I have not been to a revival meeting for decades, but once in a while I feel moved to say, “Amen!” That happened as I read the news recently.
An article reported that Thomas Hoenig, president of the Federal Reserve Bank of Kansas City who is a voting member of the Fed’s policy-making Federal Open Market Committee, has called for raising interest rates “sooner rather than later.”
The next article related how the world’s largest investment bank, Goldman Sachs, made more than $100 million in net trading revenue per day on 131 different days in their 2009 fiscal year. Since Saturdays, Sundays and holidays don’t count, that means Goldman topped $100 million per day over half the trading days in the year.
That income was from trading for its own account, not fees from corporate clients for carrying out traditional investment banking services like new stock or bond issues or advising on mergers or acquisitions. Over the year, such net revenue totaled $45.2 billion, contributing to profits of $13.4 billion.
As I read that, my mind flitted back to another assertion by Hoenig I had read moments earlier: “I think we shouldn’t be guaranteeing the markets a zero rate for an extended period.” Amen, brother! Amen, amen and amen!
I want to make clear that I don’t think the Fed’s injection of huge amounts of money into the economy over the past 30 months was a mistake. I’m not one of those people who think this was all a waste of money and that we would be in exactly the same position if we hadn’t done it.
We did stand at the edge of an economic abyss and the Fed’s actions, together with assistance from the Treasury, pulled us back from what might have been the worst global depression in a century. No one knows for sure how bad it could have been, but when former Treasury Secretary Henry Paulson testified recently that unemployment could have reached 25 percent, or more, without emergency action by the Fed and Treasury, I think he is right.
However, the fact that extraordinary money creation was justified in 2008 does not mean it is prudent to let all this liquidity slosh around the economy for “an extended period” as the Fed keeps promising. The public likes the resulting low interest rates, but these carry an unappreciated risk.
One risk is inflation. In the long run, a central bank “injecting liquidity” is tantamount to “creating money.” And, as Milton Friedman taught us, money growth that persistently exceeds the rate of growth of real production of goods and services, leads to inflation.
And if the past 15 years of U.S. history, or that of Japan in the 1980s, taught us anything, it is that excessive money growth can manifest itself in price bubbles in real estate and financial markets just as easily as in consumer prices — and with even worse consequences.
In addition to general inflation in either consumer or asset prices, excessive money growth coupled with implicit guarantees that no big financial institution will be allowed to fail, motivates financial firms to take cheap money and put it into riskier ventures. The same article that described Goldman’s trading revenue noted its average “value at risk,” a key measure of the riskiness of the trades it makes, climbed 21 percent from average levels in the preceding year.
Yes, a danger exists that the Fed could constrict money growth too much too soon. That happened in the 1930s. But the danger of being too lax is much greater than the public realizes and is heightened every time the Fed reiterates its “extended period” promise.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.