The Fed Centennial: A Brief Historical Review of the World’s Most Powerful Central Bank

6 years ago to the month, the United States entered its longest and deepest post-war recession.  18 months later, in June of 2009, economic growth finally resumed.  Ever since, barring a few  quarters of “bounceback growth” in late 2009 and blips in 2011 and Q3 2013, the recovery has been extraordinarily sluggish by historical standards.  What does this have to do with the Federal Reserve’s (recent) 100th birthday?  Lots, actually.  But first, let me go all the way back to the beginning.

100 years ago to the month, the United States entered its longest and deepest experiment in centralized banking.  Congress had passed The Federal Reserve Act of 1913 to set up the Federal Reserve System, a quasi-private quasi-governmental central banking system, in response to the many financial panics that had plagued the US since its founding (especially the severe 1907 financial crisis).  It originally started out with three specific mandates: full employment, price stability, and moderate interest rates, each of which would receive particular emphasis during different periods of time.

The Fed got off to a fairly rocky start.  It failed to adequately mitigate the severe early 1920s post-WW1 recession, and exacerbated the Great Depression by attempting to fight non-existent inflation.  After the horrendous 1930s, beginning in the 1940s the Federal Reserve placed heavy emphasis on the “full employment” mandate.  This coincided with the post-war “Keynesian consensus”, in which fiscal policy was also leveraged to support the full-employment mandate.  Growth was generally robust during this time, though during the 50s growth was slower and was repeatedly interrupted by short recessions.  During the 1960s, activist monetary and fiscal policies reached their nadir, with the Fed coming under increasing political pressure to maintain full employment at all costs.  This continuous monetary expansion helped set the stage for the stagflation of the 1970s, where too much money was chasing too few goods.  Further compounding the situation was President Nixon’s removal of the dollar from the gold-standard, putting further downward pressure on the dollar.  By 1980, inflation was running in the double-digits even as unemployment now remained above the “full-employment” level of 5-6% (challenging the Phillips Curve inflation/unemployment tradeoff theory).

It was with the appointment of Paul Volcker as Fed Chairman in 1979 that the Fed’s emphasis on price stability (rather than full employment) can be observed.  Volker enacted an extremely tight monetary policy (selling government bonds to remove money from the economy, depress bond prices, push up bond yields and thus push up interest rates) that led to the double-dip recessions of 1980 and 1981-82′ (the latter being particularly severe).  After the prime rate hit 21% in 1980, it and inflation fell rapidly, as did interest rates.  Growth rebounded strongly.  From then on until the 2008 financial crisis, the Fed maintained a steadfast commitment to lower inflation (sometimes at the price of full employment).  Rates of inflation and interest steadily declined until 2008 (with intermittent spikes now and then).

Either as a cause or effect of the Fed’s actions, savings rates also trended down beginning in the 1980s, following the pattern of interest rates (which makes sense, as depositors have less incentive to save with lower interest rates).  Lower interest rates spurred consumer spending, beginning a quarter-century long consumption boom.  Balance of payments and the federal budget recorded significant deficits for the first time.  Almost all forms of debt – governmental, commercial, and household debt – began to rise as a percentage of GDP and personal income.

This unsustainable situation, as noted, would last until the late 2000s.  Just a few years earlier, after the dot-com bubble burst at the turn of the millennium, the Federal Reserve pursued what was (up until then) one of its most aggressive monetary expansions ever.  The Federal Funds target rate was repeatedly reduced until it reached around 1% until the mid-aughts.  This monetary expansion (characterized, as all monetary expansions are by massive bond buying = higher bond prices = lower bond yields = lower interest rates to hopefully spur investment, borrowing, and spending), however, coincided with the rise of surplus financial capital in other parts of the world.  A surplus of capital almost everywhere looked in vein for investment vehicles to profit from, and safe government bonds, with such low prevailing yields, would not suffice.  As a result, they turned to riskier assets such as mortgage-backed securities (MBS).  These instruments, backed by the value of actual mortgages, would yield investors dividends essentially in the form of monthly mortgage payments – a much higher rate of return than treasury bonds yielded at the time.  The demand provided by the investors of MBS’ increased the demand and funds available for mortgages, which pushed up lending and housing prices.   Of course, we now know that many of these mortgages were sub-prime and extremely risky.


When the Fed finally began to raise interest rates in the mid-aughts, several things occurred as a result.  Higher interest rates caused a wave of mortgage defaults and foreclosures, especially among risky borrowers.  This reduced the value of MBS’ and weakened investor demand for them, putting downward pressure on the net worth and financial positions of multiple investment banks.  This weakening of investment banks weakened demand for mortgages from mortgage lenders, who thus lent less.  This started the infamous “credit crunch”, which not only lowered mortgage lending and demand for housing (further lowering housing prices) but put pressure on all forms of borrowing.  Higher interest rates also made bonds look more attractive than risky assets, causing further pullback from investors.  Although far more complex than this explanation, this is the essence of the financial crisis that sparked the Great Recession.

The Fed responded to the crisis quickly, purchasing billions worth of “troubled” or “toxic” assets in a bid to stabilize the financial system and money supply.  The Fed funds target rate was lowered to almost zero, and the conventional monetary policy of purchasing short-term bonds was commenced.  However, even with these policies, inflation remained (and still remains) precariously low.  Thus, various “unconventional” monetary policies have also been pursued, notably “quantitative easing” (QE), in which large quantities of long-term financial & commercial assets (including long-term government bonds) are purchased with newly created money to both lower long-term interest rates and raise the quantity of money in the money supply.  As of this writing, the Fed is still purchasing about $85 billion in bonds per month as part of its QE strategy.

So, about the financial crisis and our agonizingly slow economic recovery: can the Fed ultimately be to blame?  You could argue that low interest rates pursued by the Fed ultimately pushed investors into too-risky of assets.  Of course, the Fed wasn’t the only downward pressure on interest rates since 1980 – the emergence of several developing nations has given rise to a global “savings glut” that has pushed down interest rates worldwide.  The Fed may have kept the Fed Funds rate down too long during the mid-aughts – but then again, who can really blame them, considering they were desperately trying to make sure the US didn’t enter a deflationary spiral after the dot-com bubble burst?  As for its role in our slow economic recovery, that is also unclear.  Normally after recessions, an expansionary monetary policy (and the low interest rates that come with it) spur consumer & business borrowing, spending, and investment, increasing short-term economic growth.  However, this time is different, as households and businesses are still trying to deleverage from their debt overhang (a process that requires less consumer spending and increased savings for a time).  Considering that debt deleveraging (so that debt as a percentage of GDP and household income is down to more normal levels) is essential for long-term economic growth and recovery, the downward push exerted by the Fed on interest rates could actually be retarding the process as it makes it more difficult to accumulate savings to pay off debt.  At the same time, an easing of the Fed’s ultra-loose monetary policy right now may not be a good option, either, as it may cut off all sources of growth.  Whatever the Fed’s role in the crisis and its aftermath, it is clear that the crisis has provoked a strong discussion in consideration of which part of the Fed’s mandate (if any) should be emphasized from now on.

To sum up, the Fed has had a tumultuous century.  Though it has had its monetary successes (inflation taming?), its failures weigh heavily.  Ironically, the very cause of its creation  – financial crisis – also marks the end of its first centennial.  Though there has been progress, one can’t help but feel that we’re back to square one.


The Murray-Ryan Budget Agreement: Part 2

I lied when I said “…more in the morning”.  It’s now around midnight the next day.

So, in the last post I was going over the reasons I was in favor of the Murray-Ryan budget agreement.  I left off on reason #3.  Let’s continue:

4. An easing of short-term austerity might not be a bad thing.  This may surprise many people, but America has just undergone its most rapid fiscal contraction since World War 2.  The budget deficit has fallen by a whopping $700 billion in the past 5 Fiscal Years, from $1.42 Trillion in FY 2009 to $680 billion in FY 2013.  This equates to a fiscal contraction of approximately 6% of GDP.  Thus, despite claims to the contrary, America’s annual fiscal situation is improving very quickly due to a combination of revenue increases (tax hikes + sluggish economic growth) and declining expenditures (spending cuts + cyclical declines in “automatic stabilization” spending).  Now, generally I disapprove of using government manipulation of fiscal policy to try and “pump-prime” the economy, and I think that fiscal responsibility does yield long-term benefits.  At the same time, however, the rapidity of the fiscal contraction that has been occurring over the past few years has almost certainly held back short-term economic growth (as higher taxes and lower spending bite into aggregate demand).  While I’m not against continued moderate austerity, I am against austerity that is too aggressive and rapid, as there comes a point when deficit reduction starts to be cancelled out as overly-rapid austerity bites into economic growth.  This is precisely what has happened in Greece, which (unlike America now) didn’t really have a choice as to whether to pursue austerity or not – I mean, it was literally being shut out of bond markets.  We do threaten to turn into Greece, however, if our pace of fiscal contraction becomes too rapid.  An easing of the pace of austerity that would come about upon enactment of the Murray-Ryan budget is thus potentially beneficial.

5. Immediate budget balance is not necessary for fiscal sustainability (even if eventual balance is desirable).  Many people are alarmed by the existence of any annual budget deficit; after all, every annual budget deficit adds to the debt by the amount of the deficit, and continual additions to the national debt are bad, right?  Actually, no.  What really matters is the size of our national debt as compared to the size of our national economy and the pace of annual debt growth (our budget deficit) as compared to the pace of annual economic growth.  Right now, when you look at our national debt of about $17.2 Trillion, it looks pretty scary.  But absolute numbers are not as important as relative numbers.  What matters is that $17 trillion as a ratio of the size of our economy, a figure that tells us how much of a relative burden that debt is and our national ability to service that debt.  Right now, with an economy of about $16 trillion, our debt/GDP ratio is about 107%.  Even this ratio is misleading, however.  That $17 trillion debt figure is our total gross national debt; more important is the debt held by the public, which is the total debt minus intergovernmental holdings of debt (I’ll get more into these distinctions in a later post – look here for good definitions & information though :D)  Using the debt held by the public figure, the debt/GDP ratio is lower at 73% – historically high, but not at crisis levels.  It is only when this figure approaches higher levels (say, 100% of GDP +) that a fiscal crisis (characterized by serious spikes in interest rates) is a real danger.  Due to continued economic expansion since June 2009 in combination with slower increases in debt (due to lower annual budget deficits), debt held by the public has stabilized as a percentage of GDP (around that 73% figure) – meaning our fiscal situation is as of now sustainable in the short run.  Indeed, as long as the following conditions are met, our debt is sustainable: annual increases in debt are lower than or equal to our GDP growth and the debt/GDP figure isn’t already high.  For now, this is the scenario we are in.  In the long-run, though, rising entitlement & healthcare spending will drive up budget deficits to the point where debt accumulation again outstrips GDP growth, implying a rising debt/GDP figure and an unsustainable long-term situation.  The Murray-Ryan budget deal, however, does not increase annual spending enough to have debt accumulation outstrip GDP growth in the short term, nor does it add to the long-term entitlement challenges I mentioned.  If adopted, we will remain fiscally sustainable in the short to medium-term, even if our long-term prospects are shaky.

I’ll try delving even further into these complex debt & deficits concepts in a later post. Right now, it’s time for bed.

Charts, courtesy of the Heritage Foundation:

CP-fed-spending-numbers-2013-page-4-chart-1 CP-fed-spending-numbers-2013-page-4-chart-2 CP-fed-spending-numbers-2013-page-5-chart-2

The Murray-Ryan Budget Agreement: An Acceptably Flawed Deal

Sorry for the delay in posts – busy couple of weeks.  So let’s look at what’s happened as of late:

Besides the ongoing ObamaCare fiasco, the latest political buzz is all about the recent budget deal for FY 2014  and FY 2015 produced by Representative Paul Ryan (R-WI) and Senator Patty Murray (D-WA).  The deal has promptly lead to loud opposition from conservative organizations and members of Congress, as it partially reverses the sequester by restoring approximately $63 billion in discretionary spending for FY 2014 and 2015 (even while calling for these spending increases to be offset by $85 billion in cuts over the next decade).  Marco Rubio (R – FL) says the budget “…fails to tackle our long-term fiscal challenges”, and many others are stating that it reverses “progress” made under the sequester.  Here are my thoughts:

  1. Tinkering with discretionary spending has almost no effect on our long-term fiscal challenges. We’ve all heard about how the entitlement programs (Medicare, Medicaid, Social Security, etc.) will bankrupt the country in the long-run as the baby boomers retire and (partially as a result) health care costs continue their upward march.  Indeed, this is true: as the Heritage Foundation has noted, mandatory spending is estimated to grow by about 79% over the next decade alone.  I find it puzzling, then, that almost all budget battles center around discretionary spending (domestic programs, like education & transportation, and security, like national defense).  Total discretionary spending is currently capped at around $967 billion/year, which is less than 1/3 of total spending of about $3.45 trillion.  This budget deal resets those levels to just over $1 trillion/year.  To put this in context, this amount is still 8% lower than FY 2010 discretionary authority, and discretionary spending is still projected to reach record lows as a % of GDP in the coming decade (even if the Murray-Ryan deal is implemented).  Meanwhile, mandatory spending is set to reach record highs as a percent of GDP.  The point?  While I’m all for budgetary efficiency, adjusting annual discretionary spending by less than $100 billion a year (and at levels well below previous records) as the budget deal does will neither exacerbate or alleviate our long-run fiscal problems.  Although important, it is truly not the fiscal elephant in the room.
  2. An imperfect budget deal with slightly higher spending is much better than a thriftier budget acquired via the threat of debt default and other forms of brinkmanship.  Since 2011, it has become a habit of Congress (especially the House of Representatives) to use America’s debt-ceiling and the threat of governmental shutdown as leverage for spending cuts.   Those leading the brinkmanship crusades (especially Tea Party Republicans) rationalize their behavior with the (not necessarily untrue) claim high deficits and debt cause significant business uncertainty, which they cite as the #1 inhibitor of economic growth.  Being the self-proclaimed defenders of business, they thus have repeatedly used the threat of debt default and government shutdowns to lock in spending cuts.  Ironically, however, these methods of governing have instead significantly increased policy uncertainty. In fact, fiscal policy uncertainty (including increased debt yields due to the repeated threat of default) is estimated by the Peter G. Peterson Institute to have reduced economic growth by approximately 12% since 2009.  As a result, it is quite possible that much of the deficit reduction acquired through actions that have increased policy uncertainty have actually been slightly or wholly cancelled out by the resultant slower economic growth (which would produce lower than expected revenues and higher than expected expenditures). As such, the Murray-Ryan budget deal, which lays out a tentative 2-year budget plan and would temporarily end budgetary impasses is a much better alternative for both the economy and deficit reduction.
  3. Quality is just as (if not more) important than quantity.   We constantly hear tons of different budget numbers being thrown around in debate ($967 billion in discretionary spending, $17 trillion debt, etc.) While these number are important, perhaps even more important is asking whether what is being funded is a) a legitimate government function b) gives us a positive rate of return c) is being funded at adequate levels for optimal performance.  In fact, before even beginning a discussion on FY 2014’s appropriations, Americans need to have a serious discussion about what they expect government to do, with the numbers to follow that conversation.  For example, America’s defense budget has absorbed big funding cuts over the past few year, with more pain to come.  However, what we expect the military to do (patrol the seas, r&d, stabilize other nations, etc.) has not been altered as significantly.  Such scenarios are becoming more common across the budget – busy programs with declining resources.  This then begs the question as to whether it is better to have a few well-funded, well functioning programs that we actually value or many under-funded, poorly functioning programs that are not valued.  Personally, I’d rather have the former scenario.

More to follow in the morning…