Want To Fix The Fed? Get Rid Of It

Inquiring minds have been pondering Volcker's latest statements regarding stagflation, the CPI, regulation of banks, and even the need for an administrator to watch over the Fed.

Let's see where Volcker is right and wrong with his analysis of the current economic situation and what to do about it.

The US economy is not now in the kind of stagflation crisis it had been in, in the late 1970s, former Federal Reserve Board Chairman Paul Volcker told Congress today, but it's not impossible.

'I think there is some resemblance now to inflation in the early 1970s,' he warned the Joint Economic Committee. The economy obviously does not have the full-blown, double-digit inflation crisis that finally appeared, but he said, 'there is an underlying tendency to inflation.'

Volcker also told the committee that the Consumer Price Index may understate the actual rate of inflation. For example, during the real estate boom, the housing component of the CPI rose only slightly. And to consumers, 'when food and energy are running high, not for a couple of months and dropping, but running high for years, it doesn't sound quite right, it doesn't feel quite right.'

My Comment: As for not believing the CPI, virtually no one does. Inquiring minds may wish to consider CPI Numbers For April: Spotlight On Energy fora look at the latest numbers. Furthermore, as Volcker points out, housing was dramatically understated for years. Housing is overstated now. However, Volcker fails to go far enough with this line of thinking.

Other Problems Inherent With The CPI

The CPI cannot measure stock prices or prices falling because of rising productivity. Peak oil is a factor. So is worldwide demand. It's debatable that prices can even be accurately measured or that there is any such thing as a representative basket of goods and services to measure. Most importantly: the CPI is useless in measuring the magnitude of credit bubbles that manifest themselves in other ways besides prices. Finally, the CPI is a lagging indicator.

The final analysis shows that anyone who believes the CPI is (or is even supposed to be) a measure of inflation is making a huge mistake. The solution is to start with a sound definition of inflation and deflation: Inflation is a net increase in money supply and credit. Deflation is the opposite.

Inquiring minds that have not yet done so may wish to read Inflation: What the heck is it? for further discussion.

Volcker did not forecast a recession, rather he talked about a necessary rebalancing of an economy that depended too much on consumption financed with borrowing. 'Somehow that has to change,' he said. 'It's a kind of a rough ride but we have to have it happen to avoid more severe consequences.' And in fact, consumption is declining and exports rising, 'laying the basis for a sustained recovery.'

My Comment: There is clearly a need for rebalancing. However, there is no basis whatsoever for believing a sustained recovery is possible any time soon. The recession is barely a few months old, and some do not even think it has started yet.

More to the point: The jobs picture is miserable, banks are horrendously undercapitalized, and foreclosures are mounting. A Flood of Foreclosures Prove Loan Modification Isn't Working. Bank failures are coming.

In his analysis of the credit crisis, Volcker said the mathematical modelling and financial engineering behind the structured investment products involved are inherently incapable of accounting for the human element of market behaviour.

My Comment: That's easy to agree with. Some of the housing and structured credit models are completely absurd, especially at the rating agencies.

And, having necessitated Fed intervention to rescue the markets and economy as a result, the investment banks which used the financial innovations now need to face the same kind of regulation as commercial banks.

'I believe there is no escape from the conclusion that, faced with the kind of recurrent strains and pressures typical of free financial markets, the new system has failed the test of maintaining reasonable stability and fluidity,' Volcker said.

My Comment: The problem is not lack of regulation. The problem is the Fed itself is distorting the free market. Eliminate the Fed, eliminate fractional reserve lending, and eliminate borrowing money into existence and none of this would have happened, at least to any significant degree.

Asked about the Fed's arranged merger of Bear Stearns by JP Morgan Chase, he said 'I can understand' why the Fed felt it had to act as it did. The more important question, though, is whether better regulation and supervision could have prevented the collapse in the first place.

My Comment: The important question is when do we get rid of the Fed? But first we need people to see that the Fed (and fractional reserve lending) are indeed the big problems.

Faced with the threat of a cascading breakdown of financial markets, the Federal Reserve felt compelled to extend its safety net with long-dormant emergency powers.

'The natural corollary,' to that Volcker said, is that systemically important investment banking institutions should be regulated and supervised along at least the basic lines appropriate for commercial banks they resemble in key respects.'

My Comment: Speaking of corollaries, please consider the Fed Uncertainty Principle corollary #3:

The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab.

Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

By its intervention in the mortgage and other credit markets, the Fed may imply official support for a particular sector of the economy. 'The creators of the Federal Reserve could be rolling over in their graves knowing the Fed is buying mortgages,' he said.

The intervention, in turn raises potential questions about the political independence of the Fed.

My Comment: Volcker is back on track with those statements. The solution to me is easy: Abolish the Fed. Unfortunately, he comes up with a different answer as follows:

Volcker said the Fed should have the lead role in financial regulation, but to take that on, it needs a reorganization with a senior administrator and a stronger staff if it's to fulfill that roll.

Let's see: Now we need a senior administrator to watch over the Fed to watch over the banks and brokers? The Fed itself needs a stronger staff. Who is going to watch over the senior administrator? Congress? How can any of this possibly solve questions about the political independence of the Fed.

Instead of fixing the problem, Volcker proposes still more government partnerships. He never addresses the root problems: 1) Fractional reserve lending fosters credit bubbles and 2) the Fed compounds the problem by micromanaging interest rates.

In my opinion, it's time to stop the madness and abolish the Fed and along with it fractional reserve lending. Sadly, we are moving the opposite direction towards more government intervention, nationalization of banks, nationalization of housing, and more regulation on top of regulation, with increasing power to the organization most responsible for creating the mess we are in.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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