"Paying the Price for the Fed’s Success"

I try to avoid being too dependent on a single news outlet on any particular day, but it is Sunday, and the New York Times happens to have a higher hit rate than usual on relevant pieces. Reader Independent Accountant chided me for not pointing to the artilce below by the reliable and thoughtful James Grant, the editor of Grant’s Interest Rate Observer.

This piece is a fairly conventional, although well-done, retelling of the story of how benign economic conditions fuel speculation and the use of excessive leverage. However, Grant staked out this theme long before it became popular.

Grant, who has studied the history of banking and finance more deeply than just about anyone, warned of the dangers of excessive leverage so early that it was easy to dismiss him. HIs 1996 book, “The Trouble with Prosperity,” talks about the downside of the loss of fear, and even mentions the views of Austrian economists who had foretold that unduly low interest rates would lead to a credit boom and eventual bust. Grant is also fearless enough to offer observations that make him seem a borderline crank in the eyes of modern economists. He points out the virtues of the gold standard in preventing monetary excesses, and notes that the yield curve was generally negative in London from 1880 to 1914, which precluded the prevalent strategy today of borrowing short and lending long.

From the New York Times:

High finance, like some unreliable common stock, goes lower and lower. How did so many experts misjudge so badly? How could the supposedly “contained” subprime mortgage problem metastasize into a global financial panic (some days to the down side, other days to the up side)? And after this drama, what?

Ben S. Bernanke, the chairman of the Federal Reserve, inadvertently warned of the coming troubles four years ago. Speaking to fellow economists in Washington, he described the peace and quiet that, for 20 years, had been gradually settling over the American economy. Compared to the 1970s, recessions were mild and scarce, he noted. Inflation, that bane of yesteryear, was dormant. Economic growth was no longer spasmodic but smooth and almost predictable. The name he gave to these manifold blessings was the Great Moderation, and he thanked the Fed, in which he then served as a governor under Alan Greenspan, for helping to bring them about.

But it was actually the Great Complacency that Mr. Bernanke had put his finger on. In finance, to borrow from the economist Hyman Minsky, nothing is so destabilizing as stability. The paradox is easily explained. Profit-seeking people will take more financial risk when they believe the coast is clear. By taking bigger chances, however, they unwittingly make the world unsafe all over again.

Anxious people don’t ordinarily get in over their heads; it’s the confident ones who do. And nothing builds confidence like the belief that a greater power has conquered the business cycle and laid inflation low. In such happy circumstances, a calculating human will take out a bigger mortgage, build a bigger hedge fund or attempt a gaudier corporate buyout. That is, he or she will borrow more money, or, as they say on Wall Street, lay on more leverage.

So Americans proceeded to borrow. Over the past decade, household indebtedness, expressed as a percentage of the value of household assets, has shot up into record territory. Watching house prices levitate, people did what they could have been expected to do. They borrowed heavily against the accretion in value they had already seen as well as the gains they hopefully anticipated.

There was a rub, however, and this, too, our seers and experts failed to predict. The truth was that house prices were soaring beyond the reach of the average home buyer. Bridging this widening gap brought out the worst in just about everyone who had anything to do with money from 2003 to 2007.

Striving so mightily to make one and one add up to three or four or five, Wall Street, Main Street and Washington collectively brought us to the impasse of 2008, in which a debt crisis is superimposed on a downturn in the economy, which is overlaid on a bear market in real estate, which is conjoined with a persistent and worrying weakness in the overseas value of the dollar. As for the crackup in complex mortgage-backed securities, now at the center of the debt predicament, the global bank UBS has justly called it “the biggest failure of ratings and risk management ever.”

We should not forget Main Street in this 360-degree indictment of American financial practices. Fitch Ratings, shocked by the frequency of early defaults in supposedly safe mortgage structures, belatedly delved into the details of 45 individual loans it considered representative. “The result of the analysis was disconcerting at best,” the ratings agency admitted in a study released at the end of November, “as there was the appearance of fraud or misrepresentation in almost every file.”

It would be asking a lot of an ordinary mortal to hew to the literal truth in a mortgage application when, to the applicant, it seemed as if the money was being offered free. And for 12 full months, from mid-2003 to mid-2004, the Fed set its interest rate, the so-called overnight federal funds rate, at just 1 percent. It took this extraordinary step to ward off the risk of falling prices, or deflation, it said. It would not tolerate too little inflation, it explained, but wanted just enough. At the time, the cost of living was rising by 2 percent a year.

Last week, as the Fed delivered its emergency cut of three-quarters of 1 percent, dropping the funds rate to 3.5 percent, the cost of living was rising on the order of 4 percent a year. Yet inflation was almost an afterthought in the press release in which the Federal Open Market Committee, the central bank’s policy-making arm, explained its surprise intervention: “The committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.”

If stability leads to instability, it follows that instability will eventually restore tranquillity. But first must come the tallying up of the errors, misjudgments and outright criminality that blossomed during the Great Moderation. Mr. Bernanke, in an attempt to limit the damage and hasten the healing, is likely to keep the Fed’s rate low — lower, even, than the measured inflation rate.

As for mortgages, the experts had agreed that house prices couldn’t fall as stock prices sometimes do, and they structured their loans without a thought to any such coast-to-coast distress. If house prices do continue to fall, there will be many more defaults, and a correspondingly urgent cry for low and lower mortgage rates.

Nor will the credit crisis bypass corporate America. Complacent as the mortgage lenders, investment bankers designed balance sheets as if steep and prolonged recession was not just unlikely but impossible.

To lubricate the machinery of lending and borrowing, Mr. Bernanke is likely to make dollars increasingly plentiful. The trouble is that, while the Fed is America’s central bank, the dollar is the world’s currency. It lines the vaults of central banks of America’s creditors, especially the up-and-coming states of Asia and the oil-soaked principalities of the Middle East.

Such institutions hold dollars by choice, and not a few of them chafe at the greenback’s steady loss of purchasing power. For some, Tuesday’s hasty rate cut might be the last straw.

As just about nobody predicted the present troubles, humility is what becomes today’s forecaster the most. So I will offer up a humble forecast. Inflation will, at length, make its way up from the bottom of the Fed’s worry list to the very top. Not for years has it seemed to matter that the dollar is only a piece of paper. But, before very long, that homely fact will push itself back to the fore.