Yesterday, I discussed what I saw as the reasoning behind the strategy the Federal Reserve is building to reduce the massive amount of excess reserves that it has injected into the banking system. The basic strategy seemed to be logical and reasonable and consistent with the way that economists usually think. That is, the arguments of economists always contain the assumption: “all other things held constant.” In other words, this is the plan, given that nothing else changes.

In the proposed strategy the Federal Reserve is developing, what is missing that might be crucial to the success of this strategy?

How about the fiscal deficits that the government is in the process of producing?

The deficit for the fiscal year ending this fall recorded the largest deficit in United States history: $1.4 trillion. And, some projections for the next ten years place the cumulative federal deficits around $15 trillion, more or less.

The Gross Federal Debt rose by 11.6% in fiscal 2008 and the estimates published by the government for fiscal 2009 and fiscal 2010 are 22.3% and 15.4%, respectively. The federal debt held by the public rose 15.2% in fiscal 2008 and is projected to increase by 35.4% and 21.9% in the following two years.

A lot of debt is going to be created by our government in the upcoming future and the assumption is that the public is going to absorb greater increases in the amount of debt they hold than ever before in peacetime!

The increases in debt over the past seven years have been of epic proportions. Carmen Reinhart and Kenneth Rogoff, in their informative new book “This Time is Different”, state of this buildup: “Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared. Access to capital markets would be lost…” They continue, “Over the longer run, the U. S. exchange rate and interest rates could well revert to form, especially if policies are not made to re-establish a firm base for long-term fiscal sustainability.”

Why do the exchange rates of nations that exhibit such fiscal irresponsibility decline?

The answer to this is that, sooner or later, the central banks of these nations have to become active in supporting the placement of the debt and this results in the monetization of that debt.

The question then arises, “Can the Federal Reserve reduce the amount of excess reserves it has injected into the banking system given the market pressures that surround the problem of the placing of the federal debt that is going to be created?”

Let’s look what seems to happening right now.

Some have argued that the Federal Reserve’s policy of “buying everything in sight” has created an asset bubble. The result has been that the prices in many different asset classes now move together: the movements in these asset classes now possess a high positive correlation rather than a zero or negative correlation. Thus, investors can achieve very little diversification across markets. And, as a consequence, the market volatility indexes have risen to remarkable highs.

The extremely low target interest rates, the quantitative easing, and the massive flows of capital into the United States resulting from the accumulation of foreign exchange reserves by foreign central banks keep Treasury bond prices high, prices of mortgage-backed securities high, United States equity prices high, and global asset prices high. (A bubble you say?)

To support the bond market and the market for mortgage-backed securities, that is, to keep interest rates low, the Fed has continued to pump reserves into the banking system. The reserve balances that commercial banks hold at Federal Reserve banks jumped $236 billion from September 30 to October 28 so that they totaled $1.080 trillion on this latter date. Excess Reserves held by commercial banks rose by around $190 billion from the end of August to the end of September, to around $1.0 trillion.

If these security prices are artificially high (and interest rates artificially low) due to Federal Reserve support, what will happen when the economy picks up activity and the Fed has to back off its underwriting of low interest rates? What will happen if this “backing off” coincides with the need of the Federal Reserve to “exit” from its excessively loose policy?

As I wrote earlier, the proposed exit strategy that the Federal Reserve is exposing to the public seems “logical and reasonable” given that “all other things are held constant.” Unfortunately, policy makers do not work in a world in which “all other things are held constant.”

Again, the policymakers are faced with the problem of dealing with the aftermath of earlier policy actions. As I have argued, the irresponsible fiscal policy of the early 2000s and the excessively low interest rates maintained by the Federal Reserve during this time (supported by both Greenspan and Bernanke) created the environment for the financial collapse of 2007-2008. The Bernanke Federal Reserve faced this collapse, to accumulating accolades, by throwing everything it could against the wall to see what would stick. (The lesson Bernanke learned from his research on the First Great Contraction was that in order to avoid a great contraction one had to leave nothing on the table for if one is going to err one must err on the side of excessive ease.)

Now we are faced with the problem of dealing once again with the left-over’s of previous fiscal and monetary policy. We are once again faced with a situation in which there are no “good” policies that are painless. As Reinhart and Rogoff conclude from their massive study of “Eight Centuries of Financial Folly”, pain cannot be avoided once financial folly has been committed.

Let me close once again as I closed my post yesterday: the Fed is in a delicate position. They cannot get out of this situation by “throwing everything it can against the wall.” Let’s just hope that they can find a way to get out of their conundrum with the least amount of negative consequences.