Volcker warns of inflation risk with Quantitative Easing

When he was about to take office after the 2008 election, I was surprised that Barack Obama named Paul Volcker as one of his senior economic advisors.  Volcker was one of the many architects of the 1980’s economic revival, relentlessly pursuing a tight money policy during his term as Chairman of the Federal Reserve Board. As economists go, Volcker is a conservative inflation hawk.

After many years of loose money policies at the Fed, combined with progressive fiscal strategies from the Carter White House and Congressional Liberals, the country was literally on its economic knees. Volcker slammed on the brakes at the Fed, with the central bank regularly tightening credit to reduce the money supply and rein in inflation. That, combined with the new Reagan fiscal and tax policies, put the country on a record run of growth and prosperity.  That run, according to many, persisted right through the Bush 41/Clinton/Bush 43 years, ending only with the financial collapse of 2007-2008.

So, when a man like Volcker warns that Ben Bernanke’s second round of quantitative easing (flooding the banking system with liquidity) could have inflationary consequences down the road, everybody should take heed.

I don’t care who his boss is, now.  When Paul Volcker speaks, the world needs to listen up:

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“It does worry people” that “we’re going to create so much money that down the road we’ll create inflation,” Volcker, 83, said in response to a question about the global implications of quantitative easing at an event at the National University of Singapore today. “I don’t think that’s beyond the capacity of the central bank to deal with in the future. But they’re going to have to deal with it.”

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“It doesn’t alarm me that they’re thinking about buying Treasuries,” he said, referring to quantitative easing. “It’s the volume which they choose to do and we don’t know what that is,” he said, adding that “if money is too easy for too long, we’ll have more” asset bubbles.

As Fed chairman from 1979 to 1987, Volcker raised interest rates to as high as 20 percent to tame inflation, triggering a recession. “Dealing with inflation and inflation potentials is always a challenge,” he said. “It’s manageable but not easy.”

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[New financial regulations] include limits to investments by commercial banks in private equity or hedge funds, known as the “Volcker Rule” because of Volcker’s advocacy for the change. Under a measure that may not take full effect for as long as a dozen years, banks can invest in private-equity and hedge funds, though they will be limited to providing no more than 3 percent of the fund’s capital. Banks also can’t invest more than 3 percent of their Tier 1 capital.

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Quantitative easing, or QE, is a massive infusion of cash from the central bank.  The Fed buys billions in outstanding Treasury securities from member banks, in the hopes that the member banks will ease credit, begin lending more and stimulate the economy through capital investment.

The problem is, the return on capital is so low right now that banks and captains of industry are more likely to seek a less risky, albeit smaller rate of return by parking the new cash in short term, safe cash accounts and short CD’s.  Until capital demand rises enough to make the return on capital worth the risk of investment, little expansion occurs and there’s no new employment.  The cash sits on the sidelines in an economic phenomenon known as a “liquidity trap.”

The risk is that the return on capital does begin to move, and then begins to move rapidly, as all of that liquidity suddenly comes off the sidelines and starts chasing a limited supply of capital goods and the goods and services produced by the economy.  As more cash chases relatively fewer products, prices rise in a ruinous inflationary cycle, similar to what was seen in the late 1970’s. It’s a real, but longer term threat that won’t likely be fully felt until late 2011 or 2012.

The Fed would have to combat that in much the same way Volcker did in the early 80’s, and the consequences would be exquisitely more painful now than they were then.  In the 1980’s, if the US economy sneezed the world caught cold.  Today, if the US economy sneezes, China and the rest of the world’s emerging economies would die of pneumonia.

Gov't starts talks about new mortgage system—what could go wrong?

Remember that sweeping financial regulation reform bill that Democrats rammed through Congress earlier this summer?  Remember the elephant in the room that was left ignored?

Well, it’s kinda sorta starting to be not ignored anymore, and the prospects for addressing the real underlying cause of the banking crisis of 2008 don’t inspire a lot of enthusiasm:

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Talk of shrinking the government's involvement in the mortgage market is growing. Just don't expect action any time soon.

A conference Tuesday at the Treasury Department is the first of many steps toward restructuring the nearly $11 trillion mortgage market. So far, rescuing mortgage giants Fannie Mae and Freddie Mac has cost the government more than $148 billion. That number is expected to grow.

Treasury Secretary Timothy Geithner will address the conference but is not expected to offer an exit strategy Tuesday. The administration has said it won't offer its plan until next year.

Officials are pledging dramatic changes to the structure of Fannie and Freddie, which profited tremendously during good times but burdened taxpayers with losses when the housing market went bust.

"We will not support a return to the system where private gains are subsidized by taxpayer losses," Geithner said in remarks prepared for the conference.

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With Republicans likely to pick up seats in Congress in November, however, the Obama administration will need support from both political parties for the changes it proposes.

Reflecting this reality, Geithner will say Tuesday that "the failures that produced the system we have today were bipartisan. The solution must be as well."

Executives and mortgage experts are prepared to tell Obama officials that that the government must stay in the business of backing U.S. mortgages even if Fannie and Freddie disappear someday.

"At the end of the day, the government will still have a very large role to play," said Mark Zandi, chief economist at Moody's Analytics and a panelist at the event. Others include mortgage executives from Bank of America Corp. and Wells Fargo & Co, plus Bill Gross, managing director of bond giant Pimco and Lewis Ranieri, one of the creators of mortgage bonds.

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Geithner is either being intellectually dishonest, or he’s as clueless as the rest of this kindergarten crowd running the country.  The failures that produced the 2008 meltdown were far from being bipartisan.  The environment that allowed people with insufficient income or credit strength to finance homes they had no business purchasing was a whole-cloth manufacture of liberal Democrats, starting with the Community Reinvestment Act of 1977.  The act was originally intended to address a progressive feel-good objective of insuring that banks weren’t using a then-controversial process known as red-lining, where some banks would draw red lines on maps depicting areas that they would avoid lending in.  Banks’ loan-creation and community investment metrics were used to gauge banks’ processes in supporting all of the credit needs of the communities they served.  Sounds innocuous enough.

But the Clinton era changes to the bill, begun almost immediately upon inauguration in 1993, changed the consequences for banks that were considered “underperforming.” Essentially, banks were told in not-so-unclear terms that they would make loans to low-income groups, or their performance evaluations would suffer.  It went from being process-oriented to results-oriented, and the end game was completely predictable.  Picking winners and using government power to reshape markets is never, ever a good idea.

Here we are in 2010, with the consequences of credit market-meddling still being felt, and instead of walking back the CRA and the results-oriented process of forcing banks to load to bad (i.e., subprime) borrowers, they’re talking about more bailouts of Freddie Mac and Fannie Mae.  I haven’t even touched on the rank corruption found within those two organizations, but you can see why I’m not very confident that meaningful reform is in the cards.

What needs to happen is a gradual pullback of Freddie Mac and Fannie Mae’s participation in private sector loan creation.  Let banks make credit decisions based on the perceived risk of default, and make people learn to work, save and earn the American Dream.  Home ownership is a privilege not a right, and its a privilege that’s earned.  It does not come as a benefit of government largesse.  The proposals being floated for retooling the mortgage market system do nothing to restore the natural order, and simply kick an $11 trillion can down the road.

Gimme some feedback in the comments.

Fed Independence is Sacrosanct -- Kill the Sanders Amendment

Over at e21, which is an economics and finance blog and part of my daily reading menu, is a staff editorial on the need for maintaining the independence of the Federal Reserve. e21 is responding to the growing number of adherents to the Sanders Amendment, which to my eyes appears to be nothing more than a blatant power grab and foolish attempt to politicize the Fed. The popularity of Sanders' folly is driven, in part, by the inability or unwillingness of certain segments of the population to comprehend a very demanding science. Writes the editor:

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While this information is more than adequate for those interested in understanding the mechanics of the emergency lending programs that saved the global financial system, it does not suffice for conspiracy theorists eager to tie the Fed to Saddam Hussein and Watergate. Since every $100 bill circulating internationally is a Federal Reserve Note, it is not unreasonable to think extremists could tie the Fed to funding for international terrorism, the narcotics trade, or whatever other illicit transactions are conducted with U.S. dollars.
Fed Independence is Sacrosanct | e21 - Economic Policies for the 21st Century

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The editorial provides numerous links to Fed-hosted websites that provide a better accounting of Fed activities, assets and policy decisions than what we get from the Executive Branch, or even your garden variety "too big to fail" bank like BofA, Goldman Sachs or Citibank.

I can see no additional benefit whatsoever by adding another layer of oversight to an already open-books process.  It runs the calamitous risk of politicizing monetary policy.  No amount of oversight is going to satisfy the hunger for the conspiracy nuts.  They're always going to believe that the Fed is hiding something of great international importance.  But no amount of oversight or control will be enough for progressive socialists like Sanders, either.  It's not about answering questions for these people.  It's about extending power and control.

The Sanders Amendment must be defeated, and if it makes it into the final legislation, it must be vetoed by the President.

Extra Point: The conspiracy theorists tend to originate from the right. Ask yourself: Does Bernie Sanders have a solid conservative basis for auditing and greater oversight?

"Audit the Fed!" Says... Bernie Sanders?

A comprehensive audit of the Federal Reserve System has been a long-standing campaign plank of Congressman Ron Paul.  So it comes as a bit of a surprise that Vermont "Independent" Bernie Sanders has sponsored an amendment to the finance reform bill to allow the Government Accountability Office to conduct extensive reviews of policy decisions.

I frankly believe both Ron Paul and Bernie Sanders are certified kooks, hailing from diametrically different ends of the political spectrum.  Paul's motivations come from a misguided belief that the Fed is a dangerous institution that plays a high-stakes game of poker with US monetary policy with no accountability.  Sanders however, is an avowed socialist.  Paul's quixotic goal is to one day return the US to the gold standard and the elimination or restriction on the use of fiat currency.  Sanders' goal is completely the opposite.  His goal is to use the the Fed's enormous financial clout to promote a sort of Eurozone in North America.

The Fed needs to remain an independent entity.  The deliberations of the Federal Open Market Committee need to remain off-limits to political meddling, and releasing the name of every institution receiving loans from the discount window would cast a chill of market confidence on those institutions' financial stability.  If the Fed loses market confidence in its ability to combat inflation, the government would be forced to pay higher interest rates demanded by borrowers as a hedge against inflation risk.  And, if markets and the public lose confidence in private sector banks borrowing at the discount window, banking panics that were once a thing of the past could become commonplace again.

One of the hallmarks of economic growth over the last three decades or so has been a stable, non-inflationary period of prosperity.  The recessions suffered in the period have been relatively brief and historically shallow.  We haven't seen the runaway inflation present in the 1970's, either.  What we've seen in money supply growth is analagous to a large river that neither suffers catastrophic flooding nor severe, longlasting droughts.

The Sanders and Paul amendments threaten that. Paul's goals are much more admirable than Sanders, but neither amendment is going to make our economic system perform better.  They'll have the opposite effect.

Extra Point: