The Federal Reserve as Serial Arsonists

The Federal Reserve announced “Quantitative Easing 2” (QE2) last week, a stimulus program whereby the Fed will print $600 billion of paper money to buy U.S. government bonds. Fed Chairman Ben Bernanke took the extraordinary step of trying to justify this action by writing an Op Ed in the Washington Post. The article claimed his goal is to drive down longer term interest rates and drive up stock prices, so that “a virtuous circle will support further economic expansion.” The concept is that if Americans felt richer because their 401Ks went up in value there would be a “wealth effect” encouraging the public to spend more money and businesses to increase capital investments. Unfortunately, this is like starting a barbeque with a flamethrower. You will surely create a fire, but it will probably burn down the neighborhood.

Back when Lehman Brothers filed for bankruptcy in the fall of 2007, the Fed panicked and “Quantitatively Eased” by slashing interest rates and purchasing $1.7 trillion of mostly dicey mortgage related bonds from the banks at full value. The price of food and other commodities were sent skyrocketing, oil climbed to an all-time record of $145 per barrel. Consumer price inflation rose by 5 % over the next year, but the higher costs of essentials hammered personal disposable income and consumers put the brakes on their discretionary spending. As the U.S. money supply leaped, hedge funds borrowed in depreciating U.S. dollars to invest in appreciating Asian currencies.

Instead of creating an economic boom, Chairman Bernanke actions caused the worst recession since the 1930s. As business profitability tanked due to lower sales and higher material costs; production was cut and workers laid-off. The rate of unemployment and underemployment soared on Main Street. When the bubble burst and the markets fell back “under their own weight” and a period of deflation began that is probably far from over.

Wall Street on the other hand, did quite nicely thanks to Ben and his buddies at the Fed.

The Fed lent banks and brokers unlimited cash at zero percent interest rates and bought their dicey investments at full value. Last year Goldman Sachs achieved an all-time record $19.8 billion of earnings. In response to howls from analysts about the moral hazard of wealth transfers from taxpayers to the “needy” on Wall Street, Goldman’s chief operating officer, Gary Cohn, responded that the firm was just in the business of “facilitating clients”. Perhaps he really meant to say to inform the American taxpayer: “heads we win, tails you lose”.

This summer Fed officials could read the political tea leaves that the voters intended to rein in government spending and crony capitalism. Knowing the Fed would quickly be under intense scrutiny and constraint by the next Congress, Bernanke announced the $600 billion “QE2” buying spree the day after elections last week.

The Federal Reserve is actually the third national bank of the United States. Congress chartered the First Bank of the United States for twenty years in 1791. Twenty years later, the bank failed to be renewed by one vote, after the public became frightened over the bank’s immense power to pick business winners and losers. In 1816, Congress chartered the Second Bank of the United States for another twenty years; it too failed to be renewed for the same reason as the first bank. Congress privatized the Second Bank with great fanfare, only to collapse into bankruptcy in 1841. Both of the first two national banks got into trouble with the public over cronyism and creating real estate bubbles. It should not be surprising that Uncle Ben is now worried about his fate.

It took seventy-six years before the public’s memory of the national banks shenanigans before Congress passed the Federal Reserve Act to: “furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes”. These are code words for allowing the Fed to aggressively trade securities and manipulate the money supply. Less than twenty years after its founding, America was in the gripes of the Great Depression the bursting of massive real estate and securities bubbles of the “roaring twenties” facilitated by the Fed.

Since the August announcement, Bernanke’s efforts to produce a virtuous cycle is working out fine for stock prices, but is becoming downright vicious for the average American family. Prices are up 20% for food commodities and 10% for crude oil. The inflation in essentials purchases has already strangled half this year’s expected 2% gain in disposable income. As costs continue to flow through to producers, they will be forced to raise prices and consumers will suffer again. As consumers cut back spending producers will cut back on employment.

By January, the new Congress will be demanding investigations and audits of the Fed’s secretive and dubious ways. Uncle Ben is hoping he can create goodwill by igniting a little inflationary uptick in the economy before his new masters arrive in January. Unfortunately, the flames are already escaping in all directions. As the conflagration burns out and the smoke clears, the American singed and burnt the economy will fall back into deflation.