, mortgage deductability and lower credit standards for mortgages.  Anything credit-fueled is due to your Federal Reserve.


It's Time to End the Dual Mandate For the Federal Reserve


Due to the evidence that the Federal Reserve has been causing more trouble than good, it's time to reorganize the Federal Reserve and remove the "dual mandate."  They should only be responsible for controlling inflation. 

Here's a summary of my recommendations regarding the Federal Reserve:
  • Go to a 'rule-based' system for increasing credit in the economy, target something like 3% growth of credit---which is the real growth rate of the economy.
  • Replace the vast bureaucracy with a panel that includes business leaders and ordinary citizens
  • Have the Federal Reserve declare publicly that any excess credit creation during a so-called "crisis" will be withdrawn as soon as possible
  • Remove the dual mandate and replace it with a single mandate of controlling inflation.
  • The Federal reserve should renounce support for any amount of inflation and target 0% inflation---or no inflation!   None of Bernanke's bullshit of targeting of 2% inflation which doubles prices every 36 years!!

The moral of the story is don't let PhDs run anything!

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