The Worst of All Policies - Federal Reserve Policy Blunders

By: Adrian_Ash

"To lend a great deal, and yet not give the public confidence...is the worst of all policies." - Walter Bagehot, Lombard Street  

"HISTORY PROVES that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse," wrote Ben Bernanke in Foreign Policy magazine, way back in October 2000.

Dr.Bernanke was merely a Fed governor at the time, rather than chief pooh-bah at the world's biggest central bank. But with the S&P500 index already 7.5% off its top of 24th March that year – way up there at 1552 – he was clearly planning for the main event of his professional career:

Saving the United States from a second Great Depression.

Now the S&P index has just repeated that very same move, only in triple-quick time. The S&P hit an intra-day peak of 1556 on 16th July this year; on Tuesday 28th August it ended the day at 1432, down by 7.5% once again.

This pullback took little more than a month. And this time around, Ben Bernanke is wearing the long trousers. So what's to fear?

The economic outcomes of a stock-market crash, as the Princeton professor wrote in that article – A Crash Course for Central Bankers – "depend less on the severity of the crash itself than on the response of economic policymakers, particularly central bankers."

Indeed, "without policy blunders by the Federal Reserve, there is little reason to believe that the 1929 crash would have been followed by more than a moderate dip in US economic activity."

To prove his point, Bernanke pointed to the more recent deflationary slump suffered by Japan . "In some crucial aspects," he wrote, " Japan in the 1990s was a slow-motion replay of the US experience 60 years earlier. After effectively precipitating the crash in stock and real estate prices through sharp increases in interest rates (in much the same way that the Fed triggered the crash of 1929), the Bank of Japan seemed in no hurry to ease monetary policy and did not cut rates significantly until 1994."

No one, of course, could accuse Ben Bernanke of precipitating the current crash in US real estate or stock market prices – not with "sharp increases" in the cost of money at any rate! The 17 baby-steps he took from 1% up to 5.25%, however, might still cast him as the villain when the history books come to be written.

After all, it's so much easier to point the finger of blame at distant figures in history once the crisis has long since blown over. Bernanke's career as a Depression-era commentator after the fact just goes to prove it.

"Much like US officials during the 1930s, Japanese policymakers were unconscionably slow in tackling the severe banking crisis that impaired the economy's ability to function normally," he tutted in Foreign Policy magazine in October 2000. "[But] central bankers got it right in the United States in 1987."

Oh really? It's worth reading what Ben Bernanke believes – or certainly said he believed – of Alan Greenspan's response to the stock-market crash of two decades ago. It's worth comparing his actions in this financial panic to date with Alan Greenspan's decisions of two decades ago, too.

"[The Fed in late '87] avoided deflationary pressures as well as serious trouble in the banking system. In the days immediately following the October 19th crash, Federal Reserve Chairman Alan Greenspan – in office a mere two months – focused his efforts on maintaining financial stability."

Bravo Alan! Give that man a knighthood!

"For instance, he persuaded banks to extend credit to struggling brokerage houses, thus ensuring that the stock exchanges and futures markets would continue operating normally. (US banks, which unlike their Japanese counterparts do not own stock, were never in any serious danger from the crash.) Subsequently, the Fed's attention shifted from financial to macroeconomic stability, with the central bank cutting interest rates to offset any deflationary effects of declining stock prices."

Encore! Encore! But just how did Greenspan do it?

Short on detail and long on plaudits, Bernanke's short history of the Great 1987 Getaway simply says the markets were "reassured by policymakers' determination to protect the economy...Economic growth resumed with barely a blip."

Never mind that US banks are now stuffed full of securitized mortgage debt – albeit through the off-balance-sheet conduit of "special investment vehicles". (So too are banks in Japan , France , Britain , Germany , and Australia .) Because even if the banks are "in serious danger" from the house-price deflation bankrupting hedge funds across the world, all that's required is a strong central banker, standing ready to reassure the markets that nothing will harm them. Not on his watch, no siree!

"The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system."

One sentence, one message – and a shockingly clear statement of purpose from Alan "the Confuser" Greenspan. Made on the morning of Tuesday, 20th October 1987 , the statement was quickly followed by Fed bond-trading that cut three-month Treasury yields from 6.75% to barely 5% in just 24 hours. Then came nearly two weeks of large and highly visible injections of liquidity.

You might have thought Ben Bernanke would simply replay this gambit. He claims to have studied it in depth, after all, alongside every other major central-bank action of the 20th century.

But no. Dr.Ben first approved large shots of cash. Then he pushed the overnight lending rate in New York below the Fed's target. Only then did he make a statement – and that same day he slashed the "discount" rate, which offers short-term loans no longer made at a discount any way, confusing both CNBC and Wall Street's finest alike.

Instead of affirming the Fed's readiness, Bernanke's statement said the Fed was "monitoring the situation". Less reassuring still, the Fed's crisis response in 2007 including this carefully crafted piece of prose:

"[The Committee] is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."

Such strong, reassuring action is being much-used outside Washington , too. "Can we deprive ourselves of the weapon of interest rates in the face of a crisis such as we are experiencing at the moment?" asked Nicholas Sarkozy, president of France , on Friday. Jean-Claude Trichet, head of the European Central Bank, responding this week by saying his policy team "is never pre-committed" to any interest-rate decision.

With it yet? Nothing is decided. The ECB might not raise rates. Or it might. Nobody yet knows, not even the ECB executives. Put another way, "I am confident that confidence will return," as Gertrude Tumpel-Gugerell, an executive member of the European Central Bank, said to Reuters while attending a conference in the Austrian Alps today.

Perhaps she wore a straight face; maybe the phrase just doesn't bare translation. But having confidence that confidence will return – as if by magic – leaves Ms.Tumpel-Gugerell and her colleagues right in the frame if they do choose to raise interest rates next week...and Europe 's current stock market turmoil is seen to tip the Eurozone economy into a slump.

Hence the action, taken straight from the Bernanke Playbook , at the European Central Bank so far this summer. The ECB had already seen money supply growth surge to a quarter-century high in July. Its M3 measure of the Eurozone money supply rose by 11.7% from a year earlier last month, compared with 10.9% growth in June. An auction of short-term money on Wednesday this week saw Europe 's biggest banks bid for nearly 2.4 times as much cash as was on offer.

As it was, the ECB offered a record sum of 90-day money at today's sale...nearly $70 billion's worth.

"Either shut the Bank at once, and say it will not lend more than it commonly lends, or lend freely, boldly, and so that the public may feel you mean to go on lending," urged Walter Bagehot in the Victorian investment classic, Lombard Street .

"To lend a great deal," he advised the world's central banks, "and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies."

By Adrian Ash
BullionVault.com

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City correspondent for The Daily Reckoning in London and a regular contributor to MoneyWeek magazine, Adrian Ash is the editor of Gold News and head of research at www.BullionVault.com , giving you direct access to investment gold, vaulted in Zurich , on $3 spreads and 0.8% dealing fees.

(c) BullionVault 2007

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