Monday, October 28


PUNDITA: Are things getting clearer?

MICHAEL WRIGHT: Sure, now that I know my finances are run by a ghost, a pampered man-eating dog and a 300 year old paradox.

PUNDITA: Don't forget Frank, and remember it's not the paradox; it's attempts by the Federal Reserve to reverse engineer the paradox. And I don't think Petunia ever actually ate anyone, except Frank, the first Frank, but then it is a dog eat dog world.

MICHAEL: I think you should bring Mrs LeVoon back for an encore performance. Have her give the Fed another talk.

PUNDITA: Zut Alors! Madame, not Mrs. I could manage one or two sentences in her patois but no more, not without study if I didn't want the linguists and ethnologists jumping on me.

MICHAEL: A couple sentences is all you'd need. "Hear what I'm telling you. Shut it down."

PUNDITA: You wouldn't want to shut down this nation's central bank even if you could; it performs a critical function in a banking system that writes a huge volume of loans. The problem is that the Fed is suffering from a severe case of mission drift. It was supposed to perform its function for the banks and advise the federal government on the state of American business cycles. It went from advising to managing the business cycles, which it renamed "the economy," to something like a priestly caste.

All that keeps the caste at bay is Petunia, or at least that's the way it was until the 2008 financial crisis. Now the Federal Reserve wants to do Treasury's job on the excuse that it can't manage internal monetary policy if it can't also manage external policy. Yet if the Fed keeps on using the banking system as a tool of monetary policy there's not going to be any system left to speak of.

MICHAEL: You've just told me that this mission drift worked out to tremendous power. The Fed is now like a fourth branch of government. You're mistaken if you think the economists there would voluntarily give up that much power, even if they saw the error of their ways.

PUNDITA: The only power they have is what bankers have given them. The bankers got dependent on the Fed then addicted to the Fed's cheap loans. Like all addicts they fed their addiction even when it became self destructive. The bankers need to attend AA/NA meetings to see how it's done, then set up their own support groups. Stand in front of a microphone and admit that without divine intervention they're powerless to fight their addiction to the Fed's cheap money.

MICHAEL: I'd like to see you in the White House for a year.

PUNDITA: Why only a year?

MICHAEL: That's all it would take you.

PUNDITA: Everything you like about my approach to problem solving would be destroyed by bringing it into the political system.

MICHAEL: I don't agree but I have a question about the Fed. Do you think it played a role in the 2008 financial crash?

PUNDITA: Yes, a big role.

MICHAEL: How so?

PUNDITA: That's a shaggy dog story.

MICHAEL: Here we go.

PUNDITA: No no, there's no dogs in the story.

MICHAEL: So you're telling me it's a dog of a story. All right, I'll play.

PUNDITA: In the 1970s I saw James Dickey act out a shaggy dog story on the Johnny Carson show --

MICHAEL: The Deliverance author?

PUNDITA: The poet and novelist, yes. It was the one about the man who's told that his suit jacket sleeve, the left one, is a little shorter than the right one. The man pulls his right arm back into the right sleeve a little, to make it look as if the right sleeve is even with the left sleeve. Then someone else points out that the right sleeve looks a bit shorter than the left sleeve. So the man pulls his left arm a little out of the left sleeve, in another attempt to even up the appearance of the sleeve lengths. Then someone else points out that the other sleeve looks shorter, so he pulls that arm even farther back inside the sleeve.

It went on and on like that. Dickey ended up with both arms inside his suit jacket, with the empty sleeves flopping around.

I almost died laughing but when I thought about how U.S. monetary policy works, the internal policy, I said, "Oh no. It's the shaggy dog suit jacket story."

The Federal Reserve keeps trying to balance the economy between inflation and deflation but there are too many variables to get a balance, so they're always overshooting or undershooting the mark, then trying to correct the imbalance, and it goes on and on. A classic example is what happened in 2001. The Fed decided that the manufacturing numbers looked squishy --

MICHAEL: So you didn't make up that part.

PUNDITA: Well I made up Frank squatting on the chart but yes that happened; that's how the snowball started rolling downhill. Out of concern that the data portended a recession, the Fed cut the target for I think the Federal Funds Rate or one of the rates that the Fed targets control.

Here the Fed was following what had become traditional macroeconomic policy. The general idea is to make it cheaper for banks in the Federal Reserve system to borrow from the Fed, so they'll write more loans to business; this to encourage business expansion, including hiring, thus warding off a recession.

It didn't work out that way. Why? For one reason, because Fed watchers in the business, investment, and banking sectors -- and they're all Fed watchers -- were very familiar with the traditional Fed policy. They saw the rate cut and wondered if the Fed knew something about the state of the economy that they didn't, even though there was no recession. So they pulled back on investing, hiring, loan writing, and borrowing. That meant the Fed had to cut the rate again.

MICHAEL: I don't think I want to hear the rest of this story.

PUNDITA: The second round of interest rate cuts worried Fed watchers even more so they cut back more on hiring and so on. So the Fed had to cut the target rate again in another attempt to overcome fears about a recession. By this time the Fed was probably cutting all the interest rate targets they could; in any case that's how it ended up.

By the third or fourth cut the consumer got worried that the economy was tanking and pulled back on spending. So then the Fed had to cut the rates again.

It went on and on like that. The Federal Reserve cut the rate seven times. Then 9/11 struck, so then the Fed really did have something to worry about. By then the interest rates were nearing bottom but the Fed had no choice other than to cut the rate again, and again, in the same year. This put interest rates in 2001 to their lowest in 40 years.

Nine times, Michael, nine times those clowns at the Fed tried to even up the sleeves.

By October 2001 a former Fed economist, Lacy Hunt, who'd gone to work for an investment firm, had looked at the data. Hunt said wait a minute; the private sector doesn't have the balance sheet capacity to take on more debt, and the banking system is in the same boat -- it can't write more loans. Not at the level the Fed had envisioned that all the rate cuts would stimulate.

But the Fed's mathematical models had excluded the kind of data that Hunt studied. That's not all the models excluded. The slashed interest rates had plummeted the income that Americans received from their savings accounts and other savings instruments. And not only individuals; business and institutions that parked a chunk of their money in cash and near cash were now staring at the prospect of losing money if inflation heated up.

That put all those Americans in a fix. Either they could start paying down debt with their savings, which meant they could be losing money if interest rates on the debt continued to move toward zero. Or they could start speculating with the money in the attempt to offset their losses from much lower interest income and from possible inflation.

The inflation never did materialize -- not in the areas that the Fed was watching for such signs. The inflation was building in a way the Fed's mathematical models hadn't taken into account -- in the highly speculative, overpriced debt consolidation instruments known as derivatives that shadow banks and brokerage firms were packaging and selling to pension funds, retirement accounts, bankers, retail investors, and state and local governments.

MICHAEL: The Fed needs to be shut down. If there's some critical function it handles, start a new agency to handle just that function.

PUNDITA: It's not going to happen, for the same reason I don't think the banking system will be nationalized in the United States. It makes it possible for the White House and Congress to shift a great deal of blame.

MICHAEL: You don't think nationalizing the Federal Reserve would help?

PUNDITA: That would be putting the foxes directly in charge of the chicken coop, and again, that would make the federal government directly responsible for serious miscalculations by the Fed economists.

Anyway, by doing everything to ward off a recession in 2001, the Fed created a recession that year. That set up conditions for an even bigger recession. Yet to this day they can't confront what they wrought by trying to even up the sleeves.

MICHAEL: I guess the Fed's math also missed signs of the 2008 crash.

PUNDITA: Even if they saw the signs, what were they supposed to do? Call for audits of the banks? Tell the SEC to start audits? Go to Congress? All or any of that would have set off panic in the bond and stock markets. That would have led to runs on banks.

But it had all started years earlier. If James Dickey had lived to see the nine interest rate cuts in 2001 he would have put his arms inside his suit jacket and waggled the empty sleeves.

There could be a moral to this shaggy dog story, only I don't know what it is.

MICHAEL: The moral is that once you put clowns in a canoe and send them down the river they're up the creek no matter what they do.

PUNDITA: [laughing] Deliverance! Wasn't it two canoes?

MICHAEL: Not on the way back.


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