Thursday, November 8, 2012 - Tools in the Toolbox

Tools in the Toolbox

by Sinclair Noe

DOW – 121 = 12,811
SPX – 17 = 1377
NAS – 41 = 2895
10 YR YLD un = 1.63%
OIL + .60 = 85.04
GOLD + 14.60 = 1732.90
SILV + .47 = 32.41

Yesterday I was a guest on Bill Tatro's radio show: All About Money, 2PM Pacific and Mountain, right here on MoneyRadio. Most of the time Bill's show is Bill, and it's great; he's always entertaining and informative and I don't agree with everything he says but I think he does a great job of saying it; so I'm always a bit honored when he has me on as a guest. It's a different situation for me, being the guest, but Bill is an excellent interviewer. One of the questions he asked was, paraphrasing: “What tools does the Federal Reserve still have in their toolbox?”

I gave the basic answer that they didn't seem to have many tools left. I thought it was time for fiscal stimulus to match the Fed's already extraordinary use of monetary stimulus. But, as I said, this was a really good question and so I did a little more research, and today I'm going to talk with you about the tools left in the toolbox.

First, whether you like the Fed or not, the Fed's actions have had an impact on the economy and the economy has shown signs of recovery; I'm not sure what else to call it when you have 32 months of employment growth, the Dow Industrials have doubled from the lows of March 2009; not a great recovery but a recovery. Still we face a perilous path. This week's elections resulted in the status quo, there is still a fiscal cliff dead ahead, 9 of the countries in the Euro-Union are in a depression and the rest are facing recession and that affects the US, China is struggling. The IMF warned of a worldwide slowdown and the US is not immune. The path of austerity has has not worked in Europe, which should be no surprise because it didn't work in the United States back in the 1930s.

Corporate profits in the US are softening, the housing market still has a long way to go before it can be called normal again, and the average citizen is still concerned about jobs, and debt, and so they continue to keep a tight grip on their wallets.

There are a number of downside risks to the economy. We could see a shock that pushes the economy into another downward spiral, and if it happens again, it would probably be more difficult to contain than 4 years ago.

So, what's left for the Federal Reserve? Well, today, the Bank of England announced it would stop its bond buying program, the British equivalent of Quantitative Easing, and instead focus on a credit boosting initiative they call Funding for Lending Scheme, or FLS, to increase growth. The Bank of England also announced they would leave their benchmark interest rate at a record low 0.5%, while the European Central Bank announced they would hold steady at 0.75%. The thinking is that additional QE would only provide marginal benefits for the real economy, while creating longer-term risks of bubbles. Sound familiar? Of course, they could restart QE at any time but for now, they are looking at different tools.

The Funding for Lending Scheme means the British central bank will reward commercial banks with favorable rates if they provide more generous credit to help businesses wanting to expand and to create jobs. The scheme will also penalize banks if they fail to meet those goals. In other words, they will target bank lending.

The Fed actually has many tools to achieve their dual mandate to maintain stable money and maximum employment, but here's the deal, most of the tools the Fed has traditionally used tend to favor finance over industry, it works in favor of capital over labor, or Wall Street over Main Street. This has been a complaint for a long time. The Fed pumps money to the Wall Street bankers and they go out and gamble and the money never gets into productive hands. So, if the politicians are unwilling to stop acting like idiots (it may not be acting), then how can the Fed target money to the sectors that can really use it.

Well, in addition to running a printing press, it turns out that Bernanke is a pretty big-time regulator of the banking industry. The Fed could flex its regulatory muscle to unfreeze the risk-averse bankers who are still unwilling to lend—the same bankers whose reckless risk-taking nearly brought down the entire system four years ago. The Fed could create special facilities for directed lending (just as it did for the imperiled banking system) that gets the banks to relax lending terms for credit-starved sectors like small business. If bankers refuse to play, it could offer the same deal to financial institutions that are not banks.

What else? The Fed is already the biggest buyer and holder of mortgage backed securities; which is another way of saying they have quasi-nationalized the mortgage industry; and since they hold almost all the paper, who's to say they can't reduce debt for millions of underwater home mortgages? They've already managed to smooth the path to refinancing for millions of underwater homeowners; why not push debt reducing loan mods as well?

The Fed could also provide financing for major infrastructure projects: they could modernize the electric grid; they could finance green energy; they could build high speed rail systems or urban light rail; they can finance major road and bridge construction; massive water works projects; they could even finance education. The Fed could influence the investment decisions of private capital by backstopping public-private bonds needed to finance the long-neglected overhaul of the nation’s common assets.

But wait, wait (I can hear some of you sputtering right now) wait! The Fed can't do that! That's the job of the Congress; that's why we elect politicians, to make those kinds of decisions. If Bernanke crosses that line, it would surely be illegal. And I'm sure, Bernanke would like congressional cooperation, and he wants to avoid confrontation if possible.

Maybe Bernanke has already found an ally in the White House who is also exasperated with the obstructionist policies of the Republican leaders in Congress. And maybe that ally just won re-election and if the Republicans try to throw their weight around, he might just flex his own muscles.

Make no mistake, the Fed can carry out direct interventions to help the economy recover, it is legal, and it has used this power before, plenty of times. During the Great Depression, the Federal Reserve was given open-ended legal authority to lend to practically anyone if its Board of Governors declared an economic emergency. This remains the law today. The central bank can lend to industrial corporations and small businesses, including partnerships, individuals, and other entities that are not commercial banks or even financial firms. The Fed made thousands of direct loans to private businesses during the New Deal, and the practice continued for twenty years. Only in more recent times has the reigning conservative doctrine insisted that this cannot be done. 

The original authorizing legislation for such lending was enacted in 1932 as Section 13.3 of the Federal Reserve Act, and the wording was left deliberately vague. An emergency was defined as “unusual and exigent circumstances.” Whatever did that mean? In practice, it meant whatever the Board of Governors decided it meant. Fed governors must now get approval from the treasury secretary, but they do not have to ask Congress for permission. 

Section 13.3 is often depicted as antique legislation left over from the New Deal, but the provision is very much alive and active. It was invoked during the crisis of 2008. When Bear Stearns collapsed in the spring of 2008, the Fed declared “unusual and exigent circumstances” to legitimize its rescue. Bear Stearns was a brokerage house, not a bank. And then Section 13.3 was again use to justify the $180 billion bailout of American International Group. AIG is not a bank but a giant insurance company, and it was obviously insolvent. Normally, a failed corporation would proceed to bankruptcy court, where its creditors would fight over what was left. In this case, the Fed stepped in to save AIG.

The AIG bailout was not very popular, and so Congress tightened up the old law. Now, the Fed can still lend to “individuals, partnerships and corporations” if they are “unable to secure adequate credit accommodations from other banking institutions.” But it can no longer create a special lending facility to protect a single insolvent company.

Fed money is not exactly “free,” but it has this great virtue for government: it doesn’t cost the taxpayers anything; there may be ramifications but it's different than tax revenue. Fed expenditures do not show up in the federal budget, nor do they add anything to the national debt. Think of what this means when it comes time to negotiate the fiscal cliff? In a sense, this freshly created money belongs to the people, it's our money, and can be used in unusual ways to advance the shared public interest. Lincoln did this when he printed “greenbacks” during the Civil War. Various Fed governors have done it when they were faced with “unusual and exigent circumstances.” And don't forget the bailout of Penn Central. And, of course, the Fed used this to lend extensively during the Great Depression. And don't forget that Bernanke is a student of the Great Depression.

Does the Fed have any tools left in the toolbox? You better believe it.