Fight the Fed or profit from its profligacy?

The Federal Reserve is a century old this year, but instead of cheering, good economists are lauding the apology in the Wall Street Journal by a Fed insider, Andrew Huszar, a senior fellow at Rutgers Business School and a former Morgan Stanley managing director. In 2009-10, Huszar managed the Fed’s $1.25 trillion agency mortgage-backed security purchase program.

It’s important to call the Fed out on bad monetary policy, but the few who do will not change the Fed because it has the support of mainstream economics. The Fed is only doing what mainstream econ teaches it should do, so until mainstream economics changes nothing will change at the Fed. Changing mainstream economics will be difficult to do because the professors have a lot invested in their paradigm. Cracks in the paradigm will not change their minds. Nothing short of a nuclear explosion will work.

Paleo-Keynesian economics with its emphasis on government spending reigned from WWII until the 1980’s. But the disaster of stagflation through the 1970’s convinced many to change their minds. Neo-classical economics took over under the leadership of Frank Lucas, but Keynesian econ didn’t die. Nobel Prize winner Paul Krugman has led its recent resurrection. Honest Keynesians heeded the lessons of Lucas and reinvented their ideology as New Keynesian. Lately the neo-classicals and New Keynesians have synthesized their theories, but so far no one has stuck a label on the brand, other than mainstream. Anyone who wants a playbook to help identify the different schools of macroeconomics needs to read Roger Garrison’s book “Time and Money.”

Mainstream econ offers nothing but money printing as a solution to any problem. They have joined the ranks of the kings who since at least 500 BC debased their nations’ coinage by adding base metal to silver and gold coins and then stamping them with the weight as if they were pure precious metal. In other words, they defrauded their people. The Fed’s method of debasement is more sophisticated. The Fed has a monopoly on legal counterfeiting given to it by the government and it uses that power to buy real assets, such as mortgage backed bonds, with money it creates out of thin air. The Fed uses the interest paid on those bonds to finance its operations. The government benefits from Fed counterfeiting in three ways: 1) Fed profits go to the federal government. 2) Any inflation the Fed creates reduces the value of government debt. 3)  Inflation artificially inflates wages and corporate profits, thereby increasing tax revenue. 4) It reduces the interest rate the government pays on its debt.

With the advantages to the federal government that the Fed’s monopoly in counterfeiting offers, does anyone seriously think the Fed will change? What to do? Don't fight. Join them! Invest!

In spite of Mr. Huszar’s apology, look what Fed counterfeiting has done for the stock market. It has done the same for bonds and farmland and many commodities. It has helped home owners refinance and lock in ridiculously low mortgage rates while price inflation erodes the value of their mortgages in the same way that it helps the federal government reduce its debt burden.

Fed counterfeiting helps the stock market in two ways: 1) A great deal of the borrowing goes directly to the purchase of shares, either through financial companies borrowing and buying stocks, or through company repurchases of their shares. 2) Price inflation increases revenues to corporations and since cost increases lag, at least for a while, profits rise and justify higher stock prices.

What a wonderful world! What could go wrong? Well the same processes described above have unintended consequences: eventually the scarcity of capital goods will catch up with the inflation and toss a wrench into the jet engine: as has happened repeatedly over the centuries, it will cause a recession and the market will crash. We’re overdue and I expect it to happen mid to late 2014. Also, it hurts the earnings of the working poor and increased inequality, but that’s another post.

Of course, I expected it to happen in 2013, but keep in mind that economics is not as precise a science as physics. Economics is so complex it makes physics look like child’s play. In predicting the future we are fumbling in the dark feeling our way with very few hand holds. However, forecasting keeps people in finance humble, something which all economists except those of the Austrian persuasion lack.