Noland: Don't Get Hopeful About Fed Interest in Asset Bubbles

There has been a raft of articles about the Federal Reserve's new found interest in the question of asset bubbles, suggesting that the Fed might be ready to shift policy and exhibit more willingness to rein them in. Yesterday, a page one Wall Street Journal story discussed at length research central bank chairman Bernanke has sponsored at Princeton, and noted:

The Fed is giving the activist approach some thought. In a speech scheduled for delivery Thursday night, Fed Governor Frederic Mishkin suggested that while it was inappropriate to use the blunt instrument of interest-rate increases to prick bubbles, if too-easy credit appeared to be fueling a mania, policy makers might craft a regulatory response that could "help reduce the magnitude of the bubble."

Doug Noland at Prudent Bear takes issue with the view that the Fed might be changing its approach and gives a close reading of the Mishkin speech:

The conclusions from Professor Mishkin’s paper differ only subtly from previous doctrine:

First, not all asset price bubbles are alike. Asset price bubbles that are associated with credit booms present particular challenges....Second, monetary policy should not try to prick possible asset price bubbles...Instead, monetary policy should react to asset price bubbles by looking to the effects of asset prices on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability… Third, because asset price bubbles can arise from market failures that lead to credit booms, regulation can help prevent feedback loops between asset price bubbles and credit provision. Our regulatory framework should be structured to address failures in information or market incentives that contribute to credit-driven bubbles.

Mishkin suggest regulatory remedies might help prevent unhealthy booms, but even the ideas he presents as possible solutions are minimal. Information failures? The research described in the Journal article essentially said that investors get overly excited about a broad scale innovation and start bidding up prices of related investment opportunities beyond realistic levels. Those with more cautious views step aside, unwilling to get killed, until the bulls exhaust themselves. Pray what information failure can you point to in that? The negative information is out there, just as it was during the housing bubble. But it was ignored. Mishkin is pointing to instrument-specific misunderstandings, as with investors buying MBS and CDOs, they really didn't understand. But what information failure was there in the dot-com era? It was clear to all that the vast majority of companies had no realistic prospect of turning a profit, yet ownership of "eyeballs" became the new version of tulip mania.

Back to Noland:

I’ll posit this evening that the entire issue of “central bankers vs. asset Bubbles” has become little more than A Red Herring. While it is as of yet too early in the unfolding financial and economic crisis for “consensus opinion” to have reached a similar conclusion, in reality contemporary monetary management can already be proclaimed an unmitigated failure. Cloaked in ideology and a flawed conceptual framework, the Greenspan/Bernanke Fed sat idly by as history’s greatest Credit inflation and myriad resulting Bubbles irreparably damaged the underlying structure of the U.S. Credit system and real economy (before going global). And while the Fed executes its latest round of post-asset Bubble “mop up,” precarious Credit Bubble dynamics are left to run similar roughshod through global financial and economic systems. Better to downplay the asset Bubble issue for now, as we contemplate the nature of what will be a much altered post-Global Credit approach to central banking.

From Mishkin:

The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this objective in terms of stabilizing both inflation and economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate that the Congress has given the Federal Reserve.

In no way do I believe “the ultimate purpose of a central bank” is to “foster economic prosperity,” and I certainly don’t expect any such grandiose mandates to survive in the post-Bubble environment. On many levels the notion that central bank policies are instrumental in creating prosperous economic conditions is problematic. For one, it grossly over promises in regard to the long-term benefits derived from government manipulation of interest-rates. Secondly, it virtually guarantees an accommodative policy regime and, inevitably, a strong inflationist bias. Thirdly, such a nebulous objective invites overly discretionary policymaking, along with an activist and experimental approach to monetary management. Fourthly, such an approach ensures that policymaking errors beget greater and compounding errors.

Noland is correct to point to the dangers of continued Fed mission creep. Noland again returns to quoting Miskin:

From Mishkin:

After a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative. …If monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small. More generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability.

This passage, in particular, goes right to the heart of several key failings of current doctrine...The problem with post-asset Bubble “accommodation” is that it specifically accommodates the very Credit infrastructure and related Monetary Processes that financed the preceding boom. It works to validate the present course of financial innovation (think “Wall Street securitizations,” “CDOs” and “carry trades”), while emboldening those at the cutting edge of risk-taking (think “leveraged speculating community”).....

Moreover, a commitment to aggressively cut rates in response to faltering asset Bubbles openly courts leveraged bond market speculation – a market dynamic that engenders artificially low market yields and exacerbates liquidity excess during the late-stage of asset bubbles (think bond market “conundrum”). The last thing a central bank should encourage is an entire industry dedicated to placing leveraged bets on the direction of Federal Reserve policy responses...

The overriding flaw in the Greenspan/Bernanke approach has been to openly disregard Credit Bubble dynamics, in particular the increasingly profound role being played by Wall Street-backed finance in fueling Credit, market liquidity and speculative excesses. I believe The Ultimate Objective of a Central Bank is to Foster Monetary Stability in the broadest sense. In this regard, asset Bubbles should be viewed primarily as important indicators of some type of underlying Monetary Disorder. The key analytical focus must be on the underlying Credit and speculative dynamics fueling the asset price distortions – to better understand and rectify the source of “disorder” – and the earlier, the better.

The most dangerous policy approach is to further incentivize a system that has already demonstrated a proclivity for Credit and speculative excess – employment, output and “deflation” concerns notwithstanding....

Greenspan, Bernanke, Mishkin and others repeatedly stress the inability of policymakers to recognize the existence of a Bubble until after it pops. It is my view that the entire notion of asset prices dictating monetary policy is flawed. The focus should instead be on the underlying sources of monetary fuel – the Credit growth and financial flows underpinning asset inflation and economic boom....

Central bankers can and should avoid being in the difficult position of having to respond directly to inflating asset markets. Instead, there must be carefully fashioned, communicated and administered “rules of the game”. To begin with, it is incumbent upon the Fed to clearly articulate to the public (and their elected officials) the overwhelming benefits of stable Credit and financial conditions. It must be conveyed that Credit and speculative excesses are destabilizing, fostering boom and bust dynamics and structural impairment. The public must come to appreciate that the effects of destabilizing Credit inflation come in many forms, including asset price inflation and Bubbles, Current Account Deficits, currency debasement, traditional consumer price inflation, and various distortions to underlying Financial and Economic Structures.

Volcker could carry this off, as possibly could have earlier former non-academic Fed chairmen (ie, not Arthur Burns). But it seems the Fed has been badly, hopelessly captured by the industry, which is the converse of what is desirable. Unless a new President is able to find and slowly restock the Fed with men and women with some good old fashioned probity, the instability and propensity to financial excess will only get worse.

"Inflation here, there and everywhere"

Willem Buiter argues that the focus on oil and food price shocks, which economists view as relative price changes rather than inflation, is muddying the discussion about inflation. He sees considerable evidence of widespread inflation and it's central bankers' fault.

From Buiter:

Inflation is rising just about everywhere. Why is this and what can be done about it?

To get some basic concepts clear: inflation is a sustained rise in the general price level. Both the words ’sustained’ and ‘general price level’ are imprecise and in need of operationalisation. By general price level I mean a broad, representative index of consumer prices. That excludes the (headline) CPI in the UK....

I also exclude as unrepresentative various ‘core’ price indices, which exclude from the headline index such things as food, drink, energy and fuel. Among leading central banks, only the Fed has focused mainly on core inflation rather than on the headline index of consumer goods and services prices. Focusing on core inflation will be misleading unless either the relative price of core and non-core goods and services is expected to remain constant or Americans don’t eat , drink, drive cars and heat their houses or use air conditioning.

Until recently the Fed believed (a) that the best forecast of the future relative price of core and non-core goods and services was the current relative price of these sub-indices and (b) that the prices of non-core goods (mainly energy, fuel and agricultural commodities-based products) were more volatile than those of core goods and services. The volatility point was and remains empirically correct. The random walk or martingale hypothesis for the relative price of core and non-core goods was always a bad assumption empirically. In the most recent phase of globalisation, which has for much of this decade delivered a steady increase in the relative price of non-core goods to core goods and services, the assumption that it is OK to take this relative price as constant in the future is bad statistics and bad economics. Fortunately, the Fed is showing signs of kicking its core inflation habit, although painful withdrawal symptoms still are apparent from time to time. Admitting you have geen wrong is almost as difficult for central bankers as it is for politicians.

By ’sustained’ I mean,…uh, well, you know, something like ‘persistent’. And by ‘persistent’ I mean ’sustained’. Unsustained would be any one-off increase in the level of the price index that is not associated with expectations of further increases. I know this is vague and unsatisfactory, but welcome to the world of applied social science. For practical purposes, a representative price index that rises for more than two years would indicate inflation.

Who or what causes inflation?

This one is easy. In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always can be offset by the central bank, given enough time, freedom to act and courage.

So, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices - in the real prices of oil, of food, of oil and of labour for instance - if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation.

Sometimes the central bank is the political captive of the fiscal authority. This is most clearly the case in countries with underdeveloped financial systems where seigniorage (the revenues appropriated by the central bank through the issuance of fiat money) is a significant source of government revenue and the central bank is not operationally independent. Sometimes the revenue needs of the government force a non-independent central bank to monetise the governments deficits. Zimbabwe is an example today. This is not a relevant consideration in today’s advanced industrial countries, as the revenue from seigniorage is tiny (around 0.25%-0.5% of GDP or less).

But with an operationally independent, sufficiently well capitalised central bank, the monetary authorities can, on average in the medium and long term, achieve the inflation rate they want. They are responsible, no-one else.

I assume, of course, that the exchange rate either floats or is set by the central bank. With a fixed exchange rate, or an exchange rate whose value is not set by the central bank, there is no substantive central bank independence. Given a floating exchange rate or a central-bank-set exchange rate, the central bank can make inflation in the medium and long term anything it wants it to be.

The central bank pursues its inflation objective by raising its policy rate (a short default-risk-free nominal interest rate) whenever inflation is expected to be above target over the horizon the central bank can influence it in a predictable way (starting between 6 and 12 months from the present), and by lowering the policy rate whenever inflation is expected to be below target. It’s simple, really. In financially repressed systems like India, the interest rate instrument (a) cannot be used freely because of political constraints and (b) has only a very small anvil to hit. So credit controls, including selective credit controls have so supplement the exchange rate as anti-inflationary instruments. It is clear that the Chinese authorities either don’t know the degree of monetary tightening (through credit controls, interest rate increases and yuan appreciation) that is required to bring inflation first under control and then down to a lower level, or that the economically necessary degree of monetary, credit and exchange rate tightening is noty yet politacally feasible.

Inflation is rising (almost) everywhere

The UK just got a nasty inflation shock. On the Bank of Englan’s official target, the CPI, year-on-year inflation in April came out at 3.0 percent, a full percent above the 2.0 percent target. Any higher and we would have had another Letter of St. Mervyn to the Tresorians. We are likely be see another couple of espistels again this year. The increase from 2.5 to3.0 percent was both large and larger than expected. It was preceded by a slew of data showing manufacturers costs and prices rising at alarming rates. The imminent interest rate cuts that had been anticipated by markets because the marked economic slowdown that is under way will reduce capacity utilisation and bring inflation down, are likely to be shelved for the time being. If the coming months confirm the pattern of higher than expected inflation, interest rate hikes must be on the cards for the UK, as even quite sharp increases in excess capacity may not be enough to bring inflation back to its target sufficiently quickly.

The reporting of the increase in UK inflation has been abominable, even in papers that still credit their readers with IQs in double digits. The Financial Times contained a deeply misleading article headed “Familiar culprits drive surprise jump in bills”, with above it “7.2% food, 8.3% household energy,…., 18.7% fuel for transport…” etc. This is major-league disinformation as regards the drivers of inflation. There is indeed a familiar culprit for the increase in the cost of living - the Bank of England’s Monetary Policy Committee. The fact that this rise in inflation is accompanied by shocks that cause major changes in relative prices, including a nasty adverse terms of trade shock for the British consumer, is neither here nor there as regards the overall rate of inflation. If fuel for transport, food and household energy had not gone up at all, other prices would have gone up by more to produce pretty much the same overall rate of inflation.

I am willing to grant the old-Keynesians and new-Keynesians among us, the empirical regularity that at very high frequencies, the fact that most nominal commodity prices (and prices of non-core goods in general) are flexible (both ways), while most nominal core goods and services are sticky in the short run. So relative demand or supply shocks that cause the relative price of non-core goods to go up will tend to do so in the first instance through an increase in the nominal price of non-core goods rather than through a reduction in the nominal price of core goods and services; likewise relative demand or supply shocks that cause the relative price of non-core goods to do down will tend to do so in the first instance through a decline in the nominal price of non-core goods rather than through an increase in the nominal price of core goods and services.

So for a given stance of past, current and future monetary policy (as measured by the sequence of past, present and contingent future policy rates), relative demand and supply shocks that cause an increase in the relative price of non-core goods (the kind of shocks we are seeing globally today), will temporarily raise inflation above the level at which it would have been without these relative demand and supply shocks but with aggregate demand and supply at the same level. Such general price level blips work their way through the system quite swiftly; much of it is gone within a year, virtually all of it within two years. The do not ’cause inflation’.

In the Euro Area inflation has come down a little to 3.3 % year-on-year (on the inadequate HICP index, admittedly), from last month’s peak at 3.6%. For a central bank that aims at inflation in the medium term of below but close to 2 percent, this is not a great or even an acceptable performance. Unless the Euro Area level of activity slows down sharply, higher interest rates from the ECB cannot be ruled out.

Inflation in the US is running at 4.0 percent on the headline CPI inflation (which does include housing costs). This is way above what should be the Fed’s comfort zone. The die-hard core inflationists there will point out that core inflation is only 2.4%, but the only appropriate answer to that is: so what? Core inflation is of interest only to the extent that it is a superior predictor of future headline inflation. If it ever was, it has ceased to be so this millennium. The Fed has let inflation get away from it even more than the ECB and the Bank of England.

Even in Japan, inflation is positive again and rising.

In the BRICS, inflation is high and rising. China’s inflation rate just went up to 8.5 percent; and no, it’s not rice, chickens, pigs or energy, it’s inflation made by lax monetary policy in the short and medium term and a positive output gap in the short term. In fact, if we allow for inflation suppressed by price controls, the equivalent open inflation rate in China is probably above 10 percent. In Russia, inflation is well into double digits and rising. In India inflation is above 5 percent and rising. Only Brazil appears to have inflation reasonably steady at 4.73%, close to its target value.

Inflation is rising in countries that are tied to a weak currency, like the Gulf Cooperation Council States. Inflation is rising in countries tied to a strong currency. Latvia’s inflation rate came in at 17.8 percent. Inflation is rising in countries that have a floating exchange rate, like Iceland.

Central banks across the world have had it too easy for too long. It is time to bring inflation down to tolerable levels through appropriate restrictive policy. Fiscal tightening cannot reduce the short-run paid, but it can bias the composition of the necessary contraction in favour of the protection of investment. Unfortunaltely, both in the UK and in the US, discretionary stimuli instaed primarily support a still excessively buoy level of consumer demand.

As as regards those analysts and repporters who consider the inflation rate and inform you that, provided you exclude the bundles of goods and services whose prices have increased the most, the inflation rate of the rest is quite modest, cast them out, because they are not your friends.

Volcker Calls for Regulation, Questions Loyalties of GSEs

Former Fed Chair Paul Volcker reiterated some of his concerns about the Fed's recent moves and the evolution of the financial system in prepared remarks before the Joint Economic Committee of Congress. From the WSJEconomicsBlog:

“Whatever claims might be made about the uniqueness of current circumstances, it seems inevitable that the nature of the Fed’s response will be taken into account and be anticipated, by officials and market participants alike, in similar future circumstances,” Volcker said ....

The Fed, he said, “felt it necessary to extend that safety net” to systemically important institutions by “providing direct support for one important investment bank experiencing a devastating run, and then potentially extending such support to other investment banks that appeared vulnerable [to] speculative attack,” Volcker said.

“Hence, the natural corollary is that systemically important investment banks should be regulated and supervised along at least the basic lines appropriate for commercial banks that they closely resemble in key respects,” he said...

He said heavily “engineered” financial markets, using sophisticated mathematical models, led to “enormous complexity” and “opaqueness” in markets.

“In the process, close examination of particular credits with respect to risk has too often been lost; the subprime mortgage is only the leading case at point,” Volcker said. “This new system has failed the test of the marketplace.”

Volcker said the Fed’s role in banking and financial supervision “should be recognized more clearly than in present law.”

“Specifically, direct and clear administrative responsibility should lie with a senior official, designated by law” Volcker said, and more staffing at the Fed will be needed.

Given the global nature of markets, Volcker said reform can’t proceed in a vacuum and urged cooperation with the European Union and Japan, citing past successes in developing bank capital requirements, accounting standards and settlement procedures...

He also warned that initiatives by the Fed and other central banks to boost liquidity in mortgage-backed securities markets raise public policy questions. Central banks, he said, have become “supporters of the mortgage market.”

And he questioned the role of government-sponsored enterprises such as Fannie Mae and Freddie Mac during the recent turmoil in mortgage markets. “Where were Fannie Mae and Freddie Mac?” Volcker said.

“What kind of system do we have” when agencies charged with the public interest in housing are instead “out serving the interests of their shareholders?” he added.

Jim Hamilton Scolds Bernanke for Regulatory Neglect

Jim Hamilton must feel like a Cassandra. Last August, he warned that the GSEs were in danger of having the ambiguous status of their implied guarantee tested. That came in January, and was finessed with various new Fed facilities.

Hamilton has also warned repeatedly that the Fed needs to consider institutional reform, not merely bailing out the boat as it continues to founder. He continued on that theme today in Econbrowser in parsing Bernanke's remarks on Tuesday. Most observers focused on his comments on the continued rockiness of the markets; Hamilton worried about other oversights:

Bernanke concludes that it's the responsibility of the central bank to stop such self-fulfilling instability. But he neglects to discuss the key feature of a healthy financial system that is supposed to prevent such a problem from ever arising. Specifically, any institution that is in this position of borrowing short and lending long needs to ensure that a certain fraction of the funds it is lending came not from borrowers but instead from the owners of the institution itself, in the form of net equity. The goal is for the size of this net equity to be larger than the losses the institution would incur from selling its less-liquid assets at steep discounts. As long as it is, no creditors ever have reason to demand cash, and there would be no need for the central bank to step in to prevent a self-fulfilling breakdown.

And the core reason we are in the mess we are today is that these equity stakes were nowhere near sufficient for this purpose. Instead, financial institutions were allowed to take highly leveraged positions whose details are largely opaque to readers of publicly available financial statements. Exhibit A here might be Bear Stearns, whose 2007 10-K reported that Bear had outstanding derivative contracts whose notional value was $13.4 trillion. Much of these were credit-default swaps, in which the seller receives a fee in exchange for promising to pay any losses incurred by the buyer on some specified asset and time interval. If every such asset lost 100% of its value over the period, then maybe Bear is supposed to pay or receive $13.4 trillion. In practice, the actual price moves and net sum owed would be a small fraction of that notional total.

Now, there is nothing inherently wrong in making financial investments in the form of derivative contracts rather than outright loans. You're doing something similar whenever you buy or sell an option rather than the stock itself. But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.

If anything like a reasonable margin requirement had been in effect, Bear Stearns could not possibly have gotten into contracts totaling $13.4 trillion notional. But these weren't traded on a regular exchange, so there was no margin requirement, and apparently no real limit on the size of the exposures that Bear Stearns could take on, or the size of what they could bring down with them if they fell.

And that raises the question, Why were counterparties willing to accept these trades with no margin to guarantee payment? To this I'm afraid the answer is, they figured Bear was too big for the Fed to allow it to fail. And on this, I'm afraid they proved to be exactly correct.

I would feel better if Bernanke were less focused on how to "provide liquidity" and more focused on how to get the system deleveraged and more transparent.

A minor quibble: we looked at the footnotes on Bear's derivatives positions when it was going down for good, and much of it looked to be more plain vanilla interest rate swaps. But the general point is well taken. Bear was a significant CDS writer, and its equity was insufficient given the size of its derivatives book.

Waldman: Halt the Fed's Mission Creep

Steve Waldman has a typically top notch post at Interfluidity,"Let's not write the Fed a blank check," in which he dissects the implications of the Fed's request to Congress to pay interest on bank reserves.

Waldman explains the technical workings and the pros, and gets to the real issue. This represents a change from a fractional reserve banking system to a so-called channel or corridor system. Fixed reserves become incidental and might be dispensed with, since the Fed would manage interbank rates directly by setting what amounts to a bid and offered price (a bit simplified, see Waldman for details).

Now the Fed did not just wake up and decide in a fit of housekeeping to adopt this practice, which has been road tested by other central banks. The problem, as has been clear from the when this idea first surfaced, is that its main objective is to allow the Fed to circumvent its balance sheet constraints in salvaging the financial system. The method open to it now, of simply issuing liabilities so it could take on more dodgy assets, is tantamount to printing money and inflationary.

Aside: you thought the credit crisis was over? This proposal says the Fed is afraid it isn't. Per Waldman, the Fed has already used $475 billion of balance sheet capacity and has another $300 billion to go. As he points out, the amount already loaned to Wall Street equates to $1500 per person in the US; use of the additional $300 billion would bring it to $2500. Don't kid yourself; if these loans go bad, they come out of the public purse. The Fed wants approval for a mechanism that allows it to go even higher.

The Fed's mission creep is yet another sorry Greenspan era development. Earlier central banks understood their mission: to provide a stable price of money, preserve the soundness of the banking system, and promote full employment. Greenspan took an unprecedented interest in the stock market, which has never been any central bank's responsibility (a May 8, 2000 Wall Street Journal cover story discussed this at some length, although predictably not in disapproving terms). Even worse, Greenspan's predilections seemed a prescription for moral hazard: minimal regulation and a "let a thousand flowers bloom" approach to new products, no matter how geared, combined with aggressively backstopping the industry at any whiff of trouble.

Much has been written about the Greenspan put; less has been said about his Fed's other moves that extended the Fed's purview without any formal approval. The biggest, the one that set the stage for the Fed's current expansive view of its role, was the bailout of LTCM. Although the Fed did not broker the deal, it did review LTCM's books before calling 24 firms, most of which it did not regulate, to meet at its offices. While that intervention has in retrospect been presented as a success, it wasn't clear then, and cannot be determined now, whether a LTCM failure would have been a systemic event. However, at the time, it was quite controversial, precisely because the Fed was extending its reach to areas that were not part of its charter.

The problem, as Richard Sylla points out in the Palgrave Dictionary of Money and Finance, is that

.....the Fed was a compromise between two central banking traditions in America. Each was tried for extensive periods and then rejected. The first was the tradition of the corporate central bank, chartered by the State but owned wholly or in great part by private investors...After the corporate central bank was rejected, the US flirted for seven decades with a second central banking tradition, namely having the the government's fiscal authority, the US Treasury Department, serve also as the central bank.....The Federal Reserve Act rejected the earlier traditions of monetary policy controlled by bankers or the Treasury, but it gave each of these interests a voice in central bank policy formation.

Fast forward 95 years, and we are coming to the limits of this model. Not only have private interests managed to co-opt the central bank, as opposed to have a voice in monetary policy, but they have the Federal government apparently ready and willing to give the industry an unlimited, unconditional guarantee. Retail deposit insurance is capped; why should professional investors, shareholders (who unless they work for Bear, know to diversify their holdings) and incumbents, who created this mess, get a far more generous deal?

Remarkably, and sadly, Congress had the chance to rein in the Fed during its hearings on the Bear rescue. Indeed, I thought that was the point of that exercise. But having given the Fed a free pass, there is zero possibility that the legislature will leash and collar the Fed as Waldman recommends below.

From Waldman:

As long as the Fed is conducting ordinary monetary policy, switching to a channel system offers modest benefits at a modest cost to taxpayers. But the Fed's monetary policy has not been ordinary at all lately. In fact, it's been quite extraordinary....and it is in the context....that we must consider the change.

The core of the Fed's new exuberance is a willingness to enter into asset swaps with banks.... In doing so, the Fed puts taxpayer funds at risk. If a bank that has borrowed from the Fed runs into trouble, the Fed would face an unappetizing choice: Orchestrate a bail-out, or permit a failure and accept collateral of questionable value instead of repayment. Either way, taxpayers are left holding the bag.

In December, the Fed had $775 worth of Treasury securities. That stock will soon have dwindled to $300B, give or take. The difference, about $475B, represents an investment by the central bank in risky assets of the US financial sector.

$475B is an extraordinary sum of money. It is as if the Fed borrowed more than $1500 from every man, woman, and child in the United States, and invested that money on our behalf in Wall Street banks that private financiers were afraid to touch. For bearing all this risk, if things work out well, taxpayers will earn about what they would have earned investing in safe government bonds. If things don't work out well, the scale of the losses is hard to predict. The Fed will claim to have done "due diligence" on its loans, to have valued collateral conservatively, and will point to strength of bank guarantees and the enormous diversity of collateral assets to convince us that its actions are safe and prudent. But rating agencies made the same claims about AAA CDO tranches, and turned out to have been mistaken. Correlations often tend towards one when asset values fall sharply. Central bankers struggling to manage day-to-day crises in financial markets might cut corners when trying to value complex securities. They might find it convenient to err on the side of optimism, as the ratings agencies did, albeit for very different reasons. And even if the Fed is cautious and sober-minded, are we sure that central bankers can value these assets more accurately than private investors?

If the Fed were to blow through the rest of its current stock of Treasuries, it would have invested more than $2500 for every man, woman, and child in America. Public investment in the financial sector would have exceeded the direct costs to date of the Iraq War by a wide margin. Would that that be enough? If not, how much more? Just how large a risk should taxpayers endure on behalf of companies that arguably deserve to fail, to prevent "collateral damage"? Have we considered other approaches to containing damage, approaches that shift costs and risks towards those who benefited from bad practices, rather onto the shoulders of taxpayers and nominal-dollar wage earners? Does this sort of policy choice belong within the purview of an independent central bank?....

I don't love the decisions that were made, but decisions did have to be made, and there weren't very good options. But now we have a moment to reflect. If the credit crisis flares hot and bright again, how much more citizen wealth should be put at risk before other policy options are considered? That's not a rhetorical question: We need to choose a number, a figure in dollars. My answer would be something north of zero, but not more than the roughly $300B stock of Treasuries that remains on the Fed's balance sheet....

.....suppose Congress gives the Fed the authority to pay interest on reserves. Suddenly the Fed can print cash to buy all the Treasuries it wants to swap for troubled assets..... Since interest rates can be held to any level by adjusting the "corridor", the Fed would retain the flexibility to respond to inflation. At the same time, it would be able print cash in any amount that it pleases — "to infinity and beyond!" — in order to fund asset swaps (or outright purchases) at taxpayers' risk. This strikes me as a delegation of Congressional authority that would not only be undesirable, but arguably unconstitutional......

I think that Congress should grant the Fed's request, but it should simultaneously impose constraints on the composition of the Fed's balance sheet that cannot be violated without express legislative consent. This will be a complicated exercise, unfortunately. Besides government debt, central banks quite ordinarily hold precious metals and foreign exchange, and limitations on non-Treasury assets will have to take this into account. Plus, restrictions would have to be written carefully to apply to off-balance sheet arrangements such as TSLF, and contingent liabilities like the insidious reverse MBS swap proposal. Finally, Congress must consider restrictions on the Fed's ability to enter into derivative positions, whether directly or indirectly via special purpose entities, including how the bank's existing derivative book should be managed and whether the bank should or should not guarantee the liabilities of current Fed-affiliated SPEs.

Congress might also limit the quantity of reserves on which the Fed will be permitted to pay interest.

The Fed can retain full independence for the purpose of conducting ordinary monetary policy, exchanging government debt for cash and vice-versa. But if the central bank wants to put ever greater quantities of public money at risk, it will have to accept a lot more public supervision. If the prospect of intrusive oversight is too much for the Fed, then, as James Hamilton hints, perhaps the roles of central bank and macroeconomic superhero should be moved to separate boxes on the organizational chart. If we are not careful, the next bank requiring a taxpayer bailout may be the Federal Reserve system itself.

Joseph Stiglitz Lambasts Inflation Targeting

In Project Syndicate (hat tip Mark Thoma), Joseph Stiglitz takes on an increasingly common approach among central banks, namely, to announce a formal target for inflation and use interest rate policy to attempt to achieve it. Note the US does not use this approach, although one of the Fed's responsibilities is to maintain price stability. One justification for inflation targets is greater transparency. Letting market participants know what deviations might trigger a policy response is thought to encourage a certain amount of restraint among private sector actors. It also means fewer surprises when monetary authorities raise and lower rates.

Despite the seeming logic of inflation targeting, I've never been comfortable with it. Bizarrely, it seems an offshoot of Friedman's dictates, although it's precisely the sort of thing the monetarist would have ridiculed. Friedman advocated setting strict monetary growth targets (although before his death he retreated somewhat):

Nothing that I have observed in recent decades has led me to change my mind about the desirability of a monetary rule which simply increased the quantity of money at a fixed rate month after month, year after year. That rule would get rid of the mistakes and that is probably about all you could expect to get from a monetary system.

By contrast, Friedman was critical of using interest rates as a guide, perhaps based on his study of the Depression, when the central bank mistakenly saw low rates as a sign of permissive monetary policy, when in fact real rates were high, and the tightening turned a downturn into a disaster.

My impression, from afar, is that the authorities, having used monetary targets for a bit (I recall how the everyone on Wall Street fixated on the money supply announcement every Thursday at 4:00 during Volcker's tenure) came to find having a target of some sort useful and gravitated towards inflation targeting. I've never understood it, having never seen neither any compelling arguments in its favor nor any empirical support.

Stiglitz confirms my suspicions as to the lack of any sound basis for this practice. His article, "The urgent need to abandon inflation targeting." focuses on the mistakes it can generate in a setting like ours, when many countries are experience inflation due to rising costs of imported commodities. Increasing interest rates in, say, Poland will have no impact on prices set in global markets. To achieve the desired inflation level will require having domestic goods greatly undershoot the target via an overly aggressive rate increase.

Tease Stiglitz's logic out: if central banks stick to their targets, rather than yielding to domestic pressures, this means that the commodity price rise, which should dampen growth in and of itself, will lead to overly restrictive monetary policies in many countries and will worsen an international slowdown. That of course assumes that the authorities have the political will and clout to inflict that much pain, but the potential is clearly there.

From Project Syndicate:

The world’s central bankers are a close-knit club, given to fads and fashions. In the early 1980s, they fell under the spell of monetarism....After monetarism was discredited — at great cost to those countries that succumbed to it — the quest began for a new mantra.

The answer came in the form of “inflation targeting”, which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation, the best response is to increase interest rates....(Among the list of those who have officially adopted inflation targeting are: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, SA, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the UK, Sweden, Australia, Iceland and Norway.)

Today, inflation targeting is being put to the test — and it will almost certainly fail. Developing countries currently face higher rates of inflation, not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is expected to approach 18,2% this year, and in India it is 5,8% . By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?
Inflation in these countries is, for the most part, imported. Raising interest rates won’t have much effect on the international price of grains or fuel. Indeed, given the size of the US economy, a slowdown there might conceivably have a far bigger effect on global prices than a slowdown in any developing country, which suggests that, from a global perspective, US interest rates, and not those in developing countries, should be raised.

So long as developing countries remain integrated into the global economy — and do not take measures to restrain the impact of international prices on domestic prices — domestic prices of rice and other grains are bound to rise markedly when international prices do.

Raising interest rates can reduce aggregate demand, which can slow the economy and tame increases in prices of some goods and services, especially nontraded goods and services. But, unless taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. For example, even if global energy and food prices increase at a more moderate rate than now — for example, 20% per year — and get reflected in domestic prices, bringing the overall inflation rate to, say, 3% would require markedly falling prices elsewhere. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.

So, what should be done? First, politicians, or central bankers, should not be blamed for imported inflation, just as we should not give them credit for low inflation when the global environment is benign.

Second, we must recognise that high prices can cause enormous stress, especially for poorer people . Riots and protests in some developing countries are just the worst manifestation of this.

Advocates of trade liberalisation touted its advantages; but they were never fully honest about its risks, against which markets typically fail to provide adequate insurance. When it comes to agriculture, developed countries, such as the US and European Union members, insulate both consumers and farmers from these risks....Many are imposing emergency measures like export taxes or bans, which help their own citizens, but at the expense of those elsewhere.

If we are to avoid an even stronger backlash against globalisation, the west must respond quickly. Biofuel subsidies, which have encouraged the shift of land from producing food into energy, must be repealed. Some of the billions spent to subsidise western farmers should now be spent to help poorer developing countries meet their basic food and energy needs.

Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much effect on inflation; it will only make the task of surviving in these conditions more difficult.

Mirable Dictu! The Journal Says a Few Discouraging Words About the Markets and Economy

The Wall Street Journal so often presents the optimistic case that it's important to reinforce those occasions when it provides a less than cheery view. Of course, a journalist is only as good as his sources, and the bullish bias is in large measure due to the insistent upbeat posture of CEOs and sell-side analysts who are oft quoted in the business press.

The Journal even went so far as to give two separate cautionary messages. The first was in "Bulls' Optimism May Be Premature," which warned that while first quarter earnings so far had exceeded expectations, fourth-quarter estimates looked a tad unrealistic:

First-quarter earnings-per-share are on track to post a 15% decline from a year earlier, according to Thomson Reuters. Yet analysts still expect earnings to be up 10% for the full year. That translates into a slight loss in the second quarter, solid earnings growth in the third quarter and a fourth quarter that would be the most profitable in history.

Thomas Lee, equity strategist at J.P. Morgan Chase & Co., thinks expectations for the fourth quarter are too high. The consensus forecast of roughly $93 a share for the Standard & Poor's 500 stock index as a whole would amount to "unprecedented profitability," he says. Meanwhile, the only two sectors that have posted record profits are energy and materials, which combined contribute just one quarter of all the profits from companies in the S&P 500.

The companion dose of sobriety came from Greg Ip in "Economy May Face Prolonged Pain, History Suggests." While Ip no doubt read the Kenneth Rogoff/Carmen Reinhart paper on financial crises, which looked at eighteen countries that had suffered financial crises. They concluded the US situation bore a strong resemblance to the worst five, and their progress indicate that the worst is yet to come for the US.

Ip, who is widely believed to have privileged access to the Fed (and is therefore also believed to carry messages from it) focused on the similarities to the 1997 crisis in South Korea. Even though the narrow financial crisis was resolved rather quickly, the damage to the economy was severe and sustained, with growth failing to return to its pre-trauma level. Note he also made a surprisingly bald statement about the Fed's worries at the end:

The economic fallout from a crisis depends on how much underlying economic factors -- such as consumption, investment and asset prices -- are out of whack with their fundamental determinants. The 1987 stock-market crash and the near-collapse of hedge fund Long Term Capital Management in 1998 threatened the heart of the financial system. But the underlying imbalances were largely limited to the financial markets themselves: stocks overvalued relative to earnings in 1987, and excessive hedge-fund borrowing in 1998. Thus, once the Federal Reserve's rescue operations had mitigated the threat to the financial system, the economic fallout was limited.

The current crisis is different. For several years, U.S. home prices and home construction kept climbing past levels considered sustainable. Homes became collateral for trillions of dollars in borrowing. That depressed savings, inflated consumption, fueled rapid lending and loosened loan standards.

When home prices stopped rising, the diciest mortgages began to default, triggering the crisis. But even now, prices are above most estimates of sustainable levels, and household saving has barely picked up....

For a parallel, the U.S. might look to South Korea. Its financial crisis peaked on Dec. 24, 1997, when its currency, the won, hit a record low against the dollar.....Over the ensuing year, the won rose 63%. But the Korean economy sank into a deep recession. In 13 months, the jobless rate soared to 7.9% from 3%. The economy shrank 6% in 1998, a huge shock to a country accustomed to 8% growth.

Korea's economy had been bolstered for years by overinvestment by its chaebols, or industrial conglomerates....

But in early 1997, several chaebols, which had been losing competitiveness, began to experience difficulties. When Korean banks lost their ability to borrow overseas, many failed; those that survived severely cut back lending. The chaebols slashed investment and laid off thousands. Many went bankrupt. Layoffs and recession were a shock to Koreans who "were so used to high growth and very low levels of unemployment," Mr. Kim says.

Ted Truman, a scholar at the Peterson Institute for International Economics who worked on the Korean rescue as a Fed official, says the overexpansion and excessive borrowing of Korea's corporate sector in the run-up to its crisis are analogous to the overexpansion of housing and consumption in the U.S. in its crisis. In each case, a collapse in the affected sector severely wounded the financial system. Korea's recovery was led by exports, much as exports are proving a cushion to the U.S. now.

Korea's recovery began in 1999. Mr. Kim says that capital investment never fully recovered and that economic growth, while a healthy 4% to 5%, hasn't returned to the precrisis pace. Unemployment is deceptively low, he says, because of hidden unemployment, such as students who can't find jobs staying in school. Korea's lesson to the U.S., he says, is that "imbalances must be corrected." A recovery doesn't need a full resolution of those imbalances, he says, only a "convincing sign that change is taking place."

The risk for the U.S. is that weakness goes beyond the correction of housing excesses and begins to feed back into the financial system and then, again, hurts the wider economy.

By contrast, says Nouriel Roubini, an economist who heads RGE Monitor, a financial- and economic-forecasting service, the U.S. financial system has adjusted only to the losses on mortgage loans. He predicts that a wave of defaults on industrial loans, municipal bonds and consumer credit is coming, which will trigger another wave of financial-system distress.

Fed Chairman Ben Bernanke believes such feedback effects are what made the Great Depression great. Mr. Bernanke's awareness of such risks is why he cut rates last week and, despite signaling a pause, is still focused on the risks that the U.S. economy may deteriorate further.

Is the Credit Crisis Really Over? Minsky Would Say No

The "end of the credit crisis" apostates looks to be a small and shrinking group (and we don't mean just the downbeat but nevertheless accurate Nouriel Roubini or Michael Panzner).

I'm amazed our number is as small as it is, given the overwhelming counterevidence in the form of the increase in the Term Auction Facility by $50 billion and expanding the types of assets that can be pledged for the TSLF to include asset backed securities consisting of auto loans and credit card receivables. This may be a direct effort to stand in for the moribund asset backed commercial paper market. Oh, and in case you somehow missed it, the ECB joined in with a $20 billion addition, bringing the size of its program to $50 billion and Swiss National Bank increased its facilities by $6 billion to a new total of $12 billion. If things are so hunky dory, why is the officialdom throwing large amounts of money at a problem that is over?

Calculated Risk weighted in with "Credit Crisis: In the Eye of the Hurricane," which gave some cautionary views from Jamie Dimon, Goldman, and even the Wall Street Journal. The Telegraph questioned the sanguine reading in the latest issue of the Bank of England's Financial Stability Report:

"We're at the end of the beginning, not the beginning of the end," says Standard Chartered chief economist Gerard Lyons. "The next chapter will be a period of financial consolidation and economic challenges. The Bank clearly hopes that it can restore confidence to the financial markets so they are in better shape to handle future economic problems."

Hence, Sir John's bold statement that the "likely path ahead is confidence". For as long as the markets are self-fulfilling, the Bank might as well be upbeat on the credit crunch.

Others are less convinced. Danny Gabay, a former Bank official now at Fathom Financial Consulting, remains a sceptic: "I'm surprised a major central bank is taking this position at this early stage. The original source of the shock – three-month Libor – remains where it was. I'd be a lot more convinced if Libor was at half where it stands today."

A particularly persuasive reading comes from Doug Noland at Prudent Bear. A student of Hyman Minsky, he takes his theory of "Monday Manager Capitlaism" one step further into "Financial Arbitrage Capitalism," which means that the inmates are not merely running the asylum, they've learned how to position themselves not as crooks, but as prison facilities managers, expand their operations to other locales, and secure government funding.

In all seriousness, the problem that Noland alludes to is that finance is now driving the real economy. And given how speculative our financial system has become, this is leading to poor capital allocation and increased volatility, both of which will dampen growth. Keynes considered reducing volatility to be a major goal of policy, since it would lower the risk premia investors required, and more favorable interest rates would promote greater investment and with it, growth (note that Keynes did not propose the countercyclical measures that have become associated with his name). But high volatility produces the reverse effect: investors demand higher returns to compensate for heightened risk, which reduces invesment. But traders find it hard to make money in quiet markets; a certain level of fluxuation is their friend. So Wall Street's interests can and increasingly do conflict with those of Main Street.

Looking at the world through the Minksy-via-Noland lens exposes the flaw in the credit optimists' thinking. Keeping the game going in its current form requires an increase in leverage. The private sector had hit the point where credit had expanded beyond the ability of the underlying assets to support it. but rather than let asset prices fall to a level commensurate with their cash flow (or try to temper the deleveraging), central banks are instead trying to validate inflated asset values via artificially low interest rates and credit support to dodgy debt. That effort will eventually fail and eventually is likely not all that far off. The negative real rates will fuel new speculative activity, exacerbating the problem of overly high leverage relative to GDP. As AutoDogmatic pointed out:

That very complex of unusually high foreign buying of US debt (that is, lending to us) is now being choked off by its own consequences: the collapse of all the US credit markets...

The upshot is we aren't going to be able to increase our borrowing to fix the problems now. And we can't enter a war to generate the necessary stimulus (a-la FDR) because we're already completely extended fighting two of them....virtually all of the capital investment in America in the past three decades went into the military and military-related expenditures overseas, rather than truly productive areas like manufacturing back here at home, so we have nothing we can gear up to generate surplus output.

We are thus faced with the farcical situation where the government has already begun "bailing", but it is having to borrow even more to do so. Since we're past the point of exhaustion (beyond the "Minsky moment") already, this borrowing is apt to have increasingly disastrous effects. Look at the $160 billion emergency stimulus bill congress passed a few months ago (with checks having started going out in the mail a few days ago). The government is immersed in a record-breaking fiscal deficit -- so bad the Treasury Borrowing Committee is crying "uncle" -- so where is it going to get the money to pay these checks?

More borrowing, of course. But what happens when you add more borrowing when the supply of lenders is shrinking? Interest rates go up.

The Fed currently has a policy of holding interest rates down, to hold together the creaking financial system. As we discussed, borrowing is already dramatically ramping up because of structural spending needs, the war, and now bailouts. These two objectives are in conflict. Something will have to give.

Whether the Fed allows it or not, interest rates will rise. The Fed may succeed in artifically holding down interbank rates, but this will not help most of us. Soon we will be faced with the ultimate farce of mortgage rates dramatically rising because of all of our national borrowing, even though much of it has been piled on to help out those harmed by the housing bubble!

And to Noland's discussion of the progression, or more accurately, devolution, of financial capitalism:

Minksy on “Money Manager Capitalism:

”The emergence of return and capital-gains-oriented block of managed money resulted in financial markets once again being a major influence in determining the performance of the economy. However, unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits… As managed money grew in relative importance, more and more of the market for financial instruments was characterized by position-taking by financial intermediaries. These positions were bank-financed. The main financial houses became highly-leveraged dealers in securities, beholden to banks for continued refinancing. A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market...The question of whether a financial structure that commits a large part of cash flows to debt validation leads to a debacle such as took place between 1929 and 1933 is now an open question…

“In the present stage of development the financiers are not acting as the ephors of the economy, editing the financing that takes place so that the capital development of the economy is promoted. Today’s managers of money are but little concerned with the development of the capital asset of an economy. Today’s narrowly-focused financiers do not conform to Schumpeter’s vision of bankers as the ephors of capitalism who assure that finance serves progress. Today’s financial structure is more akin to Keynes’ characterization of the financial arrangements of advanced capitalism as a casino. The Schumpeter-Keynes vision of the economy as evolving under the stimulus of perceived profit possibilities remains valid. However, we must recognize that evolution is not necessarily a progressive process: the financing evolution of the past decade may well have been retrograde.” (Minsky, 1993)

I am even more convinced today than some six years ago that a whole new financial structure has evolved – and that it is definitely “retrograde.” The title “Financial Arbitrage Capitalism” is fitting for a Credit system and economy now dominated by an expansive “leveraged speculating community” seeking profits from variations and permutations of “borrowing cheap and lending dear”; by bond and investment fund managers whose entire focus is beating some indexed return; by rapidly expanding Wall Street balance sheets and influence; and by the entire wave of new Credit instruments, derivatives, and sophisticated models and strategies used for the paramount purpose of capturing “above-market” returns and resulting huge financial rewards....

Today, the financial apparatus is “beholden” – not to a coherent banking system but instead - to an ambiguous thing called “marketplace liquidity” ..... With “Financial Arbitrage Capitalism,” the bounty of seemingly limitless (until recently) speculative profits has created a reward system encouraging unprecedented debt creation, leveraging, and myriad forms and layers of financial intermediation....

Minsky noted a fundamental weakness of Money Manager Capitalism: “Unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits.” Financial Arbitrage Capitalism takes these defects to an entirely new level. Today, the major financial incentives dictating behavior are largely disengaged from the process of “capital development” and, furthermore, operate completely divorced from real economic profits overall. Or, more simply stated, current rewards spur the over-expansion of non-productive Credit – specifically debt instruments not supported by underlying wealth-creating assets (think subprime and high-yielding mortgages generally).

Mortgage Credit is the bedrock of “Financial Arbitrage Capitalism.” The Mortgage Finance Bubble provided – and continues offering to this day - the greatest bounty of speculative profits the financial world has known....

For some time now, it has been my view that “Financial Arbitrage Capitalism” was sowing the seeds of its own destruction. The incentive structures were so deeply flawed; the analyses of the inner workings of this system were critically flawed; and policymaking was devastatingly flawed. The combination of rampant non-productive Credit growth, unprecedented system leveraging and speculative excesses, and resulting economic maladjustment ensured untenable system fragility...

Will policymaking succeed over the intermediate- and long-term? Not a chance. Policymakers do today retain capacity to convince the marketplace of their power to inflate the value of debt securities and asset prices more generally. But reflationary polices and other assurances will not rescue the system, specifically because there is today nothing to stem the ongoing distortions to the underlying real economy. Validating the current structure of Financial Arbitrage Capitalism simply perpetuates the same dysfunctional incentives that got us into this mess. It may in the short-term spur the necessary Credit growth to buoy household incomes, corporate cash-flows and profits, government revenues, and securities and asset prices – but it will add relatively little in the way of real economic wealth creating capacity. And, in the end, it’s only real economy fundamentals that will determine the soundness and sustainability of a system’s Credit and Financial Structure.

Additional non-productive debt growth will definitely not alleviate the Acute Fragility associated with “Ponzi Finance” Credit system dynamics. Additional non-productive debt growth will also not stabilize dollar devaluation, nor will it help in stabilizing myriad problems at home and abroad associated with our monstrous Current Account Deficits. Instead, any extension of this period of Financial Arbitrage Capitalism will ensure the prolonging of borrowing and consuming excess, the gross misallocation of resources, massive trade deficits, a ballooning international pool of unwieldy speculative finance, and even wilder Global Monetary Disorder.

Indeed, Washington’s validation of the current dysfunctional Credit system structure could very well lay the groundwork for extreme global price distortions, volatility, and social/political unrest. On the current course of things, it’s difficult for me to not think in terms of NASDAQ 1999 or subprime 2006. Throw additional liquidity on overheated Credit, inflationary, and speculative “biases” and be prepared for the spectacular. When Financial Arbitrage Capitalism’s excesses were spurring acute U.S. securities market inflation, the system enjoyed a period of perceived rising wealth to go with a boom in Wall Street securities issuance (to help offset inflated demand). When this Structure’s excesses were directed at the Mortgage Finance Bubble, the upshots were inflating home prices along with attendant construction and consumption booms. Now, however, with acute inflationary effects prevailing throughout global markets for food, energy, and commodities, one should be prepared for the likes of problematic supply bottlenecks and shocks, hoarding, trade frictions and interruptions, and generally heightened geopolitical instability.

I argued back in 2002 that the overriding systemic issue was not “deflation” but rather myriad risks associated with an unfolding U.S. Credit Bubble. Now, some years later, these risks have expanded alarmingly, as runaway Credit Bubbles have ballooned both at home and abroad.

Why Such Timid Financial Reform Proposals? (Alan Blinder Edition)

Here we are, in the midst of the worst financial crisis since the Great Depression, and what do we see? Central banks madly pumping water out of leaky, listing vessels, some discussion of how to patch the most visible holes, but perilous little consideration of how to correct the defects of construction, poor choice of shipping routes, or recklessness of the crews and their captains.

Moreover, one has to wonder if the last two weeks' outburst of "the credit crisis is just about over" chatter isn't merely to talk up the markets, but also to forestall regulation. After all, if the worst is behind us, we clearly don't need to do anything, now do we? Of course, that view conveniently ignores the massive subsidies to the banking sector by the Fed's, the Bank of England's and now the ECB's willingness to create new liquidity facilities, and in the case of the Fed, accept increasingly dodgy collateral (I gasped out loud when I heard that the list had been expanded to include securitized credit card and car loans). But the Street knows full well that now that they have the dough, they have the advantage. It's rather difficult to renegotiate a loan once the proceeds are in the debtor's hands. Yes, technically, the Fed could refuse to roll outstanding loans, since, for example, the TAF is a 28-day facility, but the whole point of this exercise has been to avoid upsetting the financiers, so tough disciplinary measures will not be forthcoming.

The problem is that the ugly truth discovered by William Gladstone when he became Chancellor of the Exchequer is now on full view:

The government itself was not to be a substantive power in matters of Finance, but was to leave the Money Power supreme and unquestioned.

The latest example is the half-heated proposal set forth by Alan Blinder in today's New York Times, "The Case for a Newer Deal." The reference to the New Deal is disingenuous, since it brought a slew of radical, large scale interventions, some of which did not survive the 1930s. However, the securities law reforms implemented in 1933 and 1934 have not only proven to be durable, but became the template for public securities markets around the world.

Yet what Blinder recommends bears perilous little resemblance to the sweeping 1933 and 1934 acts. In fact, he even stoops to apologize for even daring to suggest regulation:

A warning to laissez-faire-minded readers: The following is mostly about the dreaded “R” word — regulation. But I’m afraid that we need more of that, starting in the mortgage market.

His first suggestion is to have a federal mortgage regulator (the notion being that the many of the worst mortgages were originated by unregulated brokers). Fine, but that's already on the table. Indeed, there is robust debate as to whether the Feds or the states should act as the supervising adults (states are arguably more motivated, give that mortgage abuses affect their communities and thus their tax bases; mortgages are subject to state, not federal law. Real estate broker licensing is also a state matter. An understaffed or half-hearted federal regulator might be even worse than the status quo).

Blinder's next observation:

Next, we should resist calls to scrap the “originate to distribute” model, wherein banks originate mortgages, which are then packaged into mortgage pools and turned into mortgage-backed securities that are sold to investors around the world.

There is good reason for us to keep it. As the refreshingly honest Lew Ranieri pointed out at the Milken conference, the securitization model saved America's bacon by distributing dodgy deals all over the world. Ranieri said the US financial system could not have withstood the amount of losses had the paper remained at home (although in fairness, I recall reading that by 2006, mortgage debt was being sold primarily overseas because US buyers weren't keen to acquire more. So the sales might have dried up sooner in the absence of access to foreign buyers and kept domestic exposures to a level we could bear).

But what Blinder misses is that model depends on credit enhancement. That's why Fannie and Freddie are being asked to assume a larger role, since they have an implicit Federal guarantee that is likely to be tested soon. Two of the three sources of credit enhancement – monoline insurance and credit default swaps – aren't an option right now (CDS are costly because few are willing to write protection right now). The only method of credit enhancement readily available right now for non-agency deals is overcollateralization, and investors appear more leery than they were in the past.

Blinder argues for having everyone in the securitization pipeline retain a piece of the mortgage pool. Um, Merrill and Citi DID wind up holding very large pieces of "super senior" tranches that they convinced themselves were fine and went out and originated more with the amount they would up retaining growing even larger. The magnitude of the fees led them to underestimate the risk. To have "keeping a piece" constitute enough of a check on behavior, the players along the pipeline would have to retain a fairly large piece, which means undermines the purpose of the approach. And Blinder fails to address another big failing: the difficulties of doing mods.

Blinder seems curiously blind to what this model hath wrought:

This seemingly convoluted model has given the United States the world’s broadest, deepest, most liquid mortgage markets. And that, in turn, has meant lower mortgage interest rates and more homeownership. These are gains worth preserving.

Liquidity is not a virtue in and of itself unless it produces a benefit to the real economy. And these vaunted lower interest rates were the result of deliberate distortion: the Fed pushing short rates to 1%, which was negative in real terms, combined with the industry pushing ARM structures for weak borrowers. This pattern, including the increase in homeownership, was a misallocation of capital, and anything but a virtuous outcome.

Reader Richard Kline gives a far more accurate picture of what happened:

How did the financial industry come to the pass we now face? This is the first question to ask in considering what structural or regulatory changes are desirable. The fundamental issue, to me, is the unwillingness of firms lending money to set aside appropriate reserves against losses, at any level. We have 300 years of modern banking history which has without exception indicated that unreserved lending is to a financial institution what the absence of an immune system is for an organism; a scratch can kill you (default cascade or credit cut off), while a real virus not only kills you but infects your neighbors. So we see again. This behavior, an unwillingness to reserve against losses, suggests its own trajectory of solutions but let’s do a brief review for context.

Loan retailers, including mortgage brokers, set aside very little for losses because they weren’t going to hold the debt; instead, they pushed it up the chain, typically for securitization. Banks skirted their reserve requirements by opening conduits with pitiful liquid reserves to park debt of various kinds while shopping it or bundling it to be shopped. Similarly, banks underwrote huge volumes of inherently risky and unstable LBO debt against which they compiled no adequate reserves because, again, they expected to sell the debt at a profit not retain it.

CDOs are the freak show exhibit for tortured ill-thinking about how to reserve against losses. The principle benefit, initially, from securitization was overcollateralization against losses. Yes, really. This had at least three legs, of unequal size. In many cases, default swaps were bundled into the CDO as a shock absorber to take first losses. The CDO was sold at a discount to the face of the underlying debt, so that a further cushion against loss was bundled in. Both of these provisions were unequally distributed to tranche buyers, but in principle offered significant reserves against loss risk. Finally, some CDOs had limited recourse provisions against the originators of the original debt in case of fraud, high failure rate or the like. These mitigation options were small and hardly universal, but again they in principal reserved against risk.

All of these ‘reserves’ have failed massively in the present circumstance, and for much the same reason: they weren’t real reserves---cash or near equivalents tied to the debt---but promises of payment. Issuers of default swaps as we see never expected to pay off more than a tiny fraction of their swaps, and to the extent that they themselves had any ‘reserves’ these proved to be not cash but debt which in a pinch they have been unable to sell to raise money. The swaps on any one CDO may pay out, but on the instruments as a whole _cannot_ pay out. Then the underlying debt bundled in CDOs has tended to be overconcentrated in single asset classes, and thus totally, even ridiculously, exposed to price declines in the same asset class. The ‘excess collateral’ has been wiped out and far more by overall price declines. And many loan originators have simply gone out of business, or are accidents awaiting liquidation, eliminating pittance mitigation from retail underwriters. There were no REAL reserves in these CDOs, only promises to pay. This is the biggest fallacy of passing risk around the financial system, that promises without substance will be honored, or even can be.

Banks lent a great deal of money against which they retained no reserves. This in fact was a principle accelerator of the bubble in asset prices, because these hot, fluid, expanding vaporbucks competed for the same assets and so inflated their prices. This had the appearance of inflating asset _values_ but this was not really the case. Hopes that actual gains in asset values would cover any potential (and putatively unlikely) losses proved utterly speculative in all the worst sense of the word. Thus, at the same time that banks contributed to a balloon of asset prices they underreserved against the risk of trafficking in and owning those same assets, in effect multiplying their exposure to loss.

The public authorities also failed to reserve against risk in this, even leaving aside their regulatory dementia in allowing banks to vastly expand their exposure without increasing their reserves. The authorities did this by their implied, and now explicit, guarantee to let no major institution fail. With that hope and belief, why would big institutions lending money hold _any_ reserves, let alone large ones? And while the Fed had 800 gigabucks to play around with here, and many regulatory fudges, that sum isn’t nearly large enough to backstop the entire financial economy of the US. So the Fed didn’t really have the money to put where their mouth has been, either.

The issue isn’t simply that the financial system, in whole and in part, took excessive risks. Far more, it is that they system and all its players convinced themselves they didn’t need to set aside money commensurate to the amounts they were moving around---because the ‘vaporbucks’ would always stay in motion until they ended up somewhere else. We need to return to the concept or requiring solid and sizable reserves against losses for parties that lend large amounts of money.

And those reserves at the Federal ‘Reserve’ System? Well, part of them need to come from increased fees levied on regulated players. However, we also need the option of nationalizing failed or failing institutions, wiping their equity holders and shaving their bondholders to the extent necessary. We need that option in part to keep the public authorities from being greenmailed by financial institutions or cartels of same ‘too large to fail.’ The public needs to be able to give failing marks to those that so merit and run them out of the game. And money set aside for the purpose in the hundred billion dollar range needs to be there so that the threat has substance.

Back to Blinder. He won't even get rid of off balance sheet vehicles, even thought that was one of the aims of Sarbanes-Oxley (I'd like someone to explain to me how SIVs aren't a violation of Sarbox). No, he'd merely increase capital charges against them. That's a limp wristed form of disincentive. If you can socialize your losses, you shouldn't get to engage in fancy footwork to increase your profits. I fail to see why that idea is treated as controversial.

But Blinder does want to reduce gearing of the big financial players to that of a typical commercial bank, say 10-12 times, versus the 20+ (or 30+ in the case of Lehman and Bear) typical of investment banks. He notes dryly that that has profit implications. He runs through the list of reform ideas for rating agencies and concludes by noting that any changes will require a coordinated international effort.

Note that Blinder fails to even consider a big dead body in the room: credit default swaps, the likely reason that the Fed bailed out Bear.

Blinder's proposal is the equivalent of seeing Prozac as the right treatment for someone who has lost their job. Mere palliatives will not get someone who is unemployed back to work, nor will they remedy serious failures in our financial system.