Ben Bernanke Loses Control of the Fed

Originally published on The Agonist


It took a while, but the financial markets are starting to realize that Quantitative Easing will end next month, possibly once and for all. The unprecedented amount of monetary stimulus being pumped into the global economy by the Federal Reserve will come to a sudden halt. Commodity markets have enjoyed a bubbly expansion since the QE2 program was announced, and they were the first to crumble when the Fed began removing the monetary supports. Stock markets are now slowly beginning to follow suit.

One reason the markets took the news sanguinely was because the Fed engineered it that way. After the May meeting of the Fed Open Market Committee, at which it was decided not to renew QE2 when it expires in June, Ben Bernanke gave a first-ever press conference by a Fed Chairman following an FOMC meeting. The media thought it was a masterful performance – which it was, but not for the reasons cited in the press. Bernanke made it sound as if the end of Quantitative Easing was the most natural thing in the world, and that all the voting members of the FOMC agreed with him. The fact is, the FOMC decision was a defeat for Bernanke and his allies, which included the two other officers of the FOMC, Janet Yellen (Vice Chair of the Fed Board) and William Dudley (NY Fed President). Dudley, just a week before the meeting, had gone public with his desire to have a QE3 program standing by, ready to aid a struggling economy.

Bernanke Loses Control of the Fed

Bernanke is the creator of the QE programs. He is the so-called “expert on the 1930s Depression” who has decided the Depression was made much worse by the Fed’s refusal to add liquidity at the time. Bernanke is determined not to make that mistake, and there is no denying he has poured trillions of dollars into the economy since the crash in 2008. He has spoken highly of the success of the QE programs, and hinted that another round of easing would be forthcoming if it was deemed necessary.

His problem is that an easy case could be made that QE3 is necessary immediately. Most economic forecasters in the US expected real GDP growth in 2011 to average around 4%, but the first quarter has come in at 1.8% and the second quarter looks weaker still. This is exactly what happened in 2010 when the first QE1 program ended, except then the weakening occurred after the program ended, making it appear as if the US economy was completely dependent on Quantitative Easing for growth to occur. This time the second program hasn’t even ended and weakness has already set in. What is the culprit now?

The Fed is blaming the earthquake in Japan for disrupting first quarter global growth, plus droughts and other natural disasters which didn’t help. The problem for Bernanke and his allies on the Fed is that hardly anyone is buying this argument. Most financial analysts, economists, and CEOs are blaming inflation for the global slowdown, and specifically, the high price of food and energy. This is the same set of circumstances that undermined the economic recovery in 2008 and brought about the financial crisis.

Bernanke has been touting the slow growth in “core inflation”, a Fed construct that removes food and energy from the price and deflator indexes. Bernanke also lauds the nearly 100% increase in the stock markets since March 2009, something he says was a deliberate outcome of Quantitative Easing. Wall Street has certainly benefited from this engineered stock market rally, as have fine art auctions, luxury auto sales, and mergers and acquisitions. Unfortunately, most everyone else in the global economy is suffering. Wal-Mart’s CEO has said that his customers are “broke” at the end of every month, leading to eight consecutive monthly declines in store sales. The high price of food and energy is eating away at Wal-Mart’s margins, and margin compression has now spread throughout the retail sector and is beginning to affect many other consumer sectors.

The explosion in commodity prices can be traced directly to the announcement in July last year of the QE2 program – to the day, in fact. The financial and commodity markets from the outset did not trust this program to perform as promised, since the first one didn’t keep interest rates down as was the intention. Many traders feared the inflationary if not hyper-inflationary consequences of so much monetary easing, and whether they brought about the inflation by buying up commodities as protection against future price increases doesn’t really matter. Inflation was the result.

Global inflation has hurt countries all around the globe. China has complained bitterly about it, and there is good evidence that the upheavals in the Middle East have been ignited by high food and energy prices. The press was at first questioning the wisdom of Bernanke’s policy, and then began to blame him directly for problems that were arising everywhere. The six other governors on the Federal Reserve Board, and the 12 presidents of the regional Fed banks, noticed as well. One after another of them, starting late last year, began to complain publicly about inflation. Several of them called for an immediate end to QE2, and refused to endorse any extension of the program into QE3.

By May of this year, Bernanke and his allies were on the defensive, and QE3 was on the ropes. At the FOMC meeting last month, what had been a unanimous board vote to initiate QE2 became a unanimous vote to end it and not renew it. Whether this was a crushing defeat for Bernanke or just a defeat is hard to say, but to avoid embarrassment, he joined with the majority in voting to end Quantitative Easing once and for all. The Fed Chairman, after all, always has to vote with the majority in order to appear in control.

Can Bernanke Recover?

How much control of the Fed has Ben Bernanke lost? We have never had a Fed board in living memory that has been so fractious in public. The Fed has always had a party line and governors and presidents are expected to have all speeches cleared in advance to ensure the party line is followed. With this Fed, so many FOMC members have come out in opposition to official policy that you have to wonder if there is a party line left any more. To the extent it revolves around Quantitative Easing, it is in a shambles.

One other sacred tenet of Bernanke’s tenure has been the assertion that core inflation remains under control and inflation expectations are tame. Bernanke has repeated this statement over and over, and it is not that it is untrue. The problem is the statement is irrelevant. People and businesses don’t deal with core inflation – they deal with real inflation, which is hurting almost everybody and appears to be out of control, or at least out of control until inflation so damages the real economy that prices peak and begin to fall (which may now be happening).

Anyone who has lived through the 1970’s bout of inflation remembers that the Fed had a similar core inflation concept that blinded them to the effects of real inflation until it was too late to control it. The obvious move would be for the Fed to abandon the whole ludicrous idea of core inflation, and this past week one Fed president – James Bullard of the St. Louis Fed – made exactly that argument. He represents a voice of reason at the Fed, but more important, a direct challenge to Ben Bernanke and his way of running things. Yet again, we are watching the Fed Chairman be outflanked by his own board members.

With this background, we have to deal with the question of whether Bernanke can recover. He is certainly adept enough politically to remake himself into an inflation hawk as if Quantitative Easing never existed. But time may be on his side and make this transformation unnecessary. The US economy is heading into the summer months on a very weak footing, and possibly flirting with recession once QE2 ends. If recession returns, and if it becomes severe or prolonged, the political pressure on the Fed is going to mount to revive the economy. The Congress, or at least the Democrats in the Congress, are going to want a strong economy heading into the 2012 elections, as certainly will Barack Obama. The Fed has always accommodated the White House in revving up the economy during a national election year (hence the four year “presidential cycle” evident in the stock market).

We may assume, therefore, that in such a circumstance the pressure on the Fed will be intense. Will it be enough for Bernanke to reestablish his dominance and bring about QE3? He certainly will feel the pressure – he is the public face of the Fed. The rest of the governors and regional presidents work in relative obscurity, making speeches occasionally to local business groups. If they are convinced that another round of Quantitative Easing will be yet another miserable failure, causing higher interest rates and even worse inflation, they might easily stand up to Bernanke and hold their ground.

They would be joined in this regard by the Republicans in Congress, some of whom are already deeply suspicious of the Fed and its money printing ways, and a few of whom want the Fed abolished altogether. The Republicans have every political reason to allow the economy to sink into a recession or worse by 2012, as long as it happens naturally, and they cannot be blamed for causing it. Doing nothing, which means passing the minimum amount of funding legislation as possible, and keeping the Fed out of the Quantitative Easing game, would be the perfect circumstances for Republicans anxious to drape the next recession around Obama’s neck.

Finally, there are the markets themselves. Establishment of QE3 might lead to an initial burst of optimism for the economy, and a concomitant replay of QE2, where stock markets rise, the dollar sinks, and commodities rally. Equally, the markets could take this to a panicky extreme on the grounds that QE3 is an inflationary bridge too far. There could be an immediate bubble in safe assets, including gold, but possibly also the dollar in the form of cash, and hard assets like commodities, art, etc. The stock market could collapse under the weight of hyper-inflationary expectations. Markets never repeat themselves exactly, so QE3 is a very high gamble for Bernanke and the Fed, as well as a very dangerous ploy for the global economy and financial markets.

The Not Very Mighty Fed

Oddly, the easiest way out for the Fed would be to do what it should have done in the first place: declare its impotence. Maybe this is no longer possible, since the Fed has spent decades building up its reputation as the mighty mover of the economy. The reality is that the Fed under normal circumstances is the very limited mover of short term interest rates. Of course, it could have done a much better job of monitoring and regulating the banks, but don’t expect that much honesty from the Fed. What it could say is: “We tried everything possible, including extraordinary steps like Quantitative Easing. We have reached the bottom of our tool kit. It is now up to Congress to do what it can to stimulate economic growth.”

For the ultimate in candor, the Fed could simply say that there is too much debt in the American economy – with the federal government, with state and local governments, with corporations, and with consumers. Until this debt is liquidated, which means massive defaults and possibly depressionary conditions, the economy will not recover.

The problem is everyone in the Fed knows who that sounds like: Andrew W. Mellon, Secretary of the Treasury under President Herbert Hoover at the time of the Depression. Mellon advised Hoover to:

"Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.

We all know that Andrew Mellon was wrong; all the experts tell us so. Just ask Ben Bernanke.



Barney Frank is trying to remove voting rights

of the regional Presidents, giving more the Fed chair and NY Fed President, which is frightening. He has a bill up.

Is Debt Really the Problem?

If we have to wait until there's no debt in America for the economy to recover, we'll wait forever, won't we? Also I keep seeing that corporations have $2 trillion in idle cash on hand.

I am not saying debt is good, just thinking there must be more to it. Or was Andrew Mellon not as wrong as people thought? It seems to me a prescription of reducing debt, while putting ourselves on a road to economic and job stability and sustainability would require sacrifice, is just about right for us.

I've certainly been thinking it's necessary since before Obama was elected and have been alternatively amazed and disappointed to see how nobody in charge is even suggesting we do what's necessary for our future. The more I think about it, the more maybe I'm a "Mellon Light" advocate.

I hope some people here who know more than me can shed more light on all this.

I should not have implied all debt needs to be liquidated

It is the debt taken on by improvident borrowers, and granted by imprudent lenders, that needs to be liquidated. The borrowers may have to head into bankruptcy, though underwater homeowners might be able to avoid that extreme if they merely hand the keys of the home back to the bank. The lenders will have to absorb very large write-offs of bad debt, and some of these lenders may not make it through the depression. The collapse of so much credit in the economy is certainly one definition of a depressionary event.

Mellon's advice was taken by Hoover, and it was the liquidation of the banks and subsequent loss of much of the national savings that made the Depression a defining social, political, and economic event. We have a way today to liquidate the banks without destroying national savings, if the US were willing and able to keep the FDIC afloat through potentially trillions of dollars of payouts to consumers on their deposits in fallen banks. We have wasted so much money on bank bailouts that don't really clean up the problem, that it is a question as whether the US could pull on enough resources to keep the FDIC going. This should have been priority number two.

Priority number one should have been to avoid the debt build-up in the first place. This is the only real answer to the problem, and of course is too late for the US and many other countries. This tends to make Mellon's advice moot. Mellon's liquidation scenario will come to pass one way or another. We can take the dramatic road of the 1930s, or the slow road to perdition that the Japanese have been on. Once the debt implosion begins, your only choice left is which road to travel.

"Some say that I'm a dreamer"

Very well written and reasoned. Thanks (I think;). The Fed as activist with Congress and the president on the sidelines is truly anomalous. You hit on a key point, one that will be our epitaph:

"Of course, [the Fed] could have done a much better job of monitoring and regulating the banks..."

Why couldn't the Fed regulate? We have the president of the NY Fed, the one regulator most responsible for the lapses in banking, in charge of Treasury. He's there to cover up and dissemble so that he and his pals don't take the blame and reap the whirlwind of anger that has yet to be expressed.

Just using U-3, there's a workforce of 154 million and an employment figure of 138 million. What if most of those 16 million find real work? Won't that dramatically alter the equation, maybe enough to avoid the roller coaster to Hell or the longer road to perdition?

How about using the American Association of Civil Engineers 2009 report care on infrastructure, a $2 trillion price tag, to generate employment and sell some bonds actually attached to something concrete?

Just asking...

Mellon was right. Ron Paul is

Mellon was right. Ron Paul is right. The Fed is evil. They give all the new money at almost 0% inbterest to their bankster buddies who turn around and loan it directly to the government at 3.5% interest as a safe way to recoup their stash lost through devious practices. The banks should have been left to fail. All of the bailouts should have never happened and all that debt liquidated out of the system. We would already be out of the mess right now if this were done. Inflation is the most evil form of taxation because the rich banksters are given the new money and are able to spend it, after they use the government to multiply it, at a period before prices rise. This is why there are sharp increases in sales of extravigant items as the cheap money begins its long journey to the poor. The poor are met with high prices long before any kind of wage increases are thought of, and the gap between rich and poor widens further. It is such an evil cycle that these crooks play out over and over again.

Fed Partnered, not regulated, the banks

New Book, review on HuffPo by NYTimes writer Gretchen Morgenson.

The problem is, we've all written our fingers off detailing this and nothing happens in D.C.

Problem is THE People

The Problem is THE People
We have a government that is elected by the people. No one forces them to vote for e.g Barnie Frank. The autoworkers were thanking and praising Obama yesterday. They will donate to him and vote for him. When the people want change, they have the means to get it. This is not Egypt etc. The Constitution is a brillient document.

The question is: Why don't the people use it? To my mind, the answer is "Bread and Circus". They have necssities (food) and television (circus). Obesity is a problem and there is 24/7 sports, movies, etc. on TV.

Volatile economy?

Just finished 'The (mis)behavior of Markets (Mandelbrot/Hudson).

Seems there is good reason to question if those (supposedly) in charge of financial matters actually understand risk.

As important, do voters (anywhere you can vote) question the ideas and policies of those ( supposedly) in charge?

Should not the approach of modern science be at least made public, even if controversial? Maybe help with all the surprises in the financial news. Just a thought.

Name Change

Well, how about if we just start by changing it's name. Since 99.9% of Americans have been duped into thinking that farce is actually a government agency, I propose this as a new name:

The Cabal Of Private Bankers Partly Owned By The Rothschild Banking Family And JP Morgan Which Was Given Control Of The Public Currency By Congress On Christmas Eve 1913 In The Middle Of The Night As Congress Voted With One Hand And Opened Their Little Envelopes Of Goodies From JP Morgan With The Other Reserve

Kind of has a ring to it.

Ring it

That name is longer that most sentences written by Max Weber, and that's saying something. Cover's the waterfront;)

It has a Proustian ring to it


Insightful article

First, thank you for the time and effort you put into this superb article. Second, the way you shed light on the inner workings of the Fed and it's fractious existence is a real eye opener. I am struggling with my next article that is going to review the QE and QE2 aspect of our stagnant economy and have been reviewing the Keynesian economic and IS/LM model's to get a better handle on why this failure occurred. Many video's and article's portray Ben Bernanke as a failure and ill trained for the position he holds but truth be known the spin that's resonating from all my research is this:
All the models employed by the Fed have had one stonewall that has stymied any possibility of success - Greedy, self-serving and hideous robber baron bankers.
The multiplier effect of the IS/LM model (circular flow model) assures that if the demand for their product exists and construction laborer's wages ignite a growth in consumer demand and spending then quantitative easing should have invigorated our economy. The one missing component for success to occur was that the banking community needed to be gracious to their benefactors for assuring they remain breathing, working, social pillars and lend money. Alas, they are at best indignant and at worse criminally liable for stealing U.S. taxpayer money. Both for accepting quantitative easing funds and then QE2 qualitative buy back of toxic debt by the Fed to bolster their confidence to lend to the public then turning their backs on us; the taxpayer and the Fed alike. Now with the Fed trying to slap some sense into this sector with the purchase of 10 and 20 year bonds to lower the interest rate on them and eliminate the 2.75% interest providing an easy(and safer) solution to pay back the remaining toxic assets on the books opening the door for a double dip recession. What are we to do with this knowledge and the realization that Republican's and Democrats are in this power play mode?

Certainly the finance sector is not behaving as it used to

I think the Fed, and thus their models, have many problems with the banking sector.

1) The sector is more bifurcated than ever before. There are thousands of community banks that were shut out of the home mortgage securitization process by the big guys, and so they concentrated on commercial real estate. They are now saddled with a heavy load of non-performing CRE loans, which is impairing lending to all their customers, including individuals.

2) The big banks are a mess. They have been consolidated into only four players, of which Citigroup and BOA are likely zombie banks propped up by distorted accounting rules. Wells Fargo may be in that camp as well - it has the worst accounting disclosure so it is hard to tell. JPM Chase looks healthy but like the others you never know as long as mark to market of their "investment" assets is suspended. Either way, none of these banks is lending, which suggests they remain fearful of loan losses on existing assets, and can't find creditworthy customers given their tightened credit standards.

3) The securitization process that constituted the core of the shadow banking system has not and probably cannot be revived. That takes out 30% or more of credit from the economy, which means we are trying to generate 2011 growth on a 1995 credit platform or maybe earlier (1990 arguably, which is when securitization began).

4) Before securitization, banks held on to almost all of their loans to maturity. They are clearly not willing to run such risks these days, or if they are it is for far fewer customers, which means the banks will not step up to replace the credit lost in the securitization process.

5) The investment banking industry has collapsed and left only two players - Morgan Stanley and Goldman Sachs, both of which were converted to commercial banking status to remain alive. However, both of them refuse to act like commercial banks and create a loan portfolio. Hence, another lost opportunity for credit creation.

6) The big banks refuse to adjust their expectations on profitability in the new environment. If we are back in a 1990's credit environment, ROEs should be on the order of 8% - 10%. Instead banks fully expect to earn 15% to 25% ROEs, which means they are forced to assume excess leverage, keep their loan loss reserves at artificially low levels, depend on bogus accounting standards to hide losses, and continue their games of equity extraction, asset stripping, and rentier activities (see High Frequency Trading) as a means of producing income that exceeds by far what could be earned on a basic loan portfolio. In other words, loans are still very poor earners for executives expecting $15 million annual bonuses, and so banks refuse to book them.

7) The Fed, if it isn't owned outright by banks through regulatory capture, is at least clueless on how to reform the banking industry. Congress, which is owned by the banks, is uninterested in fundamental reform.

Now how you put all this in a model, I don't know, but let's look at a very interesting irony here. Corporations have been engaging in global labor arbitrage for nearly 25 years, shifting jobs away from industrialized countries to emerging markets. As this cycle plays out over time, logically these corporations should see their ROEs shrink to levels typical of companies in less developed economies, which must deal with poorly educated work forces, high costs of pollution (including bottlenecks in the transportation network), costly government bureaucracy driven by bribes and other corruption, and rigged political and legal systems. Now, notice how these conditions are increasingly being applied in developed countries, the US being a prime example, where the political system is increasingly distorted by campaign financing corruption, the legal system is being subverted in favor of corporate interests at the highest level, pollution standards are weakening, and the labor force is being dumbed down. In such an environment, a corporation can achieve 15% or high ROEs consistently only if it turns itself into a crony capitalist enterprise. CEOs have to become like Carlos Slim, and instead of being faceless managers, they take the company private and become entreprenurial owners. The leveraged buyout system is essential for this process to work, but it is currently constrained by the lack of credit. Therein lies the irony. Without credit the process that was in place up until 2008, of converting industrialized economies into third world economies, is stalled. Companies will have to settle for old-fashioned, mediocre returns and minuscule bonuses if they can't get the credit machine revived.

Here too, I don't know how you model this. Just make sure the models remove a huge part of credit availability, and reduce expected corporate returns. Also, if corporate returns are reduced, so too will be investment returns, so make sure your model adjusts downwards the contributions pensions will play in the economy.

Securitzation and EEs

How do we quantify this as sucking the life blood out of the economy, in terms of historical data, percentages.

I know you are right and EE's esp. it's this "herd" mentality, they all rush in to "invest" in some "predetermined" EE, such as Brazil and it's almost like a "fad" so what are their real returns? I imagine China is absurdly profitable, but what about Vietnam which I think was EE du jour, Thailand, we know what happened there, I think Russia in a way was also at the first collapse....

Then, securitization is the scourge of the Earth, they turned people's homes into baseball trading cards and we're seeing the fall out from unstable home prices to the fraud going on with foreclosures.

It's more profitable to trip someone up and foreclose than to help them get current on their payments.

You've got multiple articles in these comments!

There are some data on shadow banking

I've seen a chart a few times - I don't remember where - that places securitization volumes on top of Fed C&I loan data. I'll try and drag it up. It is not quite what you want, because it doesn't encompass the multiple credit extensions that existed through both securitization and the use of derivatives as hedges of credit risk. A daisy chain of risk was created from bank to bank around the globe on each original security, and it was this pyramid of credit that collapsed. It's very hard to figure out how much credit was involved, because for example there were such things as CDOs squared which required very large amounts of underlying securities in order to hedge. Then, there were synthetic securities - imaginary bonds that were never issued by any company but were nonetheless the basis for some derivative transaction. That is still going on, by the way.

One reason the Fed never took this seriously is because it did not believe shadow banking had the power to extend credit. Fed economists got into long discussions from 2000 - 20004 with people like Doug Noland, who insisted that shadow banking was every bit as responsible for the explosion in credit as the banks themselves. The Fed was all hung up on its understanding of reserve banking and the multiplier, and lost sight of the reality of credit creation. I think it was only in 2006 that they finally conceded the point. I suspect at some institutional level the Fed knew credit creation was out of control and they wanted to distance themselves from responsibility for the eventual crack-up. That is why they stopped publishing M3, which very clearly showed the effects of shadow banking on the money supply.

My own impression, having been in the thick of banking and derivatives from the beginning of the product, is that around 1995, but sooner for some NY banks, the large banks moved away from keeping loans on their books and began to sell them off to other banks and to investors. This started out slowly, but by 2000 the securitization structure was in place whereby the big banks could keep but a fraction of any large corporate loan or mortgage portfolio that they booked. In fact, approvals on these deals were based on assurances from the loan officers and syndication specialists that a particular amount would be sold in the market. The game of course was to reduce assets, shift revenue away from interest income and on to fee income from churning loans through securitizations, and maximizing bank capital. The end result was that many more loans could be done than previously when the banks had to keep them entirely, and a pyramid of credit could be created through derivatives on top of these loans.

What has to be appreciated is that, since 2008, we are operating in the pre-1995 world. Some securitizations are coming back into the market, but only a fraction of what used to be done, and at much different pricing now that people see the true risks. What also has to be appreciated is that if the big banks want to revive securitization, they will need much higher levels of capital, because the passing of credit risks from one bank to another to another created enormous systemic risk that was never properly priced in the system. Capital may need to be 20% of assets, not 12%. This is about as onerous as the system we have now, where banks can operate with 12% capital levels, but securitization is dead and they therefore have to keep 100% of their loans on their books. Either way, the global lending system is grievously constrained, placing us somewhere back 15 years or more. Imagine what sort of burden that is on the global economy.

Numerian find the data, I can make the graphs

Find the databases and I can put together the graphs. We can also show correlation, I can do regression analysis and so on. We can talk offline about getting some "big picture" data. I wrote up many a piece on derivatives, all during 2008/2009 and then of course we cheese called "financial reform". So a deep research piece on where we are now, with data, would be really useful.

Maybe data on the financialization of America and global capital flows would be useful too. I can show, by industry and percentage of GDP, but the data is at best 1 year old. (BEA).