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Debt Relief for Whom? Part II

Polly Cleveland

Two new books address debt from opposite ends of the financial scale. In Part I, The Case for A Debt Jubilee in the United States, Richard Vague proposes a practical way to forgive crushing middle class debt. In Part II, The Lords of Easy Money, Christopher Leonard traces How the Federal Reserve Broke the American Economy as it protected the big banks that acquired unpayable debt.

Lords of Easy Money cover

Part II: The Lords of Easy Money

As a land economist, I was among the few who predicted the bursting of the real estate bubble in 2008. (I tried hard to persuade my husband to sell our two little brownstones before the coming crash, but in vain.) At the time, the solution seemed obvious: The federal government should allow underwater homeowners to write down mortgages. And the government should do to large banks what it has historically done to misbehaving smaller banks: Take over and restructure the banks, and prosecute the crooked managers. In The Best Way to Rob a Bank is to Own One (2013), Bill Black recounts how the government cracked down on S&Ls in the1980-90 crisis. But in 2009, newly-elected President Obama lacked the nerve and probably also the support of the Wall Street friendly Democratic Party. Instead, the Obama administration allowed the big banks like JP Morgan Chase, Bank of America, Citigroup and Wells Fargo to become entrenched as too-big-to-fail. Despite abundant evidence of fraud and inside-dealing during the bubble, not a single banker was prosecuted. (See Wall Street on Parade for up-to-the minute coverage of the “serially-criminal” banks.)

In The Lords of Easy Money, Christopher Leonard tells how the Federal Reserve—the US central bank—fell into its disastrous role of permanently supporting the big banks. Mostly, he follows the story of Thomas Hoenig, President of the Federal Reserve Bank of Kansas from 1991 to 2011. The Kansas Reserve is one of 12 regional banks belonging to the Federal Reserve System. Bank presidents attend meetings of the Federal Reserve in Washington DC, and rotate in and out of voting membership of the 12-member Federal Open Market Committee which sets interest rates. Alone among bank presidents and members of the FOMC, Hoenig opposed and voted against Fed policy after 2000.

A lifetime banking professional and conservative inflation hawk, Hoenig at first easily went along with the policies of Federal Reserve Board Chair (1987-2006) Alan Greenspan. Greenspan focused primarily on keeping interest rates low in order to stimulate the economy. However, Hoenig gradually became uneasy as low rates set off asset price inflation in the form of the dot-com stock market boom of the late 1990s. In 2000, as consumer price inflation became unmistakable, Greenspan raised rates sharply, triggering the stock market crash of 2000.

Here let me take a break to explain a bit about how the Fed works, or rather, how it used to work. In theory, the Fed controls the economy’s interest rate. In reality, it controls only one interest rate, the so-called “Fed-funds” rate, the lowest safest rate in the economy, usually in low single digits. The Fed lowers (or raises) this rate by buying (or selling) short-term government bonds or “Treasuries” from banks and dealers, paying with newly-created money transferred electronically into the sellers’ accounts. Buying bonds with new money bids up their price and lowers their yield as a percent of their value. This yield determines the Fed-funds rate.

By arbitrage*, the Fed funds rate loosely determines rates throughout the rest of the economy. These range upward from rates on longer-term government bonds, to “prime” rates banks charge their best customers, to mortgage rates, continuing up to credit card rates in the ‘teens, twenties and even thirties. The rate spread is narrowest during booms, meaning there’s more credit available to small and medium businesses and middle-class borrowers. In downturns, banks cut these off, freezing businesses and sending poorer people to payroll lenders, pawn shops and loan sharks.

The value of real estate is inversely proportional to the so-called “cap” rate. This consists roughly of the prime bank rate plus a risk premium plus property tax rate and minus expected growth in value. It’s obvious from this formula that a low prime rate and high expected growth both pump up the value of real estate. An increase in prime rate together with nervousness about growth can make real estate values suddenly plummet. That happened in 2008, and previously at roughly 18-20-year intervals. The biggest prior real estate collapse happened in the late 1920s, preceding the stock market crash of 1929.

Liberals love low rates and ensuing booms and don’t mind a bit of price inflation. After all, booms can raise wages and increase credit for consumers and small business, though of course low rates hurt small savers. Conservatives hate price inflation, especially wage inflation. It might surprise us that, while Hoenig objected, arch-conservative Greenspan kept rates so low so long during the dot-com boom of the late 1990s. The answer: Conservatives, who own most of the assets, love asset-inflation. Greenspan kept the boom going as long as possible to avoid pricking their bubble. Hoenig, though also conservative, recognized that asset-inflation worsened inequality and low rates encouraged risky investments in search of higher yields. Greenspan’s reluctance to prick bubbles also created moral hazard, leading speculators to count on a rescue from the Fed.

When the 2000-2001 crash happened, Greenspan apparently hoped he could quickly repair the damage by sharply cutting rates. Alone, Hoenig objected that the cut went too far too fast and remained too long. Indeed so. It helped set off the real estate bubble of the ‘oughts and crash of 2008. (There were other factors, notably the failure to regulate crazy derivatives and the 1999 repeal of the Glass Steagall Act of 1933, which had constrained speculation by commercial banks. Also, the roughly eighteen-year real estate cycle was due for a downturn in 2008.) In mid-2004, Greenspan belatedly began to raise rates, too little too late.

In February 2006, President Bush appointed Ben Bernanke as Fed Chair, replacing Alan Greenspan. A conservative academic economist with no banking experience, Bernanke shared Greenspan’s optimistic view that the economy was largely self-regulating. But he soon faced a growing banking crisis. It became apparent that the major banks were overloaded with bad assets—notably securitized mortgages—and pyramids of bad debt, often owed to one another.

The 19th century British economist Walter Bagehot (BADjet) advised that in a crisis the central bank should lend freely to solvent firms at a penalty rate and against good collateral. Instead, the Fed lent freely to insolvent firms at low rates with no strings attached. Bernanke began cutting the Fed funds rate, over Hoenig’s lonely but now strong objections, all the way down to zero by December 2008. And there the rates would stay until well after Bernanke left in 2014. (Hoenig retired in 2011.)

A zero-interest rate policy, or ZIRP as it became known, was unprecedented. It also was impossible using the traditional method of buying short-term government bonds—you can’t divide by zero. The Fed turned to unorthodox means, starting with buying longer term government bonds. When Lehman Brothers failed in September 2008, the Fed began to “expand its balance sheet”, that is to buy and hold more assets. And not just government bonds, but private securities like the mortgage-backed securities that had brought down the banks. The practice became known as “quantitative easing” or QE.

In buying all this stuff, the Fed put money in the hands of banks. Supposedly they would lend the money to investors and consumers, stimulating the economy. Instead, banks and their major corporate customers used much of the money to buy back shares of their stock, enriching their executives and worsening inequality. In 2013, the Fed started a feeble effort “taper” off its purchasing and raise the Fed funds rate. It quickly faced a “taper tantrum” by the banks, that is, an incipient bank panic and spike in market rates.

The Fed’s balance sheet tells us the total value of assets it holds. This value jumped from a bit under a trillion dollars before Lehman failed to over 2 trillion. The number slowly increased until the pandemic hit in 2020. Then it took an unprecedented 3 trillion leap as the Fed bought up buckets of junk securities, sending the stock market soaring. As Leonard writes, the resources from this bailout “went to large corporations that used borrowed money to buy out their competitors; it went to the very richest of Americans who owned the majority of assets; it went to the riskiest of financial speculators on Wall Street, who use borrowed money to build fragile positions in global markets; and it went to the very largest of U.S. banks, whose bigness and inability to fail was now an article of faith.”

 The Fed’s balance sheet now stands at almost 9 trillion. That’s compared to US GDP of 23 trillion and national debt of 30 trillion!

Today, as the pandemic eases, disruptions of monopolized supply chains are causing serious price inflation. The Fed is trying again to raise rates a bit. If the Fed succeeds, higher rates will undermine all those risky assets out there, including crypto Ponzi schemes and the new real estate bubble. World financial markets may panic and crash. If the Fed fails to raise rates, the US will become that much more hostage to the banks.

A hundred and forty years ago, American economist Henry George published his worldwide bestseller, Progress and Poverty. He argued that great civilizations carry the seeds of their own destruction. As they prosper, they become ever more unequal and corrupt. In the end they can no longer defend themselves from inside and outside enemies. George proposed a solution: shift all taxes onto land. By this he meant not only the land component of real estate, but all government-protected monopolies. Today these would include monopolies like spectrum licenses, geosynchronous orbits, and Big Tech. George’s ideas inspired the Progressive Movement and the New Deal. The New Deal remedy applies as much today as then: impose high progressive taxes, rein in the banks and other monopolies, and call a debt jubilee for ordinary people.

* “By arbitrage” means by the effect of comparison shopping. If the Fed drives up the price of short-term bonds, some dealers will switch to buying longer-term bonds instead, driving up their price too. The effect will ripple through the whole economy.


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