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I have been concerned about the Fed policy for years...

March 22, 2022

First, I want to thank Christopher Leonard for his book The Lords of Easy Money for his thoughtful thorough treatise on the history of the Fed. I have been concerned about the Fed policy for years, but this book beams a light of awareness around the flawed policies of the Fed for decades.

Let’s begin with why a Federal Reserve was formed. In the mid 1800s there were over 360 currencies. Almost every bank had its own currency. As a result, if your bank became insolvent, then your money was worthless. After the civil war, major banks were formed so the number of currencies shrank. 

It wasn’t until 1913 that the Federal Reserve was formed. Its purpose was the control of the currency. They became the lender of last resort. They were given the power to print money at will. They were also in control of the money supply. Increasing the supply of money stimulates the economy and decreasing the supply slows down the economy.

From 1913 to the early 70s, our currency was backed by gold. President Nixon, took that away so that there was nothing backing the dollar. This also meant that the Fed was now the only means of controlling the currency…which they did in spades in the 70s by printing a lot of money to help the economy during that decade. They were the principal reason for the high inflation at the end of the 70s. In 1979, the inflation had risen to 10.7% inflating not only consumer prices but also asset prices such as farmland and oil wells.

I think we need to study the 70s to understand where we are today. There was strong evidence that the Fed, during the 1970s, didn’t understand how monetary policy was affecting the economy and stoking inflation. Basically, the Fed kept its foot on the money pedal through most of the decade because it didn’t understand that more money was creating more inflation. Sounds crazy doesn’t it? They believed at the time that there were external forces, not them, of causing inflation such as labor unions and Middle Easter cartels. It took decades before economists revealed the truth.

By increasing the money supply, the Fed stoked demand for debt and loans, which pulls inflation higher. Cheaper money meant more loans, more borrowing and more demand for everything, which further pulled up prices. “Too much money chasing too few goods.”

What the Fed was doing (and currently doing) is addressing short term problems and leaving the long-term problems to grow. Paul Volker, the Federal Reserve chairman in 1980 had the courage and incite needed to solve the problem by increasing the short-term interest rates from 10% to 20% in just one year. As a result, asset prices plummeted. 

The biggest mess the Fed had to clean up was the failure of Penn Square, a bank in Oklahoma that had extended a chain of risky energy loans during the 1970s. When Penn Square failed, it almost took down the entire U.S. banking system with it. How does that happen? 

Leonard explains, “Penn Square was run by a guy named Bill “Beep” Jennings. He was the sort of person who drank beer out of a cowboy boot to impress clients, so it wasn’t surprising that he’d figure out creative ways to extend countless loans in an oil boom. Penn Square was an early pioneer of what’s called securitization, whereby the bankers create risky debt and then sell it to someone else. Penn Square’s version of securitization was the sale of a ‘participating loan.’”

What Beep did was make a risky loan then sell it to other banks and get most of the money back to lend again.  Each time the bank earned a fee with the actual risk of the loan default was on the other banks spreadsheet. Beep developed many complex webs of interlocking shell companies and partnerships. Between 1974 and 1981, Penn Square’s assets jumped from $35 million to $525 million. 

Paul Volker’s interest rate hike in 1980 killed demand for the loans and turned Jennings into a beggar. The Fed had to close Penn Square, but the problem was much more far reaching. What about all the participating loans? Many of those banks failed, but one of those banks was Continental Illinois National Bank and Trust. Continental had purchased $1 billion worth of these participating loans. The Fed had to extend over $3 billion in emergency loans to the bank and that was not enough. J.P. Morgan pulled together some lenders to assemble a $4.5 billion line of credit to Continental. At the same time customers pulled out $10.8 billion from the bank in one year. Continental was going to fail.

There were 2,300 banks that had money at Continental. You can see the problem. The Fed had to save Continental with taxpayer dollars and printing even more money in loans. The term “too big to fail” was voiced in Congress during this debacle. 

In 1980 the country went through a recession and in 1981 the country went through a recession with stocks faltering. What did Paul Volker's severe interest rate increase create?

Yes, it created mass bank failures and bail outs. And yes, our economy suffered with negative GDP for multiple quarters for two years. But this severe strategy also was the catalyst of one of the greatest bull markets in history. From 1982 to 2000, the markets averaged over 14% annual returns. During those 18 years, there was only one recession in 1990. There were only two down years, one down 2% and one down 6%. The right strategy can cleanse and create a healthy economy is the lesson.

From 1913 to 2008 the Fed gradually increased the money supply from about $5 billion to $847 billion. The increase in the monetary base happened slowly, in a gently uprising slope. Then between late 2008 and early 2010, the Fed printed $1.2 trillion. The Fed doubled the monetary base. Only 24 special banks have the privilege of getting this money.

In addition, the Fed slashed interest rates to zero, essentially for the first time in history. From 2010 to 2014 the Fed created another $750 billion dollars in the form of what Fed Chair Bernanke called “quantitative easing.” This was an experiment and not tested.

The idea was that the Fed would buy Treasury Bonds from the banks with this money. Since interest rates were essentially zero and since the Fed cornered the market on 10 year Treasuries, the banks were relegated to lending the money and doing so with risky loans. This would benefit a small group of people who owned assets, and it would punish the very large group of people who lived on paychecks and tried to save money. This did more to widen the divide between the rich and the poor. In addition, it began to create what we saw in the 1970s in the last decade.

What we saw in 2008 collapse of the markets was not just the Fed rescuing the economy because it bore a great deal of responsibility for the collapse.

So what are we currently facing?  “In many important ways, the financial crash of 2008 had never ended. It was a long crash that crippled the economy for years.  The problems that caused it went almost entirely unsolved. And this financial crash was compounded by a long crashing the strength of America’s democratic institutions. When America relied on the Federal Reserve to address it economic problems, it relied on a deeply flawed tool. All the Fed’s money only widened the distance between America’s winners and losers and laid the foundation for more instability. This fragile financial system was wrecked by the pandemic and in response the Fed created yet more money, amplifying the earlier distortions.

The long crash of 2008 had evolved into the long crash of 2020. The bills are yet to be paid!”

Bottom line is that the Fed needs to increase interest rates to 2% immediately and begin to take money off the table by selling much of the bonds they hold. This will create an environment where the wealthy do not get easy loans but will create a fair environment for us all.

This is not my final word on all of this, but I thought you might want to know why I am concerned and why I talk about the Fed so much. I love feed back so please get back to me if you have comments. 

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