The Fed Justifies the Means

 | Dec 01, 2011 | 2:30 PM EST
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On Wednesday, Federal Reserve Chairman Ben Bernanke supplied European banks with emergency access to U.S. dollars through swap lines, an exchange of currency between banks. There are two principal financial costs associated with this structure: one direct, the other indirect.

The direct cost of these swap lines is a nominal fee charged to the European bank for swapping euros for dollars over a specified period. The indirect cost is the effect the swap lines have on the broader capital structure of both regions. These costs are borne through higher rates for a variety of loans in the U.S. There are multiple issues and implications for these actions.

First, the swap lines reduce the immediate risk of contagion in Europe, thus reducing the chance of it cascading into U.S. markets. As a result, the flight into the safety of U.S. Treasuries reverses. As capital leaves Treasuries, yields rise. As this capital goes into U.S. equities, stocks rise. Sounds good so far, right?

But investor capital that fled European sovereign debt for U.S. Treasuries also reversed. Simultaneously, Treasury yields rose and yields in Europe fell. As of Thursday afternoon, U.S. and German yields are again converging at about 10 basis points apart as U.S. yields rise and German yields decline.

Second, this process is not a zero-sum game. The credit supplied by the Fed to Europe needs to be paid for. That payment comes in the form of higher costs of debt capital to U.S. citizens in the form of loan rates. This is not an unintended consequence.

Basically, U.S. citizens have been forced to subsidize European citizens. In the past 24 to 48 hours, residential mortgage rates in the U.S. have increased at par by about 25 basis points, or a quarter of a percent. This is a direct result of the swap lines being made available to European banks. For every $100,000 of a mortgage loan, this equals a payment increase of about $15.38 monthly. That is a 3% higher payment than what was available Monday morning.

Finally, although the immediate consequence of these actions does prevent contagion in Europe, it is also an immediate drag on the U.S. economy. Rising loan rates in the U.S. preclude consumers from consuming. A 3% increase in mortgage and consumer loan rates means that 3% fewer homebuyers and refinancer's can access credit. Fewer homes, autos, televisions, sofas, and the like will be sold.

That these actions were taken while the U.S. housing market is still contracting and while European leadership has steadfastly refused to use its own monetary authority or other domestic access to credit and capital is appalling. The defense for having taken such action is obviously that had they not, the financial fallout may have been worse.

But this is a slippery slope, as all actors can create and even cause themselves to believe that any action taken on anything is warranted by such logic. Niccolo Machiavelli expressed it succinctly in The Prince: The end justifies the means.

The founding fathers of the U.S. were very much aware of this human dynamic and moved to thwart it with a system of checks and balances within the structure of the federal government. The Federal Reserve Act and its amendments over time have been structured with two principles in mind: one, that monetary policy will be managed for the benefit of the sovereign, and two, that the policy will be reactive. Neither is defined explicitly in the Act. Ultimately, it relies on the people in charge of monetary policy to define them and act accordingly.

As world financial markets become increasingly intertwined, the Fed's actions have become more proactive and global in scope. The Fed has strayed from its original purpose of managing domestic monetary policy for the exclusive benefit of the U.S. sovereign and not to preempt actions in the private sector.

The result is that the Fed now manages monetary policy for the exclusive benefit of its member banks and their shareholders at the expense of U.S. citizens, taxpayers, consumers and the overall U.S. economy.

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