The Fed's Disastrous Ten

Unfortunately, when pundits analyze economic policy, there is far too much partisanship for there to be any real analysis. As such culprits like "deregulation", or social engineering through the Community Reinvestment Act, or even the Bush tax cuts are blamed for the economic woes. I firmly believe that once economist have the benefit of time, the bulk of the blame not only for the current crisis but for the economic uncertainty that has infected the economy for most of the last decade will fall mostly on the shoulders of the Federal Reserve. In fact, while I haven't study the history of the Fed enough to make a fair judgment, I believe these past ten years have been the worst in its history.

Beginning in late 1999, the Federal Reserve has embarked on a series of actions, and non actions, that have devastated the economy, set in motion new crises, and failed to act to limit crises. At the end of 1999, Alan Greenspan decided on setting in motion a series of Prime Rate increases. Much has been made of his motivations, including by me (detractors like myself believe he was attempting to pop the internet bubble which would an enormous, unnecessary and dangerou usurption of power), however what this rate cut did do was set in motion an economic slow down that lead to a recession. Whatever his motivations were, one thing is clear. If he was attempting to limit inflation, which is what he said he was doing, and he wound up contributing to a recession, which is what he wound up doing, this Fed action backfired spectacularly.

By the end of 2001, after furiously raising rates to avoid inflation that never materialized, Alan Greenspan set off on nearly two years of furiously dropping rates.

Just look at the chart as it speaks for itself. The Fed Chair raised rates furiously for almost two years, then took about six months off, and spent the next nearly three years lowering rates even more furiously. This is an indefensible, uncontrolled, and reckless period of rate policy. He barely had enough time to see what his rate increases would do when he immediately had to reverse course and decrease rates. What's the point of increasing rates furiously if it only immediately causes you to decrease them even more furiously.

In my opinion, his furious decrease of rates set in motion what we now call the mortgage crisis. By the time he was done, the Prime Rate was at 3,75%. The Fed Funds Rate, usually and more importantly then, traded three points below the Prime Rate. That meant the Fed Funds Rate, the rate banks borrow from each other, was less than 1%. That allowed banks to borrow for literally next to nothing. Of course, banks borrowed furiously. What exactly did he expect them to do? What he did was cause what we call loose money. Banks had far too much money. This irresponsible action lead to irresponsible actions by the banks. Could he predict the course of the mortgage crisis? Of course not. Could he predict that one irresponsible action would lead to more. He had better or he isn't qualified to be Fed Chair.

Then, as the mortgage crisis materialized, Alan Greenspan stood by and did next to nothing. Sure starting in 2004 he began to raise rates again, but by then, it was the sub prime niche that was moving. That niche wasn't affect so much by his rate cuts. What did he do to affect irresponsible lending and borrowing in sub prime. He perpetuated it that's what. In February of 2004, Greenspan made this stunning pronouncement.

American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage," Greenspan said.

By giving his blessing to Adjustable Rate Mortgages, he perpetuated a problem that was starting sub prime. Far too many people were using ARM's to buy properties the couldn't afford. Now, the king of economics was giving their irresponsible behavior his blessing. This statement was stunning on many levels. Most importantly, he was not qualified to give such a statement. The choice of a consumer of an ARM or a fixed rate is entirely due to personal factors. It depends on someone's risk tolerance, how long they plan on living in the property, and what sorts of job prospects they have. Making a blanket statement on the viability of ARM's was reckless and irresponsible, and his greenlight gave millions of novice borrowers all the greenlight they needed to proceed in exactly the sort of risky behavior that has jeopardized the economy. Meanwhile, the irresponsible bubble that was forming housing was never addressed or dealt with by Greenspan.

By the February of 2006, Greenspan was out and in stepped Ben Bernanke. Bernanke finished off a furious rate increase. The furious rate increase was of course necessary because Greenspan's equally furious rate decrease blew up the housing market so that the economy began heating far too fast. Once again, and for the third time in a row, Fed action caused an equal and greater reaction. The Fed, again, was forced to counter act its own behavior in order to avoid the reverberations of previous rate cuts.

Of course, by the end of 2006, the sub prime market was beginning to tank. Within months, the entire niche had nearly disappeared. Yet, the Fed did nothing. The seeds of this downturn were laid in early 2007 and yet the Fed didn't take any action until the end of the year.

Of course, the action the Fed took was inconsequential at best and counterproductive at worst. The Fed's furious rate cuts at the end of 2007 did nothing to halt the slowing economy. The only thing the rate cuts did was continue a pattern of fixing a problem that previous rate policy created. Once again, the Fed was furiously reversing course on rate policy. It did, however, weaken an already weak Dollar. As a result, food and gas, both priced in Dollars, both exploded in price. As such, right as the economy was weakening the middle class was faced with exploding gas and food bills.

When their rate cuts proved ineffective, the Fed had to take even more aggressive action. At the end of March of 2008, the Fed stepped in to save Bear Stearns from failing. In one weekend, the Fed brought Bear Stearns together with JP Morgan Chase, brokered a deal, and even backed the deal up with their own capital. Such a deal would take months to consummate on its own, and yet the Fed forced both parties to agree over one weekend. The Fed justified this enormous usurption of power (the Fed took on the role of investment banker, rainmaker, and creditor all at once) because it was an extraordinary circumstance and this one time action would calm the market.

Of course, no such thing happened. Over the next several months, the Fed began to pick and choose which companies to help and which companies to let die. AIG got an $85 billion credit line, while both Merrill Lynch and Lehman Brothers were left to their own devices. Suddenly, as the Fed began to realize that no matter what they did, their actions were ineffective, the finally threw their hands up. As we all know, in the last three weeks, Fed Chairman Ben Bernanke has backed a plan to allow the Treasury to buy about $750 billion worth of bad mortgage bonds. In other words, the Fed Chairman is saying that each and every enormous move by the Fed were ultimately for nothing. What if Bernanke had realized in September of last year just how dire the circumstances were? What if this action was proposed then? The country could have debated it properly. Instead, after furiously dropping rates, taking on multiple roles to consummate a merger, and then picking and choosing which companies died and/or got bailed out, Bernanke suddenly realizes that none of it is enough. Now, Bernanke, pointing a financial pistol at the nation, says that we need a $750 billion bailout or else.

The stunning incompetence isn't merely troubling but disastrous. In the last nine months Ben Bernanke has shown the incompetence of a middle manager not the head financier. Track things back for ten years and all you see is a series of missteps and oversight. The Fed, over the last ten years, has been in the middle of causing a recession, a bubble, and finally helplessly usurping enormous new power only to find that no matter what they did they were now suddenly powerless to stop the very problem they were instrumental in creating. I, for one, hope both sides of the aisle stop their partisan thought and examine the situation more closely. For the single biggest culprit in creating economic chaos over the last ten years has been the Federal Reserve.