Fed monetary policy – building a modern Tower of Babel

The story of the Tower of Babel is one of the classic legends of humanity overreaching itself.

Recorded in the Book of Genesis, the Babel story tells of a time when all the people on Earth lived united and shared a common language. They gathered in modern day Baghdad (a.k.a. Babylon) to build a great city and tower to celebrate their superiority and advanced learning. God, however, took a different view of their achievements. He came down from the tower, scattered the people across the face of the earth and introduced different languages, to confound future attempts at such hubris. Some non-Biblical versions of this story have God destroying the Tower of Babel as a punishment.

Whether or not you believe the story of the Tower of Babel, ancient insight into the human condition recognised the dangers our species can pose to itself when it becomes too assured in its ability to control all that it is surrounded by.

Sadly this lesson appears lost on modern central planners.

A few weeks ago I saw this item on Bloomberg. This is certainly not the most exciting link I will ever post, but there is a warning in it for all of us.

In summary, the article describes one of the Fed’s latest plans to manage its way out of the crisis. In October’s issue of SpreadBet Magazine, I wrote about the inflationary threat posed by the excess bank reserves held at the various banks of the Federal Reserve. These reserves have been created by the Fed’s QE programmes. The presence of such incredible excess reserves is deeply troubling because if banks start to lend aggressively against them (and there is no reason to believe they won’t if given the slightest opportunity to) then the supply of money in circulation could rapidly spiral out of control.

However, the excess reserves are only part of the problem caused by QE. In purchasing all the Treasuries it can lay its hands on, the Fed has also created a severe shortage of high grade collateral. This makes it very difficult for non-banking financial institutions to borrow and is causing an unanticipated liquidity problem all of its own.

This really is the stuff of policy nightmares.

So what has the response of the Fed been to this obvious calamity waiting to happen?

Start reducing its bond purchasing programme?

Ha! Not a bit of it!

No, in their infinite wisdom the monetary planners have contrived to create the new tool described in the Bloomberg piece. Helpfully called a “fixed-rate, full allotment overnight repo facility” this “risk free device” is meant to address the shortage of quality collateral caused by the Fed purchasing programme. It allows the non-banking financial institutions access to a similar facility as provided to the commercial banks through the excess reserves depository.

If you’re still awake (and better yet are still reading this blog!) forget about the technicalities of this move by the Fed and consider its context. The Fed believes it can still manage its way out of the crisis. Their approach has been to pile on unsustainable and complicated policy measure onto unsustainable and complicated policy measure in response to each unanticipated set of problems they create. There is no reason to believe they will pursue any other course.

The problem with unsustainable and complicated policy measures is that they can never work in the long run. They are set up to fail. Market forces will eventually sweep away all unsound attempts at manipulation, as they always do. Our current economic model is broken and has been for a long time. However, our policy makers have been unable or unwilling to accept this. In their desperate attempts to shore up the failed system they have sought to prove we can live in a world, which does not suffer the consequences of profligate spending. Just like the ancient builders of Babel these people were so supremely confident in their talents they ignored the obvious dangers of overreaching themselves.

So for the time being we can expect more bond purchasing and more measures like the “fixed-rate, full allotment overnight repo facility” until our modern monetary tower of Babel is brought down around our ears.