As Kevin Warsh Calls for Fed Reform, Market Forces Are Shutting It Down

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Former Federal Reserve vice chairman Kevin Warsh recently wrote in the Wall Street Journal that the "conduct of monetary policy in recent years has been deeply flawed." For a former insider to even lightly spank the Fed speaks to progress. The problem is that Warsh still accepts the need for a central bank to do things and to pursue "reform," when the on-the-ground reality calls for the Fed and other central banks to do nothing.

Warsh thankfully alludes to his own puzzlement that "so many academics are pushing to raise the current 2% inflation target to a higher target of 3% or 4%." No argument with Warsh there.  It's quite simply strange (per the rule of 72) that some central bankers would clamor for a doubling of the so-called "price level" in eighteen years instead of the theoretical 36 years it would take under a 2% target. But Warsh's criticism misses much bigger points not touched on by the former central banker.

What Warsh should have asked is why central bankers would want to meddle with the price level at all. Let's not forget that market-informed prices are what decentralized producers utilize to organize the market economy. This matters simply because in the real economy, prices happily rise and fall all the time for reasons that have nothing to do with monetary policy.

In 1990 The Seinfeld Chronicles was a television show idea conceived by Jerry Seinfeld and Larry David that could have been purchased for a song. Today that same franchise is worth billions. VCRs were once expensive, so were DVD players, but technological advances have rendered the first almost valueless, while the second is rushing toward a valueless future thanks to streaming technology.

More broadly, laser printers ($17,000), mobile phones ($3,995), and computers (IBM's first retailed for over $1 million) were once very expensive items only available to the richest of consumers. Thankfully venture buyers established a purpose for all three such that each can be had today for very little. Jerry Jones bought the Dallas Cowboys in the late ‘80s for $149 million, but for a buyer to enter the elite club of NFL owners today, the entering price would be over $2 billion. Warsh would have written a much more effective piece had he aggressively dismissed the very notion of central bankers presuming to control the price of anything.  

Warsh isn't a Keynesian, but he might respond to critiques of inflation targets that central bankers largely informed by Keynesian ideology would say a rising price level is essential as a way of stimulating individual consumption. But the obvious problem with such a response is that market economies are already defined by rapidly falling prices, the freer the economy the more rapidly that prices fall. And as evidenced by the declining cost of smartphones, computers, flat screen televisions and seemingly everything else, falling prices in no way deter rampant consumption in the here and now. That's why individuals are getting up to go to work in the first place; so that they can exchange the fruits of their labor for what they don't have. Producers who are producing with an eye on consumption in no way require central planners to engineer higher prices as a consumption spur.  

Also missed by those focused on consumption is that saving in no way subtracts from demand. Unless the productive are quite literally stuffing dollars earned under mattresses, their savings are quickly lent to those who have near-term consumptive desires. The latter speaks to the simple truth that production always and everywhere drives consumption. You must have the former to achieve the latter, but the act of saving will in no way limit the latter. In fact, the happy act of saving will logically increase consumption.

Indeed, missed most of all by central bankers is the basic truth that money saved isn't solely directed toward voracious consumers. Money saved also frequently morphs into the very investment that powers exponentially greater productivity that, by definition, drives even greater consumption. Let's not forget that the tractor, car, airplane, ATM, computer and internet were all the fruits of saving that authored increased production, and with it, much more consumption.  Consumption is the easy part.  We don't need central bankers to stimulate what we're already wired to do.  

Warsh writes that "The Fed often treats financial markets as a beast to be tamed, a cub to be coddled, or a market to be manipulated." Warsh properly dislikes the Fed's actions vis-à-vis markets while adding that that "From the beginning of 2008 to the present, more than half of the increase in the value of the S&P 500 occurred on the day of Federal Open Market Committee decisions." Warsh's implicit point is that the Fed has been the source of the rally.

The above assertion is debatable. If what Warsh is saying is true, how might he explain a Japanese market index that is still half of what it was in 1989 despite near constant Bank of Japan attempts to manipulate prices much higher through rate and quantitative easing (QE) machinations? He might also explain why stocks didn't rally stateside when the 21st century began despite aggressive rate cutting from the Fed.

Implicit in the popular view about the Fed being the driver of investor optimism is that the Fed's rate and QE machinations led to lots of dollars chasing yield in equities. The problem with such a view is that for every buyer made aggressive and optimistic by Fed meddling, there's by definition a seller exiting the same market thanks to skepticism about the actions of our central bank. There are no buyers without sellers, at which point it must be acknowledged that in any market, the passions of the bulls are always and everywhere equalized by the pessimism of bears. The notion that the Fed created a rally is fairly easy to dismiss.

But even if readers aren't convinced, as in if they believe that Warsh is on to something about the Fed as the source of rising markets, explicit in such a view is that the Fed's actions deprived investors of what would have been a much bigger rally. We know this simply because market corrections, like true recessions, set the stage for rallies and recoveries. Corrections and recessions happily signal market forces starving lousy companies of precious investment capital so that the better ones can attain more of it. Assuming what is unlikely (remember low rates and QE have never worked in Japan, and they most often haven't worked in the U.S.), that the Fed engineered an artificial stock-market rally, then it must be said that marginal companies were propped up at the expense of much greater ones; thus neutering a market rebound that would have been much more powerful absent the Fed's desperate measures to appear relevant.

Further evidence supporting this argument concerns governmental attempts in China over the past year to prop up shares there. The interventions logically failed. Investors aren't stupid, and they're logically going to exit markets and companies that are being falsely bolstered by artificial intervention as opposed to true market forces.

Warsh argues that "Real reform should reverse the trend that makes the Fed a general purpose agency of government." No argument there, but Warsh didn't take it far enough. More than he or any central banker or economist will realistically admit, we quite simply don't need the Fed. Figure that it began in 1913 as a lender of last resort to solvent banks, but the market reality since the Fed's creation has revealed quite plainly how unheard of it is for solvent banks to go to the Fed for a loan. Only the insolvent require access to the Fed's lending window, at which point the Fed's very existence serves to weaken the very banking system it was intended to strengthen. Imagine how impoverished Silicon Valley would be if all of its laggards had ready access to cash.

Warsh would likely agree that the Fed is a lousy bank regulator too. Indeed, Citigroup has been bailed out several times over the last twenty-five years despite the central bank's oversight. As for the Fed funds rate, that's just a price. Banks don't need the Fed to plan what is a price.

Warsh concludes that assuming a looming recession, "the Fed is poorly positioned to respond with force, efficacy and credibility." So true, but it's also Warsh stating the obvious. Too often forgotten by Fed critics and supporters alike is that the central bank's channel through which it vainly attempts to influence the U.S. economy is the U.S. banking system; the latter easily one of the least dynamic sources of credit in all of the U.S. economy. Worse, at least for the Fed, is that banks represent 15% of total U.S. lending. That number is in freefall.

Not only is the Fed's channel for influencing the economy shrinking by the day, it's also true (Warsh didn't discuss this) that the Fed can't shrink credit where economic activity already rates it, and it can't increase it where economic activity is so limp as to theoretically require central bank help. All readers need do to understand the previous truth is consider Silicon Valley and Baltimore side by side. Any central bank attempt to neuter activity in what is a hotbed of innovation would fail between breakfast and lunch thanks to global capital flows eager to attain Valley exposure. Just the same, Fed bond buying from Baltimore banks would amount to those same banks lending the extra funds well outside of the Charm City between lunch and dinner. Looked at in the bigger picture, the Fed's naïve imposition of QE didn't increase loanable dollars in the U.S. as much those dollars exited the U.S. by tens of billions each month. We operate in what is a global economy, yet the Fed's models presume a U.S. economy that is an impregnable island.

But the bigger point that Warsh failed to address altogether is that even if the Fed did have the tools to respond to recessions, how tragic if so. Warsh no doubt knows this well given the time he spends at the Hoover Institution out in Palo Alto, CA. Recessions are healthy. Recessions signal the looming boom simply because recessions are the happy sign of market forces starving the Webvans, globe.coms and eToys of the technology world so that Google, Facebook and Intel have more capital at their disposal. Silicon Valley, like all wealthy locales, is a creation of non-stop failure, and yes, lots of little recessions that drive economic progress. Assuming the Fed had the tools to fight recessions, it doing so would be to our broad economic detriment.

Warsh thinks the Fed needs new thinking, but such a view suggests that we need the Fed at all. It quite simply can't do what its supporters and critics alike think it can. Maybe Warsh knows this himself, but out of loyalty writes of reform that will prove meaningless.

But you can't reform what makes no sense, and that's perhaps the best news of all. Whether the Fed is reformed or not, or abolished (highly unlikely), none of it will matter. Market forces have rendered the Fed increasingly irrelevant no matter what. The Fed quite simply can't, and that's good for the U.S. and global economy.

 

John Tamny is editor of RealClearMarkets, Director of the Center for Economic Freedom at FreedomWorks, and a senior economic adviser to Toreador Research and Trading (www.trtadvisors.com). He's the author of Who Needs the Fed? (Encounter Books, 2016), along with Popular Economics (Regnery, 2015).  His next book, set for release in May of 2018, is titled The End of Work (Regnery).  It chronicles the exciting explosion of remunerative jobs that don't feel at all like work.  

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