The Zero Interest Rate Trap
Henry C.K. Liu

This article appeared in AToL on January 22, 2009


John Maynard Keynes formulated the phenomenon of absolute cash preference in a distressed market as a liquidity trap that can neutralize the stimulative effect of quantitative easing (increasing the money supply by changing the quantity of bank reserves) by the central bank.
Japan’s two-decades-long recession is a manifestation of a zero interest rate trap which can also neutralize the stimulative effect of credit easing (lowering the cost of credit) by the central bank.
Federal Reserves Chairman Ben S. Bernanke, in the Stamp Lecture at London School of Economics, London, England on January 13, 2009 defined the difference between quantitative easing and credit easing as follows:
The Federal Reserve’s approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach–which could be described as “credit easing”–resembles quantitative easing in one respect: It involves an expansion of the central bank’s balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank’s balance sheet is incidental. Indeed, although the Bank of Japan’s policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve’s credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses.
Each in separate ways, the liquidity and the zero interest rate traps together demonstrate the futility of macroeconomic attempts to use both quantitative and credit easing by the central bank to stimulate an economy contracting from excessive debt and leverage.
A liquidity trap can be formed when holders of cash seek safe haven from risk in a distressed market. They rush to park cash in risk-free financial instruments until the market stabilizes, causing short-term interest rates on top-rated fixed income investments to fall from market forces of supply and demand. Low short-term rate in such situation is the result and not the cause of a slowing economy. Under such conditions, central bank lowering of federal funds rate targets below that set by market forces can have the effect of pushing investors towards higher risk in search of better returns in a risk-averse market in which good investment opportunities are in short supply.
Since central bank power to set interest rates is unevenly concentrated on the short term, a liquidity trap distorts the term structure of interest rates which defines the expanding spread between short-term and longer-term interest rates.  This is because the Fed’s influence on the much larger outstanding long-term credit market is less direct than the short-term credit market where the central bank has complete control for rates for loans of short maturities.  Yet the Federal Reserve is institutionally focused more on the long-term health of the monetary system as compared to the Treasury which is institutionally more concerned with the short-term health of the financial sector. Thus to achieve the Federal Reserves’ long-term goal for the monetary system, a stable interest rate regime is ideal. Milton Friedman and other monetarists have long agreed on 3% as the most effective interest rate with up to 6% structural unemployment for avoiding wide price volatility and destructive business cycles.
The “risk structure” of interest rates defines the rising risk premium for a declining scale of credit ratings. Risk premium is defined as the difference between the rate of return on risk-free government securities and other financial instrument of higher risk. The higher the risk, the larger is the compensatory risk premium. The risk premium, which is calculated from both historical data and forward-looking estimates, adjusts the required risk/reward ratio for investments of different risk exposures.
On January 6, 2009, the yield on one-month Treasury was near zero while a year earlier it was 3.2%. In one year, the Fed cut short-term rate nearly 320 basis points to stimulate the slowing economy. On the same day, the yield on 10-year Treasury was 2.5% while a year earlier it was 3.8%.  In one year, the long-term rate fell only 130 basis points from market forces, less than half of the short term rate cut of 320 basis points by the Fed.
On January 6, 2009, the term structure between federal funds and 10-year Treasury rates was 250 basis points. A year earlier the term structure was only 60 basis points. The Fed had pushed the short term rate down further (by 190 basis points) than the fall of the long term rate from market forces, widening the normal term structure of interest rates by 2.5 times. This means significant future inflation was being seeded.
Risk/Reward Ratio
In the 16th century, Chinese rice traders observed the intricate relationships between Opening, High, Low and Closing market prices and represented them graphically using vertical bars which came to be known nowadays on Wall Street as Japanese Candlesticks because Japanese traders learned it from their Chinese counterparts and Western traders later learned the technique from Japan during the Meiji Reform Era of 1868-1912.
Today, Candlestick traders look for recognizable patterns with repeating “highs” as good probabilities for profitable trades. They do this by determining entry and exit points to meet profit targets and stop loss targets. These trading points can be located by looking at historical moving averages, Bollinger bands, or other technical indicators to evaluate probable support and resistance levels.
In the 1980s, John Bollinger developed the Bollinger Bands as a technical analysis tool from the concept of trading bands. Bollinger Bands can be used to provide a relative definition of high and low and to measure the highness or lowness of a price relative to previous trades. By definition, prices are high at the upper band and low at the lower band. This definition can enhance rigor in pattern recognition and is useful in comparing price action to indicator movements to arrive at disciplined trading decisions.

Some stock traders seek profit by buying when price touches the lower Bollinger Band and selling when price touches the moving average in the center of the bands. Other traders buy when price breaks above the upper Bollinger Band and sell when price falls below the lower Bollinger Band. Options traders, most notably implied volatility traders, often sell options when Bollinger Bands are far apart by historical standards, and buy options when the Bollinger Bands are close together, expecting volatility to revert back towards the average historical volatility level. When the bands lie close together, a period of low volatility in stock price is indicated; and when far apart, a period of high volatility in price is indicated. When the bands have only a slight slope and lie approximately parallel for an extended time, the price of a stock will be found to oscillate up and down between the bands as though in a channel.

As an illustration, a stock with a per share entry price of $20.35 can be assigned by the trader a profit target of $21.35 and a stop loss target of $19.85.  The risk of loss is $20.35 minus $19.85, or $0.50.  The reward is $21.35 minus $20.35, or $1. The trade is risking 50 cents to make $1, with a risk/reward ratio of 1:2. The return on capital of $20.35 is around 20:1, or 5% for the open duration of the trade, which could be minutes, hours, days or months. If the trade is closed out by the stop loss target, the return on capital is negative 40:1, or -2.5%. Trading and financing cost has not been included in the calculations. A long open period will reduce the positive return on capital as financing cost rises over time.
It is necessary to bear in mind that rational quantitative trading models while giving an unemotional framework for decision making, are not guarantees for achieving targets. Models are by definition abstractions of reality which is infinitely more complex. One can fail rationally as well as intuitively. Often, rationality can prolong the denial phase unconstructively even when intuition suggests something is wrong.
There is another problem of modeling reality.  Most model builders assume reality to be rational and orderly. In fact, life is full of misinformation, disinformation, errors of judgment, miscalculations, communication breakdowns, ill will, legalized fraud, unwarranted optimism, prematurely throwing in the towel, etc. One view of the business world is that it is a snake pit. Very few economic models reflect that perspective.
The risk reward ratio provides a non-intuitive quantitative evaluation of risk decisions. It does not say anything about the qualitative evaluation of the decision, which is the surmised probability of achieving the profit target, which when missed, will produce a loss of $0.50 per share plus transaction and financing cost. Price reward ratios are merely quantitative justification for taking manageable risk. High risk only means high propability of loss but it is not synonymous with certainty of loss.
Probability/Impact Ratio
Good management of risk must include a probability/impact ratio. A low probability event with high impact is more dangerous or profitable than a high probability event with low impact, which may fall into the “not worth the bother” category unless it can be exploited in large volume with high leverage. The net capital rule created by the SEC in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1. After the rule was exempted in 2004 for five big firms, many hedge funds increased their leverage to 40-to-1 to maximize profit by enlarging the risk profile.
Both Risk and Profit Magnified by Leverage
The five big investment banking firms wanted for their brokerage units an exemption from the 1975 regulation that had limited the amount of debt they could take on to $12 for every dollar of equity. The debt-to-net-capital ratio exemption would unshackle billions of dollars held in reserve as a cushion against potential losses on their investments and trades. The released equity funds from higher leverage could then flow up to the parent company, enabling it to speculate in the fast growing but opaque world of mortgage-backed securities, credit derivatives, credit default swaps which are a form of insurance for bond holders, and other exotic structured finance instruments.
In 2004, responding to financial globalization, the European Union, to attract profitable finance operations to financial centers in its member nations, passed a rule allowing the European counterpart of the US SEC to liberalize manage of risk for both broker dealers and their investment banking holding parents. In response, the SEC instituted a matching voluntary program for broker-dealers with capital of at least $5 billion, enabling the SEC to oversee both the broker-dealers and the holding parents. Deregulation was being driven by financial nationalism.
Ever since the Great Depression, the government has tried to limit the leverage available to investors in the US stock market by maintain margin requirements. But regulators, led by former chairman of the Federal Reserve Alan Greenspan, thought financial innovation would be hampered, and financial activity driven to unregulated markets overseas, if there were any attempts to impose limits on leverage in the unregulated credit and capital markets. After all, innovation was viewed as the driving force in US prosperity. The global financial system embarked on a race to assume more risk under a mentality of “if I don’t smoke, somebody else will.”
This brave new approach, which all five qualifying broker-dealers - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley - voluntarily adopted, altered the way the SEC measured their capital. The five big firms led the charge for the net capital rule change to promote financial innovation, spearheaded by Goldman Sachs, then headed by Henry Paulson, who two years later, would leave Goldman to become the Treasury Secretary, who now has to deal with the global mess after failing to secure government aid. Bear Sterns and Merrill Lynch had been sold to big commercial banks and Goldman and Morgan Stanley have turned themselves into regulated bank-holding companies. The age of independent investment banks came to an end in the US.
Growth of Structured Finance
Structured finance, the structuring of financial needs for larger market to generate greater financial value, emerged at first as means to profit from unlocking latent value of conventional debt through unbundling of risk through securitization, and from eliminating market inefficiency through arbitrage. It creates financial value by facilitating the transfer of unit risk to the credit system through complex legal entities that shifts liabilities off balance sheet. Risk transfer through debt securitization leads to degradation in underwriting standards as liability is transferred to counterparties or to market participants systemically.
Advances in computerized trading enable the handling of large amounts of market information at electronic speed to conduct profitable trades to exploit market inefficiency to restore fundamental equilibrium. The intellectual energy of structured finance came through spillovers from risk management advances in nuclear arms control during the Cold War. Before long, with financial deregulation, quantitative trading groups, known as quant shops, and hedge funds, hoping to profit from capitalizing on eliminating market inefficiency, were springing up like mushrooms after a spring rain.
Also, risk management needs by all institutions with financial risk exposures create massive market demand for derivative instruments of all varieties and complexities to transfer unit risk to systemic risk. This leads to securitization of financial obligations to manipulate risk levels to attract investors of varying risk appetite. With increasingly sophisticated hedging against risk, investors begin to assume higher tolerance for risk through hedging. Hedging then transforms from a method of protection by reducing risk, to one of achieving higher profit by assuming more risk. Risk is no longer merely an index of danger; it becomes an index to command compensatory returns.  Risk changes from something to be avoided to something that should be sought for those seeking higher returns. Finance capitalism is built on a structure of risk.
Hedging only transfers risk to other parties; it does not eliminate risk from the system. Systemic risk rises as more unit risks are hedged. But while unit risk is managed by resident risk managers, deregulation reduced the role of systemic risk managers, traditionally market regulators, which in the US are the Federal Reserve for banking institutions and the Security Exchange Commission for equity markets.
Former Fed Chairman Alan Greenspan’s argument in support for deregulation is that innovation should not be inhabited and that self interest of financial institutions would be sufficient to assure self regulation. The logic is akin to if foxes were given free run of chicken coops, self interest of the foxes would regulate consumption of chickens to ensure a steady food supply. He has since admitted that he had put too much faith in the self-correcting power of free markets.  
Seduced by Fantasy Profit Targets
The entire structured finance sector has been seduced by fantasy profit targets driven by excess liquidity of cheap money released by the central bank.  These fantasy profit targets are pushed even unrealistically higher by the under-pricing of risk due to the ease with which entity risk has been passed onto counterparties in the global credit system to get liabilities off the balance sheets of funding intermediaries and underwriters.
Instead of acting as responsible intermediaries between investors, securitizing intermediaries and borrowers, investment banks while acting as securitizing intermediaries, also became investors in structured finance instruments they themselves invent and whose risk has been under-priced and whose safety is dependent on the performance of borrowers of poor credit ratings and record.
Fantasy profit targets have permeated the entire credit market because risk has been pushed unrealistically low by spreading it to a great number of counterparties in a daisy chain. When a few counterparties in the daisy chain defaulted, it impacted the credit ratings of all parties in the global daisy chain, requiring additional compensatory collateral, placing the entire daisy chain in an unenviable position of undercapitalization. The opaqueness of the daisy chain makes it impossible to locate and strengthen the weak links and the whole system comes crashing down from undercapitalization.
The Fear Factor
A fantasy profit target cannot be justified merely by low risk, particularly if the alleged low risk assessment itself is a fantasy. There is no mileage in risking even one penny for an impossible dream. Pricing of risk is a judgment call based on confidence on likelihood of gain, the reverse of which is fear of loss. The fear factor usually faces a rising threshold in a bull market and declining bar in a bear market in reverse direction to a required risk reward ratio.  The greater the fear, the higher would the risk reward ratio be required. At some point, the fear factor can push the required risk reward ratio to infinity when risk aversion overrides any and all reasonable profit targets. That is the point when markets seize.
Historical data suggest that a 100-basis-point (1%) increase in federal funds rate has been associated with 32-basis-point change in the 10-year bond rate in the same direction. Many convergence trading models based on this ratio are used by hedge funds. The failure of long-term rates to increase as short-term rates were raised by the Fed in late winter 2003 can be explained by the expectation theory of the term structure which links market expectation of the future path of short-term rates to changes in long-term rates, as St Louis Fed President William Poole pointed out in a speech to the Money Marketeers in New York on June 14, 2005.  The market simply did not expect the Fed to keep short-term rate high for extended periods under then current bullish conditions. The upward trend of short-term rates was expected by the market to moderate or reverse direction as soon as the economy slowed. The failure of long-term rates to fall as short-term rates were cut by the Fed to near zero in December 2008 can be explained by the fear factor and by the uncertainty direction of the purchasing power of the dollar in the future.
Zero Short-term Interest Rate Can Increase Systemic Risk
A liquidity trap can also raise the risk premium as market appetite for risk wanes and investors flee towards safety. But a zero short-term interest rate trap set by the central bank can distort the historical term structure by abnormally widening the gap between short term and long term rates as long-term rates fail to fall with the short-term rate because of a rising spread in risk premiums. This distortion can increase systemic risk by tempting investors to engage in term interest arbitrage by borrowing at near-zero short term rate to invest in higher-yielding long term instruments with even normal risk premiums.
The re-pricing of short-term risk was a root cause of the 1997 Asian financial crisis and it was again a root cause of the 2007 credit crisis a decade later. Monetarism had not banished the business cycle; it merely extended the length of boom phase by making the eventual bust more painful.
A liquidity trap, together with a zero interest rate trap, can combine to lead to a structural under-pricing of risk, followed by a subsequent overshoot of the risk premium from a rising fear factor to lead to a systemic failure of the short-term credit market. In August 2008, all debts that matured in 30, 90 or 120 days could not be rolled over at previous rates, or as the fear factor escalated, at any interest rate.
Risk is inherently dangerous even if it is priced appropriately to reflect realistic market conditions. A healthy dose of risk aversion is indispensable for the survival of financial capitalism which thrives on prudent risk-taking, not suicidal heroic risk abuse. Yet under-pricing of risk driven by excess liquidity released by the central bank over long periods to stimulate economic activities, the basic strategy of monetarism, will implode as a systemic crisis at the end of the day as surely as the sun will set.
Central Banking, Democracy and Monetary Policy
The Federal Reserve Act of 1913 gave the Federal Reserve authority and responsibility for setting monetary policy, which guides central bank actions to influence the availability and cost of money and credit to help promote national economic goals. Since its founding, full employment has never been part of the US national economic goal. From the nation’s beginning, during the pioneering days, the US had faced a persistent labor shortage. In the agricultural South, the labor shortage problem was solved by the institution of slavery. During the age of capitalist industrialization, the industrial North solved the labor shortage problem with immigration after 1830 from the laboring class in Europe. Until then, The US did not have a working class, or an unemployment problem.
The winning of independence by the US from Britain in 1782 was accompanied by gloomy predictions that the new nation would not succeed in creating a stable central authority to replace the British Crown and would quickly dissolve into anarchy. It was to the great credit of the founding fathers that they were able to create a new democratic republican government which would combine freedom with order, and local self-government with national unity. The achievement was the more remarkable in view of the deep socio-economic and ideological conflicts among the American people on contradiction between individualism and collectivism, democracy and oligarchy, conservatism and liberalism, and agrarianism and mercantilism.
The democratic ideal was represented early on by Sam Adams, Patrick Henry and other Sons of Liberty. Among Constitution drafters, democratic ideals were represented by Thomas Jefferson. In the 1820s, democratic politics found expression in the new Democratic Party headed by Andrew Jackson. These early democrats believed that government should be controlled by the people and that its power should be strictly limited and its economic policy should aim at protecting the interests of the average citizen rather than the wealthy elite.
This democratic attitude was natural to economic conditions of abundance of land and self development opportunities that formed the virgin political canvas on which to paint a new city on the hill from 18th century liberalism. Before the formation of economic classes, US representative democracy was based on geographic regions focusing on sectional interests rather than class interests. This early liberalism was fundamentally different from 19th century liberalism and 21st century neo-liberalism under which the working class, while emerging as the majority of the population, is systemically underrepresented politically as control of all political machinery are captured by the moneyed class, as predicted by Alexis de Tocqueville who warned in his Democracy in America published in 1836 that the loss of "general equality of condition" would threaten equality in American society.
Alexander Hamilton was the spokesman of the American aristocratic movement, representing large landowners, foreign trade merchants and international financiers. Hamilton, a forerunner supply-sider, believed that wealth can only be created by the energetic financial elite who through their superior intelligence and character are natural entrepreneurs and innovators that can better mobilize the ignorant and undisciplined masses for high national purpose than the contended agricultural landed gentry. Politically, Hamilton thought the people could not be trusted with power and that majority rule without strong minority rights would lead to confiscation, by the undeserving poor, of the wealth created by the deserving rich. Hamilton favored a strong central government that is controlled and run by a well-born, educated elite of principle and property for the public good.
Thomas J. DiLorenzo in his new book, Hamilton’s Curse: How Jefferson’s Arch Enenemy Betrayed the American Revolution – and What It Means for America Today, argues that regarding the stipulation that policies must promote “the public good” that “no government policy can be said to be for ‘the public good’ unless it benefits every member of the public.” More often than not, the “public good” turns out to mean good only for special interests. The argument puts the test for legitimate government intervention on the populist effect of government policies.
Hamilton rationalizes state intervention on the basis of high national purpose. His view of government control of the economy is more appropriate for emerging economies, such as the US economy in the1860s, the Japanese economy in the 1950s or the Chinese economy today. Henry Clay’s American System after the War of 1812 took Hamilton’s elitist program of economic nationalism away from the upper class and offered it to the masses by making federal authority champion of the people, rather than a captured machine for narrow sectional interests. Through representative democracy as advocated by Jefferson, Clay promoted measures designed to strengthen the young nation, enhancing its economic independence from foreign economic and financial dominance with protective tariffs, and promoted national unity by developing a reciprocal relationship between agriculture and industry and the establishment of a nation bank to finance domestic development. Daniel Webster, representing New England internationalist shipping interests in Congress, opposed Clay’s populist economic nationalism. Clay’s ideas of economic nationalism are similar to Chinese economic policy today, albeit adjustments need to be made regarding the difference in historic conditions and political culture in the two countries. (Please see my December 9, 2003 AToL article: US-CHINA: QUEST FOR PEACE - Part 1: Two nations, a world apart)
Economically, while all Americans in the mainstream believe in the protection of private property by the state, Hamilton advocated the concentration of wealth in the hands of those who will profitably use it to build a strong nation, and not be distributed widely as advocated by believers of economic democracy. Modern-day neoliberals are not Hamiltonians in that they willingly compromise economic nationalism in support of empire-building globalization in the name of free trade.
Hamilton’s idea reflected the need of a new, young nation of rich undeveloped resources for capital formation in a world beginning to enter the industrial capitalist age. In the 17th and 18th centuries, the agricultural economy of the US faced a labor shortage which gave rise to the institution of slavery. The agrarian South prospered until challenged by the capitalist industrial North.
The Civil War settled more than the socioeconomic issue of slavery. It set the US economy irreversibly on the path of industrial capitalism. After 1850, early industrialization solved the labor shortage problem by attracting immigration from the underprivileged masses of Europe that formed the beginning of a laboring class, a large segment of the population whose main economic function was to provide labor to an industrial economy. The opening of the West brought about servitude immigration from China in decline under conditions not much more liberal than slavery.
As the process of industrialization in late 19th century reduced demand for labor through mechanization while immigration continued as an established policy, unemployment became a major socioeconomic issue in the US. The end of slavery after the Civil War also added to an oversupply of wage-earners in a not-so-free labor market. Unemployment has since become a structural component in capitalism as fundamental as interest charges on the use of money.
During the age of feudalism, finance was not an arena for the elite in Europe. The US, founded only in 1776, did not experience a feudal economy. In the age of industrial capitalism, industrialists were in control of the US economy, while relying on passive financial institutions for capital. Henry Ford was disdainful of bankers. Industrialists and inventors such as Ford and Edison did not consider themselves as capitalists, even though they operated under capitalism.
As finance capitalism replaced industrial capitalism, financiers wrestled control of the economy from the industrialists. Standard Oil, General Motors were financial trusts built around economic sectors through acquisition of companies to form monopolies. Financiers such as JP Morgan, John D Rockefeller were trust builders, not industrialists.  Financial engineering, a euphemism for financial manipulation, emerged as the center for profit in which the aim of economic activity becomes that of making profit to provide return on capital, rather than producing goods to satisfy consumer needs. To allow more capital formation, financial capitalism disconnects profit from fair return on production cost, to what the money market will bear. Excess profit requires low wages and leads inevitably to overinvestment in relation to market demand. On the observation of this relationship Karl Marx formulated his concept of surplus value. The monetization of surplus value became the basis of capital formation. As capital assumes dominance over labor, finance became the core of capitalism.
Overcapacity resulting from overinvestment combines with stagnant market demand resulting from low wages and structural unemployment to cause recurring crises in market capitalism, known as business cycles.  After the Great Depression of the 1930s, social security introduced as part of the New Deal created a new reservoir of wealth in pension funds of workers. In WWII, war demands soaked up all overcapacity and wage price equilibrium was established to facilitate war production.
With the growth of pension funds, capital then comes increasingly from forced savings of the working masses. Yet control of capital continues to stay in the hands of the financial elite. While entrepreneurship flowered democratically through social mobility and openness, it took almost two centuries after its founding, until after the end of World War II, that the US would admit children of poor families into finance professions, mostly due to the GI bill in support of education for returning veterans. Large numbers of Wall Street leaders today owed their opportunity to education provided by the GI Bill after WWII.
While the entrance to the arena of wealth management is now more democratic, the institutions that operate the machinery of wealth manipulation remain fundamentally biased in favor of capital against labor even though overcapacity from overinvestment has become clearly a structural problem that can only be solved by workers being allowed to get a fairer share of the wealth they essentially create. Central banking, in its adherence to monetarism that aims to protect the value of money at the expense of fair wages is a strategic bastion against a much needed new financial order to address this imbalance between the labor theory of value and the theory of marginal utility of supply and demand in a market economy.  The modern economy requires fair spreading of wealth for the common good by maintain a balance between supply and demand.
Exchange Rate and Monetary Policy
Like the federal funds rate target, currency exchange rate is not a product of market forces. It is always, directly or indirectly, the product of national policy. Although exchange rate policy has become a crucial component of the monetary policy after the 1971 collapse of the Bretton Woods regime of fixed exchange rates based on a gold-pegged dollar at $35 per ounce, the Treasury retains responsibility for setting exchange rate policy as a matter of national economic security. On exchange rate issues, the Fed follows policies set by the Treasury with no questions asked.
The Three Tools of Monetary Policy
The Federal Reserve controls three traditional tools of monetary policy: 1) open market operations, 2) the discount rate and 3) bank reserve requirements. Using these three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate, the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.
Of these three tools, the discount rate and bank reserve requirements regulate banks as market intermediaries; only open market operations interact directly in the market to keep the federal funds rate on target as set by the FOMC. Changes in the federal funds rate trigger a chain of market events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, a range of economic variables, including employment, output, and prices of goods and services and ultimately the market value of derivative instruments.
The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements which regulate liquidity in the banking system, but not liquidity in the non-bank credit markets, such as commercial paper markets and structured finance markets. The Federal Open Market Committee (FOMC) is responsible for open market operations which involve purchases and sales of US Treasury and federal agency securities. Open market operations are the Federal Reserve’s principal tool for implementing monetary policy in the market directly.
The FOMC consists of twelve members--the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York which carries out open market operations; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. Nonvoting Reserve Bank presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committee's assessment of the economy and policy options. The FOMC holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy, and assess the risks to its long-run goals of price stability and sustainable economic growth. The Chairman can call emergency meetings at any time at his/her discretion, through conference calls by phone if necessary.
Open Market Operations
The short-term objective for open market operations has varied over time, ranging from maintaining a desired quantity of reserves to affect the money supply to maintaining a desired price for funds set by the federal funds rate target.
During the 1980s, the Fed under Paul Volcker adopted a “new operating method” as a therapeutic shock treatment for Wall Street, which had been spoiled fearless by the brazen political opportunism of Arthur Burns, Volcker’s predecessor during the Nixon-Ford era. Wall Street had lost faith in the Fed’s political will to control inflation after Nixon’s misuse of Keynesianism to bypass the unappetizing choice of “guns or butter” to fund his “guns and butter” fantasy with fiscal deficits.
Volcker’s new operating method concentrated on managing monetary aggregates to levels deemed appropriate for a given state of the economy, and let them dictate federal funds rate swings to be facilitated by Fed open market operations. For 1980, the inflation momentum meant a federal funds rate target within a range from 13-19% was needed in the context of double-digit inflation.
This new operating method was an exercise in “creative uncertainty” to shock the financial market out of its complacency about the Fed’s tradition of interest-rate stability and gradualism. The market had developed a habitual expectation that even if the Fed were forced by inflation trends to raise interest rates, it would not permit the market to be volatile, lest the political wrath from both the White House and the Congress should threaten its existence by abolishing it. Banks could continue to create money through lending as long as they could profitably manage the gradual rise in rates, foiling the Fed’s policy objective of slowing the growth of the money supply to contain inflation.

Volcker's new operating method reversed this traditional mandate of the Fed, which, as a central bank, was supposed to be responsible for maintaining orderly markets, meaning smooth, gradual changes in interest rates. The new operating method was an attempt to induce the threat of short-term pain to stabilize long-term inflation expectations. The reversal was necessary because the market had come to expect the Fed only gradually to raise interest rates to keep even an unbalanced economy from collapsing.

Targeting a steady money supply generates large sudden swings in short-term interest rates that produce unintended shifts in the real economy that would then feed back into new demand for money. The process has been described as the Fed acting as a monetarist dog chasing its own tail.
Unlike the Keynesian formula of deficit financing to reduce unemployment in a down cycle, the Fed’s easy-money approach since the Nixon administration had been to channel the funny money to the rich who needed it least, rather than to the poor who would immediately spend it to sustain aggregate demand to moderate the down phase of the business cycle. This supply-side easy-money approach led to an economy of permanent overcapacity, with idle plants unable to produce goods profitably for lack of consumer demand due to low wages. Say’s law, that supply creates its own demand, is inoperative unless there is full employment, which sound money deems undesirable. Supply-side theory is cooked by its own success requiring its own failure to bring about.
Greenspan’s Measured Pace Gradualism
Alan Greenspan, who succeeded Volcker at the Fed on August 11, 1987, re-adopted a measured-paced interest-rate policy to reverse back to the Fed’s tradition of gradualism. The trouble with a measured-paced interest-rate policy in a debt-driven economy of overcapacity is that the debt cancer is spreading faster than the gradual doses of medical radiation can handle. Yet fatality is a poor tradeoff for the avoidance of hair loss from radiation. Greenspan’s measured pace represented a lack of political courage to acknowledge that it is preferable by far for the finance sector to take a huge haircut preemptively than for the whole economy to collapse later. This lack of political courage e is still evident in 2008.
Moral hazard is increased unless risk-takers in the finance sector are made to bear the consequences of their actions, and not be allowed to pass the pain from excessive risk-taking on to the economy at large. Thus any government bailout with public money should be directed in saving the economy directly and not to save wayward institutions which aim to ensure their own undeserved survival by holding the economy hostage.  (Please see my September 14, 2005 AToL article: Greenspan, the Wizard of Bubbleland)
The High Cost of Job Creation
Senator Richard Shelby, the senior Republican member of the Senate Banking Committee said the Bush administration’s effort to avoid an imminent meltdown of the US financial system could end up costing taxpayers $1 trillion. Yet after spending a good part of that huge sum, the economy lost 2.5 million jobs in 2008 with 524,000 jobs lost in December alone. The Bush administration is handing over to the Obama administration a sick economy in need of intensive care, with 7.2% unemployment, above the 6% structural tolerance, with 11.1 million unemployed workers.  Goldman Sachs projects the unemployment rate to hit 9% by the end of 2009.
The Obama economic team has proposed an $800 billion stimulus package that promises to create 4 million new jobs in two years. That comes to $200,000 of stimulus spending to create one new job. Still, with 2.5 million jobs expected to be lost each year, Obama’s stimulus plan of creating 2 million new jobs each year still leaves 500,000 newly unemployed workers. To give jobs to today’s 11.1 million unemployed, Obama’s stimulus plan would need to be around $2.5 trillion, plus another $200 billion every year for new workers entering the economy to keep the nation fully employed. Common sense would suggest there’s got to be a better way. This is not an argument for nonintervention, but an argument against ineffective intervention that insists on rescuing people in financial distress by first rescuing the distressed institutions that put them there.
One of the reasons while the New Deal was less than effective in fighting unemployment was that Franklin D. Roosevelt was reluctant to implement direct relief programs. Keynes wrote Roosevelt in February of 1938 to criticize his program for insufficient relief spending.
On the other hand, the Obama campaign for the presidency reportedly spent $105,599,963 in the first two weeks of October 2008, which came to $293,000 an hour. So spending $200,000 to create one new job is not as outrageous as it sounds. As they say, it’s all relative.
The Federal Funds Rate Target
From its low of 1% set on June 25, 2003, the federal funds rate target was raised by the Fed to 5.25% on June 29, 2006, in 17 steps of 25 basis points each, . The Greenspan Fed had kept the rate at 1% for one whole year before raising it on June 24, 2004 to 1.25%. Greenspan raised the fed funds rate another 25 basis points to 4.50% on January 31, 2005, his last day in office. Ben Bernanke assumed office as Chairman of the Fed on February 1, 2006 and continued the upward path to raise the fed funds rate target by 25 basis points to 4.75% on March 28, to 5.00% on May 10, to 5.25% on June 29 and kept it there until September 18, 2007, some eight weeks after the credit market seized in July. The Bernanke Fed then began lowering the federal funds rate target on September 18, 2007 in 11 steps, with three steps cutting by 50 basis points and two steps cutting by 75 basis points, until December 16, 2008 when the rate was lowered to a range between 0% to 0.25%, an effective zero rate.
The Fed’s Unconventional Tool - Nationalization
The Fed has exhausted its interest rate ammunition since the fed funds rate cannot go below zero. From then on the Fed would have to use “unconventional” tools to rescue the financial market, such as nationalization by other names. The New York Fed on January 5, 2009 began buying mortgage-backed securities (MBS) guaranteed by Fannie, Freddie and Ginnie Mae as part of a $500 billion program that equals a ninth of the $4.5 trillion agency MBS market.
Already stunned by the Fed-arranged rescue of Bear Stearns by JP Morgan Chase on March 14, 2008 after only narrowly avoiding collapse, investors abruptly exited short-term markets after Lehman Brothers collapsed and filed for bankruptcy protection on September 15, because the government refused to take responsibility for losses on some of Lehman’s most troubled real-estate assets, something it agreed to do when JP Morgan Chase bought Bear Stearns to save it from a bankruptcy filing earlier in March.
While offering to help Wall Street organize another shotgun marriage for Lehman, both Fed Chairman Bernanke and Treasury Secretary, being sensitive to earlier criticism over the Bear Stearns rescue, declared publicly that they would not again put taxpayer money at risk simply to prevent a private institution such as Lehman from collapse. The message marked a major reversal in government strategy established in the Bear Stearns rescue. It now remained unclear if the government had adopted firm rules of the game to draw the firm line on intervention. It became clear to the market that the piecemeal, patchwork, case-by-case fire fighting approach of the Fed and the Treasury without an overall strategy would do little to stabilize market turmoil. The government has no overall plan for stopping the spreading fire storm with an effective strategic fire break. Instead, it appeared to be running around to put out fires in isolated institutions as they started to burn.
Paulson, supported by Bernanke, was sensitive to criticism that the Bush administration had already gone too far ideologically merely a few weeks before the presidential election in which Republicans, already hard pressed by a two unpopular and unending foreign wars, were also put on the defensive on the economic front, first by underwriting the takeover of Bear Stearns in March and by the far bigger bailout of Fannie Mae and Freddie Mac announced on July 13. Accusations of enlisting socialism to be the undertaker of market capitalism were becoming vocal from conservatives who claim that once the socialist genie is out of the bottle, it would be impossible to put it back. While that assertion is on target, the assertion that the US is falling into socialism is not. What the US is doing is enlisting state capitalism to save market capitalism.
The disclosure that Merrill Lynch, now owned by Bank of America, had suffered a $21.5 billion operating loss as the value of mortgage-backed assets plunged in the last three months of 2008 came as BofA secured a $138 billion bail-out from the US government.
Bof A finalized an $18.8 billion all-share takeover of Merrill in early January 2009, received a $20 billion capital infusion and a backstop on $118 billion of troubled assets. BofA told the government in December 2008 that it would not be able to close the deal without help. Shares in BofA, which reported a $2.4 billion loss in a quarter marred by Merrill’s disastrous performance, fell nearly 14%.
Citigroup underlined the depth of banks’ problems by reporting an $8.3 billion net loss, its fifth consecutive quarter of loss. The troubled financial group suffered nearly $28 billion in write-downs and loan loss provisions in Q4 2008 as the price of mortgage securities plummeted.  Citi’s loss for 2008 was more than $18 billion. The company confirmed its plan to isolate some $800 billion worth of unwanted assets and businesses into a non-core unit called Citi Holdings.  
At his January 13, 2009 London School of Economics Stamp Lecture: The Crisis and the Policy Response, Bernanke suggested measures of nationalization of the banking system while denying the characterization. Banks have transformed from being “too big to fail” to being “too big to rescue by non-nationalization means”. In the case of Citigroup, the continuing losses have so far become so big, with still more to come, that it approaches mathematically impossible for the Fed to inject enough capital into it without taking a majority stake, thus squeezing out or at least diluting existing shareholders. The new ground rules laid down by the incoming Obama economic team for the final half of the $700 billion bailout fund, known as Troubled Asset Relief Program (TARP), called for government control over bank operations such as dividend payments and executive compensation.
Some have misleadingly suggested that the government’s approach of nationalizing the banks harks back to Andrew Jackson’s closing of the Second Bank of the United States in 1841. But in fact the equivalent of Jackson’s move would be to close the Federal Reserve Ssytem.
The First Bank of the United States was founded by Treasury Secretary Alexander Hamilton in 1791 with a charter for 20 years to handle the financial needs and requirements of the central government of the newly formed United States. Its mission was to establish financial order, clarity and precedence in and of the newly formed United State, to establish domestic and foreign credit for the new nation and to resolve the chaotic currency left the Continental Congress immediately prior to and during the Revolutionary War.
The Bank proposal was support by Northern merchants but viewed with suspicions by Southern plantationers whose economy did not need a centralized bank. The major controversy centered around the Bank’s incorporation as a private institution with public powers. Secretary of State Thomas Jefferson argued that the Bank violated traditional property laws and that Hamilton’s proposal was against both the spirit and letter of the Constitution and its relevance to constitutionally authorized powers was weak. To this day, the Federal Reserve, established in 1913, having transformed its mission from a national bank to support the development of the nation to a central bank to preserve the value of money, continues to be a private institution owned by member banks with public power granted by Congress.
By the early 1830s, populist president Andrew Jackson had come to be thoroughly antagonistic to the Second Bank of the United States because of its fraud and corruption on behalf of special interests. Jackson, ordered an investigation on the Bank which established it “as an instrument of political corruption and a threat to American liberties” and “beyond question that this great and powerful institution had been actively engaged in attempting to influence the elections of the public officers by means of its money.” A replay of Jackson’s killing of the Second Bank of the United States would be Obama abolishing the Federal Reserves System.
The $300 billion aid package of Citigroup in November 2008 and the additional $150 billion for Bank of America on January 15, 2009 relating to losses by BofA acquisition Merrill Lynch are being presented publicly not as bank nationalization moves, but in a fest of accounting gymnastics, as insurance programs for toxic bank assets.
Reversing the Treasury’s previous approach of investing billions of taxpayer dollars only in “healthy” bank recapitalization against toxic assets, the Fed is now guaranteeing the banks’ non-performing liabilities which may well turn out to cost taxpaying much more money if such guarantees have to be covered by Fed insurance. Instead of merely bailing out healthy banks by investing taxpayer dollars in exchange for bank preferred shares which would receive regular dividend and include warrants that could benefit the government should bank stocks rise in price, but letting bank shareholders take part of the loss, the Fed now has committed itself to bailing out the entire credit system against losses, to the disadvantage of taxpayers. 
The Citigroup deal covered $300 billion in toxic assets, with Citigroup agreeing to absorb the first $29 billion in losses, the Treasury then absorbing up to $5 billion, the FDIC then absorbing up to $10 billion and finally the Federal Reserve lending Citigroup at low interest rates for the value of the remaining toxic assets. The Bernanke Fed is now proposing putting a bank’s impaired assets into a separate new “bad” bank to free the bank from the need to set aside more reserves for further losses. This would prevent the bank’s common shareholders from being wiped out by the government.

January 19, 2009

Next: No Exit for Emergency Nationalization