Recently by Gary North: A Safe, Quiet Place
“Somewhere, over the rainbow, way up high.”
Federal Reserve Board chairman Ben Bernanke delivered a speech on April 13 on “Rethinking Finance.” It certainly needs to be rethought at the highest levels. Unfortunately, Dr. Bernanke has not yet begun the process. Thinking, yes. Not rethinking.
He ended his speech with this:
The financial crisis of 2007-09 was difficult to anticipate for two reasons: First, financial panics, being to a significant extent self-fulfilling crises of confidence, are inherently difficult to foresee.
This is wrong on two counts. First, in a free market, there are no self-fulfilling prophecies. That is because of the widespread distribution of knowledge. A self-fulfilling prophecy is said to take place because lots of people expect it to happen. But why would lots of people expect it to happen? Because (1) there is something fundamental taking place and (2) people share the same economic theory.
Then why is there ever a panic? The free market pits buyers against buyers and sellers against sellers. Why wouldn’t those with the best information sell the assets over time, as accurate information spreads? Why is there a panic? Why don’t prices come down in a more steady, orderly way? If someone issues a prophecy, it is not widely believed at first. It takes time for people to believe.
They believe it because it explains events in terms of a framework. They draw conclusions. They slowly come to the same conclusions. A panic takes place when the vast majority of investors put their money in the wrong investments. Overnight, the investments turn out to be ill-conceived. The economist should ask this: Why did almost everyone make the same bad investments? The normal process of competition precludes such widespread, simultaneous errors.
Bernanke asked this. His answer self-fulfilling prophesies. He did not ask the more fundamental question: How is it that these self-fulfilling negative prophesies work their black magic against the interests of the vast number of market participants?
FIAT MONEY PRODUCES BAD INFORMATION
Ludwig von Mises asked this question: Why do so many entrepreneurs make the same mistakes at the same time? His answer: there must have been misinformation conveyed to almost all market participants. But how? Because of central bank tampering with the money supply. Money is the common commodity. It conveys information to most participants. To find why people make the same mistakes at the same time, he said, look at monetary policy of the central bank and fractional reserve commercial banks.
The banks inflated, driving down interest rates. This persuaded entrepreneurs to expand production. When the fiat money expansion ceases, or is accurately forecast, rates rise, losses occur, and a leveraged banking system implodes. That is the origin of financial panics.
This is why Austrians knew the crash was imminent. We looked at artificially low interest rates in 2005, and we made a forecast: the housing bubble was about to pop. We were alone in this forecast. Professor Walter Block compiled links to the 2005 and 2006 articles in which Austrian School economists and analysts forecast the bust.
Austrians knew. The others didn’t. Why not?
BERNANKE’S NON-SELF-FULFILLING PROPHESIES
Repeatedly in late 2005, Bernanke denied that housing was a bubble. In May 2007, he said this:
…we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well.
In February 2008, he assured us,
I expect there will be some failures [among smaller regional banks]. Among the largest banks, the capital ratios remain good and I don’t anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system.
In August 2008, three weeks before Treasury Secretary Hank Paulson unilaterally nationalized Fannie Mae and Freddie Mac, Bernanke announced:
[Fannie Mae and Freddie Mac are] adequately capitalized. They are in no danger of failing [However,] the weakness in market confidence is having real effects as their stock prices fall, and it’s difficult for them to raise capital.
Apparently, Dr. Bernanke’s prophecies were not self-fulfilling. They were in fact so far off the market that he would be a laughing stock, except for the fact that the media know better than to ridicule the head of the most important Establishment institution.
The only economists prophesying what took place in 2007 (housing) and 2008 (finance) were the Austrians. How was it that this tiny band of economists outside the mainstream and dismissed as kooks by Establishment economists were right, and Keynesians, monetarists, and supply-siders were wrong? How was it that their predictions were true, despite universal scorn, thereby unleashing the much-feared self-fulfilling prophecies?
Why do bad self-fulfilling prophesies come true? How does bad theory win out? Keynesians say Austrian theory is wrong. So, it’s bad old Austrians who caused the crisis.
Think of Ben Bernanke as Oliver Hardy and Ludwig von Mises as Stan Laurel. “Well, here’s another fine mess you’ve gotten us into.” By the way, why not call economic growth a self-fulfilling prophecy? People predict it. Why does it come to pass? Is it a case of “prophesy and grow rich”? Is it mind over matter? Obviously not. Then how do the negative prophesies come true autonomously?
TRIGGERS AND LOADED WEAPONS
Bernanke blamed “triggers.” He should have spoken of loaded guns, but he instead spoke of “vulnerabilities.”
I ask: Why was the financial system vulnerable? Put another way, who sold the gun owners the ammo?
Bernanke said this.
In its analysis of the crisis, my testimony before the Financial Crisis Inquiry Commission drew the distinction between triggers and vulnerabilities. The triggers of the crisis were the particular events or factors that touched off the events of 2007-09 – the proximate causes, if you will. Developments in the market for subprime mortgages were a prominent example of a trigger of the crisis. In contrast, the vulnerabilities were the structural, and more fundamental, weaknesses in the financial system and in regulation and supervision that served to propagate and amplify the initial shocks.
Who cocked the hammer? Who pulled the trigger? Why then? Why not later? Why not earlier?
In the private sector, some key vulnerabilities included high levels of leverage; excessive dependence on unstable short-term funding; deficiencies in risk management in major financial firms; and the use of exotic and nontransparent financial instruments that obscured concentrations of risk.
I ask this: Why was there no safety lock? He blamed the government.
In the public sector, my list of vulnerabilities would include gaps in the regulatory structure that allowed systemically important firms and markets to escape comprehensive supervision; failures of supervisors to effectively apply some existing authorities; and insufficient attention to threats to the stability of the system as a whole (that is, the lack of a macroprudential focus in regulation and supervision).
So, we are to believe that over seven decades after the publication of Keynes’ General Theory, and six decades after the publication of Paul Samuelson’s “Economics,” the government economists did not know how to regulate the economy. This does not speak well of the Keynesian system. When will these people get their coercive act together?
He blamed “shadow banking.” He did not explain how such an institutional arrangement became significant enough to bring down the conventional banking system’s house of cards. How did it get so much power?
Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions – but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions.
Here was a system under Bernanke’s thumb, 2006 to 2008, yet he did not have a clue in August of 2008 that the investment banks were about to go under. Why not? What was it that blinded him and his peers? “Before the crisis, the shadow banking system had come to play a major role in global finance.” It surely did. How?
Why should we believe that the same tenured bureaucrats who have no ownership in the outcome of the system will be capable of heading off another panic?
As became apparent during the crisis, a key vulnerability of the system was the heavy reliance of the shadow banking sector, as well as some of the largest global banks, on various forms of short-term wholesale funding, including commercial paper, repos, securities lending transactions, and interbank loans. The ease, flexibility, and low perceived cost of short-term funding also supported a broader trend toward higher leverage and greater maturity mismatch in individual shadow banking institutions and in the sector as a whole.
Why didn’t this become apparent before the crisis? Why were the Federal Reserve System and the federal government’s banking regulatory bureaucrats blind-sided? He did not ask this.
The blind side is supposed to be covered. Ben Bernanke is no Michael Oher. The quarterback, George W. Bush, was flattened.
Bernanke also did not ask this. How did these institutions, which do not have the power to create money, become so dominant in the banking sector? Where is central banking theory able to explain how some institutions without the power to create money, and therefore outside the Federal Reserve’s authority, was able to threaten the entire banking structure, which Bernanke wants us to believe? He wrote a textbook on this. How did he not include a chapter?
Nobody estimated this risk adequately.
This lack of capacity by major financial institutions to track firmwide risk exposures led in turn to inadequate risk diversification, so that losses – rather than being dispersed broadly – proved in some cases to be heavily concentrated among relatively few, highly leveraged companies.
Why should anyone believe that Keynesian theory can deal with this risk, when there is no theoretical explanation offered by Keynesians as to how this development took place? He described what happened. He did not explain it. He said that “losses were felt disproportionately at key nodes of the financial system, notably highly leveraged banks, broker-dealers, and securitization vehicles.” How? Why? Why did no one in authority see this coming?
Much shadow banking lacked meaningful prudential regulation, including various special purpose vehicles, ABCP conduits, and many nonbank mortgage-origination companies. No regulatory body restricted the leverage and liquidity policies of these entities, and few if any regulatory standards were imposed on the quality of their risk management or the prudence of their risk-taking. Market discipline, imposed by creditors and counterparties, helped on some dimensions but did not effectively limit the systemic risks these entities posed.
Because there was no theory that explained how this could happen in a central bank-directed economy, there was no accurate foresight. But there still is no theory. So, on what basis will the next panic be headed off at the pass?
If these people do not know cause and effect, how can they prevent unwanted effects?
The problem was not shadow banking. The problem was central banking, which is the enforcer of the fractional reserve banking cartel.
He wants more power. Every government bureaucrat whose sector of the economy goes smash always demands more power. Then the next crash is worse. So, he demands more power.
The gaps in statutory authority had the additional effect of limiting the information available to regulators and, consequently, may have made it more difficult to recognize the underlying vulnerabilities and complex linkages in the overall financial system. Shadow banking institutions that were unregulated or lightly regulated were typically not required to report data that would have adequately revealed their risk positions or practices. Moreover, the lack of preexisting reporting and supervisory relationships hindered systematic gathering of information that might have helped policymakers in the early days of the crisis.
THE SOLUTION: SWAPS AND INFLATION
He praised central banking.
Following that advice, from the beginning of the crisis, the Fed, like other major central banks, provided large amounts of short-term liquidity to financial institutions, including primary dealers as well as banks, on a broad range of collateral.
In short, the FED swapped T-bills for toxic assets at face value, thereby saving the largest banks.
Reflecting the contemporary institutional environment, it also provided backstop liquidity support for components of the shadow banking system, including money market mutual funds, the commercial paper market, and the asset-backed securities markets.
But it will never happen again. That’s all behind us now. A New World Order has been put in place.
The Federal Reserve’s responses to the failure or near failure of a number of systemically critical firms reflected the best of bad options, given the absence of a legal framework for winding down such firms in an orderly way in the midst of a crisis – a framework that we now have.
Somewhere over the rainbowWay up high,There’s a land that I heard ofOnce in a lullaby.
Somewhere over the rainbowSkies are blue,And the dreams that you dare to dreamReally do come true.
Someday I’ll wish upon a starAnd wake up where the clouds are farBehind me.Where troubles melt like lemon dropsAway above the chimney topsThat’s where you’ll find me.
Somewhere over the rainbowBluebirds fly.Birds fly over the rainbow.Why then, oh why can’t I?
If happy little bluebirds flyBeyond the rainbowWhy, oh why can’t I?
April 18, 2012
Copyright © 2012 Gary North