Great post from Economist's View about where our reliance on risk distribution went wrong.
Discussion about China's Exchange Rate and Trade Balances from Econbrowser.
Placebo Effects: Part 2 Thoughtful analysis of where we stand in the global financial crisis.
I was browsing through the podcasts over at EconTalk and listened to a great discussion with Tyler Cowen from Marginal Revolution. The host, Russ Roberts, brought up an interesting point about a tension that exists when the Fed increases the money supply in order to lower interest rates.
We hear in the news everyday about how "the Fed lowered interest rates," but most people don't really understand what this means. There are two rates that the Fed "sets." One is the discount rate and the other is the fed funds rate. The discount rate refers to the rate that the Fed charges member banks when they borrow reserves from it. Cowen points out that changes in the discount rate are not really significant because if a bank is distressed and needs to borrow money from the Fed, the real problem is going to be the alarms that will be raised regarding the health of that bank. This is a much greater cost than the interest the member bank will have to pay the Fed. So when the Fed changes the discount rate, it does not have much of an effect.
The othe rate the Fed sets is the Federal Funds rate which is the rate at which banks lend balances to other banks. The way the Fed "sets" this rate is by buying T-Bills and other government securities using newly printed money, thereby increasing the supply of loanable funds. It is simply a matter of supply and demand. If the supply of money goes up, then the interest rates, which are the "price" of money goes down.
The interesting tension that Roberts points out is that as the Fed pumps more and more money into the system, people begin to expect inflation. If people expected, say, 10% inflation a year from today, then no one will lend for less than 10%. The interesting point here is that the Fed, in the short-run, can lower short-term real rates if it pumps money into the system once, or even a few times. But eventually, if the Fed continues to inject more liquidity, nominal interest rates will rise because of the expectations of inflation.
I think this is an interesting point to consider and I don't think most people understand it this way. It's not readily apparent that when the Fed takes actions to lower interest rates, nominal interest rates can actually rise as lenders demand an inflation premium on the funds they lend.
Cowen also pointed out that even though the Fed has lowered interest rates, this doesn't necessarily have any real effect on business activity. There is no guarantee as to what banks will do with the money. If the money simply sits there or funds projects that would have been completed anyways, then there isn't necessarily an increase in business investment.
These points are fairly basic, but important nonetheless.
There has been a lot of debate recently regarding the Fed's independence. Many want the Fed to be more accountable to the people and there is even a bill out there that seeks to audit the Fed.
What are the arguments for independence?
The Fed has been fighting the bill that has already won sponsorship by a majority of the U.S. House of Representatives, and a companion Senate measure, that would expose monetary policy decisions to audits by the Government Accountability Office.
Bernanke's position, essentially, is that he understands the need for American taxpayers to know where their money is going, but that lack of independence might alarm financial markets and drive borrowing costs higher as investors would come to fret politics, not economics, would drive monetary policy-making.
Putting aside my own dislike of the Federal Reserve system, I must say that Bernanke's point here is not withour merit. We were the ones who set up the Fed in the first place – or should I say the Congress of 1913? Either way, what we basically did was to vest total control over the monetary and financial system in the hands of a central bank, the Fed.
Congress believed there was a need for a centralized power that controls the monetary supply thereby setting interest rates, etc. So we did not want the free market to determine interest rates any longer. We basically said "we are too cowardly to let the free market determine the rates based on savings versus current consumption so we want you, a central power, to determine it for us."
So isn't the very idea of the Fed we are entrusting a few "financial wizards" to control the monetary system? In fact, the Federal Reserve Act was structured so as to insulate the Fed from politics; the members sit in staggered terms, the Fed may act without prior approval from Congress or the Executive. We put all of our faith in this group of people and asked them to save us from ourselves. So if we are unhappy with the Fed, we should just abolish it or whatever. If the argument for more accountability simply means that the President or Congress will have the power to determine monetary policy, then essentially we are abolishing the Fed. Again the whole idea of the Fed was to have an independent body that has the power to determine monetary policy by setting interest rates, controlling the supply of money (two sides of the same coin really), and regulating the banking sector. So if we begin to audit the Fed and ask for increased accountability, then we should recognize that this is essentially going back on what we asked for – which is perfectly fine, but we should call it what it is.
If the whole argument against the Fed's independence and "lack of accountability" is that in a democratic system the people deserve to know what decisions are being made and that there should be transparency, then basically we are asking to not have a Fed. Right? Am I missing something here?
We created a Fed because we didn't have the balls to control the monetary balance ourselves. So we implicitly asked the Fed to "save us from ourselves." If the Fed responds to the calls for increased accountability and audits by saying essentially that 'politics would drive monetary policy and we are saving you from yourselves' then they are right. If we disagree, then we should admit our mistake and abolish the Fed and entrust the free market with "determining" the course of monetary policy. It seems contradictory to call for the establishment of the Fed and then say "hey, wait a minute, you guys have total control!" Duh, we gave them total control.
So when Rothbard, for example, argues in his "The Case Against the Fed" that the arguments of the Fed in favor of independence are skewed because it casts a vale over this secretive organization who is allowed to operate as an oligarchical "money doctor," we should recognize that this is exactly what we wanted. We flat-out asked for a wizard money doctor. Now we aren't happy with it? Ok, that's a great first step. But we should recognize that our unhappiness is with the very institution that we willingly established.
Don't get me wrong. I think the idea of a Fed and fiat currency, are bad ideas. I just think we should stop the classic congressional game where we create a problem and then complain about the Fed as if they are to blame. We created the beast and now are not happy with it. We can pull the plug whenever we want. But doing so would be an admission that we screwed up, not the Fed. The issues everyone has seems to be with the institution per se. And we created the institution.
So within the very framework that we set up, the Fed's argument in favor of independence seems to make perfect sense. Of course, I question the whole framework, but given the situation, it does make sense.