Thursday, December 17, 2015

Unwinding the Fed's Tangled Web

Yesterday the Federal Reserve Board announced it was raising its base interest rate by 0.25% and would continue to increase interest rates slowly in the months ahead.

The last time that the Federal Reserve Board started raising rates after a big recession it raised them so slowly that we ended up in a housing bubble and the Crash of 2008. The problem was that the Fed was much too timid in raising rates when it started in 2003 and so borrowers got themselves into a bunch of home mortgages that they couldn't service as the Fed seriously tightened in 2006-2007.

So what will happen this time? The answer is that nobody knows. The Fed increased its holdings of US government debt enormously in the aftermath of the Great Crash, as the following chart shows:

Now, apparently, the Fed will be paying banks to keep their excess reserves at the Fed rather than lending to borrowers. That would be to stop a credit binge like the mid-2000s. Some observers fear that many global billionaires have got themselves overleveraged on 0% debt and are in for a shock.

What is going to happen? Will the Fed precipitate a credit crisis as it brings interest rates off zero? Or is the correction years away? Who knows? But what we do know is this:
  1. The Zero Interest Rate Policy was fiscal repression designed to help the federal government deal with the huge increase in debt that came after the Crash. The policy lowers the interest costs of the federal government.
  2. That's what the Fed is for: getting the federal government out of a jam.
  3. "Nobody knows nothing," and that certainly applies to the Fed since its founding. 
  4. The federal government usually likes to have nice compliant placeholders at the Fed, and that is what it usually gets.
  5. The next crash will not come from what the conventional wisdom expects.
Other than that, I don't have a clue what is coming next. But I do think this:
  1. The conventional wisdom is that we need a central bank to cure capitalism's excesses. That is wrong. We need a central bank to deal with government's excesses. The big swings in credit are due to governments trying to get back to normal after wars, e.g., the deflation in Britain after the Napoleonic Wars; the deflation in the US after the Civil War; the worldwide deflation after World War I. 
  2. And then there is just flat out incompetence as in 1929-33 and the promotion of home mortgages to sub-prime borrowers approximately from 1990-2006.
  3. Government should not muck with the credit system except when it is fighting a war and needs to grab all the resources it can. So no peacetime deficits. After the war it should not try to return to the old parity with gold to make creditors whole. Wars are about seizing all the resources you can to fight the war. The money is gone.
  4. Governments shouldn't be mucking up the credit system by offering credit subsidies and guarantees. They just make the credit system more fragile.
  5. Government should be at least 50% smaller. Big government makes the whole economy unwieldy, and more fragile.
Other than that, I don't know nothing.

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