|
The Fed and the Coronavirus Crisis
BY GERALD EPSTEIN | MARCH/APRIL 2020
-->
This article is from the March/April 2020 issue.
For the second time in roughly 10 years, the Federal Reserve and other central banks around the globe are being asked by bankers and politicians to save them and also save the economy—in that order. When the financial system was taken down in 2007–2008 by the outrageously reckless and corrupt behavior of regulator-enabled banks, the Fed, in partnership with the Treasury Department, committed, by some estimates, as much as $29 trillion to bail out the U.S. financial system. Other central banks took similar measures.
Now, the challenge facing the Fed and other central banks is likely to be even greater. This view might seem incorrect based on the claims of many commentators that the banks are stronger now than they were in the lead-up to the Great Financial Crisis of 2007–2008: they have less debt, have more capital buffers to stand between it and a taxpayer bailout, and have more ready cash (liquidity) to stem panic driven runs. All of this is true.
But the problems facing the Fed come not just from banks, but also from the massive financial system outside of the banks: hedgeㅐ
funds, asset managers, corporate bond markets, and a shadow banking system that are barely regulated by the Fed or other financial regulators, even though they are integrally—and now dangerously—interdependent with the banks. According to the Financial Stability Board, this global shadow finance system has been growing twice as fast as global bank assets from 2012 to 2017. And even though this time around the source of the crisis is not the financial system, finance has become a massive crisis accelerator because it has gotten so large and has been allowed to become so speculative and vulnerable, while remaining at the center of our highly financialized capitalist system.
Meanwhile, the global economy is collapsing around us, even more so than during the last financial crisis. The Fed and other central banks are thus faced with a double dilemma. They hold the keys to monetary policy which, as one of the two tools of macro- economic policy (along with fiscal policy), is tasked with maintaining high employment and stable prices—a tall order in the midst of this collapse of production, incomes, and employment. And at the same time, the Fed has to contend with preventing a meltdown of the financial system, which would make the underlying problem much, much worse. This is like being a parent and having one child who is terribly sick and needs care, while having a second child who is threatening to burn down the house unless he gets a huge treat. Can you deal with both? In what order?
During the Great Financial Crisis, the Fed made its choice. It bailed out the ornery kid and did very little for the rest of us. This time around, we are still waiting to see how the Fed will respond. In recent weeks, the Federal Reserve has undertaken a series of extraordinary measures (see Deutsche Bank Research, “COVID-19: List of Monetary and Fiscal Policy Responses by G20 Economies,” March 30, 2020, for a very useful list). First, the Fed lowered their interest rates to practically zero and then restarted quantitative easing to buy government securities and mortgage bonds. Then they restarted the multiple facilities providing liquidity and implicitly guaranteeing the operation of multiple financial operations: these markets include the commercial paper market, money market mutual funds, mortgage-backed securities and others, all of which have come under stress. Among the biggest operations is in the so-called “repo” (repurchase agreement) market, which is the major way the shadow banking system (and banks) borrow and lend to each other over the short term. In fact, this market has been having trouble since September, long before the coronavirus crisis, but now it is under even more stress. According to Deutsche Bank Research, the Fed could end up lending as much as $5 trillion in this market.
In addition, there are new problems in the markets. Major corporations have been going on a borrowing spree in recent years, as global interest rates have remained low and corporations have been wanting to finance large payouts to their executives and stockholders. This corporate bond market is huge, $7 trillion or more, and is now in serious trouble as the profits of major corporations tank. The Fed has created two facilities to help provide liquidity to this market. In addition, in recent years investment banks have been engaging in securitizing and trading assets other than the famous sub-prime mortgages they got in trouble with 10 years ago: these include student loans and car loans. The Fed has now had to create a new facility for each of these.
But what about the states, localities, cities, and small businesses that are under enormous stress and need help to keep going and provide needed services? Last time around the Fed did little to help them. Now, the government has tasked the Fed with acting more like a public bank and an arm of the Treasury in order to funnel funds to these entities and markets. The Fed is developing facilities to give loan guarantees and credits to many of these. In addition, the Federal Reserve is expected to create a facility to give loans and loan guarantees to small businesses. In the $2.2 trillion rescue package passed by Congress and signed into law, the government, through the Treasury Department, is injecting an additional $454 billion dollars of capital into the Federal Reserve that can be leveraged up to as much as $4.5 trillion in lending to try to help Main Street, not just Wall Street.
Turning the Fed into a proper public financial system in the middle of a national crisis is, in fact, a good idea. That is what Franklin D. Roosevelt did during World War II. Still, major questions of accountability and transparency abound here. During the Great Financial Crisis, the Fed and the Treasury lent billions and even trillions of dollars with very little oversight. Senator Elizabeth Warren has called for much stricter oversight this time around. But how will this really occur? The Fed is a creature of Congress, and so the Congress must exercise this oversight in the name of the public.
A big and unasked question, though, is: Why does the Fed have to bail out these massive financial markets yet again? How were these financial institutions and markets allowed to grow so massively over the last 10 years, with so little oversight? This time, wouldn’t it be better to create substitute, public institutions and bring these wild financial markets under control? A few possible steps the U.S. government could take include: nationalizing a bank or two and turning them into public utilities to support workers, families, and small business (as Doug Henwood has suggested recently); creating a postal banking system and supporting Credit Unions to provide small loans to households and small businesses; and directing a tightly accountable Federal Reserve to provide the liquidity and credit that we need to the “real economy” and to also provide dollar credit to underwrite international support for poor countries to help them survive the pandemic, while strictly limiting support to the massive global speculative financial system.
If we don’t take these critical steps, we will just keep underwriting the bloated and unproductive global financial system—helping it to lurch, prosper, and crash, from crisis to crisis.
GERALD EPSTEIN is a professor of economics and co-director at the Political Economy Research Institute (PERI), UMass–Amherst.
SOURCES: L. Randall Wray, “$29 trillion: A Detailed Look at the Fed’s Bailout of the Financial System,” Levy Economics Institute, December 2011 (levyinstitute.org); Financial Stability Board, Global Monitoring Report on Non-Bank Financial Intermediation, January, 2020; Deutsche Bank Research, “Covid-19: List of Monetary and Fiscal Policy Responses by G20 Economies,” March 30, 2020; Doug Henwood, “A Few Ambitious Points on Fighting the Crisis,” LBO News, March 20, 2020 (lbo-news.com).
http://dollarsandsense.org/archives/2020/0320epstein.html
MARCH 13, 2020
The Fed’s Baffling Response to the Coronavirus Explained
by ELLEN BROWN
When the World Health Organization announced on February 24th that it was time to prepare for a global pandemic, the stock market plummeted. Over the following week, the Dow Jones Industrial Average dropped by more than 3,500 points or over 10%. In an attempt to contain the damage, on March 3rd the Federal Reserve slashed the fed funds rate from 1.5% to 1.0%, in their first emergency rate move and biggest one-time cut since the 2008 financial crisis. But rather than reassuring investors, the move fueled another panic sell-off.
Exasperated commentators on CNBC wondered what the Fed was thinking. They said a half point rate cut would not stop the spread of the coronavirus or fix the broken Chinese supply chains that are driving US companies to the brink. A new report by corporate data analytics firm Dun & Bradstreet calculates that some 51,000 companies around the world have one or more direct suppliers in Wuhan, the epicenter of the virus. At least 5 million companies globally have one or more tier-two suppliers in the region, meaning their suppliers get their supplies there; and 938 of the Fortune 1000 companies have tier-one or tier-two suppliers there. Moreover, fully 80% of US pharmaceuticals are made in China. A break in the supply chain can grind businesses to a halt.
So what was the Fed’s reasoning in lowering the fed funds rate? According to some financial analysts, the fire it was trying to put out was actually in the repo market, where the Fed has lost control despite its emergency measures of the last six months. Repo market transactions come to $1 trillion to $2.2 trillion per day and keep our modern-day financial system afloat. But before getting into developments there, here is a recap of the repo action since 2008.
Repos and the Fed
Before the 2008 banking crisis, banks in need of liquidity borrowed excess reserves from each other in the fed funds market. But after 2008, banks were reluctant to lend in that unsecured market, because they did not trust their counterparties to have the money to pay up. Banks desperate for funds could borrow at the Fed’s discount window, but it carried a stigma. It signaled that the bank must be in distress, since other banks were not willing to lend to it at a reasonable rate. So banks turned instead to the private repo market, which is anonymous and is secured with collateral (Treasuries and other acceptable securities). Repo trades, although technically “sales and repurchases” of collateral, are in effect secured short-term loans, usually repayable the next day or in two weeks.
The risky element of these apparently-secure trades is that the collateral itself may not be reliable, since it may be subject to more than one claim. For example, it may have been acquired in a swap with another party for securitized auto loans or other shaky assets – a swap that will have to be reversed at maturity. As explained in an earlier article here, the private repo market has been invaded by hedge funds, which are highly leveraged and risky; so risk-averse money market funds and other institutional lenders have been withdrawing from that market.
When the normally low repo interest rate shot up to 10 percent in September, the Fed therefore felt compelled to step in. The action it took was to restart its former practice of injecting money short-term through its own repo agreements with its primary dealers, which then lent to banks and other players. On March 3rd, however, even that central bank facility was oversubscribed, with far more demand for loans than the subscription limit.
The Fed’s March 3rd emergency rate cut was in response to that crisis. Lowering the fed funds rate by half a percentage point was supposed to relieve the pressure on the central bank’s repo facility by encouraging banks to lend to each other. But the rate cut had virtually no effect, and the central bank’s repo facility continued to be oversubscribed the next day and the next. As observed in a March 5th article on Zero Hedge:
This continuing liquidity crunch is bizarre, as it means that not only did the rate cut not unlock additional funding, it actually made the problem worse, and now banks and dealers are telegraphing that they need not only more repo buffer but likely an expansion of QE…
The Collateral Problem
As financial analyst George Gammon explains, the crunch in the private repo market is not actually due to a shortage of liquidity. Banks still have $1.5 trillion in excess reserves in their accounts with the Fed, stockpiled after multiple rounds of quantitative easing. The problem is in the collateral, which lenders no longer trust. Lowering the fed funds rate did not relieve the pressure on the Fed’s repo facility for obvious reasons: banks that are not willing to take the risk of lending to each other unsecured at 1.5 percent in the fed funds market are going to be even less willing to lend at 1 percent. They can earn that much just by leaving their excess reserves at the safe, secure Fed, drawing on the Interest on Excess Reserves it has been doling out ever since the 2008 crisis.
But surely the Fed knew that. So why lower the fed funds rate? Perhaps because they had to do something to maintain the façade of being in control, and lowering the interest rate was the most acceptable tool they had. The alternative would be another round of quantitative easing, but the Fed has so far denied entertaining that controversial alternative. Those protests aside, QE is probably next on the agenda after the Fed’s orthodox tools fail, as the Zero Hedge author notes.
The central bank has become the only game in town, and its hammer keeps missing the nail. A recession caused by a massive disruption in supply chains cannot be fixed through central-bank monetary easing alone. Monetary policy is a tool designed to deal with “demand” – the amount of money competing for goods and services, driving prices up. To fix a supply-side problem, monetary policy needs to be combined with fiscal policy, which means Congress and the Fed need to work together. There are successful contemporary models for this, and the best are in China and Japan.
The Chinese Stock Market Has Held Its Ground
While US markets were crashing, the Chinese stock market actually went up by 10 percent in February. How could that be? China is the country hardest hit by the disruptive COVID-19 virus, yet investors are evidently confident that it will prevail against the virus and market threats.
In 2008, China beat the global financial crisis by pouring massive amounts of money into infrastructure, and that is apparently the policy it is pursuing now. Five hundred billion dollars in infrastructure projects have already been proposed for 2020 – nearly as much as was invested in the country’s huge stimulus program after 2008. The newly injected money will go into the pockets of laborers and suppliers, who will spend it on consumer goods, prompting producers to produce more goods and services, increasing productivity and jobs.
How will all this stimulus be funded? In the past China has simply borrowed from its own state-owned banks, which can create money as deposits on their books, just as all depository banks can today. (See here and here.) Most of the loans will be repaid with the profits from the infrastructure they create; and those that are not can be written off or carried on the books or moved off balance sheet. The Chinese government is the regulator of its banks, and rather than putting its insolvent banks and businesses into bankruptcy, its usual practice is to let non-performing loans just pile up on bank balance sheets. The newly-created money that was not repaid adds to the money supply, but no harm is done to the consumer economy, which actually needs regular injections of new money to fill the gap between debt and the money available to repay it. As in all systems in which banks create the principal but not the interest due on loans, this gap continually widens, requiring continual infusions of new money to fill the breach. (See my earlier article here.) In the last 20 years, China’s money supply has increased by 2,000 percent without driving up the consumer price index, which has averaged around 2 percent during those two decades. Supply has gone up with demand, keeping prices stable.
The Japanese Model
China’s experiences are instructive, but borrowing from the government’s own banks cannot be done in the US, since our banks have not been nationalized and our central bank is considered to be independent of government control. The Fed cannot pour money directly into infrastructure but is limited to buying bonds from its primary dealers on the open market.
At least, that is the Fed’s argument; but the Federal Reserve Act allows it to make three-month infrastructure loans to states, and these could be rolled over for extended periods thereafter. The repo market itself consists of short-term loans continually rolled over. If hedge funds can borrow at 1.5 percent in the private repo market, which is now backstopped by the Fed, states should get those low rates as well.
Alternatively, Congress could amend the Federal Reserve Act to allow it to work with the central bank in funding infrastructure and other national projects, following the path successfully blazed by Japan. Under Japanese banking law, the central bank must cooperate closely with the Ministry of Finance in setting policy. Unlike in the US, Japan’s prime minister can negotiate with the head of its central bank to buy the government’s bonds, ensuring that the bonds will be turned into new money that will stimulate domestic economic growth; and if the bonds are continually rolled over, this debt need never be repaid.
The Bank of Japan has already “monetized” nearly 50% of the government’s debt in this way, and it has pulled this feat off without driving up consumer prices. In fact Japan’s inflation rate remains stubbornly below the BOJ’s 2% target. Deflation continues to be a greater concern than inflation in Japan, despite unprecedented debt monetization by its central bank.
The “Independent” Federal Reserve is Obsolete
In the face of a recession caused by massive supply-chain disruption, the US central bank has shown itself to be impotent. Congress needs to take a lesson from Japan and modify US banking law to allow it to work with the central bank in getting the wheels of production turning again. The next time the country’s largest banks become insolvent, rather than bailing them out it should nationalize them. The banks could then be used to fund infrastructure and other government projects to stimulate the economy, following the model of China.
Join the debate on Facebook
More articles by:ELLEN BROWN
Ellen Brown is an attorney, founder of the Public Banking Institute, and author of twelve books including the best-selling Web of Debt. Her latest book, The Public Bank Solution, explores successful public banking models historically and globally. Her 300+ blog articles are at EllenBrown.com
https://www.counterpunch.org/2020/03/13/the-feds-baffling-response-to-the-coronavirus-explained/