Keynote speaker Dr. Robert S. McTeer, former president of the Federal Reserve Bank of Dallas, Addresses Audience at Probity Advisors, Inc. Event. Probity provides Q&A summary of Dr. McTeer’s remarks on Macroeconomic Policy and the Financial Markets.


Probity Provides Q&A Summary of Dr. McTeer’s remarks on Macroeconomic Policy and the Financial Markets
DALLAS, TX, April 19, 2012 – As part of its 2012 Speaker Series focused on Macroeconomic Policy and the Financial Markets, Probity Advisors, Inc. was honored to have Dr. Bob McTeer, former president of the Federal Reserve Bank of Dallas and Distinguished Fellow at the National Center for Policy Analysis, as the keynote speaker for its Spring Luncheon at the Belo Mansion in Dallas, TX on April 18th, 2012. Dr. McTeer shared his perspective on monetary policy in the U.S. and its impact on the federal debt and deficit. Dr. McTeer also discussed the unprecedented circumstances of the 2008-2009 Financial Crisis and the actions the Fed took in response to the nation’s liquidity issues. His keynote remarks were followed by an interactive and informative Q&A session with attendees. Probity has released the following Q&A summary of the insights shared by Dr. McTeer.
Ten Questions with Dr. Bob McTeer

1. What is causing the slow recovery of the U.S. economy?

Dr. McTeer delineated the most recent recession from previous recessions. First, the most recent recession was caused by a financial crisis, and recessions that are triggered by a financial crisis or panic tend to last longer than normal, cyclical recessions. Second, the 2008 financial crisis that triggered the recession resulted in a pervasive loss of wealth due to a number of factors, including: (1) high unemployment and loss of wages, (2) the significant decline in home equity values, and (3) the deterioration of financial assets. This is notably different than typical recessions where the burden is almost exclusively carried by the unemployed.

The tremendous destruction of wealth led to counterproductive consumer behavior known as the Paradox of Thrift. The Paradox of Thrift surmises that as individuals try to restore their wealth and liquidity by saving more and spending less, this behavior benefits the individual’s personal financial situation, but these actions adversely affect the economy–causing the recession to deepen. Compounding the slow recovery has been the weak housing sector. McTeer explained that normally, you emerge from recessions due to the interest-sensitive housing sector responding to lower interest rates. The U.S. housing market has not responded, largely due to the overcapacity of inventory and the fact that borrowers are already over-leveraged–thus being unable or unwilling to take action, despite the low interest rates.

The broad and global nature of the recession has contributed to the lack of domestic growth. Dr. McTeer pointed out that U.S. exports have been growing and have helped to generate domestic income, output and jobs. However, imports have also grown. Since our economy has been doing better than many of our trading partners, the trend has been that our imports are growing faster than our exports. This generates foreign GDP–with our trading partners–and not at home in the U.S. Dr. McTeer also cited the regulatory environment, the threat of higher taxes, and the lingering European debt crisis as additional factors contributing to the slow U.S. economic recovery.

2. What actions did the Fed take in response to the 2008-2009 financial crisis?

Dr. McTeer stated that he believed the Fed’s very aggressive actions over the last few years helped avert an even more severe economic calamity. The Fed rapidly reduced interest rates during 2008 and 2009. Once interest rates were as low as they could go, the Fed then undertook massive quantitative easing to provide liquidity to key components of the financial markets. These actions were dubbed QE1. When QE1 concluded and it became clear the financial markets were still fragile in the absence of the Fed’s support, the Fed implemented yet another round of monetary supply expansion, called Quantitative Easing 2 (QE2). QE2 focused on the purchase of Treasury bonds which effectively bolstered banks’ balance sheets by providing them with additional reserves and the necessary capital to operate. McTeer explained that when QE2 ended, the Fed announced that it would engage in a rarely used technique known as Operation Twist, where it bought longer term Treasury securities and sold shorter term securities, with no net impact on the size of the Fed’s overall holdings. The idea was to put downward pressure on longer term interest rates in order to dissuade saving and induce capital investment. With Operation Twist scheduled to conclude in June, McTeer stated that the big question on everybody’s mind is whether they let it expire, renew it, or replace it with another round of quantitative easing.

3. As a result of its monetary policy, the Fed’s balance sheet grew from about $800 billion to almost $3 trillion. Normally, that would be highly inflationary, and it would do a lot of damage to the dollar. Why haven’t the Fed’s actions caused massive inflation?

Dr. McTeer shared his view that despite all the purchasing of debt by the Fed, it hasn’t created much in the way of new money. He explained that the reserves that have gone into the banking system are being retained by the banks, and not used to make loans and investments that would create additional money supply. Inflation right now is barely above 2%, and 2% is the official Fed inflation target.

Addressing concerns related to the implications of a weakened dollar, McTeer stated that while the dollar index has gone up and down, it is basically at the same level it was before the financial crisis. There has been no net decline. McTeer expressed that while some people believe that inflation is just around the corner, he does not believe that inflation is inevitable. For inflation to rise, money has to be created. Furthermore, it has to be spent on foreign currencies. Since excess reserves are not being injected into the broader economy, money supply is not being created, and it’s not being spent on foreign currencies. McTeer added that the dollar has actually strengthened lately because every time things get worse abroad, the dollar is considered a safe haven currency. He noted that while many financial news commentators advocate for a strong currency, a strong dollar actually impedes our economic recovery because it makes our exports more expensive abroad. He noted that this distinction is rarely made.

4. Has there been a time when you disagreed with the monetary policies of the Fed?

Dr. McTeer stated that he has always been against excessive Central Bank transparency, and, in particular, the Fed’s own pronouncements that interest rates are likely to stay low until 2013 or 2014. McTeer said he thinks those promises reduce the Fed’s flexibility, and that when the time comes to take the foot off the accelerator, and possibly tap the brake, it will be harder to do with those promises outstanding.

McTeer acknowledged that the Fed’s current policy is rooted in an awareness of the lessons from the Great Depression. During the Great Depression of the 1930s, the Fed did two things that, together, caused a double dip recession. First, the Fed raised reserve requirements, and that tightened the money supply and caused the banks to contract. Second, the government raised taxes significantly in the middle of the depression. Students of the Great Depression that have examined the consequences of the Fed’s monetary policy during the 1930s may have surmised that it is better to err on the side of remaining too easy for too long than to err on the side of premature tightening.

As the Fed is essentially guaranteeing low interest rates through 2014, they have effectively penalized savers in order to encourage spenders. He elaborated that keeping interest rates low serves the greater good by helping borrowers and spenders, but McTeer said the term that has been used to describe this circumstance is financial repression. Over time, rates have to be allowed to rise without the influence of the Fed’s easing.

Dr. McTeer hopes Federal Reserve Chairman Ben Bernanke will use his creativity to find a way to not withdraw liquidity prematurely, but within that, find a way to allow interest rates to begin to normalize.

5. Do you think the Fed has the controls, insights and political will to retract this stimulus in a quick fashion if they start to see inflation rise?

McTeer affirmed that he thinks the Fed will react and “be ready to do what’s necessary once inflation starts picking up.” But he cautioned that they may wait until they see inflation rise a little bit first. He expanded to say that every time inflation has gone up lately, it’s gone up because of increased commodity prices. He pointed out it’s been fairly clear that commodities are in a bubble, which will reverse itself. So far, that’s proven to be the case. Last month, the overall consumer price index was up only 0.2%, suggesting to him that inflation is under control. McTeer pontificated, however, that central bankers aspire to go to what he called “Central Banker Heaven.” The way you go to Central Banker Heaven is to fight inflation, and, as a result, he thinks the Fed will continue to make controlling inflation their primary goal.

6. There are different perspectives on the disappointing results of the economic stimulus. One perspective is that it wasn’t big enough to get the impact the federal government wanted, and another opinion is that it isn’t so much a question of the size of the stimulus, but rather a question of how it was constituted, including the mix of tax cuts versus spending, and how, where and when the spending was targeted. What are your thoughts on this?

McTeer remarked that economic research shows that tax cuts are more stimulative than spending increases, and he said there probably wasn’t enough of a tax cut component of the stimulus versus spending. He elaborated, however, that it’s hard to imagine that spending that much extra money didn’t stimulate something, and the effect it probably had was that it delayed layoffs by state and local governments of school teachers, policemen and firemen. Although this eventually had to be done, McTeer said he believed the first beneficial effect of the stimulus was that it padded the budgets of the state and local governments to delay these layoffs. Dr. McTeer declared that TARP, the Troubled Asset Relief Program instituted by the Treasury to save the banking system, worked. And, he shared that, as far as the banks are concerned, it made a profit at no cost to taxpayers. McTeer believes that all of the investments made by the Fed in growing their balance sheet worked, although maybe not as well as they had hoped. He reiterated that not only did the Fed’s investments not cost the taxpayers anything, it helped the taxpayer because the Fed turns over its earnings to the Treasury, and by tripling the size of its balance sheet, it tripled the size of its earnings — a good thing so long as it doesn’t lead to inflation.

McTeer observed that the two big programs that worked, TARP and Quantitative Easing, did not add to the fiscal problem. However, he pointed out that the one that didn’t work very well, the American Recovery and Reinvestment Act, was the one that added to the fiscal problem. The Recovery Act was intended to create jobs and accelerate growth with approximately $800 billion in government spending. According to McTeer, it was poorly planned and poorly executed, and didn’t result in the types of shovel-ready projects it promised. McTeer stated that we’ve already had three annual deficits of over a trillion dollars. And, we are on course this year for a $1 trillion deficit that is clearly unsustainable. McTeer concluded the stimulus program probably worked a little, but it probably wasn’t worth the fiscal damage that it caused.

7. Should we be concerned about the $15-$16 trillion debt that we are carrying?

Going into this crisis, our debt was about 40% of GDP. Today, it is currently around 80%. McTeer declared that this trend is clearly unsustainable, and it can slowly debilitate the government. As the debt gets bigger, a larger and larger fraction of government spending has to go to servicing it, and that is money that can’t be spent more productively elsewhere. McTeer commented that while the U.S. needs to get its annual deficits under control in order to stop the overall growth of debt, he wasn’t necessarily of the mind that the debt had to be explicitly reduced. He suggested that if we were successful in containing our debt while simultaneously returning to more normal GDP growth rates, we would mechanically restore our financial health over time as our debt would become a smaller and smaller percentage of our GDP.

8. Are there any solutions to our sluggish economy and the nation’s debt problem?

According to McTeer, there is “no low hanging fruit to speak of” except possibly a corporate tax cut. McTeer believes doing so would have a Laffer curve effect in increased tax revenues, and it would enable corporations to bring home money they have earned abroad and kept abroad because of the high tax rate.

The Laffer curve shows the paradoxical relationship between tax rates and tax revenue collected by governments. The curve shows that as tax rates increase, government tax revenues increase, up to a certain point, beyond which tax revenue starts to decline due to the disincentive to productivity and hard work. Conversely, lowering taxes, which is somewhat counterintuitive but supported by historical observation, can actually increase tax revenue.

McTeer said that the U.S. now has the highest corporate tax rate in the world at 35%. Aside from the corporate tax issue, McTeer noted that the looming expiration of the Bush tax cuts at the end of the year could have a negative impact on growth. In particular, he noted that raising the dividend tax rate up to the ordinary income rate would be very, very damaging.

9. Do you think the Fed has enough tools in its arsenal to try to manage an economy in such a prolonged downturn, when the Fed Funds Rate is next to zero?

“Probably.” McTeer thinks of the Fed’s monetary policy primarily in terms of the money supply growth; meaning the growth of the money supply is more important than changes in interest rates. McTeer stated that the Fed is out of interest rate ammunition, but that it has unlimited power to create money. Even with that tool, however, he expressed that the money creation is getting to be a little bit harder, and people are not responding to it as aggressively as they used to. He observed that while the Fed’s arsenal is diminished, he thinks it is sufficient. Perhaps more importantly, McTeer believes the Fed still has a lot of credibility, and having credibility is ultimately the most beneficial tool in implementing monetary policy.

10. If you could start over on the tax system, what would you do differently?

On this topic, McTeer referred to Milton Friedman, a highly noted free-market economist and close associate of McTeer’s. McTeer stated that Friedman had one regret in his professional life, which was helping design the system of tax withholding for the Federal government. According to McTeer, Friedman later decided that was a mistake because it made it too easy to hide the taxes. McTeer declared, “We tend to think of our taxes of what we have to pay or get back at tax day, and we forget how much was taken out throughout the year.”

Responding specifically to an inquiry related to the probability of the U.S. implementing a Value Added Tax, McTeer observed that there are some advantages to a Value Added Tax. It doesn’t raise the prices of your exports as much as other taxes do. He added that some people would say the advantage is you don’t see it because it is generated at different stages of production, and by the time the production process is complete, the cost of the tax is embedded, or hidden. However, he believes this is a disadvantage because, again, “we aren’t going to fight it as much if we can’t see it,” in his opinion.

Dr. McTeer shared that if he could start over on the tax system, he would have the Fair Tax, or consumption tax. He expanded on this concept saying, “Why tax capital, and why not let people earn all they can earn without a tax disincentive to earn it, and then just pay taxes on what they spend on consumption?”

Probity Advisors couldn’t agree more, and we were honored to be able to host Bob McTeer and the NCPA for our 2012 Speaker Series focused on Macroeconomic Policy and the Financial Markets.

Probity Advisors, Inc. is a financial services firm based in Dallas, Texas. For more than 40 years, Probity has helped individuals, families and businesses manage their financial assets and resources in order to achieve financial independence and security. With expertise in customized portfolio management, financial and estate planning, retirement benefits consulting, risk management solutions and tax planning, Probity provides a comprehensive and integrated approach to managing and building wealth. Probity’s team of Certified Financial Planners®, Chartered Financial Analysts®, and Chartered Financial Consultants® is committed to providing sound and unbiased advice to help clients optimize their complete financial picture with a coordinated estate, investment and tax strategy.

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