Thursday, June 4, 2009

The Antichrist of Monetary Policy

Today, I want to talk about something that has been going around in my head for a while, but for some reason I have not written it down, so, here goes.

The Federal Reserve Bank can influence the growth of the money supply by using three basic tools of monetary policy. The first tool is OPEN MARKET OPERATIONS. Open Market Operations is the buying and selling of U.S. Treasury securities on the open market. If the Fed buys securities they put more reserves into the banking system, and, if they sell securities they take reserves out of the banking system. The second tool is the FED FUNDS RATE. The Fed can raise and lower the Fed Funds Rate to encourage more or less lending and thus influence the growth of the money supply. The third tool is the RESERVE REQUIREMENT for commercial banks. By raising or lowering the Reserve Requirement that banks must maintain, the Fed can again influence the growth rate of the money supply. The Fed can not control the growth rate of the money supply because if people do not want to borrow money the Fed can not force them to borrow. This is sometimes known as “pushing on a string.” You can push a frozen rope, but you can not push on a string. Try putting a piece of string on a table and pushing it with your finger. It does not work, and neither does the Fed. Let me explain.

The process of securitization of structured finance obligations, mortgage-backed bonds, etc., short circuits the Fed’s influence over monetary policy. When mortgages or any other structured financial obligations are bundled and made into fixed income securities, given the triple-A rating by the Credit Rating Agencies and sold around the world, the Fed has lost influence over the growth rate of the money supply. I do not believe that Chairman Greenspan fully understood this at the time it was happening. The more I read about Alan Greenspan the more I think he was an idiot savant. Greenspan’s interest in economics and his thing for numbers was no substitute for an understanding of the subtleties of monetary theory.

The financial bubble that was created was a direct result of the process of securitization of the mortgage market and the sale of mortgage-backed obligations to investors around the world. In essence, the Fed, our central bank, lost control and the resulting financial crisis that hit the United States and then the rest of the world began with the expansion of mortgage credit writ large by the world wide appetite for mortgage-backed bonds.

I guess if I am right, that would make me the Antichrist of monetary policy, but if it does so be it. There is a flaw in our Central Banking System, and until this flaw is recognized and dealt with, this flaw will come back to bite us all in the ass again.

Stay tuned.

1 comment:

Butch said...

Maybe this is why we have heard nothing from Mr. Greenspan since he left office. He's either wrinkling more in his bubble baths or taking a course in economics. My guess is the first.