In a new six-part series, Ticker.com will examine a number of commonly held myths that can adversely affect investment decisions of both individuals and financial professionals.
In this first article, we will focus on the widely held belief that the Fed has played a positive role in guiding the economy over the past three decades for the benefit of the general public.
In Fed We Trust
Although it was created by Congress in 1907, the Fed was not given its dual mandate for maintaining stable prices and full employment until 1977. Before that time, fighting inflation was its major concern.
The Fedís other responsibilities include: monitoring the state of the economy and its financial system; establishing and conducting the countryís monetary policy; maintaining a stable financial system; providing financial services to the U.S. and foreign governments; and regulating banking institutions.
For the most part, the public believes that Fed is on its side and watches out for its best interest. Especially during tough times, the Fed is expected to be out in front, using all of the authority vested in it by the U.S. Congress, solving the problem. Based on its track record during the last three decades, there is strong evidence that it is not living up to its responsibilities.
The Fed has often been slow to recognize the seriousness of problems as they develop, and then slower still to take action.
Whether it was the savings and loan crises in the early eighties, the collapse Long Term Capital Management in the late nineties, or the current housing market bubble, the Fed stepped up only after a developing problem became major crises that could not be ignored.
Over and over, the Fed has shown itself to be reactive, rather than proactive. In the case of the current housing bubble, the Fedís policies may have even contributed to the severity of the collapse.
Had it not been blindsided by its own ideological bias toward free market solutions, a growing body of evidence suggests that the Fed could have, and should have, damped down the mortgage lending practices that lead to the bubble.
Instead, the Fed has been guided by an ideology that assumes markets are self correcting, and that it has only a minimal role in regulating lending practices, even in the face of widespread fraud.
In fact, this ideological bias may have been the root cause that led to the current financial crisis.
That free market bias has been well imbedded at Fed for years, and especially manifested itself in policies during the reign of former chairman Alan Greenspan. Under his watch, the housing bubble was permitted to inflate largely through mortgage fraud, which ultimately resulted in putting more than six million homeowners into foreclosure and pushing the economy into the worst recession since the Great Depression.
Fed, in essence only focuses on clean up contrary to what most common man believes its role is in preventing the fire from occurring. In the buildup of the housing market bubble, Fed was warned and appraised by several fair lending agencies and consumer watchdogs.
Despite having received warnings from outside sources, including lending agencies and consumer watchdog groups, the Fed ignored the alarms. In public statements, they claimed that mortgage fraud was beyond the scope of the Fedís charter. However, the Fed is specifically authorized and mandated by Congress to prevent predatory lending practices and borrowing and other forms of lending abuse associated with the fraudulent lending practices that were widespread during the housing bubble.
When it comes to the welfare of the largest financial institutions, it is apparent where the Fed true concern lies. As noted in the Financial Crisis Inquiry Commissionís report, the Fedís decision in bailing out the countryís largest banks has created a condition of moral hazard favoring the largest institutions.
In essence, the Fed has created a system that protects institutions that are deemed too big to fail, implicitly encouraging them to take greater risks, while, at the same time, ignoring the welfare of individuals and small business who suffer the brunt of economic disruptions.
The Fedís current monetary policy exposes the same segment of the economy to an even greater risk Ė stagflation and that will hurt the weakest segment of the population the most.
With the economy still reeling from declining home prices and high unemployment, fiscal deficits are likely to run at close to 8% of GDP for as far as the eye can see. The Fedís initial response was to drop short-term interest rates to near zero to allow the large financial institutions to generate profits to cover their losses. It also gave business an incentive to invest in additional plant and equipment.
While the lower rates were good for the banks and marginally positive for business, maintaining low interest rates is a two edged sword. For the segment of the population that depends upon savings accounts for their income, the Fedís policy was a disaster, especially for the retirees. This people did the right things, keeping their expenses in check and saved and avoided borrowings, yet the Fed will punish them again.
When the near-zero rate failed to stimulate growth, the Fed engaged in two rounds of ďquantitative easing,Ē which is shorthand for printing money. By purchasing government debt, either directly or indirectly, the Fed is in essence creating money to satisfy the Treasuryís insatiable demand to cover the federal budget deficit.
While that game can continue for several more years, eventually the national debt will reach a level where the dollar will fall precipitously in world markets, the price of imported goods will rise, and interest rates will have to increase dramatically to attract investors to cover the growing debt burden. That will, in turn, put downward pressure on the economy and likely result in another recession.
The dollar has already lost more than 50% of its value against several currencies in the last decade.
Once again, it will be the general public, and especially families at the lower income levels, that will bear the brunt of the Fedís policy. The poor, the savers, the retired and the small businesses will be once again be sacrificed by the Fed while it looks out for the best interest of the largest banks.