A Critique from the Inside - Henry Kaufman

Challenge,  Sept, 2000  

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Q. On the other hand, in 1982 you rather famously became bullish about bonds.

A. Yes, in August 1982 I did make a call that we were going into a bull market in bonds, and that caused a dramatic rally both in bonds and in stocks. For that time, the rally of bonds and stocks was unprecedented in magnitude. In the financial markets, it is impossible to be bearish all the time. Most of the time the economy is doing reasonably well and the financial markets are behaving reasonably well, but at times there are inflection points that are very dangerous to a financial system and to a social and democratic system.

Q That brings us to our current situation. You seem concerned about Federal Reserve policy: not just the unwillingness to make policy aimed at suppressing or deflating a potential stock market bubble, but also the assertions by those at the Fed that they should not make policy.

A. There are a number of shortcomings in the Fed's monetary policy. They exist against a background in which the Federal Reserve, in the past four or five years, achieved a high degree of popularity, unprecedented in monetary history. Today the chairman of the Federal Reserve is a folk hero. In fact, when I started in the financial markets and William McChesney Martin was the chairman of the Federal Reserve Board, he was certainly well respected in the financial community, but hardly anyone knew him outside the financial community. Life has changed a lot.

Q. So the issue is: What are the problems with monetary policy?

A. In the past twenty or thirty years--it is not just of recent vintage--the Federal Reserve has not recognized important structural changes and their implications for financial behavior. That is one shortcoming. Let me illustrate. For example, in the early 1960s, a long time ago--practically forty years ago--the banks were allowed to issue negotiable certificates of deposit at market prices. That is, they could pay the market rate on this short-term debt, which changed the structure of banking. It allowed the banks to bid for money--that is, to attract investors--in order to invest in assets. Therefore, they could maintain the bidding for money even though the Federal Reserve raised interest rates. They simply raised the rate they offered investors. A rising rate did not choke off the bank anymore. Then the banking system devised floating interest rates on loans, floating prime rates, floating rates on mortgages. The banks were able to hold an asset where the rate of return was always at some spread above t he cost of the CD. So when the Fed raised rates, the banks were no longer constrained from making loans. They simply raised the rate they paid. The rising rate mattered only to the borrowers of the money they lent. The banks merely became conduits, which allowed interest rates to rise to unprecedented levels because high rates simply did not constrain the economy the way they once did.

Q. This occurred in the 1970s.

A. In the 1970s. The Fed did not recognize this issue.