The Fed Can't Fix a Crisis That Justifies Its Very Existence

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It is very easy at times like these to slip into the old comforts of grand historical figures. Given the nature of the incidents, a viral infection of illiquidity upon the world, prime among such a list of great persons is undoubtedly Walter Bagehot. Jay Powell would do well to study some over the coming days and weeks. Which works, though?

Everyone knows his famous decree for central banks. But Bagehot was a scholar maybe even more properly characterized as a philosopher and thinker than strictly some astute financial observer. He was a deep man already established in reputation and esteem long before leaping into the topic of central banking and money.

Six years before writing Lombard Street, Walter had published The English Constitution. The Reform Act of 1867 was being debated in Parliament so the topic of the British monarchy was central to the minds of everyone who fell under the Queen’s domain. Near half of Earth's people. To Bagehot, there was more than politics at stake.

The Queen, he wrote, indeed all monarchs, they are more than the simple functions of government. Indeed, the majesty was, in his view, a requirement for the effective function of it. This reverence was a shroud and a necessary one because being a ruler was of a far different chore than making and sticking to rules. Specialists are required for both ends.

“That secrecy is, however, essential to the utility of English royalty as it now is. Above all things our royalty is to be reverenced, and if you begin to poke about it you cannot reverence it…Its mystery is its life. We must not let in daylight upon magic.”

A government contrarily made up of bureaucrats is therefore no government at all. Stripped of all its humanity, shorn of the lights given to it by science and reason, the bureaucratic form of rule-making must inevitably devolve into dysfunction and an existence hard against its original purpose.

“It is an inevitable defect, that bureaucrats will care more for routine than for results; or, as Burke put it, ‘that they will think the substance of business not to be much more important than the forms of it.’ Their whole education and all the habit of their lives make them do so.”

These pitiful charlatans care more for what they do than what they do does. Governed by rules established long ago, or not so long ago, they care little for what may be accomplished by them only that they exist and provide the bureaucrat with existence.

Does bond buying actually work? The bureaucrat doesn’t care. They only desire that there be some expressed need to do it, so that the operation itself gives them their purpose. Efficacy becomes a defect, actually.

They said we wouldn’t be Japan.

The United States Federal Reserve is about to embark on a course beyond the already renewed full-scale QE. I have no special inside knowledge on the matter, no direct line to Jay Powell (I doubt he’d take my calls if I did). Call it a hunch, an entirely reasonable one that I believe most observers already share.

The circumstances clearly call for something. And the reason they do is because all those prior somethings amounted to exactly nothing.

Again, the bureaucrat doesn’t care. The crisis is their purpose; therefore, the presence of crisis justifies their presence. After all, it’s been very well established that failure is to be celebrated so long as it sticks within the confines of the rules. I’m looking right at you, Christine Lagarde.

In the odd twist, the modern central bank bureaucrat has been married to Bagehot’s old notions of monarchical reverence. Most people, indeed nearly all persons, no one has any real idea what central banks actually do. They’ve held some vague notions about gyrating fed funds (in the US) around or maybe something about a printing press, ideas all given to them by…central bankers.

The whole of the monetary game in this age is reverence. You aren’t supposed to ask any questions of the Jay Powell’s, merely gape in awe at their presumed presence and be warmed by it. To let daylight in upon his magic is to destroy it.

It is the worst of both worlds: the bureaucrats who care only for their rules while staying in the dark demanding the world to worship what they do as they operate purposefully in obfuscation. Maybe such a thing was necessary for Queen Victoria, I personally doubt it, hardly useful to anyone for this day and this age.

And to what end does all this majesty serve in light of Bagehot’s main dictum: to lend freely at high rates on good collateral?

With markets melting down further exposing the sham that has been QE and not-QE, this is both a time for examination as well as reckoning. To use my own frank vernacular, repo operations my ass!

These guys have no idea what they are doing. None. Secrecy has only aided in the incompetence, cloaked in the ideas of reverence while operating in bureaucracy the entire time. It was a bad marriage, the worst kind.

The funny thing about it has been this 21st century fiction of an open central bank. Ben Bernanke’s special project, indeed what he thought would be his legacy, to open up and be more transparent – so as to prove the works behind the awe. Once they let you see them up close, you’d be even more impressed and then let them set about their habits in complete peace.

How about now?

What will follow will be a parade of QE’s. Functionally, there will be differences, categorically all the same regardless. The main category they all belong to is:  failure. They won’t work, not a single one.

But Jay Powell doesn’t care. Not really. QE is the central bank’s post-2008 routine. That’s what they do; what they all do. Effectiveness is, believe me, subjective. When it does fail, as the others have, volumes of econometric literature will spring up declaring it a success by declaring success a miniature of its promises. QE lowered term premiums! (in some studies.)

The real world has much bigger problems on its hands. A little technical proficiency would go a very long way, not unlike the kind Walter Bagehot had in mind a very long time ago. Indeed, what might hold the greatest chance of successfully mitigating this unfolding disaster, more than a coronavirus vaccine, is some good ol’ fashioned currency elasticity.

Except, what currency counts for elasticity in this day and age under these systemic conditions? It would have behooved their majesties if they had found out sometime before now, maybe even around the last time it got this bad (for the same reasons, min you, and they weren’t subprime mortgages).

The central banker has only bank reserves, and we’ve observed time and again how they aren’t relevant, monetarily speaking. Whether it was during the 2008 crisis or at this very moment.

Ever since September’s curious repo rumble, Jay Powell’s followed the routine. Repo operations and T-bill buying, both upscaling the level of bank reserves. And during that time, cloaked in majesty, obscured by reverence, no one officially able to explain just what had happened – and no one seeming to care that it went unexplained. That’s the magic.

September was only a dress rehearsal, but everyone dressed up to rehearse what? That much we are finding out today even if it took six months over the interim. The global markets had been making noises for two years, unheeded because they didn’t conform to the established rules. September merely took those noises a step further, which apparently wasn’t a step far enough.

In my very much unofficial version, money dealers, who more appropriately belong at the center of all monetary understanding, had grown risk averse by nature of collateral and risk perceptions, or risk perceptions driving increasing questions about collateral. Whichever way you want to look at it, the main but not exclusive element has been the infection of the repo collateral system with too much stupid junk (on the advice of central bankers and their “globally synchronized growth”).

We’ve seen this before, you know. Jay Powell’s predecessors saw it, too. Except, this sort of thing doesn’t make entry into the central bank manual, the list of routines and rules by which predetermine to policymakers, really everyone, what policymakers will do. Therefore, it was ignored, this “strong worldwide demand for safe assets” written off as an uninteresting quirk or outlier.

Questions about collateral mean questions about all things liquidity. Risk aversion from the one equals growing reluctance about everything.

An actual quirk and outlier on September 16, 2019, a combination of unusual (but not unpredictable) factors led money dealers to step back at the first, smallest little sign of irregularity. The repo rate rose a little and rather than step in and fill the gap dealers stepped to the sidelines – and remained there convinced of such righteousness as the repo rate surged higher and higher.

While officials have been off trying to uncover what they are convinced must be the smoking gun of a benign technical factor so that we can all go back to sleep, it really was just that simple. Risk aversion about something so small could only have been a warning – for when it got real. A warning that only a bureaucrat could have so thoroughly missed.

These dealers were, in fact, showing you what they would do in that other situation. That’s why I’ve called it a dress rehearsal, play practice that Jay Powell and his buttered band of bureaucrats decided to skip so that they could conduct their own rehearsal – of their own routines.

The Fed gave us repo operations that had nothing directly to do with repo markets. The central bank raised the level of bank reserves without once establishing that the level of bank reserves had anything to do with it. Routine. Stay within the rules.

Over the last couple of weeks, collateral, collateral, collateral. What’s the superlative far beyond strong? Whatever the word might be, it is right now what belongs in front of “worldwide demand for safe assets.” And the reason is frailty, a systemic fragility never once recognized inside the official shroud.

A signal very much confirmed by the world piling into massive demand for the most pristine and useful form of repo collateral. T-bill prices, primarily, have surged. A liquidation event stemming from a global collateral call as crap collateral further implodes and therefore impedes systemic functions – as if the central bank just isn’t there.

What have dealers been doing during all this? They’ve been bidding in excess for excess funds at the Fed’s repo operations and then sitting on what they’ve procured. They are, very clearly, on the sidelines again right where six months ago they told Jay Powell they would be.

All of that crap in between, collateral and repo operations, and markets are left to wither, dealers very much proved righteous once more in their reluctance. Very predictable on all sides.

The imagined majesty of QE had you imagining a robust market system with an effective backstop against the worst of disruptions, guided by the unseen royalty of Economics. Ask no questions about time or process, just believe. Pay no attention to the lack of attentiveness, a dearth of realistic answers, and the religious, cult-like devotion to the rules of practice and routine. Bask only in the glow of bond buying!

Or, as it will be, stock buying!

What there won’t be, what there already hasn’t been, is currency elasticity. Though it may be strange and unrecognizable as such, collateral is its own currency. And that’s just where the money problems begin.

In Japan, its central bank has conducted 10 major QE-type programs, 24 different variations by my count, and that tenth one is fast approaching its seventh birthday. This certainly counts as a parade, though one you would be unlucky enough to ever have experienced.

The same parade is coming here; has just about arrived. Seeking guidance from the wrong Bagehot work, monetary authorities don’t know what else to do. Since Greenspan, operating under delusion that they are some sort of bureaucratic monarchy. True to its type, they’ll dutifully follow procedures believing the substance of their business is never more than this form of it.

And don’t you dare question it!

I’ll tell them what to do. Let the light finally shine in and destroy what’s left of their magic, before it does any more damage to the rest of the world. Enough is enough. 

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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