February 2014 – ECONOMY – Last year the Federal Reserve celebrated its 100th birthday. Only two days before Christmas in 1913, deep into the night when many legislators had already left for the holidays, Congress passed the Federal Reserve Act, creating a “non-governmental” central bank – a banker’s bank if you will – and charged it with the responsibility of controlling the nation’s monetary system. In all those years, the Fed has never engaged in a monetary explosion like it is today. We are truly in uncharted territory. In this article we’ll discuss the real reason behind the Feds easy money policy and how it could create an economic disaster, even more severe than 2008. In the midst of the Great Depression, Congress passed the Glass-Steagall Act, named after Senators Carter Glass (D) and Henry Steagall (D). Glass was a former Treasury Secretary and founder of the Federal Reserve System and Steagall was a member of the House of Representatives and Chairman of the House Banking and Currency Committee. The intent of the Act was to limit commercial banks involvement in securities activities and their affiliation with securities firms. Why? Because when banks engage in risky activities, it places depositors’ money at risk. Hence, the idea was to erect a wall of separation to protect depositors and reduce bank failures. This legislation was enacted in the wake of over 10,000 bank failures which represented about 40% of the banks in existence when the Great Depression began. During the 1960′s, the interpretation of Glass-Steagall had changed and banks were allowed to engage in an increasing amount of securities activities. Why? Perhaps because the world was becoming a global economy and U.S. banks were at a distinct disadvantage with their foreign counterparts. Although Glass-Steagall was intended to prohibit commercial banks from owning or affiliating with securities firms, in 1998 the Fed, under its own interpretation of the Act, permitted Citibank to affiliate with Solomon Smith Barney. There is a strong consensus that the elimination of Glass-Steagall was a chief contributor to the financial crisis of 2008.
When Glass-Steagall was abolished, the door was opened for what some like to call, “Capitalism run a muck.” Although I still believe this is the greatest economic system available, like anything else, extremes can occur, especially when greed is rampant. The following chart illustrates the number of bank closings each year from 2000 through 2013, according to the FDIC. When the housing bubble burst, banks were so deep in debt that mass failures seemed imminent. In essence, the lubricant of our economy (i.e.; liquidity), suddenly, and with great severity, dried up and the engine froze. This forced Congress to take drastic measures. In fact, Ben Bernanke, former fed chairman relied upon an obscure portion of the Federal Reserve Act which allowed him to lend to “any individual, partnership, or corporation” in “unusual and exigent circumstances.” This was predicated on the fact that “adequate credit accommodations from other banking institutions” was not possible. Basically, the power of the Fed was greatly expanded that day. When Congress passed the Troubled Asset Relief Program (T.A.R.P.), Washington hoped banks would loan this money to stimulate economic activity. However, as I wrote at that time, since banks were so mired in debt, they probably wouldn’t use the money for loans, but would use it to mend their wounds. In short, since the crisis was largely due to pressure from the U.S. government to make home loans to sub-prime borrowers, banks were in no mood to go down that path again, at least not so soon. Rather than use more debt to cure a problem which was caused by debt, banks tightened their lending standards and loan activity became temporarily extinct. This greatly increased the severity of the crisis. Even though the financial system didn’t actually collapse, the edge of the cliff could easily be seen from where they stood.
When the crisis began, the Fed had a balance sheet of about $800 billion. Today, after T.A.R.P., QE I; QE II; Operation Twist; and QE III, the Feds balance sheet exceeds $4.1 trillion! Here’s the troubling part. Even though the Fed has done everything possible, the economy continues to struggle. It has reduced short-term interest rates to near zero, drastically expanded the money supply, and lowered bank reserve requirements. On the other hand, prudent fiscal policy (i.e.; tax policy and spending), which is the responsibility of Washington, has been absent. Instead of a prudent fiscal policy, we have had an explosion in national debt, largely due to an increase in entitlements. One dollar borrowed today reduces future revenue since it has to be repaid. With the “official” national debt at $17.3 trillion and rising, we have a scenario where future economic growth will have to be well above average, just to repay what we’ve borrowed. Hence, the Fed has overshot its target in an attempt to compensate for the lack of fiscal responsibility in Washington. But there may actually be a greater threat looming. Much of the Feds money expansion, at least that which is not being held in reserves, has found its way into the U.S. stock market. This has increased demand for risk assets (the Fed got its wish) which is one reason for the meteoric rise in stock prices. Many experts believe that America is in a stock bubble. –Forbes