For now, we remain defensive, even purely on the basis of post-1940 relationships.
The Case against the Fed
Ever since the Bear Stearns bailout, I've been insistent that the Federal Reserve is increasingly operating outside of its statutory boundaries. As I noted in the March 31, 2008 weekly comment (What Congress and Investors Should Understand about the Bear Stearns Deal):
"The clear historical role of the Federal Reserve has been to manage the composition of Federal liabilities (by varying the mix of Treasury securities and monetary base - currency and bank reserves - held by the public). The recent transaction is a dangerous break from that role, in which unelected bureaucrats are committing public funds to facilitate private business transactions and selectively defend the holders of corporate securities. Only Congress has the Constitutional right, by the representative will of the people, to commit public funds. The Bear Stearns deal is a dangerous precedent and a dilution of Congressional prerogative."
My concerns here have nothing to do with the direction of the stock market. Ensuring the legality of Fed actions is not a Democratic issue, a Republican issue or a Tea Party issue. Rather, it is about whether we want America to function as a representative democracy. We hear a lot about the risk of "politicizing" the Fed, as if it should somehow operate outside of Constitutional checks and balances. This idea is insane. Reserving the appropriation of public funds to Congress, and by extension to the will of the American people, is central to the meaning of democracy. There is clearly a mindless carnival of circus clowns on the bubble network that is perfectly willing to sacrifice democracy as long as they can get a rally going. We should recognize what we stand to lose.
a) QE2
Over the past week, several observers have interpreted my comments about QE2 as suggesting that this second round of quantitative easing is unconstitutional. This is incorrect. Section 14.1 of the Federal Reserve Act, which relates Open Market Operations, specifically states " Notwithstanding any other provision of this chapter, any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market."
It should be clear that the purchase of Treasury debt by the Federal Reserve is legal, and because Treasury securities are issued as a result of explicit Congressional appropriations, this provision of the Federal Reserve Act also constitutional. QE2 may be reckless and ill-conceived, but it is perfectly legal and constitutional.
Bernanke offered a defense of QE2 last week in Europe that was reported as "coming out swinging," but what he swung before the world was ignorance. Bernanke correctly observed that quantitative easing was capable of "moving asset prices significantly." But he incorrectly said that "we don't know what effect this will have on the real economy." In fact, we do know. The elasticity of GDP growth to stock market changes can be easily estimated to be on the order of 0.05% or less, and transitory at that. Which is a simple way of saying that inducing fluctuations to volatile asset prices isn't interpreted by consumers as "permanent income" or stable wealth that should be consumed. Since it doesn't operate on any constraint in the credit markets that is binding, QE2 is simply a way to blow asset bubbles, and nothing more.
Paul Krugman recently said that by engaging in QE2, "it's not as if the Fed is doing anything radical." I couldn't disagree more. Look. My furnace may be intended to regulate the temperature in my house, but at the point it starts blazing at temperatures beyond anything ever intended in the wildest imagination of the engineers, there's a problem. Maybe this aversion is a Stanford thing. My views on economics were heavily influenced by John Taylor, Joe Stiglitz (both who reject QE2 even though they are at opposite sides of the political spectrum), Tom Sargent (rational expectations), Ron McKinnon (international economics), and Robert Hall (who chairs the NBER business cycle dating committee). If I had proposed a half-brained idea like QE2 at my dissertation defense, these guys would all have looked at me and wept.
I do agree with Krugman that the U.S. could use additional stimulus spending, particularly targeted at non-residential investment, infrastructure, and R&D. With respect to the deficit, it's important to target what I'd call a "full employment surplus" - policies that could reasonably be expected to produce a surplus at a normal unemployment rate - rather than imposing austerity on an already weak economy. But as for QE2, the Fed's policy is just reckless.
b) Maiden Lane and QE1
While QE2 is clearly both legal and constitutional, this contrasts with the activities of the Federal Reserve in creating Maiden Lane and other off-balance sheet vehicles to purchase private debt, as well as the first round of quantitative easing. In these instances, I am convinced that these transactions were outside of the restrictions of the Federal Reserve Act.
QE1 was clearly the most egregious, because the Fed bought obligations of Fannie Mae and Freddie Mac outright - securities that were not "fully guaranteed by the United States as to the principal and interest," and whose issuers were insolvent and in conservatorship when the Fed bought the securities. Even though Fannie and Freddie securities maturing before 2012 have since been effectively guaranteed by the Treasury, the Fed's ownership of later maturities is still legally problematic.
