Busch: FDR And Obama: Be Very Careful

Yesterday, the Federal Reserve announced no change in their interest rate policy and kept their target range for federal funds at 0 to .25%. And they expect to keep rates there for sometime due to an economy that's weak and likely to weaken further.

They do believe that things will improve in the 2nd half of the year, but they don't have a lot of confidence in this outlook. None of this was a surprise.

  • Programming Note: Tonight at 8:45 PM ET, I'll be appearing on CNBC Reports with Larry Kudlow discussing the Obama administration's stimulus plan and the US Treasury's TARP program.

The fun starts when the Fed discusses the more controversial aspects of their actions. The quantitative easing program or QE has been put in place and has purchased over $80 billion in assets with the potential to buy up to $600 billion in total. "The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets." This is simply known as monetizing the US government debt.

Next, we had a fascinating development in the US House of Representatives.

The $820 billion Obama stimulus plan passed with a vote of 244-188 with all House Republicans and 11 Democrats voting against it. It seems that this group finally used some Visine to clear out the Obama stars in their eyes and decided that this plan stimulates more pork than jobs. Again, the CBO estimates that the marginal cost of creating a new job with this plan is an astounding $140,000. This doesn't mean the US Senate will come to it's senses and re-write their version. As a matter of fact, they plan on spending more at this point. And, it's likely to pass as they only need a few Republicans to jump ship. Snowe and Collins are my choices.

The truly disturbing aspect of the stimulus fiasco is the Congressional belief that they are acting like Keynesian economists and are invoking the name of FDR to validate their actions. I would encourage members of Congress to take the time to understand what happened during the Great Depression. First, Keynes was truly revolutionary in his analysis of studying the economy from an aggregate point of view with his national income accounts. (Y=C+I+G+ net exports). Keynes argued that lower interest rates did little to spur additional investment spending (I). However, the government could increase spending as it was not constrained by income or profits.

The concept was that the government could do this directly by increasing spending without increasing taxes or it could do it indirectly by holding government spending constant while decreasing taxes. I think everyone can see the disconnect that is developing in Congress with their massive spending plans: the budget deficits are going to grow to a size where they compete with the private sector investment (I) and taxes are going to go up to pay for the spending (See Larry Summers on Meet the Press last Sunday).

As far as the comparison to FDR, I think everyone should be very careful to emulate him.

The New Deal was actually a combination of socialism and cartelization of industry with price controls. These policies failed to stimulate growth and helped plunge the economy into the "Depression within a Depression" in 1937. It wasn't until these polices were reversed and the NRA was relegated to a minor role in the government that growth returned in 1938. The other major issue was the Federal Reserve. They mistakenly stuck to the gold standard and was forced to raise reserve requirements that cut off the legs of the recovery.

    • Obama Still Seeks Support From GOP on Stimulus

Fortunately, this is not the case today. The actions by Ben Bernanke and the Fed will ensure that a recovery by the economy will not be choked off just as it begins. However, there are dangers to this policy and the monetization that may occur. The discussion of a Bad Bank and the $1-2 trillion funding of this bank is where we need to watch. The current plan being discussed is going to utilize some of the new TARP money and then issue government bonds to fund the rest. My belief is that the Federal Reserve will be called upon to buy some of this paper and thus monetize debt. Printing money to pay for programs was done with success during WWII.

Doing it today is entirely different. There is no war and there are no price controls. Should the Fed actively engage in US government debt monetization they run the risk of dramatically increasing the money supply, driving down the value of the dollar, and forcing interest rates higher which would choke off a recovery.



Andrew Busch

Andrew B. Busch is Global FX Strategist atBMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor.He can be reached here .