Central Banking’s Hogwarts Syndrome

Central Banking’s Hogwarts Syndrome
December 28, 2012

Central banks—the US Federal Reserve is one—come with the mystique of Oz. While the Fed fiercely denies that it is powerful enough to cure recessions with a click of the heels, there are those who believe it's true.

If, however, you look behind the velvet curtains and columned lobbies, you will find good men but bad wizards. In mid-December, the bank’s Open Market committee pledged $85 billion a month until unemployment drops below 6.5 percent. Such policies are a long way from Kansas and prudent finance.

Around the world central banks have become convenient instruments of public and private bailouts, accommodating lenders when citizens reject tax hikes and governments need a few trillion to bail out Greece or prop up the housing market. It helps that they are shrouded in mystery and give the impression they hold their meetings at Hogwarts, perhaps with Albus Dumbledore presiding.

Fed’s Leveraged 42:1

The reason the Federal Reserve, like many of its European counterparts, looks like a failing credit union is that its balance sheet numbers don’t add up. On November 12, 2012, the Fed showed assets of $2.9 trillion against equity of $69 billion. In other words, the bank’s leverage is 42 times its capital. At its peak, Lehman was geared 36 times; a prudent limit might be eight times.

Before 2008, the Fed’s balance sheet was less than $900 billion, and assets were short-term interbank loans and Treasury securities. Now the balance sheet is $2.9 trillion, and mixed in with the gold at Fort Knox is $886 billion in mortgage-backed securities, making the Federal Reserve the nation’s Savings & Loan.

Banking On Non-Performing Assets

Many central banks have vaults that are crammed with junk bonds, subprime exposure, unwound credit default swaps, out-of-the-money options, and sovereign debt issued by governments that have long since vanished.

Take the European Central Bank. After the 2008 crisis it encouraged banking groups to load up on sovereign credits, hoping this would prevent further collapse and stimulate local economies.

The same practice of offloading substandard loans to the Federal Reserve governed the stimulus programs of the Bush and Obama administrations, which “stimulated” the economy by moving bad loans off Wall Street and into the Fed.

Another definition for quantitative easing (QE3 in its last rendition) might be “government payday loans.” Together, the central banks of the United States and Europe are holding more than $6 trillion as “assets” on their balance sheets, which if they were accurate might read: “Advances against street demonstrations.”

Central Banks Replace Market Makers

In their modern incarnation, central banks replaced market makers and robber barons who got tired of business cycles and having to bail out commercial banks and stock jobbers who had hit the skids.

In the US, the panic of 1907 (which J.P. Morgan mitigated, although to his own ends) pushed the country to later create the Federal Reserve System that, in the future, would provide liquidity during periods of recession; its current dual mandate is to fight inflation and maximize employment.

The presence of strong central banks in North America and Europe was supposed to mean the end of sharp volatility, though it has been convincingly argued the Federal Reserve has made little difference in the many recessions since 1913, notably in the Great Depression, when it restricted the money supply.

In his history of central banking, Lords of Finance: The Bankers Who Broke the World, Liaquat Ahamed makes the point that the leading central banks in and after World War I—those of England, France, the United States, and Germany—routinely made bad decisions when it came to issuing currency, propping up the money supply, or regulating the amounts of credit and bonds in various banking systems.

Mortgaged to Political Classes

The biggest problem with central banks is they are mortgaged to the political classes and have become the funding arm of various get-elected-quick schemes. The Fed’s evolution into a casino cashier window started sometime after 1996 and continued into the administration of George W. Bush, when the equity in American homes became just another chip for Wall Street croupiers to sweep into their aprons.

Both Congress and the Fed made it easy for banks to grant mortgages based on little, if any, collateral (remember “liar loans?” I bet Alan Greenspan does). They also looked the other way when the administration decided to pay for its wars and tax cuts by using home equity to keep consumer markets irrationally exuberant. Why? Prosperity has a lot to do with reelecting incumbents, and it was those officials who regulated the regulators. Furthermore, member commercial banks, not the US government, own the Fed, even if the US President appoints the chairman.

Bankers Growing Dubious

Central bankers are finding it harder to agree their temples of finance are ministries of magic. A few, like the German and Swiss central banks, dread inflation and take a dim view of speculators. Those attitudes find little sympathy in Italy, Spain, or Greece—should we add California?—which need to kite checks to pay state pensions.

Alas, not even the Fed has deep enough pockets to fund trillion dollar annual deficits. Nor should anyone think the US government is a likely candidate to bail out the Fed, as right now it is the Fed that is bailing out America.

Matthew Stevenson (zklapper@poptwist.com) is a contributing editor of Harper's Magazine. Used with permission of NewGeography.com.