The Fed Unwind

The video exchange between Rick Santelli and Nobel winning economist Eugene Fama is receiving some coverage, mostly – as in this Zero-Hedge piece – to point out the bathwater that mainstream economists drink, for example:

If ever there was a few minutes of television to confirm the deep-seated disconnect between reality and the ivory-tower academics pulling the levers behind the curtain, CNBC's Rick Santelli just exposed it.

…when asked the impact of the Fed 'Tapering' or even selling down its $4 trillion in assets, Fama calmly says "it's basically a neutral event... It's No Big Deal!"

As I have written several times before, I think mainstream economics is quackery and mainstream economists are quacks. However – while there is a good amount of quackery in this interview – it seems to me it is not to be entirely dismissed.

Normally, the issue of tapering would be quite harmful to an economy that has grown fat on Fed stimulus.  Austrian economics suggests that past interventions require further and greater interventions to keep the party going – well, until the crack-up boom.

But what about when much of the Fed bubble-blowing remains as excess reserves – not released into the broader economy? 

The balance of excess reserves today is approaching $2 trillion.  In other words, theoretically the Fed could withdraw $2 trillion without the same (direct) impact normally associated with such an action.  So, to this extent, Fama is correct.

However, there are still open issues:

1)      If it isn’t harmful to withdraw the $2 trillion, a) why did the Fed inject it in the first place (and take significant heat for doing so), and b) why is the Fed hesitant to withdraw it?

2)      To withdraw the $2 trillion, the Fed must sell $2 trillion of securities in its portfolio.  Who will buy these?  At what price?  Crowding out what other investments?

Perhaps part of the answer to item 1) b) can be found in the issues raised in item 2).  It seems to me, additionally, that the banks need the liquidity as they hold other assets that are not performing.

I guess my only point is: this entire discussion is muddled because of the excess reserves.  I don’t know that such a scenario was considered in any of the work done by the likes of Mises, etc. 

So Fama may be a quack, but he isn’t 100% duck.

What seems clear:

1)      If the Fed slows its purchases, bond prices will go lower (and interest rates higher) than they otherwise would.

2)      The Fed will likely never shrink its balance sheet – or if they try it, they will have to quickly revert.

3)      There is some reason why the Fed pumped $2 trillion extra.  What is it?

If anyone can point me to some well thought out articles (with an Austrian slant) on this issue of tapering / reducing the Fed balance sheet in an environment of excess reserves as we have today, I would appreciate it.