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Important questions unasked of the Fed

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    Important questions unasked of the Fed

    This weekend's WSJ essay "How the Fed Averted Economic Disaster"  by Nick Timiraos finally brings into public discussion the second question we should all be asking of the Fed. What happened in the grandest bailout of all time in the covid crisis, and, more importantly, having done it twice, how are we going to avoid massive bailouts becoming the normal state of affairs? (The first question, of course, is "how did you miss inflation so drastically and when are you going to do something about it?") 

    They were offering nearly unlimited cheap debt to keep the wheels of finance turning, and when that didn’t help, the Fed began purchasing massive quantities of government debt outright.

    Translation: When dealer banks weren't buying treasury debt fast enough, the Fed lend the banks money to buy the debt, and quickly bought up the massive amount of debt themselves. 

    The Fed followed by bailing out money market funds, buying state and local government debt, buying exchange-traded funds that held junk corporate debt, and announcing a do whatever it takes pledge to keep corporate bond prices high. It worked

    It worked. The Fed’s pledges to backstop an array of lending, announced on Monday, March 23, would unleash a torrent of private borrowing based on the mere promise of central bank action—together with a massive assist by Congress, which authorized hundreds of billions of dollars that would cover any losses.

    ...Carnival Corp. , the world’s largest cruise-line operator. Its business had collapsed as Covid halted cruises world-wide. Within days of the Fed’s announcement, Carnival was able to borrow nearly $6 billion from large institutional investors...If the hardest-hit companies like Carnival, with its fleet of 104 ships docked indefinitely, could raise money in capital markets, who couldn’t?

    Let's be clear who is bailed out here: Creditors. People who lent lots of money to shaky businesses, earned nice high yields in good times, now have the Fed and Treasury bail them out in bad times. 

    It worked. 

    Today, nearly two years later, most agree that the Fed’s actions helped to save the economy from going into a pandemic-induced tailspin.

    I agree. A crisis was imminent, a toppling of a vastly over-leveraged house of cards was in the works. As "just in time" supply chains discovered they needed a bit of extra inventory around, just in time debt financing falls apart at the slightest shock, needing a bit of cash inventory and equity buffer. 

    The Fed’s initial response in 2020 received mostly high marks—a notable contrast with the populist ire that greeted Wall Street bailouts following the 2008 financial crisis. North Carolina Rep. Patrick McHenry, the top Republican on the House Financial Services Committee, gave Mr. Powell an “A-plus for 2020,” he said. “On a one-to-10 scale? It was an 11. He gets the highest, highest marks, and deserves them. The Fed as an institution deserves them.”

    I also agree, almost. But  

    The question now is what will be the long-term costs and implications of that emergency activism—for the Fed, the financial markets and the wider economy. 

    This is the question. Why did the economy get into a situation once again, so soon, that the Fed had to engineer this massive bailout? What are you going to do to make sure you don't have to do it again and again? 

    Some people have spoken: 

    Paul Singer, who runs the hedge-fund firm Elliott Management, warned that the Fed was sowing the seeds of a bigger crisis by absolving markets of any discipline. “Sadly, when people (including those who should know better) do something stupid and reckless and are not punished,” he wrote, “it is human nature that, far from thinking that they were lucky to have gotten away with something, they are encouraged to keep doing the stupid thing.”

    I.e., run companies with a lot of debt, buy a lot of high-yield junk debt, knowing that the Fed will do whatever it takes to keep the value of that debt from falling in bad times, even to the extent, now, of buying it directly. 

    Reservations about Mr. Powell’s make-people-whole mantra weren’t limited to the free-market libertarian set.

    Guilty as charged. 

    The breathtaking speed with which the Fed moved and with which Wall Street rallied after the Fed’s announcements infuriated Dennis Kelleher, a former corporate lawyer and high-ranking Senate aide who runs Better Markets, an advocacy group lobbying for tighter financial regulations.

    “Literally, not only has no one in finance lost money, but they’ve all made more money than they could have dreamed,” said Mr. Kelleher. “It just can’t be the case that the only thing the Fed can do is open the fire hydrants wide for everybody. This is a ridiculous discussion no matter how heartfelt Powell is about ‘we can’t pick winners and losers’—to which my answer is, ‘So instead you just make them all winners?’”

    The last time around, public outrage forced at least some disquiet about "moral hazard," promises to do something so it wouldn't happen again. No More Bailouts. It produced the misbegotten Dodd-Frank law and it just happened again, on steroids. At least, though, there was the decency to notice. Outside this blog and a few other eccentrics, nobody seems to notice or care. We are now firmly in the system of huge leverage, private gain in good times, public guarantee in bad times. Where are our inequality warriors on the left, and tea party hat types on the right? Or at least, where are our economists who understand moral hazard in the middle? Where is any shame from the Fed that its army of Dodd Frank regulators and stress testers so completely missed the fact that the financial system was ripe for breakdown in the next crisis, so long as it did not exactly repeat the previous one? 

    Timiaros writes 

    ...because the pandemic shock was akin to a natural disaster, it allowed Mr. Powell and the Fed to sidestep concerns about moral hazard—that is, the possibility that their policies would encourage people to take greater risks knowing that they were protected against larger losses. If a future crisis is caused instead by greed or carelessness, the Fed would have to take such concerns more seriously.

    This is absolutely wrong.  (Bold and italic, I'm shouting from the rooftops.) The moral hazard is too much debt, both issued and bought, not enough cash lying around ready to pounce on opportunities, not enough balance sheet space to intermediate, all on the expectation that there will be no buying opportunities or danger of loss in the next dip. The source of the shock is irrelevant. This fragility was caused by just as much "greed" and "carelessness" as the last one, eternals of human nature when incentives allow them. (I can just see it now. "The Fed diagnoses that the market collapse is due to too much Wall Street greed. Therefore, we're going to let companies go bankrupt and people lose their jobs?" ) 

    Pandemics happen. Wars happen. If you're of that ilk, climate risks happen. Sovereign debt collapses happen. Crises are always unpredicted. If they were predicted, they wouldn't be crises.   

    So, dear Fed, well done. The house was on fire, and you sent the entire fire department and put out the fire. A lot of people made a lot of money, as the federal debt and reserves skyrocketed. And now everyone expects more of the same next time. Not just the large bank bailouts of 2008; everyone expects that in a downturn you will buy corporate and junk bonds, as many as needed to keep prices from falling and anyone from losing money. How are you going to put this genie back in the bottle?


    Question 2: Sarah Bloom Raskin is being questioned over the interesting coincidence that a fintech company got a "master account" at the Fed just after she joined the board. 

    The question here, for the Fed, is why did the Fed deny all the other fintech companies that applied for master accounts? Why is the Fed still  forbidding narrow banks from operating? 

    Explanation: A master account at the Fed is like your bank account. Except it pays daily interest, and most of all allows instant transfer of funds from one financial institution to another. Fintech companies and narrow banks would love to give you interest-paying accounts, pay you interest, and give you much better, faster, and cheaper electronic transactions. Narrow banks would invest your money entirely in those reserves at the Fed. As a result, they can never fail. I mean that -- zero chance of failure, with essentially no regulation required. Zero chance of needing a bailout or the Fed to buy up all the assets to boost their prices, as it just did. 

    Why is the Fed blocking this? What you hear is a lot of fuzzy baloney about "systemic risk." Once again, as with "climate risk to the financial system," we pay the price that Dodd-Frank never defined "systemic risk," allowing the Fed to use it as a catch all for anything it likes. Narrow banks cause zero systemic risk. 

    Narrow banks and fintech companies do pose a threat to traditional banks that pay you no interest, do not serve Americans with lower incomes, and charge big fees on your credit and debit cards. Hmm. Perhaps the Administration could see this as part of its pro-competition agenda? 

    The central bank digital currency movement, popular on the left as well to open banking services up to all Americans, wants all of us to have master accounts at the Fed. That is not likely, but at least allowing intermediaries who are good at retail services to enter and compete might make a lot of sense. 



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