The Fed and Reducing Government Deficits and Debt
Carlos M Pelaez
Macroeconomic policy during the credit/dollar crisis and the global recession has been characterized by monetary and fiscal stimulus (Pelaez and Pelaez, Regulation of Banks and Finance, 217-27, Financial Regulation after the Global Recession, 155-70). Confidence in financial markets collapsed after the Troubled Asset Relief Program (TARP) proposed in September 2008 to avoid economic catastrophe by purchasing toxic assets held by banks. TARP alarmism on devastating impact of write downs of assets on bank balance sheets caused exacerbated perceptions of default risk in counterparty transactions. Banks and investors ceased trusting themselves or other banks and investors. The volume of financing in sale and repurchase agreements (SRP) of asset-backed securities plummeted, resulting in fire sales and lower prices of those securities. The decline of security prices eroded capital of financed entities that were forced to sell positions, causing further declines of security prices across market segments. Confidence in financial transactions returned with higher risk appetite by investors around March 2009 that had no clear link to the monetary and fiscal stimulus. In fact, the same withdrawal plan of toxic securities was proposed in imitating the Swedish bank plan of 1992-3 under the different name of Financial Stability Plan (FSP) of February 2009, which again failed in implementation. Banks facing both the initial TARP in 2008 and the FSP in 2009 would rather hold the securities and assets than sell them at temporarily depressed prices that would bankrupt them (Financial Regulation after the Global Recession, 164-6 and 170-1). The recovery of prices of the derivatives portfolio of AIG illustrates the inconsistency of the toxic withdrawal plans. Panicking by the authorities with toxic securities caused the financial panic. The major part of toxic securities originated in the purchase or guarantee of $1.5 trillion nonprime mortgages by Fannie and Freddie. It is also difficult to find a clear link to the fiscal stimulus in the recovery of real economic activity after the second quarter of 2009. Definitive judgment awaits rigorous econometric analysis, which may never be fully conclusive. The policy issue at the moment is not the effectiveness of the monetary and fiscal stimulus but the potential threats to future economic activity in not implementing a timely and effective exit strategy of the combined monetary and fiscal stimulus. Both strategies are considered in turn. First, the exit strategy of the monetary stimulus requires an adjustment of the policy rate of the Fed of 0 to ¼ percent paid on uncollateralized loans among banks of deposits at the Fed (or fed funds) and a reduction of the portfolio of securities of the Fed in the value of $1.7 trillion. At some point, quite difficult in timing and dose, interest rates must increase again. Expectations of interest rate increases are influenced by the lowering of the fed funds rate by 525 basis points in 2000-2003 followed by an increase of 425 basis points in 2004-2005 and then by a decrease of 425 basis points in 2007-2008. Markets fear that the there may be another episode in the future of sharp increases in interest rates by the Fed. Monetary policy in the form of fixing fed funds rates is conducted by the Federal Open Market Committee (FOMC) of the Federal Reserve System (FRS) composed of the seven governors of the Board of Governors of the FRS, the president of the Federal Reserve Bank (FRB) of New York and four rotating presidents of the 12 regional FRBs of which one is chosen from each of four groups of FRBs organized by region (Pelaez and Pelaez, Globalization and the State, Vol. I, 34-7, Government Intervention in Globalization, 33-5, Financial Regulation after the Global Recession, 74-7, Regulation of Banks and Finance, 102-8). The FOMC and the FRS have been characterized by competent choices of prominent professionals for governors and presidents of the regional FRBs and elite staff in research, supervision and regulation. It is imprudent to replace this system during this difficult adjustment by a new risk agency, which would lack the technical excellence and independence of the FRS, being subject to political capture and influence as Fannie and Freddie. Debates on policies are constructive and occur within the FOMC but recession regulation dismantling the FRS poses a major risk to financial stability, economic activity and employment. The minutes of the FOMC meeting on November 3 document the ongoing work on the exit strategy of the monetary stimulus. An important analysis considered in that meeting is that the low fed funds rate of 0 to ¼ percent could lead to excessive risk taking but that possibility is not considered as important currently. A key likely cause of the credit/dollar crisis and global recession is that the 1 percent fed funds rate in 2003-2004 distorted risk/returns decisions, encouraging excessive risk/leverage, low liquidity and unsound credit (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). The 0 to ¼ percent fed funds rate in 2008 caused the mirage of ever increasing commodity prices such as oil futures at $145/barrel, which is behind debacles similar to Dubai real estate. The necessary increase in interest rates will cause oscillation of exchange rates and emerging markets overvalued by the carry trade stimulated by low fed funds rates. These policy errors abound because the changing forecasts on the economy disguised as scenarios are commonly worst in predictive value than those of palm readers and astrologers. Economic policy has uncertain effects. The staff of the Fed is conducting research on the alternative policy tools to adjust interest rates and the portfolio of securities in the Fed balance sheet. There are four policies and alternative combinations in the tool kit of the Fed: (1) reverse sale and repurchase agreements (RSRP) in large scale and even with counterparties other than approved dealers; RSRPs are short-term collateralized loans consisting of the sale by the Fed of qualified securities in its portfolio with an agreement to repurchase the securities in the near term at the agreed price plus interest, resulting in withdrawal of bank reserves (Pelaez and Pelaez, Globalization and the State, Vol. I, 34-7, Government Intervention in Globalization, 34-5, 38-9, Financial Regulation after the Global Recession, 75-7, Regulation of Banks and Finance, 99-116); (2) a term deposit facility at the FRS available to depository institutions, reducing bank reserves during the term of the deposit and renewed when necessary; (3) linking the interest rate paid on reserve balances of banks held at the FRBs and the fed funds rate, directly raising interest rates; and (4) final sale of assets in the securities portfolio, withdrawing bank reserves. There is no magic in the tools for exiting: the withdrawal of bank reserves causes an increase in interest rates in all alternatives or possible combinations. The recovery of the economy will increase demand for bank loans with resulting withdrawal of all or part of the $1.1 trillion of bank deposits in the Fed balance sheet that largely financed the portfolio of $1.7 trillion of securities, causing an increase in interest rates. Second, the fiscal stimulus, decline in government revenue following contraction of economic activity, special programs and legislative agenda are causing significant increase in the public deficit and internal debt. The Cross Country Fiscal Monitor of the International Monetary Fund (IMF) for November 2009 analyzes the deficit and debt of G20 countries. The IMF is projecting that government debt in the advanced economies of the G20 will reach 118 percent of GDP in 2014 even after the end of temporary stimulus. The structural primary balance is defined as government revenue less government expenditures, excluding interest payments on the debt while adjusting for the cycle of the economy and onetime factors. Controlling government debt at 60 percent of GDP by 2030 requires an increase in the average structural balance of 8 percentage points of GDP relative to 2010. There would have to be an elimination of the current primary deficit of 3.5 percent of GDP and the creation of a primary surplus of 4 percent of GDP. Such adjustment has occurred in the past but requires firm policy and its execution. The Congressional Budget Office (CBO) baseline budget outlook projects the federal deficit to continue at more than 3 percent per year in all of the next ten years. If there is no effort of fiscal restraint, which is the assumption of that baseline outlook because the CBO does not know currently what the government will do, the debt may become explosive, forcing more costly adjustment in terms of declining growth. Major deviations from projections are common. Stabilizing the debt at levels after the credit crisis would raise interest rates in advanced G20 economies by 2 percentage points, according to the IMF. Economic policy should focus on an exit of monetary and fiscal stimulus with more prudent government expenditures. The failure of timely and effective adjustment may cause a future debt crisis with high costs in loss of production and employment. The lag of fiscal adjustment behind the monetary adjustment already discussed within the FOMC would result in much higher interest rates from continuing high federal deficit and debt issuance while monetary policy must increase short-term interest rates and also likely long-term rates by the sale of the Fed portfolio of $1.7 trillion securities. Fiscal restraint requires more delayed Congressional action and should begin to be considered immediately as the key national priority or interest rates will be higher than necessary for adjustment, restricting employment and growth. Taxing to spend will crowd out the private sector’s ability to produce and create jobs, frustrating fiscal restraint because actual government outlays are likely to exceed revenue by more than intended. (For a briefer version go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )