The
dedicated resuscitators of the Federal Reserve are doomed to lose their battle
with sanity, akin to Alexander Scriabin's fate in search of the lost chord.
Chairman Ben S. Bernanke has not a clue where this will end. Our doleful fate
is leading staunch establishmentarians to sink the Fed.
A group of worthies tacked a manifesto to the
September 17, 2012, Wall Street Journal editorial page. The five authors
are insiders; insiders being those who created and benefited from the false
economic structure compounded over the past four decades. "J'accuse"
should have been the title under which they charged the Federal Reserve with committing
every crime under the sun.
Before reviewing the convolutions and unaccountable chaos created by the
Bernanke Fed, it is worth looking at the simplicity of the original Federal
Reserve System. An above average tenth-grade student of 1913 could have
understood how the Federal Reserve functioned. That being so, if the newly
formed central banking system had stuck to the founders' intentions, we
would not be suffering a pusillanimous satrap such as Ben Bernanke hurtling the
Fed, and more importantly, the rest of us, off a cliff.
The principles upon which the central bank was founded
have been jettisoned. Few know this. Students who attended Chairman Bernanke's "Origins
and Mission of the Federal Reserve" lecture at George
Washington University in March 2012 are still in the dark. Rereading the
Chairman's lecture, he pings, pongs, and drifts in such a haphazard fashion
that his knowledge of Origins and Missions remains a mystery. Once again, it is
striking how little he knows - about anything.
H. Parker Willis was more than a scribe and less than
the author of the Federal Reserve Act. Carter Glass, Senator from Virginia, had
the vision. Willis understood the nuts-and-bolts of central banking.
Willis was a professor of economics (Washington & Lee, Columbia University)
fully versed in the English banking school, including the "real
bills" monetary doctrine. The Federal Reserve Act (signed by President
Wilson on December 23, 1913) authorized the Federal Reserve System to accept
"real bills" from banks. Government securities were not acceptable.
The original process by which the Fed operated with
banks worked as follows: An industrial or commercial concern asked its local
bank for a loan. The loan was backed by short-term, fixed-maturity payments to
be received by the Company (the aforementioned "industrial or commercial
concern"). We will assume the payment is due in 30 days. At that point,
the Company pays off the commercial loan - "commercial paper" - to
its local bank. The Company is able to do so from the payments for goods it received
from its customers: Real Bills for Real Goods.
On day five (of the 30-day period), the local bank
needs cash. Perhaps there is a bank run, or more probably, some incident or
whim of less interest to us. A guiding light before the formation of the
Federal Reserve System was to provide cash to banks in such instances as a bank
run.
The local bank - a commercial bank - presents the
commercial paper to the Federal Reserve. (This would have been one of the 12
district banks, which operated quite independently at the beginning.) The Fed
"rediscounts" the commercial paper and lends money to the local bank.
The Fed holds the paper (and can demand payment from the Company's customers
should the company fail.) The loan from the Fed will be repaid by the local
bank when the commercial paper matures.
The commercial bank's nervous customers (during a bank
run) see that the Federal Reserve is meeting the demands of any and all bank
customers (depositors). The fearful customers dismiss concerns of their money
being housed in a fractional-reserve operation, and depart the recently
mutinous bank lobby without withdrawing their accounts. Again, it was the
intention of the Federal Reserve founders to offer bank customers this
assurance. The assurance was fortified knowing the Federal Reserve's balance
sheet was limited to such short-term, self-liquidating loans that were backed
by Real Goods.
The Federal Reserve was to be a non-inflationary
central bank. In fact, all central banks were non-inflationary (over periods of
time) in 1913. "Price stability" did not need to be defined. Our
ancestors of 1913 would not have been able to comprehend a banker, an
economist, a public servant: that is, serving the public, who
would announce "price stability" means 2% inflation. (Nor comprehend
that when 2% is no help "we'll-make it-4%-then-8%-then-12%." Adam
Posen at the Bank of England has rolled out the 12% possibility.)
It was non-inflationary because the credit extended by
the commercial bank matched the level of business in the economy. This was a
fairly simple business.
In the December 1915 Political Science Quarterly,
Willis published "The First Year of the New Banking System." Being a
professor, he could not abstain from instructing his readers: "Under the
provisions of the Federal Reserve Act it is required that loans be made upon
paper protected by warehouse receipts, and such provisions have been made by
the Board in the circular relating to commodity paper (Circular No. 17, Series
of 1915)." Government bonds need not apply.
World War I disrupted this arrangement. The Great War
also deranged the world's financial system when it was found necessary to
decapitate the International Gold Standard. As mentioned above, in 1913, none
of the world's central banks were inflation-producing operations. Since 1914,
not a single central bank has accomplished much else.
The fledgling Federal Reserve did
what it was told to support the doughboys. The Fed's Annual Report of 1918
noted the institution's "duty to cooperate unreservedly with the
government [i.e., the Treasury] to provide funds needed for the war." Duty
bound, the Fed was a full-fledged participant in the U.S. Treasury war-bond
market.
In the June 1920 issue of Proceedings of the
Academy of Political Science in the City of New York, Willis discussed
"The Federal Reserve and Inflation." The professor admitted the
Federal Reserve System had diverged from its original purpose "as a system
for the accommodation of business and for the discounting of paper of fixed
maturity growing out of industrial, commercial, and agricultural
operations." At that moment the Federal Reserve "was carrying in its
portfolios about $1,500,000,000 of so-called war paper."
The only question to Willis, in his 1920 paper, was
when and how the Fed would divest itself of war paper, otherwise known as
government securities. He hardly needed to say why, but, being a professor,
mentioned "in so far as the Federal Reserve banks continue to retain this
volume of paper in their portfolios, they would be contributing to the
maintenance of inflation and would be aiding to sustain the existing level [of
inflated - FJS] prices." Another problem was holding "loans on
non-liquid security [that is loans not backed by the liquidation
of industrial, commercial, or agricultural inventory: the security of
which beat war paper any day - FJS], including Government bonds and other
obligations." Note that government bonds were not liquid. Their composition
and properties are far inferior to the short-term, self-liquidating commercial
paper.
Professor Willis attempted to resurrect the old
religion when he wrote The Theory and Practice of Central Banking in
1936. This was the same year John Maynard Keynes's General Theory of
Employment, Interest, and Money was published. Professor Willis (a native
of Weymouth, Massachusetts and son of suffragist Olympia Brown) dropped dead in
1937. This may have been caused by a broken heart after Keynes's tome won the
beauty contest, but confirmation requires further research.
The world has changed. Economics professors have
concocted a theory that hinges on government bonds being "risk-free."
The risk-free professors handed each other medals and entered astonishingly
lucrative consulting and publishing arrangements. The gist of their so-called
theory has anchored every pension plan, endowment, and financial adviser's
risk-return selection model. The consequences continue to unfold. (See: "It's
Over" and "Scarlett
O'hara's Risk-Free Rate.")
Even today, with European sovereigns beyond hope of
borrowing in an unrigged market, the academic grip remains. As for the United
States risk-free premise, it will turn to "risk-fraught" when the
Federal Reserve is no longer permitted to own U.S. Treasury securities. That day
will come. H. Parker Willis will be vindicated.
The September 17, 2012, edition of the Wall Street
Journal, unleashed "The
Magnitude of the Mess We're In," by authors George P.
Shultz, Michael J. Boskin, John F. Cogan, Allan H. Meltzer and John B. Taylor.
The rebels opened: "Sometimes a few facts tell
important stories. The American economy now is full of facts that tell stories
that you really don't want, but need, to hear."
Among the ugly truths (and I'm only addressing a small
number within their lengthy list), Schultz & Co. ask: "Did you know
that the Federal Reserve is now giving money to banks, effectively
circumventing the appropriations process?" In other words, if money is to
be given by the government to an industry, this is a decision of Congress, not
the Executive, not the Supreme Court, and certainly not a panel of bureaucrats.
Of course, it is Congress's duty to retain control of its own responsibilities.
Congress is negligent in not taking administrative or legal action to prevent
the Federal Reserve from acting outside the law.
Another unwanted, but important story: "The
Consumer Financial Protection Bureau is also being financed by the Federal
Reserve rather than by appropriations, severing the checks and balances needed for
good government." This only hints at the much larger intrusion by the Fed.
It has no budget. It can buy whatever and whomever it wants. The Schutzstaffel
never had such latitude.
On we go: "And the Fed's Operation Twist, buying
long-term and selling short-term debt, is substituting for the Treasury's
traditional debt management." U.S. Treasury Secretary Timothy Geithner
holds responsibility for managing the nation's debt. It is his duty to midwife
the structure of U.S. debt securities. A few years ago, a Treasury Secretary
stopped issuing 30-year bonds. After a bit, a different Treasury Secretary
decided to issue 30-year bonds again. Whether either decision was good or bad
is not the point. The Treasury Department, within the United States' government's
Executive Branch, controls the structure of U.S. Treasury securities. The
Federal Reserve has no business treating the size of the two- and ten-year
Treasury market like an accordion for testing failed theories.
The conflict of using the Federal Reserve balance
sheet as custodian of U.S. Treasury securities is apparent: "Did you know
that annual spending by the federal government now exceeds the 2007 level by
about $1 trillion? [R]evenues are little changed. The result is an
unprecedented string of federal budget deficits, $1.4 trillion in 2009, $1.3
trillion in 2010, $1.3 trillion in 2011, and another $1.2 trillion on the way
this year."
The latest Monthly Treasury Statement shows $179 billion of Receipts in August
2012 and $369 billion of Outlays: inflows of 48 cents for every $1.00 spent.
August either signals a disintegrating trend or was an off month. Over the
first 11 months of this fiscal year (October 2011 through August 2012), the
Treasury Department received 65 cents for every one dollar spent. Really now,
how can the credit agencies still call the United States a AAA or even AA
credit?
The Federal Reserve's forays into fiscal policy
destroy its "apolitical" claims. On August 31, 2012, Chairman
Bernanke told legislators how to construct budgets: "It is critical that
fiscal policymakers put in place a credible plan that sets the federal budget
on a sustainable trajectory in the medium and longer runs. However,
policymakers should take care to avoid a sharp near-term fiscal contraction
that could endanger the recovery." Again, these escapades are not only
Bernanke's fault; it is Congress's job to shove a rag in his mouth.
In a practical sense, the Fed now plays a critical
role in the nation's fiscal incontinence. If not for the Federal Reserve's
day-in and day-out purchases of Treasury securities, the Federal government
would be firing every other worker (using the simplifying projection of 48
cents of receipts for every dollar spent). It is not the Fed's job to finance
salaries and departments. Schultz et.al., remind us: "Did you know that,
during the last fiscal year, around three-quarters of the deficit was financed
by the Federal Reserve? Foreign governments accounted for most of the rest, as
American citizens' and institutions' purchases and sales netted to about zero.
The Fed now owns one in six dollars of the national debt, the largest
percentage of GDP in history, larger than even at the end of World War
II."
No one pretends the federal government will ever pay down its current debt, of
which the Fed may soon be the sole net purchaser. The accounts of Japan and
China are turning over (see "Peak
Imbalances Are Falling") and will probably soon be
consistently (rather than occasionally) net sellers of Treasury securities.
Simple Ben has announced open-ended buying of
any-and-all securities, forever. He is bidding for mortgages. Next week, it
could be pawn-shop loans. He, and the Fed, will be retired at some unknown
date. Copies of the The Theory and Practice of Central Banking will be
in every school child's hands and the General Theory will broil on the
bonfire of insanity.
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