Have the Federal Reserve's Monetary Policies Failed?

Now that bank profits and bonuses abound, green shoots are alleged, and stock market investors are opening their 401(k) statements again, it would be worth asking whether the Federal Reserve's monetary policies have failed. At first glance, considering that the economy seems to have taken a step back from the abyss, that might seem absurd. But let's consider where things are.

Unemployment continues to rise. Wages stagnate and shrink. Consumers are pulling back on spending. Consumer confidence is falling. Home prices are mostly falling, except in the most moribund of markets where they've already dropped more than 50%. Housing starts and home sales have more or less stabilized, but at extremely tepid levels. Consumer debt is shrinking as Americans struggle with the unfamiliar experience of saving.

The Fed has partially succeeded--its policies helped the regulated banking system to survive, for the most part (Bear Stearns, Lehman, R.I.P.). But the unregulated multi-trillion dollar shadow banking system--mortgage and other asset backed securities, and credit default swaps--has largely collapsed. The collapse of a sizeable portion of the banking system leads to economic stagnation. It happened when a number of trust companies failed in the Panic of 1907, and again when thousands of banks failed in the late 1920s and early 1930s. What we're starting to see now--a jobless recovery where growth will probably be slower than molasses--is reminiscent of the stagnation that followed earlier banking collapses.

Monetary policy is heavily entwined in how we got here. We've experienced a series of asset bubbles facilitated by the central bank. There was the tech stock bubble of 1999, the real estate and credit bubble of the mid-2000s, and the oil bubble of 2008. Each bubble caused a lot of damage. Adjusted for inflation, the stock market reached its all time high in March and April of 2000, and has never regained those levels. Thus, some losses from the tech stock debacle remain. After that, stocks lost their luster and many investors headed for the real estate markets, while others sought refuge in "conservative" mortgage-backed securities backed by the hasn't ever fallen real estate market. The ensuing morass bogs us down even today, as losses continue to mount. The oil bubble, spurred by the lowest fed funds rate ever, wrecked every business plan the auto companies might have had, forcing GM and Chrysler to seek federal help while permanently laying off tens of thousands of workers. No wonder consumers have hit the mattresses. In the last 10 years, the Fed has administered one smack down after another to the economy.

Bug-eyed, audibly breathing advocates of the gold standard cite these cycles as evidence of the failure of fiat currency, and demand a return to the gold standard. Although a lot of mouth-foaming accompanies criticisms of fiat currency, the more the Fed provokes asset bubbles, the more we need to wonder if something has gone astray with the Fed's monetary policies.

Fiat currency is paper currency not backed by gold, silver or any other physical asset. It derives its legal value from laws making it legal tender. These laws require creditors (including sellers) to accept fiat currency from debtors (and buyers). In effect, because a law says fiat currency has value, it has value. It's also possible for fiat currencies to have value as a matter of custom. The U.S. dollar is often considered more valuable in many parts of the world than the local currency, not because it is legal tender but because people simply consider it more reliable than the ruble or whatever.

The basic reason for fiat currency is that people need something as a means of exchange, and physical commodities like gold and silver aren't available in adequate supply. Currency (fiat or otherwise) is as an intermediate asset, held in between ownership of property that has use value (like food, clothing, heat, housing, etc.). Without currency, only barter exists as a means of trade. A producer of clothes needs only so much food, and a producer of food can't barter for clothes if the clothes producer already has enough food. But if a medium of exchange exists, the producer of clothes will accept currency from the producer of food because the currency can be used to buy heat, housing or other things the clothes producer does need. Both parties profit from the exchange.

When accepted currencies are not available in sufficient supply, substitute means of exchange come into use. Tobacco became a form of currency in Colonial Virginia because English currency was in short supply. Many private banks in 19th Century America issued paper currency because there was no national currency and bank customers needed a means of exchange. Currencies spur economic activity. The velocity of economic transactions increases when there exists a medium through which to transact. An abundance of currency should facilitate economic growth (which happened when tobacco came into use as currency in Colonial Virginia).

Central bank monetary policy, although implemented at an exponentially more complex level than tobacco-as-currency, is aimed at the same fundamental dynamic. By lowering short and long term interest rates, lending to banks and other financial institutions, and purchasing government and asset-backed securities, the Fed is increasing the supply of the medium of exchange in the hope of increasing the velocity of economic activity. The policy worked, spurring a tech boom, a real estate boom and a petroleum boom. Only it worked too well, and each boom ended in a bust.

Now, in 2009, we may be seeing the comeuppance of it all. The Fed has flooded the financial system with currency but economic activity remains moribund. Newly printed fiat money isn't increasing the velocity of economic activity. Banks aren't making new loans; indeed many credit card customers are having their cards cancelled without prior notice. (Sometimes, they find out when a merchant rejects the charge; we always thought the credit card companies were mean-spirited but this is a new low.) Trillions of dollars of toxic real estate-backed assets--the product of a Fed funded asset boom and bust--remain on the books of the major banks, crippling their ability to extend new credit. Nothing meaningful is being done to remove this tumor from the banking system. Official policy appears to consist of hoping that the real estate sector revives and boosts the value of these assets. But official policies to modify mortgages and otherwise revive real estate are, on good days, ineffectual. We don't have zombie companies, like Japan in the 1990s. We have zombie real estate assets, that reside more or less permanently on the books of the banking system, impairing lending and holding back the economy.

Although fiat currencies have true economic utility, central bank monetary policies can too easily take advantage of that utility and produce bipolar, destabilizing swings in asset values. Inflation, too, is a threat when the central bank floods the financial system with money. It hasn't materialized yet only because the consumer has been so thoroughly flogged by the recession that spending is almost painful and retailers dare not raise prices.

The ridge-dwelling, rifle-cleaning fringe of the gold standard crowd call for an end to central banking and fiat currencies. Neither will happen. But it's time to consider whether we've reached the limits of monetary policy. There seems to be a belief in an economic Holy Grail, that somehow the "science" of economics can simultaneously achieve stability in growth and prices, and full employment. Economists will be the last to suggest that this quest is impossible, because then none of them could achieve the purity of Galahad. But we should remember central banking's greatest hour, in 1980, when Paul Volcker, newly appointed as Fed Chairman, raised interest rates and threw the United States into a severe recession in order to break the inflationary spiral of the 1970s. A painful confrontation with economic reality, accompanied by struggle and sacrifice, produced the long prosperity of the 1980s and 1990s. There is no free lunch, no new paradigm, no magical printing of fiat money that will transport us to Avalon.

This past week, the Fed announced that, even as it continues to hold short term rates at zero, it will soon wind down its program of buying longer term U.S. Treasury securities. This may provide a tiny glimmer of hope, that perhaps the central bank is beginning to recognize the limits of its power. Let's hope so. The path out of today's stagnation won't be paved with further abuse of the fiat currency. It will be built on hard work and investment directed at boosting the capacity of the U.S. economy to produce tangible goods that Americans and others want to buy. The U.S. economy needs to produce more intrinsic value; it doesn't need more paper value.