Limits to Overused Fiscal and Monetary Policy Can Result in Self-Induced Governmental Impotence

“The [U.S.] federal budget deficit is growing faster than expected as President Trump’s spending and tax cut policies force the United States to borrow increasing sums of money.”[1] This observation was made just after the Federal Reserve Bank relented under pressure from the White House to lower interest rates because bond investors had been investing with a possible future recession in mind. With the U.S. Government’s accumulated debt standing at $22.4 trillion and interest rates already low, the limits to both fiscal and monetary policy were apparent even if most Americans in the political and business elite were focused on avoiding a possible recession in 2020.

According to the Congressional Budget Office in August, 2019, the federal deficit for fiscal 2019 would reach $960 billion; the deficit for the next year would reach $1 trillion.[2] Back during the Reagan administration in the 1980’s, deficits were in the hundreds of billions and the debt was in the trillions. It would seem that the fiscal imbalance had gotten worse since then, in spite of the fact that recessionary periods were greatly outweighed by stretches of growth. In fact, the U.S. in 2019 was in its longest period of economic expansion. Yet the deficits and thus debt rose rather than dropped. President’s tax cuts in that period of expansion played a significant role. Tax revenues for 2018 and 2019 fell more than $430 billion short of what the Congressional Budget Office had predicted.[3] In August of 2019, the president made public his consideration of payroll tax cuts just to guard against a possible recession (especially if one should hit before the next election day).

Using recessionary fiscal tools during an economic expansion means the deficits in good times won’t counter those in bad times. The result in the case of the U.S. has been a steadily increasing accumulated debt, rather than a debt from bad times being paid off in good times. That’s the fiscal theory, but it ignores the insatiable desire for instant gratification in human nature that can easily find power in a representative democracy. Accordingly, the use of leverage, or debt, by a democratic government should be extremely limited; tax cuts during periods of expansion can be seen as a red flag that a government has already gone too far.

Fortunately, lower than expected interest rates even before the Fed’s announced rate cut in August, 2019, reduced the amount of money the U.S. Treasury had to pay to its borrowers. So the public as well as policy makers could conveniently overlook the fact that the projected deficit for fiscal year 2019 was 25% higher than the prior year’s deficit. One weakness of a democracy is that if things look ok on the surface, needed work on the fundamentals—the substratum—will likely be put off. It’s more understandable that the electorate would have this weakness—less so for the elected representatives who know or should know the fundamentals and look out for the fiscal balance of the government. Speaking of balance, it is interesting that the federal system too was so much out of balance with the federal level holding most of the governmental power even though the States technically still had residual sovereignty. In other words, the tremendous fiscal imbalance can be viewed as an indication or manifestation of a more fundamental imbalance in the U.S. system of governments. In contrast, the E.U. suffered from an imbalance in the other direction, as the state governments anxiously guarded most of their powers.

See: Skip Worden, Essays on Two Federal Empires. Available at Amazon.

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1. Jim Tankersley and Emily Cochrane, “Budget Deficit Is Set to Surge Past $1 Trillion,” The New York Times, August 22, 2019.

2. Ibid.

3. Ibid.

On the Various Causes of the Financial Crisis of 2008: Have We Learned Anything?

In January, 2011, the Financial Crisis Commission announced its findings. The usual suspects were not much of a surprise; what is particularly notable is how little had changed on Wall Street since the crisis in September of 2008. According to The New York Times, "The report examined the risky mortgage loans that helped build the housing bubble; the packaging of those loans into exotic securities that were sold to investors; and the heedless placement of giant bets on those investments." In spite of the Dodd-Frank Financial Reform Act of 2010 and the panel's report, The New York Times reported that "little on Wall Street has changed." One commissioner, Byron S. Georgiou, a Nevada lawyer, said the financial system was “not really very different” in 2010 from before the crisis. “In fact," he went on, "the concentration of financial assets in the largest commercial and investment banks is really significantly higher today than it was in the run-up to the crisis, as a result of the evisceration of some of the institutions, and the consolidation and merger of others into larger institutions.” Richard Baker, the president of the Managed Funds Association, told The Financial Times, "The most recent financial crisis was caused by institutions that didn't know how to adequately manage risk and were over-leveraged. And I worry that if there is another crisis, it will be because the same institutions have failed to learn from the mistakes of the past." From the testimonies of managers of some of those institutions, one might surmise that the lack of learning in the two years after the crisis was due to a refusal to admit to even a partial role in crisis.  In other words, there appears to have been a crisis of mentality, which, as it contains intractable assumptions and ideological beliefs, as well as stubborn defensiveness, is not easy to dislodge such that legislation past Dodd-Frank could ever be passed.
It is admittedly tempting to go with the status quo than be responsible for reforms. If the reformers are also the former perpetrators, their defensiveness and ineptitude mesh well with the continuance of the status quo even if an entire economy the size of an empire is left vulnerable to a future crisis. To comprehend the inherent danger in the sheer continuance of the status quo, it is helpful to digest the panel's findings. 
The crisis commission found "a bias toward deregulation by government officials, and mismanagement by financiers who failed to perceive the risks." The commission concluded, for example, that "Fannie and Freddie had loosened underwriting standards, bought and guaranteed riskier loans and increased their purchases of mortgage-backed securities because they were fearful of losing more market share to Wall Street competitors." These two organizations were not really market participants, as they were guaranteed by the U.S. Government. That government-backed corporations would act so much like private competitive firms undercuts the assumed civic mission that premises government-underwriting. All this ought to have raised a red flag for everyone--not just the panel which stressed the need for a pro-regulation verdict. 

Lehman was a particularly inept player leading up to the crisis.     Zambio

In terms of the private sector, The New York Times reported that the panel "offered new evidence that officials at Citigroup and Merrill Lynch had portrayed mortgage-related investments to investors as being safer than they really were. It noted — Goldman’s denials to the contrary — that 'Goldman has been criticized — and sued — for selling its subprime mortgage securities to clients while simultaneously betting against those securities.'”  The bank's proprietary net-short position could not be justified by simply market-making as a counter-party to its clients, Blankfein's congressional testimony notwithstanding. 
Relatedly, the panel also pointed to problems in executive compensation at the banks. For example, Stanley O’Neal, chief executive of Merrill Lynch, a bank which failed in the crisis, told the commission about a “dawning awareness” through September 2007 that mortgage securities had been causing disastrous losses at the firm; in spite of his incompetence, he walked away weeks later with a severance package worth $161.5 million. The panel might have gone on to point to the historically relatively huge difference between CEO and lower-level manager compensation and questioned the relative merit, but such a conclusion would go beyond the commission's mission to explain the financial crisis.

With regard to the government, The New York Times reported that the panel "showed that the Fed and the Treasury Department had been plunged into uncertainty and hesitation after Bear Stearns was sold to JPMorgan Chase in March 2008, which contributed to a series of “inconsistent” bailout-related decisions later that year." The Federal Reserve was clearly the steward of lending standards in this country,” said one commissioner, John W. Thompson, a technology executive. “They chose not to act.” Furthermore, Sabeth Siddique, a top Fed regulator, described how his 2005 warnings about the surge in “irresponsible loans” had prompted an “ideological turf war” within the Fed — and resistance from bankers who had accused him of “denying the American dream” to potential home borrowers. That is to say, the Federal Reserve, a corporation wholly owned by the U.S. Government, is too beholden to bankers instead of the common good. So we are back to the issue of a government-guaranteed corporation acting like or on behalf of private companies (and badly at that).
We can conclude generally that governmental, governmental-supported, and private institutions, all acting in their self interests, contributed to a "perfect storm" that knocked down Bear Stearns, Lehman Brothers, Countrywide, AIG, and Freddy and Fannie Mae. Systemically, the commercial paper market--lending between banks--seized up and many of the housing markets in the U.S. took a severe fall such that home borrowers awoke to find their homes under water. The Federal Reserve was caught off-guard, as its chairman, Ben Bernanke, had been claiming that the housing markets could be relied on to stay afloat. Relatedly, AIG insured holders of mortgage-based bonds without bothering to hold enough cash in reserves in case of a major decline in the housing markets all at once. Neither the insurer nor the investment banks that had packaged the subprime mortgages into bonds though to investigate whether Countrywide's mortgage producers had pushed through very risky mortgages before selling them to the banks to package. In short, people who were inept believed nonetheless that they could not be wrong. Dick Fuld, Lehman's CEO, had the firm take on too much debt to buy real estate so that eventually his firm would be as big as Goldman Sachs. That such recklessness would be on the behest of a childish desire to be as big as the other banks testifies as to the need for financial regulation that goes beyond the "comfort zone" of Wall Street's bankers and their political campaign "donations."

See also Essays on the Financial Crisis: Systemic Greed and Arrogant Stupidity, available at Amazon.

Source:

Sam Jones, "Hedge Funds Rebuke Goldman," Financial Times, January 28, 2011, p. 18.

Making Too Big To Fail Costlier: A Check on Empire-Building

Testifying before the Financial Crisis Inquiry Commission on September 2, 2010, Ben Bernanke, chairman of the Federal Reserve, observed, “As of 2003 and 2004, there really was quite a bit of disagreement among economists about whether there was a bubble, how big it was, whether it was a local or a national bubble. We certainly were aware it was a risk factor, but frankly by the time it was clear it was a bubble” it was too late to address it through monetary policy. The New York Times also reported that he spoke favorably of forcing huge banks to hold much more capital, particularly if they were systemically important — so much capital, indeed, that being big would be costly. He advocated that the increased capital requirements should include capital that is more aligned with risk and able to absorb losses more effectively, and that works in a countercyclical manner, so that banks have more of it during times of stress.
Given the difficulty involved in recognizing a bubble even as it crests, Bernanke’s statements on capital-holding changes make sense. Absent breaking up banks too big to fail, making it very costly for them to be big is the next best option. The regulators would be wise to be on the look out, however, for bankers who try to hide their banks’ true sizes (and risk). Given the empire-building proclivity in the business world, designing a system that makes bigness more costly could result in an overall balance of forces. The key is to make being big sufficiently costly that the drive to empire-build is sufficiently checked in the banks.

Source: http://www.nytimes.com/2010/09/03/business/03commission.html?_r=1&ref=business

Breaking Up the Biggest Banks: The Impact on Moral Hazard

Citing the “slap on the wrist” culture at the U.S. Federal Reserve and the Securities and Exchange Commission (SEC), U.S. Senator Elizabeth Warren called on Congress in April 2015 to break up the big banks such as Bank of America, Citigroup, JPMorgan Chase, and Goldman Sachs.[1] She coupled the ‘break-up” approach to reducing the systemic risk with limiting the Fed’s ability to bailout individual banks. The synergy in Warren’s approach is worthy of further analysis.

The full essay is at "Breaking Up the Biggest Banks."

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[i] Reuters, “Elizabeth Warren Calls on Congress to Break Up the Big Banks, Change Tax Rules,” The Huffington Post, April 15, 2015.

Banks Too Big To Jail: A Systemic Conflict of Interest

When a blatant conflict of interest is ensconced in a regulatory system, the public can expect to be insufficiently protected from being harmed. Such a people is probably too tolerant of such conflicts, or else too weak to effectively counter the concentrated power of the vested interests benefitting from the sordid design. I submit that the relationship between U.S. banks and the Federal Reserve is plagued by a clear conflict of interest, and furthermore that the refusal of the Fed and the U.S. Justice Department to go after fraud committed at the big banks is a direct result.

The full essay is at Institutional Conflicts of Interest, available in print and as an ebook at Amazon.

On the Federal Reserve’s Quantitative Easing: Impacts on the U.S. Debt and Inflation

With government-bond purchases of $3.9 trillion (including mortgage-backed bonds) from November 25, 2008 to October 30, 2014, the U.S. Federal Reserve Bank stimulated the American economy by keeping interest rates low. This in turn kept the U.S. Treasury department’s interest payments on the gargantuan federal debt lower than would have otherwise been the case. Put another way, the Federal Reserve Bank’s massive foray into stimulating the economy made holding debt and borrowing still more money less costly than it would otherwise have been, and thus enabled the government’s penchant for debt-financing over raising taxes and/or reducing spending. “Enabling an addict” would be a less charitable way of putting the Fed’s role vis-à-vis the U.S. Government. In this essay, I explore problems resulting from the Fed’s stimulus on the government’s debt-financing.

The central bank created the $3.9 trillion (less reinvested principal and interest payments received) out of thin air—increasing the number of dollars relative to economic output. The implied inflationary impact was hidden by the lack of demand-pull inflation during the recession and even the recovery, given the stationary income level and the relatively few new, full-time jobs created. Cost-push inflation was also low, with oil prices in particular dipping in 2014. In spite of Janet Yellen, the Fed’s chair, being worried more about deflation than inflation (as if years of piled-on low inflation should not naturally be balanced by years of low deflation), I am reminded of the interest-rate hikes that Fed chair Paul Volcker instituted in 1981 to squeeze years of high inflation out of the system.[1] Unlike cost-push and demand-pull inflation, more dollars chasing relatively less goods—even when the economy is growing—is bound to give rise to inflation at some point.

More troubling yet even more subtle, the Fed’s creation of dollars to buy treasury bonds means that the Treasury Department does not have to pay as much in interest as it otherwise would because the interest rates are lower. Congressional legislators and the president have in turn been more inclined than they otherwise would have to go the route of borrowing even more; for not only is the cost of borrowing less, they knew the Federal Reserve Bank would create money to buy treasuries. This feedback loop is inherently bad, both in terms of political economy and ethics.

First off, although the Federal Reserve is an independent federal agency, it is part of the federal government. Created by an act of Congress, the central bank can come to rescue of the U.S. Treasury Department but not those of the Union’s states (unlike the ECB in the E.U.). So a conflict of interest is exploited when a Fed chair decides to create money to finance (or lower the cost of) the government’s debt. Imagine what would happen if a person could create money to pay for food such as ice-cream and cake. It would be too tempting for the person to eat too much—his or her self-maintenance role would likely succumb to his or her pleasure-seeking role. Taking the Fed as federal institution, the conflict of interest lies in two or more such institutions, including the Fed, essentially colluding to get free (or reduced cost) debt. A scenario in which Congress and the president want to borrow $1 trillion and the Federal Reserve simply creates the money and sends it to Treasury.

One way the Federal Reserve can partially deconstruct the conflict of interest and reduce the chance of inflation is for the central bank to destroy rather than hold or reinvest the returned principal (and interest revenue less costs) when the bonds come due.[2] Ideally, all of the money that the Fed created for its Quantitative Easing program should be destroyed. To be sure, even temporarily creating money to buy treasuries makes it easier than would otherwise be the case for Congress and the White House to borrow. With an accumulated debt of around $17 trillion, the U.S. Government was already over-extended beyond the point of no return. For the Federal Reserve to create money to buy government bonds may only compound the quagmire even if the economy is stimulated in the short run. Examining these more subtle implications can thus potentially enhance the ability of the popular sovereign—the People—to keep the federal government from heading down a ruinous path.

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[1] John Waggoner, “Easy Come, Easy Go: Beginning of the End,” USA Today, October 30, 2014.

[2] Darrell Delamaide, “A Pat on the Back for Yellen—But Lots of Hurdles Ahead,” USA Today, October 30, 2014.

The New York Fed: A Case of Regulatory Capture

According to The Wall Street Journal, a study sponsored by the Federal Reserve Bank of New York in 2009 uncovered “a culture of suppression that discouraged regulatory staffers from voicing worries about the banks they supervised.”[1] Whereas the report points to excessive risk aversion and group-think as the underlying problems, a fuller explanation is possible—one with clear implications for public policy.

The full essay is at A Case of Regulatory Capture.

Timothy Geithner: A Regulator Beholden to a Bank?

In her article in The New York Times, Gretchen Morgenson raises the possibility that Tim Geithner, president of the New York Federal Reserve from 2003 to early 2009 and U.S. Treasury Secretary during Obama’s first term, was a captured regulator, “a man locked into the mind-set of the very bankers he was supposed to oversee.”[1] I contend that while a shared mindset was part of the mix, he was actively doing the bidding of Wall Street, and one bank in particular, which he owed big time. That is to say, it is not just that he worked with Republicans such as Ben Bernanke, chairman of the Fed, and Henry Paulson, Bush’s Treasury Secretary. There is more to it in him being portrayed throughout his confirmation hearing for Treasury as “a tool of Wall Street.”[2]

The full essay is at "Geithner.

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1. Gretchen Morgenson, “Geithner, Staying on Script,” The New York Times, May 17, 2014.

2. Timothy Geithner, Stress Test (Random House: New York, 2014), p. 2.