The paper I am critiquing can be found here

Edited for formatting, grammar and spelling

This is my first R1. I have been lurking around this place for a while and I thought I’d put my economics knowledge to some use. Any constructive criticism is appreciated.

I am doing this because I saw /u/Vodkahaze bring up this paper in the Silver Thread and said he would not mind if someone beat him to it.

The paper is written by a guy named Tim Canova, the new darling of the Bernie Sanders wing of the Democratic party after Elizabeth Warren “sold out” by endorsing the presumptive nominee. He is currently challenging Debbie Wasserman-Schultz’s seat in the primary.

Without further ado, let us get into it.

The first couple of sentences of this paper are immediately suspect:

Throughout the past year, Federal Reserve chairman Ben Bernanke has led the choir in warning about the size of the federal deficit. In July, he endorsed extending the Bush tax cuts for the wealthiest households while suggesting spending cuts to offset the revenue loss.

The past year, with respect to this paper, was 2010. Bernanke was the Fed Chair at the time and it is rather unlikely that he would offer a full-throated endorsement of a fiscal policy decision given his role.

The footnote for this claim is this Bloomberg article. Here is what Bernanke said:

“In the short term I would believe that we ought to maintain a reasonable degree of fiscal support, stimulus for the economy,” Bernanke said yesterday under questioning from the House Financial Services Committee’s senior Republican. “There are many ways to do that. This is one way.”

As you can see, this is not a full throated endorsement of a “tax-cut for the wealthy” as Mr.Canova would have you believe. This is merely a statement that says that the economy would be helped by short-term fiscal support and these tax-cuts were merely one way out of many. He did not endorse anything except short-term fiscal support. Bernanke could not, in his capacity as the Fed Chair, endorse fiscal policy actions.

Moving on, the next suspect claim comes a few lines later:

Bernanke’s view may well be the consensus of both Washington and Wall Street. But it is also the polar opposite of the fiscal advice offered by Marriner Eccles, the Fed chairman in the 1930s and 1940s who called for larger deficits and increases in government spending programs to pull the country out of the Great Depression.

Bernanke argued for fiscal-support. The advice he gave was consistent with that of Marriner Eccles. Mr.Canova appears to be building upon his earlier misrepresentation.

The next few paragraphs of the paper are a paean to the “good old days” when America emerged the victor from the Second World War as the only major participant whose mainland hadn’t been devastated by the war. Mr.Canova writes:

During the past two years, the Federal Reserve has purchased more than a trillion dollars of mortgage-backed securities, the so-called toxic assets held by the Fed’s banking and hedge fund clientele. In contrast, during the 1940s the objective of the Fed’s open market operations was more transparent and socially neutral. It was not to bail out private financial interests, but rather to accommodate the federal government’s fiscal policy agenda.

There is a lot to parse here. I will start with the claim that the Fed has “Hedge Fund Clientele.” By law, the Federal Reserve can only lend to depository institutions, generally Banks (not of the investment variety) and S&Ls (not of the Saturday Night Live variety). To be sure, there are circumstances where the Federal Reserve can go beyond that.

It can do this by invoking Section 13(3) of the Federal Reserve Act. The last time it used these powers was to lend JP Morgan USD 29 billion to buy out Bear Stearns. The Fed took on USD 29 Billion worth of Bear Stearns’ liabilities while JP Morgan took on over USD 350 Billion. Admittedly, the Fed took on some of the more toxic stuff. Before this action, the last time that the section was invoked was during the depression. The Federal Reserve was infact paid back in full.

As Jamie Dimon himself noted in 2012 here:

Dimon was not made available for further comment, but during the Council event he made his doubts clear. He added that he had asked the Fed to take on more of Bear Stearns’s mortgage securities. “I thought, ‘If you hold these things, since you guys borrow at zero percent, you’d get all of your money back.’ They’ve gotten all of their money back and are going to make a multimillion profit,” Dimon said. “I should have negotiated that whatever the extra billions are, you’re going to give it back to me to pay for litigation costs.”

The Federal Reserve managed to sell off the MBS assets held under a holding company and was thus paid back in full with interest. This should put to bed the nonsense that the Fed has “Hedge-Fund Clientele.”

It could reasonably be argued that the Federal Reserve’s actions during the crisis of 2008-09 were entirely in keeping with the public interest. Smooth-Credit markets are key to the functioning of the economy. The objective of the Fed’s Open Market Operations (OMOs) are quite transparent. Traditionally, OMOs are used to maintain the Fed Funds rate at the announced level. In 1977, Congress, via the Federal Reserve Act, made its objectives for the fed quite clear. The famous “dual-mandate” was thus born.

The objective of the Federal Reserve is not fiscal accommodation. Mr.Canova argues it should be. To counter the argument that if the Fed expressly financed the deficit, inflation would eventually result, Mr.Canova harks for a return to the good old days of Wage and Price Controls:

Since the Federal Reserve could no longer ratchet up interest rates to preempt potential inflation during this pegged period, the federal government had to find new ways to keep prices stable. The administration turned to price controls, as well as bond sales to the public and highly progressive taxes to dampen consumer purchasing power.

I am tempted to launch into a harangue about the costs of using price controls as a policy to combat inflation. However, there is too much to do here. I will refer readers to this short article explaining the follies of such a policy. Most economists also disagree, or strongly disagree with Rent Controls, a classic form of price controls.

Mr.Canova himself goes on to admit that this policy failed during the Korean War because it failed to contain inflation:

But political support for the interest rate peg was eventually undermined after the war by the Truman administration’s failure to contain inflation.

It should be noted that the Dual Mandate was born in 1977, after the failure of Nixon’s price controls.

Mr.Canova also argues for capital-controls:

During the pegged period, this was largely prevented by a range of central bank restrictions on short-term capital flows, including prohibitions on the sale of Treasury debt abroad. Although today’s proposals for taxing speculative capital flows seem quite tame by comparison, they have nonetheless been rejected for more than a decade by both the Federal Reserve and Treasury.

Mr.Canova should be given points for consistency. In his R1 for Mr.Canova’s platform, /u/DracoX872 noted the same argument for “taxing speculation.” I refer you here to the same article on the Tobin Tax that he did. As noted, it reduces all trading, not just speculative trading.

Mr.Canova is also obsessed with “banker interests” that “control” the Fed’s policy. He writes:

Unfortunately, it is the banker interest that has skewed Federal Reserve policy, first in its lax regulatory oversight leading to the financial crisis, and since then in its response to the crisis.

At this point, I would like to point to Ben Bernanke’s recent book. He notes in Chapter 5: The Subprime Spark that:

CLEARLY, MANY OF US at the Fed, including me, underestimated the extent of the housing bubble and the risks it posed. That raises at least two important questions. First, what can be done to avoid a similar problem in the future? Improved monitoring of the financial system and stronger financial regulation are certainly part of the answer. A second question is even more difficult: Suppose we had done a better job of identifying the housing bubble in, say, 2003 or 2004? What, if anything, should we have done? In particular, should we have leaned against the housing boom with higher interest rates? I had argued in my first speech as a Fed governor that, in most circumstances, monetary policy is not the right tool for tackling asset bubbles. That still seems right to me.

Bernanke also notes in the same chapter that the Fed was not really responsible for regulating a lot of these entities. The lack of good oversight was not really the Fed’s fault but rather the result of a muddle of regulatory agencies created by the Congress’ ad-hoc approach to regulation:

The result was a muddle. For example, regulation of financial markets (such as the stock market and futures markets) is split between the SEC and the Commodity Futures Trading Commission, an agency created by Congress in 1974. The regulation of banks is dictated by the charter under which each bank operates. While banks chartered at the federal level, so-called national banks, are regulated by the OCC, banks chartered by state authorities are overseen by state regulators. State-chartered banks that choose to be members of the Federal Reserve System (called state member banks) are also supervised by the Federal Reserve, with the FDIC examining other state-chartered banks. And the Fed oversees bank holding companies—companies that own banks and possibly other types of financial firms—independent of whether the owned banks are state-chartered or nationally chartered. Before the crisis, still another agency, the Office of Thrift Supervision (OTS), regulated savings institutions and the companies that owned savings associations. And the National Credit Union Association oversees credit unions.

Institutions were able to change regulators by changing their charters, which created an incentive for regulators to be less strict so as not to lose their regulatory “clients”—and the exam fees they paid. For example, in March 2007, the subprime lender Countrywide Financial, by switching the charter of the depository institution it owned, replaced the Fed as its principal supervisor with the OTS, after the OTS promised to be “less antagonistic.”

Bernanke notes that only 20% of Sub-prime loans in 2005 were issued by institutions under Federal supervision. The rest were made by non-bank subsidiaries, independent non-depository lending firms and a host of other entities under state supervision, which tended to be abysmal.

You can blame the regulatory framework, state regulators, congress or whoever you want for the lack of good oversight, but you cannot easily blame the Fed for it. The one thing you can criticise the Fed for is perhaps not fully utilising its broad-based power under HOEPA (The Home Ownership and Equity Protection Act) to ban “unfair or deceptive” lending practices which would apply to all lenders.

The Fed did infact use these powers after the problems with the subprime markets were fully realised, but it was too late by then. The justification given by Bernanke in Chapter 5 of his book with regards to the failure to use HOEPA powers more aggressively earlier on is:

Why the support for subprime lending? Historically, lenders had often denied low-income and minority borrowers access to credit. Some lenders redlined whole neighborhoods, automatically turning down mortgage applications from anyone who lived in them…Subprime lending was widely seen as the antidote to redlining—and thus a key part of the democratization of credit. It helped push the U.S. homeownership rate to a record 69 percent by 2005, up from 64 percent a decade earlier. Many of the new homeowners were African Americans and Hispanics, and people with low incomes.

In other words, the Fed tolerated subprime lending not because “the banksters had corrupted it” as Mr.Canova would have you believe, but because of a genuine belief that subprime credit could help borrowers with poor credit ratings achieve a key part of the “American Dream,” homeownership. In hindsight, its tolerance of many of those practices was a mistake, but one cannot (and should not) ascribe corrupt and malevolent intentions without hard evidence.

Mr.Canova concludes his, thankfully short, paper with this line:

Instead, today’s new normal is a central bank captured by private financial interests and pursuing an elite agenda of deregulation, fiscal austerity, and bailouts and bonuses for bankers.

Mr.Canova repeats the claim that the Federal Reserve is pursuing “fiscal austerity” and an “elite agenda of deregulation.” He even goes as far as to claim that the Federal Reserve wants to give “bonuses to bankers.” I can only assume that Mr.Canova lives in some sort of a fantasy world in which everyone is out to screw Joe-the-taxpayer (or, if you prefer, Joe The Plumber). His prescriptions of price controls and money-financed deficits have been tried with great “success” in Venezuela.

To be sure, I am sympathetic to some arguments made by “Helicopter-money” proponents but even they are not arguing for money-financed deficits as a permanent state of affairs as Mr.Canova wants. Through his assertions that low interest rates fuel growth, Mr.Canova displays a striking ignorance about the concepts of the natural-interest rate, inflation targeting, the NAIRU to name a few.

Mr.Canova, in his nostalgia for the “post-war US” as utopia and the export surpluses that followed, fails to note that after the war, the US was the only industrial power left intact. Britain, France, Japan and the Soviet Union had been ravaged by the war. The Soviet Union in particular suffered tremendously from the loss of a substantial portion of an entire generation and a large portion of its industrial and agricultural base.

Generally, I am not a man of (so) many words, but this paper by Tim Canova compelled me to write this. The ignorance displayed in this paper is striking.