Sunday, March 30, 2008

Road to Sefdom: The Fed and the Henhouse

In an earlier post, I discussed Hayek's The Road to Serfdom. He observed how failures of government are used as excuses to grab more power:
Hayek further argued that the failure of central planning would be perceived by the public as an absence of sufficient power by the state to implement an otherwise good idea. Such a perception would lead the public to vote more power to the state, and would assist the rise to power of a “strong man” perceived to be capable of “getting the job done”.

We see another example of this now with the Treasury Department's proposal to make the Federal Reserve the chief regulatory authority on financial markets. So let's get this straight. The government is largely responsible for this credit collapse and the answer is that we need to give the government more power. The Federal Reserve bears most of the blame of any government agency and so we need to increase its responsibility. Mish does an excellent job making the case for this in his post The Fed and the Henhouse. Here's a taste from the post:

Let's Take a Look at "Timely"
Gee, that sure looks "timely" to me.

Who is to blame for the mess we are in?

And who is to blame? The Fed course, with help of Congress, and the SEC.

Congress passed legislation to create GSEs to foster affordable housing. Now the definition of "affordable" is over $700,000, and calls to reduce the role of the Fannie Mae are now calls to increase the role of Fannie Mae in the wake of the housing crisis. There were 300 some programs to create affordable housing and every program made the situation worse. All those programs really amounted to was handouts to the building industry and banks.

And if Congress would stop wasting money on needless programs the dollar would stop sinking. Of course the government is wasting trillions of dollars trying to be the world's policeman, a role we can no longer afford.

The SEC in its infinitely poor wisdom, decided to give government sponsorship to Moody's, Fitch, and the S&P and this led to extremely risky garbage being rated AAA. I talked about this problem in Time To Break Up The Credit Rating Cartel.

But the Fed deserves the brunt of the blame for micro-managing interest rates like some central planners from the Soviet Union. The Fed does not know how to set the correct price for money (interest rates) any more than it knows how to set the correct price for orange juice. Only free market forces can properly set prices so that economic distortions do not occur.

Unfortunately, every problem Greenspan faced was an excuse to cut interest rates. Even non-problems like the silly Y2K (year 2000) scare was an excuse to cut rates.

When the dotcom bubble collapsed, the Fed slashed interest rates to 1% to get the economy moving again. The housing bubble was the result. Greenspan added more fuel to the fire along the way by openly praising ARMs and derivatives.

Greenspan May 5th 2005: "Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth."

I compared Greenspan to Buffett in Who's Holding The Bag?

Buffett in stark contrast to Greenspan called the explosive use of derivatives an "investment time bomb".

It's perfectly clear now who was right. For those who have not pieced the story together properly, it was fear of a dominoes style chain reaction collapse of Credit Default Swaps starting with Bear Stearns that caused Bernanke to force a shotgun wedding between Bear Stearns and JP Morgan.

So what does the Treasury Department propose? The Orwellian answer of course is to give the Fed still more power to wreak havoc.

I couldn't say it better myself.


Vijay said...

There's a lot of misinformation being spread about the root cause of the current economic crisis. Especially by ideological sophists like Paul Krugman. Jeffrey Sachs explains in some detail why the Fed is largely to blame in this article:

The US federal reserve's desperate attempts to keep America's economy from sinking are remarkable for at least two reasons. First, until just a few months ago, the conventional wisdom was that the US would avoid recession. Now recession looks certain. Second, the Fed's actions do not seem to be effective. Although interest rates have been slashed and the Fed has lavished liquidity on cash-strapped banks, the crisis is deepening.

To a large extent, the US crisis was actually made by the Fed, helped by the wishful thinking of the Bush administration. One main culprit was none other than Alan Greenspan, who left the current Fed chairman, Ben Bernanke, with a terrible situation. But Bernanke was a Fed governor in the Greenspan years, and he, too, failed to diagnose correctly the growing problems with its policies.

Today's financial crisis has its immediate roots in 2001, amid the end of the Internet boom and the shock of the September 11 terrorist attacks. It was at that point that the Fed turned on the monetary spigots to try to combat an economic slowdown. The Fed pumped money into the US economy and slashed its main interest rate - the Federal Funds rate - from 3.5% in August 2001 to a mere 1% by mid-2003. The Fed held this rate too low for too long.

Monetary expansion generally makes it easier to borrow, and lowers the costs of doing so, throughout the economy. It also tends to weaken the currency and increase inflation. All of this began to happen in the US.

What was distinctive this time was that the new borrowing was concentrated in housing. It is generally true that lower interest rates spur home buying, but this time, as is now well known, commercial and investment banks created new financial mechanisms to expand housing credit to borrowers with little creditworthiness. The Fed declined to regulate these dubious practices. Virtually anyone could borrow to buy a house, with little or even no down payment, and with interest charges pushed years into the future.

As the home-lending boom took hold, it became self-reinforcing. Greater home buying pushed up housing prices, which made banks feel that it was safe to lend money to non-creditworthy borrowers. After all, if they defaulted on their loans, the banks would repossess the house at a higher value. Or so the theory went. Of course, it works only as long as housing prices rise. Once they peak and begin to decline, lending conditions tighten, and banks find themselves repossessing houses whose value does not cover the value of the debt.

What was stunning was how the Fed, under Greenspan's leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash. There were a few naysayers, but not many in the financial sector itself. Banks were too busy collecting fees on new loans, and paying their managers outlandish bonuses.

At a crucial moment in 2005, while he was a governor but not yet Fed Chairman, Bernanke described the housing boom as reflecting a prudent and well-regulated financial system, not a dangerous bubble. He argued that vast amounts of foreign capital flowed through US banks to the housing sector because international investors appreciated "the depth and sophistication of the country's financial markets (which among other things have allowed households easy access to housing wealth)."

In the course of 2006 and 2007, the financial bubble that is now bringing down once-mighty financial institutions peaked. Banks' balance sheets were by then filled with vast amounts of risky mortgages, packaged in complicated forms that made the risks hard to evaluate. Banks began to slow their new lending, and defaults on mortgages began to rise. Housing prices peaked as lending slowed, and prices then started to decline. The housing bubble was bursting by last fall, and banks with large mortgage holdings started reporting huge losses, sometimes big enough to destroy the bank itself, as in the case of Bear Stearns.

With the housing collapse lowering spending, the Fed, in an effort to ward off recession and help banks with fragile balance sheets, has been cutting interest rates since the fall of 2007. But this time, credit expansion is not flowing into housing construction, but rather into commodity speculation and foreign currency.

The Fed's easy money policy is now stoking US inflation rather than a recovery. Oil, food, and gold prices have jumped to historic highs, and the dollar has depreciated to historic lows. A euro now costs around $1.60, up from $0.90 in January 2002. Yet the Fed, in its desperation to avoid a US recession, keeps pouring more money into the system, intensifying the inflationary pressures.

Having stoked a boom, now the Fed can't prevent at least a short-term decline in the US economy, and maybe worse. If it pushes too hard on continued monetary expansion, it won't prevent a bust but instead could create stagflation - inflation and economic contraction. The Fed should take care to prevent any breakdown of liquidity while keeping inflation under control and avoiding an unjustified taxpayer-financed bailout of risky bank loans.

Throughout the world, there may be some similar effects, to the extent that foreign banks also hold bad US mortgages on their balance sheets, or in the worst case, if a general financial crisis takes hold. There is still a good chance, however, that the US downturn will be limited mainly to America, where the housing boom and bust is concentrated. The damage to the rest of the world economy, I believe, can remain limited.

Peyman said...

I do believe that the Fed deserves much of the blame for the current mess. It's wacky to me how the US/World financial markets hang on every word of decisions made by a bunch of guys in a closed-door meeting. That said, no one forced the commercial and investment banks to create the financial instruments that led to such highly leveraged investments, to lower loan standards, to not do credit checks, etc.

"commercial and investment banks created new financial mechanisms to expand housing credit to borrowers with little creditworthiness. The Fed declined to regulate these dubious practices."

Greed suspended judgment long enough for herd mentality to set in. A lot of people (banks, hedge funds, flippers, etc) "cashed in" and made out like bandits.

Vijay said...

Peyman, you said "That said, no one forced the commercial and investment banks to create the financial instruments that led to such highly leveraged investments, to lower loan standards, to not do credit checks, etc."

This is sort of like saying I left a $100 bill on the ground but I didn't force the person who walked by to pick it up. The incentive created is so great there's little difference between forcing the person to take the $100 or letting them pick it up of their own volition.

The source of our problems is that no one owns the money that the Fed creates. It's collectively owned. Whenever anything is collectively owned it's not managed with the same care as when it has a private owner. The Fed didn't care that the money is was injecting into the financial system was being used recklessly because no one really owns that money.

Ever wonder why public toilets are in general so disgusting?