Saturday, January 17, 2015

Congress vs the Fed, 2007 to 2008

The debate rages about whether the Fed was correct in selling securities from late 2007 until mid 2008.  There are three parties here, Congress, the bond market and the Fed.  As you can see from the red line, Congress was quite happily borrowing all it could. And the blue line shows that the bond market was even more willing to lend.  What is not shown are the securities held by the Fed, but they were dropping as the fed was selling into the market, competing with Congress. Then came the material change in the economy, mid 2008.  Everyone knew by then we had likely entered a recession.

Now the Keynesians and the monetarists will take the side of Congress, they were correct in borrowing. Congress was the only borrower at the time, so those who favored low rates favored Congressional borrowing.

Then we all discovered we were in deep doo doo.  What happens next? All parties to the debate claim their priors were confirmed.  We hit a recession, the Fed did it.  No, we hit a recession, Congress did it; no we hit a recession the bond market did it.

Will we ever get the right answer?

Not from the economics profession. How do we get the proper answer? Notice the somewhere around 2009 both the Fed and the bond market finally came to an agreement, leaving the one year at 2.5%. What do the monetarists say? Do they say that both the bond market and the Fed were wrong, leaving the Congress the odd man out?  But that was only for a quarter or so, then the bond market rejoined Congress, and the Fed gave up. Then Congress begin reducing the deficit, but the bond market continued lending, and the Fed begin lending, leaving the Congress the odd man out.   Right now, some six years later, Obama wants to increase borrowing, Republicans always want to increase borrowing, the bond market wants to lend, and the Fed is the odd man out.

There is one major takeaway.
The Fed's gains during the whole period were immediately returned to Congress, the sole borrower. Hence, the most likely answer is that everyone was clueless, the Fed, the Bond market and certainly the economists.

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