Monday, June 25, 2012


What if I told you that you could achieve all 4 of these objectives with one simple policy option?

1)      Increase the money supply to stimulate economic growth
2)      Capitalize small banks to prevent further financial institution bankruptcies, while allowing for greater competition against the TBTF banks
3)      Allow homeowners to renegotiate their underwater mortgages to prevent personal bankruptcies, also clearing the way for recovery in the housing market
4)      Decrease the National Debt

I realized that the Federal Reserve has the power, but perhaps not the willingness, to single handedly get the economy back on track – just like the ECB has the power, but perhaps not the willingness, to end the Eurozone’s woes. The ECB just has to announce that they will purchase, or at least explicitly back, government debt in the Eurozone. This is something that the Federal Reserve already does in the United States. But there is an alternative, one that would work both for the Eurozone and the US, but I am sure it would be tantamount to a bailout and therefore politically infeasible…

The Federal Reserve needs to announce another round of Quantitative Easing. This time, though, buy up all mortgages and mortgage-backed securities held by small banks throughout the US.

In QE1, the Federal Reserve did this - among other purchases - to large banks, mainly the TBTF institutions, in order to prevent an immediate financial collapse. It provided capital to cushion losses while taking the toxic assets, you know - what caused all the other losses in the first place, off their balance sheet. It worked, but further institutionalized TBTF by making them a beacon of stability while smaller banks are still on the verge of collapse. There are still close to 1000 small, mostly local, banks in the US that are on the Unofficial ProblemBank List – and therefore are not lending and operating anywhere close to normal.

In QE2, the Federal Reserve was much more hesitant in making policy by only purchasing short-term US Treasury bonds. This drove down the interest rates that the US Treasury could sell its bonds at by a few hundred basis points, which therefore helped in long term debt relief.  Now we have one branch of government paying interest payments to another branch of government that rebates those interest payments to the original branch of government. Sound confusing and almost silly? That’s because it is. Though it did increase the money supply, its up todebate on how much this actually helped the US economy grow out of itsslump. 

The Federal Reserve then pursued a placeholder policy called Operation Twist, where they would sell short-term Treasury bonds and buy up long-term Treasury bonds while still maintaining the same size portfolio. This drives down long term interest rates that the US can borrow money at, but isn’t much for monetary or economic stimulus. Nonetheless, some economists believe that this will have a greater impact than QE2. The Federal Reserve just announced that it will continue this policy through the end of the year.

All Eyes are on the Federal Reserve to announce QE3. After drastically cutting the Federal Reserve economic growth predictions for the next couple of years, Bernanke announced that continued slow growth would prompt the Federal Reserve into pursuing policy that would fulfill the second half of its dual mandate of ensuring full employment. Goldman Sachs believesthat this foreshadowing will turn into real policy during the FOMC’s Augustmeeting. Merrill Lynch still has its money on September. Few don’t think that its coming at all.  Which leaves us qith the question of what shape will it take?

Something closer to QE1 than QE2 makes more sense, but this time the target needs to be the little guys. By buying up mortgages (and other mortgage related assets) of small banks, you can achieve objectives 1 and 2 on that list. BY the Fed announcing that they are willing to negotiate with home owners of the mortgages that were just bought the ability, then they can do principal write downs which will keep people in their homes and stabilize the housing market. Small banks have not been wiling to do this because it means that they have to recognize the losses on their balance sheets. In foreclosures, at least they can recover the assets. The Fed on the other hand has no such hesitation to write off bad loans. Finally, when homeowners do make payments on their homes, the money is then passed on from the Federal Reserve onto the Treasury which then can be used to pay down the National Debt.

Bing. Bang. Boom. One simple policy solves America’s economic woes. Here is the kicker: You do not need permission from the US Congress – which during a normal year is next-to-impossible to get, much less an election year. In the 1970s, Paul Volcker did what needed to get done, nomatter how unpopular a move it was at the time, to address the nation’s problems. Let’s just hope that Ben Bernanke follows in his footsteps. 

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