The Daily Reckoning
London, England
Thursday, July 19, 2007
The Daily Reckoning PRESENTS: The Federal Reserve has been around since 1913, and in that time, we've seen Fed Chairmans come and go, but no made as lasting an impression as Paul Volcker and his successor Alan Greenspan. Tom Au looks at the policies of both, below…By Tom Au
SourceThe Federal Reserve Board (or Fed) was established in 1913, pursuant to the 16th Amendment to the Constitution to oversee the nation's money supply. But it took almost four decades before it could truly perform this function. In fact, in its early years, the Fed acted almost as an adjunct to the Treasury Department. Specifically, it was called upon to keep bond yields low by buying Treasury bonds, thereby artificially increasing the money supply.
By the late 1940s, the Fed balked at being a de facto arm of the Treasury Department, and in 1951, managed to reach the so-called Accord with the Treasury. This allowed the Fed to use its own discretion in buying Treasury securities, and otherwise become a financial policy-maker independently of the executive branch; effectively creating a fourth branch of government. As a sop to the Treasury, William McChesney Martin Jr., originally a Treasury official, was appointed chairman of the Fed, where he became its longest-serving head (Alan Greenspan was a close second). In this role, he was supposed to be as a "Trojan Horse," for the Treasury, but surprised everyone by upholding the Fed's independence more than any chairman before or since.
With memories of the 1930s Great Depression fresh in peoples' minds, the Fed's implicit mandate was to prevent a recurrence. William McChesney Martin Jr. vividly described the Fed's role as to "take away the punch bowl." In essence, the Fed was supposed to be the "adult chaperone" at an economic party that was likely to get out of hand. Thus, the Fed was supposed to allow, even induce, if necessary, the occasional recession to cleanse the excesses of the economy. This would ensure that short-term imbalances did not persist for the longer term. The Martin mandate later gave way to one of pursuing steady growth, which would allow full employment (the lack of which was considered the major bane of the Depression). But this new mandate would not address the longer term problems that have since ossified into intractable trade and budget deficits.
Even so, the Fed's most celebrated moment came around 1980, when a newly-appointed chairman, Paul Volcker, broke the back of inflation by controlling the money supply, come what may for interest rates. It also probably had a major impact in limiting the Presidency of Jimmy Carter to one term. But this was the last time that the Fed dared to "lean against the wind," of an Administration, to use another expression of its earlier mandate.
Under Mr. Volcker's successor, Alan Greenspan, Fed policy became increasingly aligned with that of prevailing Administrations, both Republican and Democrat. In part this was because of the nature of the crises, such as Black Monday, in 1987, and the Y2K scare, just before 2000. Both of these were basically one-time shocks, rather than being endemic to the economy, and therefore, it was easy to agree on solutions. And backed by some major political tailwinds (the collapse of the Soviet Union, the 1991 Persian Gulf War victory, and the resulting decade of artificially low oil prices and cheap money), the Fed and the Administration managed in the 1990s to co-operate in creating an unprecedentedly long peace time expansion. It may have been this success that caused the Fed to lose sight of its "check-and balance" role vis-à-vis the executive branch.
But an "Austrian" (economist) might describe Mr. Greenspan's posture toward the Administration by using a Marlene Dietrich song (the English translation from the original German is mine):
If I'm supposed to dance,
Then I'll do it.
If I'm supposed to laugh,
Then I'll laugh it.
If I'm supposed to turn my head,
If you please, then it's done.
This abdication was most apparent around the turn of the century. I believed then, and am confident now, that the Fed made a mistake when it lowered rates aggressively in 2001 in order to ward off an impending recession. That is after looking at what Fed Chairman Greenspan probably saw; a looming case of "financial bronchitis." Unlike Mr. Greenspan, (and like Paul Volcker), I would have urged the Fed to "stay the course" with rates and accept "bronchitis" in order to ward off a later "pneumonia." Mr. Greenspan opted for the other path and avoided the "bronchitis" several years ago. This, however, led to excesses in the U.S. trade accounts and the housing markets that seem likely to soon lead to a far worse "pneumonia."
In fact, Mr. Greenspan derived his policies from an intensive study of economic data made possible by the revolution in information technology. What was a pipedream in the1960s, "fine-tuning," had finally been made possible; the Fed is, in fact, very good at solving short-term problems. But that misses the point; that the Fed is not just supposed to manage for the short term, but rather to anticipate longer term problems. Mr. Greenspan's claim that a bubble in stocks, or housing could not be foreseen until after the fact is a cop-out. The Fed's main job is precisely to do this, as it did in the 1950s, 1960s, 1970s, and early 1980s under William McChesney Martin Jr., and his successors, Arthur Burns, and Paul Volcker.
But the real problem is that the Fed's policies are now hostage to those of the Administration. Such policies may be successful or not. But because they mimic those of the executive branch, they will be wise or foolish according to whether the underlying policies of the ruling Administration are wise or foolish; the Fed has resigned its earlier chaperone role. Or to paraphrase Warren Buffett, the Fed's conduct no longer "rises to that of a responsible bartender, who, when necessary, refuses the profit from the next drink to avoid sending a drunk out on the highway." The spirit, if not the letter of the 1951 Accord has been violated, and de facto, the Fed is no longer an independent entity.
Regards,
Tom Au
for The Daily Reckoning
Editor's Note: Thomas P. Au, CFA, is a principal with R. W. Wentworth, a financial services firm in New York City. Earlier he was an emerging markets portfolio manager for the investment arm of Cigna Corp. and an analyst with Unifund, S.A. of Switzerland and Value Line. He graduated cum laude with a B.A. in Economics and History from Yale University and an M.B.A. in Finance from New York University. Mr. Au is the author of "A Modern Approach to Graham and Dodd Investing."