The Dangers Of The Next Fed Chairman

Contributed by Chriss Street. Newport Beach, CA.

Thomas M. Hoenig, Vice Chairman of the FDIC, former president of the Kansas City Fed, and former member of the Federal Open Market Committee, wrote an editorial today in the Washington Post complaining it is unfair that the huge too-big-to-fail banks have less scrutiny by investors because they receive government deposit insurance guarantees, borrow from the Federal Reserve at virtually no cost and have gained public confidence that when they get in financial trouble the taxpayers will bail them out through programs such as the 2008 Troubled Assets Relief Program.

It may seem strange that someone so powerful in the U.S. financial regulatory system would complain about the obvious flaws in the American banking scheme. But I believe the editorial is a warning that if Janet Yellen is chosen to replace Federal Reserve Chairman, Ben Bernanke, her strategy of igniting inflation to reduce unemployment will cause another banking crisis.

The Federal Reserve Bank of the United States is actually the third central bank of the United States; the first two went bankrupt. The Fed operates a national fractional-reserve banking scheme that allows member banks to retain cash funds equal to only a portion of the amount of their customers’ deposits as readily available liquidity reserves. The remainder of their customer-deposits can be used to fund loans to other customers. But each time a bank funds loans by depositing money into their borrowers bank account, the new deposit creates another opportunity leverage of the initial customer’s deposit with a new loan.

The lower the percentage of fractional-reserves required by a central bank, the greater the profit banks can realize from leveraging the same initial customer deposit into multiple loans. But this also creates huge risks that banks may operate at such high rates of leverage that small loan losses can wipe out the bank’s liquidity, creating a “run on the bank” as depositors rush to try to get their money out before the bank fails. The back of the U.S. dollar has the “All-Seeing Eye of God” on top of a pyramid, because fractional-reserve banking can be a dangerous pyramid scheme without bankers operating with the wisdom of Providence. In Cyprus, banks lacked this wisdom of God.

Janet Yellen currently serves as the Vice Chair of the Federal Reserve, has sterling academic credentials and served as Chair of the Council of Economic Advisers under Bill Clinton. Dr. Yellen is the leading contender to follow Bernanke, because she fully supports stimulus spending and leveraging the Fed’s balance sheet to reignite inflation as a strategy to revive the U.S. economy. In a January 2011 speech Yellen remarked:

“[L]et me reiterate that the program of asset purchases initiated by the Federal Open Market Committee in November is intended to support economic recovery from an exceptionally deep recession and to restore inflation to, but not above, levels that FOMC participants consider consistent with price stability. It will not be a panacea, but I believe it will be effective in fostering maximum employment and price stability.”

When Dr. Yellen spoke at the National Association for Business Economics Policy Conference last month she justified the Federal Reserve’s on-going policy of converting all its maturing short-term investments in Treasury bonds into long term maturities and buying $85 billion of Federal Agency guaranteed mortgage-backed securities as a strategy maximize employment. She justified this high risk tactic as necessary because the real unemployment rate, including discouraged workers and part-timers who want to work full-time, at 14.4% or 22 million workers remains higher at any time in the 24 years prior to the Great Recession that began in 2009. Although she acknowledged this policy has already pushed up energy, food, and commodity prices, she remained confident that the other elements of inflation will continue to run at or below 2% through mid-2015. These are code words for the Fed is willing to flood banks with cheap money to blow inflationary bubbles under real estate, stocks and bonds.

Dr. Yellen admits her policies are in complete contradiction to the Federal Reserve’s commitment to maintaining price stability, but she emphasizes that the current situation is very unique. Carmen Reinhart and Kenneth Rogoff analyzed the 224 historical banking crises for the last 800 years: “This Time Is Different: Eight Centuries of Financial Folly”. The authors demonstrate that leaders in each crisis underestimated the destructive force of combining leverage and some inflation to stimulate growth. Once the public fears their banks are unsafe, banking crisis becomes financial panic. Giving Janet Yellen the powers of the Federal Reserve may be dangerous proposition. Contributed by Chriss Street.

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