The Federal Reserve Turns Left
Federal Reserve Board Chairman Ben Bernanke. REUTERS/Molly Riley
Washington is lost in a snarl of confusion, cowardice and wrongheaded ideological assumptions that threaten to keep the economy in a ditch for a long time. That prospect is not much discussed in the halls of Congress or the White House. It’s as though the crisis has been put on hold until after the presidential election.
As almost everyone understands, nothing substantial will be accomplished this year. President Obama is campaigning on warmed-over optimism and paper-thin policy proposals. Republicans propose to make things worse by drastically shrinking government spending, when the opposite is needed to foster a real recovery. The president, like the GOP, embraces large-scale deficit reduction. In these circumstances, it’s just as well that the two parties cannot reach agreement. After the election they may make a deal that splits the difference between bad and worse. In the worst case, they might inadvertently tip the economy back into recession.
In this sorry situation, there is really only one governing institution with the courage to dissent from the conventional wisdom—the Federal Reserve. The central bank declines to participate in the happy talk about recovery or in the righteous sermons attacking the deficit. In its muted manner, the Fed keeps explaining why the house is still on fire, why more aggressive action is needed, and is gently nudging the politicians who decide fiscal policy to step up. But its message is ignored by Congress and the president and viciously attacked by right-wing Republicans who say, Butt out.
The stakes in this elite dialogue are enormous. The outcome will be more meaningful for ordinary citizens than any other issue at play in this year’s campaign. If the Fed is right and politicians refuse to act, Americans may be condemned to a bitter slog through many years of stagnation.
Japan in the 1990s is the appropriate comparison. After its financial bubble burst, Japan saw its “lost decade” stretch into fifteen years of stunted growth. Its central bank responded hesitantly, and its monetary policy proved ineffective—rendered impotent by a “liquidity trap,” a condition identified by John Maynard Keynes. The United States experienced a similar fate in the Great Depression of the 1930s. As an economics professor, Fed chair Ben Bernanke is a scholar of that period. He is determined not to let it happen again. A decade ago, he scolded Japanese authorities for failing to be more imaginative and aggressive. They needed “the courage to abandon failed paradigms and to do what needed to be done,” Bernanke advised. His model was Franklin Roosevelt, whose “specific policy actions were, I think, less important than his willingness to be aggressive and to experiment—in short, to do whatever was necessary to get the country moving again.”
Maybe the Fed chair should give the same lecture to American politicians. But Bernanke is at risk of embarrassment himself: despite the Fed’s firepower, it has been unable to restart the economy. And monetary policy is running out of gas. Five years ago, in the heat of crisis, Bernanke’s response was awesome. The Fed created trillions of dollars and flooded the system with easy money—enough to stabilize financial markets and rescue wounded banks. It brought short-term interest rates down to near zero and long-term mortgage rates to bargain-basement levels. It provided a huge backstop for the dysfunctional housing sector, buying $1.25 trillion in mortgage-backed securities, nearly one-fourth of the market.
Flooding Wall Street with money saved the banks, but it didn’t work for the real economy, where most Americans live and toil. The housing sector kept falling. The Fed knows (even if politicians do not) the danger of sliding into a liquidity trap, which would utterly disarm its monetary tools (Charles Evans, president of the Chicago Federal Reserve Bank, thinks the trap has already closed). So the Fed wants Congress and the White House to borrow and spend more, which, when the private sector is stalled, only the government can do. To advance this cause, the central bank is promoting its recent white paper on housing, proposing, ever so gingerly, the heretical remedy of debt forgiveness for the millions of homeowners facing foreclosure.
The august central bank is engaged in a startling role reversal. It has turned left, so to speak, abandoned old positions on fundamental matters and endorsed Keynesian principles it once spurned. Bernanke would doubtless protest that this is not about left or right, that the Fed is simply doing what it’s supposed to do in a crisis—using the stimulative power of money creation to act as “lender of last resort.” Nevertheless, for nearly three decades, first under Paul Volcker and then Alan Greenspan, the Fed did pretty much the opposite. It was the conservative authority that dominated policy-making, scolding politicians for their spending excesses and threatening to punish over-exuberant growth by raising interest rates.
A tidal shift in governing influence is under way, because monetary policy is now eclipsed. As the central bank loses control, the stronger hand shifts to the fiscal side of government. That seminal insight originates with economist Paul McCulley, retired after many years as Fed watcher for PIMCO, the world’s largest bond fund. McCulley is a Keynesian who never bought into the ideological fantasy of self-correcting markets. His views won respect at the Fed because he was right. Only politicians still don’t get it. After thirty years of deferring to conservative orthodoxy, both parties are afraid to break from the past. While the Fed pushes for fiscal expansion, Congress and the president remain obsessed with deficit reduction.
“This was not supposed to happen,” McCulley observes. “The fiscal authority was always supposed to be afraid of the Fed. The Fed would say, Don’t do this, don’t do that. And the fiscal side would back off. Now you have a situation where monetary policy is effectively impotent and the Fed is openly inviting the fiscal side to do what for decades the Fed told it they couldn’t do.” The “missing partner,” McCulley says, is the fainthearted politician who clings to old dogma about fiscal rectitude, even though the crisis has made those convictions “irresponsible.”
As a longstanding critic of the Federal Reserve, I am experiencing a role reversal of my own. In the new circumstances, I find myself feeling sympathy and a measure of admiration for Bernanke’s willingness to stand up for unorthodox ideas and to switch sides on the sensitive matter of debt reduction for failing homeowners. For many years, I have assailed the institution’s unaccountable power and anti-democratic qualities, its incestuous relations with powerful banks and investment houses. Those flaws and contradictions remain unreformed, yet I now think the country needs a stronger Fed—a central bank not afraid to use its awesome powers to help the real economy more directly.
People ask, How come the Federal Reserve can dispense trillions to save Wall Street banks but won’t do the same to rescue the real economy? Good question. They deserve a better answer than the legalisms provided by the Fed. At this troubled hour, the Federal Reserve should find the nerve to abandon “failed paradigms” and to use its broad powers to serve a broader conception of the public interest.
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The Fed belatedly turned its attention to the foreclosure crisis when it realized that the housing sector, clogged with millions of failed mortgages and vacant houses, was a big part of why Bernanke’s monetary policy failed. Housing, of course, is an issue that belongs to the fiscal side of government, but the Fed can help out because its “dual mandate” in law requires monetary policy to support both maximum employment and stable money. If the housing market does not get well, Fed experts reasoned, there will be no recovery.
Though it seemed out of character for the austere central bank, the Fed has staged its version of a media blitz on behalf of troubled homeowners. In the span of seven days in January, two governors from the Federal Reserve Board in Washington and three presidents from the twelve regional Federal Reserve Banks delivered strong speeches on how to stop the bleeding and revive housing. They asked the elected politicians to consider a broad campaign to reduce the principal owed by the 11 million homeowners who are underwater, owing more on their mortgages than their homes are worth. Most of them can’t sell and can’t keep up with their payments, and are thus doomed to foreclosure.
All this was explained in the white paper Bernanke sent to Capitol Hill, which explained why cleaning up the housing mess is necessary for a “quicker and more vigorous recovery.” Housing advocates and community activists had been telling the central bank the same thing since the collapse began. Fed governors listened politely but never responded—until now. If nothing changes, the white paper warned, market adjustments “will take longer and incur more deadweight losses, pushing house prices still lower and thereby prolonging the downward pressure on the wealth of current homeowners and the resultant drag on the economy at large.”
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The white paper was hedged with lots of qualifiers, but it read like a handbook for recovery. A prime mover behind the initiative was William Dudley, president of the New York Fed. A Goldman Sachs alumnus, Dudley is first among equals, because the New York Fed is always closest to Wall Street. Dudley suggested $15 billion in bridge loans to tide over unemployed homeowners. He urged Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) now in conservatorship, to loosen their tightfisted control over mortgages and reduce outstanding balances on delinquent loans—which most likely will never be repaid anyway.
“I am uncomfortable with the notion that ‘underwater’ borrowers who owe more on their mortgages than their homes are worth should have to go delinquent before they have a chance of securing a reduction in their mortgage debt,” Dudley told an audience of New Jersey bankers in January. The standard objection to debt reduction is “moral hazard”—the fear that it will encourage bad behavior by other debtors. Dudley dismissed this as overblown. Most people in trouble, he said, are victims of bad luck—they bought their house at the peak of market prices or they became unemployed through no fault of their own. “Punishing such misfortune accomplishes little,” he said.
Dudley’s remark suggests a different tone at the Fed, one more sensitive to the human dimensions of economic crisis. Governor Sarah Bloom Raskin, who was appointed to the Federal Reserve Board by Obama, delivered an unusually caustic message to bankers last year. She is pushing substantive penalties for banking-sector abuses—the regulatory diligence neglected by the Greenspan Fed. “In the housing sector, we traveled a very low road that had nothing to do with looking out for the greater good,” Raskin declared. “On the contrary, there were too many people in all of the functional component parts—mortgage brokers, loan originators, loan securitizers, subprime lenders, Wall Street investment bankers and rating agencies—who were interested only in making their own fast profits…. Now it is time to pay back the American citizenry in full.”
A sense of moral resonance runs through the white paper. Fairness, it turns out, is an economic variable. So are the social consequences of doing nothing. The foreclosure mess, the Fed noted, hurts innocent bystanders when their neighborhoods are ruined by other people’s failure. Towns burdened by lots of empty houses lose property-tax revenue needed to sustain public services. The foreclosure process piles up “deadweight losses” in which nobody wins, not even bankers.
Mortgage relief, on the other hand, in effect redistributes income and wealth from creditors to debtors. “Modifying an existing mortgage—by extending the term, reducing the interest rate, or reducing principal—can be a mechanism for distributing some of a homeowner’s loss (for example, from falling house prices or reduced income) to lenders, guarantors, investors, and, in some cases, taxpayers,” the Fed document explained. Both the lender and the borrower can gain from reducing the size of an underwater mortgage, the Fed asserted. “Because foreclosures are so costly, some loan modifications can benefit all parties concerned, even if the borrower is making reduced payments.”
Refinancing at a lower rate and reducing the principal allows a family to keep its home with the promise of regaining equity as they pay down the more affordable mortgage. The modification can also restore the loan as a profitable investment for lenders, who will gain a greater return than they would if they had let the mortgage slide into foreclosure. Writing it down acknowledges that the original debt was never going to be repaid anyway. The lender suffers an accounting “loss” on the forgiven debt, but in real terms earns back more.
The same logic can apply to the economy as a whole, the Fed explained. The short-term costs of adjustment are upfront for lenders, but the long-term benefits will be much greater for the overall economy if clearing away bad debt revives the housing market. “Greater losses…in the near term might be in the interests of taxpayers to pursue if those actions result in a quicker and more vigorous recovery,” Fed governors concluded. Which would taxpayers choose? Reducing deficits or achieving “a quicker and more vigorous recovery”? I feel certain most people would choose jobs over balanced budgets. But we don’t really know what the people think, because the choice is never put to them in those terms. Neither political party has the nerve, and the media have failed to do so. It has fallen to the cloistered central bank.
For most Republicans the Fed’s message is alarming. It sounds suspiciously liberal. The Wall Street Journal raked Bernanke over the coals for his “extraordinary political intrusion,” denouncing the white paper as “a clear attempt to provide intellectual cover for politicians to spend more taxpayer money to support housing prices.” In a stern letter Senator Orrin Hatch told the Fed chair to back off. “I worry that…your staff’s housing white paper…treads too far into fiscal policy, and runs the risk of being perceived as advocacy for particular policy options,” Hatch wrote. Some GOP presidential hopefuls had uglier things to say about Bernanke.
The Fed did not push back. It could have replied that it has a direct stake in solving the foreclosure mess—the clogged housing market is a principal reason Bernanke’s monetary policy failed to revive the economy. The chair had assumed that, as the Fed brought mortgage interest rates below 4 percent, homeowners would rush to refinance. The savings would give them new disposable income, thus increasing aggregate demand for the weakened economy. The lower rates would trigger a wave of home buying and building, igniting the rebound in real estate. Housing has always been the classic channel by which the Fed has stimulated recovery, which it does by reducing the cost of credit. This time it didn’t happen, because the channel was blocked. One explanation is that the Obama administration and Congress were standing in the way, nullifying Bernanke’s accomplishment. Bankers, investors and especially Fannie Mae and Freddie Mac, were preventing homeowners from taking advantage of the reduced rates. They threw up various obstacles to refinancing and squeezed borrowers, trying to collect the last drop from homeowners before foreclosure. This is shortsighted politics, resisting immediate losses when doing so prevents the larger rewards of a genuine recovery. To put it another way, government has done a lot to protect the creditors from the costs of their misadventures. For the borrowers, not so much.
From the start, the administration has protected the bankers and other financial players, who have resisted the painful reckoning needed to unfreeze the housing sector. Presumably, the White House and Treasury feared that relief for debtors would threaten bank revenues, maybe their solvency. The GSEs, which guarantee 80–90 percent of mortgages, have cost the taxpayers some $150 billion. Congress gave them stern instructions to stop the losses. Obama has danced on both sides of the issue. He has launched several programs that promised to rescue homeowners, but he never used the full power of his office to force the financial sector into cooperating. Housing advocates thought Obama’s initiatives seemed designed to fail, and one by one, they have.
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Early in his presidency, Obama made fateful choices that have come back to haunt the country. He and his advisers, joined by the Federal Reserve and other regulators, decided to give the fragile financial sector “forbearance.” That is, they looked the other way. It was a banker’s version of “don’t ask, don’t tell.” Government has given generous interpretations to the wounded balance sheets of the largest banks. Examiners have not challenged toxic assets booked at inflated valuations. The assumption was that over time the economy would recover and so would the worth of those assets, especially in housing. But that hasn’t happened. The result is a blanket of leftover debt, which is still burdening the economy.
Mitt Romney described this with impressive clarity while campaigning in Florida. “We’re just so overleveraged, so much debt in our society, and some of the institutions that hold it aren’t willing to write it off,” he told a foreclosure forum. “The banks are scared to death, of course, because they think they’re going out of business…. They just want to pretend all of this is going to get paid someday so they don’t have to write it off…. This is cascading throughout our system, and in some respects government is trying to just hold things in place, hoping things get better…. My own view is you recognize the distress, you take the loss and let people reset. Let people start over again…. This effort to try and exact the burden of their mistakes on homeowners and commercial property owners, I think, is a mistake.”
Over the past four years, a substantial portion of overvalued mortgages have migrated onto public balance sheets and are guaranteed by the GSEs. So taxpayers are on the hook for losses, one way or the other. The economy would benefit if these uncollectible loans were cleared away. But who wants to tell the taxpayers they are picking up the tab?
The government’s vast holdings in fact have created another obstacle to housing recovery. Thanks to the Fed, Washington is the 800-pound gorilla now holding about 20 percent of the secondary market in mortgage-backed securities (MBS). That may inhibit private investors from restoring normal trading on their own. In past financial disasters, like the savings and loan crisis of the 1980s, regulators swiftly disposed of government-held assets acquired from failed banks. This time, government has held on too long. Eric Rosengren, president of the Boston Federal Reserve Bank, explained the problem. “One of the big mistakes the Japanese made,” he said, “was they kept a huge inventory of problem real estate loans at commercial banks and government agencies. Their housing market didn’t come back because everyone was waiting for the next shoe to drop. When were the government and banks going to dispose of those loans? You don’t want a situation where there is a huge overhang of real estate loans with government agencies as a very large seller.”
The Obama administration was warned of this risk early by Sheila Bair, chair of the FDIC, and Elizabeth Warren, chair of the Congressional Oversight Panel, as well as numerous housing advocates. They urged Obama to clean up the foreclosure crisis upfront to generate a quicker recovery. The warnings were not heeded. The pattern is not entirely clear, but it suggests a government decision made somewhere to transform private liabilities into public obligations. Banks repackaged MBS and sold them to Fannie and Freddie. The GSEs applied the government guarantee and sold the MBS to the Fed, which now has $850 billion worth of them on its balance sheet. The Fed is thus directly implicated in the government’s tolerance for wishful thinking.
The extent of likely losses is evidently not known. The New York Fed, I learned, did not examine the MBS it purchased to find out how many have inflated prices or are burdened by too many underwater borrowers who can never repay them. I was told the Fed didn’t bother to look further because the securities are guaranteed by Fannie and Freddie. That seems like ludicrous reassurance—one federal agency guaranteeing the holdings of another agency. The taxpayers are thus on both ends of the transaction and certain to lose if the securities turn out to be duds.
Instead, the problem is passed around like a hot potato. The Fed creates the money and buys a trillion dollars’ worth of MBS from Fannie and Freddie. Thanks to the Fed’s vast holdings, the securities are trading above par. Thanks to its interest income from the MBS, the Fed makes a profit, about $70 billion a year. At the end of the year, it remits the money to the Treasury, which uses it to offset budget deficits. All three agencies are handling the public’s money but from narrow-minded, self-protective perspectives. A more rational response, Paul McCulley suggests, would be to take the Fed surpluses and use them to finance a massive write-down of mortgage debt by the GSEs. Alas, in the bizarre mechanics of federal accounting, no one knows how to get the money from here to there.
The Federal Reserve should act because nobody else will. That sounds unfair, since the Fed has already taken heavy flak for poaching beyond its traditional domain. Further experiment will enrage right-wing critics, but the central bank is running out of options. Monetary policy-makers say they face formidable legal limits that people like me don’t appreciate. But the Fed still has enormous leverage. I believe what Wall Street financiers tell me: the Fed can usually find a way to accomplish what it really wants to do. In this case, it can break the political impasse and goad other parties into taking action. That does not require it to violate the Federal Reserve Act. It does require reinterpretation of the vaguely defined “dual mandate,” which has always been heavily biased in favor of Wall Street finance over the real economy. If stagnation drags on for years, tearing up society and destabilizing politics, demands for more radical action will swell and eventually overwhelm the old restraints.
Here is a modest example of what the Fed could do to shake up the system and help housing revive. It could announce its intention to buy only new mortgage-backed securities that have been subjected to the process of refinancing and modification to establish positive equity and more realistic valuations. The mere announcement would cast a cloud over the existing stock of GSE mortgages and probably trigger a wave of market-driven mortgage adjustments. The Fed, in effect, would not only provide a model for debt write-downs generally but help create the market for them. The Fed’s presence would assure people the process does not threaten the banking system. For distressed homeowners, it would amount to redistribution of income and wealth—sharing the costs of the financial catastrophe among other players instead of dumping all the pain on borrowers. Unilateral action would send a cleansing shock wave through the political system.
If this country ever gets back to a time when real questions are asked about democracy and our unrealized aspirations, people and politicians will have to talk about the Federal Reserve and its “money power.” I have a hunch current events are educating citizens and their elected representatives toward that day. It no longer makes sense to keep fiscal and monetary policy separate, pulling the economy in opposite directions. The present crisis suggests that monetary tools should be coordinated with the fiscal side. How this could be done in a democratic way is a tough question, but it cannot be answered until people and politicians are educated far beyond their primitive level of understanding.
The other promising challenge is to convince ourselves that money created by government really belongs to the people. Could it be used—judiciously—to finance long-term public projects, like infrastructure and high-speed rail? The government as employer of last resort? Make your own list of what the nation needs. Imagine if highest-priority projects were financed with the new money mysteriously created by the mighty Federal Reserve. That would be a future worth arguing over.