The Fed’s announcement after yesterday’s FOMC meeting reveals that they are completely out of touch with reality. Their actions since March have significantly worsened the financial crisis. They still don’t get it.
As I have been screaming for a year, the U.S. crisis is a capital market event, not a GDP or CPI event. Investors lost confidence that they were able to understand the cash flows they would receive as security owners. They simply refused to own bonds, which shut down the mortgage market. The capital market has been frozen like a fly in amber, with prices no longer a reflection of the value of the underlying cash flow streams.
The job of policy makers in this case is to fix the capital market problem and end the blackout before it infects the GDP economy. That means providing clarity and visibility over after-tax returns and it means providing adequate liquidity until markets open again.
They botched the job.
Congress and the administration were distracted by the stimulus package they hastily slapped together last spring. Sending checks to mailboxes is straight out of the textbook–the wrong textbook. It is designed to deal with a spending problem, not a capital market blackout. Spending has never been the problem. Now Congress is talking about doing another round of the same stuff. Great short-term politics. Terrible economics.
The Fed’s job is to provide liquidity. Instead, they diverted their energies to propping up troubled banks and investment banks by extending massive loans to institutions that were never eligible before. At the same time, they adopted procedures to sterilize the resulting reserve increases by selling T-bills in the open market to suck the additional reserves back out of the market. The net result was simply to shift bank reserves from healthy banks who were making loans to their customers to the sick ones. Total reserves did not go up at all. The monetary base has not grown in the past year. The Fed’s balance sheet has imploded.
The upshot of all this is the Fed has provided no liquidity whatsoever and we have had one crisis after another.
The FOMC statement today, in writing about the balanced risks of growth and inflation shows they do not have a clue what is wrong with the system. The Fed does not print oil and should not chase growth-induced commodity price swings up and down with monetary policy. We don’t have an inflation–housing prices–the largest asset class for every American family–are still falling. It is time for the Fed to wake up and stabilize the capital markets.
And will somebody please tell the candidates and members of Congress that this is not a good time to talk about increasing tax rates on capital gains, on dividends, or on income.
JR
Yes, that is why I said that whether or not revenue actually increases or decreases depends on that elasticity.
Rick & Dale:
With a high cap gains tax, I might NOT sell a stock in order to move to another stock, and the IRS gets NO income. With a lower cap gains tax, I might move my capital to a better stock, and then the IRS gets some tax income.
And the economy gets capital moving to “better” investments.
Re: Rick.
That entirely depends on the elasticity in supply and demand of those markets and the rate of the capital gains taxes. All actual study and inquiry into the situation however has found that the peak revenue is very likely much higher than our current marginal rate.
That is not to say its a good idea to increase taxes, but it is to say that increasing taxes will likely increase revenues.[As decreasing taxes has, pretty much unfailingly decreased revenues in the past]
Increasing tax rates on capital gains does not cause an increase in tax revenues from capital gains. Each taxpayer makes a voluntary decision to sell a capital asset and recognize the gain. When the tax rate on capital gains is increased, less taxpayers will choose to sell their assets. Hence, total revenues from capital gains will not increase. In a recession/near recession/capital crisis/asset deflation, lower capital gains tax rates will incentivize more taxpayers to sell more of their assets at profits.
The issue is not the rate charged for making a profit on capital investments. The issue for the government should be at what price charged the taxpayer does the government realize the most revenues. This is the same issue that every retailer faces when deciding upon a price to charge for an item.
John, I listened to the Goldman Sachs earnings report today an David Viniar, their CFO agreed that as you say, the issue is uncertainty in the value of financial instruments. He also said that there was excessive liquidity in the market, so that when it turns around, it will turn around quickly.
Can you give me your thoughts?
BTW – your book is some of the best and most interesting stuff that I’ve read in a long time.
It’s never “a good time to talk about increasing tax rates on capital gains, on dividends, or on income.” But this has to be done. I, too, will suffer from the fallacies of the past 8 years of reckless spending, wars, and general incompetence. We will all be hurting. For a long time….
While I agree completely that the banking “crisis” will not be fixed by more government borrowing, transfers of poorly valued assets, or nationalizations and I agree that the Fed/Administration has its collective head up its four-point-of-contact, I completely disagree that this is not an inflation problem.
Simply put, fiscal and monetary policy over the past 8 years has been geared toward collapsing the value of the dollar against the Asian currencies. While the policies have been effective at collapsing the dollar, they have also wrecked the ability of US consumers and firms to purchase assets or commodities from abroad. The collapse in the dollar has been the main reason behind the outlandishly high inflation rates in the US, and has also led foreign investors (namely soverign wealth funds) to shy away from US debt instruments.
Add to that a troubled housing market and viola, the entire house of cards that is the financial system collapses.
Simply put, instead of trying to shore up this administration’s place in history by inflating the currency, the Fed should have started raising interest rates a year and a half ago to choke out dollar price inflation in assets and commodities. Sure we would have had a mild recession, but since when were recessions events comparable to the sun blinking out.
There may be no inflation in the largest asset class for American households, but that does not mean that there is no inflation or that an increase in the money supply would not induce it.
The problem probably is a capital market problem, but that doesn’t mean that the problem will be fixed with an increase in liquidity or that it won’t cause other problems.
It seems to me, that if the problem is, as you describe it, a problem with the perceived value of mortgage backed securities, the solution will be in regulating those securities so that their true value can be seen. The market will only regulate itself when the knowledge base regarding the problem securities is brought up to speed, but before then, no amount of liquidity is going to stabilize a market when no one trusts assets backed by the “the largest asset class for every American family”. All then, you would do with an influx of money into the capital economy would do is induce inflation, which can have all sorts of other problems regarding the real value of fixed return investments.
Also, can someone please tell me [i]when[/i] its a good time to talk about increasing taxes. I mean, besides “as soon as i am no longer a tax payer”. The U.S. government is facing real problems regarding future expenditures and long term debt. If we don’t start increasing taxes now, we’re going to have to increase taxes to likely unsupportable levels later. Frankly i would rather pay more taxes now and stay on the right side of the laffer curve than risk dropping off the back end. Think of it as a capital investment in the nations solvency.
John;
You say, in regards to the Fed;
“…..That means providing clarity and visibility over after-tax returns and it means providing adequate liquidity until markets open again;”
and
“…that means providing liquidity.”
How EXACTLY would you desire the Fed do this?
If the capital markets are frozen and the “true” value of underlying cash flow streams mis-represented by the markets, how does one then establish the “true” value.
Should the Fed just buy those bonds that the market refuses to buy, and after the mess is all settled, re-sell them, at a profit, on the open market? (Presumably, the “true” value will, by then, be re-established).
Your response will be greatly appreciated.
AL
Some of the nineteenth century economists saw things differently than their successors, often in illuminating ways. One of them had a description of what you’re writing above. A crisis in the realm of circulation (money and banking, etc.) typically leads to a crisis in the realm of production, the direct economy.
I don’t think anyone has come up with a better way to explain business cycles since.
db
You are right, the FED doesn’t get it. The monetary base is hardly growing, as is MZM. They are tight even with the rates quite low