Fisher Investments Editorial Staff
Politics, Reality Check

Independent for a Reason

By, 10/01/2014
Ratings194.394737

Let’s play a fun little game. Pretend you’re out on Main Street talking to the average Joe and Jane about the economy. You ask them, “what is the best way to make growth higher and financial crises less painful?” Chances are they would probably say something like, “make it easier for my next-door neighbor Bob to get a loan to open his second trinket shop.” Or, “make powerful people do whatever they need to do so folks don’t totally freak out and start a bank run when things look bad.” In our experience, they would probably not say, “Put a bunch of unelected political officials, central bankers and bureaucrats together until they figure it all out.” Yet this is the conclusion some academics arrived at in a widely publicized new paper. After exploring alleged conflicts between Fed and Treasury policy in recent years, they decided the two should just coordinate already so we can all be better off. Yet reality isn’t so simple or shiny. Their solution invites politicizing the (theoretically) independent Fed—and as we saw firsthand in 2008, when these two bands collaborate, havoc ensues.

Our merry band of academics (including former White House economic adviser Larry Summers) focused their analysis on the Fed’s quantitative easing (QE) program, which they see as de-facto “debt management policy.” In their view, the Fed’s long-term bond purchases pulled down long-term rates by deliberately shortening the US’s average debt maturity, but the Treasury effectively worked against them by issuing more long-term debt—extending average debt maturity—and inadvertently boosting interest rates.[i] Now, from a transaction standpoint, we guess this is factual—but philosophically, it misses. Debt management implies trying to, you know, manage the debt. In the Fed’s case, this would imply buying bonds directly from the Treasury at auction—actually funding the government. But all the Fed did was buy existing bonds on the secondary market, a simple financial transaction. Just as its purchases of long-term mortgage-backed securities weren’t a form of household debt management, buying Treasurys isn’t government debt management. More broadly, as the analysis pertains to interest rates, we see the point that there were conflicting supply-side policies, but the notion the Treasury should have mirrored the Fed, or they should have joined for some sort of super QE, is wide of the mark (see our general thoughts on QE here, here and here.)

Setting QE aside, the notion the Fed and Treasury are a match made in heaven is patently false—we saw that in 2008, and the partnership clicked about as well as Dewey Leboeuf. This was emphasized in a recent New York Times article, which re-examines whether Lehman Brothers had to die. On the day it went bankrupt, Lehman’s assets exceeded debt. It just couldn’t meet short-term funding obligations because of FAS 157’s impact on collateral. As Matt Klein nicely explained in this Financial Times article, Lehman was illiquid, not insolvent.

Fed people have always maintained publicly they were powerless to rescue Lehman. But transcripts of the Fed’s morning-after meeting show Fed head Ben Bernanke, Treasury Secretary Hank Paulson and their cohorts simply decided not to fund potential Lehman buyers, going against their decision to help JP Morgan buy Bear Stearns under near-identical circumstances that March.

Now, when a bank has a liquidity crisis—also known as a bank run—the Fed’s traditional role is to be “lender of last resort,” filling the funding gap at a higher interest rate for as long as the bank needs help, provided they have the necessary collateral. The Fed had a program to do this for Lehman, called the Primary Dealer Credit Facility, established March 2008. If the Fed were focused solely on fulfilling the purpose it was created for after the panic of 1907—lender of last resort—we strongly suspect it would have provided liquidity during Lehman’s bank run.

But the Treasury’s involvement introduced political concerns—like the need to convince voters politicians weren’t bailing out Wall Street at the expense of Main Street. From the transcripts, it is clear this mentality influenced the Fed’s decisions. We have no counterfactual, so we’ll never know, but it is difficult to envision the Fed denying funding to Lehman or its potential buyers (i.e., Barclays) if the Treasury weren’t intimately involved. The Fed outsourcing crisis management invited political concerns to take precedence over actual precedent and common sense.

Now that’s all speculation. But we do know the Fed and Treasury were in cahoots as the crisis spiraled—and panic stemmed from their inconsistent actions. The Fed helped fund JP Morgan’s shotgun wedding to Bear Stearns but refused to supply Lehman’s dowry—despite Barclays’ willingness to buy. Government entities Fannie Mae and Freddie Mac and insurance giant AIG were nationalized, wiping out shareholders. Goldman Sachs and Morgan Stanley were allowed to convert from investment banks to bank holding companies overnight so they could tap the Fed’s emergency discount window. The Fed crafted wacky bailouts designed at first to buy assets incorrectly deemed toxic; then shifted to buying preferred equity stakes in banks; then created new Fed-brokered vehicles to buy these “toxic assets,” only to discover the banks wouldn’t sell. And the Fed never once used time-tested crisis remedies like reducing the reserve ratio requirement or dropping the discount rate below fed funds. The Fed and Treasury stood shoulder-to-shoulder on all these deals. We fail to see how this improved policy.  

We see this kinda like Fed Governor Jerome Powell—any coordination between the Treasury and Fed threatens the latter’s independence. Allowing the cabinet to influence the Fed’s behavior can lead to haphazard measures designed to keep voters happy, regardless of what makes most sense economically and according to the Fed’s mandate. The risk is apparent during expansions too. You could get the administration telling the Treasury to tell the Fed to cut rates before an election, regardless of what economic conditions warrant. This happened in Hungary, and it isn’t pretty there. You see it in Brazil too, where President Dilma Rousseff has continually tried to goad the Banco Central do Brasil (BCB) into suboptimal policies seemingly to score political points. America is best off with an independent Fed that isn’t coerced into making moves for the administration’s political gain. Far be it from us to say central banks make perfect decisions. But politicizing matters makes them even worse.
 

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[i] Yes, boosting, that is their argument. Because the sub-2% 10-year Treasury rates seen for most of mid-2011 through mid-2013 weren’t low enough.

 

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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