Tuesday, April 09, 2013

Ben's choice.

When former Reagan OMB Director David Stockman charged Ben Bernanke with  “exploding the Fed balance sheet” in his recent New York Times op-ed piece and in various interviews on his book tour, he was tapping into a topic rife with controversy and skepticism. Few areas of our politics are as rich with conspiracy theory in the public imagination as the workings of the Federal Reserve Bank.

Ben Bernanke has been a stalwart of federal economic policy since the 2008 collapse. While most of the original crafters of TARP and the bailouts of the banks are off writing their memoirs, Bernanke has soldiered on. Someday, perhaps, history will credit him with guiding the U.S. economy—and in its wake the rest of the world—through a treacherous time, but that time has not yet come.

From a certain perspective, Bernanke has done an admirable job. After all, while the rest of the advanced industrialized world—notably Europe and Japan—continue to struggle to find a path to growth, the U.S. economy is growing—albeit at a slower rate than in prior recoveries. And for all the continuing anger at the financial sector, the U.S. banking system has returned to viability, while European banks in particular continue to navigate a precarious path forward. Every month we see new evidence of the long, slow implosion of the Eurozone, while Japan’s failure to escape its long-running recession is now the stuff of legend. Meanwhile, flight capital from the rest of the world’s continues to strengthen the dollar as the reserve currency of the global economy and push U.S. Treasury yields to historic lows.

There are two particularly crimes that Stockton and others lay at Bernanke’s feet. The first is the impact of keeping short-term interest rates near zero. Facing the disinclination of the Congress and the U.S. public to recapitalize the banking system directly, Bernanke has used monetary policy to achieve this outcome. It is now (somewhat) widely understood that one of the primary objectives in keeping interest rates low has been to allow a “carry trade” whereby banks borrow funds from the Fed at near zero cost and purchase higher yielding U.S. Treasury securities, and earn a spread that flows through their earnings to rebuild bank assets that were destroyed with the collapse of housing bond values.

The consequence of this, as Stockman and many others have pointed out, is that it has enriched the banks while impoverishing the elderly, worker retirement systems and other savers across the economy. Our parents and grandparents who live off their savings have seen interest earnings on certificates of deposit decline from the range of four or five percent to below one percent. Similarly, the now-critical underfunding of public pension systems—which were universally fully funded a decade ago—is in part a direct result of Federal Reserve interest rate policy.

Bernanke, as Fed chairman, had to make a choice, and he did. Keeping the Fed Funds rate at near zero has had little to do with stimulating bank lending—and indeed the lack of lending is a major criticism of the banking system—but rather it has been to rebuild bank balance sheets that were destroyed with the 2008 collapse.

This focus on rebuilding the balance sheets of our largest banks parallels the second charge leveled at Bernanke. The Federal Reserve Bank balance sheet has grown significantly since the 2008 collapse. At the end of August 2008, just before the ensuing September crash, the Fed balance sheet showed assets and liabilities (which are equal in the language of Fed accounting) of $909 billion. Four and one-half years later, as of March 27th, Fed assets and liabilities had more than tripled, to $3.2 trillion. During this time, bank deposits with the Fed (shown as liabilities on the Fed balance sheet, because the they are assets of the depositing banks) grew from a negligible $19 billion to over $1.8 trillion.

For most people in the world, the previous paragraph is largely incomprehensible, so a few comments on monetary economics is in order.

As the U.S. central bank, the primary role of the Federal Reserve Bank is to regulate the money supply. That is to say it literally manages the amount of money that is in circulation. At the upper edge of every U.S. dollar bill are the words “Federal Reserve Note,” indicating that the dollar is “fiat” (or paper) currency issued by the Fed. Historically, the primary objective of the Fed has been to control inflation, though in recent decades it has been charged as well with keeping unemployment at acceptable levels. An essential premise of monetary economics is that a rapid increase in the money supply will necessarily lead to an increase in inflation, based on the very simple notion that if there are more dollars floating around purchasing the same amount of stuff, the price of stuff will rise as people throw more dollars at it.

Traditionally, one of the primary ways that the Fed increases the money supply is to lend money to the banks that are members of the Fed system, which they would then lend out to private borrowers. This has the effect of putting that money into circulation in the economy, and by lowering the cost of money (the Fed Funds rate) the Fed can increase the amount of lending. But as an alternative, when there is little borrowing going on at any price--such as during the current period of massive private sector de-leveraging--the Fed can put new money into the economy is by purchasing securities from banks.

This practice, generally referred to as quantitative easing, allows the Fed to put new money into circulation even if there is little private lending going on. Here is how it works: If a bank owns a bond and sells that bond to the Fed, the Fed literally pays for that bond by creating currency that it gives to the bank in exchange for the bond. One day, the bank owns $1 million in bonds, the next day it has $1 billion in cash. After that transaction, the Fed has a new $1 million in assets (the bonds it purchased) while the bank has newly minted money. On the liability side of the Fed balance sheet, the Fed shows that $1 million as either bank deposits, if the bank is not planning on lending that money out in the near future, or bank notes, similar to those in your wallet. (Just to close the circle, should the Fed want to slow down economic activity and inflation, it would do the opposite, selling securities to banks, effectively taking cash out of circulation and reducing the liquid resources available to the banks for new lending.)

Based on the Fed balance sheet numbers noted above, in the post-2008 period, the Federal Reserve has “inflated” the money supply by around $2.3 trillion. According to Bernanke detractors, this growth in the money supply must necessarily portend disaster. The accusation is that Bernanke is pumping up the money supply in order to “monetize” or devalue, the debt of the government. The monetization of debt constitutes nothing less than the expropriation of savings from the virtuous, and Bernanke’s actions will ultimately result in the impoverishment of America, suggesting images of Weimar-era Germany.

But there is an alternate perspective.

Back in the spring of 2008, I happened to be in the offices of Bear Stearns the day that its sale to J.P. Morgan was announced. The collapse of Bear Stearns marked the beginning of public discussions of the magnitude of bank losses in bad housing bonds that would ultimately lead to the passage of the $700 billion Toxic Asset Relief Program, or TARP. A colleague of mine, a very bright guy named Andre, made the casual, yet prophetic, observation, that aggregate losses across the U.S. banking system in bad housing bonds was far greater than the hundreds of billions of dollars then being discussed, and would ultimately be in the range of $2 to 4 trillion dollars. (I remember the conversation well because it was the first time I heard the word “trillion” used in casual conversation).

Andre’s casual prediction that Spring day has turned out to be an accurate demarcation of the range of bank losses in the 2008 collapse. These were real losses in real dollars from the asset side of the U.S. banking system. In some cases, U.S. banks have recognized (an accounting term that loosely translates into “admitted to”) these losses, while to a great extent accounting rules have allowed banks to defer loss recognition, so these bonds remain on the books. The TARP program, incidentally, was a complete failure specifically because it would have required banks to recognize the magnitude of their losses.

Ultimately, Andre’s $2 to 4 trillion dollar estimation of losses mirrors the amount of value that Bernanke is seeking to restore to bank balance sheets. Bernanke has essentially broadened the role of the Fed from managing inflation to assuring the viability of the banking system. His primary tool for doing this has been “quantitative easing,” a practice widely viewed as a means of managing the money supply in a period of low loan demand, but which is being used by Bernanke as a means to recapitalize banks, increase their liquidity and restructure the risk profile of their balance sheets.

The extent of Bernanke’s success to date can be seen in the $1.8 trillion of bank deposits referenced above. According to this perspective, what detractors view as excess money supply creation can be seen from Bernanke’s view new money channeled onto bank balance sheets necessary to replace the assets that were lost in the 2008 collapse and thereby restore solvency to the national banking system. In this view, the $2.5 trillion growth in securities held by the Fed reflects its success in converting long-term assets on the books of private banks to cash, and thereby reducing the aggregate duration of bank assets and further increasing bank liquidity.

Bernanke detractors are unarguably correct on one score: Fed policy of keeping the Fed Funds rate near zero was a policy choice between the interests of the banks and the interests of savers across the economy. The destruction of the solvency of senior citizens and pension funds was deemed by Bernanke to be acceptable collateral damage of policies designed to save the nation's largest banks.

Bernanke faced a dilemma of the sort that few public officials are ever forced to confront. Neither the banks nor the political system were prepared to take the steps necessary to stabilize the banking and economic system. The banks that held the toxic assets that effectively made them insolvent steadfastly refused to sell those assets as envisioned by the creators of the TARP program, while our politics made the nationalization of those insolvent banks a non-starter. Bernanke was clearly of the view that a collapse of several major banks was for all involved the worse outcome than the destruction of the savings of millions of people across the economy, and he acted accordingly.

David Stockman blames Bernanke specifically for making a choice that destroyed the virtuous at the expense of the profligate, and so he did. But the predictions after the fact by Stockman and so many others about how much better off we would be today if instead the banks had been allowed to fail are easy to make but impossible to prove.

But the “exploding the Fed balance sheet” debate is one for which we ultimately will have an answer. If Bernanke’s strategy of recapitalizing the banking is ultimately successful, the $2 trillion or so of new currency created under his watch will ultimately come to replace bank assets lost in the 2008 collapse, restoring solvency to the banking system but resulting in little material net increase in the supply of money in circulation. If Bernanke’s detractors are correct, those trillions of dollars will instead become the source of new and uncontrollable inflation. This is an empirical question, and the answer will largely determine how history judges Ben Bernanke.