Fed-Bashing Three Ways

Beating up on the Fed used to make you an oddball. Does it still?

Sen.-elect Rand Paul, R-Ky.

According to a pre-election Bloomberg poll, 60 percent of likely voters who self-identified as Tea Party members said they want to see the Federal Reserve either reined in or abolished. Rand Paul, the Republican senator-elect from Kentucky, campaigned in part on an anti-Fed platform. Fed-bashing is often shrugged off as something that oddballs do whenever the country hits hard economic times. But if that’s the case, then why is Jeremy Grantham railing against the Fed too?

Grantham, the chief investment officer of the big Boston money management firm GMO, is nobody’s idea of an oddball; he is a well-respected longtime professional. Yet he just wrote a report titled “Night of the Living Fed.” The cover page resembles a poster for a horror flick, complete with a subhead—”Something Unbelievably Terrifying!”—and scary captions: “Homes Destroyed! Runaway Commodities! Currency Wars!”

The thought process behind the anger at the Fed isn’t uniform. If Dante had nine circles of hell, then the Fed has three circles of doubters. The first circle is critical of the Fed’s current policies. The second circle thinks that the Fed has been a menace for a long time. The third circle wants to seriously curtail or even get rid of the Fed.

Let’s start with the first circle. The Fed recently announced that it will purchase $600 billion in longer-term Treasury bonds. This is known as “quantitative easing.” The idea is that the Fed’s buying binge will increase demand for Treasuries and drive down interest rates, which in turn will encourage more borrowing, get the economy’s gears moving, and ultimately, if indirectly, chip away at the 9.6 percent unemployment rate. The current round of quantitative easing is called “QE2” because the Fed previously purchased some $1.75 trillion in Treasuries and mortgage-backed securities starting in early 2009, when the credit markets were frozen stiff. According to Paul Sheard, the chief economist at Nomura International, by the time the Fed completes QE2 (and assuming no changes in other asset levels) it will have expanded its balance sheet by a remarkable 221 percent from precrisis levels. That is a really big deal.

To some extent, QE2 has already worked: On Nov. 4, the day after the Fed confirmed its plans, the Dow finally surpassed the level it had hit before Lehman Bros.’ collapse two years ago. But the plan has also created an outpouring of skepticism. When the Fed launched QE1 in early 2009, markets were locked up. Today, rates are already shockingly low. Is another tiny reduction going to convince debt-laden consumers to spend or get companies that already have oodles of idle cash ($1 trillion, according to some estimates) to start investing? Do higher asset prices create the confidence we so desperately need—or are higher asset prices just another bubble that is destined to pop?

Those who worry that QE2 will lead us down a dark path include bond king Bill Gross, the founder of the giant bond management firm Pimco, who told Reuters that the Fed’s plan could lead to a “debasement of the dollar.” Gross fears that QE2 will weaken U.S. currency by as much as 20 percent over the next few years. Kansas City Reserve Bank President Thomas Hoenig, who voted against the Fed’s plan, told the Wall Street Journal that QE2 was a “bargain with the devil.” Hoenig thinks it could create inflation and future financial instability. Many foreign countries, including China, Brazil, and Germany, are complaining about QE2 because they fear a falling dollar will wreak havoc on their economies. (Fed chief Ben Bernanke defended QE2 in a Nov. 4 Washington Post op-ed; it’s worth noting that other countries are hardly innocents when it comes to currency manipulation.)

Grantham occupies the second circle. He sees the repeat of a familiar pattern in which the Fed’s low-interest-rate policies create bubbles. In the 1990s, the bubble was in tech stocks. In the aughts, the bubble was in housing. Now the bubble might be in junk bonds and commodities. What typically happens, Grantham argues, is that the Fed disavows any responsibility for spotting or stopping the bubbles before they wreak havoc. (Remember both Greenspan’s and Bernanke’s insistence that there was no nationwide housing bubble? Greenspan called it “froth.”) The madness in housing, Grantham writes, “was a direct outcome of a policy that is clearly still in place.” The Fed’s “complete refusal to learn from experience” makes it harder to create “a healthy, stable economy with strong [i.e., low] unemployment,” Grantham concludes.

Even the bitterest Fed critics can occupy the second circle. For instance, Rick Santelli, the CNBC reporter often credited with inspiring the Tea Party, said in late October: “I’m not going to stand here and tell you I think the Fed ought to be disbanded. … I personally think this Fed’s heart is in the right place, but they’re out of control in terms of trying to accomplish what their noble purpose is.”

Santelli’s words are anathema to occupants of the third circle, who do not think the Fed’s purpose is noble. Kevin Duffy, who co-manages a small hedge fund called the Bearing Fund, says that criticizing Fed policy, rather than the Fed itself, is “a bit like dismissing Stalin and Mao as well-intended but not the right men for the job.” Duffy’s camp wants to return to the gold standard in order to check the Fed’s power to weaken the dollar—the scarcity of gold limits how much money the Fed can print—but even that is just a half step. Best of all, the third circle believes, would be to seriously curtail or abolish the Fed altogether.

The argument goes something like this: The very existence of the modern Fed creates artificial confidence that there’s a government backstop to the banking system. Maybe that confidence has helped to make bank runs a relic of the past—but maybe the threat of a bank run wasn’t such a bad thing, because it forced bankers to be disciplined. Jim Grant, the founder of Grant’s Interest Rate Observer and a longtime Fed skeptic, titled a 1990 piece “Bring Back the Bank Run.” (Grant puts himself in my third circle but notes that he is “not so much against the existence of the Fed as its nature,” meaning that if Fed’s role in the economy were tightly circumscribed, it wouldn’t pose the same problems.)

It’s tempting to think of the members of the third circle as, well, oddballs. Certainly it seems pretty unlikely their aims will be realized. Not even the newly elected Tea Party candidates will necessarily back any major revamping of the Federal Reserve. When Ron Paul, the Republican congressman from Texas who is Rand’s father and a hero to the third circle, was asked on CNBC on Nov. 8 whether his son was “Paul lite,” he answered, “I think you have to wait and see how he’s going to vote.”

On the other hand, never underestimate the power of troubled economic times to make people rethink their beliefs. Paul also said that “a lot more people are looking at what we’re talking about.” In that same Bloomberg poll that found 60 percent of Tea Partiers favored reining in or abolishing the Fed, 45 percent of the general population favored the same thing. Murray Rothbard, the controversial libertarian economist who many consider the intellectual father of the anti-Fed movement, wrote in 1994 (“The Case Against the Fed“) that if the Fed were to be abolished, then “the banks would, at last, be on their own, each bank responsible for its own actions. There would be no lender of last resort, no taxpayer bailout [italics mine].”

Hedge-fund manager Duffy lets his third-circle worldview inform his investment choices. And guess what? Between June 2002 and September 2010, his Bearing Fund returned 226.6 percent net of all fees, or 15.3 percent a year. That compares with a return of about 4 percent a year for the S&P 500, including dividends, over the same period. Maybe it’s the rest of us who are the real oddballs.

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