The Fed, Our Fiscal Health, and the Road Out – Part 2

There are three problems with our current situation, one of which is relatively straight forward to address.  Of the remaining two problems, one is much bigger, and the other much longer-term.  

The easy one would be to roll back the lion’s share of Dodd-Frank: a knee-jerk reaction by a bunch of goofballs who neither understand money, nor have ever met a regulatory opportunity they didn’t like.  The financial chaos they have unleashed in their 2,300 page bill is abhorrent.  As of the end of 2011—18 months after the bill’s passage—75% of the deadlines related to 400 rule-making requirements had not been met.   To listen to CEOs of major money-center banks say in the year 2012 that they’re not sure how to plan for Dodd-Frank because they don’t know what the rules will be is simply stunning.  The degree to which this one law has amplified strategic uncertainty for financial institutions almost cannot be overstated.

The big problem is that even after the Fed nearly tripled the size of its balance sheet, and despite Congress’ massive stimulus bill, we’ve learned that our government's power to impact our macroeconomic situation is asymmetrical.  In other words, between the Fed, the White House, and Capitol Hill, our leaders have been able to temporarily avert disaster, but they have very little ability to actually engender economic growth.  

It might help to picture John Maynard Keynes with only one leg: sure, he can stand up, but he can't really move anywhere.     

    

To tackle this problem, we're going to have to drop this childish fantasy that government bureaucrats actually grow anything in the economy.  Our government exists and runs only because the private sector (individuals and businesses) funds it through taxes.  There are no ultra-smart Wizard of Oz guys in Washington, making the whole thing work magically.  There are a bunch of little old men behind the curtain who think the levers they're pulling are doing important things, but again, their contribution is at best asymmetrical.

A pro-growth policy asks "How can we incentivize the private sector to grow the economy, so that the government can collect just enough money to meet its obligations?"  You can read more about the relationship between taxes and economic growth here.
 
The long-term problem looks like this: in a fractional reserve system, what happens if banks should quickly turn most of the $1.5 trillion of reserves into loans?  The money supply would explode, and as Friedman reminds us, that means inflation.  Like, you know, a LOT of inflation.  The fear of inflation is a main reason why gold is in such a massive bubble right now.  

By the way, if you’re invested in gold, what’s fair value for 1 ounce?  You can get back to me on that one.     

The Fed’s only surefire tool to hold all that potential liquidity behind the dam and avert runaway inflation is to permanently increase the level of required reserves.  That may sound easy enough, however reducing the percent of each dollar that can be lent will have a huge impact on the speed of future economic recoveries.  Unwinding this situation could take decades. 

   

All is not hopeless.  If we pursue pro-growth policies, we can mitigate these threats, and we can do so more rapidly than you’re probably picturing.  What this looks like is reducing massive, choking regulation (e.g., Dodd-Frank) in favor of higher bank capital requirements (a la Basel III).

It means that the Fed should quit paying interest on excess reserves immediately (and maybe even charge interest on them), which would encourage banks to lend more right now.  Although, if banks don't lend, it's not necessarily just because they don't want too.  It may be hard to believe, but there is mounting evidence that many businesses simply don't want to borrow in an environment of such regulatory uncertainty.  But that is, as they say, 'a whole nother' topic, one I'll illustrate in a future blog post.  

In tandem with ceasing to pay interest on excess reserves, the Fed should announce a temporarily higher reserve requirement, accompanied by a schedule to reduce the required reserve ratio to normalized levels over a few years.  John Taylor's recent article summarizes well the argument for a rules-based monetary policy.

I have two framed displays on the wall of my office, one right above the other.  The top one holds a gold-backed Chinese government bond from 1913 on which the republican government defaulted when the Japanese invaded Manchuria.  When the communists took over, they repudiated this issue and several other bonds as "the debt of an illegal regime."  So far, the Chinese are the only G-10 country to repudiate portions of their own debt.  The other frame holds four original German banknotes showing the runaway inflation of the 1920s: 100, 1,000, 1 million, and 1 billion mark notes.  In August of 1922, it was still worthwhile for Germany to print 100 mark notes.  By September of 1923, they were printing 1 billion mark notes.

As a global investor, I keep those displays there to remind me of the two options governments have when they get into deep trouble: inflate the value of their debt away, or simply default on it.  Greece just chose option B.  The looming Medicare crisis on top of our $15 trillion worth of federal debt (growing at the rate of over $1 trillion per year) potentially lead to our very own Chinese bond situation.  $1.6 trillion of accessible excess reserves potentially leads to our very own German mark situation.  I wish I were making this stuff up, but I'm not.

We can still avoid both default and runaway inflation, but we have to act quickly, and smartly.  Do we have the will to do so?

The Fed, Our Fiscal Health, and the Road Out – Part 1

Our banking system is based on fractional reserves.  Banks take in deposits and make loans with most—but not all—of the deposit money.  The portion that is not loaned out is called a reserve.  There are both required reserves and excess reserves, the former is what the Federal Reserve Bank mandates that banks hold back and keep deposited in their accounts at the Fed.  Excess reserves are the dollars which banks are allowed to lend, but which they have chosen not to lend.  

Under normal circumstances, banks have very little incentive to keep any excess reserves—the Fed pays almost nothing in interest and they usually can make a lot more money by lending.  Only if a bank has made loans which it anticipates will fail, or when it sees no attractive lending opportunities, will it allow excess reserves to grow.

The ‘money supply’ (crudely, the number of dollars in our financial system) grows faster or slower, depending mainly upon how much of their reserves banks decide to lend.  Milton Friedman once famously said that “inflation is first and everywhere a monetary phenomenon.”  By that Friedman meant that we get inflation when too many dollars are chasing too few goods.  

Stick with me—I’m building up to a relevant point.  I promise.  

   

For most of the history of the Federal Reserve Bank, total reserves were comprised of ~95% required reserves and ~5% excess reserves.  During periods of financial stress, or when the Fed is said to be “easing”, the amount of total reserves has tended to go up (and down again when the Fed “tightens”), but the ratio of required to excess reserves has stayed remarkably constant.  For instance, Total Reserves in August 2001 stood at $39.98 billion, went up to $57.96 billion in response to 9/11, but were back down to $39.51 billion by May 2002.       

This link shows the history of reserve ratios from January 1959 through March 2012. 

In August 2008, total reserves stood at $46.59 billion and $44.72 billion of that, or 96%, was required.  But then look what happens beginning in September 2008: total reserves begin to sky rocket, while required reserves increase much more slowly.  Today, total reserves are a whopping $1.66 trillion, or a 3,500% increase since August 2008.  

With total reserves of $1.66 trillion, how much are the required reserves?  Only $98.08 billion, or about 6% of the total.  In other words, the ratio of required reserves to total reserves has been turned completely upside down.  “OK,” you say, “that rises to the level of marginally interesting, but still—so what?”  Think back to the fractional reserve system of banking.  Normally banks lend right up to the amount they’re able to lend, but now they’re keeping 94% of their reserves in their Fed accounts.  This is the bank equivalent of ‘mattress money.’  

That reality has been frustrating to those at the Fed, who’ve been hoping that banks will turn excess reserves into loans, thus stoking economic growth.   Instead all that money just sits there: 10% of our annual GDP is parked at the Federal Reserve, doing nothing but collecting 0.25% interest.  Why aren't the banks lending the excess reserves?

But here's the really big question: what will happen to the prices of the things we buy (recall Friedman's point above) if $1.5 trillion of excess reserves come rushing back into the economy by way of new loans?

I've Decided to Become a Fashion Writer

Sure, I’m a middle-aged, white guy who loves fishing in farm ponds.  I live smack dab in the middle of one of the classic 'fly-over' states.  And I may look at a dress worn by an emaciated, morose model on a runway and think, “Golly, I wonder how she even puts that sucker on?”

But, come on, I wear clothes!  And I know that Milan is in France, how hard can it really be?

A little thing like not knowing what she's talking about doesn't stop NPR’s Terry Gross.  It’s one thing to not know what you’re talking about—can a radio host possibly be an expert in everything?—it’s something else entirely to know so little about a subject that you choose to interview someone who doesn’t know what they’re talking about.  

Am I being caustic again?  Probably.   But before you write me off as mean-spirited, I just want to note that Charlie Rose never seems to make these kinds of mistakes.   

Here’s the transcript to Gross’s recent interview with Jesse Eisinger.  Now, admittedly, understanding the financial crisis has been very, very difficult for those of us who get how these things normally work.  For most of the population, I’m sure it’s almost impossible to understand.  But Eisinger should know better—he’s at ProPublica now and was previously at the Wall Street Journal and The Street.com.

The interview is riddled with misinformation.  It's appalling, really.  

Here are a few problems I have with this bit of “news” from Terry and Jesse:

Is it really news that Sheila Bair thought the banks needed more capital but the Fed did not?  And why does Eisinger think the Fed is subject to lobbying pressures but FDIC isn’t?  What if both Bernanke and Bair just arrived at independent but different conclusions?  No one knew exactly how much additional capital was needed and how fast the banks needed to get there.  All anyone suspected was that bank capital was too thin to sustain another major financial crisis.  The original stress test wasn’t totally rigorous, but it was real—it confirmed that JP Morgan was significantly better capitalized than Bank of America. Also, it's not like the Fed stopped at one stress test; the most recent results were released this past Tuesday.

On the other hand, our fractional reserve system relies on banks retaining a small minority of each deposit as capital.  Jacking capital retention ratios north of, say, 15 – 20%—as we saw some Swiss banks do—would only serve to weaken velocity when the banks began to lend, putting more strain on the central bank to stoke growth.    Besides, Basel III is raising capital levels and requiring more secure types of capital for banks globally.  US banks could quickly become disadvantaged if they pushed farther faster than their European and Asian competitors.  The key was, and is, to get there (higher, stronger capital) in a coordinated fashion. 

Can we really generalize about “the banks” when critiquing things like dividend payments and acceptance of capital from the Fed?  JP Morgan had Fed capital forced down its throat—CEO Jamie Dimon never wanted it and never needed it.  In fact, he was the white knight that kept Bear Stearns’s clients tucked in.  Bank of America (thanks to its Countrywide and Merrill Lynch acquisitions) was an utterly and completely different story—they were a hair’s breadth from failing themselves.  

Is the fact that the Fed took a position in preferred stock something to lament?  And who cares that they didn’t get a vote with the preferreds?  They’re the Fed, for crying out loud!  They have all the voting power any stakeholder could ever want.  A share class is “preferred” because its owners have a senior claim to common stock holders.  In hindsight, sure the Fed could’ve made more money by buying the common shares, but when you don’t know if Bank of America is going to ultimately fail, should you really gamble with tax-payers’ money?  

Also, Warrant Buffett owns preferred shares in Bank of America and that means one thing: the bank just isn’t in the bad shape that Eisinger thinks it is.  Buffett may make goofy, populist, guilt-induced, political arguments about taxes, but he’s an incredibly sharp investor.  

Eisinger is correct that banks are currently making a healthy spread between their cost of money (what they pay to depositors), which is almost 0%, and what they can earn from buying Treasury bonds (2-3%).  And, sure, it would be nice for them to lend more (though Commercial & Industrial lending has already been pretty strong).  But ask yourself this question: if the Fed really wanted the banks to lend, why are they paying interest on bank excess reserves at their Fed accounts?  Shouldn’t they charge the banks to keep the money in the mattress?  Moreover, if the banks are really in the trouble Eisinger wants you to think they are, then shouldn’t he be delighted with healthy net interest margins because they’re allowing the banks to beef up capital?  

Dividends are taxed twice—there is no good argument for taxing them more.  Terry & Jesse are concerned that banks want to reinstate dividends because it's a more tax efficient means of compensation for executives than cash.  Well, let's see, here JP Morgan's tax rate last year was 27%, so if we add 15% tax on CEO Jamie Dimon's dividend (because dividends are after-tax cash flows), we get an effective tax rate of 42%.  If Jamie Dimon instead took the full amount of his dividend as a cash bonus his top federal tax rate would've been 35%, 7% less than his actual rate.  No, my friends, the banks aren't trying to pay the executives through stock dividends so they can avoid taxes, they're incentivizing them as owners.
   
Last point: if you prohibit the banks from paying dividends for a long period of time, who would want to own their shares?   Let’s face it, banking isn’t exactly a growing industry, and bank stocks aren’t that exciting.  For seniors, pensions, or endowments which rely on dividends (which, because of ultra low rates, have replaced reliable CD & bond interest) they’ve been a reliable source of income.  The point is that if you eliminate all dividends indefinitely, you drive away the vast majority of your potential investors.  And when those guys leave, your stock price falls.  Bad idea.

I should be more fair to Terry Gross: she's a widely respected interviewer who's been doing her job a long time.  Still, she has a story to tell, airtime to sell.  She's naturally drawn to a certain type of interview, one that's controversial—apparently even when the controversy is fanciful.  If you don't get something, should you really comment on it?