spoke at Harvard Law School, and sounded almost Austrian School in his criticism of the Federal Reserve and other central banks:
We are amidst an extraordinary period of governmental and central bank intervention in the U.S. economy that is widely distorting the nature and functioning of global capital markets.
Since the 2008 financial crisis, the Federal Reserve (Fed) has made itself an increasingly outsized player in the U.S. government debt markets, roughly quintupling its balance sheet from $905 billion in early September 2008 to almost $4.5 trillion today,41 equal to one-fourth of the U.S. economy and nearly five times its pre-crisis level.42 Through its “quantitative easing” (QE) program, the Fed has purchased an unprecedented 61 percent of all Treasuries issued, peaking at close to 80 percent in 2014.43
Today, the Fed has become the multi-trillion dollar “Washington Whale.”44 Its intervention in the Treasury and mortgage-backed security markets misprices the true cost of credit below its natural level and distorts the integrity of prices and exchange rates.45 The Fed is having an increasingly direct and immediate impact on all other markets, from corporate bonds to equities and foreign exchange rates to developing nations’ sovereign debt.46 It has reduced the heterogeneity of the investor base, herding it into one-way bets on anticipated changes in Fed policy rather than traditional fundamental credit or value analysis.47 According to one veteran observer, the Fed’s “exceptional measures” have “conditioned financial markets to develop a deep dependence on the central bank as a suppressor of financial volatility and a booster of financial asset prices.”48
The Fed’s outsized market participation contributes to greater market volatility. It hazards periods of sharp illiquidity in response to relatively normal market shocks as crowded market participants quickly seek to adjust such correlated positions upon the slightest hint of changes in Fed policy.49 It has increased the risk that when investors rush to reduce these correlated positions, they will flood the market, causing a pronounced drop in prices and the possibility of a new crisis.50
The Fed is not the only central bank engaging in such extraordinary market intervention. The phenomenon extends to the People’s Bank of China (PBOC),51 the Bank of Japan52 and the European Central Bank (ECB),53 the priorities of which seem to be market stability over vitality and price setting54 over integrity of asset values.55
These days, market leaders and regulators who have responsibility for market health and safety must account for the impact of the Fed’s role as the “Washington Whale” and that of its overseas brethren. Central banks have replaced major dealers and money center banks as marketplace Leviathans plunging into increasingly shallower pools of trading liquidity. With one flip of their policy tails, these central bank behemoths can whack a whole lot of smaller market participants out of once-liquid markets and leave them stranded.56 As market overseers, we must understand the risks posed to market liquidity and price integrity by the ballooning role of central banks in increasingly shallower financial markets.
(ht Perianne Boring)