By Robert Romano — Federal Reserve Chairman Ben Bernanke has in the past said he opposes a return to the gold standard because it would reduce the central bank’s ability to intervene in the economy, effectively reducing his role to little more than a clerk.
Apparently, he has had little problem since the financial crisis with being the government’s ATM (automated teller machine).
Since Aug. 2007, when the downturn began in earnest, the Fed has more than doubled its holdings of the national debt by some $890.2 billion to $1.681 trillion — effectively monetizing the $15.6 trillion national debt. It already holds more than 10 percent of it now.
Such unprecedented actions by the central bank have not been seen since the World War II, when the national debt last went north of 100 percent of the Gross Domestic Product (GDP).
It has even led some economists, particularly those in the Modern Monetary Theorists camp, to suppose there is no limit to how much debt the Fed can monetize. As described by the Washington Post’s Dylan Matthews, the theory postulates that “the government can never run out of money. It can always make more.”
In that sense, the central bank is viewed as nearly invincible when it comes to servicing the government’s financing needs.
But, if that were true, why then does Bernanke see the need for fiscal restraint?
Speaking to Congress last year, Bernanke warned that spending and borrowing needed to be brought under control. Said Bernanke, “One way or the other, fiscal adjustments sufficient to stabilize the federal budget must occur at some point.”
He said one way or another, they will happen, it’s just a question of how: “The question is whether these adjustments will take place through a careful and deliberative process that weighs priorities and gives people adequate time to adjust to changes in government programs or tax policies, or whether the needed fiscal adjustments will come as a rapid and painful response to a looming or actual fiscal crisis.”
That’s quite an admission from the Fed head. Here, Bernanke let the curtain drop, if just for a moment, showing his hand.
The Fed is not invincible. The house of cards will not stand on its own forever — no matter how much support the central bank provides for the debt.
That might be news to the Modern Monetary Theorists — or the rest of Washington, D.C. for that matter. They all assume the Fed has unlimited capacity to pad financial institutions with zero-interest rate dollars to be then be lent to the federal government at low interest rates; and to otherwise fill in the gap of funding with direct purchases of sovereign debt.
But perhaps that assumption misleading.
Bernanke is indicating that market forces can indeed be brought to bear on our borrowing capacity. He could be hinting at the possibility of the dollar losing its world reserve currency status because of our profligacy, the only thing in my mind that could provoke such a crisis, disrupting the current status quo and sending interest rates to the moon.
All of which could mean a showdown between the Fed and Congress is on the horizon.
The last time that happened was after World War II. As chronicled by University of California professor and San Francisco Fed scholar Carl E. Walsh, former Fed head Marriner Eccles was deposed by Harry Truman because Eccles wanted to discontinue the central bank’s support of government bond auctions.
During the war, the Fed kept lending rates to the government artificially low, keeping borrowing costs down. Afterward, the policy led to unacceptably high levels of inflation, causing the central bank to seek to rein in the easy money. The Treasury and Truman resisted. Then, the Korean War was heating up, and the government wanted the cheap money.
By Walsh’s account, Truman and the Treasury tried to muscle the Fed into compliance, attempting “to bind the Fed to the maintenance of low interest rates through public announcements.”
In 1950, writes Walsh, the “Secretary of the Treasury, John Snyder, announced that consultations with President Truman and the Chairman of the Federal Reserve Board had led to a decision that new long-term debt issues would continue to be offered at a 2 1/2 percent interest rate, a view apparently not shared by the Fed. When Fed disagreement became known, President Truman called the entire FOMC to a White House meeting to discuss policy.”
Walsh continues, “The White House and the Treasury then announced that the Fed would continue to support government bond prices. Eccles, who was still a member of the Board of Governors, then released the Fed’s confidential minutes of the White House meeting, minutes that contradicted the White House and Treasury claims of a Fed commitment to keep rates fixed.”
That was when Eccles’ successor Thomas B. McCabe stood up to Truman, refusing to continue the policy. Afterward, the Fed and Treasury reached the Accord of 1951, which seemingly lifted the central bank of the obligation to monetize the debt. Interest rates started rising again.
Of course, then McCabe was not reappointed either. Just three weeks after the Accord, Truman next installed William McChesney Martin as Fed, the Treasury official who had negotiated the agreement — perhaps to remind the Board of Governors just who was the boss. Nonetheless, it is generally thought the Fed had in reality asserted its independence.
So, did it work? 61 years later, the Fed is more involved in monetizing the debt than ever. And even Bernanke knows it cannot last forever.
The question is: Does Bernanke have the courage of his convictions to stand up to the Obama White House?
Bernanke’s calls for fiscal restraint are commendable and should be heeded by members of Congress, but Bernanke is well aware that the politicians are likely to wait for the fiscal crisis he described.
Unless the Fed just says no. Bernanke could, in the tradition of Eccles and McCabe, get the nation’s fiscal house in order rapidly, just by taking the punch bowl away. That is, if he means what he says that “fiscal adjustments sufficient to stabilize the federal budget must occur at some point.”
Only time will tell. But if Bernanke’s right — time is running out.
Robert Romano is the Senior Editor of Americans for Limited Government.
