Tag: paul volcker

If the ‘Volcker Rule’ Is So Great, Why Exempt Treasuries and Agencies?

One of the more controversial provisions of the Dodd-Frank Act is its restrictions on proprietary trading, contained in Section 619. Setting aside the fact that even Paul Volcker has said the provision would have done little to avoid to the recent crisis, the Act’s various exemptions illustrate the confusion and hypocrisy underlying the rule.

Foremost among these exemptions is the allowance of proprietary trading when the financial instrument in question is either a U.S. Treasury bill/bond or a security issued by Fannie Mae and Freddie Mac. These instruments are actually the bulk of proprietary trading. Remember the failed hedge fund Long Term Capital Management? Their signature trade was arbitraging on-the-run and off-the-run Treasuries. Ever hear of Bear Stearns? The largest single asset in Maiden Lane I, those Bear Stearn assets guaranteed by the New York Federal Reserve, were Fannie and Freddie securities.

Countries around the World, such as Japan and Canada, have already raised concerns that if their government debt is subject to the Volcker rule, the result will be less liquidity and higher funding costs. But then one has to suspect that former senator Chris Dodd (D-CT) and Rep. Barney Frank (D-MA) understood this, as they allowed an exemption for Treasuries and Agencies (Fannie/Freddie). While I’m no expert on trade policy, this may very well raise World Trade Organization questions since the Volcker rule, as proposed, favors U.S. debt over foreign debt. Of greater concern should be that the Volcker rule favors non-productive investment, that of the U.S. government and Fannie/Freddie, over productive investment, such as corporate paper.

As in so many other areas, Dodd-Frank does leave the actual decision-making to the bank regulators. (Is it too much to ask Congress to actually legislate?) Section 619 is very clear that regulators may exempt Treasuries and Agencies, which implies they also may not. The first best solution would be to just scrap the Volcker rule, but if we are going to have it, then apply it to everyone and all asset classes. Otherwise, one is just introducing additional distortions into our financial markets, some of the same distortions that actually lead to the financial crisis.

The Federal Reserve, the ‘Twist,’ Inflation, QE3, and Pushing on a String

In a move that some are calling QE3, the Federal Reserve announced yesterday that it will engage in a policy called “the twist” – selling short-term bonds and buying long-term bonds in hopes of artificially reducing long-term interest rates. If successful, this policy (we are told) will incentivize more borrowing and stimulate growth.

I’ve freely admitted before that it is difficult to identify the right monetary policy, but it certainly seems like this policy is – at best – an ineffective gesture. This is why the Fed’s various efforts to goose the economy with easy money have been described as “pushing on a string.”

Here are two related questions that need to be answered.

1. Is the economy’s performance being undermined by high long-term rates?

Considering that interest rates are at very low levels already, it seems rather odd to claim that the economy will suddenly rebound if they get pushed down a bit further. Japan has had very low interest rates (both short-run and long-run) for a couple of decades, yet the economy has remained stagnant.

Perhaps the problem is bad policy in other areas. After all, who wants to borrow money, expand business, create jobs, and boost output if Washington is pursuing a toxic combination of excessive spending and regulation, augmented by the threat of higher taxes.

2. Is the economy hampered by lack of credit?

Low interest rates, some argue, may not help the economy if banks don’t have any money to lend. Yet I’ve already pointed out that banks have more than $1 trillion of excess reserves deposited at the Fed.

Perhaps the problem is that banks don’t want to lend money because they don’t see profitable opportunities. After all, it’s better to sit on money than to lend it to people who won’t pay it back because of an economy weakened by too much government.

The Wall Street Journal makes all the relevant points in its editorial.

The Fed announced that through June 2012 it will buy $400 billion in Treasury bonds at the long end of the market—with six- to 30-year maturities—and sell an equal amount of securities of three years’ duration or less. The point, said the FOMC statement, is to put further “downward pressure on longer-term interest rates and help make broader financial conditions more accommodative.” It’s hard to see how this will make much difference to economic growth. Long rates are already at historic lows, and even a move of 10 or 20 basis points isn’t likely to affect many investment decisions at the margin. The Fed isn’t acting in a vacuum, and any move in bond prices could well be swamped by other economic news. Europe’s woes are accelerating, and every CEO in America these days is worried more about what the National Labor Relations Board is doing to Boeing than he is about the 30-year bond rate. The Fed will also reinvest the principal payments it receives on its asset holdings into mortgage-backed securities, rather than in U.S. Treasurys. The goal here is to further reduce mortgage costs and thus help the housing market. But home borrowing costs are also at historic lows, and the housing market suffers far more from the foreclosure overhang and uncertainty encouraged by government policy than it does from the price of money. The Fed’s announcement thus had the feel of an attempt to show it is doing something to help the economy, even if it can’t do much. …the economy’s problems aren’t rooted in the supply and price of money. They result from the damage done to business confidence and investment by fiscal and regulatory policy, and that’s where the solutions must come. Investors on Wall Street and politicians in Washington want to believe that the Fed can make up for years of policy mistakes. The sooner they realize it can’t, the sooner they’ll have no choice but to correct the mistakes.

Let’s also take this issue to the next level. Some people are explicitly arguing in favor of more “quantitative easing” because they want some inflation. They argue that “moderate” inflation will help the economy by indirectly wiping out some existing debt.

This is a very dangerous gambit. Letting the inflation genie out of the bottle could trigger 1970s-style stagflation. Paul Volcker fires a warning shot against this risky approach in a New York Times column. Here are the key passages.

…we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4 or 5 percent a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes. The siren song is both alluring and predictable. …After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? …all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth. …What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate. …At a time when foreign countries own trillions of our dollars, when we are dependent on borrowing still more abroad, and when the whole world counts on the dollar’s maintaining its purchasing power, taking on the risks of deliberately promoting inflation would be simply irresponsible.

Last but not least, here is my video on the origin of central banking, which starts with an explanation of how currency evolved in the private sector, then describes how governments then seized that role by creating monopoly central banks, and closes with a list of options to promote good monetary policy.

And I can’t resist including a link to the famous “Ben Bernank” QE2 video that was a viral smash.

Volcker Unloads on Bankers

As reported in today’s Wall Street Journal, Paul Volcker, who is a former Fed Chairman and current adviser to President Obama, challenged bankers to produce a “shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy.”  Yet some of these innovative financial products brought the economy to “the brink of disaster.”   Profits in banking are being restored in part by playing financial brinkmanship once again.

How can this be?  Volcker focuses in on public policies that back excessive risk taking by bankers.  They and their stockholders garner the profits, but, through bailouts and government guarantees, manage to socialize the losses. That process is what economists call moral hazard.

He questions whether improved regulation can resolve the problems without serious structural change.  He repeats his longstanding policy of separating traditional commercial banking from what has been aptly termed casino banking. Casino banks must not be protected by the government.

Here is my suggestion for a start.  Hedge funds can serve a very useful function in the economy. But banks taking insured deposits should not be permitted to operate hedge funds in their institutions.  Most proprietary trading by banks amounts to an in-house hedge fund.  Separate the activity from banking.

Tough Words

In the Wall Street Journal, Mary Anastasia O’Grady got Dallas Fed president Richard Fisher to go on the record about current Fed policy. He talks tough about inflation. “Throughout history, what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can’t let that happen.”

What is lacking is a plan to match the tough words with tough actions. Only when a tough and resolute U.S. president, Ronald Reagan, was matched with a tough and resolute Fed Chairman, Paul Volcker, did the Fed turn into an effective inflation fighter. There is no such match up now in the face of trillion dollar deficits forecast with no end in sight.

Ms. O’Grady describes Fisher as “the lead inflation worrywart” on the Federal Open Market Committee of the Fed. But Fed officials do not act in a political vacuum, and regional Fed presidents cannot on their own stop the Fed’s printing money in the face of the deficits. That requires leadership at the top from both the Fed chairman and the U.S president.

The Administration’s plan appears to be “to print their way out of an unfunded liability.” Thus far, despite tough words from some quarters, the Fed seems ready to accommodate “the political class.”