A Fed That Is Distressingly Incompetent

A Fed That Is Distressingly Incompetent
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A few weeks ago, across the Atlantic, the people of South Wales had occasion to mark a half century since one of the area's gravest tragedies. On October 21, 1966, a large coal slag, a huge pile of coalmine waste debris, fell over onto the town of Aberfan. In the direct wake of the avalanche was the Pantglas Junior School, completing the staggering tragedy that stole 116 children's lives, as well as those of 28 adults.

Since 1947, the mine that had contributed the waste for the disaster was run by the National Coal Board, not any private company. It had been standard procedure to simply dump, or "tip", coal waste on the ridge overlooking the town. In 1964, just three years before the disaster, a local politician warned the Board of the specific danger not just to the town in general but of the school specifically. Less than a year after that, a petition was presented to the local Borough Council signed by mothers of children attending the Pantglas protesting the ongoing "tip."

The NCB itself first denied there was anything that could have been done to prevent the avalanche. Its Chairman Alfred Lord Baron Robens of Woldingham claimed that its cause was the existence of unknown natural springs beneath the giant pile that degraded its stability, even though those springs had been marked on geological surveys and maps.

The Davies Tribunal, named after the head of the inquiry, Lord Justice Edmund Davies, was perfectly clear as to what really happened. It sat for 76 days, the longest in UK history to that point, deposed 136 witnesses, examined 300 exhibits, and heard 2.5 million words of testimony, including those of Lord Robens who continued to deny any responsibility on the part of the NCB. But the Tribunal concluded against him anyway in the harshest possible language:

"...the Aberfan Disaster is a terrifying tale of bungling ineptitude by many men charged with tasks for which they were totally unfitted, of failure to heed clear warnings, and of total lack of direction from above. Not villains but decent men, led astray by foolishness or by ignorance or by both in combination, are responsible for what happened at Aberfan."

It also found the NCB legally liable for injuries, deaths, and damages, a judgment it asserted as "incontestable and uncontested." Officials saw no reason to accept the conclusion, however, as to pay out any claims would be to increase the NCB's operating deficit requiring only more taxation to fill the hole. This was no private business whose operating surplus or private assets could be sold to raise money for the relief. Instead, the NCB provided £500 per fatality, less for injury or destruction of property.

In lieu of accepted responsibility, a private charitable fund was set up, and, as usual, proving the glint of humanity at some of its darkest hours, the British people responded. Raising £1.6 million (about £30 million in current terms) from nearly 100,000 individual contributors, the village of Aberfan would, however, suffer but a second government indignity. Prime Minister Harold Wilson's government insisted on charging the charity fund £150,000 pounds to help meet the cost of removing the very coal debris that its coal entity negligently allowed to inundate the town. Lord Robens had refused to allow using NCB funds for removal of its own waste (though the Board did eventually pay some of the freight).

Despite so much straight ineptitude and disgrace, nobody was ever charged with any crime, nor any regulatory sanction heard let alone meted out. As the Tribunal also said, the disaster was as "incompetence" rather than wickedness. Lord Robens in September 1967 offered his resignation seemingly in response to the Davies Inquiry's scathing and damning report, but, as later investigation would uncover, it was disingenuous from the start, a sham with which to calm public perception that rightly smelled political corruption.

The NCB Chairman had first checked with the certain officials to be assured that any offer of resignation would be rejected; as it was. The Wilson government found Lord Robens to be a useful political operative, especially in the coal business and especially at that time. It was being reformed and Robens was particularly helpful with avoiding labor union strife, himself being a union leader in the 1930's. Incompetence was, apparently, no excuse for losing such a strategic political asset.

There were complicities throughout the official channels. Attorney General Sir Elwyn Jones claimed, "it is highly undesirable that any comments should be made in the press or on the radio or on television on matters which will be the express function of the tribunal to investigate." The Sunday Mirror responded to the veiled threat with a headline titled, A Friendly Warning to the Attorney-General Who Issued the Unfriendly Warning, writing further that it was more than a "touch of pomposity which unfortunately afflicts those in high office" before asking, "Is it contempt of court we are really considering, or the unconsidered reflex of the Government machine?"

The British government in 1997 repaid the Aberfan survivor fund the £150,000 pounds it subtracted, without interest. Lord Robens continued as Chairman, and a few years later was somehow appointed to chair a government committee on workplace health and safety that in the form of the 1972 Robens Report championed the principle of self-regulation; as if Aberfan had never happened.

There are incompetent people in government just as there are anywhere else. The fact that they are so often found in government isn't voided by the fact that is where they are. In so many cases, their lack of ability seems to be enhanced in that twisted way by being so insulated. Politics so often prizes such attributes especially where cause and effect might be so disturbed as to be unclear. In the doings of "great" things it is perhaps so common so as to find the people involved in those things are the sorts of people who in a perfect world would be kept far away from them. The tragedy of Aberfan might be an outlier, or it might be far too representative, a debate of perceptions perhaps.

Our system of government was not meant to be like this, however, as the founders sought to achieve limited governance precisely because they knew from time to time it would be "led" by men who couldn't lead. To limit the damage meant not just limit the reach, but also to impose accountability by election if nothing else. It required the informed consent of the governed as the final balance against the corrupt and the moronic.

It has become more common of late to believe that those American principles, indeed the basic logic of common sense, are no longer applied or ever to be applied again. Corruption seems to be endemic if not beyond entrenched to have become the very fabric of so many seemingly ill-suited institutions. That is partially because corruption is not always the exchange of money for favors; it is so often direct incompetence that goes on as if forever. This is government that holds itself to no standards at all. But has it always been this way, many of us just now noticing because there are far more and bigger reasons to notice? When "things" are in general going well, we might stand the usual idiocy; when they aren't, there is a tendency to believe every witch needs to be burned.

It is hard when the world seems lost to connect such dots, but if the issue is truly dissatisfaction about the future because of the way a great many of us perceive how things are, then it isn't a witch-hunt it is progress. Nobody ever voted for QE or ZIRP, but now that the agency responsible for them has moved to disown both and all else prior, there are still no answers. Worse, much of the same people who espouse the very same philosophies are left in place to plan the next great failure.

An objective review of the Federal Reserve's record of the past nine years would reach the same conclusions as the Davies Tribunal did of the NCB's conduct at Aberfan. These are not evil men and women who seek the world's overthrow on behalf of their Wall Street overlords; they are just captured by a worldview and blinded by an ideology that isn't suited for the world that we live in. It makes for great and elegant mathematical theory, but statistics don't answer why China has a "dollar" problem when Japanese banks are threatened by British changes.

But the Fed's failures are even more basic than all that. The guiding doctrine of monetary policy is actually quite easy to understand in its operational intentions; to use a target for the federal funds rate in order to achieve a stable 2% rate of inflation. It is assumed by that method of "monetary" control to that level of economic success (inflation being the economic barometer of money) unemployment will settle easily so as to satisfy their third mandate.

Before August 9, 2007, the Fed had already failed at its inflation target, though, it should be pointed out, at that time it wasn't an explicit policy arrangement. Still, both the CPI and the Fed's preferred measure the PCE Deflator remained above 2% despite the fact that Alan Greenspan's Fed had started a determined "tightening" policy lasting from June 2004 to June 2006. While the federal funds market and related money measures "obeyed" those target changes, more of what truly mattered did not (I won't recount yet again in this space the statistics for credit default swaps as well as how they were used in monetary function).

The inability to achieve the inflation target was a warning about what would come next. On August 7, 2007, Bill Dudley, then head of the Open Market Desk at FRBNY, claimed that there was nothing imminent for the FOMC to be concerned about. Two days later, on the 9th, the federal funds market would show that this more basic target was likewise unachievable. In afternoon trading that day, some trades were conducted at rates not just far above the target level but well above the Primary Credit "ceiling." In response, on the morning of the 10th, the Open Market Desk initiated a huge "liquidity" operation so as to regain control only to instead find the federal funds market had went the other way where "liquidity" just piled up in NYC, with some trades taking place at 0.0%.

The truth of the matter is that from that point on, the federal funds target was lost, nothing more than a joke. By the September 2007 in the regular FOMC meeting of that month, Bill Dudley acknowledged the contours of this more open realization without, apparently, appreciating it for what it was.

"First, the turmoil in money markets did impair the functioning of the foreign exchange swap market. This made it more difficult for banks in Europe that are structurally short of dollars to obtain the dollar funding needed to fund their assets."

To answer this spreading monetary problem the Fed responded by reducing its target for the federal funds rate by 50 bps, as if that would reduce "turmoil in money markets" to therefore allow better function with regard to the global "dollar" short. This was the operating doctrine that had lasted ever since that unknown point in the 1980's when the Fed decided unilaterally that federal funds ruled all monetary components; and therefore an enforced target for federal funds was believed the sum total of necessary operational control for everything out to that stable 2% inflation.

The events of August 2007 in the US but more so Europe actually demonstrated quite well this doctrine had already by that early stage been undone in total; it was all a lie. They couldn't actually enforce control over federal funds which meant there was nothing in eurodollars, and soon inflation that had been stubbornly over target sank sharply under it - briefly negative in 2009. The Fed promised ample liquidity through its targets, but the world was soon greatly deprived of all such money in every part of the markets and economy.

Again, there has not been any accountability as to how the Federal Reserve who had pledged economic stability for all of us based on their ability to target just one interest rate suddenly found itself at the worst possible time unable to do even that. What did happen was that quietly the US central bank as well as others around the world devised new ways in which they intended to accomplish those same goals. The Fed, for instance, received expedited approval to move up paying interest on reserves, a belated acknowledgement about exactly how they couldn't put in a floor for federal funds. Overseas, especially after 2011, foreign central banks would experiment with how these additional tools might be used.

The ECB, for example, in June 2014, after having been thwarted time and again with other policy methods, decided to decrease its IOER equivalent, their deposit account, to less than zero interest (NIRP) in a world's first. The theory is, as always, quite simple: force banks to use bank reserves that were piling up and those that would in the near future as the European bank was about to embark upon a parallel balance sheet expansion.

But as the balance sheet expanded, eventually by full-blown QE, and its deposit rate even more negative, the banking system only proved all over again the incompetence. As of Wednesday, the ECB reports €417 billion on balance with its deposit facility "paying" -40 bps "interest", with another €822 billion doing nothing in its current account. Since June 2014, the central bank through its constituent National Central Banks has purchased €1.13 trillion in securities under its PSPP (QE), €197 billion in covered bonds, €37.8 billion in corporate bonds, and €21.5 billion in asset-backed paper.

When all that started back in June 2014, the deposit account that was then "paying" 0.0% held just €13.6 billion, while there was just €498.7 billion in the current account. Inflation in Europe was 0.5% (HICP) in June 2014; and was just tabulated to be 0.5% for October 2016, after spending most of the intervening two years near and below 0.0%.

In the US, calculated inflation has similarly ticked up of late, but not to any degree that would suggest anything has actually changed. How is it that despite a $4.5 trillion balance sheet, the CPI and PCE Deflator can best be described as meandering higher? Even when inflation slightly accelerates, it does so in a manner totally different to established history and expectations. As I wrote last month with regard to the CPI:

"A sharp deceleration or even drop in prices, like economic output, should lead to an equal or sharper rise in prices (or output) after the weakness passes. The CPI was -2.1%, for example, for July 2009 and still negative as late as that October; but it finished the year at +2.7%, a nearly 5% swing from low to high in a matter of months. In the dot-com recession, the CPI bottomed out shortly after its end at 1.1% for June 2002. Just eight months later, it was back at 3% all over again."

These are not merely academic discussions of a misguided emphasis on precision. The common refrain is to suggest that perhaps there isn't really all that much wrong; shopping malls are still places of significant activity, people are traveling and vacationing again, restaurants are plentiful, and gigantic ships still sail from port to port loaded with goods. If you didn't know better, you might even think everything is normal. But the people do know better, as there isn't as much mall traffic as you would expect at "normal" (or the online equivalence), leisure or restaurant receipts are well off, and certainly not nearly as many ships traverse the world's oceans.

In Europe as the United States (as Japan, China, Canada, Australia, Brazil, etc.) orthodox practitioners claimed that by targeting these specific things the unthinkable would be impossible. Yet, we discover that the cost of time has become truly staggering, and that though we can try to tally the cost the true loss is immeasurable though more and more tangible nonetheless. In conceptual terms, the loss of economy in Europe is something like €748 billion (quarterly rate) for the EA18 group of nations, on a base of €2.49 trillion. In other words, had the Great "Recession" been kept as a recession as all those monetary targets meant to do, quarterly European GDP in Q2 2016 would have been around €3.24 trillion rather than the €2.49 trillion currently estimated.

In the US, in annual GDP terms, the difference is similarly overwhelming; real GDP of $16.7 trillion in Q3 should have been, had it resumed its pre-2008 trajectory, $21 trillion. Personal Income should have been closer to the $18.4 trillion baseline rather than the $14.1 trillion that was estimated (SAAR) for September. There are an enormous number of Trump as well as Sanders voters who can "feel" and appreciate the $4.3 trillion difference; just as there were in the UK who noted the missing €748 billion, and others on the continent who would follow Brexit.

It isn't just those who are receiving zero income after seven years of "recovery." Those who are working understand all-too-well what $21 trillion in real GDP would have meant about their own future and prospects for better opportunities as opposed to the economy of $16.7 trillion that in reality closes off so many options that really should have been there but weren't and likely aren't going to absent some accountability somewhere.

To explain this disparity, economists and policymakers have resorted to the increasingly absurd, usually some form of demographics, so as to play the role of Lord Robens all over again; "it's not our fault, it just happened." The reason they get away with it is that they have never, never been made to account for their most basic derelictions. The Federal Reserve said without question or doubt they would target the federal funds rate and that would keep the economy in an even place. And when it was disrupted by the very normal course of business cycle recession as it surely would be, that federal funds target properly adjusted and enforced would limit the downside and assure quick recovery to the prior trend growth. If they couldn't even enforce the federal funds target...

In June 2004, the Congressional Budget Office (CBO) estimated that constant trend (potential) growth would mean the US economy as measured by real GDP would be $13.63 trillion in constant 1996 dollars ten years forward. On a relative scale, that would work out to an expectation for 59.3% more real GDP at the end of 2014 than in the first quarter of 1999. In August this year, in the latest of a constant downgrade of "potential GDP", the CBO figured that the US potential was only be 40.7% more than Q1 1999. Actual estimated GDP registered a gain of just 36.4%. What changed between June 2004 and August 2016?

There is a great deal that would answer that question, but almost all of it traces back to this very incompetence. The Fed couldn't actually maintain even its federal funds target rate, let alone how everything was supposed to follow from it, and ever since that was shown to be the case nothing has been normal again. If we are ever stirred enough to do it, should we gain something like the Davies Tribunal to investigate our own lost decade and all the disruption it will have sown, I have no doubt that its conclusions will sound distressingly similar: terrifying tale of bungling ineptitude by many men charged with tasks for which they were totally unfitted. Politics loves the empty suit; civilization cannot bear the burden of so many for so long in such important places.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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