The populism that fueled the rise of Donald Trump and Bernie Sanders came from the perception that the federal government responded like Superman when it saved Wall Street and Clark Kent when it came to helping everybody else.
While these emergency measures helped to stabilize the financial system, they also slowed down the recovery. They need to be removed if the economy is to grow again at normal levels.
Along with Treasury Department’s $420 billon dollar Troubled Asset Relief Program (TARP), the Federal Reserve increased its balance sheet from $870 billion in 2007 to almost $4.5 trillion in 2014.
Since then, it has kept the figure constant by buying just enough securities to replace the securities that matured. Most of these assets were purchases in Treasury securities ($2.5 trillion) and mortgage-backed securities ($1.8 trillion).
Along with assets, the liabilities side of the balance sheet has also radically increased. Before the crisis, most of the Federal Reserve’s liabilities was currency. The amount of currency in circulation has increased from $814 billion in July 2007 to $1.5 trillion today. The bank reserves have increased from only $17 billion in July 2007 to approximately $2.3 trillion.
Former Federal Reserve Chairman Ben Bernanke wrote in his memoirs that the Fed failed to stop the housing bubble in part because of a “a tidal wave of foreign money that poured into the United States. These inflows — largely unrelated to our monetary policy — held down longer-term rates, including mortgage rates, while increasing the demand for mortgage backed securities.”
The Chinese alone purchased hundreds of billions of dollars in American assets including mortgage-backed securities to keep their currency low and promote export-led growth. In a communist country where there is no rule of law, it is safer for people to invest in the United States because fortunes can be lost overnight to the government.
The most important factor in the downturn was Congress and its affordable housing policies. In 1992, Congress forced Fannie Mae and Freddie Mac to meet quotas where 30 percent of loans were given to people who were at or below the median income. This forced Fannie and Freddie to lower their underwriting standards. Since Fannie and Freddie were dominant players in the mortgage market, others followed their lead. By 2008, more than half of all mortgages were subprime mortgages.
When the Federal Reserve increased short-term interest rates in 2004 and 2005, it found itself overpowered by the flow of foreign capital and the low mortgage standards. Before the 2008 crisis, the Fed couldn’t keep long-term interest rates down. After the collapse in housing, the Fed had to use quantitative easing in part to keep long-term rates down.
Even after the housing market recovered, Professor Benjamin Friedman of Harvard has argued for having a large balance sheet of $1.8 trillion: “Sales of mortgage-backs, in large quantity, would have reduced the speculative fervor in the mortgage market. Higher mortgage lending rates would have taken the top off of the housing boom.”
It is understandable for some to believe that the Fed lacked the adequate powers to handle the last crisis, but I think the real lesson is that there are limits to monetary policy. Congress is primarily responsible for this crisis and must work with the Fed to prevent another one.
The asset purchases brought interest rates to zero. This helped people as they were deleveraging from their debts, but it also discouraged banks from lending. Banks could earn interest by keeping their money parked in the Federal Reserve. This explains why there is over $2 trillion in bank reserves.
The bank reserves are also a sign that the situation can be fixed with the right leadership. In December 2010, President Clinton said, “The money is there to get this country out of this mess. Two trillion dollars in the bank is $20 trillion in loans.”
Beyond low interest rates, investors are too afraid to lend. Washington constantly creates more regulations, which makes it impossible to know what the market will be like five to ten years from now. This why I have argued in the past that this Republican Congress should pass the REINS Act, which just says that Congress will have to vote on any regulation that will cost the economy more than $100 million.
Repealing Dodd-Frank would also be helpful. This piece of legislation did nothing to address the causes of the crisis and it increased the regulatory power of the Federal Reserve. The Federal Reserve is a central bank and any extra regulatory power should be transferred to a federal agency that is not independent of congressional oversight.
Regulation is necessary, but the wrong combination can be toxic to the financial system. For example, Glass-Steagall was only four provisions of the Banking Act of 1933.
In 1933, 75 years before the collapse of Lehman Brothers, Congress understood that it needed to prevent bank runs by creating FDIC insurance. The problem was that it knew it had to separate commercial banks from investment banks at the same time.
With FDIC insurance, investment bankers could take enormous risks knowing that the federal government would bail out people who lost their savings. Of the three possible combinations, no FDIC insurance and no Glass Stegall, FDIC insurance and Glass-Stegall (1933-1999), and FDIC insurance and partial repeal of Glass Steagall (1999 to present), the worst combination is the current system.
Congress needs to encourage banks to lend by promoting a predictable regulatory environment and tax reform. President Trump has already impacted the Supreme Court. With three vacancies on the Federal Reserve Board, President Trump could substantially impact the course of the Federal Reserve Board. Both Chairwoman Janet Yellen and Vice Chairman Stanley Fischer are up for reappointment in 2018. Trump and a Republican Senate could have a chance to appoint five of the seven members of the Federal Reserve Board of Governors.
The question is what kind of appointees do we need. We need people who believe that they can restore growth not because they believe in regulations and quantitative easing, but because they believe in the American people.
While some people may want the government to act like Superman and save the day, there are limits to how much the Federal Reserve can do. So instead of re-appointing Janet Yellen, maybe we need another type of “hero.”
In the season finale of the first season of the hit series Supergirl, Supergirl is fighting aliens that have used a mind-control device, called Myriad, to enslave the human race. Supergirl and her friends realize that the machine can only be overcome if the people believe in themselves again. Supergirl gives a speech to galvanize the people to fight back:
Your attacker has sought to take your free will, your individuality, your spirit, everything that makes you who you are. When facing an attack like this it’s easy to feel hopeless, we retreat, we lose our strength, lose ourselves. I know. I lost everything when I was young. When I first landed on this planet I was sad and alone. But I found out, that there is so much love in this world, out there for the taking. And you, the people of National City, you helped me, you lead me be who I’m meant to be. You gave me back to myself, you made me stronger than I ever thought possible, and I love you for that. Now, in each and every one of you there is a light, a spirit that cannot be snuffed out, that won’t give up. I need your help again. I need you to hope. Hope, that you will remember that you can all be heroes. Hope, that when faced with an enemy determined to destroy your spirit, you will fight back and thrive.
The Federal Reserve can raise interest rates, but it cannot raise consumer confidence. It can play an important role, but it will not succeed unless the American believe that our elected officials, in concert with the Federal Reserve, can foster an environment where the people can help themselves.