Todd Suomela's Library tagged the-fed →  View Popular, Search in Google

So far, so good. Except, there's a hole. That hole is that the Fed hasn't followed the simple "Taylor rule." In fact, there's been a significant gap between Taylor rule and interest rates. Or more exactly, two of them.

 

The first was between 1994 and 1998 -- the Fed was consistently above the Taylor rule. This lead several more left-leaning economists to call for lower interest rates to get more growth. The second was between 2001 and 2008 - the Fed was consistently below the Taylor rule. What a coincidence. So the argument that the Fed was a transparent carrier of the economic demand for funds breaks down. The other point is that there is a simple explanation for all three - short term rates, inflation, and budget deficits moving in tandem over the last 10 years, namely that they represent the same thing, not a  market that is clearing, but three different forms of the same thing, namely, risk aversion.

The reality is that Federal Reserve interest rates, government bond auctions, and federal budget deficits all have one thing in common: they aren't markets in the sense of "many independent actors making independent decisions." The Fed's decision is in the hands of a few people, most of the buyers of government treasuries is a small number of large players, and of course, the Federal budget deficit is written by a few hundred people and their staff members. These are not large markets, but small ones. Hillary was pilloried for saying that it takes a village to raise a child; but the evidence here -given that the results of the last 10 years have been a market crash, a terrible recovery, and a massive global downturn- is that it took "The Village" to raze the economy.

The central bank was undermined more gravely by further deregulation, which encouraged the migration of lending functions from traditional bank loans to market securities, like the bundled mortgage securities that are now rotten assets.

Central bankers attempted to fix the problem, but they may have made it worse. In the late '80s, the Fed and Wall Street leaders, joined by foreign central banks, created an international regulatory regime that requires banks to hold greater levels of capital instead of bank reserves. Reserves are the Fed's traditional cushion for ensuring the "safety and soundness" of the system. Banks were required to post non-interest-bearing accounts on their balance sheets to backstop deposits and as the means for the central bank to brake bank lending. It was assumed that the new capital requirements would do the same. Instead, the so-called Basel Accords (named for the Bank of International Settlements in Basel, Switzerland) applied very little restraint on lending but created an unintended vulnerability for banking. The new rules have acted like a pro-cyclical force--driving banks into a deeper hole as the crisis has spread because bank capital is destroyed directly by the mounting losses from market securities. The more banks lose on their rotten assets, the more capital they have to borrow from wary investors, who understandably refuse to play. That spreads the panic and failure that governments are trying to cure with public money. 

 

  Meanwhile, acting at the behest of bankers, the Fed has practically eliminated the old safety cushion by allowing reserve levels to fall nearly to zero. Bankers complained that reserves were a drag on profits and were no longer needed given the capital rules. In a shocking new arrangement, the Fed, with approval from Congress, has started to pay interest to the banks on their reserves. The commercial banks already enjoyed privileges and protections from the government that were unavailable to any other business sector. Now they insist on getting paid for their public subsidy.