Edward Harrison annoyed me this morning. He writes the useful but sometimes disagreeable Credit Writedowns blog and he has a post up on why the Fed should never buy Italian Government bonds. His conclusion – which sounds reasonable but is dead wrong, is repeated below.
First of all, a central bank’s buying dodgy assets is always a solution to a liquidity crisis that is fraught with peril. if those assets go bad and losses are crystallized, it could render the central bank technically insolvent and undermine confidence in the central bank. Fear of this technically insolvent outcome was a major reason the Europeans did not allow the ECB to participate in the ‘voluntary’ haircuts that it has attempted to coerce onto the private sector in the latest Greek bailout.
Clearly, the ECB could just print money and use the seigniorage from that printing to earn its way back into solvency without having been declared insolvent. But you can see the problem. To maintain the ECB’s credibility it would need to be recapitalised.
But if the Federal Reserve were to load up on Italian bonds, then the seigniorage route is out. The Fed would be exposed to default on foreign currency assets. If Italy defaults, then the Fed is on the hook. Officially, the Fed is under Congressional jurisdiction. The US Congress has oversight of the Federal Reserve and Congress should never allow the Fed to make unsecured loans to foreign governments without prior and specific Congressional approval.
The Fed should never buy foreign currency assets. And if it does, Congress should intervene.
America’s monetary problem however is that they are in a liquidity trap.
Six or seven years of 6 per cent inflation, 2 per cent interest rates and to stick the losses to the Chinese who (in their mercantilist fashion) own the debt would be a wonderful way out of America’s malaise. And you would think you could induce 5 per cent inflation by printing money. You would think the option is open. Indeed you would swear, given how much money the Fed has printed, that it would have happened.
But it has not happened.
Sure the Fed has printed money. And when it finished that it printed some more. Soon we will get to QE4 and yet another round of “quantitative easing” and we will still not manage to induce 5-7 per cent inflation, 2 per cent interest rates and to stick the losses to the Chinese.
If you had – without any understanding of monetary theory – been told that the Fed could increase money stock from say $800 billion to $3 trillion and not result in an inflationary torrent you would not have believed it. It would have sounded like nonsense.
But you better believe it because it happened. And that requires an explanation.
The explanation is simple enough. The Federal Reserve has too much credibility. Each time it increases the money supply it buys some asset (say a government bond or even a foreign security) and issues cash. And people hold the cash because it is a reasonable store of value. And it is a reasonable store of value because they trust – at the end of this cycle – that the Federal Reserve will eventually take its vault full of assets, sell the assets for hard cash (which it will destroy) and will thus suck the excess liquidity out of the system.
If people really believed the cash was trash they would all try to get rid of it (ie buy something) but collectively they could not get rid of it (every time they buy something it would have a new owner) and the result would be inflation. Inflation would then reduce the real value of the money stock to a level where people were comfortable holding it.
To get inflation you need to damage the Federal Reserve’s credibility. You need the Federal Reserve to make a credible promise to be reckless.
And Ben Bernanke – despite the helicopter speech in which he outlined this view of the world very clearly – is not your man. Maybe it is the facial hair, but he looks, well, just too responsible.
When he got on 60 Minutes he proved the point. He was asked point-blank whether the Federal Reserve could print all that money and control inflation and he said it could. He was right of course – but it was the wrong message. He had his one-mass-market-opportunity to be credibly reckless and his media-conservatism meant that he squibbed it. He should have just said that he did not know but that it was a risk that was necessary to take…
When he appeared all media-conservative I knew he blew it. I was thinking then of asking for his resignation because he was just not up to the job that he himself outlined in the famous helicopter speech.
But the European crisis gives the Fed Chair the opportunity to get it right this time, being credibly reckless. Indeed what I want is for him to be incredibly reckless. He should not only announce that the Fed is buying Italian debt, he should do it whilst wearing a Hawaiian shirt and carrying a marijuana pipe. (I would even buy him the pipe…)
Ok, the marijuana pipe is not happening – but I dream of a day when a central bank knows that the best way out of a debt-deflation is inflation induced by deliberately and credibly reckless policy rather than an endless austerity-recession and deflation.
In this case – where the debt is held disproportionately by the Chinese the Fed has an opportunity to stick the losses to someone else. Come on Ben – what do you say about that?
And when we are done we can sit down, you can have a joint and I will have a beer.
Post script: Edward Harrison reminds me (fairly) that he is not generally opposed to inflationary solutions and he (fairly) thought that this post implied he was. I am diametrically opposed to his view about the necessity to maintain Federal Reserve credibility. Indeed few things have annoyed me quite as much as the referred to post. However we are closer much of the time.
Post post script: Ed Harrison thought that the issue was democracy – congressional oversight of buying of foreign bonds. That I think is peculiar – central banks have been buying foreign bonds since – well – forever. It is how they hold foreign reserves. But he does think it unreasonable and subject to oversight for a central bank to buy stressed foreign bonds. Respectfully I disagree – but that is another story.
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