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Musings on the Fed

Message Siegfried Othmer
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Whether we want to or not, we now have to have an eye on the Federal Reserve Board. In 1913 the Federal Reserve Board was established specifically to lodge the creation of money outside of the reach of the Executive and Legislative branches of government. We had been through numerous cycles of boom and bust in our nation's history that were exacerbated by political control of money. Rightly or wrongly, the new approach took the control of money out of the hands of elected officials who might bias monetary policy in favor of their immediate electoral imperatives.
The main rationale, let me reiterate, was to insulate the monetary authorities from the immediate vicissitudes of the political (and commercial) world. Monetary regulation required a steady hand, a long-term perspective, and a stability reminiscent of the Rock of Gibraltar. This could only be accomplished by an agency that was insulated from the day-to-day political ebbs and flows.
I am neither an economist nor a Constitutional scholar, but I feel the need to get on top of what is happening now because it will probably matter deeply to us all, and to our national future. It has been argued that moving the control of money to an independent agency violates our Constitution. But even if we are not inclined toward such a legalistic preoccupation at the moment, the Fed does give the appearance of being a fourth branch of government. In its domain, it has an independence equal to that of the other three branches. And that is potentially alarming.
The inventiveness of our financial gnomes has given us a world in which monetary instruments play the role of money without actually being money. And by now these instruments dominate our affairs. By the same token, the stability of the financial edifice can no longer be assured by the Fed just doing business the old-fashioned way. It must exercise some regulatory authority over this larger financial universe.
Thus the case is made that every incremental step in the Fed's authority is rationally based in our larger self-interest. An instability of sufficient size can escalate rapidly to bring down the whole system, and that must be avoided at all costs. The Bear Stearns debacle clarified that for everyone involved. Nobody wanted to be around to witness the fallout of the apoptosis (cell death) of Bear Stearns. (The "pop" in apoptosis seems somehow fitting, don't you think?) Why should this be the case now, when it would not have been twenty years ago?
We are now living in a world of hedging strategies and of derivatives that vastly exceeds in size the underlying basket of securities. Each individual act of hedging reduces the microscopic risk of the parties to the transaction, but collectively the hedging strategy has increased macro-economic risk. A simple analogy is to the climbing rope that ties together a group of climbers. The rope reduces the risk to the individual climber, but increases it for the whole group. And whereas the rope is apparent to everyone who is tied to it, no one knows any longer where the risk is lodged in a hedging universe.
Everybody must assume that the other party will make good on its part of the financial bargain. When a local cataclysm sunders that assumption, the ripples go through the entire fabric of network relations like a run in an old nylon hose. The run is not self-arresting. There is no stopping it.
The risk is lodged in the weakest link. Or it could be lodged in what is simply suspected of being the weakest link. At some point, financial actors will protect themselves individually against this hazard; the weak actor gets cut out of the network and collapse becomes inevitable. The very thing that was feared will have been brought about. Everyone will have acted rationally at every point along the way. We have a positive-feedback situation that leads to instability and from thence to catastrophe. The system is no longer unconditionally stable. The hedging regime, brought into prominence as a risk-management strategy, has made the system as a whole more vulnerable to collapse under some conditions. Such a system cannot be left entirely to its own devices. An external regulator is mandatory.
What we have also witnessed in the apoptosis of Bear Stearns is the extraordinary rapidity with which things can go to hell. Now it was already known in Wall Street that BS was the baddest gunslinger in the East. It didn't take much for rumors of trouble to gain credibility and to propagate. But in order to intervene effectively at all, the Fed had to really have its fingers on the pulse---and to put a package together over a weekend.
Of course it was a bailout. The only way the absorption by JP Morgan Chase went down was with the lubrication of a $30B dowry from the Fed, in which the Fed assumed responsibility for the most toxic of the waste in the BS inventory. For the Fed, read the taxpayer. This only looks good when it is compared to the alternative. Now one might well ask why no one had the relevant imagination beforehand, particularly when we have been here before.
Remember Long Term Capital Management? It had a couple of trillion dollars outstanding in arbitrage, and whole house of cards was threatening to come down around its ears with the Russian default. The whole hedging business was a lot smaller then, and a lesson learned then might have put us in a better place now. But the Fed bailed LTCM out and the lesson remained unlearned. The mathematical wizards at LTCM were basically operating on the simple principle of the Bell curve that the tails of the curve diminish at exponential rates. That is to say, large excursions from the mean don't happen. The boldness in their investment strategy hinges on the confidence they have in that asssumption. In reality, of course, large excursions do happen. But because these step out of the bounds of any model, they cannot be readily predicted. This is known as the long tail, or the fat tail. If the Fed protects organizations against the occasional disastrous miscalculation, then boldness in investing other people's money will know no bounds.
This is all quite nightmarish enough. But we have even bigger issues to worry about. Read on, dear long-suffering reader.
For the Fed to do its job in this new-fangled financial universe, it must be much more intimately informed about what is going on at the financial institutions whose viability it is now guaranteeing. The tendrils of connectivity to Wall Street will be ever more elaborate and extensive. Once again, every step along this path is rationally defensible. What we end up with, however, is the very opposite of what had been originally designed.
There is no more distance, no more isolation, between the regulator and the regulated. Wall Street and the Fed are becoming one living organism, each one explicitly dependent on the welfare of the other. The duality reminds one of the sympathetic and parasympathetic nervous systems in our own bodies. The sympathetic branch handles our engagement with the world. The fight/flight response matches up nicely with greed and fear. The parasympathetic branch handles our vegetative needs, analogous to the Fed meting out funds to keep the economic organism well supplied.
The biological analogy suggests that the symbiosis of the Fed and Wall Street might actually be a sound idea. But all is not well. While indices of volatility have gone down over the years on the Street, documenting a decrease in the perception of risk, the Fed's regulatory actions have become ever more frenetic, ever more volatile, ever more precipitous, ever more extreme. There is no longer any stability to speak of, no long-term predictability. The Fed will do whatever it has to do to prop up Wall Street in the moment, even deciding on interest rates on a Sunday, as it did recently. When a country's central bank is constantly in the news, something has gone terribly wrong.
With the globalization of commerce, the American taxpayer is only the incidental beneficiary of the Fed's intimate relations with the captains of finance. Consider that the Fed loses a lot of leverage in a deflationary period. The Fed cannot push on a string, a reality the Japanese central bank wrestled with for ten years. The biggest unspoken fear by Bernanke is of a prolonged period of price deflation. There is an old adage that "a bear market returns money to its rightful owners." This option is to be foreclosed. Every bubble is then a ratchet to a new price niveau. Letting air out of the bubble is too hazardous to contemplate. And if such a deflation cannot be arrested, then it is time to turn the burners on under yet another bubble. Inflation is given mere lip service, so inflation is what we'll have. The creation of money does not imply the creation of value.
The public is ultimately defrauded of its birthright---a stable currency, of which the Fed was to be the guarantor. In this case, however, the American taxpayer is not the only victim. As the custodian of the world currency, the Fed has an implicit obligation to all the foreign holders of dollars as well. The casual, unlamented debauchery of our currency that we are now witnessing proves that there aren't any rules any more, no standards or points of reference. No heads are rolling, or even under threat of disgrace. Nothing is left but for tactics to keep the game going. This does not bode well for the future when this fraud on the public is finally exposed. It will, of course, only be discerned clearly in retrospect. On nearly every issue of national import in recent years, we have a history of avoiding prudent, prospective, and preventive action.
The center of power in our country has already gravitated from Washington to Wall Street. Its incestuous marriage to the Fed completes the hegemony of capital over our political institutions. On the one hand, capital claims the freedoms accorded all private ventures. And on the other hand the Fed has been deliberately insulated from public pressures. The marriage of private capital with the fount of all money means that the people hardly matter any more in our ersatz democracy. This is, of course, the very essence of fascism---the alliance of commerce and finance with the powers of government into common enterprise. The functionally integrated entity is essentially autonomous, and insulated from any effective redress by a disenfranchised populace.
Whereas in German and Italian fascism industry danced to the government's tune, in these United States our elected officials are the marionettes and Wall Street pulls the strings. We have all been recruited into the service of the well-being of the queen bee, our economy, and Wall Street is the arbiter of what constitutes well-being. Nothing quite matches in importance these days the vital signs of our economy. Guess who wrote the script for this movie.
Nevertheless, we must act as if we still had a democracy in which we have an effective voice. And if we did, what should we insist upon? First of all, it should be recognized that the Fed is offering a kind of insurance to the financial industry. Why should that not come at a cost? The Fed can only peddle its dollars as long as they are wanted, as long as they have value. Ultimately the whole country stands as a support for the currency that the Fed is doling out. So Wall Street should pay whatever is necessary to maintain the value of the currency that in turn is supporting Wall Street. If the consequences of a melt-down of the financial system are incalculably large, then so is the value of avoiding such a scenario. What is that worth? Whatever it costs to maintain the value of our currency and to support the stability of the system.
The financiers should not be able to continue to raid the bottomless ATM that is the Federal budget and send the bill to the next generation. They have been spotted hundreds of billions during Bush's stolen-from-the-people presidency, and now they must pay it back. No tickee, no washee. And if we cannot get this done, then the next time they can fight their own war, and assume their own risks.
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Siegfried Othmer is a physicist who over the last 33 years has been engaged with neurofeedback as a technique for the rehabilitation and enhancement of brain function. He is Chief Scientist at the EEG Institute in Los Angeles. Coming to (more...)

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