End the Fed

The Federal Reserve is supporting and maintaining a system of finance capitalism that by the ‘rules’ of capitalism should have disappeared in 2008. Wall Street, with its outposts now circling the globe, claims its ‘due’ under the premise its system of savage capitalism—permanent displacement of labor, evisceration of restrictions on activities businesses can and cannot engage in, planet-wide shifting of business costs from capital to unaffiliated citizenries, effective takeover of governments and the systematic ‘harvesting’ of constituent value from institutions built in social contexts from social resources, now asks that the rules it has put forth not be applied to it. And the Federal Reserve is the central entity keeping this system alive and intact as a permanent ward of its victims: we, the people.

In contrast to the studied ignorance of the economic mainstream, there is history to consider here. In central respects the current and ongoing ‘Great Recession’ has roots eerily similar to those of the 1930s. By 1929 the highly leveraged financial system was as unfathomably complex and nearly as filled with purposely-fraudulent garbage as Wall Street was in 2008. Throughout the 1930s the Federal Reserve saw its charge as protecting the large banks (Wall Street) as thousands of smaller banks were allowed to fail. The retrospective explanation / apologia from economists is ‘policy failure,’ but the result of banking consolidation to the benefit of the large banks was the same then as it is today. And as ‘austerity’ economics ebbs and flows in the political discourse, the same excuse of ‘policy failure’ is again being put forth to contrast the massive effort to save the financial system of benefit to bankers and plutocrats while ‘adequate’ fiscal stimulus to salve the economic pain of the populace is nowhere to be found.

While economist John Maynard Keynes is credited with developing the economic theories used to patch the capitalist system from the 1930s through the mid-1970s, left out of this explanation is that the banks were turned into utilities, were very heavily regulated, as part of this process. ‘Liquidity provision,’ providing loans and massive infusions of money into the financial system to prevent the forced closure of otherwise viable financial institutions due to temporary ‘panics,’ is today being confused with / being used as cover for / public support for institutions that made loans that never should have been made and for structuring themselves for the benefit of connected insiders in ways perfectly contrary to the interests of maintaining viable institutions. Bankers killed their own banks, not nature, and it is these very same bankers whose interests the Fed represents.

By 2008 and 2009 (and years earlier) the problems with the Wall Street banks were clear to economists familiar with the work of economist Hyman Minsky—a massive ‘Ponzi’ lending cycle, loans made on the basis of rising asset (collateral) values rather than sustainable cash flows, rendered the banking system insolvent once asset values began to decline. Additionally, a ‘shadow’ banking system premised on cash-flow leverage, a/k/a permanently cheap funding from the Fed, produced a systemic suicide mechanism. How clever was this?—the Fed raised interest rates as asset prices fell and the system collapsed. Who benefited?—the bankers who paid themselves from illusory profits and are still being bailed out by the Fed. Who lost?—everyone on the receiving end of the savage capitalism pushed by the banks but from whose ‘rules’ the banks now claim exemption.

The historical lesson mainstream economists in the monetarist tradition (Bernanke, Krugman) learned from the thousands of bank failures of the Great Depression is that dumping large amounts of money into a banking system in crisis provides both time for crisis sentiment to abate and for the facilitation of necessary transactions such as withdrawals by panicked depositors and the liquidation of assets at ‘reasonable’ prices. Without monetary ‘stimulus’ otherwise viable banks were forced to close (and liquidate assets) due to bank runs. And with insufficient money in the financial system, liquidation of assets took place at much lower prices than during ‘normal’ times. Lower asset prices produced a self-reinforcing cycle, systematically lowering the value of the collateral banks held bringing them ever closer to ruin. In contemporary terms as well as those of the Great Depression, homeowners who owed more on their mortgages than their houses were worth entered a ‘debt deflationary’ spiral where stagnant or falling wages were used to pay for houses and other assets worth increasingly less than the money owed against them.

In the narrow terms of mainstream debates over the Fed’s monetary policies, the monetarists have a point—the sudden withdrawal of money from a highly leveraged financial system will force ‘unnecessary’ bankruptcies and asset liquidations at prices below what the assets would be worth in times of abundant liquidity. But this frame deflects attention from relevant particulars such as the nature of bank lending leading to the crisis and the structure of the financial system that leaves individual banks in an interrelated financial system to increase individual bank ‘profits’ by maximizing the risk of systemic crisis. There is ample evidence of rampant lending fraud to feed the securitization pipelines of the Wall Street banks in the most recent housing boom-bust. And the cash-flow leverage of the shadow banks rendered asset values largely irrelevant in a narrow sense as long as low cost funding was continuous in a system where low cost and abundance are known to be cyclical and at the systemic level, because of pledged collateral, asset values remained crucial.

Put another way, Wall Street created a system where either an increase in interest rates (see variable rate mortgages below) or a material decline in asset values would kill the world economy in a world where the Fed ‘manages’ the broader economy by raising and lowering interest rates and the value of assets held by banks is (was) a function of the level of prudence in the lending process. This leaves bankers as either hapless idiots too stupid to know the basics of the monetary economics that govern their industry or cynical sociopaths willing to kill the global economy, with the attendant mass misery doing so is guaranteed to cause, for a fatter paycheck. On the side of stupidity, Fed Chair Ben Bernanke seemed sincerely clueless as the housing bust unfolded on his watch. On the side of cynical sociopaths, in the midst of the worst of the crisis Wall Street bankers connected to the New York Fed were arranging insider deals to personally profit from the bailouts then being engineered by the New York Fed. Neither stupidity nor avarice is mutually exclusive. And since the crisis unfolded Fed policy has been dedicated solely to restoring the fortunes of the malefactors behind it.

To a point poorly understood by mainstream economists- cash-flow leverage works as follows: say a bundle of fraudulently underwritten mortgages was intended to yield 8% but will realistically yield 3%. Thanks to cheap money and lax lending standards the bundle can be leveraged 20X at cost of 1%, that is, for $1 invested in the mortgages $20 of the bundle can be bought with a realistic yield of 3% (cash-flow) – 1% funding cost = 2% X 20 (leverage) = 40% return per year on 20:1 leverage with the $1 of every $20 worth of mortgage bundle serving as collateral. How do bankers get a 1% funding cost against weak collateral? Thank you Federal Reserve. The drop in expected cash flow from 8% to 3% (fraudulent lending) on a 10-year instrument results from approximately 60% of the mortgages not paying, or 12X the collateral value, but the money is borrowed. The borrower realizes a 100% principal loss less the leveraged cash-flow yield and the lender realizes the 60% principal loss if the loan is ended ‘prematurely’ and the cash flow leverage could potentially make up the lost principal if the deal is left in place. This is in effect the Bears Stearns ‘hedge fund’ that blew up in the early stages of the financial crisis and the entire shadow banking system. But here is the important point—they blew up and did so at values far below their collateral values in an interrelated system where when one bank is short of collateral, they all are.

This system was built on abundant, cheap (private) credit provided by an ‘accommodative’ Fed and a banking system willing to kill the broader economy for individual gain with certain knowledge the Fed will bury the bodies and create enough money to revive the system. Five years hence mainstream economists are still prattling on about a ‘zero lower bound’ on interest rates when fiscal policy could have recovered ‘aggregate demand’ four years ago and the structure of the banking system keeps the likelihood the Fed will raise interest rates at minus 100%. (My published forecast in 2008 was the Fed wouldn’t (couldn’t) raise interest rates in my actuarially expected lifetime, then more than a few decades into the future). Put another way, five years into this crisis the Fed is still in full life support mode for the financial system and this is five years after the start of a purported economic ‘recovery.’ The real and promised infusion of tens of trillions of dollars in public funds did solve the narrow issue of avoiding large numbers of bank failures and the deflationary pressures of large scale forced liquidations of assets. But this has both perpetuated and accelerated the stranglehold finance has on the economies of the West. And the Fed’s plan today is to re-flate asset values to bubble levels, not to ‘fix’ the economy.

Fed interest rate policy—keeping interest rates near zero for an extended period, has a number of dimensions, most of them poorly understood. First, the same policy that can be explained in terms of helping ‘consumers,’ e.g. homeowners who have variable rate mortgages that would make the mortgages unaffordable if interest rates rose, can be better explained as helping the banks. Most of the truly egregious mortgage loans made at the height of the housing bubble were marketed (by private mortgage originators) as ‘affordability’ products to less financially sophisticated and more economically marginalized borrowers at greatest risk of being unable to repay them. These also happened to be mainly variable rate loans, many whose principal value could get larger through ‘negative’ amortization. These mortgage types were geographically concentrated in the areas of greatest house price inflation. So yes, ‘consumers’ benefit from lower interest rates in the sense many would otherwise be forced into foreclosure. But the concentrations of geography, financial fragility of borrowers and loan types that cause maximum economic damage in exchange for maximum short-term fees for the banks weight the decision of the Fed on the side of already over-leveraged, insolvent banks. Alternatively, using fiscal policy to raise the incomes of these marginal borrowers and / or using the bailout money to pay the difference between amounts owed on the mortgages and current house values would serve their interests more than low interest rates, but doing these has never been under serious discussion. (And the latter, paying ‘underwater’ mortgage amounts, would have also served the banks by making collateral value equal to loan amounts).

If the government had an interest in fixing the economy, fiscal policy—government jobs programs, large-scale investment in ‘green’ infrastructure and technology, and public investment in education and healthcare could do most of the heavy lifting. This has not happened. Additionally, toxic institutions that are self-perpetuating and eventually all consuming if not brought to heel like the military and banking industries could be brought to heel. This has not happened. This is to say: ‘the government’ has no interest in fixing the economy. To then argue the Federal Reserve is the sole institution left to fix the economy begs the question: why? This brings up actual Fed policy, which is explained by the economic mainstream as acting in the public interest when Fed policies could be more credibly explained as serving the interests of the banks and bankers who killed the global economy. The incomes and wealth of connected plutocrats and the bonuses and paychecks of bankers have indeed been ‘recovered’ by Fed policy—this was accomplished with specific Fed policies such as Quantitative Easing to re-flate the value of financial assets. In fact, the best argument to be made by mainstream economists in favor of Fed policy is if the rich are made rich enough they can hire us to scrub their toilets and mow their grass (wealth effect). This is to say the least effective policies to benefit most people—those suffering most from adverse circumstances, are the only ones being implemented.

Calls to ‘end the Fed’ are the bread and butter of gold bugs and economic conspiracy theorists on the right. But some of the intellectual founders of this movement, Austrian economists, framed their critiques of Fed policy in terms roughly similar to what is written here. The Fed has engineered economic recessions and recoveries in the interest of bankers (banks benefit from deflation, hence the bugaboo of inflation versus say, mass unemployment). The economic mainstream in favor of the Fed’s monetary policies sees them as better than nothing when it is the financial system the Fed is maintaining that continues to bleed the economy dry. As with military policy and domestic surveillance, the political / economic center has become the ‘rational’ voice for what are increasingly fringe institutions in terms of their social utility. The Fed, as is its history, has recovered and covered up for the system of finance capitalism so it may kill again. The crooks and fools behind ‘teaser rate, variable rate negatively amortizing mortgages’ are currently busy gaming collateral requirements for exchange traded ‘swaps’ ($700 trillion plus in outstanding notional value). House prices in permanent boom / bust regions like Southern California are once again booming. These also happen to be the areas with the most bank exposure to residential real estate. For those elated with the boom, just wait a while—the engineered bust is coming just as certainly.

Some very bright and well-intentioned commentators argue the Fed is ‘liberal’ compared with its European counterparts. But this is only one of the potential ways to frame its role. How does the history of the Federal Reserve stack up against the possibility of a system designed to serve the public interest, the poor as well as the rich? The U.S. government has issued currency quite competently in circumstances where it had to. The Fed’s boom / bust cycles always benefit the well to do and punish the economically marginal. Place these words in the back of your mind for the next inevitable economic calamity engineered by the banks and facilitated by the Fed. Another world is not only possible, but also necessary.

Rob Urie is an artist and political economist in New York.
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Rob Urie is an artist and political economist. His book Zen Economics is published by CounterPunch Books.

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