A Round Trip
The dedicated resuscitators of the Federal Reserve are doomed to lose their battle with sanity, akin to Alexander Scriabin's fate in search of the lost chord. Chairman Ben S. Bernanke has not a clue where this will end. Our doleful fate is leading staunch establishmentarians to sink the Fed.
A group of worthies tacked a manifesto to the September 17, 2012, Wall Street Journal editorial page. The five authors are insiders; insiders being those who created and benefited from the false economic structure compounded over the past four decades. " J'accuse" should have been the title under which they charged the Federal Reserve with committing every crime under the sun.
Before reviewing the convolutions and unaccountable chaos created by the Bernanke Fed, it is worth looking at the simplicity of the original Federal Reserve System. An above average tenth-grade student of 1913 could have understood how the Federal Reserve functioned. That being so, if the newly formed central banking system had stuck to the founders' intentions , we would not be suffering a pusillanimous satrap such as Ben Bernanke hurtling the Fed, and more importantly, the rest of us, off a cliff.
The principles upon which the central bank was founded have been jettisoned. Few know this. Students who attended Chairman Bernanke's "Origins and Mission of the Federal Reserve" lecture at George Washington University in March 2012 are still in the dark. Rereading the Chairman's lecture, he pings, pongs, and drifts in such a haphazard fashion that his knowledge of Origins and Missions remains a mystery. Once again, it is striking how little he knows - about anything.
H. Parker Willis was more than a scribe and less than the author of the Federal Reserve Act. Carter Glass, Senator from Virginia, had the vision. Willis understood the nuts-and-bolts of central banking.
Willis was a professor of economics (Washington & Lee, Columbia University) fully versed in the English banking school, including the "real bills" monetary doctrine. The Federal Reserve Act (signed by President Wilson on December 23, 1913) authorized the Federal Reserve System to accept "real bills" from banks. Government securities were not acceptable.
The original process by which the Fed operated with banks worked as follows: An industrial or commercial concern asked its local bank for a loan. The loan was backed by short-term, fixed-maturity payments to be received by the Company (the aforementioned "industrial or commercial concern"). We will assume the payment is due in 30 days. At that point, the Company pays off the commercial loan - "commercial paper" - to its local bank. The Company is able to do so from the payments for goods it received from its customers: Real Bills for Real Goods.
On day five (of the 30-day period), the local bank needs cash. Perhaps there is a bank run, or more probably, some incident or whim of less interest to us. A guiding light before the formation of the Federal Reserve System was to provide cash to banks in such instances as a bank run.
The local bank - a commercial bank - presents the commercial paper to the Federal Reserve. (This would have been one of the 12 district banks, which operated quite independently at the beginning.) The Fed "rediscounts" the commercial paper and lends money to the local bank. The Fed holds the paper (and can demand payment from the Company's customers should the company fail.) The loan from the Fed will be repaid by the local bank when the commercial paper matures.
The commercial bank's nervous customers (during a bank run) see that the Federal Reserve is meeting the demands of any and all bank customers (depositors). The fearful customers dismiss concerns of their money being housed in a fractional-reserve operation, and depart the recently mutinous bank lobby without withdrawing their accounts. Again, it was the intention of the Federal Reserve founders to offer bank customers this assurance. The assurance was fortified knowing the Federal Reserve's balance sheet was limited to such short-term, self-liquidating loans that were backed by Real Goods.
The Federal Reserve was to be a non-inflationary central bank. In fact, all central banks were non-inflationary (over periods of time) in 1913. "Price stability" did not need to be defined. Our ancestors of 1913 would not have been able to comprehend a banker, an economist, a public servant : that is, serving the public, who would announce "price stability" means 2% inflation. (Nor comprehend that when 2% is no help "we'll-make it-4%-then-8%-then-12%." Adam Posen at the Bank of England has rolled out the 12% possibility.)
It was non-inflationary because the credit extended by the commercial bank matched the level of business in the economy. This was a fairly simple business.
In the December 1915 Political Science Quarterly , Willis published "The First Year of the New Banking System." Being a professor, he could not abstain from instructing his readers: "Under the provisions of the Federal Reserve Act it is required that loans be made upon paper protected by warehouse receipts, and such provisions have been made by the Board in the circular relating to commodity paper (Circular No. 17, Series of 1915)." Government bonds need not apply.
World War I disrupted this arrangement. The Great War also deranged the world's financial system when it was found necessary to decapitate the International Gold Standard. As mentioned above, in 1913, none of the world's central banks were inflation-producing operations. Since 1914, not a single central bank has accomplished much else.
The fledgling Federal Reserve did what it was told to support the doughboys. The Fed's Annual Report of 1918 noted the institution's "duty to cooperate unreservedly with the government [i.e., the Treasury] to provide funds needed for the war." Duty bound, the Fed was a full-fledged participant in the U.S. Treasury war-bond market.
In the June 1920 issue of Proceedings of the Academy of Political Science in the City of New York , Willis discussed "The Federal Reserve and Inflation." The professor admitted the Federal Reserve System had diverged from its original purpose "as a system for the accommodation of business and for the discounting of paper of fixed maturity growing out of industrial, commercial, and agricultural operations." At that moment the Federal Reserve "was carrying in its portfolios about $1,500,000,000 of so-called war paper."
The only question to Willis, in his 1920 paper, was when and how the Fed would divest itself of war paper, otherwise known as government securities. He hardly needed to say why, but, being a professor, mentioned "in so far as the Federal Reserve banks continue to retain this volume of paper in their portfolios, they would be contributing to the maintenance of inflation and would be aiding to sustain the existing level [of inflated - FJS] prices." Another problem was holding "loans on non-liquid security [that is loans not backed by the liquid ation of industrial, commercial, or agricultural inventory: the security of which beat war paper any day - FJS], including Government bonds and other obligations." Note that government bonds were not liquid. Their composition and properties are far inferior to the short-term, self-liquidating commercial paper.
Professor Willis attempted to resurrect the old religion when he wrote The Theory and Practice of Central Banking in 1936. This was the same year John Maynard Keynes's General Theory of Employment, Interest, and Money was published. Professor Willis (a native of Weymouth, Massachusetts and son of suffragist Olympia Brown) dropped dead in 1937. This may have been caused by a broken heart after Keynes's tome won the beauty contest, but confirmation requires further research.
The world has changed. Economics professors have concocted a theory that hinges on government bonds being "risk-free." The risk-free professors handed each other medals and entered astonishingly lucrative consulting and publishing arrangements. The gist of their so-called theory has anchored every pension plan, endowment, and financial adviser's risk-return selection model. The consequences continue to unfold. (See: "It's Over" and "Scarlett O'hara's Risk-Free Rate.")
Even today, with European sovereigns beyond hope of borrowing in an unrigged market, the academic grip remains. As for the United States risk-free premise, it will turn to "risk-fraught" when the Federal Reserve is no longer permitted to own U.S. Treasury securities. That day will come. H. Parker Willis will be vindicated.
The September 17, 2012, edition of the Wall Street Journal, unleashed "The Magnitude of the Mess We're In," by authors George P. Shultz, Michael J. Boskin, John F. Cogan, Allan H. Meltzer and John B. Taylor.
The rebels opened: "Sometimes a few facts tell important stories. The American economy now is full of facts that tell stories that you really don't want, but need, to hear."
Among the ugly truths (and I'm only addressing a small number within their lengthy list), Schultz & Co. ask: "Did you know that the Federal Reserve is now giving money to banks, effectively circumventing the appropriations process?" In other words, if money is to be given by the government to an industry, this is a decision of Congress, not the Executive, not the Supreme Court, and certainly not a panel of bureaucrats. Of course, it is Congress's duty to retain control of its own responsibilities. Congress is negligent in not taking administrative or legal action to prevent the Federal Reserve from acting outside the law.
Another unwanted, but important story: "The Consumer Financial Protection Bureau is also being financed by the Federal Reserve rather than by appropriations, severing the checks and balances needed for good government." This only hints at the much larger intrusion by the Fed. It has no budget. It can buy whatever and whomever it wants. The Schutzstaffel never had such latitude.
On we go: "And the Fed's Operation Twist, buying long-term and selling short-term debt, is substituting for the Treasury's traditional debt management." U.S. Treasury Secretary Timothy Geithner holds responsibility for managing the nation's debt. It is his duty to midwife the structure of U.S. debt securities. A few years ago, a Treasury Secretary stopped issuing 30-year bonds. After a bit, a different Treasury Secretary decided to issue 30-year bonds again. Whether either decision was good or bad is not the point. The Treasury Department, within the United States' government's Executive Branch, controls the structure of U.S. Treasury securities. The Federal Reserve has no business treating the size of the two- and ten-year Treasury market like an accordion for testing failed theories.
The conflict of using the Federal Reserve balance sheet as custodian of U.S. Treasury securities is apparent: "Did you know that annual spending by the federal government now exceeds the 2007 level by about $1 trillion? [R]evenues are little changed. The result is an unprecedented string of federal budget deficits, $1.4 trillion in 2009, $1.3 trillion in 2010, $1.3 trillion in 2011, and another $1.2 trillion on the way this year."
The latest Monthly Treasury Statement shows $179 billion of Receipts in August 2012 and $369 billion of Outlays: inflows of 48 cents for every $1.00 spent. August either signals a disintegrating trend or was an off month. Over the first 11 months of this fiscal year (October 2011 through August 2012), the Treasury Department received 65 cents for every one dollar spent. Really now, how can the credit agencies still call the United States a AAA or even AA credit?
The Federal Reserve's forays into fiscal policy destroy its "apolitical" claims. On August 31, 2012, Chairman Bernanke told legislators how to construct budgets: "It is critical that fiscal policymakers put in place a credible plan that sets the federal budget on a sustainable trajectory in the medium and longer runs. However, policymakers should take care to avoid a sharp near-term fiscal contraction that could endanger the recovery." Again, these escapades are not only Bernanke's fault; it is Congress's job to shove a rag in his mouth.
In a practical sense, the Fed now plays a critical role in the nation's fiscal incontinence. If not for the Federal Reserve's day-in and day-out purchases of Treasury securities, the Federal government would be firing every other worker (using the simplifying projection of 48 cents of receipts for every dollar spent). It is not the Fed's job to finance salaries and departments. Schultz et.al., remind us: "Did you know that, during the last fiscal year, around three-quarters of the deficit was financed by the Federal Reserve? Foreign governments accounted for most of the rest, as American citizens' and institutions' purchases and sales netted to about zero. The Fed now owns one in six dollars of the national debt, the largest percentage of GDP in history, larger than even at the end of World War II."
No one pretends the federal government will ever pay down its current debt, of which the Fed may soon be the sole net purchaser. The accounts of Japan and China are turning over (see "Peak Imbalances Are Falling") and will probably soon be consistently (rather than occasionally) net sellers of Treasury securities.
Simple Ben has announced open-ended buying of any-and-all securities, forever. He is bidding for mortgages. Next week, it could be pawn-shop loans. He, and the Fed, will be retired at some unknown date. Copies of the The Theory and Practice of Central Banking will be in every school child's hands and the General Theory will broil on the bonfire of insanity.
Frederick Sheehan writes a blog at www.aucontrarian.com