Streetwise Professor

May 25, 2009

Zimbabwe? Or, A Triumph of Hope Over Experience

Filed under: Economics,Financial crisis,Politics — The Professor @ 8:56 pm

Philadelphia Fed President Charles Plosser has publicly acknowledged concerns about damage to the Fed’s credibility as a result of its aggressive quantitative easing program, and its close coordination with the Treasury:

The Federal Reserve’s myriad emergency programs for the U.S. economy threaten the central bank’s independence, raising the risk of future inflation, Philadelphia Federal Reserve President Charles Plosser said on Thursday.

To resolve the problem, Plosser argued the Treasury Department should agree to take on riskier assets like mortgage bonds that have been absorbed by the Fed in an effort to free up credit markets.

“When a nation’s treasury or finance ministry and its central bank work too closely together, there is a clear risk that the government’s spending will end up being financed by the central bank’s power to create money,” Plosser said at a Money Marketeers meeting in New York.

“History shows us that you can get very bad economic outcomes with rapidly rising inflation,” he said, citing the case of Zimbabwe as an extreme example.

. . . .

Plosser emphasized the need for autonomous central bank policy to a healthy and stable financial system. He expressed worries about the more than $360 billion in mortgage debt that the Fed has taken onto its balance sheet, part of a commitment to buy up to $1.5 trillion in mortgage and agency debt.

Such obligations, he said, are no less the debt of the U.S. government than an actual Treasury note.

“We need to draw a bright line once again between monetary policy and fiscal policy,” Plosser warned, adding that some aspects of the current debacle were “eerily reminiscent” of the 1970s.

“We have rapid monetary expansion in the face of an apparently substantial output gap.”

. . . .

Plosser has supported the Fed’s actions as a temporary support, but has been consistent in warning that there should be a better game plan.

“These actions have the potential of altering the delicate political balance of the (Fed), putting at risk its independence and, in so doing, diminishing its credibility and ability to maintain price stability,” Plosser said.

“Eerily reminiscent of the 1970s”=Stagflation.  That’s what Plosser is warning about, and I agree.

Richard Fisher, President of the Dallas Fed, has similarly acknowledged the threats to the Fed’s credibility and independence, and the resulting threat of inflation:

His bigger concern these days would seem to be what he calls “the perception of risk” that has been created by the Fed’s purchases of Treasury bonds, mortgage-backed securities and Fannie Mae paper.

Mr. Fisher acknowledges that events in the financial markets last year required some unusual Fed action in the commercial lending market. But he says the longer-term debt, particularly the Treasurys, is making investors nervous. The looming challenge, he says, is to reassure markets that the Fed is not going to be “the handmaiden” to fiscal profligacy. “I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program.”

. . . .

Mr. Fisher defends the Fed’s actions that were designed to “stabilize the financial system as it literally fell apart and prevent the economy from imploding.” Yet he admits that there is unfinished work. Policy makers have to be “always mindful that whatever you put in, you are going to have to take out at some point. And also be mindful that there are these perceptions [about the possibility of monetizing the debt], which is why I have been sensitive about the issue of purchasing Treasurys.”

He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. “I wasn’t asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about.”

As I listen I am reminded that it’s not just the Asians who have expressed concern. In his Kennedy School speech, Mr. Fisher himself fretted about the U.S. fiscal picture. He acknowledges that he has raised the issue “ad nauseam” and doesn’t apologize. “Throughout history,” he says, “what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can’t let that happen. That’s when you open the floodgates. So I hope and I pray that our political leaders will just have to take this bull by the horns at some point. You can’t run away from it.”

And Fisher’s last sentence is what scares me.  Prayer is the right word to use there, for rational calculation suggests that political leaders are highly unlikely to take the bull by the horns. His diagnosis of the actions of the “political class throughout history” pressuring the central bank into profligate printing of money is spot on.  So why should we expect things to be that much different in the US in 2009, especially given the degraded condition of our politics, and our political leadership?  Fisher’s “prayer” brings to mind Samuel Johnson’s judgment on second marriages: a triumph of hope over experience.  

Plosser’s and Fisher’s statements suggest a coordinated plan by the Fed to calm fears regarding the Fed’s credibility and independence.  Bernanke suggested as much in his answer to my question at the Atlanta Fed conference two weeks back.  

And these fears are very real.  It’s nice and all that Bernanke et al are trying to allay concerns, but talk is just that.  The question is whether the Fed can withstand the intense political pressure that will come as the Fed tries to navigate between the dangers of throttling an incipient recovery and sparking a huge inflation.  With the massive government spending in the coming years, and the resulting explosion in the Federal debt, the Fed’s apparent commitment to supporting the housing sector, and myriad other factors, there is a major risk that today’s fine words will mean little when push comes to shove.  Given the choice between voting for a massive tax increase, or dragooning the Fed into an imposing on inflation tax for which it will have no accountability, my money is on Congress doing the latter. After all that’s what political classes have done throughout history.  Just as Richard Fisher.

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1 Comment »

  1. Well, since we’re into prayer mode, I can’t help but think once again:

    The guvmint has no business acting like an insurance company for investors.

    And more importantly, I can’t help but remember why the mortgage “market,” through securitization, etc., expanded so much in the first place.

    Even though FannieMae and FreddieMac are not the government, it was “widely viewed and perceived” that securities issued by them would indeed have the full faith and credit of the US guvmint behind those securities.

    Thus, one of the “incentives” to buy mortgages secured by the pledges of all of the Bawney Fwank “affordable housing” borrowers who couldn’t afford to pay.

    So here we are – a mistake by the guvmint in the first place (thank you Bawnney Fwank and others – NOT) being compounded by yet more mistakes.

    I keep harking back to the huge difference between now and how it was all solved in the oil-producing states back in the early ’80s, during the oil bust, when the FDIC and the RTC stepped in, when the bankruptcy courts were very busy (the busiest one in the country being the court in Oklahoma City), when foreclosures left and right were the order of the day. Penn Square, Chase Manhattan, Continental Illinois – it all got sorted out. And all of the people who moved in to cash in on the oil boom of the late 70′s and early 80′s moved out.

    This despite the fact that all sorts of politicians regularly flew in to siphon huge political contribution from “eagles” and such.

    I guess it pays to be geographically closer to DC and New York.

    Much easier to justify government distortions from close up.

    Comment by elmer — May 25, 2009 @ 9:17 pm

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