Recent Fed actions won't help matters

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On Sept. 13, the Federal Reserve System’s Open Market Committee announced another monetary stimulus program: The Fed will buy $40 billion of mortgage-backed bonds per month until employment is deemed to have improved.

THIS PROGRAM joins two other similar failed efforts (Q1 and Q2). But unless the root cause of these failures is addressed, it, too, is very likely to fall short – not only fail, but accelerate the potential for an inflationary binge when, and if, the
economy moves into high gear.

The cause of the failure to ignite a recovery is a miserable lack of risk-taking private investments. It is this kind of spending that stimulates further activity in the economy and, what is most important, has the most direct impact on swelling private employment. While businesses have rosy plans for expansion, they remain on the shelves because of their perceived riskiness: Their attractions are discounted by constant White House threats of further tax increases, magnified by added class-warfare invective, and accelerated by current and future regulatory burdens. These actions are hardly tasty food for arousing “animal spirits.”

CONTINUED Fed bond-buying has several consequences. Yes, announcement of the bond-buying program does provide a short-lived spike in stock prices. Investors feel better. But what does the buying do to the Fed’s balance sheet? The initial result is an increase in assets, namely “bond investments.” This purchase is paid for by increasing reserves of local banks held at the Fed, a liability of the Fed. Quite miraculously, this is where the Fed finds the cash to pay for the bonds.

(Out of thin air? Yes, of course, which is one reason the Fed is such an object of endearment to politicians.)

Banking theory provides that these increased reserves at local banks will induce them to make more loans. But under current economic conditions, there is little in the way of improved lending terms that banks can offer to business borrowers. To cut this Gordian knot, President Obama must dramatically soften his rhetoric, eliminate his needless threats to risk-takers (I have yet to encounter one who has horns), and extend a cordial hand of friendship.

Meanwhile, over the period of the recession, the Fed sees its assets swell from about $1 trillion to $3 trillion (from Q1, Q2 and other special programs); and its liabilities (including local bank reserves) rise proportionately. Should an economic recovery pick up steam, the Fed is aware that these trillions of dollars in assets have the potential to wreck inflationary havoc.

THE READER obviously suggests: Why, at this point, doesn’t the Fed reverse this process and simply sell the bonds? By reversing the procedure, reserves of local banks would go down thus reducing local bank alacrity for making loans, and hence slow economic activity. But this process could halt the recovery! The Fed is keenly aware of this dilemma. It is confident, however, that it can maneuver the economy through these tricky shoals. Good luck.

More importantly, there is nothing in the bond-buying activity that directly increases entrepreneurial incentives to take added risks, to undertake risky investments or to increase employment.

What contributes to this dilemma is that Congress has placed two incompatible goals for the Fed to aim for: a stable price level, and full employment. The Fed cannot help but become cross-eyed attempting to ride two independent horses at the same time.

(The writer is a professor emeritus of financial economics at the University of Georgia. He lives in Aiken, S.C.)

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soapy_725 10/14/12 - 10:41 am
Two thoughts...

Full employment, 100%, is a myth not even attainable in a totalitarian state. Three to four percent is reasonably because of seasonal and transitional circumstances.

Taxation beyond about forty-five percent of gross income is unsustainable. The Laugher Curve. People will stop working and paying taxes when it become get one give one.

omnomnom 10/14/12 - 10:48 am
Dr. Beranek, thank you for

Dr. Beranek, thank you for this detailed explanation of how the federal reserve works, and how it is destroying whatever value or trust is left in U.S. currency.

socks99 10/14/12 - 06:06 pm
Beranek may understate the

Beranek may understate the perils of purchasing even MORE mortgage backed securities by the Fed!

Massive purchases of bonds bids up their prices in the same way mortgage securitization bid-up the prices of homes; a similar boom and then bust in asset prices may occur;

A steep decline in bond prices would create a steep rise in bond yields; and may provoke a U.S. currency devaluation and hyperinflation;

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