Auld Lang Syne—for the Sake of Old “Financial” Times

January 1, 2011by Hoy Grimm0

Happy New Year!

During a recent church Christmas party, a young man said he was hoping to get a new transmission for his truck. He explained that his transmission was malfunctioning, so he needed a new one in order for him to do his job. This request stayed with me.

Now that refrains of Robert Burns’ famous Auld Lang Syne poem have faded into the new year, our Federal Reserve members should stop to consider the difference between “old times” and our modern society.

Why can’t our country’s financial system learn from the past to avoid future mistakes?

Back in the 60’S and 70’s when you needed to borrow money, you went to your local bank. They calculated the interest rate on your loan based on the rate they had to pay depositors in the bank plus a profit on the loan. This simple relationship allowed the Federal Reserve an unadulterated path to affect economic activity through monetary policy. When the Fed increased their rates, depositors would earn more, and borrowers paid more and vice versa.   As the cost of borrowing money increased or decreased, the economy would respond in kind (with a modest delay in timing).

Flash forward to the 80’s and 90’s when Wall Street investment firms with ample prodding from Washington added several layers of complexity to our financial system. With the help of new government agencies like Fannie Mae and Freddie Mac, investment bankers developed new securities based on mortgages and just about every other loan that had collateral backing it. These new securities were called collateralized mortgage obligations or CMOs, and they were the precursor for the subprime mortgage market. Wall Street created a substantial market for these loans, and banks found it more profitable to originate the loan then sell it. Since the market set the rates and provided the cash, bankers didn’t have to worry about those factors. Washington took credit because their new programs were making mortgages more affordable, and homeownership was spreading rapidly.

Despite its successes, an unintended consequence developed from this new complexity, and we have to learn how to deal with it.  Now, it is more difficult for the Federal Reserve to impact economic activity with these added layers of financial middlemen.

Getting back to the young man’s transmission story I mentioned earlier, the Federal Reserve’s monetary transmission system is broken, and Santa didn’t bring them a new one. No longer can Bernanke and Co. expect a change in Fed funds to filter down to the local banks deposit rates or lending activity. They have tried everything they can think of to no avail, because it isn’t getting transmitted to the economy. They have pressed the gas pedal to the floor with near zero rates and Quantitative Easing but the wheels aren’t turning. The fear is that the economic transmission will unexpectedly kick into gear, and the economy will hurdle uncontrollably into the next financial crisis–inflation.   But, that is another story for a different day.

Hoy Grimm

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