Monday, December 7, 2009

The Problem of the Fed

With Federal Reserve Chairman Ben Bernanke up for renomination, United States senators are taking the opportunity to grandstand. And the editors at National Review aren't too pleased.

Neither the Fed nor the Treasury nor the FDIC has functioned flawlessly throughout this crisis, but together they have functioned well enough: better, even, than many had expected, and Bernanke’s clear thinking has helped to unify and coordinate their efforts.

The problem with the Fed is not whether or not it functioned well during the financial crisis. The problem is the way that a government central bank makes crises more likely.

The Federal Reserve System's most important vital role is as lender of last resort. Crudely speaking, that means that the Federal Reserve will print money, in a crisis, to bail out the credit system.

But the only reason that a credit system ever needs bailing out is that some players are suspected of being unable to make good on their obligations. This is inevitable in a highly leveraged credit system. Quite simply, when an institution is highly leveraged it means that it can't honor their obligations if things go south. When you are 90 percent leveraged, it means that when the underlying assets decline by a mere 10 percent, you are insolvent.

And, of course, banks are the primary culprit in this game. Banks are allowed to leverage beyond 90 percent.

But banks belong to the era of horse-drawn credit, when there wasn't a large market for securities. Today there is a global market for credit in all its ramifications from equity to secured debt to unsecured debt to derivatives. All of these different financial instruments display different combinations of risk and reward.

It shouldn't be that hard to set up rules to keep everyone above water, to limit the exposure to debt (which is a rigid contract to pay interest and principal) and encourage equity (which is a partnership for sharing risk).

But the problem is government. Government likes to make credit cheap, meaning encourage debt financing. But that tends to make it riskier.

No problem, says the government. We have a central bank which can fix a credit crisis as lender of last resort.

Well, yes. But there is a cost to the lender of last resort role. The cost is inflation. The job of the lender of last resort is to flood the jammed wheels of credit with oceans of lubricating debt. Prudent investors pay the price in devalued dollars.

When people like Ron Paul agitate for an end to the Fed, they are calling for an end to the moral hazard of a government central bank. When the central bank is owned by the government, it represents the interests of the government first and the people second.

And clearly, the Fed has been the government's central bank, not the people's central bank. It bails out the government--or the government's banking system, and the people pay for it.

The simple fact is that the value of the dollar has decreased by about 98 percent on the Fed's watch. In the first century of the USA, when it didn't have a government central bank, the value of money declined by 10 percent.

We are Americans, and we can do better.

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