Lipstick on Bernanke's Pig

On October 15, Chairman Ben Bernanke delivered a lecture to the Economic Club of New York, titled, “Stabilizing the Financial Markets and the Economy.”

I am sure the title resonated to members of the Economic Club of New York, who saw the Dow Jones Industrial Average fall another 733 points before the day was over.

He began his speech with these inspiring words:

I will focus today on the economic and financial challenges we face and why I believe we are well positioned to move forward.

I am reminded of Mort Sahl’s comedy album in 1958: “The Future Lies Ahead.” Yes, it does.

I, for one, have no desire to be well positioned to move backward.

The problems now evident in the markets and in the economy are large and complex, but, in my judgment, our government now has the tools it needs to confront and solve them.

Does he mean that only now does the government have the tools? Is he saying that for the last sixty years, Keynesian economists, Chairmen of the Federal Reserve System, and Secretaries of the Treasury did not have these tools? They said they did. Were they wrong?

The government has always had the tools by which it has dealt with the crisis over the last six weeks: taxation, inflation, and blarney.

It would have been polite of Dr. Bernanke to tell us about these “large and complex” problems. He didn’t. He gave no indication of a looming crisis so large that it would bring the international capital markets to gridlock, i.e., “frozen.” Actually, the capital markets were not frozen. I was offered a 30-year fixed-interest mortgage for 5.7% two weeks ago, with 10% down. Prevailing interest rates revealed no evidence of freezing up, according to free market economist Robert Higgs.

But without the hoopla about frozen markets, politicians around the world would not have capitulated to an increase of government debt of something in the range of $4 trillion in one month.

Our strategy will continue to evolve and be refined as we adapt to new developments and the inevitable setbacks.

“Evolve.” “Be refined.” Translation: “Making this up as we go along.”

But we will not stand down until we have achieved our goals of repairing and reforming our financial system and restoring prosperity.

“Restoring prosperity.” Yes. Yet somehow I do not recall that Dr. Bernanke, President Bush, or Henry Paulson ever admitted before that we had lost our prosperity. As I recall — I am getting older — they all insisted repeatedly that there was no recession at all.

As in all past crises, at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets.

A lack of confidence is a symptom of the crises, but the question arises: What was the basis of this loss of confidence? He avoids the answer: a looming recession in the real economy. The possibility of such a recession was denied by all policy-makers until about six weeks ago.

The crisis will end when comprehensive responses by political and financial leaders restore that trust, bringing investors back into the market and allowing the normal business of extending credit to households and firms to resume.

This is the Party Line, all over the West: the crisis stems from the financial system. A bailout of the financial system by taxpayers is the only workable solution. No one has suggested that the crisis was engineered by Alan Greenspan’s policies of loose money, and the bankers’ faith that the government would bail out the system in a crisis — which is exactly what the government is attempting to do.

In that regard, we are, in one respect at least, better off than those who dealt with earlier financial crises: Generally, during past crises, broad-based government engagement came late, usually at a point at which most financial institutions were insolvent or nearly so.

What would Dr. Bernanke call the Bear Stearns fire sale in March? What would he call the Office of Thrift Supervision’s seizure of Washington Mutual on September 15? What would he call the bankruptcy of Lehman Brothers on September 15? That was the largest bankruptcy in American history, dwarfing Enron: half a trillion dollars. The value of its bonds was recently settled at less than 9 cents on the dollar.

Waiting too long to respond has usually led to much greater direct costs of the intervention itself and, more importantly, magnified the painful effects of financial turmoil on households and businesses. That is not the situation we face today.

It isn’t? It surely looks as though it is. The recession has not played out. That was the message sent by the stock market before the day was over.

Fortunately, the Congress and the Administration have acted at a time when the great majority of financial institutions, though stressed by highly volatile and difficult market conditions, remain strong and capable of fulfilling their critical function of providing new credit for our economy.

Substitute the words “fiat money” for “new credit,” and you have the Federal Reserve’s solution. It was Greenspan’s solution in the 22% stock market meltdown in October 1987. It was his solution in 1999. It was his solution after 9-11. Each time, it has created asset bubbles.

This prompt and decisive action by our political leaders will allow us to restore more normal market functioning much more quickly and at lower ultimate cost than would otherwise have been the case. Moreover, we are seeing not just a national response but a global response to the crisis, commensurate with its global nature.

In short, politicians have put taxpayers on the hook for at least $4 trillion in just six weeks.

What caused this? Federal Reserve policy under Greenspan? This was never mentioned. It was world confidence in the United States.

Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage, and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress.

But what was the source of these large inflows of capital? The capital fairy, perhaps? No? Actually, a team of capital fairies. One capital fairy is the People’s Bank of China, which inflates at 20% per annum. It buys U.S. Treasury debt. Another is Russia, whose oil exports have blessed the central bank with half a trillion in foreign exchange reserves.

But China and Russia are still buying Western governments’ debt. So, what happened? Why did the West’s financial system go into decline?

The Austrian theory of the business cycle tells us. As I have been writing since early 2007, Greenspan’s policy of monetary inflation was followed by Bernanke’s policy of tight money. The Austrian theory of the business cycle teaches that this reduction in monetary inflation creates a recession. That was why I began predicting recession in 2007. That was why Dr. Kurt Richebächer predicted a monumental financial crisis around the world. He predicted this for six years, 2001 to 2007. He died in August 2007, as the first stage of the crisis revealed itself.

The unwinding of these developments, including a sharp deleveraging and a headlong retreat from credit risk, led to highly strained conditions in financial markets and a tightening of credit that has hamstrung economic growth.

This is exactly what Richebächer had predicted, based on the Austrian theory of the business cycle.

The important thing from the point of view of the men in charge, who did not see this coming and who denied that it was a crisis until the government, without Congress’s approval, nationalized the American mortgage market by nationalizing Fannie Mae and Freddy Mac on September 7, is to make it look as though the government has a handle on all this.

The Federal Reserve responded to these developments in two broad ways. First, following classic tenets of central banking, the Fed has provided large amounts of liquidity to the financial system to cushion the effects of tight conditions in short-term funding markets.

In other words, it returned to Greenspan’s policies of fiat money. You can see the chart here.

Second, to reduce the downside risks to growth emanating from the tightening of credit, the Fed, in a series of moves that began last September, has significantly lowered its target for the federal funds rate.

The FED lowered its target because the T-bill rate fell to .03% in September, indicating total panic in the capital markets. Banks would not lend to each other, so the FED made fiat money available for them.

We will continue to use all the tools at our disposal to improve market functioning and liquidity, to reduce pressures in key credit and funding markets, and to complement the steps the Treasury and foreign governments will be taking to strengthen the financial system.

What tools? Inflation and asset swapping. The FED swaps T-bills for bonds that banks and finance agencies hold that have no market, despite their AAA-rating. The banks then tell the regulators that these Treasury assets, borrowed for 30 days (but renewable forever) constitute their capital. “Look at all this rock-solid Treasury paper. We’re solvent!” It is a massive charade that the whole world understands is a charade.

On this charade the recovery of the world economy is supposedly secure — until the FED runs out of Treasury debt to swap. A chart of its reserves is here.

With the exception of Austrian School economists, who reject government interference — before the crisis and also after — all other schools of economic opinion abandon their commitment to free market solutions as soon as a credit crisis threatens the stock market. In 1970, Leonard E. Read of the Foundation for Economic Education, wrote an essay, “Sinking in a Sea of Buts.” He was referring to this statement, “I believe in the free market, but. . . .”

Dr. Bernanke is a typical but-man.

The Federal Reserve believes that, whenever possible, the difficulties experienced by firms in financial distress should be addressed through private-sector arrangements — for example, by raising new equity capital, as many firms have done; by negotiations leading to a merger or acquisition; or by an orderly wind-down. Government assistance should be provided with the greatest reluctance and only when the stability of the financial system, and thus the health of the broader economy, is at risk.

I love this: “greatest reluctance.” That’s what I have observed of the government over the last half-century: great reluctance to interfere, to tax, and to inflate. Maybe you noticed that, too.

In those cases when financial stability is broadly threatened, however, intervention to protect the public interest is not only justified but must be undertaken forcefully and without hesitation.

Translation: “Whenever the solvency of large New York City banks (or Bank of America) is threatened, the Federal Reserve System intervenes. This has been true since 1914.”

Importantly, the financial rescue legislation, which I will discuss later, will give us better choices. In the future, the Treasury will have greater resources available to prevent the failure of a financial institution when such a failure would pose unacceptable risks to the financial system as a whole.

Translation: “Until the Treasury spends the $700 billion, which will not take too long, we have got this under control. When the Treasury burns through the first $700 billion, it will be back to Congress for more. It will get it, because the 2008 elections will be behind us, so Congress will not even pretend to resist.” With respect to the Treasury’s access to more money, see this. It explains Bernanke’s confidence.

If the crisis originated with flows of capital coming into our capital markets — his argument — and if Asian and Russian central banks were the primary sources of this credit — my argument — then what we need is a free market program to block this from ever happening again. The FED has now adopted a policy where the United States, as the world’s leading debtor nation (an $800 billion a year balance of payments deficit) will lend newly created dollars to European central banks, so that they can lend to American banks and brokerage houses operating abroad.

Indeed, this week we agreed to extend unlimited dollar funding to the European Central Bank, the Bank of England, the Bank of Japan, and the Swiss National Bank. These agreements enable foreign central banks to provide dollars to financial institutions in their jurisdictions, which helps improve the functioning of dollar funding markets globally and relieve pressures on U.S. funding markets. It bears noting that these arrangements carry no risk to the U.S. taxpayer, as our loans are to the foreign central banks themselves, who take responsibility for the extension of dollar credit within their jurisdictions.

No risk to the taxpayer? Why, it’s the capital fairy again. The FED creates money to lend, which creates worldwide dollar inflation, and the taxpayer does not bear the costs. Isn’t central banking creative?

The expansion of Federal Reserve lending is helping financial firms cope with reduced access to their usual sources of funding and thus is supporting their lending to nonfinancial firms and households. Nonetheless, the intensification of the financial crisis over the past month or so made clear that a more powerful, comprehensive approach involving the fiscal authorities was needed to address these problems more effectively. On that basis, the Administration, with the support of the Federal Reserve, asked the Congress for a new program aimed at stabilizing our financial markets.

Translation: “The FED in September pumped in new money at an annual rate of 132% (adjusted monetary base). This could not go on without destroying the dollar. So, the Treasury got Congress to borrow money to bail out the financial industry. This way, the FED can back off the printing press.”

Second, the Treasury will use some of the resources provided under the bill to purchase troubled assets from banks and other financial institutions, in most cases using market-based mechanisms.

Market-based mechanisms? What market-based mechanisms? We have seen the nationalization of the mortgage market. We have seen an enormous increase in government debt.

Mortgage-related assets, including mortgage-backed securities and whole loans, will be the focus of the program, although the law permits flexibility in the types of assets purchased as needed to promote financial stability.

“Flexibility in the type of assets purchased” means “anything that large New York City banks want to palm off on the government.”

Unclogging the markets for mortgage-related assets should put banks and other institutions in a better position to raise capital from the private sector and increase the willingness of counterparties to engage. With time, the provision of equity capital to the banking system and the purchase of troubled assets will help credit flow more freely, thus supporting economic growth.

Translation: “When the banks stick taxpayers with toxic debt, private investors will start buying bank stock again . . . especially since the Treasury will also be buying bank stock, as Paulson has announced.”

These measures will lead to a much stronger financial system over time, but steps are also necessary to address the immediate problem of lack of trust and confidence.

Translation: “The economy is still heading into the tank, despite fiat money, asset swaps, and the $700 billion bailout. Lack of trust and confidence are with us still.”

I would like to stress once again that the taxpayers’ interests were very much in our minds and those of the Congress when these programs were designed.

Translation: “Ho, ho, ho. And, I might add, ha, ha, ha.”

In the case of the TARP program, the funds allocated are not simple expenditures, but rather acquisitions of assets or equity positions, which the Treasury will be able to sell or redeem down the road. Indeed, it is possible that taxpayers could turn a profit from the program, although, given the great uncertainties, no assurances can be provided.

Taxpayers could turn a profit. “No assurances can be provided.” He’s got that right! If there is any profit to be turned, Congress will allocate it for more pork. That $700 billion is gone forever. But still the charade goes on.

Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away. Economic activity had been decelerating even before the recent intensification of the crisis.

Translation: “A recession is coming, and it is going to be a whopper.”

Ultimately, the trajectory of economic activity beyond the next few quarters will depend greatly on the extent to which financial and credit markets return to more normal functioning.

Translation: “If Main Street suffers, Main Street will be compelled by Congress to bail out Wall Street . . . again.”

I have laid out for you today an extraordinary series of actions taken by policymakers throughout our government and around the globe. Americans can be confident that every resource is being brought to bear to address the current crisis: historical understanding, technical expertise, economic analysis, financial insight, and political leadership.

Translation: “It is business as usual: inflate, tax, and juggle the books.”

I am not suggesting the way forward will be easy, but I strongly believe that we now have the tools we need to respond with the necessary force to these challenges.

The tools have not changed. The rhetoric has changed. In short, it’s lipstick on the pig. Again.

Although much work remains and more difficulties surely lie ahead, I remain confident that the American economy, with its great intrinsic vitality and aided by the measures now available, will emerge from this period with renewed vigor.

Translation: “Deficits don’t matter.”


The more things change, the more they stay the same.

October 18, 2008

Gary 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.

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