Over at the Agenda, Reihan Salam writes that Andy Kessler’s argument on why the Fed should pursue an alternative to its quantitative-easing program “seems sensible.” But Reihan still would like to hear other suggestions, “as the prospects of having taxpayers take on vast quantities of debt” — as Reihan properly describes Kessler’s proposal — “seems highly unappetizing.”
There is an alternative, but it’s a hard one, and it involves revisiting problems that Congress and President Obama have incorrectly declared solved.
Kessler, in the original piece that Reihan cites, is right about the Federal Reserve’s motive in its new round of printing money to purchase longer-term government debt. In pumping more dollars into the economy, the Fed hopes to inflate the real-estate market. The Fed would thereby head off a potential panic over the prospect of fresh 12-figure losses at large financial firms, which still hold lots of overvalued property-related debt.
Truthfully, one can sympathize with the Fed. It must be tempting to make one last-gasp attempt to avoid chopping through the Gordian knot of real-estate-related structured finance that binds up the economy even as it cocoons banks’ balance sheets from the real world.
But, as Kessler notes, asset re-inflation is unlikely to work.
Kessler, however, is wrong on his solution. He says that the alternative to QE2 is for the Fed to “detoxify and recapitalize the big banks,” using its new authority under the Dodd-Frank law to shield short-term lenders. Kessler says nothing about the fate of long-term bondholders or derivatives counterparties.
Any revival of the government’s 2008 strategy — taking extraordinary measures to protect creditors to troubled financial institutions — is unlikely to work any better now than it did the first time. The “too-big-to-fail financial industry” would continue to borrow money on unfair terms, thanks to the government’s permanent support of its debt. This institutionalized perversion of free markets sets up an unhealthy recovery and guarantees a replay of the past quarter century’s worth of financial crises.
The Fed can do something else. It should use its authority as a regulator to require financial institutions to value their assets properly on their own. Proper valuation for housing-related assets, for example, would include completing foreclosures in a timely, consistent, and legal fashion. In cases where servicers cannot complete foreclosures, it would mean revaluing principal to take loans out of a process that does not apply.
If financial institutions cannot withstand the proper valuation of their assets and the legal and contractual claims that would accompany this necessary remedy, so be it. Let shareholders, bondholders, derivatives counterparties, and other creditors take their losses, as warranted, according to their place in the capital structure.
The problem is such a solution likely would expose the four-month-old Dodd-Frank financial-regulatory law as a failure. Despite politicians’ assurances, the law has not created an orderly system for financial-firm failures.
If exposing Dodd-Frank in this manner, though, were to spur yet another panic, the Fed would have done the country a service in demonstrating that the law has not created what the nation needs: a way for markets to discipline financial firms without taking down the economy in the process.
Better to learn this lesson now than five years from now.
— Nicole Gelinas is a contributing editor to the Manhattan Institute’s City Journal and a senior adviser to E21.