Dr. John Rutledge, ace capital markets maven (in 1981 a co-architect of Reagan's tax cutting bill), spots (scroll down to his March 17 posting) a flaw in the Federal Reserve's rescue strategy: For every dollar the Fed extends as increased reserves to investment banks in trouble, the Fed is reducing the reserves of healthy commercial banks, thus negating the intended economic stimulus. Rutledge's charts show that despite all the ostensible easing of credit, the monetary base has been contracting, exactly the kind of action that worsens a credit crunch. The Fed, Rutledge explains, is on the brink of repeating its mistakes in 2000, which led to a protracted credit shutdown.
In his March 18 Fed posting (scroll up on his page), Rutledge says that the Fed's job is not to control relative prices, but to prevent the long-term return on the tangible asset base from exceeding that for the long-term return on cash flow--the Fed must therefore control the monetary base so that it does not inflate over the long run and erode the value of the dollar. The below-4 percent yield on long-term bonds, Rutledge argues, shows that to date the Fed is not eroding the monetary base in that way. Rutledge sees one recent bright spot (scroll to his 3/21 post): the signing of Sovereign Wealth Fund accords with Abu Dhabi & Singapore. The accords encompass voluntary principles: SWFs will not be invested to pursue political ends; the US will dismantle barriers to foreign direct investment; greater transparency for SWFs. The 3 signatories pledged also to work closely with the OECD and the IMF.
Former Hudson institute scholar Irwin Stelzer writes that the Fed's role echoes that played by J.P. Morgan in the Panic of 1907, who then singlehandedly assembled a consortium to rescue the economy; Morgan's feat led to the creation of the Fed, which came in 1913, the year Morgan passed on. Stelzer notes that this time, the deal cobbled together by Treasury Secretary Hank Paulson, while not bailing out Bear Stearns investors (who lost 98 percent of their investment), did require that taxpayers guarantee $30 billion of Bear's hard-to-value assets, as part of the deal by which J.P. Morgan Chase (fittingly the rescuer, given its name) stepped in to buy Bear's assets. Stelzer points out other collateral impacts: China fears the falling dollar, due to its vast reserves; Gulf Arab states pay their imported workers in dollars, and depreciating greenbacks could cause unrest in those fragile sheikdoms. For banks to avoid worse balance sheet trouble, housing prices must recover, which no one expects. Stelzer believes that ultimately the problem will be dealt with by an unhappy tripartite remedy: banks cutting dividends to conserve capital, "bottom-fisher" investors snapping up assets at basement prices, and yes, more bailout funding or guarantees from the taxpayers.
My own addition to all this: Often in times of panic, the cure is worse than the disease. Three such big problems are: (1) seeking economic stimulus by asking the Fed to do the work of fiscal policy, which inflates the currency; (2) seeking to protect workers from low-cost foreign competition, via protectionism, which is a lose-either way path that could trigger global depression, as happened in the 1930s; (3) "twin deficits" obsession, which can lead to competitive devaluation in pursuit of a better trade balance, coupled with tax hikes to balance the budget, lethal in a recession.
Stelzer may well be right, and it his predictions are hardly good cheer, but if Rutledge is right, be afraid, be very afraid.
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