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While the Fed’s Open Market Committee (FOMC) promised more monetary easing on Wednesday, the announcement was overshadowed by an exceedingly gloomy report on the state of the economy. The official statement warned of “significant downside risks to the economic outlook, including strains in global financial markets.” That’s all it took to send shares tumbling as jittery investors jettisoned stocks and fled to the safety of risk-free US Treasuries. The Dow finished down 283 points on the day while the bloodbath spread overseas to Asian and European markets.
Here’s an excerpt from the FOMC statement:
“To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative….
To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.”
The Fed is pounding down long-term rates (“Operation Twist”) hoping to fire-up the moribund housing market and ignite a credit expansion. At the same time, it’s recycling revenues from maturing bonds into mortgage-backed securities (MBS) in order to boost housing sales and to provide another subsidy to the banks. Fed chairman Ben Bernanke hopes that a refinancing boom will help keep more people–who are currently underwater on their mortgages–in their homes. But that probably won’t happen. The fact is, most of these people will still be unable to refinance because of tighter underwriting standards or because they have no equity in their homes. Lower interest rates alone won’t do the trick.
So, for all the fanfare, the Fed’s new program is basically a bust; it’s just more arranging of deck chairs. The perception now is that the Fed is out of bullets at the worst possible time, just as the economy is starting to crater. Here’s how MFR’s Joshua Shapiro sums it up:
“Nothing the Fed has left in its arsenal, including today’s moves, will have a large effect on real economic growth. The level of interest rates has never been an impediment to growth in the current recovery, and it certainly is not at the moment. Moreover, creditworthy borrowers have ready access to credit, and it is doubtful that anything the Fed may do is going to encourage banks to lend in great quantities to less creditworthy borrowers (nor should it).” (Wall Street Journal)
This is why the markets are in freefall, because the Fed has no more rabbits in its hat and because political gridlock precludes another round of fiscal stimulus. So, down we go.
But why is it that neither Bernanke nor Obama can figure out what needs to be done? Is there some dispute about how we got here or is this an ideological issue?
First, let’s look at this summary of recent events to see if we can agree about “how we got here”. That will help to determine what the policy should be. This is from an article by John Judis titled “Doom”:
“Today’s recession does not merely resemble the Great Depression; it is, to a real extent, a recurrence of it. It has the same unique causes and the same initial trajectory. Both downturns were triggered by a financial crisis coming on top of, and then deepening, a slowdown in industrial production and employment that had begun earlier and that was caused in part by rapid technological innovation…..
In each case, the financial crisis generated an overhang of consumer and business debt that—along with growing unemployment and underemployment, and the failure of real wages to rise—reduced effective demand to the point where the economy, without extensive government intervention, spun into a downward spiral of joblessness. The accumulation of debt also undermined the use of monetary policy to revive the economy. Even zero-percent interest rates could not induce private investment….
….when firms continued to cut back, unemployment continued to rise, and tax revenues dropped—creating a budget deficit—office….
Cutting spending and raising taxes to balance the budget had made things much worse….
To extricate themselves from this mess, the United States and other leading nations are going to have take the same kind of steps that the West took after World War II—steps that led to 25 years of prosperity. After World War II, governments came to play a much greater role in national economies, particularly in the United States…..In the future, the United States will once again have to raise rather than lower the level of federal spending as a percentage of GDP.” (“Doom!”, John Judis, The New Republic)
Great article. And, it really clarifies the main issues. When the economy is in a hole, stop digging. That’s the message. We can’t starve our way to prosperity nor can we induce people to spend money they don’t have when they’re already deep in the red. So, the government share of net spending has to increase or the economy will tank.
But Obama’s not doing that. The stimulus has run out and government spending is now contractionary, mainly because cutbacks at the state and local level have cancelled out federal transfer payments. So the economy is sliding backwards. Everyone knows that, which is why 72 percent of the people think the country “is headed in the wrong direction”. It’s because it is.
Now look at this shocker from Scott Reckard at the LA Times:
“Bank deposits soar despite rock-bottom interest rates Americans are pumping money into bank accounts at a blistering pace this year, sending deposits to record levels near $10 trillion …In the last three months, accounts at U.S. commercial banks have increased $429 billion, or 10%, almost double the increase for all of last year.
The large amount of cash only adds to expenses such as paying for deposit insurance premiums. ……
[Some banks are] stashing it in a safe but unrewarding place: Federal Reserve banks, which are paying them an interest rate of just 0.25% to tend the funds. Such deposits rose to more than $1.6 trillion at the end of August from about $1 trillion a year earlier, according to the Fed.” (“Bank Deposits increase Sharply”, Calculated Risk)
Have you ever seen a more damning indictment of Fed monetary policy? Three years after Lehman Brothers, and people are still so petrified that they’re slamming their life’s savings into deposits that earn zilch. What’s next? Stuffing money into mattresses?!?
There are no productive outlets for investment because the economy is dead. But that doesn’t matter, because people are not in a “wealth enhancing” mode anyway. They’re in a “wealth preservation” mode. The surge in deposits is a sign of panic; hoarding equals fear. And the reason people are scared is because the system is out-of-whack, the policy is wrong, and things are getting worse not better.
Do you know why people cling to money when they get scared?
Bernanke doesn’t. Bernanke’s a technocrat who thinks that if he moves the right lever at the Fed, people will start borrowing again and the economy will kick back into gear. There’s just one flaw in Bernanke’s theory; it doesn’t work. After 3 years of trimming rates, expanding the Fed’s balance sheet will trillions in worthless bonds, and endless rounds of quantitative shell games; people are dumping more money in bank deposits than ever. Monetray policy has been a total flop.
On the other hand, there was someone who understood why people cling to money when they’re scared. John Maynard Keynes. Keynes understood that markets were driven by human psychology not interest rates. Here’s a clip from The General Theory that gives a sample of his thinking:
“Our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future….The possession of actual money lulls our disquietude; and the premium we require to make us part with money is the measure of the degree of our disquietude.”
Bingo. This explains why a sudden downturn in the market can quickly turn into a full-blown crash. Investors get antsy, withdraw their money and hunker down. Pretty soon, the equity share supporting the markets vanishes and a bank run ensues thrusting the economy into a long-term swoon. And it’s all because people are afraid, so they grab their money and hang on for dear life.
So, what’s the remedy?
We need to restore confidence, and building confidence depends on three things; jobs, jobs and jobs. When people are employed; they’re less fearful and more optimistic about the future. And, they spend money, too, which boosts demand, increases growth and leads to a virtuous circle. FDR said it best in his First Inaugural Address, March 4, 1933. Here’s a clip:
“Our greatest primary task is to put people to work. This is no unsolvable problem if we face it wisely and courageously. It can be accomplished in part by direct recruiting by the Government itself, treating the task as we would treat the emergency of a war, but at the same time, through this employment, accomplishing great — greatly needed projects to stimulate and reorganize the use of our great natural resources….
And finally, in our progress towards a resumption of work, we require two safeguards against a return of the evils of the old order. There must be a strict supervision of all banking and credits and investments. There must be an end to speculation with other people’s money. And there must be provision for an adequate but sound currency.
These, my friends, are the lines of attack.” –Franklin Delano Roosevelt, First Inaugural Address, March 4, 1933.
Mike Whitney lives in Washington state. He can be reached at email@example.com