Friday, November 22, 2013

The Federal Reserve's Expanding Omniscience

Following is an expanded version of a speech delivered for With Integrity Financial: "Securities and Advisory Services offered through Commonwealth Financial Network, a Member FINRA/SIPC, a Registered Investment Adviser."

The Federal Reserve's Expanding Omniscience

 Speech Delivered November 13, 2013, Plymouth, MA.

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The Federal Reserve System is approaching its one hundredth anniversary, a period often dubbed the American Century. The Fed played its part in making it so, which has been characterized by expansion and inflation. The inflation has not been solely in money. We might consider if monetary inflation followed the inflated tendencies of Americans.

I will start with the origin of the idea of the Federal Reserve. "Civilized" countries had a central bank. The United States, it was said, demonstrated its primitiveness during the financial Panic of 1907. It was left to commercial bankers to halt the panic and restore solvency to America's financial system.

That year, the financial system shook, and bankers convened nightly at J.P. Morgan's library desk. Morgan had a "bunch of young men with nice green eyeshades and who know how to read a balance sheet," in the words of David Stockman. The young men examined the balance sheets of financial houses at night, "and when the morning hour arose, they concluded if you were solvent or insolvent."

Those banks and trust companies deemed solvent were told by the banks and clearinghouse of banks that financed their salvation: "We will make you a loan but "all you officers and the board of directors - all of you are gone. We are putting new people in the bank when it opens at 9:00 this morning."

That was quite unlike 2008, a bailout of a financial system that preserved failure, of institutions and their bank officers. The saviors of 1907 could not print money. In 2008, TARP and other alphabet soup windows of reincarnation acted as a black hole of impenetrability to the Fed, the U.S. Treasury, the bankers, and the public, alike. "Policy makers" - they love to call themselves that - took two routes both unavailable and anti-ethical to the bankers in 1907. They printed an astonishing increment of new money: electronic credits to the banking system, in modern parlance. They terrorized the people and Congress into craven submission, instead of calming Americans. This used to be the mark of leadership.

A second difference: The House of Morgan had to contend with a real money-market: a market-clearing, borrowing rate - one that shot to 80%. In 2007 and 2008, the Fed cut the borrowing rate - on its way to zero. Later, I will discuss the same tactic used by the Fed in 1930 - to no avail.

A third difference was the source of the money lent. It was the banker's own, in a time when bank shareholders were subject to double liability. Thus, the no-nonsense dispersal of failed bankers.

The Federal Reserve was voted into existence on December 23, 1913. It started operations in 1914. It was an institution of high ideals. A champion was Irving Fisher, Professor of Economics at Yale, famous beyond what that position may sound. He was an expert on everything and not hesitant to splay his omniscience on all. Fisher summed up the founders' vision in 1907:

"The world consists of two classes-the educated and the ignorant-and it is essential for progress that the former should be allowed to dominate the latter. But once we admit that it is proper for the instructed classes to give tuition to the uninstructed, we begin to see an almost boundless vista for possible human betterment."

Not everyone was so beguiled by human nature - dominators or dominated. The December 23, 2013, vote by the Senate was 43 "ayes" and 26 "nays". Elihu Root, senator from New York, stood firmly against the formation of a Federal Reserve Bank. In the 1913 debate, he warned:

"[W]ith the exhaustless reservoir of the government of the United States furnishing easy money, the sales increase, the businesses enlarge, more new enterprises are started, the spirit of optimism pervades the community. Bankers are not free of it. They are human...when credit exceeds the legitimate demands of the currency and the currency becomes suspected and gold leaves the is the United States that is discredited by the inflation of its demand obligations which it cannot pay."

Benjamin Strong, who was one of the young men with the green eye shades during the Panic of 1907, helped prepare Elihu Root's speech.

Such warnings were overwhelmed by the progressive camp. The Wall Street Journal proclaimed on September 13, 1913: "Some attention is devoted in the pending currency bill to the question of improving the examination of national banks. It is by no means a minor detail in the general perfection of our banking system."
 Note the inflated opinion of ourselves. Specifically, the godlinessof those who would administer improvement upon lesser beings, known colloquially today as the "99%":
 "Progress" "Boundless vista" "Human Betterment" "Perfection" - of a banking system?
             Here, I will jump to the end. 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, formerly at the Bank of England rolled out the 12% possibility.  
The original legislation is worth time to understand. It so contrasts to the Brunhilde that developed.  
            The structure was anything but central. It was a system. It is still called the "Federal Reserve System," but it is not. There were and are 12 regional Federal Reserve banks. Each of the 12 originally operated with a high degree of autonomy. This structure recognized the seasonal flows of finance. The country was still, to a large degree, agrarian. It was not until 1920 that a U.S. census showed more than 50% of the American people lived in towns and cities with a population of greater than 3,000. Every year, rural - agricultural areas of the country - needed to finance the autumn harvest. The country banks called upon the New York banks, which held the reserves necessary for the rest of the year. This notable difference between New York - Chicago, Boston, and Philadelphia also fit the bill - and much of the rest of the country, was a reason for establishing regional districts. 
Each of the twelve regions set its own discount rate to meet its character - and veer towards the "perfection" of banking, as the Wall Street Journal anticipated. It is notable that the Federal Reserve governors in Washington were a backwater for Federal Reserve policy until the1930s.  
The original legislation was a world apart from what we see today. The Fed was intended to function according to the "real-bills" doctrine. I think this is worth taking a few minutes to explain. Very important, in my opinion, the "real bills" firmament is instructive in how finance expanded or contracted according to the needs of business. Not to the desires of finance: the "Main Street" and "Wall Street" distinction so often discussed today. 
First, "real bills" handcuffed Federal Reserve operations to a narrow mandate. The original legislation was written to prevent serendipitous expansion of the money supply and credit by the Fed. Second, it shows how much more closely banking - and money in existence - was tied to real business.  
Two of the founding fathers should be recognized. Carter Glass, senator from Virginia, understood banking better than any other senator.

H. Parker Willis was the nuts-and-bolts man who coordinated the design of the Federal Reserve System. 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 authorized the Federal Reserve System to accept "real bills" from banks. Government securities were not acceptable.

That was non-inflationary. The credit extended from the Federal Reserve to a commercial bank was backed by payments owed to the commercial business. The business, had likely borrowed against a 30-day receivable that was used as collateral to obtain a loan: A shoe manufacturer had sold shoes to a store, that must pay the bill within 30 days. This was fairly simple. At least, it made sense. Central bankers were not witch doctors, spawning $85 billion a month of electronic credits - which is not "money" in any real sense - off a keyboard.

In December 1915, after the first year of Fed operations, Willis wrote: "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)." In other words, a bank borrowing from its regional Federal Reserve Bank must present a "real bill": a bill payable to the commercial customer of the commercial bank. Again, U.S. government securities were not acceptable. Governments had a history of not paying off their loans. They still do.

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. In 1913, none of the world's central banks were inflation-producing operations. Since 1914, central banks have done little else.

The fledgling Federal Reserve did what everyone else did in time of war. It followed orders. 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. The 1919 Federal Reserve Annual Report excused the excesses: "an incident of the general credit expansion" and "occasioned by crop-moving and other seasonal needs." This was less than the truth and there was no turning back, either from fibbing or as purchaser of the federal deficit.

The Federal Reserve initiated open-market operations in the 1920s. Open-market operations are the conduit through which the Fed fills the banking system with newly created dollars. The Fed could now manipulate the money-market rate and boost the supply of money in the economy.

The Fed, through money-market operations, also decreases the money supply at times. In that instance, the Fed sells bonds from its portfolios to banks. Banks purchase the bonds. The dollars, now departed from the commercial bank to the Fed, have also departed the banking system - thus, from the machinery of the economy. Banks can not make as many loans.

I can say with a high degree of confidence the Fed is institutionally incapable of decreasing - contracting - the money supply ever again. It's all one way from here.

It was not immediately clear the Fed would avail itself of the flexibility open-market operations that were permitted, post-war.

Benjamin Strong was president of the New York Fed. Power had been sucked from the eleven other regions into New York, and into the hands of Strong. In 1923, he was a staunch foe of the Fed meddling either with the money-market rate or the money supply. Strong wrote:

"What I can't understand is the willingness of thoughtful, studious men who presumably have been brought up in the spirit of American institutions and should be imbued with their principles, proposing a scheme to Congress which in effect delegates avowedly and consciously this vast power for price fixing" - please note that - "price fixing" - "to a small group of men who, in an economic sense, might come to be regarded as nothing short of a super-government. It is undemocratic, absolutely contrary to the spirit of America institutions, and so dangerous in its possible ultimate developments that I cannot see the slightest merits for its proposal."

Unless Strong is referring to "miscalculation" in that final sentence, he does not even mention: "the power ceded to a bunch of old men who may have no idea what they are doing." Yet, it would have been inconceivable to Strong this super-government would - "progress," I'm sure they believe - to a bunch of college professors.

As one of J.P. Morgan's around-the-clock, green-eyeshade saviors of the financial system in 1907, Strong knew the calamity that can follow a period of irresponsible lending. In 1913, he helped Elihu Root compose the senator's warning about the shortcomings of human nature.

Possibly, though I suppose it is unlikely, Strong decided to prove Root correct: that the United States should never have created the Federal Reserve System.

He authorized open-market issuance of dollars three times in the 1920s. The most consequential watering of the dollar stock was in 1927. Many have concluded this was a most unnecessary and fatal injection, causing the stock market crash of 1929. Few have stated the consequence more forcefully than Adolph Miller, a member of the Federal Reserve Board, from 1914 and through Strong's tenure. He issued a summary of the New York Fed's inflationary intrusion: "[I]t was the greatest and boldest operation ever undertaken by the Federal Reserve System, and, in my judgment, resulted in one of the most costly errors committed by it or any other banking system in the last 75 years. I am inclined to think that a different policy would have left us with a different condition at this time." (Miller was speaking in 1931. Strong died in 1928.)

The Federal Reserve System has never been held accountable for Strong's miscalculation. Today's Federal Reserve Chairman Ben S. Bernanke, revered for his scholarship of the Great Depression, recites a tale taught by his professors to enhance the power of the Fed and of his professors. He - they - ignore the 1920s and claim the Fed's mistake was that it did not act after the stock market crash.

Forgetting about Ben Bernanke's ignorance or suppression of the 1920s, it is not even true the Fed did not act. It acted immediately in response to the stock market crash. In addition to ignoring the 1920s, they ignore 1930.

On December 27, 1930, the Wall Street Journal reported the Federal Reserve's latest rate cut - from 2.5% to 2.0%. In an editorial, the Journal noted this was the seventh rate cut by the New York Fed since November 1929. The editorial writer explained that each cut was hailed as a hopeful market factor, but they have had little effect so far.

This was disappointing. We know the feeling.

However, the Journal was hopeful. We know that feeling too. There were reasons to believe this latest cut might be - now quoting the Journal - "the turning point of the whole economic situation." The Journal went on: The psychological effect is likely to be far reaching; for one thing, it "affords assurance that the whole credit and banking structure in this country is sound." It also indicated the Fed is likely to maintain very easy money in the coming months: "Unless all signs fail, the stage has now been reached ... when large supplies of available cheap credit must produce the traditional effect of stimulating new enterprise and ... expansion ... [T]here is every reason to feel that a turning point cannot be far away."

The opposite happened. In 1931, the economy and markets caved in. "Every reason to feel that a turning point cannot be far away," ignored tremendous imbalances left by the 1920s. To name just one - considerable liquidation of inventory and the consequent credit write-offs had barely begun.

What the Fed really did in 1930 remains unknown to Federal Reserve Chairman Ben Bernanke, the "expert on the Great Depression."

His professors and Ben consorted to:
First - they have ignored the Federal Reserve's inflation of credit and assets in the 1920s,
Second - they have misrepresented the Federal Reserve's reaction to the stock market crash,
Third - they do not know - or, pretend not to know - the Fed, after the stock-market crash and into 1930, responded just as Bernanke said it did not respond - but should have. This neglectful scholarship paved the way for Bernanke's money printing and zero-interest rate policy - also known as "ZIRP"

In 2006 and 2007, after permitting the credit bubble to grow and pop, Bernanke repeated exactly what had failed in 1930 and 1931. His expert scholarship missed the fact that in 1930:

First - Bank reserves increased during 1930 from $3.178 billion to $ 3.316 billion.
Second - Companies issued more long-term bonds in 1930 ($2.8 billion) than in 1929  ($2.4  billion).
Third - Corporate bond prices rose in 1930.
Fourth - Corporate profits fell but, in the aggregate, were at the same level as 1926 and 1927.

            Such "facts" need to be reviewed in context and in comparison. There were worrying developments. However, Ben Bernanke does not question the orthodox party line in his Essays on the Great Depression: the depression would not have been "Great" if the Fed had opened the levies in 1930. And, of course, you'd rather drop an atomic bomb on the country than live through price deflation.           

Now, dispensing with the Great Depression, we will turn to the depressing career of Alan Greenspan. Rather than talk much about him, I will discuss how the United States has changed over the course of his so-called professional career. I hope you will keep in the back of your mind through this, the discarding of the "real bills" doctrine by the Fed, and the "boundless vistas" opened to the Fed after it was discarded. From World War I on, open-market operations have worked to separate money - and credit extended by the banks - from business. Wall Street has benefited from ZIRP while Main Street is filled with nail salons.

Alan Greenspan understood how the Fed compromised its mandate. In 1959 - Greenspan was a 33-year-old consulting economist at the time - he was interviewed by Fortune magazine. Greenspan explained that before World War I, "prices could not get too far out of line with real values because the supply of credit was automatically constricted by a limited money supply."

Since 1914, "[w]ith one eye necessarily cocked on politics, the Fed has always maintained a more than adequate money supply even when speculative booms threaten."

The "automatic constriction of the money supply" that Greenspan refers to is the restriction on Fed credit creation, and, the pre-World War I gold standard. Note, by prefacing his statement, "Since 1914," he dismisses the derivative gold standards. First, the interwar experiment that failed. It never really got off the ground. Second, and notably, the Bretton Woods agreement, signed in 1944, that was moving slowly towards its 1971 demise when Greenspan spoke.

One measure of how the structure of the United States has changed is who has made the money. In 1950, 59% of corporate profits were in manufacturing, 9% were from financial activities. During the period from 2000 to 2008, 18 percent of profits were from manufacturing and 34 percent were from finance. The latter is much higher if financial activities of non-financial companies are included.

We can see in our daily lives that greater quantity produces lower quality. As the volume of credit expanded, quality deteriorated.

Among the past century's downgrades, a significant development was the borrower's promise that stands behind a "security," a word that once credibly described a paper contract backed by appropriate collateral.

An important change in quality was the product of President Richard Nixon's decision to default on the United States' promise to pay $35 for an ounce of gold on August 15, 1971. This severed the attachment of dollars (thus, credit) from redemption. Until that date, when it was still possible for the French or Germans to demand gold for their dollars, a link between commercial needs and credit still existed. But after August 1971, everyone was on their own. If a French treasury clerk showed up at the U.S. Treasury with $35, the U.S. Treasury clerk would hand over $35, quite possibly produced for that purpose by the Arthur Burns, chairman of the Federal Reserve.

In Debt and Delusion, author Peter Warburtin wrote: "It is easy to forget that, as recently as in the 1960s, the government budgets of the OECD countries were in approximate balance and that net issues of debt were comparatively rare. The outstanding stock of debt in public hands was a meager $800 billion at the end of 1970. At that time, debt issue was typically reserved for the financing of large construction projects or investment in power generation by publicly owned corporations."

Most everyone here remembers the price inflation during the 1970s. There were four years of double-digit inflation, reaching an apex in 1980: when the Consumer Price Index was calculated at 13.5%.

There were other consequences, after the creation of dollars had been de-linked. This is not solely because of Nixon's decision to drop gold. There were a lot of changes in their air. One could debate cause and effect.

Long-term investment collapsed. Inflation reduces long-term investment. Planning is more difficult since the change in prices - goods, wages, profits - are not predictable. Long-term investment is very good for a company: It produces barriers to competition that are hard to hurdle.

At the same time, Americans were becoming more impatient. The middle-class profile that was shifting from saver to spender was due to inflation and also to ourselves: The Federal Reserve has not evolved in a vacuum.

Alan Greenspan saw no good in all this. In 1979, interviewed in the New York Times, he warned the "[e]xpansion of manufacturing capacity has fallen short of the pattern in earlier business cycles." He thought, "more ominous", was the "shift in research and development budgets towards quick-payoff 'development' projects."

Greenspan was right on the money. By the way, that means Greenspan's gripe was common chatter. He would never stray from the favor of those who pay his rent. That's how he's made the big bucks. Our boy was in nauseating form last week when, up popped a Bloomberg headline: "Yellen Gets Big Vote of Confidence from Greenspan." He had made the gutsy call: "I forecast she'll get confirmed."

This shift has been disastrous for America. Greenspan also hit the bull's eye in 1980 when, again writing in the New York Times, he waxed nostalgic for the "halcyon days of the 1950's and 1960's" when "business investment decisions seemed appropriately focused on longer-term payoffs." But now, "it is not surprising that in recent years business capital investments have become increasingly concentrated in assets with quick cash payoffs."

In 2003, Greenspan was Fed chairman. There was concern about the decline in American manufacturing. It was "all finance, all the time." Greenspan turned his wise advice from two decades before inside out. He concluded it no longer mattered if we made anything at all.
The inflationary seventies had enlightened Alan Greenspan as to human adaptability. In 1980, again, in the New York Times, he demonstrated a knowledge that a house-trading public might come in handy. He explained to the New York Times "that the translation of home-ownership equity into cash available for consumer spending is perhaps the most significant reason why the economy in 1975 to 1978 was consistently stronger than expected."

Now we will contrast. There was one Federal Reserve governor who sized up Greenspan during the mid-1990s. That was Larry Lindsey. He did not tire of lecturing the FOMC at every meeting between 1993 and 1996. He could see that, following recovery after the early-1990s recession, the United Stated was floating on a sea of finance. This had restructured the economy.

Lindsey gave several presentations to the FOMC on a single theme: the "1%" and the "99%." Those were his words. Simply stated, the middle class was not recovering from the recession of the early 1990s, but it was still spending. The public relied on more credit and gains from financial markets, since cash payment for work was slipping. Quoting Lindsey: "Among the "bottom 99 percent.... [w]e're seeing a big change in the functional distribution of income away from wages." He compared the period from 1983 to 1988 when "56% of all the personal income was paid in the form of wages." .... to 1993 - when that fell to 38%."

In Lindsey's conclusion, "the non-rich, non-old live paycheck to paycheck, quite literally. That's where all their income comes from. Remember, virtually none of the capital income or business income goes to them. They have to live on their wages and that wage share is also declining."

Of course, Lindsey got nowhere with that bunch and left the Board of Governors.

Looking at the imbalances that grew between 1950 and the Lindsey Lectures:

Inflation of prices never stopped.
Asset inflation was now beginning its assent.
Individuals were borrowing more and saving less, even though they were living:"paycheck to paycheck"
The traditional path of savings, towards long-term investment, had fallen.
The economy was tending more towards finance than towards industry.

At FOMC meetings, Alan Greenspan rarely responded to Lindsey's lectures, but he did offer an opinion at the May 1995 FOMC meeting. "[T]urnover" - he's speaking of existing house sales - "has induced large realized capital gains that have been financed in the mortgage market. Those funds are going disproportionately into the financing of consumer durables."

Greenspan consistently kept interest rates too low. This propelled the house-trading market, and, the ancillary corridors of the GDP such as durable goods, construction jobs, and mortgage lending.

In 1995 - the year in which Chairman Greenspan was just quoted - home mortgage debt increased $153 billion. At a 2002 FOMC meeting, Greenspan concluded a fairly long monologue on house-trading, with the comment: "Previously, consumers were not able to extract cash easily from the rising value of their houses, but they can now, and that source of funds has been a strong sustaining force for spending through the recession."

In 2005, Americans increased their mortgage debt by $1.1 trillion, by which time, 42% of homebuyers were putting no money down. The manufacturing capacity of the U.S. economy had been hollowed out.

As we know, the finance-driven economy collapsed in 2007 and 2008. Ben Bernanke's Fed resurrected Wall Street, by methods opposite to J.P. Morgan's green-eyeshade decisions that wiped the slate clean in 1907.

Insolvencies were papered over. To this day, "the insolvencies are called
"liquidity problems."
The officers of banks were untouched.
The U.S. has swerved even more fatally towards a credit-driven economy.
Assets are more concentrated in the five largest banks than before.
Five years of ZIRP has left Americans with a lower median income than in 2007.

To add to our misery, on January 25, 2012, the Bernanke Fed notified the American public that the FOMC - the monetary, decision -making body of the Fed - "judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate." The excuse for this truly New Era inflation target is the incineration of Americans if we were to suffer - price deflation! There, I said it. The unmentionable.

Alternatively, Bernanke could have said: "The FOMC will hereby confiscate 22% of American savings over the next 10 years."

That is: if the Fed hits its mark.

I will finish with this. The mandarins asserted and repeat the U.S. would have suffered a calamity worse than the Great Depression if not for the Fed's heroic, gutsy credit handout in 2008. If you are so told, I suggest you ask: "Why?"

You may not receive much of a response. The assertion is not one to question. Why, for instance wouldn't 2008 turn into a depression like the one in 1920-1921, when real GDP fell 4.4% in 1920 and by 8.7% in 1921? The wholesale price index fell 37%. What was the result of that deflation? This possibility of deflation today resonates with terror from the lips of central bankers and the media. In 1922, the GDP rose by 15.8% and in 1923, by 12.1%, and the twenties roared.