Democracy and accountability

Megan McArdle has a very interesting piece addressing the legitimacy of the Fed's aggressive, central role in the policy response to the ongoing financial crisis:

But here's the problem: the Fed has performed vastly better on any
metric except "being elected" than the Congress. There's little doubt in
my mind that if we had not had an independent central bank, unemployment would
be many percentage points higher, GDP would have contracted much more strongly,
and we wouldn't now be making optimistic noises about the thing bottoming
out...

I think that the political process will hopelessly screw up the
management of this crisis (something which libertarians are perfectly able to
see when the government screwing things up is a left-wing populist one in Latin
America). But maybe The People, God bless them, deserve to screw up their
economy if they want. On principle, I am opposed to saving people from
themselves. And anyway, maybe I'm wrong and the wisdom of crowds will
prevail.

On the other hand, do they have a right to screw things up for everyone
else? Should a populist 60% be allowed to plunge their neighbors deeper
into crisis? In the case of America, to plunge the whole
world deeper into crisis?

The uncomfortable conclusion I'm coming to is that yes, they
should. Ben Bernanke should be hamstrung even though it's likely that this
would make everyone worse off. And people who advocate for ending the
independence of the central bank should be willing to accept all that this
entails: inflationary monetary policy (the people love inflation!), bad
and unpredictible banking policy, the collapse of the US economy. I just
wish I didn't have to go along for the ride.

Huh? I don't follow her logic at all. A modern democracy is a sophisticated political system. For some specialist functions like monetary policy, undemocratic actors do a much better job. In such cases, democratic lawmakers can voluntarily cede authority to an institution that's insulated from political pressure.

But here's the catch. No one's saying they couldn't take that power back if they wanted to. The Fed's only independent because elected lawmakers chose to make it so. They did this because they judged it to be in the long-term interests of the country.

So do we still have to hamstring Ben Bernanke? I'm just asking. He seems like a pretty nice guy.

Update: By sheer coincidence, Dave writes almost the exact same post at IPE Journal. Really, it's kind of spooky how similar they are.

Be afraid, be very afraid

This is the single most frightening passage I've read since Lehman Brothers fell. If it's true, then it sure gives credence to the doomsday prophets.

On C-Span, Rep. Paul Kanjorski (D-PA) explained how the Federal Reserve
told members of Congress about an electronic run on the banks "to the tune of
$550 billion dollars" within "an hour or two" last fall. According to Kanjorski,
on September 18, 2008 the Fed tried to "stem the tide" by pumping money into the
financial system but it didn't work and decided instead to announce an immediate
increase in deposit insurance to $250,000 per account to stop the panic.
Said Kanjorski: "If they had not done that, their estimation is that by 2 p.m. that
afternoon, $5.5 trillion would have been drawn out of the money market system of
the U.S., would have collapsed the entire economy of the U.S., and within 24
hours the world economy would have collapsed. It would have been the end of our
economic system and our political system as we know it."

On bailouts and buyers

Not to make light of the recent troubles on Wall Street but Megan McArdle echoed today a thought that had been running through my head given the bailouts, conservatorships, or whatever the Paulson and the Fed want to call their actions to keep Americans happy.

All of New York's rebound has been paid for by taxes on the financial industry -- a few hundred thousand people in the industry pay the lion's share of taxes for the entire city. Tale them away, and the city will rapidly lurch bak towards bankruptcy.

One question. Is Bloomberg going to bailout the City if the Korea Development Bank doesn't bite?

(Photo by Christopher Chan)

Recession obsession

News is trickling in on the backs of quarterly reports that suggests Asian and European economies are not nearly as decoupled from American economic conditions as previously thought. The contagion of the American "credit crunch" is spreading and though these markets may be technically independent from the US economy (i.e. they have not bought securitized loan packages from American banks) they still face a number of problems.

The instruments of financial (not monetary - the ECB is notoriously opaque) work in Europe are close to ours. The loan bubble that caused the "credit crunch" here exists in Europe as well; it simply manifests in a slightly different form. Look at the housing markets in Spain and Britain, unemployment pretty much anywhere but Germany, and contracting export margins throughout Europe and Asia (especially China and Japan). Unlike the quick action of the Fed, the sclerotic pace of EU regulation and the inflation-bent of the ECB won't do anything to counter these effects anytime soon.

There are a number of other significant problems in what is increasingly looking like a global recession, which Larry Summers ties up nicely. But the problems now seem beyond the scope of interventionist policy. Even if they were not, I am not convinced the Fed could responsibly round up enough liquid cash to implement any type of further "injection" to buoy the economy. With more and more banks facing huge writedowns and even insolvency, the Fed cannot feasibly expand its own balance sheet. The one thing policy wonks should not be adding to the cacophony is a cry for another stimulus. The term "credit crunch" conjures up ideas that the situation would be resolved if there was simply more money around to lend out. This simply isn't the case.

The Fed "injects" money into the economy (whether it's a tax stimulus or a bail-out) by controlling the reserve supply of cash to banks. To ease short term interest rates (and thus push money) the Fed buys securities by crediting the account of their primary dealer (who is free then to lend out these reserves) thus expanding its own balance sheet. This practice, if ensconced permanently in policy, will yield disastrous results: essentially, an even greater expansion of GSEs (and not just ones dabbling in mortgages either) with bills passed to the taxpayer and profits distributed to managers and shareholders. This encourages reckless and risky investment policies which will even further undermine the financial system.

The crunch needs to be felt by those who helped cause it, not passed indefinitely down the line. Free markets need to be free in the good times and the bad. If only Paulson had seen it coming.

Monetary policy: Between a rock and a hard place

Blog note: sorry for being off the radar for a few days - the next few weeks are crunch time for my Master's dissertation. Fortunately, I see my illustrious coauthor has kept you entertained with stories about kites, voicemail, and Schlitz. I'll do my absolute best to keep posting at least once a day.

Anyways, right now is a good time to thank your lucky stars that your name isn't Ben Bernanke and that your business cards don't read "Chairman of the Federal Reserve." Mr. Bernanke is facing a daunting combination of high inflation (year-to-year inflation in June was 4.1%, the largest annual increase since May 1991), anemic growth (1.9% in the 2Q, largely on the back of fiscal stimulus checks), and stubbornly high food and energy prices.

Going into the Fed's August meeting on Tuesday, it's an impossible position to be in. Raise interest rates and you risk aggravating a delicate situation where credit remains tight, energy prices remain volatile, and the housing market may not have quite bottomed out yet. Lower interest rates and you risk stoking the fires of inflation.

What to do? Realistically, probably nothing. In June, the last time the Fed met, they left interest rates unchanged at 2%. Wall Street is betting that they'll do the same thing this time, and I think they've got it right. When interest rates are this low, realistically it's hard to lower them much further, and Mr. Bernanke is still more concerned about pumping liquidity into the system than inflation. The real question becomes: how much inflation is Mr. Bernanke willing to tolerate? If he wants to keep rates this low, it will have to be a lot.