Fed can’t fix broken economy, politics

August 12, 2010

The Federal Reserve’s decision to move to a kind of quantitative neutrality is a tacit admission that it, or rather that the United States, is in a political bind that makes a bold response to a deteriorating economy difficult.

Despite reams of evidence that conditions are worsening — much of it cited in the statement the Fed made as it left rates on hold — the U.S. central bank made only a token gesture; announcing that as mortgage-related debt it holds on its balance sheet comes to term and is repaid it will replace it  with new, mostly long-term, Treasuries.

That keeps its quantitative easing policy essentially static, a strategy dubbed “quantitative neutrality” by Northern Trust economist Asha Bangalore.

So, given that key measures of inflation are trending towards zero, that businesses are reluctant to hire, that corporations and banks alike are sitting on cash and that the outlook for the recovery, if indeed we want to call it that, is dimming, why such a feeble response?

In the end monetary policy has to have a political consensus behind it, and there is arguably less of that now than at any time in my 20 years of following markets.

That is partly because during the collective fantasy of the Great Moderation we all believed that monetary policy could somehow be technocratic and above politics. Up to a point …

The Federal Reserve, for totally understandable reasons, often got out in front of the political process to make bold moves during the dark days early on. They did things, to be blunt, that went beyond their mandate. They paid off AIG’s contracts and, by buying up mortgage debt supported one sector of the economy over the others, poaching on Congress’ turf and setting themselves up for risks to their independence.

That is the significance of quantitative neutrality; the Fed is getting out of the capital allocation business and are, in so many words, saying to Congress and the White House that the next move is theirs.

That next move is not likely to be much of anything other than infighting ahead of November elections. Congress has passed $26 billion in aid to the states, a drop in the bucket and likely the last thing that gets through before the polls open. It may prove a disaster, but there simply isn’t consensus for much more, and so, much more may not arrive.

After the election, if the Democrats lose the house as many expect, the outlook for meaningful further stimulus is even dimmer.

In many ways, this mirrors Japan’s lost decade, except in typically speeded-up American style. Japan was unable to agree politically to keep the stimulus coming year after year, easing up in the late 1990s. Many believe that this set the stage for another lapse into deflation and recession, but of course no one really knows.

QE II or Titanic II?

Is it the fed’s job to do the heavy lifting when the political process isn’t “working”? Many in financial markets seem to think so, but the Fed does not exist to cut the Gordian knot of politics.

Might the Federal Reserve embark on Quantitative Easing II without strong political support? Maybe, but not likely, and what is clear is that strong political support for much of anything is not likely to happen in the next several months, almost regardless of the data or the evolution of the economy.

There are too many people who, right or wrong, are highly suspicious of all accommodative policies, fiscal or monetary.

That may be good policy or it may be bad, but the anger about government spending and policy is real, and the United States is heading into November elections in which many who supported the massive stimulus will be returned to the world of lobbying, consulting and just possibly answering their own mail.

My guess is that inaction is bad policy and that the United States needs more stimulus but this is a debatable point.
A recent ECB working paper showed that stimulative government spending in Europe is producing diminishing returns compared to the 1980s, a phenomenon it attributed to rising debt levels. This may be true too in the United States, though perhaps to a lesser extent.

What is very likely true is that the United States will discover that its economic fix is very serious and that its own political process will be unable to muster much of a response.

It may be that only a market panic brings the parties together, setting the stage for strong government action, and with it a decisive and bold Fed.

That panic, sadly, may be just what we get, as investors realize, as perhaps they were during Wednesday’s market sell-off, that the Adults can’t agree.

Nothing brings consensus as rapidly as an emergency.

15 comments

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“A recent ECB working paper showed that stimulative government spending in Europe is producing diminishing returns compared to the 1980s, a phenomenon it attributed to rising debt levels”
– Hello?! Anyone? Keynesian economics doesn’t work mates! Wake up!

Posted by pesheff | Report as abusive

The sad fact is that over the past 3 years the American people have seen their elected officials hand over most of the hard work and tough decisions to nonelected officials at the Fed and Treasury and Wall Street enforcement duties to the AG of NY. Our Congress – both Houses and both Parties – has come up completely lame when when confronted by any leadership demands other than rubberstamping some lobbyist scam or contrived National Crisis. It is become impossible for the electorate to expect anything from the elected other than “elect me” rhetoric. Apparantly that is the only responsibility our Senators and Reps have any more – getting re-elected. Everything else is someone else’s responsibility. It is not in any way shape or form the Fed’s job to originate the stimulation of our economy. It is Congress’ job. When are we going to start expecting Congress to start doing their job again?

Posted by Woltmann | Report as abusive

You should read the actual paper, which is linked in the article. It says, clearly, Keynesian economics works!

“The short-run economic effectiveness of government spending in stabilizing real GDP and private consumption has increased until the late 1980′s.” To quote the authors of the original working paper.

“We find that a higher ratio of credit to households over GDP, a smaller share of government investment, and a larger share of public wages over total government spending have led to decreasing contemporaneous multipliers.” The second point disputes the anti-Keynesians directly. Smaller government investment has led to decreasing returns. Another no brainer.

Also, right here at home, one only need look back at the New Deal to know that Keynesian policies work when does like Keynes said, during recessionary times outside the normal business cycle and only on projects that don’t require continued funding further down the road. Every year the New Deal increased GDP and decreased unemployment, except 1938, which was the year that Roosevelt bowed to the austerity agenda. It took three extra years and billions extra to recover from austerity. One heck of an expensive lesson.

Even more recently, Obama’s stimulus wasn’t the best stimulus our money could buy, but that’s because he tried to be bipartisan and compromise with the Republicans on taxes instead of stimulus. Still, Obama turned a negative GDP into a 5.7% positive GDP by Q4 of 2009 thanks to keynesian stimulus.

Yes, the gap between the rich and poor and the ensuing reliance by the poor and middle on credit to try to make up for transferred wealth means that we are more reluctant than we would otherwise be to consume as normal. Well, that and the fact the Republicans here in America keep attacking job stimulus and long-term UI benefit extensions while they fight for entitlement subsidies for the rich ala the Bush tax cuts.

You cannot starve your way out of a recession. Saving money now for a sunny day, doesn’t make economic or common sense.

Posted by signupbites | Report as abusive

“That is partly because during the collective fantasy of the Great Moderation we all believed that monetary policy could somehow be technocratic and above politics. Up to a point …”

Isn’t the ‘Recovery’ the latest collective fantasy that we have been living in?

Posted by yr2009 | Report as abusive

good article..thanks, Jim Saft, and Reuters..

Posted by gramps | Report as abusive

Now that we have shipped most of the jobs overseas, perhaps the federal reserve could just send anyone
who has lost a job due to outsourcing a check every week.
Ross Perot had it right when he said there will be a giant sucking sound of jobs out of the USA if NAFTA is enacted.
Well now that NAFTA is fully phased in we have 10% unemployment rate and probably many more underemployed or have just stopped looking for work. What a mess these politicians have got this country into. World trade was suppose to equal word peace, that proved to be a miserable failure. Pray for our nation.

Posted by paul3669 | Report as abusive

the american people need to force the removal of obama from office and bring in someone willing and able to work on the countrys growing problems……

Posted by langco | Report as abusive

Not being a high paid government economist or know-it-all politician, it seems that EVERY dollar of the “stimulus” money was wasted. The only real way to get an economy moving is with private sector jobs — not government jobs because of low productivity and no product — and not union jobs which are grossly overpaid to produce junk product (are you listening UAW?). What we need are jobs that pay market wage and produce a product. Look at Japan over the last 50 years and China today, both powerhouse economies built on production of goods which are increasingly better quality, and with jobs, pumping money back into their economies. Yet the current administration did nothing to stimulate USA job creation. Conversely, only in America could a few people make a billion dollars by dumping derivatives, futures, swaps, and other financial garbage on us — while they employed no one, produced nothing and only undercut our economy. If stimulus money had been spent to stimulate private industry to employ people, with an effort to make regulation less onerous, then our economy would be improving. Now unfortunately the money is gone, the government is broke, and unemployment is worse than ever. No employment = no spending or savings = a contracting economy so be prepared for much worse conditions in the next 2-3 years. We might soon be looking at 2010 as the “good times”.

Posted by cynicalme | Report as abusive

I agree with cynicalme, and would like to add that most of the stimulus money bought government workers jobs. I saw no money pointed at small manufacturing jobs.

Posted by fred5407 | Report as abusive

Unlike Zambia or Weimar Germany of old, the United States has the computational technology to create electronic currency and print massive warehouses of paper money, each note bearing a unique serial number. Software with the complexity of weather modeling can manage Wall Street and the Dollar on world markets. The Fed has unprecedented powers to just about do anything they want.

Inflation the economy needs? Done. The Fed provides it! The Fed is the world’s economic power like the military controls global security. The reason the Fed can print its way out of this crisis unparalleled in modern times is precisely because it controls everything economic.

Remember the famous opening salvo of the 1963 television series The Outer Limits? The Fed ought to paraphrase that opening when it entertains the media and public in its hallowed halls, their PR tweaking it to something like this: “There is nothing wrong with your television set. Do not attempt to adjust the picture. We are control money creation. If we wish to make inflation, we will create more money. If we wish to make deflation, we will discourage banks from lending. We will control unemployment statistics. We will control venture funding. We can roll the image, make it flutter. We can change the focus to a soft blur or sharpen it to crystal clarity. For the next century sit quietly and we will control all that you see and hear in the media. We will control all that you earn and spend.”

Posted by DisgustedReader | Report as abusive

The Recovery That Ain’t

It’s my belief that the Fed could not, can not, and will not be able to fix on even improve the economy (except temporarily). What grips me is that they did such a poor and stupid job of spending the people’s money. I’m cerainly not saying that an intelligent spending of the money would have had any lasting effecton the economy.

But if their goal was making the rich much richer at the expense of the long-suffering US taxpayer, I’d have to give them an A++ for achieving that goal.

So main street is Fed-up! !Que surpresa!

Posted by gAnton | Report as abusive

@cynicalme

So who are you going to sell your prducts to at the prices American workers need to manufacture them…..you cant have cheap at walmart and USA manufactured. it has to be one or the other you dont get to eat your cake as well as bake it.

Posted by wickii | Report as abusive

Stimulus money needs to focus on job creation. The Feds would be wise to institute a metric that measures accurately and publically x new jobs for $M spent.

Posted by CuriousOne | Report as abusive

In order to produce job growth, government investment and incentives must be poured into: research and development of clean energy and biochemistry, mass transit, improved infrastructure. Big business is not allowing these investments due to their fear that their stranglehold on the general public will loosen. Big business is not going to produce jobs, since they have just had a clear lesson in the willingness of its current workforce to increase production to keep their jobs. Only new business ventures will produce the jobs needed and that can’t happen with giant companies controlling Congress.

Posted by lhathaway | Report as abusive

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