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Fed Ed: Frankenstein's Monster

Posted on November 5, 2013

“Man, how ignorant art thou in thy pride of wisdom!” - Victor Frankenstein, character in Frankenstein by Mary Shelley

Last week, we wrote an Insight entitled The Genesis in which we looked at the historical events leading up to the creation of the Federal Reserve back in 1913. This week, we look at how the influence and mandate of the Federal Reserve has greatly expanded over the past century as we come up on the 100 year anniversary of the Fed this Christmas Eve. Furthermore we are excited to be partnering with Liberty Street Films to bring their new documentary, Money for Nothing: Inside the Federal Reserve, to our local community in Colorado Springs. We are in the middle of a four week series entitled “Fed Ed” to lay some groundwork for better understanding and appreciating the material that will be covered in the film. We invite everyone living in the Colorado Springs area who reads our Insights to attend and have reserved free tickets for clients of our firm.

As we touched upon briefly in last week’s Insight, the idea of a central bank in the United States was birthed out of two desires: 1) to create a more uniform system of credit & 2) to stabilize the banking system. From this humble beginning the Fed mandate has increased significantly over the past 100 years as it has learned (or at least believes it has learned) things along the way.  In the novel Frankenstein by Mary Shelley, Dr. Victor Frankenstein takes pride in his wisdom and decides to play god by experimenting with the creation of life. The result is a hideous monster, which becomes self-aware and wreaks havoc on its surroundings. In a similar vein, the Federal Reserve was born out of the wisdom and confidence that a central bank can benefit a country’s citizenry by managing the economy. This commitment to “playing god” with the economy is the core reason why the Federal Reserve has grown into what some would consider the most powerful and influential institution in the world.

Up until the early part of the 20th century, banking was a very fragmented industry where the availability and cost of credit varied widely from bank to bank. In addition, seasonal factors such as planting and harvesting cycles or the need for people to withdraw cash during the holiday season put an unnecessary liquidity strain on the system. When liquidity was constrained, banks would raise their borrowing rates because they didn’t have the ability to lend money as freely, so interest rates and the availability of credit was very seasonal. The Federal Reserve and its regional branches were established to provide more “elasticity” to the banking system. They were given the power to issue new currency (backed by assets such as gold or commercial paper at the onset) in order to meet the demands for money in the economy. The chart below shows how the Fed was successful in smoothing the seasonality of the interest rate cycle by creating a more uniform system of credit, which had previously been heavily influenced by rural supply and demand factors.

2013-11-05_Comm_Paper_Rate.png

The second objective of the Federal Reserve was to provide stability to the banking system in order to reduce the frequency of financial panics which were very much the norm at the end of the 19th and beginning of the 20th centuries. During the Roaring Twenties, speculation was rampant and asset prices were bubbling up to new stratospheric highs. One of the main factors driving the speculation was an unintended consequence of the Fed’s policy to smooth out the interest rate cycle and make it easier for banks to lend money.

Eventually the Fed decided they needed to do something to stem the speculation so they raised interest rates in order to make it harder for speculators to borrow money and invest in the stock market. The move worked a little too well and money quickly fled out of the stock market causing the now infamous Crash of 1929. The shift in sentiment from the stock market crash coupled with higher interest rates brought the unintended consequence of a reduction in capital spending in the “real economy” on equipment and infrastructure. The fall in the market and the economy led to bank runs as people feared they would lose their savings if their bank went belly up. As the lender of last resort, the Federal Reserve was in prime position to dampen the fallout by providing funds to distressed banks, but at the time, Fed policy limited the Fed’s reach to member banks with sufficient collateral, so cash-starved banks failed by the thousands.

After the fallout from the Crash of 1929, Congress passed several acts to expand the Federal Reserve’s power and authority. The Fed was given the power to conduct “open market operations” (QE falls into this category) and the authority to regulate bank holding companies. In addition the Federal Open Market Committee (FOMC) was established to oversee the Fed. After World War II, the Fed’s mandate was again expanded to include the goal of promoting maximum employment as soldiers returned to the workforce. To accomplish this, the Fed kept interest rates at the same low levels used to finance the war for an extended period of time. The path of least resistance for policy makers was to keep rates low in order to execute on their new mandate of maximum employment. This in turn helped politicians get elected by their fully employed constituents. The unintended consequence of this free lunch policy was the stagflation of the 1970’s where both inflation and unemployment grew in tandem. It was during this time that Congress gave the Fed a new mandate to maintain “stable prices” in addition to their previous mandate of maximum employment; the combination of which is now commonly referred to as the Fed’s “dual mandate.”

The Fed was finally able to get inflation under control after Chairman Paul Volcker ignored the maximum employment part of the Fed’s dual mandate by making the very unpopular decision to raise interest rates to historically high levels during a recession. Once inflation was under control and price stability was reestablished, the economy began to recover. This set the stage for over two decades of credit expansion and prosperity known as the Great Moderation, which was largely credited to the Fed’s ability to tame the business cycle. The unintended consequence of the Great Moderation was the Financial Crisis of 2008 in which the credit bubble over two decades in the making finally burst. Individuals defaulted on debts and banks quickly became insolvent when the mountain of AAA loans on their books were proven to be more of the junk variety. In response the Fed took “extraordinary measures” by cutting rates all the way to zero, pumping money into the economy at record rates, and facilitating the bailout or buyout of several institutional banks.

The actions of the Fed during the 2008 Financial Crisis definitely saved the banking sector and by extension the US economy from something that could have been much worse, but at what cost? What will be the unintended consequences of this go-round of playing god with the economy? One of our favorite economic analysts is Dylan Grice at Edelweiss. In a recent publication, he wrote the following snippet which beautifully captures the conundrum of playing god with the economy.

Regular readers of our irregular publication will be aware of our thoughts on inflation, but for those who are not we would summarize them thus: inflation is not measurable. We can summarize our views on money with similar succinctness: it is poorly understood. And as for the economy, we know only this: it is a complex system. From these observations can be derived a straightforward corollary on economic policy makers: trying to control a variable you can’t measure (inflation) with a tool you don’t fully understand (money) in a complex system with hidden, unobservable and non-linear interrelationships (the economy) is a guaranteed way to ensure that most things which happen weren’t supposed to happen.

No one knows what the unintended consequence will be for this most recent round of monetary intervention, but unless one thinks history is not a guide and buys off on the “free lunch” philosophy of QE infinity, one must believe that there will be consequences. If those consequences are severe, maybe the Fed will express remorse over bringing more harm than good to the world, much like Dr. Frankenstein’s monster felt after realizing he had brought harm upon his beloved creator. But then again, how ignorant is the Fed in its pride of wisdom?


elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.


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