I know from personal experience as president of the Dallas Fed that GAO auditors are only too eager to support the political agendas of their Congressional sponsors. Past efforts to have ongoing GAO audits have excluded monetary policy and promised financial audits only. The current bill specifically targets monetary policy.

I’ve enjoyed my brief encounters with Mr. Paul. I like him personally, but I can’t get around the fact that his agenda is nothing less than abolishing the Federal Reserve.  Abolishing the Fed is not a hidden agenda on his part. In fact, End the Fed is the title of his latest book.

His book shows that he has given a lot of serious thought to his positions, including his lifelong study and admiration for Austrian economics, which longs for a gold standard. Unfortunately, in my opinion, he also praises the burning of dollar bills by young people at his campaign rallies. In fact, the title of his book, he says, came from the chants of students at a rally while holding up burning dollar bills. (Page 4 of End the Fed.) Burning dollar bills, to me, is almost as repugnant as burning the American flag–certainly not a source of pride.

Frankly, I’m flabbergasted at the attacks on the Fed in Congress. I think the Fed performed well in the financial crisis, pulling us back from the brink. The country and Congress owe it gratitude, not derision. I guess it’s true that no good deed goes unpunished.

It’s an honor to be on this panel with all these distinguished people. But I’m afraid I was invited because I’m considered soft on bailouts. That’s a terrible reputation to have. What is it they say about poker? “If you look around the table and you can’t tell who the sucker is, it’s you.”

The case for bailouts is usually systemic risk. You do it, not for the bailout-ee, but to limit the collateral damage, damage to the whole “system.” The case against bailouts is that by saving management and owners from the consequences of their excessive risk-taking or bad decisions, you create moral hazard and encourage similar behavior by others.

In most of the so-called bailouts during the Panic of 2008—bunched together in September 2008—the decision-makers were not saved or rescued. Top management, directors and stockholders generally lost their jobs and much of their wealth, and were maligned in Congress and by the press.

They didn’t benefit from a “heads I win, tails you lose” proposition. They had won for a while; then they lost.

Future decision makers under similar circumstances will remember both sides of that coin and not want to go there. Public humiliation is not something you want to emulate.

Mr. Paulson, in fact, seemed eager to fire people at the top who had done no wrong specifically so that he could not be accused of creating moral hazard. The CEOs of Fannie and Freddie were following policies mandated by Congress and were not the same CEOs in place during the earlier accounting scandals. I believe the fired CEO of AIG had been on the job only a few months. And Ken Lewis of Bank of America has learned that no good deeds go unpunished.

Moral hazard did get us into this mess. The making and securitizing of subprime mortgage loans and selling those mortgage bonds all over the world was the mother of moral hazards, since mostly independent unregulated mortgage brokers made the credit decisions and unsuspecting owners of the bonds—misled by their AAA ratings—bore the risk.

Many pundits who were saying “let ‘em fail,” “let ‘em fail” later said letting Lehman Brothers fail was the biggest mistake of the crisis. I tend to agree.

There were a lot of tall dominoes, standing close together. I’m not sure the system could have survived many other failures like Lehman’s, which cost me about 40 percent of my little portfolio.

Given time, I’m sure the Treasury’s TARP program could have been better designed and executed, but under the circumstances I think it’s working pretty well for almost 700 banks caught holding mortgage-backed securities and other assets no longer trading. We only hear of the top nine or the top 19.

I won’t try to defend TARP’s use outside the financial system or the way Congress has used it to fan and pander to our worst populist instincts, to demonize bankers, and as a pretext to expand government power, violate contracts and private property rights. It has been shameful.

The public, egged on by politicians, regards TARP as the Government spending their money to support “evil doers.” Most people have no idea that the Treasury will be able to sell its preferred stock and warrants received from banks, likely at a profit.

There will be losses here and there, on individual transactions and banks, but, overall, I won’t be surprised if taxpayers come out ahead net. The Treasury has earned about 18 percent on the banks that left the program early.

The Federal Reserve’s extraordinary lending last year and security purchases this year are even more likely to earn a net profit for taxpayers. The Fed generally turns over about 90 percent of its earnings to the Treasury’s general fund. Those earnings are rising significantly with the expansion of the Fed’s balance sheet, and those earnings will benefit taxpayers. Even the individual losses here and there, to the extent there will be any, would not be a loss of existing money, but only a loss of the new money created by the transaction—an opportunity cost loss.

Skeptics make much of the Fed’s expansion of bank reserves and money and take it for granted that it will be highly inflationary. Possibly, but I doubt it.

New money must be spent before it can cause inflation. Banks are holding most of their new reserves idle as excess reserves because they are scared to death. And the public has similarly reduced the velocity, or turnover, of money sharply. With the velocity of money collapsing, and credit shrinking, rapid money expansion has not been inflationary. So far, rapid money growth has been needed to forestall deflation.

Despite some pick-up lately, both the Consumer Price Index and the Producer Price Index remain below year-ago levels. Prices for the year are down, not up.

The trick for the Fed will be to adjust money growth as velocity returns toward normal—the exit strategy.

Chairman Bernanke’s study of the Depression has convinced him that tightening monetary policy prematurely is a greater danger than tightening too late. Most pundits on financial TV seem to assume the opposite.

During the Depression the Federal Reserve increased reserve requirements on banks to “mop up” banks’ excess reserves. The banks reacted by contracting credit further. It turned out that the reserves were not considered excess by the banks themselves. They wanted an extra cushion against uncertainty.

Today, the pundits are urging the Fed to make the same mistake—to “mop up’ excess bank reserves before they are used for loans and investments that might create inflation. But the banks are holding those excess reserves voluntarily—for the same reasons they did during the depression, as precautionary balances. Just because they may be excess reserves in a regulatory sense doesn’t make them excess in a more real sense.

While I give passing marks to the Treasury’s capital injections into banks and to the Fed’s direct and indirect lending, I put the massive stimulus program on the other end of the spectrum. It reminds me of hunting wild hogs with a shotgun rather than a rifle. There is a lot of firepower, but it’s diffused–not focused enough. It has probably prevented some layoffs at the state and local levels, but at a huge cost in money, deficits, and debt.

The Fed made loans and the Treasury made investments. The stimulus program, however, was old-fashioned spending. Money spent, money gone.

The deficit as a percent of GDP has tripled and outstanding debt is headed above its recent level of about 40 percent of GDP.

Instead of targeted marginal tax-rate cuts to stimulate the private sector, we face the prospects of repeating a huge mistake made during the depression—raising taxes in a weak economy. Not only the expiration of the Bush tax-rate cuts, but also additional taxes to finance new government programs.

In the 1937-38 period during the depression, the government raised taxes to finance new government programs already put in place. They wanted to balance the budget. We face the prospect of new taxes for existing programs and new programs yet to come.

Another negative feature of the Depression that we seem to be copying is class warfare against business leaders. How that is supposed to help anything is a mystery to me. But, to my knowledge, even Roosevelt didn’t think to have a pay czar.

Another depression-era mistake we’re in danger of repeating is protectionism. We haven’t gone as far as the Smoot-Hawley tariff increase yet, but we are on a slippery slope in that direction, with the violation of the NAFTA agreement on Mexican trucks, tariffs on Chinese tires, and buy-American policies spread all over the stimulus bill.

Will we ever learn?

Amity showed great restraint in writing her book. A scholar with her expertise could have driven the ideological lessons home and saved those of us on a practical mission some time. Instead, she patiently let the characters and the circumstances speak for themselves letting the nuance show through for us to savor.

While I wasn’t totally clueless about the depression, not having lived through it, you see, I must admit that my knowledge of many of the details was limited.

Here’s what I thought I knew going in:

* There was still debate over whether the October 1929 stock market crash caused it, just preceded it, or how big a role it played.

There was general agreement that:

* The Smoot-Hawley tariff was a terrible mistake that made it much worse, and may have made the difference between recession and depression.

* The Fed made it worse by allowing the money supply to shrink.

* Things got better in the mid-thirties, but then worsened again, probably because of policy mistakes.

* Hoover was totally ineffective and did next to nothing to help, while

* Roosevelt was an activist who experimented with cures and generated public hope and was generally successful.

* The depression really didn’t end until WWII.

* The most important change made to prevent future depressions was the FDIC’s deposit insurance.

* The semi-socialist measures of the Roosevelt administration saved capitalism from something far worse.

Here’s what I thought of a couple of things mentioned above:

* I couldn’t really deny the Friedman and Swartz charge that the Fed erred by allowing the money supply to shrink.

* However, I thought insufficient attention had been paid by the economics community to the following factors:

- The shrinkage of the money supply was primarily a by-product of bank failures.

- The world was still on a gold-standard and policymakers were presumably supposed to follow the “rules” of the gold standard game.

- There was no consensus within the economics community on what to do to get out of a depression.

- This consensus would await the publication of Keynes’ General Theory in 1936 and its subsequent popularization and incorporation into economics textbooks.

Here are some of the things I learned by reading the book:

Much of what Roosevelt did on a large scale was begun or done first on a smaller scale by Hoover. Hoover was not sitting on his hands waiting for better times.

Hoover came off better in the book than I expected. Roosevelt came off badly, as expected, based on his economic policies and actions. What I didn’t expect to learn was that Roosevelt was rather petty and vindictive.

The Smoot-Hawley tariff, arguably Hoover’s biggest mistake (expected), came very early (1930) in the first year of his administration without a lot of thought given to it. Protectionism was apparently accepted Republican dogma at the time; so Hoover accepted it almost routinely. (He would try to improve it; not oppose it.)

Hoover’s “economic philosophy” was really an engineer’s view of the world where planning was useful and where problems can be fixed. He was willing to tamper with the machinery up to a point, but he respected the constitution, including the constitution of the gold standard, as limitations on government action.

Roosevelt, on the other hand, had no philosophy to speak of, he cared little about the constitution, and he broke the gold standard with his prolonged devaluation of the dollar. (I had known about the devaluation of the dollar, of course, but I had missed that it wasn’t an immediate thing. Instead, Roosevelt enjoyed setting the price of golf every morning from his bedroom. Different strokes for different folks.)

Roosevelt’s lack of a “North Star” to guide his way made him particularly vulnerable to being pulled in different directions by his staff and “brain trust.” During his administration, policy shifted back and forth between stimulus measures (job creating) and a desire to get back to fiscal rectitude by balancing the budget with large tax increases.

Large and untimely tax increases in the middle of the depression—probably not considered that way then—killed off an incipient recovery.

This should be a huge lesson for us today. Among other potential tax increases implied by various programs under consideration today, we have the pending reversal of the Bush tax-rate cuts looming next year. Could we possibly repeat that mistake?

As for other lessons, for now, I think Chairman Bernanke was very much influenced by this last factor and has resolved to avoid premature “fiscal rectitude.” He considers declaring victory prematurely a bigger danger than waiting too long.

He has already avoided the mistake of allowing the money supply to shrink and have deflation psychology take hold. His critics on that, however, are getting louder and louder, calling for an “end game” sooner rather than later.

One issue involving monetary policy is very much relevant for today: the excess reserves on banks’ (and the Fed’s) balance sheets. As in the 1930s, the banks have more reserves than the law or regulations require them to have—hence the term “excess” reserves. However, also as in the 1930s, banks have good reason to be cautious and remain even more liquid than the law requires. Attempts to “mop up” those excess reserves before they are used in ways that might contribute to inflation could have disastrous results. The fact that banks are holding them voluntarily is proof enough for me that they are “required” reserves in the minds of the bankers and that banks would try to restore them if they were removed by the Fed prematurely.

One final note:  I didn’t realize that our current mob-rule attitude toward successful people that has us cutting executive pay and hauling executives before congressional committees to be humiliated had a counterpart in the 1930s, but, apparently there is nothing new under the sun. Amity has an entire chapter on “Prosecutions” that amounted to political payback. It’s like our leaders are bent on taking the worst lessons from the past.

I had wondered whether Keynes had had much influence on administration policies during the depression since The General Theory came too late. Even though he had earlier influential books, I gather not. My favorite part of Amity’s book was when she describes a meeting that Keynes had with President Roosevelt on May 28, 1934, lasting fifty-eight minutes, about the time of a class-room lecture. Both Keynes and Roosevelt indicated that the meeting did not go well.

The President indicated that “Keynes had left him, disappointingly, with a ‘rigmarole of figures.’ He must be a mathematician rather than a political economist.”

Don’t you just love “rigmarole of figures?”

P.S. I worry that I have done Amity Shlaes, The Forgotten Man, a disservice by my inadequacy in describing it. Even if I haven’t conveyed its merits sufficiently, trust me, it’s great, and well worth your time.

The timing was odd, however, and awkward, for the Governor since it was so soon after an FOMC meeting in which he didn’t dissent. It looks like he’s trying to have it both ways. Of course, it’s always possible that he and the Chairman together are trying to have it both ways.

One phrase in the piece scares me. He said

“. . . policy makers should continue to communicate as clearly as possible the guideposts, conditions and means by which extraordinary monetary accommodation will be unwound, including the removal of excess bank reserves.” [Emphasis added.]

As I’ve written here before, the treatment of “excess” bank reserves is fraught with danger, as the Fed’s experience in the Great Depression demonstrates. The reserves may be excess in the sense that they exceed the amount required by the Fed. However, they may not be excess in the minds of the bankers. Under the recent unusual circumstances, as with the Great Depression, bankers may think extra reserves are needed. If so, premature attempts to drain those reserves may lead to an unanticipated bank contraction. That happened during the Depression when the Fed raised reserve requirements to “mop up” excess reserves.

The Fed has a new tool—the payment of interest on reserves—that may help them navigate around the rocks, but it had better be sure that its view of those reserves is shared by their owners.

When I was president of the Dallas Fed (1991-2004), I frequently spoke to the graduates of our rank-and-file training programs. I just ran across the following summary outline someone made of my remarks on such an occasion in February 2002. Maybe you can use my suggestions on your kiddos. Commenters may want to add their own favorites to the list.

1. Plan your life on paper. Where would you like to be in your career in 5 years?  10 years?

2. Do a time line.

3. Write out your goals, objectives and ambitions. Be very specific and detailed.

4. Translate your goals into activities and schedule those activities on your calendar. Write your to-do lists with your goals in mind.

5. Watch people and take an inventory of those you admire. Check their attributes against your own. You can learn from people even if they aren’t perfect.

6. Talk good. An observation: The higher the level or rank of a person, the simpler their language. (The “good” was intended as a joke.)

7. Develop your brand.

8. Have an Australia—a plan B. (As in “I’m not dependent on this job. If it doesn’t work out, I can always go farm my little plot in Australia.”)

9. Beaver chip. Reduce large goals and objectives to bite size.

10. Focus like a laser. Don’t get distracted on unimportant tasks. (This is where “do as I say, not as I do” comes in.)

11. Keep a journal or a notebook.

12. Read.

13. Spend time outside your comfort zone.

14. Be alert for paradigm shifts.

15. Be alert for epiphanies.

16. Understand the difference between “playing the percentages” and trying to “beat the odds.” (Mothers call attempts to beat the odds “tempting fate.”)

17. Try to see familiar things from a new and different perspective.

18. Plan your life and career with the end in sight. Pretend you are writing the report on what you’ve accomplished.

19. Understand that you know more about the future than you might think. Some basic skills that will probably remain important include these:

Writing well

Speaking well

Comfort with technology

Pleasant to be with

Interesting to be with

Not a whiner

Pleasant to look at

20. Realize that leadership comes in many flavors.

21. Figure out why you will be successful. In other words, find the source of your self-confidence.

22. Realize that life is a journey, not a destination. (Sorry about that.)

Put the Dallas Fed on your shoulders and climb high.

Bob McTeer

This is the year that the whole world apparently discovered the importance of the Fed's Balance Sheet. Unfortunately, their discovery was made when it suddenly doubled in the context of a severe financial panic. This is awful! Right? We've got to get it back down to size! Right?

The suddenness of these revelations prevented useful perspective on why the balance sheet is important and why the composition of the balance sheet is just as important as the size. Money and banking text books for decades have discussed the Fed's balance sheet in the context of bank reserves and the Fed has for decades provided a statistical release on "Factors Affecting Reserves."

The two main ways the Fed conducts monetary policy are to purchase and sell Treasury securities in the open market and to encourage or discourage discount lending to eligible institutions. Both these things add to or subtract from the Fed's total assets. But other purchases may also add to the Fed's total assets, such as building a new building or buying new computers. All expansion of assets may have monetary implications on the liabilities side of the Fed's balance sheet. The net effect of the other asset purchases on monetary liabilities are taken into account when the Fed conducts open market operations to deliberately affect bank reserves. For example, if it is buying lots of new main frame computers for the wire transfer or ACH systems, it would presumably buy fewer Treasury bills to achieve a given target expansion of bank reserves.

There is some justification, therefore, for looking at the sum of the assets on the Fed's balance sheet (which will equal the sum of its liabilities). The recent focus on the Fed's balance sheet, however, has been on total assets as if all the asset growth results in growth in bank reserves or the monetary base (reserves plus currency outstanding). There are nonmonetary liabilities on the Fed's balance sheet, however, that may rise or fall with the expansion or contraction of total assets without affecting monetary liabilities. To the extent that is the case, all the talk about the "doubling" of the Fed's balance sheet and how it has to be "unwound" exaggerates the problem and the difficulty of correcting the problem.

To put this in roughly textbook form, on the Fed's balance sheet, you have:

Total Assets = Monetary Liabilities + Other Liabilities,

Therefore:

Monetary Liabilities = Total Assets – Other Liabilities

Therefore in the Fed's H.4 release, assets are the factors supplying reserves and other liabilities are factors absorbing reserves. The difference represents the change in reserves. In other words, asset expansion may expand Fed liabilities other than bank reserves.

One easy example to illustrate the point that not all asset expansions are equally insidious, are central bank swaps, where we borrow foreign currencies and lend an equivalent amount of dollars to foreign central banks and agree to exchange back at the same rate some time in the future. Those transactions expand both the assets and the liabilities on The Fed's balance sheet without affecting monetary liabilities, and they can be reversed without affecting monetary liabilities.

In the future, when you hear extreme statements about the likely impact of the expansion of the Fed's balance sheet, check into its composition as well.

Channeling the FOMC

I remember once when the head of the trading desk at the New York Fed was giving his report on international operations, the FOMC broke into applause when he announced that there had been no dollar intervention during the past year. While fixed exchange rates was once the orthodoxy, central bankers came to appreciate their ability to concentrate on domestic economic needs under flexible exchange rates. Do what's right for the domestic economy and let the exchange rate adjust to that. The alternative is to target the exchange rate and let the domestic economy do the adjusting. Fortunately, sound domestic policy promoting low inflation is more likely than not to produce a strong dollar.

So, when talking heads say the Fed's job is to support the dollar, Fed policy-makers agree, but they view supporting the dollar as protecting its domestic purchasing power. That's not usually what the critic had in mind; but they rarely acknowledge the downside of targeting the dollar.

Skeptics worry that the Fed won't be able to avoid having the current financial crisis end in hyperinflation, given all the "liquidity" that's already been created, and given the size of the budget deficits and growing debt. It will be tricky, but conceptually it's not very hard. As the depressed velocity of money begins to rise toward more normal levels, the FOMC will promote a slower growth in money so that money growth times velocity is sufficient for growth but not fast enough to promote inflation.

Given the slack in the economy, with the unemployment rate likely to be in the neighborhood of 10 percent and with capacity utilization in the 60s, the appropriate rate of spending (Money x Velocity) won't have to be held back that much at first. Spending that would normally be inflationary won't be until slack is used up. So some gentle tapping on the brakes and watching the result will be appropriate.

What about the complicating factor of large deficits?

The FOMC should ignore the fiscal deficits. They should buy just enough government debt in the open market to hit their monetary target–no more, no less. That means that some of the deficits will be monetized and some won't. Most likely the volume of debt not monetized will gradually put upward pressure on interest rates as the slack in the economy is used up. Crowding out may eventually become an issue, but not at first, and not abruptly. No week-end meetings will be necessary.

Rising interest rates in the short term should attract foreign  capital and sustain the dollar in foreign exchange markets. The FOMC's success in achieving the transition without serious inflation will tend to support the dollar in the longer run. A strong and stable dollar will not be the target of policy, but it will be the by-product of policy.

What I'm describing here is Milton Friedman's prescription:   control over the quantity of money domestically with flexible exchange rates to reconcile the domestic ideal with foreign realities.

A footnote on Helicopters: 

I don't know how Chairman Bernanke feels about his nickname, Helicopter Ben? It probably makes him smile. I don't want to rob him of that smile, but it bothers me that so many people seem not to realize that that image was around long before he uttered those words. Somehow, I think many people actually believe that his use of them as a joke reveals a predilection he has toward monetary recklessness.

I don't recall or know who used it first, but I do recall it being commonplace when I was studying money and banking in the 1960s. One context was how to get out of a Keynesian liquidity trap, when interest rates won't go lower as a result of more money being pumped into the economy. The answer was to keep pumping–drop money from helicopters if necessary. At some point people will start spending it. (Diminishing marginal utility applies to money too, you know.)

Economics majors from that era might recall it in the context of the Pigou Effect or the Pigou-Patinkin Effect.

Anyway, our Ben was making a little inside joke. Lets go along with it, but don't take it too seriously.

Should Bernanke be Reappointed?

I'm asked that a lot these days. My answer is "Yes, of course, and he should be given a medal for saving our financial system." Then comes, "But he, or the Fed, didn't see the crisis coming," or, "The Fed caused the crisis by creating the real estate bubble." There are more "ors," but let's start with these two.

The Fed didn't see the crisis coming.

Nobody with the authority to do something about it saw it coming. Not the Fed; not the SEC; not the banking regulators (OCC, FDIC or OTS); not Congress. In fact, Congress kept giving Fannie and Freddie quotas to meet to expand home ownership among low income people.

The Fed created the real estate bubble with easy money.

If we're talking about 2002 and 2003 here, the Fed was leaning against a weakening economy experiencing disinflation and threatening outright deflation. This was true to a lesser extent after the Fed began a gradual tightening in June 2004. Few bother to explain how a monetary policy leaning against economic weakness and promoting disinflation in the broad economy is creating rapid inflation in only one sector.

The real estate bubble didn't cause the crisis anyway.

Have we already forgotten the moral hazard created by the making and securitization of subprime loans? The financial crisis was caused, not by too many loans, but by too many bad loans and the sprinkling of those bad loans into mortgage backed securities all over the globe. Many things made the contagion worse, but they weren't the cause of the crisis.

(I first learned that people take the wrong lessons from crises during the S&L crisis in Maryland in 1985. Ohio had a major problem with privately insured S&Ls. Maryland had a similar system; so a silent run on Maryland's state chartered privately insured S&Ls began immediately, eventually prompting the closing of 102 of them. A few problems, including fraud, were uncovered during the examinations to reopen them. Those few problems were taken to be the cause of the crisis even though the crisis and the closings had occurred months earlier.)

Notice how the same type thing is happening now. We rarely hear about subprime loans any more. Instead, the problem is attributed to greed, Wall Street, the banks, executive compensation, corporate meetings in Vegas, company planes, the Bush Administration, and so forth.

Let me offer the view that it already has. The Fed's balance sheet ballooned last fall and peaked in December. Since then there has been no net new growth in total assets, but the composition of those assets have changed with circumstances. First, borrowing through special loan facilities grew rapidly, but the FOMC pretty much offset that by reduction in Treasury bills. The liquidity went where it was needed most without bloating liquidity throughout the system.

That special borrowing tapered off and has now diminished, but has been replaced with special assets such as commercial paper, mortgage backed securities, and consumer securitized debt, designed not to expand bank reserves and money but to unfreeze those markets and get them working again. Longer-term Treasuries have also been purchased to put downward pressure on longer-term interest rates, particularly mortgage rates.

People worry that purchasing longer-term Treasuries is "printing money" and is therefore particularly inflationary. Money is created when the Fed purchases assets, and it makes no difference in that regard whether it is long-term Treasuries, short-term treasury bills, or potatoes for the cafeteria. (Did I spell that right?)

While the total assets on the balance sheet first grew explosively and then flattened out, remarkably the growth of the M2 money supply has continued fairly steadily under the unusual circumstances. M2 growth has been faster than would be desirable under normal circumstances, but faster is appropriate when the velocity of the M2 measure of money has fallen. It's not money created that matters; it's money spent. Not money (M), but money times velocity (MV).

As confidence improves the velocity of money will presumably move back toward normal. It will not be difficult to see that and respond accordingly with slower money growth. Since gross domestic product equals money times velocity (GDP = MV) and since velocity equals GDP divided by money (V = GDP/M), a close eye on GDP growth is another way to see the need coming.

This is not rocket science.