Friday, October 28, 2011

Targeting the Fed

If there is anything that demonstrates the failure of expert-led government it is the Federal Reserve Board. Every time the economy tanks we find out that the Federal Reserve Board screwed up again and we hear demands for a new target to guide the Fed in its monetary policy.

In the 1920s the Federal Reserve was sterilizing gold flows; after the late 20s boom that was declared a failure.  In World War II and after the Fed targeted long term interest rates and monetized World War II debt.  In the early 50s that policy was abandoned that when inflation increased.  Then in the 70s Nixon turned back to inflationism in order to get reelected.  In the late 70s, after the dreadful inflation, the new target was the rate of increase in the money supply.  In the Greenspan years the target became inflation.

Now everyone agrees that inflation targeting is all wrong.  What is needed, according to economist Scott Sumner is "NGDP targeting."  Instead of targeting consumer prices or the GDP deflator, we should just increase nominal Gross Domestic Product by a sensible amount each year.

Maybe this new target would be better than the old target.  Who knows?  The problem is that central bankers are, first of all, the government's banker.  Central bankers make sure to smooth credit conditions for the government.  Smooth credit conditions for the government may not be the best policy for the economy.

Central bankers sit in the hot seat, so ever since government took over the central banks central bankers have been government bureaucrats and they have wanted a simple rule to govern their actions.  And there lies the problem.

The central problem in economic management is not money supply or inflation or economic growth.  It is to keep the credit system healthy.  Borrowers must make payments on time and people must have confidence that the balance sheets borrowers and lending institutions are healthy.

The proximate cause of the current crisis was that the holders of home mortgages failed on both these counts.  Overextended borrowers started failing to pay their mortgages.  That meant that their mortgages, considered as assets at the bank, were worth a lot less.  Thus the balance sheets at the banks got hammered.  Everyone headed for the exits.

Sensible bankers would have said by the mid 2000s: Wow!  Housing prices have shot up.  We should clean up our balance sheet and make sure that, if this developing bubble should pop that we have good assets that won't melt away if home prices drop.

But they didn't.  They couldn't, because the government had forced them to originate lots of loans at high loan-to-value (risky because a slight decline in home prices would put the loans under water) and lots of loans to borrowers with poor credit (risky because those borrowers are more likely to default).

There's a lot of mumbo jumbo around banking and credit.  So it helps to look at the experience of a banker like the young W.T. Sherman, of Marching Through Georgia fame.  This inexperienced banker became manager of a small bank in San Francisco in the mid 1850s.  He didn't like the look of the economy so he cleaned up the bank's balance sheet.  A key action was in reducing the loan balance of a politician that he didn't trust.  When the politician skipped town, leaving millions in defaulting debts, Sherman's bank easily survived a run, while other banks went under.

How hard can it be?  OK, it helps if the government isn't breathing down your throat forcing you to do stupid things.

The problem with government financial regulation is that it is always backward looking.  The time to stiffen credit terms is on the upswing of the business cycle, to say: Wow, asset prices are really climbing; we should not be originating any 80 percent or 90 percent loans.  Instead we get Barney Frank calling for Fannie and Freddie to roll the dice.  The time to relax credit conditions is right now, when asset prices have tumbled for a couple of years and aren't likely to decline much more.  Instead we get the Dodd-Frank bill that stiffens credit standards with impenetrable regulations.

There's a way forward here, but it isn't some new simple-minded target for the Fed.  What we desperately need is for the financial system to be run by leaders like old J.P. Morgan who really know what they are doing.  Politically-connected chaps like Alan Greenspan and Ben Bernanke just don't cut it.

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