Most of my
blog is a bit “fluffy,” and certainly personal. It is not intended to be
informative in the way that a newspaper is supposed to be informative. Mostly
memoir things, with a lot of nostalgia thrown in.
Just to
demonstrate that all my correspondence is not that way, I thought I would throw
in a portion of some discussion I have had with my correspondent in Brazil, Gerry Martin, who is a high school classmate and long-time friend. We seem to occupy different places on the political spectrum. These
comments were made in the middle of November 2012. There are references here to
on-going debates (he likes Paul Krugman…actually, “likes” is too mild a word…and
I enjoy tremendously making fun of Krugman who I think is a hack who won a
Nobel prize, like someone else we know).
There is a
minimum of editing that went on in these exchanges, so pardon the lack of
fluidity sometimes.
If you are
one of the approximately 7 billion people not interested in this topic or our
argument in that regard, skip it. Otherwise, if you continue and you are either
bored or offended, it’s your fault.
DAY ONE
Bob,
You sent me something a while back that seemed to be based on the
assumption that the Fed's purchase of Treasury dept was the only reason for the
current low interest rates, probably on the assumption that the Fed is buying a
much higher percentage of the debt than it is. Perhaps you even read and
believed something Mitt Romney said, i.e. that the Fed is buying 75% of the
Federal debt.
I don't know the details, and I don't understand the implications
between the Fed's purchase of mortgage-backed securities and its purchase of
Treasury debt, but I do know that the Fed's purchases have not been
constant. People have all along predicted inaccurately that as soon as
the round of "quantitative easing" was over there would be a spike in
interest rates.
Gerry
DAY TWO
Gerry
Thinking about my response to this, I
concluded that a lot of responses would remind you of some British snob…but
without the shitty accent. I will try to keep the “know-it-all” out of it, but
probably won’t be successful.
The blog article was about as superficial and
uninformed as a lot of blogs are (yours, of course, is the exception) and
unfortunately shed little light on a complex subject. This is so complex that
they give out Nobel Prizes for just describing a little piece of it, even to
people like Krugman (I just threw that in there to piss you off). I think my
earlier comments may have actually coincided with Krugman’s (if you take his
recommendations for Japan in the 1990’s and his advocacy of Keynesian solutions
recently as his positions) that the result of all this expansionary spending
will be inflation.
Romney’s comments, taken as they are, were
simply wrong. Maybe he has a better understanding of it all, but I don’t know
that, positive or negative. Just taking one or two phrases as they stand, they
are not correct. However, the blog didn’t do much to enlighten, either. If you
take Krugman’s comment regarding Japan to “start the printing presses” as an
example, he knows that is not correct, but it illustrates the process even if
the literal phrase is wrong.
Here is the problem as I see it, and I don’t
teach at Princeton. All my information comes from teaching money and banking
classes and from being involved on a professional level for more than 10 years.
The Fed has several tools that it can use to control interest rates, and it has
actually controlled interest rates for many years. I don’t think anyone
denies that it has been successful in that process. Now, there are only a
couple of ways that money can be created, and “revving up the printing presses”
is not really one of them. The two ways money is created is for a national
bank (trust me on this, not a credit union, not a state bank, not a savings and
loan) to make a loan or for the Federal Reserve to buy and own US debt.
The
making of loans by the national banks has often been called “pushing on a
string.” You can lead a horse to water… that kind of thing. Right now, as I
have complained before, the banks are worthless. Mortgage debt would appear to
be shrinking, not only as debts are written off like in the case of the home we
are buying, but because of amortization and the fact that new homes are just
not going up like they used to. Also, with the poor economy, it is not only
unwise or unnecessary for businesses to borrow, but the banks are so worthless
that it is impossible for even the really good borrowers to obtain loans. You
can blame this on a lot of things, but I know that some of it is because of the
bureaucracy, encouraged by the Obama administration, who finally could stomp on
the private sector and teach them a final lesson as they destroyed them.
When there is no borrowing, the money supply
shrinks. When that happens, you have deflation. In 1939, after seven years of
the New Deal and its Keynesian policies of expansion, you had what we could
call “natural” deflation, when Treasury Bills sold at a premium and had, in
fact, negative interest returns. You paid the government to store your money
for a few months. I don’t know what we have now, but it isn’t “natural,”
because the Fed is encouraging the low rates, but anyone who studies this very
long really understands that deflation has more serious social problems and
worse consequences than inflation—although hyper-inflation (ala the Weimar
Republic and Brazil at one time??) is terrible, also. Deflation in this economy
would be pretty damaging, in my opinion, and I would bet even Krugman would
agree.
So now we get to the way that the Fed keeps
interest rates low. One, the bank discount rate, is pretty much eye wash, in
that it is seldom used. It is a signal to the markets, “moral suasion” is the
term I think they use. It is minor-scale bank bailouts that have been there for
decades. Not as public as the big bank bailouts recently, but along the same
lines.
The real tool that the Fed uses to control
interest rates is “Open Market Activities.” This is when the Federal Reserve,
for their own account, buys US Treasury securities when they are issued at the
auctions or from the “open market.” There are several levels of an “orderly
market” in securities, and I think it is reasonable to use an example: in the
recent issuance of securities by Facebook, a “managing broker” decided how much
to issue and at what price, based on their knowledge and expertise (which, in
this case, was awful and the guy who was responsible got fired), and they then
“allocate” the issue to their “syndicate members” who are going to sell them to
their customers. The Managing Broker is really important in this process, and
they undertake the obligation to maintain an “orderly market,” just like the
“market makers” in stocks who routinely buy shares for their own account and
sell shares that they don’t actually own (the definition of “short sale” that
makes sense to people like me from the old days, not the current real estate
definition) in order to keep the market from having big up and down swings.
The Syndicate members (and here, “syndicate”
is a real term, a term that is carefully defined in practice and in law, not
the slang term) have a responsibility to have capital to perform their
functions and expertise to generate the sales to customers. There are a lot
more details, but when the offering is unsuccessful, and the securities decline
in value while the Managing member and the Syndicate members still have unsold
shares in their own accounts, they take a loss. They don’t like that.
The Fed is the “Market Maker” in several
auctions per week, and they are scheduled way in advance—the T Bills are on
certain days of the week, the two-year on a certain day of the month, the 10
year, etc. This is by far the most active, highest dollar volume market
anywhere in the world. Any realistic criticism of the Fed has to take into
account their activities in this regard where, if they were to be absent, this
market could get chaotic very quickly.
Open Market Activities take on a few forms,
but they also can be involved in Fed Funds through the discount rate, and that
may be the largest market in the world for all I know, as it is the buying and
selling of funds between banks on a daily basis. The most likely tool is to
“make the market’ in US Treasury securities. There are several auctions of
these securities each week, and you have to be qualified as a dealer or a
national bank (like the bank I worked at) to present a bid for securities in
the auction, and as a practical matter, the pricing is left in the hands of
perhaps 6 or so very large dealers while the rest of us would signify that we
wanted to buy “at the market” and we would take whatever they decided. Well,
the Fed could control this market by signifying either a lack of interest or a
keen interest, so their bid would be significant to the auction pricing.
In these times, with the banks doing such a
shitty job of doing what they are supposed to do, the Fed had to own AND RETAIN
a lot of Treasury debt to keep interest rates down. If they hadn’t the money
supply would have decreased and interest rates would have gone up, and we
probably don’t want that.
Regarding the purchase of mortgage-backed
securities, this is just another open market activity, but one that is pretty
recent (September), follows the Jackson Hole meeting, is a departure from
traditional Fed activities, and is designed to bring mortgage rates down even
further. I think I mentioned how the rate we will get (3.5%?) will cause our payment
per month to be significantly lower than if the rates were in the range we have
considered to be “normal” during our lifetime, say 9% (less than $1,300 versus
$2,300 per month, not counting taxes and insurance) and the effect that could
have later on if interest rates go up. I guess it technically changes the
nature of the Federal obligation in that mortgage-backed securities come in two
varieties, those with the guarantee of the Fed (GNMA) and those that have the
backing of the Fed (FNMA and others). This is a significant distinction to the
market that prices them differently with the “indirect” obligation having a
higher yield.
Sum it up: the purchase of
mortgage-backed securities is a “rifle” approach to making a change in the
interest rates of one particular economic segment and there really aren’t any
“implications” other than the effect that activity will have. The activities of
the Fed have something to do with the prevention of deflation right now, as it
tried to prevent inflation for most of the last 50 years, and that explains, in
conjunction with the ineffective banking industry and the dead housing
industry, why they hold a lot of securities in the Fed’s own account. And
finally, Romney’s comment is wrong if that is all he knows. The blogger wasn’t
very helpful. No mention of the Obama administration, and I haven’t heard much
one way or the other from the administration about the Fed.
OK, now I’ve probably told you more than I
know. Honestly, I tried to say things without “spin” but to describe what I
know or my opinion about the situation.
Bob
DAY THREE—
Bob
Thinking about my response to
this, I concluded that a lot of responses would remind you of a British snob…but
without the shitty accent. I will try to keep the “know-it-all” out of it, but
probably won’t be successful.
The blog article was about as
superficial and uninformed as a lot of blogs are (yours, of course, is the
exception) and unfortunately shed little light on a complex subject. This is so
complex that they give out Nobel Prizes for just describing a little piece of
it, even to people like Krugman (I just threw that in there to piss you off). I
think my earlier comments may have actually coincided with Krugman’s (if you
take his recommendations for Japan in the 1990’s and his advocacy of Keynesian
solutions recently as his positions) that the result of all this expansionary
spending will be inflation. I think the subject of the article was much
smaller than you suggest, since it focused simply on the assertion that the Fed
was buying 75% of the Federal debt and the dire predictions of what would
happen when that stopped. But let it pass.
Romney’s comments, taken as
they are, were simply wrong. Maybe he has a better understanding of it all, (It is more
likely, given his campaign, that he knew what he said was wrong, but he knew
what his audience wanted to hear. Remember, he was responding to a questioner
who wanted this answer.) but I don’t know that, positive or negative. Just taking one or
two phrases as they stand, they are not correct. However, the blog didn’t do
much to enlighten, either. If you take Krugman’s comment regarding Japan to
“start the printing presses” as an example, he knows that is not correct, but
it illustrates the process even if the literal phrase is wrong. I don't
know exactly what statement of Krugman's you are referring to, but I believe it
is true that he is on record as saying that it would be a good thing if we had
an annual inflation rate of about 1.5%, but I also know you are wrong if you
are suggesting that Krugman has set Japan as a role model for what we should be
doing. True, he has shown that even in the "lost decade" of 1990 -
2000, Japan's economy was performing in some respects better than our own is
currently, but hardly as a model for us to emulate.
Here is the problem as I see
it, and I don’t teach at Princeton. All my information comes from teaching
money and banking classes and from being involved on a professional level for
more than 10 years. The Fed has several tools that it can use to control
interest rates, and it has actually controlled interest rates for many
years. I don’t think anyone denies that it has been successful in that process.
Now, there are only a couple of ways that money can be created, and “revving up
the printing presses” is not really one of them. The two ways money is created
is for a national bank (trust me on this, not a credit union, not a
state bank, not a savings and loan) to make a loan or for the Federal Reserve
to buy and own US debt.
The making of loans by the national banks has often been called
“pushing on a string.” You can lead a horse to water… that kind of thing. Right
now, as I have complained before, the banks are worthless. Mortgage debt would
appear to be shrinking, not only as debts are written off like in the case of
the home we are buying, but because of amortization and the fact that new homes
are just not going up like they used to. Also, with the poor economy, it is not
only unwise or unnecessary for businesses to borrow, but the banks are so
worthless that it is impossible for even the really good borrowers to obtain
loans. You can blame this on a lot of things, but I know that some of it is
because of the bureaucracy, encouraged by the Obama administration, who finally
could stomp on the private sector and teach them a final lesson as they
destroyed them. This seems
to get at the argument of whether we have a supply-side or a demand-side
recession. You clearly seem to be on the supply-side. This brief explanation from
your friend Paul Krugman explains it very nicely.
When there is no borrowing, the
money supply shrinks. When that happens, you have deflation. In 1939, after
seven years of the New Deal and its Keynesian policies of expansion, you had
what we could call “natural” deflation, when Treasury Bills sold at a premium
and had, in fact, negative interest returns. You paid the government to store
your money for a few months. I don’t know what we have now, but it isn’t
“natural,” because the Fed is encouraging the low rates, but anyone who studies
this very long really understands that deflation has more serious social problems
and worse consequences than inflation—although hyper-inflation (ala the Weimar
Republic and Brazil at one time??) is terrible, also. Deflation in this economy
would be pretty damaging, in my opinion, and I would bet even Krugman would
agree.
So now we get to the way that
the Fed keeps interest rates low. One, the bank discount rate, is pretty much
eye wash, in that it is seldom used. It is a signal to the markets, “moral
suasion” is the term I think they use. It is minor-scale bank bailouts that have
been there for decades. Not as public as the big bank bailouts recently, but
along the same lines.
The real tool that the Fed uses
to control interest rates is “Open Market Activities.” This is when the Federal
Reserve, for their own account, buys US Treasury securities when they are
issued at the auctions or from the “open market.” There are several levels of
an “orderly market” in securities, and I think it is reasonable to use an
example: in the recent issuance of securities by Facebook, a “managing broker”
decided how much to issue and at what price, based on their knowledge and
expertise (which, in this case, was awful and the guy who was responsible got
fired), and they then “allocate” the issue to their “syndicate members” who are
going to sell them to their customers. The Managing Broker is really important
in this process, and they undertake the obligation to maintain an “orderly
market,” just like the “market makers” in stocks who routinely buy shares for
their own account and sell shares that they don’t actually own (the definition
of “short sale” that makes sense to people like me from the old days, not the
current real estate definition) in order to keep the market from having big up
and down swings.
The Syndicate members (and
here, “syndicate” is a real term, a term that is carefully defined in practice
and in law, not the slang term) have a responsibility to have capital to
perform their functions and expertise to generate the sales to customers. There
are a lot more details, but when the offering is unsuccessful, and the
securities decline in value while the Managing member and the Syndicate members
still have unsold shares in their own accounts, they take a loss. They don’t
like that.
The Fed is the “Market Maker”
in several auctions per week, and they are scheduled way in advance—the T Bills
are on certain days of the week, the two-year on a certain day of the month,
the 10 year, etc. This is by far the most active, highest dollar volume market anywhere
in the world. Any realistic criticism of the Fed has to take into account their
activities in this regard where, if they were to be absent, this market could
get chaotic very quickly.
Open Market Activities take on
a few forms, but they also can be involved in Fed Funds through the discount
rate, and that may be the largest market in the world for all I know, as it is
the buying and selling of funds between banks on a daily basis. The most likely
tool is to “make the market’ in US Treasury securities. There are several
auctions of these securities each week, and you have to be qualified as a
dealer or a national bank (like the bank I worked at) to present a bid for
securities in the auction, and as a practical matter, the pricing is left in
the hands of perhaps 6 or so very large dealers while the rest of us would
signify that we wanted to buy “at the market” and we would take whatever they
decided. Well, the Fed could control this market by signifying either a lack of
interest or a keen interest, so their bid would be significant to the auction
pricing.
In these times, with the banks
doing such a shitty job of doing what they are supposed to do, the Fed had to
own AND RETAIN a lot of Treasury debt to keep interest rates down. If they
hadn’t the money supply wwould have decreased and interest rates would have
gone up, and we probably don’t want that. I believe this "AND
RETAIN" was an anticipated part of the Qualitative Easing project, no? But
in the last quarter, according to the article I sent you, the Fed has actually
reduced its net holdings of debt. In other words, retention need not be
permanent, right? All of this boring (sorry) Fed activity does not have totake
place over night, does it? The Fed can continue to reduce its holdings over
time?
Regarding the purchase of
mortgage-backed securities, this is just another open market activity, but one
that is pretty recent (September), follows the Jackson Hole meeting, is a
departure from traditional Fed activities, and is designed to bring mortgage
rates down even further. I think I mentioned how the rate we will get (3.5%?)
will cause our payment per month to be significantly lower than if the rates
were in the range we have considered to be “normal” during our lifetime, say 9%
(less than $1,300 versus $2,300 per month, not counting taxes and insurance)
and the effect that could have later on if interest rates go up. I guess it
technically changes the nature of the Federal obligation in that mortgage-backed
securities come in two varieties, those with the guarantee of the Fed (GNMA)
and those that have the backing of the Fed (FNMA and others). This is a
significant distinction to the market that prices them differently with the
“indirect” obligation having a higher yield.
Sum it up: the purchase
of mortgage-backed securities is a “rifle” approach to making a change in the
interest rates of one particular economic segment and there really aren’t any
“implications” other than the effect that activity will have. The activities of
the Fed have something to do with the prevention of deflation right now, as it
tried to prevent inflation for most of the last 50 years, and that explains, in
conjunction with the ineffective banking industry and the dead housing
industry, why they hold a lot of securities in the Fed’s own account. And
finally, Romney’s comment is wrong if that is all he knows. The blogger wasn’t
very helpful. No mention of the Obama administration, and I haven’t heard much
one way or the other from the administration about the Fed. Every article can't mention everything aspect of the problem/issue.
The question on the table was Romney's statement.
OK, now I’ve probably told you
more than I know. Honestly, I tried to say things without “spin” but to
describe what I know or my opinion about the situation.
Bob
DAY FOUR
Bob,
If time is, indeed, money, then I guess I should thank you for your investment in this response.
Actually, I want to thank you anyway; you impressed me with your knowledge. It'll take you some time for you to knock Krugman off his niche, but it is an impressive essay, particulary as it deals with the day-to-day working of the Fed and the banking system.
Thanks.
Gerry
DAY FIVE
Gerry
If
nothing else, I am sure that you recognize that it is an arcane system and
subject, it would seem, to serious misunderstanding although every commentator,
political candidate and guy sitting on the bench outside the hotel wants to
express an opinion on it.
Bob
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