We are experiencing the devastating consequences of a chain of major economic policy errors, which, to use a current cliché, created the perfect storm. These government blunders temporarily paralyzed the global credit system and are now sending the U.S. and Europe into recession, while sharply cutting back Asia's growth rates.
Left to its own devices, the credit crisis, which began in August 2007, would have crushed economies as severely as did the Great Depression.
Belatedly, but thankfully, governments recognized that the only way to get credit flowing again was for them to make quick and direct massive infusions of new equity into beleaguered banks, as well as commit to other emergency measures hitherto unimaginable.
If sensible rescue efforts continue--and they will--the immediate crisis will quickly pass. Shell-shocked businesses and consumers won't recover rapidly from the trauma of recent months, especially as we now cope with recession. But the downturn shouldn't be prolonged: The economy here and those overseas should start to pick up no later than next spring.
That soon? Despite the crisis, the global economy still retains enormous strengths. Between the early 1980s and 2007 we lived in an economic Golden Age. Never before have so many people advanced so far economically in so short a period of time as they have during the last 25 years. Until the credit crisis, 70 million people a year were joining the middle class. The U.S. kicked off this long boom with the economic reforms of Ronald Reagan, particularly his enormous income tax cuts. We burst from the economic stagnation of the 1970s into a dynamic, innovative, high-tech-oriented economy. Even in recent years the much-maligned U.S. did well. Between year-end 2002 and year-end 2007 U.S. growth exceeded the entire size of China's economy. Obviously China's growth rates were higher, but China was coming off a much smaller base.
The world is flush with cash. It's frozen because of fear, but the cash is there. Productivity gains are burgeoning.
So, will this global boom resume next year, slowly at first and then with increasing momentum? It should. Whether that happens, however, depends on the next, highly dangerous phase: the political aftermath.
Will we and other countries pursue policies that hinder growth and retard or abort a full-blown recovery, e.g., regulations that stifle innovation and taxes that harm the creation and deployment of capital? Washington politicians are asking: If the federal government can bail out banks, why not other battered businesses? Congress recently voted for $25 billion in loan guarantees aimed at helping Detroit automakers. (This money is to be used not only to aid Detroit but also to prevent another flare-up of the credit crisis. If the Big Three defaulted on their debts, holders of credit default swaps--which in recent years have grown like toxic weeds--would demand payment from those who wrote the insurance on the automakers' bonds. This would create another wave of losses for financial institutions.)
Some liberal political activists are advocating using Washington's new powers to pursue other agendas, such as forcing tighter emissions curbs or mandating costly health insurance coverage. New attempts to restrict corporate pay, at least in some sectors, is a given--overlooking the unintended side effects of Bill Clinton's attempt to limit CEO pay packages back in 1993. (The deductibility of CEOs' salaries was capped, which led companies to use stock options as never before.) Protectionists are renewing calls for trade restrictions in the name of consumer safety and promoting "better" labor and environmental standards. Politically resurgent labor unions and other activists will push for rules on who sits on corporate boards to "better represent consumers and investors." They want an implicit veto power over the policies of publicly held companies. They're also ready to remove barriers, such as the secret ballot, in order to coerce workers into joining unions.
The financial sector will certainly face new rules and regulations. Will these be sensible, such as rationalizing our myriad, overlapping financial regulatory structures and pushing for the creation of exchanges and clearinghouses for exotic instruments, such as credit default swaps, so we have transparency and standardization? Or will they be punitive and costly like the Sarbanes-Oxley Act? Washington's new powers over banks may make our capital markets more hostile to entrepreneurs--savings bonds won't give you high returns, but they will protect you from political fallout. Or, as happened with Fannie Mae and Freddie Mac, will they make banks do things for political not economic reasons?
A chilling result of the crisis will be furthering the deadly process of criminalizing business failures. In the old days when an enterprise failed, the proprietors often ended up in debtors' prison. One of the significant advances of civilization and economic progress was the idea of limited liability, which took hold in the 19th century: Investors would be liable only for the money they actually put into a corporation; their other assets would be safe. If an enterprise failed, they lost only what they had invested. Limited liability thereby set off a positive explosion of risk taking. Our standard of living today would be where it was in the 1850s were it not for the wide use of limited liability.
But in recent years, particularly after the Enron/WorldCom corporate scandals, federal and local prosecutors began actively pursuing evidence of fraud whenever a big business went bust. Yes, there has been corporate wrongdoing, and miscreants have been tried and jailed. But many noncriminal individuals have been pursued.
One notorious case was the IRS' attempt to prosecute KPMG and a number of its partners and employees for alleged tax fraud. The shelters KPMG sold in the 1990s were not illegal. The IRS still determined, however, that they weren't valid. That kind of tax dispute would normally be settled in civil court. Instead, prosecutors threatened KPMG with annihilation: Settle on our terms or we will hit you with an enterprise-killing indictment. Arthur Andersen had recently been destroyed by such an indictment, even though the courts subsequently threw the charges out. The feds even pressured KPMG not to pay the legal bills of the targeted individuals--which would have forced these people to settle, as they couldn't afford the massive legal costs of defending themselves. Thankfully, a courageous federal judge stopped this abuse.
But the itch to indict remains. No sooner had Bear Stearns, Lehman Brothers and AIG gone bust than criminal investigators swarmed in. They will find evidence of "fraud"--why didn't you more aggressively mark down the value of suspect paper even if there wasn't a market for it? Why the expressions of confidence in the soundness of your businesses when the rumors of trouble were surfacing? Lost in all this will be the fact that Lehman and AIG didn't know they were in mortal peril until almost the very end. There will be indictments. The chilling lesson: Unsuccessful risk taking or failing in business can send you to prison.
So what should our responses be now? To answer that, we must first understand the crisis' causes.
What started in August 2007 was not the failure of free markets but the outcome of bad government actions. Greed and recklessness always run rampant during bubbles, and the mania that engulfed housing and much of the financial sector was no exception. The behavior of mortgage bankers and of Wall Street packagers of subprime mortgages, as well as the excesses and misuses of exotic instruments, will be grist for investigators and writers for decades to come. But all this came about because of government errors--regulatory and monetary.
In 2004 the Federal Reserve made a fateful miscalculation. It thought the U.S. economy was much weaker than it was and therefore pumped out excessive liquidity and kept interest rates artificially low. When too much money is printed, the first area to feel it is commodities. Thus the Fed begat a global commodities boom. The price of oil, copper, steel, international shipping--even mud--shot up. The price of gold roared above its average of the previous 12 years. For nearly 4 years the dollar sank against the euro, yen and pound. Domestically the already booming housing market went on steroids. Housing was experiencing above-average price rises because of a favorable change in the tax law in 1998 that virtually eliminated capital gains taxes on the sale of most primary residences. Now with money easy, a bubble mentality took hold. The reasoning was that housing prices always go up; therefore, lending standards could be safely lowered. If a dodgy borrower defaulted, it didn't matter--the value of the house would always be higher. Wall Street's appetite for these fee-generating packages of subprime mortgages became gluttonous. Rating agencies also drank the Kool-Aid and gave AAA ratings to this stuff, which, thanks to securitization, was spread all around the world. The Fed and other bank regulators stood by as the bubble ballooned.
Why didn't the Treasury Department--behind the scenes--tell the Fed to strengthen the enfeebled greenback? Because the Bush Administration likes a weak dollar, feeling that it will improve our trade balance by artificially making our exports cheaper. Not since Jimmy Carter has the U.S. had such a weak-dollar Administration. This mania would never have reached the proportions it did had the Fed and Treasury had a strong-dollar policy.
The housing bubble burst in 2007, and banks and investors began to be fearful--who had this junk, and how much did they hold? The credit system showed the first signs of panic. The Federal Reserve responded with another round of easy money, thus creating yet another commodities bubble. Finally, this summer, the Fed ceased spraying money like a fire hose. Dollars that had been lent out through the Fed's various borrowing facilities were then soaked up in its open-market operations. That's why, when the panic reached a peak this fall, gold prices didn't go through the roof as everyone sought safety. In fact, gold never reached the level it had in July.
Maybe, just maybe, Ben Bernanke has learned a lesson about the need for stable money that his predecessor, Alan Greenspan, never did.
Another factor fanning the housing bubble was Fannie Mae and Freddie Mac. They were smarting from studies (including a couple from the Federal Reserve) concluding that these two "government-sponsored enterprises" had little or no positive impact on helping the housing market. And they were also reeling politically from egregious accounting scandals. The companies, therefore, decided they could justify their existence by becoming champions of "affordable housing." They guaranteed $1 trillion of less-than-prime mortgages and kept more than $100 billion of this suspect paper on their balance sheets. Mortgage banks and Wall Street packagers of securities knew that Fannie and Freddie were there to buy whatever questionable stuff they offered up.
Over the years efforts by a handful of senators and representatives to rein in these two monsters were easily brushed off, as were those of the Fed to have them shrink their mammoth sizes. (Of course, now that the bubble has burst, what was once dubbed as promoting affordable housing is being portrayed as "predatory lending.")
Even with Fannie and Freddie inflating the bubble and the Fed and the rest of the Bush Administration weakening the dollar, the crisis never would have become so unprecedentedly destructive but for a seemingly arcane accounting principle called mark-to-market, or fair value, accounting. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down. That works when you have very liquid securities, such as Treasurys or the common stock of IBM or GE. But when the credit crisis hit there was no market for subprime securities. Yet regulators and lawsuit-fearful auditors pressed banks and other financial firms to relentlessly knock down the book value of this subprime paper, even in cases where these obligations were being serviced in the payment of principal and interest. Mark-to-market became the weapon of mass destruction.
When banks wrote down the value of these assets they had to get new capital. The need for new capital was a signal to ratings agencies that these outfits might be in need of a credit-rating reduction. This forced financial firms to increase collateral for credit default swaps--which meant more calls for new capital.
Result: Investment banks that still had positive cash flows found themselves in a death spiral. Of the $600-plus billion that financial institutions have written off, almost all of it has been book writedowns, not actual cash losses. This accounting madness sank Fannie and Freddie this summer when the government effectively took them over and provided them with a $200 billion loan facility. The two entities are still cash positive and haven't drawn down a dime of this new line of credit.
Rigid mark-to-market accounting is similar to a highway that has a speed limit and a speed minimum. When snow appears on the road, bad road conditions cause drivers to go slowly. Under a mark-to-market concept, police would be ticketing these slow drivers for going below the minimum speed.
If this accounting asininity had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the U.S. would have collapsed. We would have had a second Great Depression.
Congress has made it clear that it wants mark-to-market suspended or abolished, but the SEC and the Treasury Department still refuse to meaningfully modify it. This is the one big piece of business left undone in ending the credit crisis.
The final factor in this perfect storm was short-sellers. They quickly saw how mark-to-market made seemingly impregnable companies vulnerable to destruction. They picked their targets and relentlessly sold financial stocks short. The SEC helped them out. In the summer of 2007 the commission abolished the uptick rule, which held that a stock couldn't be shorted unless it had gone up in price. It's no surprise to anyone but the SEC that market volatility exploded after the uptick rule ceased. There were no speed bumps left when shorts went after a stock.
Compounding this lunacy was the SEC's inexplicable failure to enforce the rule against "naked" short-selling. Before an investor can short a stock, he is supposed to borrow the shares and pay a broker or stockholder a fee. What sellers soon realized was that the SEC was turning a blind eye to naked short-selling, thus adding even more pressures to beleaguered bank equities.
As the crisis progressed, Treasury errors didn't help, particularly its policy of virtually wiping out the value of Bear Stearns' common stock. With that precedent set, shareholders knew that at the merest whiff of a bad rumor they'd better bail out of a bank or insurance company, or their money could be obliterated. That's why Fannie's and Freddie's stocks collapsed so quickly, not to mention those of Lehman Brothers, AIG and Wachovia.
Letting Lehman Brothers fail was also a blunder. The fallout vastly exceeded what would have come down if Bear Stearns had filed for bankruptcy. Had the Treasury not announced in mid- September that it would seek a $700 billion bailout facility, Morgan Stanley and Goldman Sachs would have been destroyed as well.
Blame the Victim
Not surprisingly, despite government's big, basic blunders in this debacle, politicos and much of the media are blaming "excessive deregulation." "A free-market failure," they call it.
We've been here before. The experiences of the two big economic disasters of the 20th century--the Great Depression in the 1930s and the great inflation of the 1970s--dramatically demonstrate how government mistakes can lead to economic stagnation or impoverishment and geopolitical disaster. Both of these economic horrors were blamed on greedy corporations and "economic royalists."
The Depression was actually triggered by the Smoot-Hawley Tariff of 1929--30, which imposed massive taxes on countless imports. Other countries retaliated in kind. The global trading system collapsed. International capital flows dried up. The legislative history of Smoot-Hawley is instructive. When it first surfaced in Congress during the fall of 1929, the stock market cratered. When near the end of 1929 it appeared that Smoot-Hawley was being sidetracked, stocks rallied, ending the year almost where they had begun. But then in early 1930 Smoot-Hawley resurfaced, and stocks resumed their slide, which continued after Smoot-Hawley was signed into law that June. A devastating global contraction ensued.
Compounding that error was the U.S.' giant tax increase in 1932. President Herbert Hoover thought a balanced budget would restore confidence. The top income tax rate was raised from 25% to 63%. Hoover even legislated an excise tax on checks--you had to pay Uncle Sam a fee every time you wrote a check. Not surprisingly, strapped consumers withdrew massive amounts of cash from banks in order to conduct their business, which put even more stress on troubled banks. This check tax was one of the factors leading to the bank closures of 1933. The huge tax increase deepened the U.S. economic slump.
If not for the Depression, Hitler would never have come to power--the Nazis had carried only 2% of the vote in 1928.
The 1970s were a decade of stagnation. The U.S. cut the dollar loose from gold, and other central banks gleefully followed suit. The results were three massive bouts of inflation, each more severe than the one before. The U.S. turned inward. Communism seemed ascendant. Nicaragua fell to a pro-Soviet dictatorship, and its neighbors looked likely to follow. Islamic fanatics seized power in Iran.
By the time Ronald Reagan took office, our military was in a shambles, with the U.S. seen as fatally weak. Our economy was in dreadful shape, with short-term interest rates reaching nearly 21%. But Reagan pursued the right policies. The American economy came booming back, and the U.S. won the Cold War, signaled by the fall of the Berlin Wall.
Okay, now that we are finally effectively dealing with the crisis, what should be done going forward?
A formal strong-dollar policy is essential. Economists gag at the thought, but the best barometer of monetary disturbances is gold. The Fed should tie the dollar to a gold price range of, say, $500 to $550. Though the dollar is stronger today, markets rightly fear that monetary blunders will happen again.
Which brings us to the Fed's enormous new powers, not to mention its current ones. Our central bank is now the U.S.' de facto commercial bank and our commercial paper market. It is bailing out private firms. The necessary change here is simple: After the crisis, the Fed must undergo a dramatic downsizing and be given a focused mission. Otherwise, it'll be a dinosaur-size beast that will severely hurt our country. The Fed is politically unaccountable. Yes, its chairman makes periodic appearances before Congress, but the Fed is not dependent on congressional appropriations. It literally prints its own budget. It pays for its operations out of the interest it receives on all the securities it holds and then remits the rest to Uncle Sam. Talk about the ATM that keeps on giving. In a democracy this is an intolerable situation for an agency that now has such enormous power over the American economy.
The big change--the Federal Reserve should have only two missions. They are: keeping the dollar as good as gold and dealing with financial panics. If it does the dollar part right, a panic should be a once-in-a-century occurrence.
Years ago Congress mandated that the Fed do its part to keep unemployment low and the economy growing. But it is truly preposterous to think this bureaucracy can direct a $13 trillion economy. Look at how impotent the Fed has been in resolving the financial troubles of the past 14 months.
Regulating banks? Clearing checks for banks (which the Fed still does)? Leave those tasks to other agencies.
The dollar must be a fixed measure of value. Changing its value is disruptive, similar to repeatedly changing the number of minutes in an hour or inches in a foot. Since the dollar was cut off from gold nearly 40 years ago, the U.S. and the world have had repeated monetary disruptions. Thanks to the ingenuity of free markets we've still achieved enormous progress. But the pernicious idea that manipulating money is a sound economic tool has repeatedly wrought havoc: the great inflation of the 1970s; the stock market crash of 1987 (which was triggered when the U.S. threatened to let the dollar go into a free fall); the 1994 Mexican peso crisis; the 1997 Asian "contagion," which gratuitously battered the entire Pacific Rim; and the 1998 Russian financial collapse.
Cutting tax rates is also a necessity. Political cultures have a hard time understanding that taxes don't just raise revenue, they are also a price and a burden. The tax you pay on income is the price you pay for working, just as the tax on capital gains is the price you pay for taking risks that work out and the tax on profits is the price you pay for success. If you make it more worthwhile for people to work productively and take risks, they will do so. Rebates are useless--they don't change incentives the way lower tax rates do. Ideally, we should enact a simple flat tax. Twenty-five countries have adopted some form of a flat tax, all successfully.
Economic growth will help prevent another financial time bomb--credit default swaps, a form of debt insurance--from exploding. The nominal amount peaked at $62 trillion and is now down to $55 trillion. Renewed prosperity will enable big companies to service their debts, thus nullifying the need to ever collect on the insurance. Most of these swaps will expire within five years.
Sensible, not punitive, regulations in the financial sector are needed, such as standardization of new financial products so that there is more transparency.
Fannie and Freddie should be broken up into a number of new, recapitalized companies that have no ties to Uncle Sam.
If we have the kind of policies that marked the 1980s and not the kind that marked the 1930s and 1970s, we will be in for a dazzling era of innovation and economic advances. Free-market capitalism will save us--if we let it.
Left to its own devices, the credit crisis, which began in August 2007, would have crushed economies as severely as did the Great Depression.
Belatedly, but thankfully, governments recognized that the only way to get credit flowing again was for them to make quick and direct massive infusions of new equity into beleaguered banks, as well as commit to other emergency measures hitherto unimaginable.
If sensible rescue efforts continue--and they will--the immediate crisis will quickly pass. Shell-shocked businesses and consumers won't recover rapidly from the trauma of recent months, especially as we now cope with recession. But the downturn shouldn't be prolonged: The economy here and those overseas should start to pick up no later than next spring.
That soon? Despite the crisis, the global economy still retains enormous strengths. Between the early 1980s and 2007 we lived in an economic Golden Age. Never before have so many people advanced so far economically in so short a period of time as they have during the last 25 years. Until the credit crisis, 70 million people a year were joining the middle class. The U.S. kicked off this long boom with the economic reforms of Ronald Reagan, particularly his enormous income tax cuts. We burst from the economic stagnation of the 1970s into a dynamic, innovative, high-tech-oriented economy. Even in recent years the much-maligned U.S. did well. Between year-end 2002 and year-end 2007 U.S. growth exceeded the entire size of China's economy. Obviously China's growth rates were higher, but China was coming off a much smaller base.
The world is flush with cash. It's frozen because of fear, but the cash is there. Productivity gains are burgeoning.
So, will this global boom resume next year, slowly at first and then with increasing momentum? It should. Whether that happens, however, depends on the next, highly dangerous phase: the political aftermath.
Will we and other countries pursue policies that hinder growth and retard or abort a full-blown recovery, e.g., regulations that stifle innovation and taxes that harm the creation and deployment of capital? Washington politicians are asking: If the federal government can bail out banks, why not other battered businesses? Congress recently voted for $25 billion in loan guarantees aimed at helping Detroit automakers. (This money is to be used not only to aid Detroit but also to prevent another flare-up of the credit crisis. If the Big Three defaulted on their debts, holders of credit default swaps--which in recent years have grown like toxic weeds--would demand payment from those who wrote the insurance on the automakers' bonds. This would create another wave of losses for financial institutions.)
Some liberal political activists are advocating using Washington's new powers to pursue other agendas, such as forcing tighter emissions curbs or mandating costly health insurance coverage. New attempts to restrict corporate pay, at least in some sectors, is a given--overlooking the unintended side effects of Bill Clinton's attempt to limit CEO pay packages back in 1993. (The deductibility of CEOs' salaries was capped, which led companies to use stock options as never before.) Protectionists are renewing calls for trade restrictions in the name of consumer safety and promoting "better" labor and environmental standards. Politically resurgent labor unions and other activists will push for rules on who sits on corporate boards to "better represent consumers and investors." They want an implicit veto power over the policies of publicly held companies. They're also ready to remove barriers, such as the secret ballot, in order to coerce workers into joining unions.
The financial sector will certainly face new rules and regulations. Will these be sensible, such as rationalizing our myriad, overlapping financial regulatory structures and pushing for the creation of exchanges and clearinghouses for exotic instruments, such as credit default swaps, so we have transparency and standardization? Or will they be punitive and costly like the Sarbanes-Oxley Act? Washington's new powers over banks may make our capital markets more hostile to entrepreneurs--savings bonds won't give you high returns, but they will protect you from political fallout. Or, as happened with Fannie Mae and Freddie Mac, will they make banks do things for political not economic reasons?
A chilling result of the crisis will be furthering the deadly process of criminalizing business failures. In the old days when an enterprise failed, the proprietors often ended up in debtors' prison. One of the significant advances of civilization and economic progress was the idea of limited liability, which took hold in the 19th century: Investors would be liable only for the money they actually put into a corporation; their other assets would be safe. If an enterprise failed, they lost only what they had invested. Limited liability thereby set off a positive explosion of risk taking. Our standard of living today would be where it was in the 1850s were it not for the wide use of limited liability.
But in recent years, particularly after the Enron/WorldCom corporate scandals, federal and local prosecutors began actively pursuing evidence of fraud whenever a big business went bust. Yes, there has been corporate wrongdoing, and miscreants have been tried and jailed. But many noncriminal individuals have been pursued.
One notorious case was the IRS' attempt to prosecute KPMG and a number of its partners and employees for alleged tax fraud. The shelters KPMG sold in the 1990s were not illegal. The IRS still determined, however, that they weren't valid. That kind of tax dispute would normally be settled in civil court. Instead, prosecutors threatened KPMG with annihilation: Settle on our terms or we will hit you with an enterprise-killing indictment. Arthur Andersen had recently been destroyed by such an indictment, even though the courts subsequently threw the charges out. The feds even pressured KPMG not to pay the legal bills of the targeted individuals--which would have forced these people to settle, as they couldn't afford the massive legal costs of defending themselves. Thankfully, a courageous federal judge stopped this abuse.
But the itch to indict remains. No sooner had Bear Stearns, Lehman Brothers and AIG gone bust than criminal investigators swarmed in. They will find evidence of "fraud"--why didn't you more aggressively mark down the value of suspect paper even if there wasn't a market for it? Why the expressions of confidence in the soundness of your businesses when the rumors of trouble were surfacing? Lost in all this will be the fact that Lehman and AIG didn't know they were in mortal peril until almost the very end. There will be indictments. The chilling lesson: Unsuccessful risk taking or failing in business can send you to prison.
So what should our responses be now? To answer that, we must first understand the crisis' causes.
What started in August 2007 was not the failure of free markets but the outcome of bad government actions. Greed and recklessness always run rampant during bubbles, and the mania that engulfed housing and much of the financial sector was no exception. The behavior of mortgage bankers and of Wall Street packagers of subprime mortgages, as well as the excesses and misuses of exotic instruments, will be grist for investigators and writers for decades to come. But all this came about because of government errors--regulatory and monetary.
In 2004 the Federal Reserve made a fateful miscalculation. It thought the U.S. economy was much weaker than it was and therefore pumped out excessive liquidity and kept interest rates artificially low. When too much money is printed, the first area to feel it is commodities. Thus the Fed begat a global commodities boom. The price of oil, copper, steel, international shipping--even mud--shot up. The price of gold roared above its average of the previous 12 years. For nearly 4 years the dollar sank against the euro, yen and pound. Domestically the already booming housing market went on steroids. Housing was experiencing above-average price rises because of a favorable change in the tax law in 1998 that virtually eliminated capital gains taxes on the sale of most primary residences. Now with money easy, a bubble mentality took hold. The reasoning was that housing prices always go up; therefore, lending standards could be safely lowered. If a dodgy borrower defaulted, it didn't matter--the value of the house would always be higher. Wall Street's appetite for these fee-generating packages of subprime mortgages became gluttonous. Rating agencies also drank the Kool-Aid and gave AAA ratings to this stuff, which, thanks to securitization, was spread all around the world. The Fed and other bank regulators stood by as the bubble ballooned.
Why didn't the Treasury Department--behind the scenes--tell the Fed to strengthen the enfeebled greenback? Because the Bush Administration likes a weak dollar, feeling that it will improve our trade balance by artificially making our exports cheaper. Not since Jimmy Carter has the U.S. had such a weak-dollar Administration. This mania would never have reached the proportions it did had the Fed and Treasury had a strong-dollar policy.
The housing bubble burst in 2007, and banks and investors began to be fearful--who had this junk, and how much did they hold? The credit system showed the first signs of panic. The Federal Reserve responded with another round of easy money, thus creating yet another commodities bubble. Finally, this summer, the Fed ceased spraying money like a fire hose. Dollars that had been lent out through the Fed's various borrowing facilities were then soaked up in its open-market operations. That's why, when the panic reached a peak this fall, gold prices didn't go through the roof as everyone sought safety. In fact, gold never reached the level it had in July.
Maybe, just maybe, Ben Bernanke has learned a lesson about the need for stable money that his predecessor, Alan Greenspan, never did.
Another factor fanning the housing bubble was Fannie Mae and Freddie Mac. They were smarting from studies (including a couple from the Federal Reserve) concluding that these two "government-sponsored enterprises" had little or no positive impact on helping the housing market. And they were also reeling politically from egregious accounting scandals. The companies, therefore, decided they could justify their existence by becoming champions of "affordable housing." They guaranteed $1 trillion of less-than-prime mortgages and kept more than $100 billion of this suspect paper on their balance sheets. Mortgage banks and Wall Street packagers of securities knew that Fannie and Freddie were there to buy whatever questionable stuff they offered up.
Over the years efforts by a handful of senators and representatives to rein in these two monsters were easily brushed off, as were those of the Fed to have them shrink their mammoth sizes. (Of course, now that the bubble has burst, what was once dubbed as promoting affordable housing is being portrayed as "predatory lending.")
Even with Fannie and Freddie inflating the bubble and the Fed and the rest of the Bush Administration weakening the dollar, the crisis never would have become so unprecedentedly destructive but for a seemingly arcane accounting principle called mark-to-market, or fair value, accounting. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down. That works when you have very liquid securities, such as Treasurys or the common stock of IBM or GE. But when the credit crisis hit there was no market for subprime securities. Yet regulators and lawsuit-fearful auditors pressed banks and other financial firms to relentlessly knock down the book value of this subprime paper, even in cases where these obligations were being serviced in the payment of principal and interest. Mark-to-market became the weapon of mass destruction.
When banks wrote down the value of these assets they had to get new capital. The need for new capital was a signal to ratings agencies that these outfits might be in need of a credit-rating reduction. This forced financial firms to increase collateral for credit default swaps--which meant more calls for new capital.
Result: Investment banks that still had positive cash flows found themselves in a death spiral. Of the $600-plus billion that financial institutions have written off, almost all of it has been book writedowns, not actual cash losses. This accounting madness sank Fannie and Freddie this summer when the government effectively took them over and provided them with a $200 billion loan facility. The two entities are still cash positive and haven't drawn down a dime of this new line of credit.
Rigid mark-to-market accounting is similar to a highway that has a speed limit and a speed minimum. When snow appears on the road, bad road conditions cause drivers to go slowly. Under a mark-to-market concept, police would be ticketing these slow drivers for going below the minimum speed.
If this accounting asininity had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the U.S. would have collapsed. We would have had a second Great Depression.
Congress has made it clear that it wants mark-to-market suspended or abolished, but the SEC and the Treasury Department still refuse to meaningfully modify it. This is the one big piece of business left undone in ending the credit crisis.
The final factor in this perfect storm was short-sellers. They quickly saw how mark-to-market made seemingly impregnable companies vulnerable to destruction. They picked their targets and relentlessly sold financial stocks short. The SEC helped them out. In the summer of 2007 the commission abolished the uptick rule, which held that a stock couldn't be shorted unless it had gone up in price. It's no surprise to anyone but the SEC that market volatility exploded after the uptick rule ceased. There were no speed bumps left when shorts went after a stock.
Compounding this lunacy was the SEC's inexplicable failure to enforce the rule against "naked" short-selling. Before an investor can short a stock, he is supposed to borrow the shares and pay a broker or stockholder a fee. What sellers soon realized was that the SEC was turning a blind eye to naked short-selling, thus adding even more pressures to beleaguered bank equities.
As the crisis progressed, Treasury errors didn't help, particularly its policy of virtually wiping out the value of Bear Stearns' common stock. With that precedent set, shareholders knew that at the merest whiff of a bad rumor they'd better bail out of a bank or insurance company, or their money could be obliterated. That's why Fannie's and Freddie's stocks collapsed so quickly, not to mention those of Lehman Brothers, AIG and Wachovia.
Letting Lehman Brothers fail was also a blunder. The fallout vastly exceeded what would have come down if Bear Stearns had filed for bankruptcy. Had the Treasury not announced in mid- September that it would seek a $700 billion bailout facility, Morgan Stanley and Goldman Sachs would have been destroyed as well.
Blame the Victim
Not surprisingly, despite government's big, basic blunders in this debacle, politicos and much of the media are blaming "excessive deregulation." "A free-market failure," they call it.
We've been here before. The experiences of the two big economic disasters of the 20th century--the Great Depression in the 1930s and the great inflation of the 1970s--dramatically demonstrate how government mistakes can lead to economic stagnation or impoverishment and geopolitical disaster. Both of these economic horrors were blamed on greedy corporations and "economic royalists."
The Depression was actually triggered by the Smoot-Hawley Tariff of 1929--30, which imposed massive taxes on countless imports. Other countries retaliated in kind. The global trading system collapsed. International capital flows dried up. The legislative history of Smoot-Hawley is instructive. When it first surfaced in Congress during the fall of 1929, the stock market cratered. When near the end of 1929 it appeared that Smoot-Hawley was being sidetracked, stocks rallied, ending the year almost where they had begun. But then in early 1930 Smoot-Hawley resurfaced, and stocks resumed their slide, which continued after Smoot-Hawley was signed into law that June. A devastating global contraction ensued.
Compounding that error was the U.S.' giant tax increase in 1932. President Herbert Hoover thought a balanced budget would restore confidence. The top income tax rate was raised from 25% to 63%. Hoover even legislated an excise tax on checks--you had to pay Uncle Sam a fee every time you wrote a check. Not surprisingly, strapped consumers withdrew massive amounts of cash from banks in order to conduct their business, which put even more stress on troubled banks. This check tax was one of the factors leading to the bank closures of 1933. The huge tax increase deepened the U.S. economic slump.
If not for the Depression, Hitler would never have come to power--the Nazis had carried only 2% of the vote in 1928.
The 1970s were a decade of stagnation. The U.S. cut the dollar loose from gold, and other central banks gleefully followed suit. The results were three massive bouts of inflation, each more severe than the one before. The U.S. turned inward. Communism seemed ascendant. Nicaragua fell to a pro-Soviet dictatorship, and its neighbors looked likely to follow. Islamic fanatics seized power in Iran.
By the time Ronald Reagan took office, our military was in a shambles, with the U.S. seen as fatally weak. Our economy was in dreadful shape, with short-term interest rates reaching nearly 21%. But Reagan pursued the right policies. The American economy came booming back, and the U.S. won the Cold War, signaled by the fall of the Berlin Wall.
Okay, now that we are finally effectively dealing with the crisis, what should be done going forward?
A formal strong-dollar policy is essential. Economists gag at the thought, but the best barometer of monetary disturbances is gold. The Fed should tie the dollar to a gold price range of, say, $500 to $550. Though the dollar is stronger today, markets rightly fear that monetary blunders will happen again.
Which brings us to the Fed's enormous new powers, not to mention its current ones. Our central bank is now the U.S.' de facto commercial bank and our commercial paper market. It is bailing out private firms. The necessary change here is simple: After the crisis, the Fed must undergo a dramatic downsizing and be given a focused mission. Otherwise, it'll be a dinosaur-size beast that will severely hurt our country. The Fed is politically unaccountable. Yes, its chairman makes periodic appearances before Congress, but the Fed is not dependent on congressional appropriations. It literally prints its own budget. It pays for its operations out of the interest it receives on all the securities it holds and then remits the rest to Uncle Sam. Talk about the ATM that keeps on giving. In a democracy this is an intolerable situation for an agency that now has such enormous power over the American economy.
The big change--the Federal Reserve should have only two missions. They are: keeping the dollar as good as gold and dealing with financial panics. If it does the dollar part right, a panic should be a once-in-a-century occurrence.
Years ago Congress mandated that the Fed do its part to keep unemployment low and the economy growing. But it is truly preposterous to think this bureaucracy can direct a $13 trillion economy. Look at how impotent the Fed has been in resolving the financial troubles of the past 14 months.
Regulating banks? Clearing checks for banks (which the Fed still does)? Leave those tasks to other agencies.
The dollar must be a fixed measure of value. Changing its value is disruptive, similar to repeatedly changing the number of minutes in an hour or inches in a foot. Since the dollar was cut off from gold nearly 40 years ago, the U.S. and the world have had repeated monetary disruptions. Thanks to the ingenuity of free markets we've still achieved enormous progress. But the pernicious idea that manipulating money is a sound economic tool has repeatedly wrought havoc: the great inflation of the 1970s; the stock market crash of 1987 (which was triggered when the U.S. threatened to let the dollar go into a free fall); the 1994 Mexican peso crisis; the 1997 Asian "contagion," which gratuitously battered the entire Pacific Rim; and the 1998 Russian financial collapse.
Cutting tax rates is also a necessity. Political cultures have a hard time understanding that taxes don't just raise revenue, they are also a price and a burden. The tax you pay on income is the price you pay for working, just as the tax on capital gains is the price you pay for taking risks that work out and the tax on profits is the price you pay for success. If you make it more worthwhile for people to work productively and take risks, they will do so. Rebates are useless--they don't change incentives the way lower tax rates do. Ideally, we should enact a simple flat tax. Twenty-five countries have adopted some form of a flat tax, all successfully.
Economic growth will help prevent another financial time bomb--credit default swaps, a form of debt insurance--from exploding. The nominal amount peaked at $62 trillion and is now down to $55 trillion. Renewed prosperity will enable big companies to service their debts, thus nullifying the need to ever collect on the insurance. Most of these swaps will expire within five years.
Sensible, not punitive, regulations in the financial sector are needed, such as standardization of new financial products so that there is more transparency.
Fannie and Freddie should be broken up into a number of new, recapitalized companies that have no ties to Uncle Sam.
If we have the kind of policies that marked the 1980s and not the kind that marked the 1930s and 1970s, we will be in for a dazzling era of innovation and economic advances. Free-market capitalism will save us--if we let it.
No comments:
Post a Comment