The Bernanke Bind

Federal Reserve Seal

One problem with Central Banks is that too many people think they’re all powerful. For years the Fed chairman was considered America’s economic manager, and folks suggested that what the rest of the government did mattered little. So, in the 90’s, we had adulation of Alan "the Maestro" Greenspan.

And it’s true that central banks, and especially the Fed, are very powerful. Practically the first piece of investing advice I ever received was "don’t fight the Fed." But the Fed, while powerful, is not all-powerful and the Fed’s instruments are rather crude.

The Fed’s main economic management tools all fall under what is known as "monetary policy." The Fed controls, to some extent, how much money there is in the economy and how much you have to pay for it. (Interest rates are the price of money.) It doesn’t just have monetary powers, of course, it also has regulatory powers over banks, but mostly, if the Fed wants to accomplish something it does that by manipulating how easy, or how hard, it is for folks to get short term money (the supply of long term money is much less under Fed control). In addition to changing the price of money through changes in short term interest rates, the Fed can also engage in open market operations in which it buys or sells securities and it can also simply "print money."

For most of the recent decades the primary tool used by the Fed has been interest rate changes. It has manipulated the cost of money. Whenever you read about the Fed cutting or raising interest rates, that’s what they’re doing, changing how much money costs. Make money cheaper and more people will borrow, more activities will become profitable (because if you can make say an 8% profit not including capital costs and your cost of capital is 2% you’re profitable. If your cost of capital is 8% and your profit is 8%, well, your profit is actually 0%).

So, if the Fed wants more economic activity it decreases interest rates and a lot more money gets borrowed, either for consumption or to create or grow businesses.

The Fed increases interest rates when it wants to reduce inflation. As the cost of money goes up, less economic activity occurs and economic actors (businesses and workers both, ideally) lose pricing power. Unable to pass on costs to consumer, to negotiate raises with employers and so on, price increases tend to halt. The most notable example of this in recent years would be the Volcker Fed, which raised interest rates to double digit numbers in order to reign in inflation. That, of course, also turned what would have probably been a mild recession into an absolutely awful one because a ton of businesses became unprofitable, borrowing for consumption was crazy expensive and business expansion became painfully expensive (and was crowded out by the fact that you could lend money for double digit percents, so why not do that rather than invest in yourself?)

So this is the Bernanke Bind. Bernanke can’t simultaneously fight inflation and at the same time try and bail out an economy (or rather, a financial sector) which is collapsing around him. This is a classic policy bind, where no matter what you choose, there will be strong negative consequences.

Bernanke chose to lower interest rates. Which means that he has chosen to let inflation, already high in key sectors like energy and food, burgeon out of control. Last year I was predicting stagflation (high interest rates and high inflation, like in the late 70s) and that is now moving towards a consensus view.

Privatize the Profits, Socialize the Losses

But interest rate changes are only one tool the Fed has. There are other things it can do and it has chosen to do some of them. The most notable is that the Fed has agreed to swap banks (and starting soon, brokerages) treasuries in exchange for other types of securities – most notably Agencies, which is to say mortgage backed securities guaranteed by either Freddie Mac or Fannie Mae, the federal mortgage guarantee agencies.

At this point in time, even Agency backed securities are trading very far from face value, assuming you can even find someone who is willing to buy them, which you often can’t. Treasuries, being issued by the federal government, on the other hand, are selling like hot cakes. They are liquid, and more to the point, they are effectively cash. You can borrow against treasuries at nearly 100% so if you need money to meet margin calls, or to meet reserve requirements, treasuries are effectively the same thing as having stacks of bills in your vault.

The problem with banks and brokerages right now is not a liquidity crisis – it isn’t that there isn’t enough money around, it’s a solvency issue. People don’t believe that various securities, of which mortgage backed securities are only one kind, are worth the face value. In fact they don’t know what they’re worth, and fear they’re worth effectively nothing. So they won’t buy them and they won’t let them be used as collateral against other loans. Worse, when funds like the Carlyle Fund go bankrupt they have to sell off these securities. And then you do get a price. And then accounting rules force all the other banks, funds and brokerages holding the same securities to write them down. And billions of dollars just disappear overnight.

When that happens highly leveraged institutions (and many are leveraged at 30:1 or more) find that they no longer have the collateral against their outstanding loans (including margin). To meet those requirements they too potentially have to sell. That pushes down the price of these issues even more, provides prices (bad prices) for more of them, and that itself causes a self reinforcing downward spiral.

The end result of all that could be that a number of banks, brokerage houses and government backed agencies would go bankrupt. (In fact, my guess is that many are already bankrupt and just refuse to know it.)

All of this assuming that banks and other credit grantors don’t simply yank loans come renewal time, even if your assets haven’t been forced into a revaluation, because they’re betting they will be. They’ve got this junk on their books, they know they can’t move it, and they know you can’t move yours either. Why would they loan you money you probably can’t pay back? And if they do loan it to you, they’ll charge higher interest rates than they would otherwise. The ability of brokerages and banks to borrow from each other has been drying up as each of them individually tries to protect themselves.

So what the Fed has done is say that it will accept these dubious financial instruments at face value, or near face value, and in exchange give the banks and brokerages securities that are actually worth something, which can be used as collateral, and which are liquid.

Strictly speaking these exchanges are for 30 days only, but in practice they are likely to continue in perpetuity or until the crisis is over. If the Fed, after all, doesn’t keep rolling them over, then all the problems the Fed was trying to avoid will occur, plus a confidence crisis caused by the Fed pulling back.

Likewise it should be noted that there’s a very good chance of the Fed getting caught with these junk securities. If a bank or brokerage goes under anyway, the Fed will be stuck with securities that are worth cents on the dollar. So what the Fed has done is socialize the risk because ultimately, you the taxpayer are on the hook for Fed losses, either directly or through inflation if they print money to cover them. It’s a nice game if you think about it. Wall Street has been giving away record bonuses for years. Heck, bonuses paid for 2006 were greater than the raises of 80 million Americans. Bonuses given for 2007, in 2008, after everyone knew that large chunks of Wall Street were probably insolvent, were even larger! These guys privatized the profits, making themselves into millionaires. And now the government is picking up the losses.

This is especially the case in the bailout of Bear Stearns, which was done with "non-recourse, back-to-back financing". JP Morgan borrows money from the Fed’s discount window, lends it to Bear Stearns in exchange for securities and if the Bear defaults, JP doesn’t have to repay the Fed. Morgan will insist on Bear’s most valuable securities in exchange for the money (still worth less than par, but certainly not worthless) and if the Bear goes under, JP keeps those securities and doesn’t repay the Fed. Good deal, eh?

In some respects this amounts to buying an ownership stake in Bear Stearns, without the advantages of just out and out nationalizing the Bear, telling the stockholders that they get nothing (which is a risk they signed up for when they bought stock) and then unwinding the position slowly. Except that JP Morgan gets to make a bunch of money, where direct nationalization and winding down (or even nationalizing and operating) would mean reduced expenses for the government and no private profit. We sure wouldn’t want for the public to take the minimal soaking possible and for Wall Street not to profit from a firm that ran itself into bankruptcy, would we?

The Fed’s balance sheet at this point is approximately 800 billion. This may not seem large, but it is real unleveraged money, known as the monetary base. The Fed has currently committed about half of that to various facilities which are or will accept crap paper for treasuries. This means that the Fed has about 400 billion of maneuvering room left before it runs out of the ability to just swap paper around and pretend it’s all the same sort of paper.

Four hundred billion seems very unlikely to be enough. Neither does eight hundred billion. The terrible beauty of reverse leverage means that banks and Wall Street are exposed to much more than 800 billion of downside risk. Normally that doesn’t matter, but when people start insisting on real money, not leveraged money, it does. Bernanke is betting that markets will settle on a reasonable price for distressed securities; a price that is lower than par, but not so low that the sector collapses. And he’s betting that the markets will do it before he runs out of willingness to push inflation through the roof. (Central bankers never run out of money, though they can run out of money worth anything.)

So what happens if the Fed pushes up to 800 billion, and finds out that isn’t enough? Well, at that point it has to create new assets, on its own. It has the power to do so, but doing so is effectively the same as running the printing presses. Running them hot.

Which leads us back to Bernanke’s bind. Doing that would put into play significant inflationary pressures. Printing money when the economy isn’t expanding at the same rate as you’re printing it inevitably leads to inflation. Since the US economy is actually contracting, printing money will almost certainly cause even more inflation.

The Bernanke Bind: the central bank can’t do two things at once. It can’t fight inflation and prop up financial markets and the economy at the same time. It is simply not possible. And, sadly, while the Fed can usually have any one thing it wants, in this case, because this is not a liquidity crisis but a crisis of confidence and a solvency crisis (i.e. a question of whether banks and other financial institutions are bankrupt or not) it’s questionable if the Fed can even have that one thing, short of the Fed just throwing up its hands and running the presses hot. In which case the US could have a solvent financial sector worth nothing because the US dollar would be worth nothing.

So what should Bernanke do?

Wrong question. Bernanke’s in a bind. He can choose his poison, which he’s done, but he can’t fix the bind by himself. The Fed, powerful as it is, just doesn’t have the tools. Monetary policy alone will not get the US out of this.

A solution requires fiscal policy, and that means Congress and the President. Which means nothing useful will will be done at least till 2009, and maybe not even then.

Assuming, however, Congress and the President did actually want to take action and were willing to do what it takes, there are options. I’ll discuss some of those options in upcoming posts.

Related posts:

1. NPR, the IMF, and the Global Savings Glut
2. The Independence of the Fed at Risk: Watt vs. Paul-Grayson
3. The Song Remains The Same: Too Much Money At The Top of The Economy
4. Another Failed Innovation: Auction-Rate Securities
5. It Takes The Village To Raze the Economy: Some Notes On Krugman and the Return of Keynes