I have written
a speech for Chairman Ben to record on his home video camcorder
and then post on YouTube on the morning of September 18, which
is the date of the next scheduled meeting of the Federal Open Market
Committee. He may use it free of charge. It is my gift to him.
* * * * *
* * * *
As you will
no doubt read in the financial press, the Federal Open Market Committee
has voted to reduce the target interest rate for the Federal Funds
market to 4.75%, half a percentage point lower than the prevailing
5.25%. I voted against this decision. I want to explain why.
my entire academic career, I have operated on the assumption that
a free market is incapable of providing monetary and price stability.
Like most economists and all Federal Reserve Chairmen, I was convinced
that in affairs of money and banking, it would be economically suicidal
to rely on the self-interested decisions of bankers who operate
as agents of the depositors. As I and my peers said, “Money is too
important to be left to the bankers.”
with us. They long ago figured out that the banking system offers
lots of advantages to bankers, but with these advantages come risks.
So, they have long called for the creation of restraints on trade,
namely, for the creation of state licensing. This keeps out competitors.
There is nothing like a legal license to print money. That’s what
fractional reserve banking is. If you haven’t heard about how fractional
reserve banking allows commercial banks to expand the money supply
and collect interest by lending the newly created money, you need
to re-read the section on banking in your college textbook in economics.
called for the creation of a government-licensed monopoly called
the Federal Reserve System, whose primary goal has always been to
protect overextended banks from runs by their depositors. They all
have seen “It’s a Wonderful Life,” and all of them were terrified
by the scene where the depositors wanted to withdraw their money
at the same time. America’s bankers decided decades ago that they
were not about to dole out their honeymoon money to soothe depositors’
fears. Also, they knew that all the other depositors would line
up the next morning. Frank Capra neglected to put that scene in.
we economists have praised the efficiency of the free market and
the inefficiency of government-created restraints on trade, we always
had an exception: the banking system. Here, we have all assured
the public, the free market cannot be trusted.
this myself until mid-August of this year. I believed that the Federal
Open Market Committee could safely raise the target rate of interest
for the money that banks lend overnight to each other. This rate
had been set by the FOMC under my predecessor, Alan Greenspan, at
1%, in 2003. Then the Committee started raising the rate. When he
resigned in late January, 2006, to return to the private sector,
the target rate was 4.5%. Under my leadership, the Committee raised
it to 5.25% in three moves, where it sat since June 29.
For over a
year, I looked at the data supplied to me by my staff. I concluded
that an increase of this interest rate by almost six-fold would
have no adverse economic consequences. The only economists who said
that it would surely create a capital crunch are members of the
Austrian School, and they do not believe in the legitimacy of central
banking, so no one pays any attention to them, especially at the
Federal Reserve System.
On March 28,
I reassured the Joint Economic Committee that things were going
well, despite a few problems in the subprime mortgage market.
the turmoil in the subprime mortgage market has created severe financial
problems for many individuals and families, the implications of
these developments for the housing market as a whole are less clear.
The ongoing tightening of lending standards, although an appropriate
market response, will reduce somewhat the effective demand for housing,
and foreclosed properties will add to the inventories of unsold
homes. At this juncture, however, the impact on the broader economy
and financial markets of the problems in the subprime market seems
likely to be contained. In particular, mortgages to prime borrowers
and fixed-rate mortgages to all classes of borrowers continue to
perform well, with low rates of delinquency. We will continue to
monitor this situation closely.
Notice that I
did what any academic economist would do. I said the topic deserved
further study. Thus, Senators and Congressmen could rest assured that
we at the Federal Reserve were monitoring things closely, and there
was no problem. Anyway, no big problem. Hardly any problem to speak
of. The problem was contained. Anyway, this was likely, other things
being equal. More or less.
On June 5,
in a speech in South Africa, I again surveyed the fall in America’s
residential real estate markets, the rise in delinquencies, and
the increase in foreclosures. I offered this assessment:
will follow developments in the subprime market closely. However,
fundamental factors — including solid growth in incomes and relatively
low mortgage rates — should ultimately support the demand for housing,
and at this point, the troubles in the subprime sector seem unlikely
to seriously spill over to the broader economy or the financial
I ended my speech
with these uplifting words:
with other regulators and the Congress, we have much to do and many
issues to consider. We undertake that effort with utmost seriousness
because our collective success will have significant implications
for the financial well-being, access to credit, and opportunities
for homeownership of many of our fellow citizens.
seemed to have said the exact opposite two weeks before at the May
17 meeting of the Federal Reserve Bank of Chicago.
market innovations have expanded opportunities for many households.
Markets can overshoot, but, ultimately, market forces also work
to rein in excesses. For some, the self-correcting pullback may
seem too late and too severe. But I believe that, in the long run,
markets are better than regulators at allocating credit.
I have been quoted
out of context regarding the inability of regulation to match the
free market’s system of profit and loss. My very next paragraph, which
closed my speech, reasserted my commitment to active regulation.
at the Federal Reserve will do all that we can to prevent fraud
and abusive lending and to ensure that lenders employ sound underwriting
practices and make effective disclosures to consumers. At the same
time, we must be careful not to inadvertently suppress responsible
lending or eliminate refinancing opportunities for subprime borrowers.
Together with other regulators and the Congress, our success in
balancing these objectives will have significant implications for
the financial well-being, access to credit, and opportunities for
homeownership of many of our fellow citizens.
I was careful
to focus on fraud, not basic monetary policy. What I did not see coming
then was, first, by 2007 the horse was not only out of the barn, the
barn was on fire. Second, the problem of fraud was far deeper than
the ethics of mortgage brokers. You may have noticed that I have always
talked about fraud in general, not specific fraud. I never, ever talk
about specific fraud. The worldwide subprime market started coming
unglued in August. So, either there was fraud on a massive scale or
else the fraud had to do with prior monetary policy, which led directly
to the subprime mortgage crisis.
I have been
careful always to speak of the long run whenever talking about good
results, and to speak of the short run whenever confronting results
that are perceived as bad by the financial press in general, but
especially Jim Cramer. I just did not understand in June and July
how short the short run was.
At my June
10 speech at the Federal Reserve Bank of Atlanta, I commented on
the credit supply. I had no clue that within two months, this issue
would move from theory to reality.
banks, nonbank lenders have to raise funds in order to lend, and
the cost at which they raise those funds will depend on their financial
condition — their net worth, their leverage, and their liquidity,
for example. Thus, nonbank lenders also face an external finance
premium that presumably can be influenced by economic developments
or monetary policy. The level of the premium they pay will in turn
affect the rates that they can offer borrowers. Thus, the ideas
underlying the bank-lending channel might reasonably extend to all
private providers of credit. Further investigation of this possibility
would be quite worthwhile.
When I said that
“Further investigation of this possibility would be quite worthwhile,”
I did not have in mind the opportunity to study, first-hand, the worldwide
collapse in mid-August of the credit markets for subprime mortgage
loans and other collateral-backed obligations. I just meant research
by academic economists, who never are asked to put their money where
their mouths are, let alone reveal their investment track record.
You know — people just like I was throughout my entire academic career.
I did not
think then that nine weeks later, on August 17, the Federal Open
Market Committee would be forced by events to release this statement
to the press:
market conditions have deteriorated, and tighter credit conditions
and increased uncertainty have the potential to restrain economic
growth going forward. In these circumstances, although recent data
suggest that the economy has continued to expand at a moderate pace,
the Federal Open Market Committee judges that the downside risks
to growth have increased appreciably. The Committee is monitoring
the situation and is prepared to act as needed to mitigate the adverse
effects on the economy arising from the disruptions in financial
I did not think
that we would be forced that day to reduce the interest rate at the
discount window from 6.25% to 5.75%, and then accept otherwise unmarketable
mortgages as collateral for the loans. I did not think the four largest
banks in the United States would borrow $500 million each on August
the collapse of the secondary markets for subprime debt, and because
of the volatility of the American stock market, the Federal Reserve
System believes that it has an obligation to be perceived as not
being asleep at the wheel. This makes things difficult because of
what I and other Federal Reserve officials said regarding the containment
of spillover effects from the subprime credit markets. It surely
looks as though we were all asleep at the wheel.
Here is the
inescapable reality: the only things we have in our toolbox are
monetary inflation, obfuscation, and blarney. Obfuscation ceases
to work when markets collapse. This leaves monetary inflation and
is as follows. The Federal Reserve spends any newly created money
into circulation. Normally, this money goes to the U.S. Treasury.
The FED buys U.S. government debt. The other option is to lend short-term
money directly to banks based on collateral. We do this through
the so-called repo market, which sounds suspiciously like an unpleasant
aspect of the used car market. But it is actually the opposite of
repo’s in that market. Ever since August 17, we have advanced money
to lenders based on collateral that is about to turn into the equivalent
of the used car repo market. Prior to August 17, we advanced money
based on much better collateral. That was then. This is now.
with our mode of creating new funds to supply liquidity is that
this liquidity, meaning newly created money, does not go to the
companies that really need it. It goes to companies that qualify
for our loans, which means the largest banks in the country. This
money serves as legal reserves for banks to make loans. So, the
banks then lend money. But they lend it to borrowers who look nothing
like the holders of all those subprime mortgages.
two possible exceptions: Fannie Mae and Freddie Mac, the mortgage
conglomerates. They are loaded with mortgages, and if these two
institutions ever look as though they are about to go bankrupt,
we will buy anything they offer to sell us.
is, it takes new money to bail out bad collateral. That means a
lot of new money unless banks start lending to high-risk markets.
But our new, improved regulatory policies have clamped down on this.
the end of my program to reduce the rate of inflation in the country.
I have talked of little else from the day I took over in February
1, 2006. So did my predecessor. So did his predecessor, and so on,
all the way back to 1938.
I have given up. We can bail out the mortgage market or we can pursue
monetary stability. We cannot do both at the same time. I think
fighting price inflation is the most important thing that the Federal
Reserve System can do, not protect overextended banks. This is why
I voted against the new official federal funds target rate. The
only way we can attain this rate is to put a lot of fiat money into
the economy. Our repo rate is going to go through the roof. We have
to lend directly to banks, not the U.S. Treasury. The free market
federal funds rate has been pushing against 5.25% for months. To
supply funds to push it to 4.75% will take a lot of fiat money.
So, late in
my career, I have come to a new conclusion. The best policy that
a central bank can pursue is to target nothing except the rate of
increase of central bank credit. This rate of increase should not
exceed zero percent per annum. The Federal Reserve System should
cease issuing new money or buying new assets. So should all other
it is time for every central bank to stop doing anything. It is
time for a free market to allocate credit, just as it allocates
capital in the equity markets.
Will the rate
of interest rise? There is more than one rate of interest. Short-term
rates will rise until recession hits. Then they will fall. Long-term
rates will fall immediately. Why? Because stable money will produce
price deflation. This will lower long-term rates. The inflation
premium in long-term loans will disappear. It will eventually go
So, to Jim
Cramer, George Bush, and the U.S. Congress, I say this:
need a return to the free market. No more central bank follies in
trying to set an appropriate interest rate — any interest rate.
Let borrowers and lenders work this out among themselves. Why should
anyone trust a group of academic economists with tenured positions
in a government-created monopoly? I can’t think of a good reason.”
a major change of opinion for me. I used to believe all the hype I
wrote about the positive results of regulation and wise central bank
monetary policy. Folks, it was all a crock. It was subprime economic
theory, which led to subprime economic policy.
I intend to
keep on saying this for the remainder of my tenure as Chairman.
And if Jim
Cramer doesn’t like it, who cares?
* * * * *
* * * *
do not expect to see this video. But YouTube is surely the best
place to get wide distribution.