Topic: Finance, Banking & Monetary Policy

If the Economy Is All About Confidence…

…then why are our so-called leaders in Washington doing so much fear-mongering and thrashing around?

Verizon’s CEO Ivan Seidenberg exhibits much better economic leadership than anything we’ve heard from congressional leaders, President Bush, or Treasury Secretary Paulson. He simply has confidence, and he hasn’t mistaken “investment banking” or “banking” for “the economy.”

From a WSJ Deal Journal post called “No Bailout For Me, Thanks”:

We have to retool the work force. We’re not going to do it by hunkering down,” Seidenberg told the attendees of the Dow Jones-Nielsen Media and Money conference. “We’re going to do it by reinvesting.…we can’t allow this period in which we feel bad about dislocations to take away from what America should be doing, which is creating competitive edge. If we ever lose our nerve to continue to take risk, then we’re in a lot of trouble.

While political leaders shivver in their boots and talk about confidence, here’s a genuine leader getting on with it.

The Biggest Economic Nonsense Since the Great Depression

An otherwise interesting Washington Post front-pager on “What Went Wrong” claims the current situation “has erupted into the biggest economic crisis since the Great Depression.”  On the contrary, that honor surely goes to 1980-82, with 1973-75 as a close runner-up.

This may indeed be the biggest postwar financial crisis, but that is a very different thing.

The biggest postwar financial crisis so far was the S&L collapse of the late 1980s, when nearly 3000 financial institutions were closed.  But the impact  of the S&L debacle on the real economy was minor at best (the economy grew by 2.9% a year during that “crisis”).  The stock market crash of 1987 inspired many hysterical predictions but no recession at all.

An economic crisis implies a deep and prolonged drop in real output and employment, not just another routine recession.  To describe current conditions as a worse economic crisis than 1980-82 is fanciful nonsense.

I’m from the Government, and I’m Here to Help You, Whether You Want It or Not

This story says a lot about who most wants bank bailout money, and why:

Community banking executives around the country responded with anger yesterday to the Bush administration’s strategy of investing $250 billion in financial firms, saying they don’t need the money, resent the intrusion and feel it’s unfair to rescue companies from their own mistakes.

But regulators said some banks will be pressed to take the taxpayer dollars anyway. Others banks judged too sick to save will be allowed to fail.

The government also said yesterday that it will guarantee up to $1.4 trillion of private investment in banks. The combination of public and private investment is intended to refill coffers emptied by losses on real estate lending. With the additional money, the government expects, banks would be able to start making additional loans, boosting the economy… .

Peter Fitzgerald, chairman of Chain Bridge Bank in McLean, said he was “much chagrined that we will be punished for behaving prudently by now having to face reckless competitors who all of a sudden are subsidized by the federal government.”

At Evergreen Federal Bank in Grants Pass, Ore., chief executive Brady Adams said he has more than 2,000 loans outstanding and only three borrowers behind on payments. “We don’t need a bailout, and if other banks had run their banks like we ran our bank, they wouldn’t have needed a bailout, either,” Adams said.

“Pressed” how, exactly? One wonders. But common sense suggests two strong indicators that money is being misallocated. The first is when it goes to an institution with a track record of failure. The second is when it’s being urged on a recipient who does not even want it. It seems that we’re faced with one or the other now.

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!