Bernanke Eats a Large Helping of Crow

Email Print


Why did the
Federal Open Market Committee drop its official target rate for
overnight bank loans on October 31? If it was a plan to head off
a stock market sell-off, it went awry. The Dow fell by 362 points
on November 1.

The obvious
answer is that the FOMC feared a turndown in the economy. But minor
decreases in the federal funds rate will not head off the recession.
Greenspan’s boom is turning into Bernanke’s bust. A fraction of
a percentage point’s decline will not alter the economic fundamentals.

In August,
the Dow fell by over 10%. A rebound came only because investors
believed that Bernanke’s tough talk to Congress about the reasonably
strong economy was so much piffle. They believed Jim
Cramer’s August tirade
. They also believed that Cramer and his
peers would get the ear of the FOMC, no matter what Bernanke says
about an independent Federal Reserve System. The FED may be legally
independent of Congress. It is not independent of the howls of agony
from Cramer and his peers. The Supreme Court follows the election
returns, as Mr. Dooley said so long ago. Similarly, the FED follows
the stock market.

Why should
the FED care? Because the FED is the front for the banking cartel.
The banks have loaned money by the hundreds of billions to borrowers
who then put the money into arcane debt instruments that are now
visibly unraveling. The bankers have no clue as to how they can
get their money back if these debt instruments become insolvent.
These instruments are part of the carry trade: borrowed short and
lent long. This is what brought down the savings and loan industry
in the 1980’s. It threatens to bring down the banks today.

So, Bernanke
must talk calmly to Congress in order not to spread panic. He must
also take symbolic steps to keep Jim Cramer from going on TV and
throwing another tantrum. Why? Because if Cramer is scared, his
capital management peers are scared. If his peers are scared, investors
who bankroll these carry trade schemes will stop putting in their
money. This will end the trade. The banks will then get stiffed.

This almost
happened in 1998. The New York FED called in the major banks that
had lent Long Term Capital Management its money, which LTCM then
had used as margin money in the futures market. The FED strongly
suggested that the banks pony up another $3.5 billion to keep LTCM
from being forced to unload their positions at fire sale prices.
The banks did what was suggested.

This time,
the FED is not facing one lone company whose leveraged positions
have gone south. The FED is facing an entire segment of the U.S.
capital market, which soon may not be able to raise money to keep
its CDO (collateralized debt obligation) projects officially solvent.
As long as these projects are solvent, the banks don’t have to write
off the loans.

The banks are
in a situation eerily similar to the Japanese banks in 1992. They
are sitting on top of visibly bad loans, but they are allowed by
bank regulators to keep these bad loans on their books at face value.
This lets them stay in the lending business.


Let me review
briefly what should be familiar to you.

On October
15, he declared confidently,

It does seem
that, together with our earlier actions to enhance liquidity,
the September policy action has served to reduce some of the pressure
in financial markets, although considerable strains remain. From
the perspective of the near-term economic outlook, the improved
functioning of financial markets is a positive development in
that it increases the likelihood of achieving moderate growth
with price stability.

He said he
was worried about the "moral hazard" problem: the creation
of an expectation that the FED will protect investors’ assets. He
did not want the FED to convey the wrong impression. There would
be no "Bernanke put" to bail out a falling stock market.

in such situations, one must also take seriously the possibility
that policy actions that have the effect of reducing stress in
financial markets may also promote excessive risk-taking and thus
increase the probability of future crises. As I indicated in earlier
remarks, it is not the responsibility of the Federal Reserveu2014nor
would it be appropriateu2014to protect lenders and investors from
the consequences of their financial decisions.

Yet what the
FOMC did on October 31 is nothing less than a stock market bailout
"to protect lenders and investors from the consequences of
their financial decisions." The market had been rising for
two weeks. In
an October 26 report issued by MarketWatch, we read:

widely expect that the U.S. Federal Reserve will lower its federal
funds rate from 4.75%. Markets have fully priced in a quarter-percentage
rate cut at next week’s Federal Open Market Committee policy meeting,
and some believe another half-point cut is possible.

"A 25-basis
point rate cut is the consensus expectation for next week’s FOMC,
according to our survey median, as well as the Fed funds futures
market," wrote analysts at Action Economics.

don’t believe another rate cut is necessary at all, though the
lack of protests from policymakers to consensus expectations of
a rate cut probably makes the move a fait accompli," they

But, Bernanke
asked rhetorically
, what if, in certain special cases, the financial
markets look as though they are coming unglued? Then the FED will

But developments
in financial markets can have broad economic effects felt by many
outside the markets, and the Federal Reserve must take those effects
into account when determining policy. In particular, as I have
emphasized, the Federal Reserve has a mandate from the Congress
to promote maximum employment and stable prices, and its monetary
policy actions will be chosen so as to best meet that mandate.

The FED acted.
Conclusion: "economic effects felt by many outside the markets"
were about to become very painful.

The next day,
they became painful, to the tune of 362 points.

What was his
concern? Officially, the FED’s mandate "to promote maximum
employment and stable prices." But prices have been stable:
rising more slowly than a year ago. So, that was not the problem
facing the FED. This leaves "maximum employment." That
means economic growth.

But hasn’t
he assured everyone that there is no problem here? Of course he
has. He has smooth-talked Congress in a way that Greenspan didn’t.
He has talked clearly about an economy that is not facing a setback.

Then why did
the FOMC cut rates? Twice?

The FED is
trapped by the stock market, with Cramer as its vocal spokesman.
He called for a "Bernanke put" back in August, and Bernanke
gave it to him. Twice.

Bernanke is
acting as all FED chairmen and all FOMCs act. He cut rates when
there was a mere 10% decline in the Dow Jones Industrial Average.

Stock market
bulls discounted a quarter-point cut. They bought shares. Why? On
the assumption that the FOMC would cut the FedFunds rate. This forced
the FOMC’s hand. It did exactly what the forecasters had said it
would, and had run up the market in anticipation.

Let’s look
at the press release that accompanied the FOMC’s action.

growth was solid in the third quarter, and strains in financial
markets have eased somewhat on balance. However, the pace of economic
expansion will likely slow in the near term, partly reflecting
the intensification of the housing correction. Today’s action,
combined with the policy action taken in September, should help
forestall some of the adverse effects on the broader economy that
might otherwise arise from the disruptions in financial markets
and promote moderate growth over time.

What is the
focus here? The financial markets, not the underlying economy, which
is said to be "solid." This is consistent with the FED’s
real purpose in life: to protect the banking cartel. The banking
cartel has loaned a lot of money to the financial markets. The symbol
of these markets is Merrill Lynch, which just lost $8 billion in
subprime loans and whose chairman is about the get fired (and take
away $159 million for his trouble). The press release continued:

on core inflation have improved modestly this year, but recent
increases in energy and commodity prices, among other factors,
may put renewed upward pressure on inflation. In this context,
the Committee judges that some inflation risks remain, and it
will continue to monitor inflation developments carefully.

inflation risks remain." This was Greenspan’s mantra. He said
it over and over for 18 years. Then the FOMC increased the money
supply, year by year, so that consumer prices had doubled by the
time Greenspan returned to the land of the coherent. So, as it turned
out, his warning was right. It was a warning against his policies.

The Committee
judges that, after this action, the upside risks to inflation
roughly balance the downside risks to growth. The Committee will
continue to assess the effects of financial and other developments
on economic prospects and will act as needed to foster price stability
and sustainable economic growth.

"The committee hasn’t any idea what it will do." This
statement is seen as some sort of semi-assurance not to reduce the
target rate again. It is no such thing. It is the FED’s standard
"we continue to keep all options on the table."

vote was 8 to 1.


On August 20,
ran a story on Bernanke
that went straight to his academic ego.
It described him as a rookie.

Federal Reserve
policy makers, who declared that inflation was their paramount
challenge just two weeks ago, have been forced to make financial-market
stability the trigger for changes in interest rates.

By lowering
the discount rate and issuing a statement conceding threats to
the economy, Federal Open Market Committee members effectively
ripped up the economic-outlook statement from their Aug. 7 meeting.
Some economists describe the about-face, coming after months of
assurances that the subprime-mortgage rout was contained, as Chairman
Ben S. Bernanke’s first serious error since taking office last

was a rookie mistake," said Kenneth Thomas, a lecturer in
finance at the University of Pennsylvania’s Wharton School in
Philadelphia. The Fed "underestimated liquidity needs"
of investors and the fallout from the housing recession, he said,
adding, "This demonstrates the difference between book-smart
and street-smart."

The spin was
obvious. Bernanke, as an academic, was holding to a moderately inflationary
policy, not goosing the stock market with a rate cut. What an academic
thing to do, what with Jim Cramer going berserk and everything.
What Bernanke needed to do was listen to the likes of Jim Cramer.

Then, again,
maybe it really was a crisis.

the dynamics change very, very quickly," said former Fed
governor Laurence Meyer, who voted for the three reductions in
1998 after currencies in Asia, Russia and Latin America tumbled.
Bernanke’s shift "tells us how difficult it is to translate
financial turbulence into the macroeconomic forecast."

The piling-on
continued. Martin
Feldstein, a Harvard University economist, testified to FED members
at their all-expense-paid annual retreat at Jackson Hole, Wyoming.
Feldstein is a heavy hitter. He is the CEO of the private research
organization, the National Bureau of Economic Research. It is this
august body that announces in retrospect years later when a recession
began and ended. He was also Reagan’s early Chairman of the Council
of Economic Advisers. He told the FED audience that it was time
to lower the FedFunds target rate. A Bloomberg report summarized
his message.

The economy
could suffer a very serious downturn. . . . A sharp reduction
in the interest rate, in addition to a vigorous lender-of-last-resort
policy, would attenuate that very bad outcome.

He called for
a cut to 4.25%. That would have been a major cut, for the rate was
at 5.25%. Bernanke wasn’t in the room to hear this, but other FED
members were.

outlined a "triple threat" from housing: a "sharp
decline" in home prices and construction; higher borrowing
costs and a "freeze" in credit markets stemming from
subprime-mortgage losses; and fewer home-equity loans and refinanced
mortgages, leading to less consumer spending.

Bernanke blinked.
He buckled. He rolled over and played dead. He and the FOMC lowered
the target rate to 4.75%. Then they did it again.

What thanks
did they get? None. The next day, the Dow fell by 362 points. Once
again, the rule holds: "Buy on the rumor. Sell on the news."


The economy
is facing the prospects of drip-drip-drip bad news from the housing
sector. It is also facing similar bad news from what I call the
carry-trade sector: borrowed short, lent long. The lure of Greenspan’s
low interest rates did to the domestic debt market what the lure
of Japan’s low interest rates did to the worldwide bond market.
The smart money borrowed short and bought long-term income streams.
Now the flow of short-term money has stopped because of fear regarding
the solvency of the organizations created to serve as the middlemen.

Because the
reduced flow of investment money into subprime mortgages, the mortgage
market is in turmoil at the margin. The same is true of the CDO
market. Nobody knows what the market value is for the high-risk
portions (tranches) of these broken-up credit instruments. The investors
played "street smart" for years. They never asked what
the exit strategy was, or what discount the secondary market would
impose when it was time to run toward the exit.

Investors are
now asking about the exit strategy. There isn’t one. There is no
phone call from the New York FED over the weekend to put together
a bailout plan for a single overextended firm. There are too many
overextended firms.

The FED is
now learning that fooling around with the FedFunds rate is not going
to solve the solvency problem.

will be six weeks until the next FOMC meeting. If it intervenes
ahead of time, this will send a loud signal: "It’s panic time!"

There are far
more reasons for the stock market to go down than up. The FED has
shot its wad. It was a pellet gun fired at a charging elephant.
Now the bears take over.

The economy
will not be far behind.

3, 2007

North [send him mail]
is the author of Mises
on Money
. Visit
He is also the author of a free 20-volume series, An
Economic Commentary on the Bible

North Archives

Email Print