The Fed Dilemma

Yes, it is responsible for market crashes, but the origin of the problem traces back to the very roots of the institution

The Federal Reserve building in seen in Washington on Aug. 22, 2018. Chris Wattie/Reuters

Commentary

For the most part in 2017 and 2018, only academics and easy-money cranks scolded the Federal Reserve for raising rates. After all, the stock market was bubbling up and the economy was strong.

The economy is still strong, but the stock market has ended its record 10-year bull-market run with a bang. The 20-percent drop in the S&P 500 during one of the worst quarters in market history classifies as a bear market, although prices rebounded at the end of 2018 and in early 2019.

Now everybody from traders to retirees as well as President Donald Trump is scolding Fed Chairman Jerome Powell for his relentless path to higher interest rates and a reduction in the Fed’s balance sheet.

To make a long story short, yes, the Fed is chiefly responsible for this and other stock-market routs, which often precede recessions. There are other contributing factors, such as worries about the Chinese economy and trade, as well as the government shutdown, which will reduce the $1 trillion yearly spending spree of the federal government. But the Fed is at the center of the storm.

And the problem didn’t begin with the Fed’s actions over the past two years. The roots of the issues we now face have their immediate origins in the last financial crisis, but ultimately can be traced back to the founding of the Federal Reserve itself.

The Current Crash

The problem on the surface right now is that the Fed is taking away easy money from market participants and economic agents through its raising of the federal funds rate as well as the $50 billion per month reduction of its balance sheet.

The Fed balance sheet, as well as the federal funds rate, is the foundation of the entire global financial system. For every dollar by which the Fed expands its balance sheet, banks and shadow banks around the world can create many dollars’ worth of debt on top of it.

Terms like balance-sheet expansion and contraction, or quantitative easing (QE) and quantitative tightening (QT), are fancy words for printing money or removing money from circulation.

Since its creation in 1913, the Fed has had the power to print money and fuel booms, and contract money and create busts. So it has to take responsibility for the vicious business cycles since its creation, such as the Great Depression or the 2008 financial crisis.

You can trace this game back to the Fed’s origins, but here, let’s confine it to recent history.

In 1998, the giant hedge fund Long Term Capital Management collapsed and almost took the global financial system with it. The Fed pumped money into the system and we had the dot.com boom, which ended in a bust in 2000 after the Fed had tightened credit conditions.

It then pumped even more into the system to create the subprime boom, which ended in a bigger bust in 2008, again after the Fed had been raising rates for some time.

To “save the system” this time, the Fed boosted its balance sheet to more than $4 trillion and lowered interest rates to zero, in an unprecedented exercise in money printing. This has led to a bubble in corporate debt, student loans, auto loans, and real estate—again.

Popping the Bubble

But booms fueled by money printing usually fuel economic mirages and lead to investments that wouldn’t have been made otherwise, like subprime or dot.com. And even the boom from the past two years has seen a shallow economic recovery, with many people feeling left out.

Now, with interest rates up 2.5 percent, the balance sheet shrinking by $50 billion per month, and the stock market draw-down of 20 percent, we are looking to go into bust mode again.

The stock market reaction this time is particularly pronounced because the market has relied on the Fed to either ease monetary policy or delay tightening whenever there was a correction of 10 percent or so.

The fact that the market reacted so violently to a paltry 2.5 percent increase in rates tells us how dependent it is on easy money. The current Fed Funds rate is still lower than at most other times in recorded history.

And Chairman Powell has made it very clear that he isn’t “market dependent” but would rather follow his usually wrong and inaccurate models, as well as the philosophical concept of the neutral interest rate. He did backpaddle a little bit in early January, but the Fed has a history of talking up markets when talk is cheap.

Because even if the Fed doesn’t raise rates at the next meeting at the end of January, the balance sheet reduction will surely continue.

Either way, the economy can only be put back on solid footing if the bad investments of the boom are liquidated, which always causes asset-price collapses and economic recessions.

If the market is left to its own devices, these contractions are quick and painful, as in 1921, and then provide a solid basis for expansion.

So if Powell’s intention is to pop the bubble and go through the readjustment pain to put the economy on a long-term real growth trajectory, he is doing the right thing, even though he won’t be able to centrally plan the exact right rate for market clearing. But it would be a good start, and would require no bailouts this time around, unlike 2008 when the Fed and the Federal Government bailed out the whole banking system.

Contrary to popular opinion, there are ways and methods to orderly liquidate banks, as investment manager Barry Ritholtz points out:

“Let’s use Bank of America as an example. Bank of America gets nationalized, which really means Uncle Sam provides debtor in possession financing. This is really what happens normally with small companies. Someone who takes them out of bankruptcy give some operating money to keep functioning.

The equity gets down to zero—senior management out the door. There is certainly a layer beneath, which can get promoted without a problem. Bondholders, effectively they are highest in the line of who owns what’s left as the lenders. So they take what comes out of that minus Uncle Sam’s share of providing debtor in possession financing.

And you slowly feed all the pieces to the public. So you clean up the balance sheet and take all that debt. By the way there is no such thing as toxic assets. Well at 100 cents on the dollar they are toxic. But at 15 or 20 cents on the dollar there is plenty of upside there. So you take those assets and auction them off and you take what you get—maybe 15, 20, 25 percent. You take Merrill Lynch, which now has no bad debt on its books and you spin it off as a stand-alone.”

No Stability

The Fed claims it wants to promote economic stability and improve on the workings of the markets. But history in the 20th century shows that central banking has made business cycles worse than they were under a gold-based system and free banking, although credit crises existed before the Fed and are to be blamed on fractional reserve banking.

On top of that, the dollar has lost more than 90 percent of its value since the Fed’s inception. Stability looks different.

Whether it is incompetence or malevolence, as some historians have suggested, it doesn’t matter, because the Fed can’t replace a free market for capital.

In essence, setting interest rates and printing legal tender and reserves or contracting them at a whim is central planning. And this gets worse because private players are forced to accept Fed money as legal tender and we are forced to use Fed-powered bank money in the payment of taxes.

In fact, central banks look more like a Soviet politburo rather than a competitive market system, although they are privately owned. The few players in control of the system are using the state’s power to reap private profits and pile losses onto the taxpayer.

In contrast, the competitive market system is also the best system for money and banking, not just for other goods.

As economist Murray Rothbard points out, nobody thinks about installing a Board of Governors to supervise shoe production and their prices, so why do we need one to supervise money production and set its price?

In fact, President Franklin D. Roosevelt did think central planning would also be better for shoes and chicken, so he set up private cartels similar to the Fed for almost every industry under the National Industrial Recovery Act.

Unfortunately for him, it was ruled unconstitutional. Not surprisingly, constitutional lawyers like Edwin Vieira and many others believe the Fed isn’t compliant with the U.S. Constitution, of which Article 1, Section 10, states:

“No State shall ... coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts.”

Now, we have paper and electronic notes issued by the privately owned but not privately accountable Federal Reserve System, with the number of such notes expanded and contracted at will.

Sound Money

The Founding Fathers were rather fond of gold and silver, and were against central banking and the ever-expanding government debt that central banks finance.

“And I sincerely believe with you, that banking establishments are more dangerous than standing armies; [and] that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale,” Thomas Jefferson wrote in a letter to John Taylor in 1816.

Under the supervision of central banks with the power to print money and a government to bail them out, banks are indeed dangerous and will continue to cause boom-and-bust cycles. However, a return to sound money and competitive banking could put an end to this vicious loop.

Gold has traditionally served as sound money, and it could be used again by the marketplace and even banks to create a free market in capital, similar to the end of the 20th century.

“Look at the era of the classical gold standard, from 1871—the end of the Franco–Prussian War—until the beginning of World War I,” monetary philosopher Saifedean Ammous said.

“There’s a reason why this is known as the Golden Era, the Gilded Age, and La Belle Epoque. It was a time of unrivaled human flourishing all over the world. Economic growth was everywhere. Technology was being spread all over the world. Peace and prosperity were increasing everywhere around the world. Technological innovations were advancing.

“I think this is no coincidence. What the gold standard allowed people to do is to have a store of value that would maintain its value in the future. And that gave people a low time preference, that gave people the incentive to think of the long term, and that made people want to invest in things that would pay off over the long term.”

Ammous, author of “The Bitcoin Standard” also says that Bitcoin could serve as the digital gold of the future and replace the current system even without official government adoption.

But whether gold or Bitcoin, sound money would serve as a stable basis for the banking system, banks would have to be set free from the control of the Federal Reserve, be accountable for their actions, and be allowed to fail if they make bad investments.

This would remove moral hazard and create a more accurate clearing price for capital, which wouldn’t prevent, but would greatly reduce malinvestments and business cycles.

Chance for the Future

Given its dismal track record and probable unconstitutionality, the Federal Reserve System should be dissolved and sound money returned to the United States and the globe.

The fact that Powell is maneuvering us into the bust cycle could provide the opportunity to execute this momentous plan.

The promoters of the Fed used the stock market and economic crisis of 1907 to push its creation through Congress in 1913.

If this bust cycle is going to be worse than 2008—and by many financial metrics, it well could be—the political elite around Trump could use the next crisis to do the reverse of 2008 and 1913.

This article is part of a special Epoch Times series on the Federal Reserve. Click here to see all articles.