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The Fed’s Credibility Problem

Note: The Trade is not subject to our Creative Commons license.

May 17: In response to the discussion this column generated, it has been updated with a response from the author.

The economics world has been having a lot of fun with hedge fund managers.

After several such managers at a recent conference denounced the aggressive money-printing policies of Ben S. Bernanke, the Federal Reserve chairman, the economic blogosphere rose up to mock them.

Many hedge fund managers have been predicting that high inflation and fleeing creditors would send interest rates skyrocketing. Stanley Druckenmiller, Paul Singer, J. Kyle Bass and David Einhorn — all big names in the investing world — have warned against the supposedly runaway central banker. Mr. Druckenmiller said that Mr. Bernanke was "running the most inappropriate monetary policy in history."

And they have been wrong. Those silly hedge fund managers. They don't understand macroeconomics! As Paul Krugman (and many others) have explained, the lack of demand explains why there isn't any inflation and why interest rates haven't risen despite all the money-printing.

Economists and bloggers have been competing to figure out why these supposedly smart guys are so confused. In an astute post, a Berkeley economist, Brad DeLong, explained his theory: Hedge fund managers thought they could muscle the Fed into caving on its big trade, much like they got JPMorgan Chase to cave on the "London Whale" trades. But they fought the Fed, and the Fed won.

Or perhaps they are simply expressing class preferences. They are ideologues, worried about their tax bills and redistribution policies. Hedge fund managers are wealthy. Asset owners hate inflation because it destroys the value of their holdings.

Or, more subtly, maybe it's an expression of preferences in their narrow professional role. These fund managers get paid mainly to manage other people's money. It's much easier to do that when assets are more volatile and when the short-term interest rates are significantly lower than long-term rates. Fixed-income managers like Pimco used to make a decent return buying long-term Treasuries, essentially investing in risk-free assets and charging fees to do it. No longer. Mr. Bernanke has revealed many of these managers to be empty suits — and they are lashing out.

The Druckenmillers of the world have been and will continue to be wrong about a coming debt crisis and runaway inflation. A dose of moderate inflation would help the economy right now. It would spur spending and investment, and ease debtors' plight.

But what these investors are expressing should trouble all of us: they have almost no confidence in the Federal Reserve or the economics profession. And for good reason.

It's impressive that the Fed and many economists have successfully predicted the path of interest rates and inflation in the wake of the worst financial crisis in a generation. But neither the central bank nor academicians managed to predict or prevent the crisis in the first place. The failure dwarfs the accomplishment.

The Fed's track record is out-and-out abysmal. Fund managers remember only too well how Alan Greenspan encouraged the stock bubble of the late 1990s, convincing investors that he would bail them out if the stock market dropped severely. Worse, Mr. Greenspan urged people in 2004 to buy homes by taking out adjustable rate mortgages. Then the central bank did nothing to curtail the housing bubble. (Whether the Fed kept rates too low for too long is hotly debated; in Mr. Greenspan's defense, the credit bubble kept inflating after the Fed started raising rates.)

The Fed began its lender-of-last-resort role in 2007, but did little to avoid or minimize the financial crisis. Once it hit, it did the right thing to flood the markets with money, but — along with the Treasury and a passive Justice Department — let banks and top executives off the hook. And now, asset prices are going wild. Junk bonds are up. Stocks are up. Housing in Phoenix and Brooklyn is going mad.

This prebubble euphoria only undermines the Federal Reserve's fragile credibility. It reinforces the notion that it seems to know only two things: how to inflate bubbles and how to studiously not recognize them.

Flush from their victory predicting inflation and interest rates, some economists discount the worrisome market activity. Mr. Krugman, a columnist for The New York Times, recently urged Mr. Bernanke to ignore bubble talk.

And lo and behold, the Fed chairman gave a talk on the very subject last week.

The Fed needs to convince the markets that it is on high alert for excesses that could cause the next crisis. And it has to come from the chairman. Encouragingly, Mr. Bernanke said the Fed was on the lookout for unusual valuations, high leverage, new and dangerous products and excessive risk-taking.

Alas, the speech had shortcomings. Right up at the top, Mr. Bernanke delivered this laugher: "Of course, the Fed has always paid close attention to financial markets, for both regulatory and monetary policy purposes."

Of course. With notably rare exceptions, as Mr. Greenspan might put it.

Then Mr. Bernanke scared hedge fund managers out of their open-collar shirts and fleeces by reiterating long-standing Fed dogma: that bubbles cannot be identified ahead of time and that "neither the Federal Reserve nor economists in general predicted the past crisis."

Answering questions, he gave an example of what the Fed might be looking for. "Microsoft's stock is worth well more than it was some time ago, and it could still prove to be a bubble," Mr. Bernanke said, "but so far, so good."

Microsoft? Hello 1999! Is this what state-of-the-art monitoring gets us?

But Mr. Bernanke hasn't spoken about what may be a deeper problem: What if the Fed's loose monetary policy, with its giant bond purchases, is harmful?

If the price of lower unemployment were that hedge fund managers get a little richer, of course, we'd take the jobs. And if the choice were between helping someone get a job today or curtailing a potential crisis in the future, you put people to work now (though it depends on how big the crisis is likely to be).

But that might not be the choice. It sure seems like Fed policy is helping only the wealthy, and not doing much for the economy. The net worth of the top 7 percent of American households rose in the first two years of the recovery, while the net worth of the bottom 93 percent declined. The percentage of working-age people who have jobs is dangerously low. Median income was lower in 2011 than it was in 1999. This cannot all be laid at the feet of the financial crisis. Working-age male income has been squeezed for decades. The economy has deeper problems.

Maybe monetary policy is simply reinforcing these trends.

Professional investors see it that way.

"What a lot of hedge fund managers are worried about is the inflation in asset prices, not cost and wages," said James Chanos, a noted hedge fund manager who is left of center. "This is leading to recurring booms and busts, which in addition are exacerbating income inequality."

The Fed has explicitly welcomed rising asset prices as a sign that its monetary policies are working, as lower rates push investors to put their money to work. But something is wrong. Companies are sitting on their profits. Businesses aren't investing and hiring enough.

In fact, the Fed may be inadvertently making things worse. What if it succeeds in bringing average people back into the markets right at the top? Is the Fed setting these poor suckers up to come in to buy from the hedge fund managers?

"The people you are trying to help don't get the message till the end of move," Mr. Chanos said. "You keep impoverishing them."

Now, I'm not remotely suggesting that the hedge fund denunciations are motivated out of a desire to help the unemployed. Please.

But they can read markets, and they can see that the Fed isn't engineering the hiring, inflation and recovery it would like. Instead of dismissing the critiques, the Fed and economists would do well to pay heed.

* * *

Update (May 17):

My most recent column incited a robust and welcome discussion. But few of my many critics, including Paul Krugman on his blog and many commenters on DealBook, seem to have engaged with my main point.

My piece was not celebrating hedge fund managers. It was not predicting inflation and imminently rising rates or a debt crisis. Nor was the main point to rehash who got the financial crisis right or not.

Lastly, the main point was not to dwell on the Federal Reserve's credibility problem, though I think that's important.

What was my main point? We are four years into the One Percent's recovery. Now, we are in Round 3 of quantitative easing, the formal term for the Fed injecting hundreds of billions of dollars into the economy by purchasing longer-term assets like Treasury bonds and Fannie Mae and Freddie Mac paper. What's that giving us? Overvalued stocks. Private equity firms racing to buy up Arizona real estate. Junk bond yields at record lows. Ratings shopping on structured financial products.

These are dangerous signs of prebubble activity.

But, much more important, quantitative easing is not giving us a self-sustaining recovery and job creation. As I put it in the column, hedge fund managers "can read markets, and they can see that the Fed isn't engineering the hiring, inflation and recovery it would like." There's been a breakdown in the connection between wages and productivity. Labor participation is desperately low.

So are we moving from the bust to the bubble and missing the recovery for average people?

And if so, why?

Many people argue that we need more fiscal stimulus. That's persuasive, but it's clearly not happening with today's Washington.

In response to my column, people have said: What else should the Fed do? Things would be far worse if the Fed weren't buying $85 billion in bonds a month. Look at Europe, whose monetary policy has been almost as big a disaster as its fiscal policy.

But how long do we have to wait? How much more wealthy do the One Percent get to become through speculation — how much house flipping do private equity firms get to do — before we see some sustained improvement in the rest of the economy?

And could it be that with a heavily indebted populace and a dysfunctional banking system still unable to lend effectively, that this round of quantitative easing is having a counterproductive effect? As evidence that the banking system transmission mechanism isn't working well, small businesses are having a hard time borrowing, according to a recent New York Fed poll.

One solution is that the Fed needs to have a heavy regulatory hand to limit speculative activities. Perhaps regulators should raise margin requirements for stocks. Put the ratings agencies on notice that they are watching out for any loosening of criteria. Make these efforts public and keep talking about them.

And then, maybe quantitative easing needs to be refocused away from long-term Treasuries and housing. Maybe the Fed could figure out a way to buy student debt or municipal bonds to support infrastructure.

If quantitative easing is necessary, it should support investment, not speculation.

A lot of speculation in this piece, but of course that comes with the what-if territory. The underlying message looks to me like “Bernanke and the Fed are hopelessly lost in the swamp” and “hedge fund managers are just empty suits (or fleeces)”. I agree with both of those views. The adults are not in charge at high levels, and that’s a big part of the reason why things look pretty bleak, economically speaking. The meaning of ‘down to earth’ seems to be completely unknown to these guys, possibly as a result of too many expensive lunches and private jet flights.

Russell Miller

May 15, 2013, 2:54 p.m.

The Dollar is the international reserve currency.  The “Euro” has tried to compete but by their huge deficits and adherence to Keynsian policies find the world unwilling to invest in a depreciating asset when safer alternatives are available…The Dollar.

When Bernanke prints money “everyone” holding dollars and dollar denominated investments get diluted. When this dilution results in depreciation Bernanke, Krugman and Keynsian pudits will be nowhere to be found. Where is Mr. Greenspan?

The world will find a solution to this problem as the US economy shrinks as a percentage of the world economy and our deficits increase the percentage of foreigner’s holdings in dollars. Dilution will start to matter.

Ask the Germans what it is like holding a depreciating currency caused by other’s deficits and printing! When the rest of the world finds out the Feds won’t be able to print enough money!

“But they (hedgies) can read markets, and they can see that the Fed isn’t engineering the hiring, inflation and recovery it would like.”

(a) As for engineering “hiring” and “recovery” (pretty much the same thing), Bernancke has made it clear over and over that The Fed needs help from fiscal policymakers (Congress). Instead of fiscal stimulus, however, he’s been getting contractionary measures (austerity) from Congress.

(b) Yes some economists argue that The Fed could do more to raise inflation expectations and thus boost the sluggish recovery. What do you think hedgies’ response to that would be?

Eisinger’s column is something of a muddle. But he really went off the track with that last paragraph.

Donald Isenman

May 15, 2013, 5:32 p.m.

It must be said that many economists saw the housing bubble being inflated but were kept from being heard.That was willful obstructionism by the Real Estate Industry the Fed and banks (and by news organizations who never cross either entities) that lent money to people without resources assuring them that appreciation would pay for the extravagances—but of course knowing they could slip the property out from under them, a fraudulent activity mostly gone unlitigated when the bubble bursts.

To assume that these entities were doing all this in ignorance is laughable.

I was a bystander with the knowledge of 80 years of seeing Real Estate Fraud happening every few years. To say that no one else knew this when I and many other amateurs knew full well what was happening is risible as is

The last bubble was being blown to cover up income inequality, but it, and off the books wars, crashed the economy, unsurprisingly.

Though he claimed he never could imagine such a crash happening, Greenspan and his psychopathic ilk knew what they were doing: making money for the 99.9%, a la Ayn Rand.

The phrase to look for among people in the financial sector is inflation as a “hidden tax,” and one that disproportionately harms the poor by diminishing their savings.

Given that poor people—pretty much by definition—can’t save, it’s clear that they’re objecting to the future buying power of their own portfolios.

Also, Donald is absolutely right.  Most of these money people know exactly what they’re doing.  I heard more than one person talk about wanting to get into Bernie Madoff’s fund, for example, because whatever he was doing (we now know it was a Ponzi scheme, of course) had to be illegal.

To at least a significant subset of high-rolling investors, destruction and illegality are selling points.  Claims that they were all shockingly blind to what was clear to anybody looking at the market is naive at best, complicit at worst.

And notice that inflation in currency (which is generally healthy—more dollars help an economy to grow) is terrible.  However, unsustainably inflating a market past the point of collapse?  Oh, that’s fine, because you can make a profit on that.

Jesse Eisinger

May 16, 2013, 11:09 a.m.

Few of my many critics, including Paul Krugman on his blog and many commenters over at Dealbook, seem to have engaged with my main point. The fault must be my own articulation of it.

My piece was not celebrating hedge fund managers. It was not predicting inflation and imminently rising rates or a debt crisis. Nor was the main point to re-hash who got the financial crisis right or not. I’m not economists, obviously. For those interested in bone fides about the markets, check my piece from the November 2007 issue of Conde Nast Portfolio, “Wall Street Requiem,” (http://propub.ca/12dSIrz) describing how over-levered the Wall Street investment banks were and how they could go out of business, starting with Bear Stearns and followed by Lehman. Lastly, the main point was not to explain the Fed’s credibility problem.

What was my main point? We are four years into the One Percent’s recovery. Now, we are in round three of quantitative easing. What’s that giving us? Overvalued stocks. Private equity firms racing to buy up Arizona real estate. Junk bond yields to record lows. Ratings shopping on structured financial products.

These are dangerous signs of pre-bubble activity.

But it’s not giving us a self-sustaining recovery and job creation.

So are we moving from the bust to the bubble and missing the recovery for average people?

And if so, why?

I stand with those who argue we need fiscal stimulus. But it’s clearly not happening with today’s Washington.

One possible argument for the Fed’s current policy is that it is simply holding the line and things would be far worse if the Fed weren’t buying $85 billion in bonds a month.

But how long do we have to wait? How much more wealthy do the One Percent get to become —how much house flipping do private equity firms get to do—before we see some sustained improvement in the rest of the economy?

I would love to see monetary policy experts grappling with why the broad-based asset price surge is somehow not translating fully into the broader economy and when it is likely to work. Something about the transmission mechanism seems broken. 

-Jesse Eisinger

clarence swinney

May 16, 2013, 11:15 a.m.

CUT RICH TAXES CUT POOR FOOD STAMPS
The House Farm Bill proposes reducing Food Stamps $39.7 B over next ten years.
Much of this cut comes from food stamps and other nutritional programs.
No expiring tax cuts for top 2% with incomes As high as $1000 Million.
Wall Street is staffing with former government employees who have influence in Congress.
The Big Banks in particular. Ben White at Politico gave a list showing hires by Goldman Sachs, Morgan Stanley, IBM, GE,, Citigroup, Credit Suisse and JP Morgan.
Buying influence.
The Republicans in the House plan to held another Debt Ceiling Hostage to demanded unspecified tax reform at a future date. The leaders are too chicken to tell their backers that we have to increase the debt ceiling to pay off bills Congress has already voted on and spent.
We have a $14,000 Total National Income and in 2013 fiscal year we get $2700B Revenue And spend $3600B. We borrow $900B. Shameful that the richest nation refuses to tax wealth to balance the budget. $2700B of $14,000B is a 19% Tax Rate.  If we were to tax to pay our budget of $3600B
it would be a 26% National Tax Rate.
We rank third in OECD nations As least taxed.
It is time to tax wealthy estates and top incomes at a much higher Effective rate.

Russell Miller

May 16, 2013, 1:46 p.m.

I usually never comment like this but decided to start since it is no longer politically correct to have an opinion that differs from the intellectual elite.

Russell Miller

May 16, 2013, 1:57 p.m.

Sorry about that.

When you add up all of the sources of debt US governmental entities have on and off the books it is pretty huge to say the least.  Social Security, Medicare, pensions, let alone US debt.  All of this spending is either artificial growth or promised spending effecting spending behavior to the receipients.  We now have the intellectuals discussing how inflation is good.  We are addicted to artificial stimulas and artifical tricks.  This same
mindset has turned our financial markets into video gambling with high frequency trading, unregulated derivatives, etc.  What happened discussions about savings and investing instead of consumer spending and quarterly results.

But Jesse, isn’t the answer obvious?  Post-Ford (who overpaid his employees and insisted on certain moralist behavior to ensure they’d be his customers), employees have almost always been a “necessary evil.”  Any job that can be done without paying someone, that’s what the CEOs want to do.  There was an aberration when offices were packing in middle management for some strange reason, but nobody really found that satisfying, and I don’t think it was particularly good for the economy to soak up talented people farting around with Gantt charts.

Work may come back to the United States, but those jobs probably won’t, because automation is or will be far cheaper.  I’ve even seen demonstrations of software that writes and designs support brackets.

And why is Washington supporting them and not us?  Obviously, because we don’t have mobs of lobbyists explaining the benefits of having a population that isn’t starving.  We don’t fund reelection campaigns.  We aren’t “experts” who can frame our needs (or the good of the country) in unshakeable dogma.

Plus, austerity is the flavor of the day.  Sure, it’s making Europe sick and the EU might die from the treatment, but that’s because it’s old and frail or not thinking positively or something.  It’s totally not because money only contributes to the economy when it circulates, meaning that if the people don’t spend, the government must, by definition…

And let’s be honest, we don’t have very a good track record with stimulus in this country, either.  Smart stimulus would be to lower food prices or deploy public WiFi or do anything that helps people.  Instead, we get Bushisms of give every family a few hundred bucks to buy a TV manufactured in China and wonder why the only jobs it creates are in Shenzen.

Me, I have high hopes for the DIY-type movements.  Now that we’ve been reduced to consumers, we can fight back by not consuming, and tools like 3D printers are making it increasingly easy to avoid funneling paychecks right into Wall Street coffers.

clarence swinney

May 18, 2013, 9:41 a.m.

BARNEY FRANKS SPEAKS
“ Every time a group would come in my office for more money for housing, elderly, I would say you forget one thing. You forgot to say Raise taxes and Cut the out of control military.”
So much truth.  Three things will ruin our fiscal condition. Military, Medicare and Interest.
All three can be reduced. We can pay down debt. We must tax wealth. We can cut Medicare and military. We are in peace time why keep loading $$$ on the Pentagon where they now own almost one third of our Total budget when you add in Energy Dept. and Veterans.
We must do better.  Two things brought down empires. Internationalism and Debt.

Donald Isenman

May 18, 2013, 10:03 a.m.

If the above garbled quote is verbatim, it was as well that he left office.

There’s an assumption on both sides here that the rates the Fed controls can affect employment. That’s probably not the case.  We just don’t need that many people to do all the work any more. Many more jobs can now be cheaply automated now than ten years ago.  That’s why we’re having a “jobless recovery”.

Someone will grumble about “Luddites”. Historically, the big problem in society was simply producing enough products.  Not until the 1960s did production catch up with demand for the basics, and that was only in parts of the developed world.  Historical analogies to periods before that don’t apply. Today, the developed world, which at this point includes most of the planet except sub-Saharan Africa, has more than enough capacity to make more products than people can use.

We’re short of work, wages, and the resulting demand. We have plenty of productive capacity. The US isn’t short of land or natural resources. The US could probably double its manufacturing output if necessary.  (We did more than that in WWII). With near-zero interest rates, there’s a capital glut.  There’s a lot of money that would be very happy to find an investment that returned 5%. All the Fed can do is pump more money into the banking system. That bailed out the banks, but doesn’t have much effect beyond that.

The political system has no clue what to do in this situation.

Russell Miller

May 19, 2013, 11:20 a.m.

Not only does the political system want for answers, it also won’t discuss controversial themes compounding problems. An example is does productivity gains increase systemic unemployment and if so how do you measure this so job creating is not foolish spending?  Imagine a politician admitting that full employment might be at 10% unemployment!

<< So are we moving from the bust to the bubble and missing the recovery for average people?  >>

Excellent article.  Less because author promotes some way forward out of the Fed’s decision quagmire, but rather because he tells us he’d like to, and still cannot.  That’s noticeable to me—for financial columnist to seat the discussion in the muck of ambiguity.  But that’s where it actually is.  Glad to hear someboy saying so.

Also:  Fed shouldnt care what hedge fund mgrs think.  Fed has that privilege and should be exercising it.  If/when it does, no one should fuss about policy that caters to 1%.  If the rich are richer, it’s not the Fed’s doing, nor Fed’s responsibility to prevent it.  It’s an unintended consequence of trying to save the US economy from disaster, and the Fed may not have the right stuff to do that.  That needs to be out front and center so we don’t oin false hopes on wring horse…

Clarence, I disagree with taxing wealth, per se.  I’d rather tax people whose income doesn’t correlate to work or to expanding the economy.

If you create and manufacture a product in the United States, your taxes should be very low, no matter how much money you make.  If you create an automated service, your taxes should be higher.  If you make money through interest, higher still.  If you export both jobs and profit (i.e., almost every large company, today), you should be taxed 100% of income, no matter how little.

I think that also solves John Nagle’s issue.  If you employ Americans (ideally by creating products that can’t yet be manufactured automatically, rather than just adding managerial bloat), you’d get a tax break.

That’s the way I’d do it, at least.  Tax what hurts the economy until it goes away and help the people who are helping others make a living.

The alternative I see (assuming we must tax wealth directly) is to do some math and find out how much more than a dollar each “incremental dollar” is worth.  That is, if I have a hundred bucks to my name, I can buy something worth a hundred bucks and that’s about it.  If I have a thousand, I can pay a bill or buy goods.  At ten thousand, you start to see leverage possibilities, plus everything else.

In other words, dollars aren’t linear.  Each extra one you have increases your purchasing power by more than one, because your opportunities are broader, plus the possibility for credit and/or interest, which magnify things further.

If we could quantify that excess value, we could tax income at the rate that linearizes the value of each dollar and has each taxpayer charged for the literal value they get from keeping the economy stable.

While the Fed is trying to help, the rest of government is not.  Basicaly, with Congress dysfunctional on any meaningfull scale and the Fed printing money in hope it is right about how well that will work, the majority of people (and their problems) are slowly sinking into more and more debt from student loans hampering starting families and careers to rising health care expenditures.  Huge spending on infrastructure puts people to work and builds up our ability to progress.  Our economy has been hijacked by Supply SIde thinking since Reagan.  Without demand, there can be no recovery.  The proven way to increase demand is to put people to work.  Failing that, the second best way is to give the bottom 50% more help, thus freeing up their ‘disposable income’ to spend on other than necessities.  We are effictively doing the opposit where we are undercutting the help for the bottom 50% and pampering the top 10% with low taxes and ‘friendly’ regulation. 

I believe that Europe is ahead of us on the learning curve on how to get out of this recession.  They are recognizing that Austerity is not working and that government debt is not so horrible when compared to rising civil unrest.  The goal of government should be to raise all boats as things improve, not just bolster the FInancial Markets.  Getting Capitalists under control, and paying their fair share of taxes is basic to recovery.  There is little talke here of getting things under control.  We seem to be putting ever more bandaides and lipstick on the pig.  When the Student Loans (and high interest rate loans so common now) become unbearable, and ‘efficiencies’ stripping ever more jobs from the economy become the norm, there will be a second and more serious crash.  People are tired of the status quo, where the top keeps getting richer and the rest keep having to paddle harder to stay in place.  They are tired of seeing Wall Street soar while Main Street collapses. 

The Keynesian style got us out of the last Depression, and the same package of government spending on infrastructure, strong controls on Business and Finance, and breaking up ‘too big to fail’ entities, would get us out of this one.  But that would upset big campaign donors, and our democracy now runs on those donations just as our country runs on oil.  TIme to break the chain on both.  Kill and eat the pig and let’s start over having learned from our misstakes.

Russell Miller

May 20, 2013, 1:25 p.m.

Keynesian economics advocated stimulas when needed followed by contractonary fiscal policy during growth periods.  Why is it that no matter how many bubbles our financial system generates during growth period that we never repay debt???  The reason why Keynesian economics doesn’t work is not a theoretical flaw, rather a reality created by politicians buying votes. I agee with Mr. Boyle that Keynesian economics got us out of the last depression, but it is also the reason why the western liberal democracies are overburdend with debt and or bankrupt due to abuse of perpetual stimulas (deficit) spending.

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Jesse Eisinger

About The Trade

In this column, co-published with New York Times' DealBook, I monitor the financial markets to hold companies, executives and government officials accountable for their actions. Tips? Praise? Contact me at .(JavaScript must be enabled to view this email address)