The Federal Reserve Turns Left
Source Dave Anderson
Date 12/04/13/12:57
The Federal Reserve Turns Left
William Greider

WASHINGTON IS LOST IN A snarl of confusion, cowardice and wrongheaded
ideological assumptions that threaten to keep the economy in a ditch
for a long time. That prospect is not much discussed in the halls of
Congress or the White House. It’s as though the crisis has been put on
hold until after the presidential election.

As almost everyone understands, nothing substantial will be
accomplished this year. President Obama is campaigning on warmed-over
optimism and paper-thin policy proposals. Republicans propose to make
things worse by drastically shrinking government spending, when the
opposite is needed to foster a real recovery. The president, like the
GOP, embraces large-scale deficit reduction. In these circumstances,
it’s just as well that the two parties cannot reach agreement. After
the election they may make a deal that splits the difference between
bad and worse. In the worst case, they might inadvertently tip the
economy back into recession.

In this sorry situation, there is really only one governing
institution with the courage to dissent from the conventional
wisdom—the Federal Reserve. The central bank declines to participate
in the happy talk about recovery or in the righteous sermons attacking
the deficit. In its muted manner, the Fed keeps explaining why the
house is still on fire, why more aggressive action is needed, and is
gently nudging the politicians who decide fiscal policy to step up.
But its message is ignored by Congress and the president and viciously
attacked by right-wing Republicans who say, Butt out.

The stakes in this elite dialogue are enormous. The outcome will be
more meaningful for ordinary citizens than any other issue at play in
this year’s campaign. If the Fed is right and politicians refuse to
act, Americans may be condemned to a bitter slog through many years of

Japan in the 1990s is the appropriate comparison. After its financial
bubble burst, Japan saw its “lost decade” stretch into fifteen years
of stunted growth. Its central bank responded hesitantly, and its
monetary policy proved ineffective—rendered impotent by a “liquidity
trap,” a condition identified by John Maynard Keynes. The United
States experienced a similar fate in the Great Depression of the
1930s. As an economics professor, Fed chair Ben Bernanke is a scholar
of that period. He is determined not to let it happen again. A decade
ago, he scolded Japanese authorities for failing to be more
imaginative and aggressive. They needed “the courage to abandon failed
paradigms and to do what needed to be done,” Bernanke advised. His
model was Franklin Roosevelt, whose “specific policy actions were, I
think, less important than his willingness to be aggressive and to
experiment—in short, to do whatever was necessary to get the country
moving again.”

Maybe the Fed chair should give the same lecture to American
politicians. But Bernanke is at risk of embarrassment himself: despite
the Fed’s firepower, it has been unable to restart the economy. And
monetary policy is running out of gas. Five years ago, in the heat of
crisis, Bernanke’s response was awesome. The Fed created trillions of
dollars and flooded the system with easy money—enough to stabilize
financial markets and rescue wounded banks. It brought short-term
interest rates down to near zero and long-term mortgage rates to
bargain-basement levels. It provided a huge backstop for the
dysfunctional housing sector, buying $1.25 trillion in mortgage-backed
securities, nearly one-fourth of the market.

Flooding Wall Street with money saved the banks, but it didn’t work
for the real economy, where most Americans live and toil. The housing
sector kept falling. The Fed knows (even if politicians do not) the
danger of sliding into a liquidity trap, which would utterly disarm
its monetary tools (Charles Evans, president of the Chicago Federal
Reserve Bank, thinks the trap has already closed). So the Fed wants
Congress and the White House to borrow and spend more, which, when the
private sector is stalled, only the government can do. To advance this
cause, the central bank is promoting its recent white paper on
housing, proposing, ever so gingerly, the heretical remedy of debt
forgiveness for the millions of homeowners facing foreclosure.

The august central bank is engaged in a startling role reversal. It
has turned left, so to speak, abandoned old positions on fundamental
matters and endorsed Keynesian principles it once spurned. Bernanke
would doubtless protest that this is not about left or right, that the
Fed is simply doing what it’s supposed to do in a crisis—using the
stimulative power of money creation to act as “lender of last resort.”
Nevertheless, for nearly three decades, first under Paul Volcker and
then Alan Greenspan, the Fed did pretty much the opposite. It was the
conservative authority that dominated policy-making, scolding
politicians for their spending excesses and threatening to punish
over-exuberant growth by raising interest rates.

A tidal shift in governing influence is under way, because monetary
policy is now eclipsed. As the central bank loses control, the
stronger hand shifts to the fiscal side of government. That seminal
insight originates with economist Paul McCulley, retired after many
years as Fed watcher for PIMCO, the world’s largest bond fund.
McCulley is a Keynesian who never bought into the ideological fantasy
of self-correcting markets. His views won respect at the Fed because
he was right. Only politicians still don’t get it. After thirty years
of deferring to conservative orthodoxy, both parties are afraid to
break from the past. While the Fed pushes for fiscal expansion,
Congress and the president remain obsessed with deficit reduction.

“This was not supposed to happen,” McCulley observes. “The fiscal
authority was always supposed to be afraid of the Fed. The Fed would
say, Don’t do this, don’t do that. And the fiscal side would back off.
Now you have a situation where monetary policy is effectively impotent
and the Fed is openly inviting the fiscal side to do what for decades
the Fed told it they couldn’t do.” The “missing partner,” McCulley
says, is the fainthearted politician who clings to old dogma about
fiscal rectitude, even though the crisis has made those convictions

As a longstanding critic of the Federal Reserve, I am experiencing a
role reversal of my own. In the new circumstances, I find myself
feeling sympathy and a measure of admiration for Bernanke’s
willingness to stand up for unorthodox ideas and to switch sides on
the sensitive matter of debt reduction for failing homeowners. For
many years, I have assailed the institution’s unaccountable power and
anti-democratic qualities, its incestuous relations with powerful
banks and investment houses. Those flaws and contradictions remain
unreformed, yet I now think the country needs a stronger Fed—a central
bank not afraid to use its awesome powers to help the real economy
more directly.

People ask, How come the Federal Reserve can dispense trillions to
save Wall Street banks but won’t do the same to rescue the real
economy? Good question. They deserve a better answer than the
legalisms provided by the Fed. At this troubled hour, the Federal
Reserve should find the nerve to abandon “failed paradigms” and to use
its broad powers to serve a broader conception of the public interest.

* * *

The Fed belatedly turned its attention to the foreclosure crisis when
it realized that the housing sector, clogged with millions of failed
mortgages and vacant houses, was a big part of why Bernanke’s monetary
policy failed. Housing, of course, is an issue that belongs to the
fiscal side of government, but the Fed can help out because its “dual
mandate” in law requires monetary policy to support both maximum
employment and stable money. If the housing market does not get well,
Fed experts reasoned, there will be no recovery.

Though it seemed out of character for the austere central bank, the
Fed has staged its version of a media blitz on behalf of troubled
homeowners. In the span of seven days in January, two governors from
the Federal Reserve Board in Washington and three presidents from the
twelve regional Federal Reserve Banks delivered strong speeches on how
to stop the bleeding and revive housing. They asked the elected
politicians to consider a broad campaign to reduce the principal owed
by the 11 million homeowners who are underwater, owing more on their
mortgages than their homes are worth. Most of them can’t sell and
can’t keep up with their payments, and are thus doomed to foreclosure.

All this was explained in the white paper Bernanke sent to Capitol
Hill, which explained why cleaning up the housing mess is necessary
for a “quicker and more vigorous recovery.” Housing advocates and
community activists had been telling the central bank the same thing
since the collapse began. Fed governors listened politely but never
responded—until now. If nothing changes, the white paper warned,
market adjustments “will take longer and incur more deadweight losses,
pushing house prices still lower and thereby prolonging the downward
pressure on the wealth of current homeowners and the resultant drag on
the economy at large.”

* * *

The white paper was hedged with lots of qualifiers, but it read like a
handbook for recovery. A prime mover behind the initiative was William
Dudley, president of the New York Fed. A Goldman Sachs alumnus, Dudley
is first among equals, because the New York Fed is always closest to
Wall Street. Dudley suggested $15 billion in bridge loans to tide over
unemployed homeowners. He urged Fannie Mae and Freddie Mac, the two
government-sponsored enterprises (GSEs) now in conservatorship, to
loosen their tightfisted control over mortgages and reduce outstanding
balances on delinquent loans—which most likely will never be repaid

“I am uncomfortable with the notion that ‘underwater’ borrowers who
owe more on their mortgages than their homes are worth should have to
go delinquent before they have a chance of securing a reduction in
their mortgage debt,” Dudley told an audience of New Jersey bankers in
January. The standard objection to debt reduction is “moral
hazard”—the fear that it will encourage bad behavior by other debtors.
Dudley dismissed this as overblown. Most people in trouble, he said,
are victims of bad luck—they bought their house at the peak of market
prices or they became unemployed through no fault of their own.
“Punishing such misfortune accomplishes little,” he said.

Dudley’s remark suggests a different tone at the Fed, one more
sensitive to the human dimensions of economic crisis. Governor Sarah
Bloom Raskin, who was appointed to the Federal Reserve Board by Obama,
delivered an unusually caustic message to bankers last year. She is
pushing substantive penalties for banking-sector abuses—the regulatory
diligence neglected by the Greenspan Fed. “In the housing sector, we
traveled a very low road that had nothing to do with looking out for
the greater good,” Raskin declared. “On the contrary, there were too
many people in all of the functional component parts—mortgage brokers,
loan originators, loan securitizers, subprime lenders, Wall Street
investment bankers and rating agencies—who were interested only in
making their own fast profits…. Now it is time to pay back the
American citizenry in full.”

A sense of moral resonance runs through the white paper. Fairness, it
turns out, is an economic variable. So are the social consequences of
doing nothing. The foreclosure mess, the Fed noted, hurts innocent
bystanders when their neighborhoods are ruined by other people’s
failure. Towns burdened by lots of empty houses lose property-tax
revenue needed to sustain public services. The foreclosure process
piles up “deadweight losses” in which nobody wins, not even bankers.

Mortgage relief, on the other hand, in effect redistributes income and
wealth from creditors to debtors. “Modifying an existing mortgage—by
extending the term, reducing the interest rate, or reducing
principal—can be a mechanism for distributing some of a homeowner’s
loss (for example, from falling house prices or reduced income) to
lenders, guarantors, investors, and, in some cases, taxpayers,” the
Fed document explained. Both the lender and the borrower can gain from
reducing the size of an underwater mortgage, the Fed asserted.
“Because foreclosures are so costly, some loan modifications can
benefit all parties concerned, even if the borrower is making reduced

Refinancing at a lower rate and reducing the principal allows a family
to keep its home with the promise of regaining equity as they pay down
the more affordable mortgage. The modification can also restore the
loan as a profitable investment for lenders, who will gain a greater
return than they would if they had let the mortgage slide into
foreclosure. Writing it down acknowledges that the original debt was
never going to be repaid anyway. The lender suffers an accounting
“loss” on the forgiven debt, but in real terms earns back more.

The same logic can apply to the economy as a whole, the Fed explained.
The short-term costs of adjustment are upfront for lenders, but the
long-term benefits will be much greater for the overall economy if
clearing away bad debt revives the housing market. “Greater losses…in
the near term might be in the interests of taxpayers to pursue if
those actions result in a quicker and more vigorous recovery,” Fed
governors concluded. Which would taxpayers choose? Reducing deficits
or achieving “a quicker and more vigorous recovery”? I feel certain
most people would choose jobs over balanced budgets. But we don’t
really know what the people think, because the choice is never put to
them in those terms. Neither political party has the nerve, and the
media have failed to do so. It has fallen to the cloistered central

For most Republicans the Fed’s message is alarming. It sounds
suspiciously liberal. The Wall Street Journal raked Bernanke over the
coals for his “extraordinary political intrusion,” denouncing the
white paper as “a clear attempt to provide intellectual cover for
politicians to spend more taxpayer money to support housing prices.”
In a stern letter Senator Orrin Hatch told the Fed chair to back off.
“I worry that…your staff’s housing white paper…treads too far into
fiscal policy, and runs the risk of being perceived as advocacy for
particular policy options,” Hatch wrote. Some GOP presidential
hopefuls had uglier things to say about Bernanke.

The Fed did not push back. It could have replied that it has a direct
stake in solving the foreclosure mess—the clogged housing market is a
principal reason Bernanke’s monetary policy failed to revive the
economy. The chair had assumed that, as the Fed brought mortgage
interest rates below 4 percent, homeowners would rush to refinance.
The savings would give them new disposable income, thus increasing
aggregate demand for the weakened economy. The lower rates would
trigger a wave of home buying and building, igniting the rebound in
real estate. Housing has always been the classic channel by which the
Fed has stimulated recovery, which it does by reducing the cost of
credit. This time it didn’t happen, because the channel was blocked.
One explanation is that the Obama administration and Congress were
standing in the way, nullifying Bernanke’s accomplishment. Bankers,
investors and especially Fannie Mae and Freddie Mac, were preventing
homeowners from taking advantage of the reduced rates. They threw up
various obstacles to refinancing and squeezed borrowers, trying to
collect the last drop from homeowners before foreclosure. This is
shortsighted politics, resisting immediate losses when doing so
prevents the larger rewards of a genuine recovery. To put it another
way, government has done a lot to protect the creditors from the costs
of their misadventures. For the borrowers, not so much.

>From the start, the administration has protected the bankers and other
financial players, who have resisted the painful reckoning needed to
unfreeze the housing sector. Presumably, the White House and Treasury
feared that relief for debtors would threaten bank revenues, maybe
their solvency. The GSEs, which guarantee 80–90 percent of mortgages,
have cost the taxpayers some $150 billion. Congress gave them stern
instructions to stop the losses. Obama has danced on both sides of the
issue. He has launched several programs that promised to rescue
homeowners, but he never used the full power of his office to force
the financial sector into cooperating. Housing advocates thought
Obama’s initiatives seemed designed to fail, and one by one, they

* * *

Early in his presidency, Obama made fateful choices that have come
back to haunt the country. He and his advisers, joined by the Federal
Reserve and other regulators, decided to give the fragile financial
sector “forbearance.” That is, they looked the other way. It was a
banker’s version of “don’t ask, don’t tell.” Government has given
generous interpretations to the wounded balance sheets of the largest
banks. Examiners have not challenged toxic assets booked at inflated
valuations. The assumption was that over time the economy would
recover and so would the worth of those assets, especially in housing.
But that hasn’t happened. The result is a blanket of leftover debt,
which is still burdening the economy.

Mitt Romney described this with impressive clarity while campaigning
in Florida. “We’re just so overleveraged, so much debt in our society,
and some of the institutions that hold it aren’t willing to write it
off,” he told a foreclosure forum. “The banks are scared to death, of
course, because they think they’re going out of business…. They just
want to pretend all of this is going to get paid someday so they don’t
have to write it off…. This is cascading throughout our system, and in
some respects government is trying to just hold things in place,
hoping things get better…. My own view is you recognize the distress,
you take the loss and let people reset. Let people start over again….
This effort to try and exact the burden of their mistakes on
homeowners and commercial property owners, I think, is a mistake.”

Over the past four years, a substantial portion of overvalued
mortgages have migrated onto public balance sheets and are guaranteed
by the GSEs. So taxpayers are on the hook for losses, one way or the
other. The economy would benefit if these uncollectible loans were
cleared away. But who wants to tell the taxpayers they are picking up
the tab?

The government’s vast holdings in fact have created another obstacle
to housing recovery. Thanks to the Fed, Washington is the 800-pound
gorilla now holding about 20 percent of the secondary market in
mortgage-backed securities (MBS). That may inhibit private investors
from restoring normal trading on their own. In past financial
disasters, like the savings and loan crisis of the 1980s, regulators
swiftly disposed of government-held assets acquired from failed banks.
This time, government has held on too long. Eric Rosengren, president
of the Boston Federal Reserve Bank, explained the problem. “One of the
big mistakes the Japanese made,” he said, “was they kept a huge
inventory of problem real estate loans at commercial banks and
government agencies. Their housing market didn’t come back because
everyone was waiting for the next shoe to drop. When were the
government and banks going to dispose of those loans? You don’t want a
situation where there is a huge overhang of real estate loans with
government agencies as a very large seller.”

The Obama administration was warned of this risk early by Sheila Bair,
chair of the FDIC, and Elizabeth Warren, chair of the Congressional
Oversight Panel, as well as numerous housing advocates. They urged
Obama to clean up the foreclosure crisis upfront to generate a quicker
recovery. The warnings were not heeded. The pattern is not entirely
clear, but it suggests a government decision made somewhere to
transform private liabilities into public obligations. Banks
repackaged MBS and sold them to Fannie and Freddie. The GSEs applied
the government guarantee and sold the MBS to the Fed, which now has
$850 billion worth of them on its balance sheet. The Fed is thus
directly implicated in the government’s tolerance for wishful

The extent of likely losses is evidently not known. The New York Fed,
I learned, did not examine the MBS it purchased to find out how many
have inflated prices or are burdened by too many underwater borrowers
who can never repay them. I was told the Fed didn’t bother to look
further because the securities are guaranteed by Fannie and Freddie.
That seems like ludicrous reassurance—one federal agency guaranteeing
the holdings of another agency. The taxpayers are thus on both ends of
the transaction and certain to lose if the securities turn out to be

Instead, the problem is passed around like a hot potato. The Fed
creates the money and buys a trillion dollars’ worth of MBS from
Fannie and Freddie. Thanks to the Fed’s vast holdings, the securities
are trading above par. Thanks to its interest income from the MBS, the
Fed makes a profit, about $70 billion a year. At the end of the year,
it remits the money to the Treasury, which uses it to offset budget
deficits. All three agencies are handling the public’s money but from
narrow-minded, self-protective perspectives. A more rational response,
Paul McCulley suggests, would be to take the Fed surpluses and use
them to finance a massive write-down of mortgage debt by the GSEs.
Alas, in the bizarre mechanics of federal accounting, no one knows how
to get the money from here to there.

The Federal Reserve should act because nobody else will. That sounds
unfair, since the Fed has already taken heavy flak for poaching beyond
its traditional domain. Further experiment will enrage right-wing
critics, but the central bank is running out of options. Monetary
policy-makers say they face formidable legal limits that people like
me don’t appreciate. But the Fed still has enormous leverage. I
believe what Wall Street financiers tell me: the Fed can usually find
a way to accomplish what it really wants to do. In this case, it can
break the political impasse and goad other parties into taking action.
That does not require it to violate the Federal Reserve Act. It does
require reinterpretation of the vaguely defined “dual mandate,” which
has always been heavily biased in favor of Wall Street finance over
the real economy. If stagnation drags on for years, tearing up society
and destabilizing politics, demands for more radical action will swell
and eventually overwhelm the old restraints.

Here is a modest example of what the Fed could do to shake up the
system and help housing revive. It could announce its intention to buy
only new mortgage-backed securities that have been subjected to the
process of refinancing and modification to establish positive equity
and more realistic valuations. The mere announcement would cast a
cloud over the existing stock of GSE mortgages and probably trigger a
wave of market-driven mortgage adjustments. The Fed, in effect, would
not only provide a model for debt write-downs generally but help
create the market for them. The Fed’s presence would assure people the
process does not threaten the banking system. For distressed
homeowners, it would amount to redistribution of income and
wealth—sharing the costs of the financial catastrophe among other
players instead of dumping all the pain on borrowers. Unilateral
action would send a cleansing shock wave through the political system.

If this country ever gets back to a time when real questions are asked
about democracy and our unrealized aspirations, people and politicians
will have to talk about the Federal Reserve and its “money power.” I
have a hunch current events are educating citizens and their elected
representatives toward that day. It no longer makes sense to keep
fiscal and monetary policy separate, pulling the economy in opposite
directions. The present crisis suggests that monetary tools should be
coordinated with the fiscal side. How this could be done in a
democratic way is a tough question, but it cannot be answered until
people and politicians are educated far beyond their primitive level
of understanding.

The other promising challenge is to convince ourselves that money
created by government really belongs to the people. Could it be
used—judiciously—to finance long-term public projects, like
infrastructure and high-speed rail? The government as employer of last
resort? Make your own list of what the nation needs. Imagine if
highest-priority projects were financed with the new money
mysteriously created by the mighty Federal Reserve. That would be a
future worth arguing over.

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