On April 27^th the Administration buzzed Manhattan with an F-16 and a Boeing 747. On May 5th, it cracked down on General Mills, the maker of Cheerios, an illegal drug found in many schools, playgrounds, and lunchboxes.

So you may have missed the May 12^th critique suggesting that inept government policies threaten to disrupt more than tall buildings or your breakfast morn.

As hard as it is to believe, the government is also screwing up monetary policy.

Speaking at a financial markets conference sponsored by the Atlanta Fed, economist and keynote speaker John Taylor of Stanford closely examined (in Systemic Risk and The Role of Government) the responsibility that the government had for provoking and continuing the current crisis.

Government As Enabler

Professor Taylor declared:

1. Today’s crisis was induced by the government:

• The primary culprit was the Federal Reserve, which maintained interest rates at unjustifiably low levels from 2002 – 2005;
• These low rates produced a housing boom and encouraged the wide use of adjustable rate mortgages; and
• Government sponsored enterprises – Fannie and Freddie – “fueled the flames of the housing boom” and promoted speculative risk taking through their government-induced purchases of higher risk loans.

2. Today’s crisis was prolonged by the government:

• The government “misdiagnosed” the situation as a liquidity problem, rather than one involving counterparty risk; and
• It responded by slashing rates too quickly, sharply depreciating the dollar. This caused oil prices to skyrocket, hammering the economy and the auto industry.

3. Unclear government policies worsened the situation even as the government rescued Bear Stearns and let Lehman fail:

• The government botched the roll out of TARP;
• A plan that had been designed to purchase distressed assets was confusingly transformed into one that acquired the equity of distressed institutions.

A Prospective Look At Systemic Risks

The government would like us to believe that the current problems could be solved through the creation of a Systemic Risk Regulator, with the power to review, regulate, and limit financial innovation.

But in looking forward at systemic risks, Professor Taylor believes that the government is the biggest source of future systemic risks. These risks are posed by:

1. Enormous federal deficits and growing debt:

• In ten years time, the Congressional Budget Office estimates that federal debt will equal 82% of GDP (twice the current percentage);
• Either a 60% tax increase or a decade of inflation (that is, 10% a year for 10 years) will be required to manage this burden.

2. Explosive transformation of the Fed’s balance sheet:

• Since September 2008, the Fed balance sheet has ballooned from $8 billion to $800 billion – will the Fed be able to dispose of these assets in a non-inflationary fashion?

3. Apparent miscalculation, by the Fed, of the degree to which it can provide non-inflationary liquidity:

• The Financial Times reports (see Days of Swine and Poses) that the Fed believes that current interest rates should be equivalent to negative 5%, using the Taylor Rule;
• Professor Taylor (it is his rule) says that “Fed’s calculation reported in the Financial Times has both the sign and the decimal point wrong” and that the correct rate is not – 5% (negative five percent) but +0.5% (positive one-half of one percent).
• The Fed does NOT have much time before it must remove liquidity and raise rates, if it is to prevent inflation.

4. Finally, and most importantly, today’s “capricious” and “intrusive” government interventions disrupt:

• private employee compensation arrangements;
• contractual obligations to debtholders; and
• corporate governance.

They threaten to destroy the US rule of law - “the most important ingredient to the success of our economy since America’s founding.”

Rather than creating a new systemic risk regulator, Professor Taylor urges the government to get its own house in order, and rein in the risks that the government itself poses to the future soundness of our economy.

After that, we can turn our attention to the real problems that darken our skies and mornings – a) low flying planes, and b) those evil, toasted, whole grain circles of oat.

I used to work with numbers for a living. Guess I’ll have to switch to Corn Flakes as I begin my search each morning for a new job, or at least my next idea. Till next time.