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Is the Fed’s ‘Great Unwind’ a Nonevent or the Chickens Finally Coming Home to Roost?

By Paul Solman

Merle Hazard performs “The Great Unwind,” his latest economics music video, produced by Nashville Public Television.

In his latest music video, which we debuted on Wednesday, econo-crooner Merle Hazard, aka Nashville money manager Jon Shayne, addresses the problem the Federal Reserve Bank faces with the more than $2 trillion it has created since the Crash of ’08.

Read how Jon developed the idea for Merle’s latest hit, and check out the lyrics here.

Should the Fed continue to run the moral hazard of printing and circulating money that may cause inflation? Or should it shut off the money flow to the banking system, beginning the “great unwind,” and risk another mega-contraction? “Are we on the mend?” asks Merle, “or near the end of fiat money as we know it?”

But how worried about “the great unwind” should we be? Thursday, we heard from Reaganomics muse Arthur Laffer and George W. Bush’s Undersecretary of the Treasury for International Affairs John Taylor, both of whom share Merle’s concerns. We also heard from MIT’s Simon Johnson, who took issue with Merle’s contention about “bond-buying destabiliz(ing) inflation expectations” and a serious, imminent “unwind.” (We’ll get to Merle’s response to Johnson a little bit later).

Art Laffer, John Taylor, Simon Johnson

On the Fed’s ‘Great Unwind’ Problem

Friday, we turn to four more of our economist friends to respond to Merle. That their responses cannot be categorized into neat, ideological camps perhaps says just as much about the complexities of Fed policy as it does about Merle’s lyrical content.

First, Kenneth Rogoff (part of the Harvard Rogoff-Reinhart duo whose controversial work has made such a mark on the international debt debate) delivers a surprising response to Merle, suggesting that growing income inequality is a bigger concern than the “great unwind” and that maybe the “great unwind” isn’t such a big deal after all:

Another great performance from Merle Hazard. However, I would worry more about the long-term effects of lingering unemployment and growing income inequality than the risks of quantitative easing (QE). QE may seem mysterious, but in fact there is not much difference between quantitative easing (when the Fed buys long-term Treasury debt in return for very short-term Federal reserve debt) and simply having the U.S. Treasury issue more short-term debt and less long-term debt. After all, the U.S. government owns both the Treasury and the Fed. What matters is their consolidated balance sheet. In either case, the real risk is that there will be a sharp rise in interest rates making it very expensive to roll over growing issuance of short-term debt. As long as that doesn’t happen, the “great unwind” will be a non-event.

Far removed from Rogoff on the ideological spectrum, an economist whom we might have expected to be the one to raise income inequality, but who seems to share some of Rogoff’s “non-event” prediction: The University of Texas’ James Galbraith, author of “Inequality and Instability.” Here’s what he had to say about Merle’s latest:

The great problem of the great unwind? I’m unimpressed.

One possibility is that the economy grows and the Federal Reserve can unload its holdings into a rising market with few problems. The other is that the economy stagnates and it can’t, in which case, after a try or two, it will stop.

And as Stephen Foley pointed out in Thursday’s Financial Times, the Fed has already announced that it won’t, after all, try to sell the $1.25 trillion in mortgage-backed-securities that it now owns.

Is there a third possibility? There may be some who would “greatly unwind,” damn the consequences, even though it causes a crash. I doubt they will prevail.

P.S. I did like the three suits, though.

Next, we turn to the University of Michigan’s Justin Wolfers, whose impressions of the Fed are somewhat more hopeful and plauditory than Merle’s:

Country music star Merle’s Hazard’s latest turns to a far more important theme than the usual fare of unrequited love, dead dogs, old trucks and ‘merica, worrying instead about how the Fed will unwind it’s balance sheet. Is Ben Bernanke a monetary outlaw or the trusted sheriff who’ll restore order? I’m betting on the latter, but either way, I tip my (ten-gallon) hat to the strumming balladeer and dismal scientist.

And finally, back over on the right, we hear from Harvard’s Greg Mankiw:

The Federal Reserve faces some daunting challenges ahead, as it pursues the endgame of its recent unconventional measures. Perhaps these challenges can be made a bit more manageable if put to music. Thank you, Merle Hazard!

Now that we’ve heard from seven economists whose politics and (and somewhat unpredictable) responses to Merle represent an ideological range, we return to Merle Hazard himself for the last word. Here he responds to Simon Johnson, whose critique you can read in Thursday’s post, and to Ken Rogoff, whose comments appear above.

First Merle develops several of his points, and responds to Rogoff’s concerns about income inequality:

I beg to differ, at least a little, with the professor. I think Ken has alluded to the points I am about to make, but I think it worth fleshing them out, all the same.

We are not in exactly the same shape as if the U.S. Treasury had issued Treasury bills (very short-maturity paper) instead of long-maturity bonds. If the Treasury had done that, the amount of bank reserves would not have increased at all. In fact, what has actually transpired since the crisis is that the Federal Reserve bought long Treasury debt by “printing” new money. Bank reserves held at the Fed have increased by more than $2 trillion. These reserves enable new lending by banks, even though that lending mostly has not happened yet. The reserves create a potential for inflation at some point. It is likely, as Ken’s research shows, that we are years from facing that inflation, so in that sense, no harm done. But there is potential for it, and risk, coming from the printing. High inflation causes high interest rates, so this could be the trigger for the rise in rates that Ken mentions. We would not face this scenario under the alternate scenario of the Treasury simply borrowing short rather than long.

Ken is surely correct that high unemployment and income equality have the potential to rend the social fabric. If Congress could do more than it has, it would help. The Fed may be straining its capacity to address these problems. By kicking this problem to the Fed, Congress has helped Wall Street, because when the Fed buys securities from Wall Street firms, and pays banks an above-market rate of interest on reserves in order to sterilize these reserves, as it has been doing, the benefit to investors and Wall Street is direct. The benefit to the public is only indirect. I wonder whether this helps address income inequality, or worsens it.

Also, readers should understand that the Fed has not limited its buying to long-dated Treasuries. They have also bought over $1 trillion of mortgage securities from quasi-governmental corporations such as Fannie Mae and Freddie Mac. So, again, there is distance between what has actually happened and what would have happened had the U.S. Treasury simply issued short debt instead of long.

This is nothing that Ken doesn’t know. I see a little more to worry about in it than he does, however.

And to Simon Johnson, Merle suggests they may not disagree that much:

Not worried about moral hazard? I should remind professor Johnson that “Merle Hazard” is my middle name! I mean, my stage name. It is a problem — a big one. I commented on it (with some much-appreciated help from him, come to think of it) two years ago in the song “Diamond Jim.” So yes, ultimately moral hazard is at the root.

I agree that inflation is not a problem now, and, most likely, will not be one for years to come. This is why I put the words “some day” into the song:

If they sell off bonds, the markets tank;
If not, some day inflation.

Having been a teenager during the 1970s, I have vivid memories of a time when the U.S. economy was weak, but inflation was high. In our current crisis, the damage to the credit system has been so severe that we almost certainly have some time before serious inflation becomes a problem again. But I think the Fed is, itself, worried about inflation to a degree: paying banks interest on reserves is a way of tamping down the money supply, broadly measured, without selling off bonds. If the Fed had no concern at all, I don’t think it would be offering banks money not to lend. So I do think inflation is always an issue, even though it is almost certainly off in the distance now.

Banks, and non-bank banks, need to be regulated tightly and have very high capital requirements, so I am in more agreement with Simon than he probably realizes from the song.

This entry is cross-posted on the Rundown — NewsHour’s blog of news and insight.

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