From the July 1, 2008 Weekly Standard online
July 1, 2008
by Irwin Stelzer
Last week the Federal Reserve Board's monetary policy committee (technically, the Federal Open Market Committee, or FOMC) decided to leave interest rates as they are. And thereby hangs a tale of oil, our chief bond salesman, the White House, and the Fed Family. What follows is a combination of hard fact and my own surmise, mixed together so as to shield highly placed sources.
The "Fed family" is not as shady as a Mafia family, but far more powerful. Its members include Chairman Ben Bernanke and the six other members of the Board of Governors, appointed by the president; the presidents of the 12 regional Fed banks, five of whom serve on the FOMC; and several influential alumni who are frequently consulted by Bernanke and the White House, and whose public utterances Bernanke cannot ignore.
In times like these, when recession looms, inflationary pressures are rising, and many banks are, er, teeter-tottering, many of the Family members weigh the several dangers differently. Some worry about rising employment, and want to keep interest rates low; some worry more about inflation, and want to raise rates; others worry about the health--or lack of it--of the banks, and favor the sort of open-handed policy that Bernanke has adopted to provide liquidity to the banks; still others worry that bank bail-outs will create moral hazard and produce even more reckless lending behaviour. Gone are the good old days when benign economic conditions led to virtual unanimity of views.
So far, so obvious. But two things are not so obvious. The first is the intensity of the battle within the Fed Family. That has an advantage: Bernanke benefits from a wide range of views, which he says he welcomes. The board of governors generally worries most about the soundness of the banking system. The presidents of the regional banks, selected by local businessmen and bankers, generally worry more about inflation than anything else, which is why the presidents of the Fed regional banks in St. Louis, Dallas, Kansas City, Boston and St. Louis have opposed recent rate cuts. The members of the FOMC worry about everything. And the alumni sit on the sidelines, sniping or supporting the chairman, depending on their view of each of his actions. Not a bad system, messy though it is.
Enter Hank Paulson, the Saudis, and the White House. Someone has to find customers for the billions in Treasury IOUs that result from our on-going federal budget deficits. That's Paulson's job, making him the nation's number one bond salesman. The Saudis are among his most important customers. But the decline in the value of the dollar is steadily reducing the value of the dollar-denominated bonds that they hold. So Paulson decided to go to Riyadh late in May to soothe some ruffled royal feathers. Reliable sources say that the Saudis "hinted, as is their style" that if the United States wants more oil, and if the United States wants the Saudis to continue pegging their currency, the riyal, to the dollar, America should do something to shore up the dollar.
Paulson brought that message back, got clearance from the White House, and issued a statement that America intends to stabilize the dollar. As the Left is wont to say, it is no coincidence that the Saudis announced several increases in oil production. But the story doesn't end there.
The threat of an increase in interest rates upped the downward pressure on bank shares, as it made it more expensive for them to raise the new capital they desperately need. Bank shares plummeted. The members of the Fed family who worry most about the stability of the banking system saw meltdown in America's future, and decided to do something to help the banks even though some of the alumni were already mightily annoyed at the Fed's solicitude for banks that had lent recklessly.
Most vociferous has been William Poole, until recently head of the St. Louis Federal Reserve Bank and a member of the Fed's interest-rate setting committee. Dr. Poole has called the Bernanke-Paulson decision to take some of the banks' diciest loans onto its own balance sheet "appalling"; former senior staff member Vincent Reinhart called it "the worst mistake in a generation" according to the Washington Post. That can't be the point of view of Timothy Geithner, president of the New York Fed. Geithner sees what is going on in financial markets up close, and backed the decision to prevent the bankruptcy of Bear Sterns, which decision he was called from relative obscurity to defend before congressional committees. Which all observers, even those who think the Fed should have let Bear go under, agree he did rather well.
So here we are. Paulson, with the backing of President Bush, pacified the Saudis by promising to support the dollar, which means higher interest rates that threaten already-shaky banks. But the Fed has to worry about our banks as well as Saudi sensibilities. So in last week's statement it refused to go as far as the Treasury would have wished when it indicated that it is worried about inflation, but "expects inflation to moderate later this year and next year." No rate increases needed unless inflation accelerates.
That puts it squarely up to Paulson. He promised a stronger dollar in return for a bit more oil, mostly of the sour, heavy sort for which there is no available refining capacity. But the interest rate rises that would have enabled him to keep his promise were simply too threatening to the stability of the financial system. He does, however, have the power to intervene directly in currency markets, and start buying dollars in an attempt, probably futile, to prevent a further drop in the value of the greenback. Or he can try to persuade his royal customers, who kept their end of the bargain, that the currency traders' fear that he just might intervene is enough to strengthen the dollar.
This is the stuff of which good novels are made. But it is not fiction. The Saudis have now extended their influence over oil prices to U.S. monetary policy. If another reason for America's politicians to end what President Bush calls the nation's addiction to oil is needed, surely this is it.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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