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10 Reasons to Be Critical of the Federal Reserve
January 31st, 2008
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The recession threat, credit crisis, housing market correction and weak dollar have many Americans looking for someone to blame. Potential targets abound. In the case of the subprime collapse — still the biggest negative influence on the economy — everyone seems to share responsibility. Aspiring home owners took on more debt than they could handle, real estate speculators assumed home prices would rise forever, and mortgage lenders made reckless loans because they were able to sell off the risk. Investment banks packaged the loans into complex securities that even the banks themselves were apparently unable to understand, and the rating agencies supposedly dedicated to disclosing the underlying riskiness cheerfully went along for the ride. Aiming higher, some critics are blaming the Federal Reserve for subprime as well as the greater state of the economy. Here are the criticisms they are likely to voice.
Interest rates too low for too long The argument: Former Fed chairman Alan Greenspan’s tenure was marked by aggressive interest rate cuts, beginning after the stock market of 1987. That initial move helped to prevent wider economic consequences, but rate cuts in the late 90’s made startup capital too easy to come by and helped cause to the dot-com bubble. Similarly, failing to raise rates in the past few years encouraged the wave of short-sighted, frenzied borrowing that ended so abruptly in 2007.
Selective attention The argument: The Fed always keeps its eyes peeled for signs of inflation, which manifests itself primarily in the prices of goods and services. That means the Fed is keen to deflate any “bubbles” it sees in these markets by taking money out of the economy. It devotes a similar amount of attention to employment figures. Bubbles developing elsewhere, such as in the prices of assets like houses, get lost in the mix. And under Greenspan, they were knowingly disregarded. One critic thinks, “Mr. Greenspan consistently argued that central banks have no legitimacy to intervene to prevent asset price bubbles, and to substitute their judgment for that of millions of market participants. But central banks have no problem whatsoever intervening when they think that product prices are inflating, or when labor markets are overheating.”
Stumped by the “conundrum” The argument: The Fed did dramatically raise the target for its most important rate between mid-2004 and mid-2006, but real life interest rates didn’t follow. Greenspan called the phenomenon a “conundrum.” One explanation is that the global spread of capitalism has increased the demand for U.S. debt and thereby made investors settle for lower returns (i.e., lower interest rates). This external market force has “substantially weakened” the Fed, according to an economist in the Fed’s Dallas branch. It follows that the central bank’s reliance on setting interest rate goals first — and following up by changing the money supply afterwards — is outdated. The eminent economist Milton Friedman, for one, said about a year ago that he was “puzzled” by the current order of operations.
The “Greenspan put” The argument: The Fed lowered its target for interest rates in 1998 after a major hedge fund collapse. Some on Wall Street subsequently claimed that the Fed under Greenspan’s leadership was artificially supporting the securities markets by manipulating monetary policy. Taking a term from stock options trading, they called this perceived strategy a “put” because it seemed to guarantee a minimum value below which security prices would not fall, regardless of downturns in the market. Financial market participants took excessive risks, believing the Fed would rescue them if things got too bad. That recklessness seems to have carried over into the lending practices that created the subprime disaster.
Reward for bad behavior The argument: Just as the Greenspan put encouraged bad behavior, Fed policy in the wake of the economic slowdown seems to reward it. Financial stocks have been justifiably hammered in recent months, but the Fed’s recent economic interventions are tailored to bailing them out first. As one critic has noted, “It has not been lost on the Wall Street titans that the government is the reliable first responder to scenes of financial distress, or that there will always be enough paper dollars to go around to assist the very largest of financial institutions” (see next link). Bear markets must coexist with bull markets in a truly free market, but the Fed seems bent on eliminating all but the upside. That might work in the short term, but not long afterwards. Moreover, it’s not capitalism at all, but a sort of “socialism for the rich.”
Warning signs ignored The argument: Early subprime whistleblowers, including a senior Fed official, tried in vain to elicit a reaction from the Fed. It’s true that the Fed should never act as a regulator, but it could have easily called for lending reform. Instead, it did nothing, apparently viewing the environment of deceptively easy credit as a means of propping up the economy and achieving the White House’s much touted “ownership society.”
Too little too late The argument: If the Fed has committed to a strategy of lowering target interest rates, it should commit fully and make more significant cuts. Wall Street clearly voiced this argument last month, when it drove the Dow down by almost 300 points after the Fed cut its benchmark rate by one a quarter of a percent rather than a half. The traders’ opinion is biased, of course, but the stock market they control is, for better or worse, the most prominent indicator of the state of the economy. The Fed might have erred on the side of caution, given that a more drastic rate cut would fuel inflation, but critics think it simply extended its penchant for inaction.
Wrong on inflation The argument: The Fed’s view of inflation has two significant flaws. First, it focuses on “core inflation,” which excludes energy and food costs, rather than “headline inflation,” which includes them. European economists, who favor headline inflation markers — and, by extension, believe that extremely high energy prices are a long-term phenomenon — are taking the Fed to task. Second, the Fed’s comments on inflation seem to confuse cause and effect .
Opening the discount window The argument: The Fed is placing a rare emphasis on it’s own lending capacity, known as the discount window, rather than the lending that occurs between banks in the private sector. The central bank has decreased the rate it charges on direct loans by 1.5 percent since September, while lowering its target for loans between other banks by only one percent. In December it also established a special mechanism, known as the Term Action Facility, for discount window auctions, and at least two auctions will occur through it in January. The first couple auctions at the end of last year were quite successful, but a heavy reliance on discount window operations does not have any real precedent. No one can predict whether it will be successful. In addition, the Fed is still working out several kinks that have made this type of lending undesirable in the past. Now might not be the best time for experimentation.
The Austrian take The argument: No survey of criticisms directed at the Fed can be complete without mention of the seemingly radical argument that the Fed should not exist at all. Proponents of this view, most of whom come from the “Austrian School” of economics, believe the very basis of current monetary policy is flawed. They think all dollars should be backed by an asset like gold, as they theoretically were until as recently as the ’70s, or at least exist in the reserves of banks. The “fractional reserve” system the Fed now oversees, in which only a small amount of the money supply can readily be withdrawn from banks, causes an artificial business cycle of “booms” and “busts.” The most prominent Fed abolitionist these days is Presidential candidate Ron Paul, who squarely blames the existence of the Fed for the economic events of recent months.
http://www.currencytrading.net/2008/10-reasons-to-be-critical-of-the-federal-reserve/