Topic: Finance, Banking & Monetary Policy

The Blame Game

In the now-heated effort of D.C. policymakers and pundits to afix blame for the current financial mess, some fingers are being pointed at the Federal Reserve. The criticism: the Fed kept interest rates too low in the early 2000s, resulting in a lot of easy money. That money, in turn, created the housing bubble and subsequent collapse, ushering in the financial crisis.

Is this criticism sound?

Figure 1 shows the three-month Treasury Bill rate and the Federal funds rate over the past several years. It indicates that, yes, money was easy in the early 2000s, but not because of the Fed. The Fed was forced to reduce and maintain a low Fed funds rate in response to the market’s high price (and corresponding low interest rate) for short-maturity securities such as 3-month T-Bills.

So why were market rates so low?

Chairman Bernanke has suggested that foreign capital inflows were the true cause of easy money earlier this decade. Figure 2 shows that net international capital inflows surged beginning in 1998 and remained high thereafter. Superficially, the interest rate vs. international capital inflows correlation is not strong enough to clinch his argument. Critics could ask why interest rates did not fall until January 2001. Perhaps the answer would be that a strong U.S. economy and stock market during the late 1990s held up interest rates for a time. But then why did asset markets tank in January 2000, followed by the economy in January 2001? Some folks might respond that the Fed funds rate was unsustainably high during 2000. But we don’t really know the answer as yet.

Another question is why did market short-term interest rates increase after mid-2004 despite strong capital inflows? I don’t think anyone has a good answer for that, either.

But let’s return to the fact that the Fed had to cut its funds rate earlier this decade in order to keep pace with declining short-term market interest rates. So long as the Fed’s objective is to maintain the amount of bank reserves in circulation at a level that is just enough to achieve its non-inflationary growth objective and to do so through an interest rate targeting operation, it has no choice but to set the Fed funds rate as close as possible to short-term market interest rates. Otherwise, the Fed would risk injecting too much (or too little) liquidity into the economy — precisely what it’s now being incorrectly blamed for.

This brings us to the question of what, in light of the current crisis, the Fed should do to achieve its sometimes-conflicting objectives of maximizing non-inflationary growth and also ensuring systemic stability — that is, to avoid widespread failures among large financial institutions of the kind we have witnessed this year. The Fed appears to have no systematic approach or tools to achieve its second objective.

One possible method is stricter imposition of regulatory constraints, to prevent home price inflation from incentivizing excess and risky mortgage lending. But that approach was rejected by Fed and Treasury officials (see yesterday’s NYT). And they did that, possibly, for good short-term reasons: a buoyant asset sector returns political dividends, but the systemic problems happen on someone else’s watch. Or, more charitably, Fed officials may have genuinely believed that financial innovations (such as dynamic hedging) meant that the risks were spread so broadly that they didn’t matter anymore.

Another possibility is for the Fed to incorporate asset prices in its measure(s) of price stability — that is, include home and stock prices instead of just consumer goods when trying to determine if inflation is occurring. Doing so could lead the Fed to implement pre-emptive monetary strikes against perceived systemic risks in order to avoid an asset inflation party. That would be consistent with the definition of the Fed’s role (take away the punch-bowl just before the party really gets going), but it may not be any less “socialist.” Fed officials have now acknowledged that they are studying this issue and the jury is still out on it.

However, now we are paying the price for the lack of a proper market-oriented governance framework for dealing with systemic instability — by gravitating toward direct socialist control of the financial sector in an unproductively panicked manner.

The End of American Capitalism?

At the top of today’s front page, the Washington Post joins other Big Media in dancing on the grave of capitalism and smaller government. And compared with such past headlines as “A Fresh Look at the Apostle of Free Markets” or “Crisis Turns Free Marketeers into Regulators,” the Post goes all the way: “The End of American Capitalism?” It does have a question mark.

But what is the Post’s evidence that “American-style capitalism” is a casualty of the financial crisis? Well, for one, “The Bush administration is considering a partial nationalization of some banks.” I’m not sure that an administration that has given us nationalized schools, expanded entitlements, burdensome Sarbanes-Oxley securities regulations (how’d those work out, by the way?), nation-building around the world, and a trillion-dollar increase in federal spending is exactly an example of free-marketers finally giving in to the lure of big government.

But it’s not just American politicians, the Post tells us, who have lost faith in capitalism. “European leaders … are calling for broad new international codes to impose scrutiny on global finance.” So the people who run the U.S. government and the people who run European governments are united in seeking more power for governments.

But wait, there’s more. “To some degree, those calls are even being echoed by the International Monetary Fund.” So even an intergovernmental organization devoted to forced wealth transfers also wants more power for governments.

Also Nobel laureate Joseph Stiglitz: “We told them if you wanted to be like us, here’s what you have to do — hand over power to the market. The point now is that no one has respect for that kind of model anymore given this crisis.” So the most left-leaning Nobel laureate thinks our policies should move to the left. But if reporter Anthony Faiola had interviewed such recent laureates as Vernon Smith, Ed Prescott, Robert Mundell, Gary Becker, Myron Scholes, Douglass North, or James Buchanan, he might have gotten a different answer.

There’s no question that the global financial crisis is causing people to question how well capitalism works. But we’re still not in any Great Depression. And the evidence in this article is almost entirely that governments are — as usual — taking advantage of a crisis to expand their scope and power.

Of course, if this crisis leads us to question “American-style capitalism” — the kind in which a central monetary authority manipulates money and credit, the central government taxes and redistributes $3 trillion a year, huge government-sponsored enterprises create a taxpayer-backed duopoly in the mortgage business, tax laws encourage excessive use of debt financing, and government pressures banks to make bad loans — well, it might be a good thing to reconsider that “American-style capitalism.”

Join the Financial Bailout Debate

What if you could sit side by side with a Cato scholar at a debate forum and offer suggestions on topics like the financial bailout plan, health care, national security and education?

The Cato Institute is participating in a debate series hosted by a new interactive site, Google Knol. The debates on Knol are meant to offer a variety of in-depth opinions from experts, and afford visitors the opportunity to engage scholars on the ideas that are posted.

Cato Senior Fellow Daniel J. Mitchell is debating the aftermath of the financial bailout bill with John Irons, research and policy director for the Economic Policy Institute. Starting today, you can log into Google and offer suggestions, edits and comments to each side of the discussion.  Mitchell and Irons will both field your comments and may even add them to their arguments.

The debates will not end with the financial bailout plan. Over the next few weeks, Cato scholars will tackle a series of issues, and each time, you will have the chance to participate.

The discussion about the financial bailout is going on right now on Google Knol, so don’t miss out on your chance to join the conversation.

Hot Air in the Senate Bailout

What does global warming have to do with the liquidity “crisis?” Nothing!  But not according to the Senate, whose bill includes a provision, Section 117,  directing the National Academy of Sciences to “undertake a comprehensive review of the Internal Revenue Code of 1986 to identify the types of and specific tax provisions that have the largest effect on carbon and other greenhouse gas emissions and to estimate the magnitude of those effects.”  For this, The National Academy  is appropriated $1.5 million.

In other words, somehow the government’s purchase of bad loans is related to global warming? This is a naked attempt by environmental extremists to use people’s fears of financial collapse as an excuse to ultimately skew the tax code in such a way that it makes energy even more expensive. Some bailout! 

Treasury Can Only Spend $50 Billion Per Month

So why give them $700 billion?

Representative Spencer Bachus (R-AL) is before the House Rules Committee arguing that the Treasury Department can’t even use all of the $700 billion that the bailout legislation would authorize. Congress can allow Treasury some of the money, take a look later at a couple of months of the program, and see how well it’s being used.

His colleagues are beating him up for it, but it makes simple sense. The right answer is not to bail out Wall Street at all - and for heaven’s sake do away with the government-sponsored enterprises that got us here - but a compromiser would let the program run for a few months, with the new Congress in January taking a look at how it’s working.

Laissez-Faire and Corporatism

I’ve just read Steven Horwitz’s excellent “Open Letter to My Friends on the Left,” on the subject of the credit crisis. I highly recommend it, whether you’re on the left or not:

In the last week or two, I have heard frequently from you that the current financial mess has been caused by the failures of free markets and deregulation. I have heard from you that the lust after profits, any profits, that is central to free markets is at the core of our problems. And I have heard from you that only significant government intervention into financial markets can cure these problems, perhaps once and for all. I ask of you for the next few minutes to, in the words of Oliver Cromwell, consider that you may be mistaken. Consider that both the diagnosis and the cure might be equally mistaken.

Consider instead that the problems of this mess were caused by the very kinds of government regulation that you now propose. Consider instead that effects of the profit motive that you decry depend upon the incentives that institutions, regulations, and policies create, which in this case led profit-seekers to do great damage. Consider instead that the regulations that may have been the cause were supported by, as they have often been throughout US history, the very firms being regulated, mostly because they worked to said firms’ benefit, even as they screwed the rest of us. Consider all of this as you ask for more of the same in the name of fixing the problem. And finally, consider why you would ever imagine that those with wealth and power wouldn’t rig a new regulatory process in their favor.

The seemingly arcane difference between laissez-faire and corporatism is one of the most important in today’s public policy debates. Laissez-faire means the equality of all before the law, with the state neither helping nor hindering any market actor. Corporatism means offering special favors to those who’ve already succeeded. (Just for starters: “Too big to fail” is corporatism.)

If only this distinction were more clearly understood by lawmakers, journalists, and the general public. Too often all of these groups just use the vague word “capitalism,” which seems mostly intended to split the difference – or to obscure it. But laissez-faire and corporatism are directly opposed to one another, and if more people on the left understood this, they might be far more sympathetic to free markets. Even, perhaps, while keeping a healthy mistrust of corporations.