interest rates

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Are We That Dumb?

Apparently.

The growing consensus in the media and commentariat is that a recovery has begun, that the economy is therefore OK, and so we need to shift our attention to setting the stage for tightening both fiscal and monetary policy. And this tightening had better come soon since there is a tsunami of problems ready to destroy the civilized world if we don’t act now. Or even sooner.

The problem I have with this train of thought is that nothing in the data suggests it’s true.

Nothing.

I have just read Paul Krugman’s blog where he notes the same thing. His conclusion is that we have entered one of those all too familiar periods of US history where the facts and the consensus opinion our not in step. What makes things worse is that, inevitably, it is the facts that lose in such a confrontation. The last time we were like this was during the run up to the Iraq war when no amount of fact checking could persuade the media that an invasion was the wrong course of action.

I just hope this current disconnect does less damage, and that we do not have to be subjected to a string of mea culpas over the next few years as the economy flounders deep in depression.

Because that’s where we will be if this herd mentality infects policy too much.

I fear it may be too late anyway.

The simple fact is that our economy is very weak. The recovery is more technical than real. Jobs are horrendously scarce and the employment outlook is still grim. Don’t just listen to me: the general consensus of economic forecasters is that we will still have an unemployment rate in excess of 8% deep into 2012. Think about that. Nearly three years from now our unemployment rate will be higher than it was when Bill Clinton used a poor economic record to wrest the White House from Bush Senior.

This nugget of information is not exactly top secret, so I would have thought that the current administration would be pulling out all the stops to get unemployment down as rapidly as it can. Winning elections usually focuses political attention on inconvenient things like a lack of jobs.

But no. The Obama folks have fallen under the same spell as the media. All the talk now is of tough action to be taken soon to tighten the Federal budget. Just in case those nasty bond people decide to pull the rug out from underneath us.

Here’s another interesting nugget: PIMCO our largest domestic bond fund, and one of our most successful, just bought up a huge pile of US bonds. That does not sound like an imminent panic. On the contrary it sounds like a vote of confidence.

The only way I can explain the disconnect between the facts and the curious fiction found in the media is that we live in an era of attention deficit disordered reporting. No matter what the crisis is, no matter how deep, nor how difficult it might be to cure, it must not last long. We need new angles and new stories to keep the front page fresh. So, after due time, we must shift our attention to the aftermath of the crisis rather than on its continued existence. After all the fact that we have a crisis is soooo yesterday.

We have reached the Age of Immaturity.

To some degree this explosion of stupidity is being fed by the counter-revolutionaries of the free market brigade. They have manned the intellectual barricades in order to salvage what reputation they can from the chaos their ideas have wrought. This resistance to honest re-appraisal of theory and its concomitant embrace of delusion pervades the entire fabric of all institutions who were fully invested in the free market deregulatory era. Don’t forget that our society became obsessed with stock market watching over the last few years. We gorged on spurious economic and financial data and were spoon fed market based ideology by endless cable TV talking heads all who seem to have grown up in the post Reagan era. Not one seems to have heard of Keynes. And few seem bothered by the prospects of depression. Since nothing lasts long in this fast paced world, the assumption is that the recession cannot last long either. Every news station and cable TV channel pours out daily minutia about the economy and therefore the competition to be on the leading edge of the next story trumps [sorry about the pun] any need to dwell on the current story.

This is why risk management failed us so miserably over the last few years: it got in the way of a good, positive, message.

The funny thing is that, as I reflect on my years in banking, the same problem existed back then. The difference between the two eras is that nowadays the stupidity is magnified by the vast array of news outlets. Back then the damage was confined to the banks whose managers fell prey to the good time stories. And there were plenty of them even then.

So here we are rushing full tilt into a group think disaster. The economy is great. The stock market is flying again – that’s all that really matters – and the only hiccup between here and nirvana is the potential threat from the bond market and the falling dollar.

Therefore all serious people will surely act early and firmly to demonstrate our commitment to defending the dollar and balancing the budget. [Does anyone care that the dollar dropped like a stone during the Bush years and that none of these same commentators mentioned it?]

Damn the consequences.

Apparently it far better to sink on a neatly run ship than to float on a messy one. It shows our commitment.

How else do I explain tepid financial reform? Weak stimulus? Dithering on jobs programs? Ridiculous commentary about bond rates?or hysteria about debt levels?

Are we that dumb?

Yes we are.

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Whacky Bond Markets

With deficit hysteria now growing with each passing day the risk that our leadership will blink and do something really dumb like raise interest rates gets larger. You all know how stupid I think such a move would be, but, hey, this is the all-knowing bond market we are talking about. You know that place inhabited by ultra smart, uber brilliant investors who hone their computer analyses and are invariably right about absolutely everything.

Like mortgage backed securities.

I suppose I am not allowed to point out the fallibility of the gods of Wall Street.

They seem to have such short term memories.

So do all the commentators who pay attention to them.

Let’s be honest we need to sell bonds. That makes the folks who buy them pretty important right now. We need to keep them all happy. To an extent.

You see investing is a two way street. We need them to buy our bonds so we can spend like crazy and bail ourselves out of the economic mess created by the insanity of the big banks and other investment companies who failed to analyze risk properly back in the run up to the big credit bust of 2008.

And they need us. Where else are they going to park their cash? There is a limit to the places all that investment can go right now. Think about it: the private sector is simply not investing. It is hoarding cash. Part of that hoard finds its way into our bonds. I realize that most of the stash goes into Treasury bills, which most folks regard as cash rather than as investment. But for the longer term investor US bonds are a safe bet. After all the possibility of a US default on its debt is just absurd.

Or not.

Here’s the fun part:

The activity in those notorious Credit Default Swaps on sovereign debt – i.e. the debt of a country rather than a company – has picked up a goodly pace. And not just on the places you would expect: Russia, the Ukraine, and so on are fairly weak economies with a track record of playing fast and loose with the bond markets. No the real action is now in CDS’s on US and UK debt. Spreads have widened a bit recently indicating that someone, somewhere, is a little nervous that the US will default on its debt. So those people are buying insurance in the form of CDS contracts just to be safe. That way when the US implodes totally and refuses to pay back its debt these wise folks can collect their money anyway.

Very clever.

And where do they buy these insurance contracts? Who is it that will be left standing even after the US has crumbled into ruin?

The big banks.

Ummmm.

Would these be the very same banks that rely on the US for bail out cash?

Yes they would.

Let me ponder this for … oh … all of a second.

Someone pays the big banks to provide them insurance against a default by the very Treasury responsible for shoring up the same big banks.

No I know I can be dumb sometimes, but help me out here. If the US Treasury defaults on its debt, just how stable will those banks – or any others – be? More to the point will they be there the day after in order to pay up on the CDS contracts?

Didn’t think so.

This is just one more example of the whacky way in which analysts and commentators get their proverbials in a gigantic twist.

So obsessed are they, and much of the financial media, with US debt levels, that they have taken leave of their senses. They actually think that Goldman Sachs, for example, is more credit worthy than the US itself. That would the same US that bailed Goldman out last year.

Not happening.

But because the analysts and commentators are getting hysterical about debt they no longer think of simple things. They are fixated on that debt level and see the end of the world all about them. We read silly articles about the US going the way of Argentina. We read about the urgency of tightening the Federal deficit and raising rates even though that would precipitate a Depression. We read about the profligacy of the US government and about its enormous unfunded liabilities.

And some people read all that and rush out to buy CDS coverage against their US bond portfolio.

I have a bridge I would sorely like to sell these people.

They would probably buy it if they knew Goldman Sachs was selling it. But they’d never buy it from its actual owners, because the owners are a government. And governments are the problem to quote my favorite incompetent president.

Sorry to be so sarcastic. But really. These are the self same geniuses who nearly sank the world economy. They bought toxic assets with unfounded glee and abandon. They packaged and securitized their mothers for all I know. Their credibility is zero. And now they bitch about the debt levels we need to reach in order to straighten out the mess they made.

Ugh.

On a serious note. For those of you who want to track just how the grown ups feel about our fiscal condition – which means turning off cable television – keep an eye on the spread between US bonds and the inflation proofed version of the same. That spread gives us a good indicator of just how much risk there is perceived to be in US debt. Not much given the latest data. Or you can take a peek at the US bond rates themselves: not very high at all. Or, for the truly daring, take a look to see if Goldman’s debt costs more then the US treasury debt does. Which is thought of as the riskier?

Get my drift?

Here’s the thing: yes our debt levels are shooting up. Hello: we have a crisis to deal with! Much of the deficit creating that debt stems from a drop off in revenues: people who are unemployed tend not to pay much income tax. Profits tend to be weaker in recession so businesses pay less tax too. Duh! Top that off with the need to bail out the banks and kick the economy into gear and we end up with an awful debt level. But it isn’t permanent. The deficit starts to drop off the minute the economy grows. So the ratio of debt to GDP peaks and then falls as soon as we get going again. GDP growth itself will lessen the ratio as long as we don’t keep our foot on the accelerator after the recovery is well established. And no one I know is saying we should. On the contrary I think there is too much premature talk of tightening. That moment is still someway off. We all want fiscal conservatism down the road. That means taking a good hard look at the budget and cutting some stuff out. It also means raising taxes at some point. Sorry folks nothing’s free.

If there’s one thing that the years of illusion should have taught us it is that the Federal budget should be balanced now and again, especially in years of good GDP growth.

Yes Messrs Reagan, Bush, and Cheney: deficits do matter. They always did.

Meanwhile let the bond market have its whacky moments. At some point as we pay down debt we will start to hear the lament of the late 1990’s: we need more debt! After all where are the investors going to get a safe return?

CDS coverage on US debt.

Please!

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The Next Bubble?

OK I am officially done with this. We are scarcely beyond the crisis, indeed from my perspective we are still firmly mired within it, than we are faced with a torrent of hand wringing about our ‘over accommodating’ monetary policy. Not just here but worldwide.

How many times do we need to talk about this?

Too many, obviously.

There is a new catch phrase in town we all need to get used to: the ‘carry trade’. This apparently is something so dire that we need to raise interest rates right now even though everything we know tells us otherwise. Deficit hawks all over the globe are now talking ‘carry trade’ at every opportunity.

What’s that?

The phrase carry trade describes the flow of capital around the world based upon borrowing short term in low interest rate currencies – notably the dollar – and investing in higher return and usually longer term assets elsewhere. In the old days this flow would be called ‘hot money’. Nowadays we call it ‘the carry trade’.

The source of the flow is all that liquidity we pumped into defunct economies like the US. Trillions of dollars are now sitting about the place with nowhere to go: the US is determinedly avoiding investing in its own businesses and infrastructure, so the cash needs a home. Naturally it tends to flow to where the returns are highest. At the moment that’s the Asian market place where local economies have regained a goodly growth rate and therefore look, for now, like a good bet.

But since the amount of cash available is way in excess of the opportunities to invest in sensible stuff like factories it is finding its way into silly stuff like Hong Kong apartments and commodity stockpiles.

Can we all say bubble?

Since we have all just been burned by the stupidity of the banking system and its complete inability to discern the difference between good and bad investments, it is only natural that conservatively minded folks around the world are now building up to a panic over the possibility of a new bubble. The flow of cash into flat-out speculative and downright silly investments is well under way. No doubt the geniuses on Wall Street are currently figuring out how to securitize and sell it all to unsuspecting investors. That’s what financial geniuses do. Anything to make a quick buck and hit this week’s quota.

The drumbeat of reaction is building and the financial media is almost hysterical over the potential damage this all could do if and when interest rates in the US start to rise.

Here’s the problem: in the carry trade nothing is invested for long. Yes the assets may look long term, but they are being held speculatively for the short term – until something better pops up. Once US rates rise the arbitrage gets squeezed and the speculators run for cover. All that hot money flees home and the asset prices that depended on it, indeed the asset prices that were inflated by it, collapse. This sparks a banking crisis. And we all know how that goes.

So the world’s central banks are riddled with fear that if rates stay too low for too long this new round of bubbles will implode soon.

Hence calls for the US to raise its rates even though unemployment is way too high.

Let them eat cake. Just protect those banks.

Here’s what these finance ministers seem to be missing: if that hot money does move and create big holes in stupid bank balance sheets [is calling a bank stupid an oxymoron these days?], who cares? It is not necessarily a macro economic or fiscal policy event. It is a financial regulatory policy event. It would call for a bail out of the banking system. Again. It would not call for the ending of expansionary fiscal policy.

At its root the ‘carry trade’ panic is a reaction to fiscal deficit spending by people who ideologically oppose such spending anyway. They see ghostly bubbles everywhere they look simply because of their visceral dislike of government deficits. Naturally these are the same folks who argued we should not do anything about the US real estate bubble that caused all this commotion in the first place, but, hey, who wants to be consistent when there’s a good ideological panic to stir up?

I agree that we need to get back to something at least resembling fiscal rectitude in the long term. The US has been reckless ever since Reagan and the Republicans abandoned conservatism in favor of illusion. Since then the US has failed to make choices. Instead it has acted as if the world owed it a high standard of living and that, by golly, it didn’t have to actually … you know … work for it. This was the illusion. The idea was that deficits didn’t matter. The US, we were told, was so vibrant and wonderful, that foreigners would simply trip over themselves to invest here come what may. That’s because w are so special. We defy gravity too if you close you eyes and imagine hard enough. It’s the American Dream. Or something.

But the carry trade is some dark force undermining all this. It is the flood of cheap dollars we have had to print to avoid depression that now is going to boomerang and spike us.

So, we are told, we have to raise rates and stifle the carry trade arbitrage opportunity. It is our duty. Even if it means plunging into a decade long depression.

Frankly nothing could be more stupid.

If it weren’t coming from the mouths of bankers and finance ministers I would fear for their intelligence. As it is I regret it is simply an innate elitism. The kind that pervades finance folks who seem to see everything in terms of interest rates, currencies, and arbitrage. Apparently the little people have to be sacrificed once more in order to save the bankers from their own folly.

I think not.

If the banks want to throw their capital down the drain by financing the carry trade, go ahead. The same goes for the hedge funds and the private equity investors. Clearly they are all too lazy to think through the consequences of their actions even though every finance media outlet is now full of breathless analyses of impending doom. Maybe they don’t read.

In any case nothing could be more damaging than raising interest rates at the moment. Our economy could not stand the shock.

Plus: there is a very sound case to be made that we all could do with a healthy dose of inflation. Japan has just announced that it has fallen back into deflation. This is despite the massive run up in the Japanese deficit, which makes ours pale by comparison.

The lesson is all very clear: if we want to avoid a decade of horrible economic conditions and endemic unemployment we have to persist in inflating the economy. That means government spending to fill the gap left by the fear crazed and irrational private sector. And it means pumping inflation up to the 3% to 4% range – above the current Fed target of 2%. That extra inflation will have the effect of reducing debt burdens and allowing deleveraging to take place without Hoover like pain. It will allow home prices to restore equity levels and thus restore consumer confidence. It will relieve the burden on GDP of the government debt being piled up and make paying that debt down much more palatable.

But none of this will happen.

The deficit hawks have the upper hand.

We should all study the life and times of Hoover. We could well be re-living those days shortly.

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Bernanke Speaks: Modest Growth Ahead?

In comments made today Bernanke has given a cautiously optimistic view of the economic outlook. I emphasize the word cautious.

Allow me to summarize:

  • The economy grew about 3.5% in the third quarter, breaking a four quarter span of decline.
  • Bernanke sides with the optimists in arguing that this growth came from sufficiently diverse sources that it is likely to continue even when the inventory adjustment subsides, and the effects of temporary government actions such as the ‘cash for clunkers’ and first time home owner credit programs dissipate.
  • So he sees the economy growing throughout 2010.
  • Nonetheless there are big risks: obviously unemployment is too high, and the flow of credit too weak.
  • Unemployment has started to end its free fall. The economy is shedding about 220,000 jobs a month now rather than the 560,000 a month common at the beginning of the year. The economy needs to add about 100,000 jobs a month just to keep up with population growth, so we are a long way from reaching a tipping point where jobs become more abundant.
  • Unemployment has hit the young particularly hard with the unemployment rate in that category reaching over 19%. This is very damaging long term since it means that younger workers are being denied a chance to develop skills and gain experience that we will need in the future. This imposes a ‘hidden’ cost on the economy as the delayed development of such workers will slow productivity growth down the line.
  • On the other hand: current productivity is growing at very high rates: by about 5.5% this year. This is largely due to employers making surviving workers do more work; and to the shorter work week: average hours worked per week have now shrunk to about 33, the lowest since World War II.
  • The actions taken to bail out the banks worked in that the crisis in the credit markets has eased – as measured by things such as risk spreads. However, banks are lending less. The level of consumer debt has now fallen for the first time since 1951. Lending terms have been tightened significantly although there is evidence that the tightening is at an end. In general banks remain cautious and are likely to stay that way for some time – especially in view of the oncoming commercial real estate refinancing problem.
  • Because of the probable damage done to bank balance sheets by the commercial real estate refinancing problem, the TARP and TALF programs should remain in place at least through next year.
  • There is no upward pressure on inflation presently. The economy is awash with spare capacity so the are few resource constraints – production bottlenecks are a normal source of price pressure during the early stages of a recovery – and the bond market seems quiescent: the expected inflation rate being built into bond prices is well within the limits the Fed sees as prudent [ the Fed has an upper limit of about 2% per year in mind].
  • The dollar is likely to weaken some more, although the current flux in exchange markets is probably not going to last much longer. The Fed remains committed to a ‘strong’ dollar as part of an approach to international financial stability.
  • Taking the state of the credit markets, the low expected rate of inflation, and the outlook for the dollar into account and then setting those against the need for ongoing support until the economy is securely on a growth track, the Fed sees no reason to raise rates in the near future. Indeed there is every chance rates will remain very low for an ‘extended’ period.

OK.

That’s what he said. Is there anything of note in those statements?

Not really.

Bernanke is solidly in the pragmatic-but-optimistic camp. He clearly acknowledges that there remain significant downside risks next year, but he argues that the central tendency of the economy is modest growth. However he wants us to note that the variability is mostly on the potential negative side: the combination of weak credit and weak labor markets could well threaten growth and push us back into recession. He thinks a second downturn is unlikely, but that the threat remains.

As for inflation and interest rates: Bernanke sees a quiet time ahead. Since inflation is not an immediate threat – notwithstanding the hysteria in some media outlets – there is no need to lift rates. On the contrary: given the weakness in domestic demand the bias is still to maintain the very low, and thus stimulative, level of rates for a long time.

As for the dollar: he ‘soft shoes’ around that one. I suspect he would like to see a little more devaluation to help lift exports and thus support growth. He probably doesn’t mind a steady decline in the dollar’s value. What he wants to avoid is anything precipitous. That would force his hand and could potentially threaten the recovery. So he ends up talking pablum about a ‘strong’ dollar without saying what that would look like.

Overall his view seems to fit with where I think things are going. I am less upbeat about next year because i am less sure than Bernanke is about the sufficiency of the current burst of growth: I see much more of the third and fourth quarters coming from stimulus and inventory adjustments, and thus less from ongoing sustainable growth.

The difference?

He puts growth next year in the low 2% range; whereas I am still in the 1.5% range.

No big deal, as long as credit and jobs don’t cause any ripples. My outlook just has less room for maneuver and thus more chance for a downward shift.

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Finance Reform

Well things are heating up. Senator Dodd released his much awaited – by people like me that is – proposed legislation for the reform of our broken down financial regulatory structure. The legislation weighs in at 1,136 pages of text, so I doubt whether anyone has read it yet unless they received a copy ahead of time. I certainly won’t be wading through it all. I will use the executive summary as my source for the major proposals.

Here are the highlights, or ‘lowlights’ if you’re at the Federal Reserve Board:

  1. Dodd proposes to establish a single large new regulatory agency[the Financial Institutions Regulatory Administration or ‘FIRA’], similar to the FSA in the UK, that will take over many if not all the regulatory powers now vested in the warren of agencies in Washington. The idea behind this centralization is to prevent banks from getting themselves regulated by the most lenient overseer. This ability to shift the regulator with oversight over your bank – an ability known as ‘regulatory arbitrage’ – undermines the current system and allows banks to cherry pick the regulations they want to be governed by. Ending this ability is key to future enforcement. I have doubts whether Dodd will get his way with this proposal, the current agencies all have cheering sections in Congress and the massive inertia within the American system will most likely kill the initiative off. Plus centralization in the US is simply a first step: international regulation needs to be tightly synchronized as well is we are to eliminate global regulatory arbitrage.
  2. Once FIRA is set up the current Offices of Thrift Supervision and Comptroller of the Currency would both be abolished and their functions absorbed into FIRA. Likewise the bank regulatory aspects of the FDIC would be rolled into FIRA as would those of the Federal Reserve Board.
  3. The proposal also gives the SEC an ability to fund itself by keeping the fees it levies on the financial industry.
  4. A controversial aspect of the Dood reform is that it establishes a Consumer Financial Protection Agency [‘CFPA’], which is designed to monitor and control the products that banks create and sell to consumers. This is obviously a reaction to the sub-prime mess when lenders ran amok with fancy, and often incomprehensible, loan types, and then sold them to people who were not credit worthy if the fine print in the loan ever kicked in. Naturally the fine print always kicked in and precipitated the mass of delinquencies and foreclosures we are now cleaning up. I like this idea. The so-called innovation in banking is not innovative at all. It is simply an endless permutation of the same old products wrapped in ever more obtuse legal language. Innovation is supposed to drive higher value to the customer, but most bank ‘innovation’ is designed simply to open new sources of fee income for the banks. This proposal is vehemently opposed by the Republicans – they object to anything that seems to limit the good deeds of the market place – and the various bank lobby groups are pouring money into a fight to stop its successful passage. Given that both the House bill and the Obama administration endorse a similar concept, the odds are that we will get some form of CFPA. Good.
  5. Dodd also proposes setting up a new agency to govern financial stability. This agency is the lynchpin of the new Dodd style system of limiting the damage ‘too-big-to-fail’ banks can do to us all. The idea behind this agency is that it would monitor and manage the systemically important organizations – think Citicorp or Goldman Sachs – and suggest rules and limits on their activities to prevent their gambling taking us all down the way they did in 2008. The need for such an authority is an open acknowledgement of the total failure of the current system to account for the risk embodied in all the interconnections between the biggest banks. Remember it was our complete failure to understand systemic risk that led us to have to bail out AIG and bail out pay off Goldman Sachs et al through the back door by honoring those counter-party positions they had all foolishly entered into. The overall notion in this initiative is to limit the extent of the socialization of losses needed in future – Dodd’s fine print even has this agency given the power to recommend breaking up banks that are deemed too large for the safe operation of the entire system. Also good.
  6. The proposal also includes a raft of measures designed to discourage banks from becoming to big. In this respect Dodd’s legislation fits right in with all the other proposals floating about. This is also a welcome change, although I remain skeptical about its impact: we have capital regulations now. The question is getting them enforced.
  7. Small banks would find themselves subject to federal regulation if Dodd gets his way. This will annoy all those country bankers who have a cozy relationship with their local state regulator. It is about time we abolished the state level regulatory structure – not only does in encourage regulatory arbitrage, it helps maintain a fragmented industry. The proliferation of small banks prevents the emergence of new medium and larger banks that could compete with, and therefore limit the growth of, the existing mega banks. If we believe in a market system then we need to ensure that system is full of competitors and is not dominated – as it now is – by an oligopoly who can impose rents on the rest of us. {Rent seeking is the word economists use to describe activities where one person or organization can extort wealth from others by employing legal, but non-competitive, methods. Enforcing a patent is an example. Lobbying and getting preferential legislation is another}. One way to limit the damage of the pervasive rent seeking now current in finance is to encourage the emergence of healthy and innovative competitors. Getting all our small banks onto one regulatory playing field would be a step in this direction because it would probably encourage consolidation across state lines, where asnow the various State regulators discourage such activity.
  8. The last big change Dodd proposes is to bring all hedge funds under a strict regulatory framework. They would be required to register with the SEC. Further: hedge funds and private equity firms would be subject to capital requirements for the first time and may even be broken up if deemed systemically too large. This is a major step towards bringing the so-called ‘shadow banking system’ into the daylight and set up under the same controls as the normal system. This is a very good move.

That’s about it.

Predictably the Fed and the FDIC have already mounted the barricades in defense of their entrenched positions. The Fed’s big criticism of the Dodd proposal is that it strips away their ability to use their regulatory control of big banks as a way to take the pulse of the economy – they regard this ‘touchpoint’ as an important source of information as they manage the money supply. They also reject the measures the proposal includes to open up their activities to wider scrutiny – by making appointments more subject to public input for instance. They are wheeling out the dreaded ‘the Fed must be politically independent’ defense tactic, which is sure to energize the financial market and right wing analysts to become allies of the Fed.

I agree the Fed should be independent of direct political control. Its Board should have a mandate unfettered by political agendas. But, just as important, the Board should not be dominated by the banking industry – the Chairman of the New York Fed is an ex-Goldman executive who was trading his Goldman stock at the same time as sitting in on meetings to determine who should, or should not, be bailed out. It is this clear conflict of interest that Dodd is taking aim at, not political independence.

In any case the recent record of the Fed just doesn’t stand up: they are so embedded with Wall Street that they are incapable of executing a regulatory mandate effectively. They have swallowed the same free market ideology that misled the banks and even now don’t seem willing to admit much by way of error during that 2002-2007 period when the current bubble was being inflated largely as a result of Fed policy and inept oversight.

I will end with this latter point: defenders of the Fed loudly proclaim its need for independence. But in a broader sense the Fed, under Greenspan in particular, was anything but apolitical: it was a vehement advocate of the same theory and ideology that was the foundation of Reagan/Bush style Republicanism. Greenspan, more than once, intervened to prevent regulation of things like derivatives, and openly supported the modern Republican view that government is a problem and not a source of solutions. While I admit the entire political world has been infected with this worldview – Rubin and Summers in the Clinton years were just as culpable – the Fed under Greenspan became more than usually tainted by a particular political point of view.

So the question becomes: can the Fed ever be ‘independent’? Or is the search for independence simply a cover for its adoption of free market ideology?

This is not academic.

The big discussion at the Fed currently is when and whether to raise interest rates. Those that want higher rates advocate a raise because they want to defend price stability – they are afraid of inflation – which is one of the Fed’s two legal mandates. They are by and large are the free market folks. Those that push back are driven by the other mandate the Fed has: to support employment. During recent years the first of these two mandates, the fight against inflation, has dominated the other. This is a political choice that favors business and banks over workers. It gets interesting this year if unemployment keeps rising even while the economy starts to grow. The pressure to raise rates will increase as GDP ticks up. But such a move would damage the prospects for a fall in unemployment. Left wing politicians will want lower unemployment. Right wing politicians will want to limit inflation.

Whichever course the Fed chooses is thus political.

So just how independent can the Fed truthfully be?

Not so much.

Which is why opponents of opening up the Fed with a more transparent management style need to find a better defense than its purported independence.

Meanwhile … back at the regulatory ranch.

The Dodd legislation conforms fairly well with the House and administration proposals. I hear the the administration is even willing to support the establishment of FIRA, which they initially opposed.

Given the total opposition coming from the Republicans, I don’t see to much time being invested in a fruitless search for ‘bipartisan’ support for reform. Having been burned in the health care pseudo- debate, where bipartisanship was mocked by the actual discussions, I hope the administration and the Democratic leadership plunge onward without distraction.

This is not to say I wouldn’t support debate. Clearly on something this important we need healthy discussion. But I emphasize that word ‘healthy’. Name calling and obduracy are not healthy and don’t constitute debate. They are merely obstructionism and should be ignored.

Given the recent crisis and the evident failure of our laissez-faire system, we need to re-regulate finance. With the Dodd proposal now on the table the process has begun in earnest. I would like the Republicans to play a constructive role in getting the nation’s banking system safe again. If they join in the debate, then good. If not, well that’s just fine.

Either way we will get reform.

Good.

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