Happy New Year from Rosie

by Roy C. Smith

Yes, it has been an ugly year.

We’ve had Syria, terrorism, the refugees, a collapse in oil prices, a European sovereign debt crisis, trouble with China and Russia, and world economic growth slumping towards a pathetic 3%. And we have had Trump and the Republican wannabes that make Hillary look good, and a lot of other stuff that has taken the winds of confidence out of our sails.

Unemployment is down to the 5% level, but only 63% of the workforce has jobs, the lowest percentage since 1978.

US stocks are likely to end the year in the red for the first time since 2008, but investors are nervous about rising interest rates without seeing much to look forward to in the general economy.

So, I asked my old friend Rosie Scenario out for a holiday drink, to see if she could cheer me up.

“You’re too gloomy,” she said.

It is true that the US economy has had a rough fifteen years, with two financial crises, a Great Recession and a war in the Middle East that has cost $4-$6 trillion and still isn’t over.

But, she added, after a prolonged period of slow economic growth that has averaged barely 2% per year, things are settling down for a long-term recovery.

The Fed has decided that after eight years the economy is strong enough to leave to its own devices, so it has ceased its price-distorting QE interventions, and allowed rates to rise a little, at least symbolically. Both regulators and litigators have hammered the banks, but corporations have been able to get what they needed from a record level of new bond issues, and consumers and small business are getting a boost from “peer-to-peer” lending, “fintech” and from private equity funds.

The traditional economic “factors of production” – wages, resources, capital and enterprise – still at low costs, are ready for another round of expansion. Real estate activity is up about 10%, consumers have cleaned up their balance sheets and are active again. US GDP for 2016 is expected to be about 2.5%; not great but better than it has been, and building up momentum for a push in the right direction.

Rosie also sees the international situation also looks better than it did.

It has been bleak, she said, but the worst is over. The EU and the euro looked like it might be shaken apart by its sovereign debt crisis, but Angela Merkel and the ECB showed they had the clear head and courage to commit the resources needed to settle things down. The hodge-podge economic union of 28 states, with a common currency used by 19 of them, has survived its first serious existential crisis and is stronger for the experience.

A bigger set of problems now exists in the BRIC countries that are also facing existential issues. Brazil has been affected by collapsing commodity prices and high inflation, but its main problem, like Argentina’s, is political, and can be turned around by a new government.

Russia’s GDP will be down 3.6% this year, mainly due to oil prices, but Putin’s machismo behavior that drew sanctions over his Ukrainian actions has added to his difficulties, and sent him a message – his fifteen years of domination of Russian politics has been enabled by a robust growth in per capital GDP, but because of the recession and the collapse of the ruble, GDP per capita (in terms of current prices) will be 40% less in 2015 than in 2013.

Putin knows that strong, authoritarian leaders in Kiev, Cairo and Tripoli have been brought down by public protests, and seems to realize now that further confrontations with the US and the EU will only make his economic problems worse. After all Europe is Russia’s biggest customer for its oil and gas, and increasingly there are alternative sources of supply available to it. All in all, Putin is likely to end up more helpful than we expected in Syria and Iran, and start to make nice again to get back into the good graces of the EU. Maybe the UN’s agreement to secure a cease-fire in Syria, in which Russia played an important part, is an example. 

China, too, faces big issues in the next few years – it has to be able to deliver economic growth sufficient to satisfy the billion or so Chinese who are not yet among the middle class but aspire to be there. Growth has fallen from 12% in 2010 to 7% in 2015, with government expectations of 6.5% in 2016 (and others looking for less). Efforts to confront falling growth rates resulted in a stock market bubble that burst last summer. Serious government efforts to stabilize markets were not very successful, showing the limits to its power.

Indeed, China’s growing influence in the world has been a result of its extraordinary growth over the last thirty years. A slowdown in growth rates to a more normal level brings many challenges to the Chinese government -- domestically to avoid pressures for the level of political freedom that rival Taiwan has achieved; in South East Asia, where Chinese bellicosity has been fueled by its rising economic power; and in the broader world where China has been accepted as a superpower, but without showing it has the capacity to remain one.  It is hard to see how China’s Communist Party can remain in power without a transition to a more open and democratic state in the future. Slowing growth rates may accelerate this process, which would be good for China, its neighbors and trading partners.

Terrorism is still a big issue, Rosie says, but nowhere near as big as we (and our political candidates) make it out to be. Radical Islam has been most dangerous to other Muslims in the Middle East. It has been less dangerous in Europe, but of course its profile there now is very high (and likely to get the attention it needs). In the US since 9-11, terrorism has been less dangerous than school shootings; so far consisting only of radicalized individuals or small groups operating on their own.

In the US and the EU, terrorism is largely a police issue and the more incidents there are, the more cooperative police become with each other in developing their abilities to prevent attacks. In the Middle East, military force will be needed to contend with ISIS, but it will have to be supplied by Middle Easterners.

Finally, Rosie thinks our wild and awkward political process is likely to produce the best of all possible results.

The drama of primary elections is necessary in a country of 330 million people, who have different things to say about issues and want to vent about them. Sure, candidates say and do whatever they can to attract votes, but in the end, it winnows down to two (or possibly three) viable candidates, who stimulate the economy with billions of dollars of spending on advertising and other expenses. After the election, we either have a “divided government,” i.e., one in which the Presidency and the Congress are not controlled by the same party, or we don’t. If we don’t, then the party in control can enact whatever platform it can get by a 60-vote hurdle in the Senate. That condition doesn't occur very often, and is unlikely this time.

If it doesn't happen, the country will muddle along somehow, with minimal changes in major political or economic positions. When no one gets what he or she wants, not much actually happens. We can live with that, especially if it keeps stuff we really don’t like from being enacted.

The President, of course, can start wars or other military engagements that are hard to get out of.  After a year or more of listening to the candidates, we will know which are more warlike than others. Whatever it thinks of any candidate at any particular time, however, the American electorate has very little enthusiasm for wars in the Middle East or anywhere else.

Meanwhile, after a tumultuous year, the new Speaker, Paul Ryan, managed to get the House Republicans (and the others) to pass a $1 trillion government-spending bill, rather than shut down the government.

So, all in all, Rosie says, things are also messy, but the US will continue to be the strongest economy in the free world, positioning itself through market actions for a return to higher growth rates. The rest of the world is sorting itself out for the best, and our politics aren’t as bad as they look.   

Well, Rosie has always been able to cheer me up (at least for a few weeks), and maybe she will cheer you up too.

Happy New Year from us both.

Did the Fed Really Curb its Emergency Lending Powers?

By Roy C. Smith

Last week the Federal Reserve announced that it would adopt restrictions imposed by Dodd Frank to limit its emergency lending powers under Section 13(3) of the Federal Reserve Act, but it now has even more room to act in the next crisis.

Section 13(3) provisions allow the Fed to lend funds to any entity outside the banking system if circumstances are deemed to be “urgent and exigent.”

In 2010, a Congress angered by federal “bailouts” of banks and other financial institutions passed the Dodd Frank Act, including in it an amendment to the Federal Reserve Act of 1913 to limit 13(3) programs that enabled loans to Bear Stearns and AIG during the financial crisis. The amendment requires such programs be limited to those with a “broad base” of eligibility (now interpreted to mean involving at least five different participants) that are also approved by the US Treasury Secretary.  The idea is to limit 13(3) to only being able to provide liquidity to multiple, solvent financial institutions in times of crisis.

It took the Fed five years to come up with these new rules to implement the amendment, despite its being spurred by Senator Elizabeth Warren, Representative David Vitter and others in Congress from both parties who seek to limit the Fed’s powers.

The Fed’s action, according to Congressman Vitter, “is the first real acknowledgment from the Fed that it needed to do more to curtail its own bailout authority.” 

The new rules will prevent the Fed from lending money to prop up a single failing firm, said Fed Chairman Janet Yellen. Both the Bear Stearns and AIG rescue operations were considered crucial to the 2008 effort to stabilize the financial system by both Ben Bernanke, then Fed Chairman, and Hank Paulson, Treasury Secretary at the time.

But a lot has changed since 2008 that makes the one-off emergency lending powers of Section 13(3) less important to maintaining stability.

First, there are no longer any potential too-big-to-fail financial institutions that are outside the orbit of regulatory control established by Dodd Frank for “systemically important” financial firms.

Of the five large, independent US investment banks existing in September 2008, only two have survived and both are now bank holding companies regulated by the Fed. And, four of the largest other US nonbank financial firms have been designated as systemically important by the Dodd Frank authorized Financial Stability Oversight Council, thus requiring them to be regulated by the Fed and subject to enhanced capital controls, intervention and other constraints that should reduce systemic risk, and thus the need for a future 13(3) loan.

Other large nonbanks (e.g., Fidelity, BlackRock, and some hedge fund groups) have successfully argued that as managers of other people’s money through hundreds of different investment vehicles, they should not be considered as a single entity whose failure would have systemic effects.  So far the Fed has bought (or has been forced by political pressures to buy) into these arguments, so presumably it would have no reason to assist them in a crisis.

So, the lost power to intervene in individual cases of systemic risk is now a power no longer needed. However, since September 2008, other powers available to the Fed to avert and manage crises have been greatly increased.

Dodd Frank conferred additional authority and influence on managing systemic risk to the Fed. It now conducts annual qualitative stress tests on large banks and can deny those who fail the ability to pay dividends or do other things. The Fed also sets capital adequacy levels, leverage limits, and the requirement for “total loss absorbing capital” (in which bond holders participate in losses). It monitors banks closely and has the power, and apparently the will, to force them to remain in safe waters.

The banks have complied with the Fed’s post-crisis requirements, so are safer. But this has meant that much of the financial risk the banks used to carry on their balance sheets has migrated into capital markets and the nonbank sector.

This sector is a multitude of nonsystematic firms that operate in financial markets, but it is not directly subject to Fed regulatory control.

But, don’t worry, the Fed has found important ways to assert de-facto control over the nonbanking sector too.

This is done through market intervention programs, in which the Fed, through asset purchases, can inject large amounts of capital to preserve market functionality and alleviate liquidity panics. After September 2008, the Fed began an unprecedented effort to stabilize financial markets across the board, ultimately expanding its balance sheet to $4 trillion from less than $1 trillion.

Indeed, as early as March 2008, after Bear Stearns was rescued by JP Morgan (with Fed assistance), the two-dozen or so authorized market makers in Treasury securities were struggling to maintain their funding arrangements. As a result, the Fed established a temporary Primary Dealers Credit Facility and Term Securities Lending Facility to assist them. This was the first time in the history of the Fed that it had provided funding for nonbank broker-dealers in its efforts to maintain market stability.

These programs usually are ended after stability returns, but the Fed seems comfortable in starting them up whenever they seem to be needed.

Today, as a result of capital and other constraints, many banks have reduced their exposure to the repo markets, and nonbank money market funds and other participants have increased theirs. Consequently, in 2013 the Fed offered a $300 billion Reverse Repo Facility to assist dealers in this important market.

If a problem in the nonbank sector should require it, the Fed can intervene more precisely by declaring a 13(3) lending condition after designating five or more intended recipients in order to stabilize their broad based ability to roll over maturing liabilities of their own or of funds they manage. This would be within the scope of the new rules, even if only one firm (targeted for assistance) actually used the facility.

Though there are many in Congress who would like to clip the wings of the Fed further, the Fed is more powerful than ever. "We're perfectly happy now that there are alternative ways to deal with a failing firm,” said Ben Bernanke recently, “the Fed doesn't have to intervene in [individual cases] the way we did in 2008."

And, he might have added, what we have learned from our various intervention efforts has increased our confidence that when another crisis comes we will have the tools needed to meet it.