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The US Federal Reserve System is the most powerful central bank in history and the dominant force in the US economy today. The Fed is often described as having a dual mandate to provide price stability and to reduce unemployment. The Fed is also expected to act as lender of last resort in a financial panic and is required to regulate banks, especially those deemed “too big to fail”. The Fed also represents the US in central bank meeting venues such as the G20 and the Bank for International Settlements (BIS), and conducts transactions using the Treasury’s gold hoard. The Fed has been given new mandates under the Dodd-Frank reform legislation of 2010 as well. The “dual” mandate is more like a hydra-headed monster.
From its creation in 1913, the most important Fed mandate has been to maintain the purchasing power of the dollar; however, since 1913 the dollar has lost 95% of its value. Put another way, it takes $20.00 today to buy what $1.00 would buy in 1913. Imagine an investment manager losing 95% of a client’s money to get a sense of how effectively the Fed has performed at its primary task!
The Fed’s track record on dollar price stability should be compared to that of the Roman Republic, whose silver denarius maintained 100% of its original purchasing power for over 200 years, until it began to be debased by Emperor Augustus in the late 1st century BC. The gold solidus of the Byzantine Empire had an even more impressive track record, maintaining its purchasing power essentially unchanged for over 500 years, from the monetary reform of AD 498 until another debasement began in 1030.
Fed defenders point out that while the dollar may have lost 95% of its purchasing power, wages have increased by a factor of over 20, so that increased wages have offset decreased purchasing power. The idea that prices and wages move together without harm is known as money neutrality. This theory, however, ignores the fact that while wages and prices have gone up together, the impact has not been uniform across all sectors. The process produces undeserving winners and losers. Losers are typically those working people who are prudent savers and those living on pensions whose fixed returns are devalued by inflation. Winners are those using leverage as well as those with a better understanding of inflation and the resources to hedge against it with hard assets such as gold, land and fine art (in other words, not you). The effect of creating undeserving winners and losers is to cause misallocation of capital, creation of asset bubbles and increased income inequality. Inefficiency and unfairness are the real costs of failing to maintain price stability. However, it does make the exceedingly rich even richer which is obviously the plan.
Another mandate of the Fed is to function as lender of last resort. In its classic formulation this means that in a financial panic, when all bank depositors want their money at once, a central bank should lend money freely to solvent banks against good collateral at a high rate of interest to allow banks to meet their obligations to depositors. This type of lending is typically not construed as a bailout, but rather as a way to convert good assets to cash when there is no ready market for the assets. Once the panic subsides and confidence is restored, the loans can be repaid to the central bank and the collateral returned to the private banks.
In the depths of the Great Depression, when this lender of last resort function was most needed, the Fed failed utterly and completely! More than ten thousand banks in the US were either closed or taken over and assets in the banking system dropped almost 30%. Money was in such short supply that many Americans resorted to barter, in some cases trading eggs for sugar or coffee, and local currencies. This was the age of the wooden nickel, a homemade token currency that could be used by a local merchant to make change for a customer and then accepted later by other merchants in the community in exchange for goods and services.
The next time the lender of last resort function became as critical as it had been in the Great Depression was the panic of 2008. The Fed acted in 2008 as if a liquidity crisis had begun, when it was actually a solvency and credit crisis. Short-term lending can help ease a liquidity crisis by acting as a bridge loan, but it cannot cure a solvency crisis, when the collateral is worthless junk. The solution for a solvency crisis is to shut down or nationalize the insolvent banks using existing emergency powers, move bad assets to government control and re-privatize the new solvent bank in a public stock offering to new shareholders. The new bank is then in a position to make new loans. The benefit of putting the bad assets under government control is that they can be funded at low cost with no capital and no mark-to-market accounting for losses. The stock and bondholders of the insolvent bank and the FDIC insurance fund would bear the losses on the bad assets, and the taxpayers would be responsible only for any excess losses.
Once again the Fed failed utterly and completely. Instead of shutting down insolvent banks, the Fed and Treasury bailed them out with TARP funds and other gimmicks so that bondholders and bank management could continue to collect interest, profits, and bonuses at taxpayer expense. This was consistent with the Feds actual mandate dating back to Jekyll Island to save bankers from themselves, their greed, and their avariciousness. The Fed completely ignored the classic formulation of what it means to be a lender of last resort. It did lend freely but took crap, literally worthless junk, as collateral, and which is still lodged on the Fed’s books. The Fed charged virtually no interest instead of the high rates typically demanded from borrowers in distress. The Fed also lent to insolvent banks rather than just the solvent ones worth saving. The result is an economy having an extremely difficult time returning to self-sustaining growth.
When most needed to perform its lender of last resort functions, the Fed has bungled both times. First in 1929-1933, when it should have provided liquidity but did not. Then again in 2007-2009, when it should have closed insolvent banks but instead provided liquidity. The upshot of these two episodes is that the Fed has revealed it knows very little about banking. This is a wise stance to take, for if it can be shown that the Fed does know something about banking I believe it could be brought up on criminal charges of defrauding the citizens of the United States.
In 1978, the Humphrey-Hawkins Full Employment Act, signed by Jimmy Carter, added management of unemployment to the Fed’s mandate. The act mandated the Fed and the executive branch to work together in order to achieve full employment, growth, price stability and a balanced budget. The act set a specific goal of 3% unemployment by 1983. Fact is, the Fed has not delivered on its mandate to achieve full employment. As of 2011, full employment, as defined, is still 5 years away according to the Fed’s own estimates.
To these failures of price stability, lender of last resort and unemployment must be added the greatest failure of all: bank regulation. The Financial Crisis inquiry Commission created by Congress in 2009 to examine the causes of the current financial and economic crisis in the US heard from more than 700 witnesses, examined millions of pages of documents and held extensive hearings in order to reach conclusions about responsibility for the financial crisis that began in 2007. The commission concluded that regulatory failure was a primary cause of the crisis and it laid that failure squarely at the feet of the Fed! The official report reads:
“We conclude this crisis was avoidable. The crisis was the result of human action and inaction… The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the only entity empowered to do so and it did not… We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts… Yet we do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it… The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup’s excesses in the run-up to the crisis. They did not… In case after case, regulators continued to rate the institutions they oversaw as safe and sound even in the face of mounting troubles.”
The report goes on for 500 pages to detail the Fed’s regulatory failures in minute detail. As noted in the above excerpt, all of the Fed’s failures were avoidable.
One last test of Fed competence involves the Fed’s handling of its own balance sheet. The Fed may be a central bank, but it is still a bank with a balance sheet and net worth. A balance sheet has two sides: which are the things owned, and liabilities, which are the things owed to others. Net worth, also called capital, equals the assets minus liabilities. The Fed’s assets are mostly government securities it buys, and its liabilities are mostly the money it prints to buy them.
As of April 2011, the Fed had a net worth of about $60 billion and assets close to $3 trillion. If the Fed’s assets declined by 2%, a fairly small amount in volatile markets, the 2% decline applied to $3 trillion in assets produces a $60 billion loss – enough to wipe out the Fed’s capital. The Fed would then be insolvent. Could this happen? It already has, but the Fed does not report it because it is not required to revalue its assets to market value. This situation will come to a head when it comes time to unwind the Fed’s quantitative easing program by selling bonds. The Fed may ignore mark-to-market losses in the short run, but when it sells bonds, those losses will have to be shown on the books.
The Federal Reserve is well aware of this problem – even for those who profess not to know much about banking – In 2008, the Fed sent officials to meet with Congress to discuss the possibility of the Fed propping up its balance sheet by issuing its own bonds as the Treasury does now. In 2009, Janet Yellen, then president of the Federal Reserve Bank of San Francisco, went public with this request in a New York speech. Regarding the power to issue the new Fed Bonds, Yellen said: “I would feel happier having it now” and “It would certainly be a nice thing to have.” Yellen seemed eager to get the program under way, and with good reason. The Fed’s lurch towards insolvency was becoming more apparent by the day as it piled more leverage on its capital base. By getting permission from Congress to issue new Fed bonds, the Federal Reserve could unwind quantitative easing without having to sell the existing bonds on its books. Sales of the new Fed bonds would be substitutes for sales of the old Treasury bonds to reduce the money supply. By this substitution, the losses on the old Treasury bonds would stay hidden. Not bad for not knowing how to run a bank, eh?
This bond scam was shot down on Capitol Hill, and once it failed, the Fed needed another solution quickly. It was running out of time before QE would be reversed. The solution was a deal arrived at between the Treasury and the Fed that did not require approval from Congress.
The Fed earns huge profits every year on the interest received on Treasury bond the Fed owns. The Fed customarily pays these profits back to the Treasury. In 2010, the Fed and Treasury agreed that the Fed could suspend the repayments indefinitely. The Fed keeps the cash and the amount the Fed would normally pay to the Treasury is set up as a liability account – basically an IOU. This is unprecedented and is s sign of just how desperate the situation has become!
Now as losses on future bonds sales arise, the Fed does not reduce capital, as would normally occur. Instead, the Fed increases the amount of IOUs to the Treasury. In effect, the Fed is issuing private IOUs to the Treasury and using the cash to avoid appearing insolvent! As long as the Fed can keep issuing these IOUs, its capital will not be wiped out by losses on its bond positions. On paper, the Fed’s capital problem is solved, but in reality the Fed is increasing its leverage and parking its losses at the Treasury. Corporate executives who played these kinds of accounting games would, at one time, have been sent to jail (today they are rewarded). It should not escape notice that the Treasury is a public institution while the Fed is a private institution owned by the banks, so this accounting scam is another example of ripping off taxpayers for the benefit of the banking cartel.
The US now has a system in which the Treasury runs non-sustainable deficits and sells bonds to keep from going broke. The Fed prints money to buy those bonds and incurs losses by owning them. Then the Treasury takes IOUs back from the Fed to keep the Fed from going broke. It is simply a high-wire act, but amazing to behold. The Treasury and the Fed resemble two drunks leaning on each other so neither one falls down. Today, with its 50-to-1 leverage and investments in volatile intermediate-term securities, the Fed looks more like a poorly run hedge fund than a central bank.
If the Fed were to ask, “How’m I doin’?” the answer would be that since its formation in 1913 it has failed to maintain price stability, failed as a lender of last resort, failed to maintain full employment, failed as a bank regulator and failed to preserve the integrity of its balance sheet. On the whole, it is difficult to think of another government agency that has failed more consistently, yet greatly profited a small wealthy minority, on more of its key missions than the Federal Reserve.
Freely adapted from the book ‘Currency Wars’ by James Rickards