Alan Greenspan: The Fed is Blameless

Alan Greenspan says to quit blaming the Fed for the housing bubble:

The Fed is blameless on the property bubble, by Alan Greenspan, Commentary. Financial Times: I am puzzled why the remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006 are not seen to have a common cause. The dramatic fall in real long-term interest rates statistically explains, and is the most likely major cause of, real estate capitalisation rates ... that declined and converged across the globe. ...

[S]ome point to Federal Reserve monetary policy complicity in the US bubble. But ... the evidence that monetary policy added to the bubble is statistically very fragile. Paul De Grauwe ... conclude[s] that the low funds rate was the source of the US housing bubble. ... De Grauwe asserts that “signs of recovery” ... were evident before 2004 and hence the Fed should have started to tighten earlier. With inflation falling to quite low levels, that was not the way the pre-2004 period was experienced at the time. As late as June 2003, the Fed reported that “conditions remained sluggish in most districts”. Moreover, low rates did not trigger “a massive credit ... expansion”. ...

Bank loan officers, in my experience, know far more about the risks and workings of their counterparties than do bank regulators. Regulators, to be effective, have to be forward-looking to anticipate the next financial malfunction. This has not proved feasible. ...

Aside from far greater efforts to ferret out fraud..., would a material tightening of regulation improve financial performance? I doubt it. The problem is not the lack of regulation but unrealistic expectations about what regulators are able to prevent. ...

The core of the subprime problem lies with the misjudgments of the investment community. Subprime securitisation exploded because subprime mortgage-backed securities were seemingly underpriced ... at original issuance. Subprime delinquencies and foreclosures were modest at the time, creating the illusion of great profit opportunities. Investors of all stripes pressed securitisers for more MBSs. Securitisers, in turn, pressed lenders for mortgage paper with little concern about its quality. Even with full authority to intervene, it is not credible that regulators would have been able to prevent the subprime debacle.

Martin Wolf argues in the FT that central banks “can surely lean against the wind” even if they cannot eliminate bubbles. I know of no instance in which such a policy has been successful. ... I doubt that it is possible. If it turns out to be feasible, I would become a strong supporter of “leaning against the wind”. ...

Much of the commentary critical of my FT article (Comment, March 17) is directed less at its substance and more ... at “the ideology I display”. Ideology defines that set of ideas that we each believe explains how the world works and how we need to act to achieve our goals. ...

I do have an ideology. ... I trust our views are subject to the same standards of evidence that apply to all rational discourse. My view of how the efficiency of global capitalism has evolved over the decades as new evidence has appeared contradicts some earlier judgments and confirms others. I have been surprised by the fierceness of investors in retrenching from risk since August. My view of the range of dispersion of outcomes has been shaken but not my judgment that free competitive markets are the unrivalled way to organise economies. We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence?

I'll turn the criticism of the position that the Fed is blameless over to Steve Waldman:

Central banks are dangerous, by Steve Waldman: I really thought that Michael Shedlock was overstating the case:

The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing...

Don't expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem...

The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

But then I read this piece, by Robert Shiller (hat tip Yves Smith), and all of a sudden I'm frightened. It's one thing when Hank Paulson proposes turning the Fed into the macroeconomy's philosopher king. Paulson will be gone in a blink of an eye. But Robert Shiller is an increasingly influential economist. He's already got Mark Thoma signed up for the plan. These guys are smart, they matter, and they will continue to matter next January. So let's think about this very, very carefully.

Shiller points out that...

In recent years, central banks have not always managed macro confidence magnificently. The Fed failed to identify the twin bubbles of the last decade — in the stock market and in real estate — and we have to hope that the Fed and its global counterparts will do better in the future. Central banks are the only active practitioners of the art of stabilizing macro confidence, and they are all we have to rely on.

He's right on both counts. For now, central banks are all we have to prevent a catastrophic unwinding of our unstable financial system. But they had everything to do with getting us here. It's not just the Fed, with its famous "serial bubble-blowing", its cheering on of any novelty as beneficial innovation, its absolute refusal to peer into the magical sausage factory that Wall Street had become. The problem with central banks is much bigger than that. If you haven't been obsessing over every word Brad Setser has written for the past several years, you owe yourself an education. A growing "official sector" has largely defined the global macroeconomy in the first years of this millenium. In the USA, Japan, China, Europe, central banks have indeed been "active practitioners of the art of stabilizing macro confidence". For most of those years, it seemed like they were succeeding. They were never succeeding. Call it what you want, call it "Bretton Woods II", call it "financial imbalance" or a "global savings glut" or "exorbitant privilege". Each central bank, while trying to stabilize its own bit of the world, found itself with little choice but to support and expand unsustainable financial flows on a scale so massive they have reshaped the composition of every major economy on the planet. As Herb Stein told us, what cannot go on forever won't. "When the music stops, in terms of liquidity, things will be complicated." Remember that? The music may have stopped already for Citibank, but it's still playing for the USA. The record is just beginning to skip. ...

Things may turn out okay. We've already begun to "adjust", and knock on wood, we'll manager a worldwide reequilibriation before things get too ugly. But it'll be a close call. That financial alchemy by central banks is the ultimate source of skyrocketing inflation in China and the Gulf states, and an ominous sign that Stein's Law is beginning to bite. We may yet escape, but we have been drawn very close to something very dangerous, to a genuine crisis of scarcity in the United States and a catastrophic failure of Say's Law in China, to mass unemployment, social instability, and fingers and missiles pointed in both directions across the Pacific. This is serious stuff. And central banks are largely to blame.

Private, profit-seeking actors would not have generated the corrosive financial flows that have characterized this millennium. "Financial imbalance", a euphemism for real resource misallocation, would have quickly been corrected, had Wall Street and the City of London not learned that the official sector could be their best customer. Less politically-independent monetary authorities could have leaned against unsustainable financing. A bit of capital-account protectionism might not have been bad policy for the United States during this period, but a central bank blind to obvious "facts on the ground", accountable only to an economic orthodoxy, did not even consider such a thing.

As readers of this blog know, I'm not a laissez-faire, the-private-sector-is-always-right kind of guy. I like to think about the "information architecture of the financial system". That leads me to dislike actors large enough to unilaterally move markets, especially when their motives might not be aligned with wise resource allocation. I dislike large private banks, and think they should be broken into itty-bitty pieces or turned into safe, regulated utilities. For the same reason, I dislike central banks. They have the power to act consequentially, but they do not have, and cannot have, the information or the wisdom to always be right. And when they are wrong, the consequences are devastating.

So, what to do? For now, we have no choice but to "use the army we have". Our long-term plan, though, ought not be to canonize central banks, but to render them obsolete. It won't be easy. The usual "sound money" trope, reviving the gold standard, is not a good idea. Much as it is suddenly out of fashion, we will need some "financial innovation" to build a new monetary architecture. Just because we've had a glut of snake-oil on the market recently doesn't mean there's no such thing as penicillin. We'll have to do a better job of distinguishing novel idiocies from good ideas. But we will need the good ideas. We can and should liberate money from the bankers, central and otherwise.

I don't think we will be rid of the Fed, or some version of it, any time soon, so right now the Fed has two choices on the regulatory front. Do nothing and hope that financial markets fix themselves - that seems to be the Greenspan position - or do something. I don't think this will fix itself so that the problems cannot reoccur, so we have to do something. But what?

I believe that Shiller is right to say that financial institutions have changed substantially since the inception of the Fed's main regulatory powers around seventy five years ago. We need to broaden our concept of what a bank is, and broaden the Fed's authority to regulate financial institutions to fit this updated definition of what defines a bank. If we look at the financial instability in the U.S. prior to the existence of the Fed, particularly once its powers were broadened after the Great Depression, there is little doubt that the Fed has promoted stability and confidence in the financial sector. No, the Fed isn't perfect, and it won't be able to prevent all instabilities with regulation or any other means, there will be good and bad times. But over the entire period the Fed has been in existence, financial markets have done fairly well, and with an effort to learn from our mistakes and update the Fed's regulatory authority to be consistent with modern financial markets, we can hope for relatively stable markets in the future.

I don't think the correct lesson to be learned from the entire history of the Fed's interaction with financial markets is that we should take away the Fed's regulatory authority because it has failed us when we needed it most. It didn't react very well during the Great Depression, but we learned, the Fed evolved, imposed new policies and new regulation, and we enjoyed a much more stable period afterward. When stock markets crashed in later years and reserves began falling (or, say, during 9/11), the Fed knew how to react, injected reserves, and prevented major problems. We were better off because the Fed was around to offset the fall in reserves. The Fed didn't react very well during the 1970s when we were hit with oil price shocks, but the Fed learned, and recent shocks have had a much different impact (to be fair, that's partly due to a changed economic structure, so it wasn't all changes in how the Fed reacted).

There are many instances where we see the Fed not reacting as well as we might hope the first time it encounters a problem, learning, and then doing better the next time. I see no reason to expect the present episode to be any different. We need a larger overhaul than in many past instances because we allowed the Fed's authority to fall far behind changes in financial markets - we didn't recognize soon enough how far out of date the Fed's authority had become. But we know now, and we'll do our best to plug the holes. We might not anticipate the new problems that will invariably arise, the ones never seen before - those are hard to see coming - but if the conditions that led to our present problems reoccur in the future, the Fed will be in a much better position to prevent them from erupting into bigger problems if we learn from the present and update its authority as needed.

I'm not ready to give particulars just yet (and your thoughts are very welcome), but as I think about the changes that are needed, a first step is, as noted above, to broaden our definition of what a bank is, and to broaden the Fed's regulatory authority over such institutions. Second, risks need to be made as transparent as possible, and there are many, many steps we can take along these lines. Regulation to ensure that market participants have the information they need to make good decisions, e.g. disclosure requirements, truth in labeling, etc., have been very successful in improving how markets function in other settings, so there may be hope that these types of regulations could do some good here as well. With transparency and known risks, better decisions will be made, and there's less need for other types of regulation to prevent excessive risk accumulation. As a third step we need to ensure that no single financial institution, or no small set of institutions, can be so important that the entire economy is at risk if one or a few of them fail. This is a significant vulnerability, but I'm not fully certain how to proceed. Steve Waldman's ideas to break up financial institutions into smaller pieces or regulate them like utilities are worth considering along with other approaches, but whatever approach we take, we should not be so dependent on the fortunes of such a small number of firms, and we should do our best to find a way to reduce this vulnerability without sacrificing our ability to channel funds where they are most needed. [Let me add: Even if there are no vulnerabilities due to the existence of one or a few large firms that are too important too fail, it is still possible that a shock to the entire financial system could cause widespread losses and require the Fed to intervene to prevent a complete collapse. So we should also look for ways to prevent system-wide vulnerabilities due to the accumulation of risks that are common across firms. The Fed should be concerned when there is a concentration of risk for any reason, e.g. due to very large, "too important to fail" firms, or due to a build-up of common risk factors that can cause widespread failure of financial institutions, because when risk is concentrated, there is the potential for financial collapse.]

Comments

[Emmanuel]

Greenspan is a true Randian till the bitter end.

[ken melvin]

Who gave charter to these 'financial innovations' and what was that charter?

[save_the_rustbelt]

Gee, nobody thought 1.5% interest rates might be too low?

Didn't Bart Simpson have a line that reminds me of Greenspan?

[save_the_rustbelt]

Ooops.

LEESBURG, Virginia (Reuters) - Million-dollar fixer-upper for sale: five bedrooms, four baths, three-car garage, cavernous living room. Big holes above fireplace where flat-screen TV used to hang.

The U.S. housing crisis has come to McMansion country.

Just as the foreclosure crisis has hollowed out poorer neighborhoods, "for sale" signs are sprouting in upscale developments so new they don't show up on GPS navigation screens.

Poor people weren't the only ones who took out risky, high-interest loans during the housing boom. The sharp increase in housing costs -- and the desire to live in brand-new, spacious houses with modern features -- led many affluent buyers to take out loans they couldn't afford.

"People had in their head, 'I need a mud room, I need giant columns, I need a media room, and I'm going to do anything to get it,"' said Robert Lang, co-director of Virginia Tech's Metropolitan Institute, a research organization that focuses on real estate and development.

The crisis has hit especially hard here in Loudoun County, Virginia, where upscale developments have supplanted horse farms over the past fifteen years...................

[Dickeylee]

Andrea says quit picking on her Paul! It wasn't his fault, it wasn't, it wasn't, it wasn't. He's a good man, really he is. Why, just the other day Lynn Cheney was commenting about was a great guy Paul was...

[CathyG]

Mr. Greenspan is supposed to be a pretty good man with numbers. Maybe he could put together a few models which will predict some of the outcomes of his disdain for regulation and his faith in the strength of “enlightened” self-interest in forming and preserving markets. In particular I’d like to know his estimates of the impact of this financial debacle on:

homelessness, joblessness, under-employment, divorce, domestic violence, juvenile delinquency, crime, hunger, addiction, and suicide.

We have a federal government that has, at worst, aided and, at best, accepted the formation and bursting of speculative bubbles which generate huge wealth for a few players, but are absolutely devastating for far too many innocent bystanders. These bubbles and their consequence are intolerable in and, ultimately, dangerously destabilising to societies which value justice and fair play.

[john jansen]

Regarding the Federal Reserve and its knowledge of the economy and the financial system: The street and market participants err when they ascribe perfect knowledge to the Central Bank. They possess more complete information than most other observers but that information is not perfect. Some who speak to the Fed ,I think, view speaking to them as similiar to talking to a priest in the confessional booth. He is not telling anyone what he has learned in the exercise of his prdained powers. So this confessional effect motivates some to bare their soul to the central bank.

I think another analogy works best. The Federal Reserve is sitting on the 50 yard line of a football game with a better view of the action than 99 percent of the patrons at the game. Unfortunately, every once in awhile a vendor will walk by and obstruct their view.

I think that is the case this time and they failed to surmise the depth of the problem that the asset bubble posed.

[Bruce Webb]

Prof. Thoma is amazingly smart, tolerant of people outside the academy in way that is truly stunning even those of who put forth some nutty views (and you include me in that number), is kind of alarmingly tech savvy (he tracks my more crazy stuff by IP address) yet since I came on board somehow he has elevated his game to international status. I don't know how to explain this in a sense that won't be insulting to a guy that is a personal icon, but the econoblog Economist's View seemed to have pushed Prof. Thoma into a position that continual attempts to place papers into Econometrics wouldn't.

Prof. Thoma deserves every plaudit he is earning. But is hard to think of a path that leads from small town northern California to Chico U to Oregon to Internationally recognized economist that doesn't run through the Internet.

I like Prof DeLong, I am a huge fan of Prof Thoma, that they ended up in pretty much the same conceptual space is kind of mind numbing. Who knew that technology could offset or at least equalize CV?

[plschwartz]

I am afraid of the concentration of power in a new Fed. And I am equally wary of the Fed taking power away from Treasury.
I like the fact that financial regulation is composed of smaller agencies which act as a check and balance with each other. This fragmentation seemed not to hinder the working-out of the BSC "bail-out"
It was said that Mussolini made the Italian trains run on time, suggesting that centralized power made for efficiency. And so does the argument that the Fed needs to have increased responsibility.
It may well that Schiller's idea is sound. But if this responsibility were given to the Fed, then I would feel much more comfortable if some of its duties were hived off.
We feel blessed to have Bernanke lead this rescue. But what if Greenspan had wanted another term. Would he have let Bear go under?
Anyway let us be sure that we include checks and balances in any major increase in Fed responsiility.
BTW is anyone discussing breaking up the big banking firms? And any discussion of how to limit their interconnections.
Lets face it. Right now they are the Borg

[donna]

Sorry, free competitive markets allow market failures. Greenspan and Bernanke can only be right one way or the other, but not both. They can't claim free markets "work" when the government then has to bail out the failures. They can't privatize profits and socialize losses and call that a free market.

Greenspan was not solely responsible, true. But he created the cheap funding and all that sloshing around of money looking for a bigger return created the subprime mess. He IS responsible, whether he wants to be or not.

[dissent]

Martin Wolf argues in the FT that central banks "€œcan surely lean against the wind" even if they cannot eliminate bubbles. I know of no instance in which such a policy has been successful. ... I doubt that it is possible.

Odd, that Greenspan throws up his hands when Ian MacFarlane, his counterpart as head of Australia's Reserve Bank, successfully intervened in that country's housing bubble. Is this yet another instance of American incompetence under conservative rule?

McFarlane, hat tipYves Smith, lays out his views:
The biggest single challenge starts with the recognition that as an economy becomes more developed, its financial side grows a lot faster than its real side. As a result, economic outcomes will depend more on what happens in asset markets and less on what happens in the real side of the economy, such as in the goods and labour markets....If a major financial shock were to occur, such as a large fall in share or property prices, the effect on the economy would be greater than before.

So the central question is whether booms and busts in asset markets are more likely to occur in the future. No one knows, but there is no reason to believe that they will become less frequent or smaller. We know that since financial markets have been deregulated we have seen some pronounced asset price booms and busts, the most notable being the Japanese bubble of the 1980s and the high-tech share market bubble in the United States in the late 1990s. Both of these were followed by recessions. Australia had an equity and property boom and bust in the late 1980s, and a house price boom during the past decade that had many of the characteristics of a bubble, but fortunately it was not followed by a bust.

If it is likely that asset price booms and busts will be at least as common as over the past two decades and that their effect on the economy will be larger, what can monetary policy do about it? There was a time when we felt that monetary policy, by returning the economy to low inflation, would have a stabilising effect on asset markets.... But the broader evidence does not support the view that low inflation will prevent booms and busts developing in asset markets....Some have even gone as far as to suggest that low inflation may encourage the build-up in asset prices.

So, if low inflation does not provide any insurance, what should a central bank do if it suspects that a potentially unsustainable asset price boom is forming, particularly when the boom is being financed by debt?...

Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it for two reasons.

First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, such as house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may not be much affected at first by the higher interest rates, but the rest of the economy may be.

Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence in inflation, but nowhere, to my knowledge, have they been delegated the task of preventing large rises in asset prices, which many people would view as rises in the community's wealth. Thus, if they were to take on this additional role, they would face a formidable task in convincing the public of the need.

Even if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not...In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed....

The interest rate decision is not the only decision that a central bank has to make ....[T]here are other ways of addressing the problem. Central banks have some credibility and authority, which can be used in a public awareness campaign to make people recognise the risks they are taking in plunging into an overheated market....At the Reserve Bank, we had some success with this approach during the recent house price boom....

But that still leaves the central bank with a very limited armoury with which to fight a potentially dangerous asset price boom - the interest rate, which it does not have a clear mandate to use, and public suasion, which is of limited effectiveness. How would it cope if it faced an asset price boom of the magnitude of those that occurred in the US in the 1920s or Japan in the 1980s? Not very well, I expect, but it would probably be held largely responsible for the distress that accompanied the bubble's eventual bursting.

Looking back at the evolution of monetary and financial affairs over the past century shows that policy frameworks have had to be adjusted when they failed to cope with the emergence of a significant problem. The new framework then is pushed to its limits, resulting in a new economic problem. The lightly regulated framework of the first two decades of the 20th century was discredited by the Depression and was replaced by a heavily regulated one accompanied by discretionary fiscal and monetary policy. This in turn was discredited by the great inflation of the 1970s and was replaced by a lightly regulated one with greater emphasis on medium-term anti-inflationary monetary policy. This has acquitted itself well over the past 15 years and is still working effectively, but over the next decade or two will probably face the type of challenges I have outlined.

No one is very good at picking the next major epoch, and we mainly react after the damage has been done. I am influenced by the fact that as the great inflation of the 1970s was building from the mid-1960s, no one, including the central bank, had a mandate to prevent it. As we struggled to come to grips with it, governments made decisions that effectively gave the central bank a mandate, and central banks worked out a framework that to date has been effective in dealing with it. No one has a clear mandate at the moment to deal with the threat of major financial instability, but I cannot help but feel that the threat from that source is greater than the threat from inflation, deflation, the balance of payments and the other familiar economic variables we have confronted in the past.

[mik]

I don't know much about economics. I don't think economists know much about economics.
Just ask them where mortgage rates will be in 3 months.
Then ask an astronomer where Mars will be in 3 months.
The answers will tell you all you need to know about fake science.

But one thing I do know. We had two bad bubbles in 10 years.
Greenspan was presiding over both.

Greenspan may be a genius, I don't know. But his views on subjects I know a bit, immigration, free trade, open borders, are quite conventionally idiotic.

If I will never hear from the old dude again, it will not be too soon.

[Steve]

Greenspan was a cheerleader for subprime lending. He repeatedly claimed there was no bubble, even when prices soared above historical price/income ratios. He was a cheerleader for OTC derivatives, claiming they spread risk to those who could take it on. They were plenty of warnings about counterparty risk and tight coupling, which his blind allegiance to ideology caused him to ignore. He despises regulation, and thinks central banks exist to provide cheap money to speculators. He likes to talk about economic history, but his entire program was to return the US to 1928.

[Lafayette]

Of mighty oaks

Article: Bank loan officers, in my experience, know far more about the risks and workings of their counterparties than do bank regulators. Regulators, to be effective, have to be forward-looking to anticipate the next financial malfunction. This has not proved feasible.

Still in denial, this guy.

The Fed has oversight authority across all financial markets. But only if it effectuates that authority. The dot.com bubble 'n burst responsibility dropped through the crack between SEC and Fed oversight. Higher collateral could have been invoked for speculative equity purchasing on margin. They weren't.

It should have been scrutinizing the manner in which mortgage debt was being allocated willy-nilly and in sub-standard conditions, then come down hard on the perpetrators. I don't buy the argument that it had "no authority to do so". Who did, if not the Fed?

Why did not the Fed increase collateral requirements on such credit to dampen the ardor of the sellers ... or was the resulting mess (once again) acceptable "exaggerated exuberance"?

Yes, it happened on HIS watch. (Of mighty oaks, historical perspective often makes acorns.)

[a]

" I know of no instance in which such a policy has been successful. ... "

This kind of comment worries me. How does one observe a counterfactual, that is, an economy not having a bubble because of a central banks' actions?

I guess Greenspan might think you can do this with cross-country analysis, but things are just too interlinked for that too work. The Nasdaq bubble in the US spread to Europe as the MTM bubble - because one can arbitrate stock prices between the two. The behaviour of the Bank of England has caused property prices in France to go up.

So I'm either worried about Greenspan's belief that it might be *possible* to know, or about his disingenuousness hiding behind an epistemological doubt when he understands full well that one can't know in any case.

[wjd123]

Bank loan officers, in my experience, know far more about the risks and workings of their counterparties than do bank regulators. Regulators, to be effective, have to be forward-looking to anticipate the next financial malfunction. This has not proved feasible. ...--Alan Greenspan

I agree, but what's the point if regulatory policy undermines the fiduciary responsibilities of the bank officer. They are undermined in a world where banks can quickly resell mortgages. In that world the loan officers are encouraged to be remiss in their fiduciary responsibilities.

The Fed could have reinforced the likelihood that fiduciary responsibilities would have been carried out by making banks hold loans for years rather than months. That would have been a way to make regulations into markets reinforce market discipline.

Regulators don't have to know every detail of a loan to know that this link between the regulatory environment and reinforcing market discipline is their responsibility to care for when the banking industry comes knocking at their door with its problems.

[Lafayette]

Not the practice, but the practitioners

a: The behaviour of the Bank of England has caused property prices in France to go up.

Uhhhhh ... only for those Brits financing their purchases in France with a £-Sterling mortgage in the UK. (Which exposes the debtor to unfavorable exchange rate fluctuations.)

The French never allowed sub-prime mortgages. They require that a person show the ability to finance their debt with at least a copy of monthly payslips for the last three months of employment. Then they apply the "3 to 1 rule" -- your total income must be three times the mortgage/credit repayments. And, that rule can get even tougher if you report other loan repayments that show your net income is closer to 2 to 1.

(Do the French have foreclosures. Of course they do. Public Notaries constantly have realty auctions to sell properties that have been foreclosed for non-payment.)

If you lie or cheat on the information given, it is considered Credit Fraud. Out you go, the bank repossesses the property. (Unless you are really down and out, and a special Pauper's Law will allow bankruptcy arrangements that will keep you in the property, but try to reschedule payments.)

It is for these reasons that the French smirk at the sub-prime mess in America. Of course, they weren't smirking when a rogue trader, employing the same market manipulations as traders in the States, almost ruined a prestigious French bank. And, why did he get away with his machinations?

Because the internal controls were not in place to detect them. And those external controls that signaled his curious trading patterns were disregarded. (The trader was cited by German regulators, having purchased and resold German derivatives in a curious fashion.)

So, whether controlling overheated markets in credit financing or global financial trading, the Control Game is the same. Control, control, control ... not of the practice (of finance engineering) but its practitioners.

The Fed got too removed from their markets, sitting on a Cherubic Cloud in Washington and had no vision whatsoever of what was happening in its credit markets. This is characterized negligence in supervisory oversight responsibilities.

Somebody should have got fired. But, he had retired anyway ...

[hari]

@ Mark -

Thanks for a rather full plate of arguments on the coming struggle for regulatory control of hi fi markets.

First, I happen to buy AGs argument that Fed is more often than not a blunt instrument of last resort when it comes to policy. More reason why Feds micro knowledge of the credit markets should come into the forefront, I think. Because it will allow Fed to move in front of the curve, sort of. At the moment, if you read AG carefully, Feds main function is to react to market disruptions - not to allay such imminent financial costraints. This implies the frameowrk of policy and control mechanism will change, due to subprime fraud and so on, as Congress decides to broaden on oversight and punish fraudulent practices by hi fi markets.

Second, Waldman is a typical ideological *nut* who can't see beyond his own nose! Sorry, but that's the way I read is nonsense - although at the end he attempts to become a bit more *rational* in his analysis. I've read him now for a while...and there are a lot of such *mudcrackers* in the blogsphere... who don't impact overall policy, me thinks.

Third, G-7 will meet (soon) in Washington and this will be a seerious topic on their collective agenda. And if you have followed my comments on this subject, I want and demand now a serious attempt to co-ordinate macropolicy atleast at G-7 level. These policy makers are more than conversant with their own policy shortcomings, including lack of regulatory oversite and controls. I expect their meeting to produce a bit of headline for a change. Look for their press statement.

Fourth, monetary policy alone cannot mitigate financial catastrophes. Fiscal policy is out on a limb right now because Congress is hemstrung by ideological stand-off under 8yrs of *The Decider*. Next Admin will have a chance to review and decide on how to proceed to stabalize global financial markets. I don't expect any intervention from current admin. in throes of its last days.

Fifth, globalization unleached this instable hifi markets, as we witnessed it during the Asean meltdown and also in Russia. AG is claiming the housing bubble in Spain is more dangerous than what's happening in America. The realestate market in Spain is seriously down...and going bust.

Conclusion
Given the paradigm shift in international finance ushered in by Globalization of 7/24h hi fi markeets, there is adequate grounds to consider ways and means of not only regulating certain segments of volatile instruments (out there in the market) but to deliberately slow down the system, if at all possible. You can't control if you can't manage these new financial instruments.

Why? Fed/ECB and other CBs need to understand better the ways in which these markets have been *misused and leveraged*. Finally some financial innovations will have to be construed as *unacceptable* and therefore null and void.

[ndd]

A few brief notes:

1. I am glad, as is Bruce Webb, that our gracious host is getting such well-deserved attention.

2. I agree with Mish that the remedy for the Fed screwing up is NOT to give the Fed even more power.

3. I repeat what I said yesterday, "Power corrupts and absolute power absolutely corrupts". Imagine a Fed Chairman with a political agenda and all the power our gracious host and otherrs are willing to grant. Any such grant of power needs soom dramatic checks and balances, for example, perhaps the SEC and the States being able to challenge the Fed in court to enforce existing rules, with preliminary injunctions to do so being liberally granted.

4. The Fed is not the only game in town. Even more than the Fed, we need regulatory reform from the Political branches of government. The immediate problem is, of course, that the current Administration will have none of it. But for the longer term, that is where the power most properly lies.

[a]

"Uhhhhh ... only for those Brits financing their purchases in France with a £-Sterling mortgage in the UK."

I'd disagree. There are a lot of Brits who compare the price of a house in France and the price in the U.K. and decide that France is a much better value (and not just for secondary houses; some actually just get up and move). They then borrow in Euro from a French bank. (Many also then start complaining that no one in the French government speaks English to them, or they complain about French bureauracracy, or they just complain to complain...)

[swells]

I have to be honest here. I don't understand the arguments because I don't have the requisite background in economics. But, it does seem to me that the more concentrated power becomes the more leverage that power supplies the wielder of it. I think it highly unlikely that perfection is possible in the application of that leverage. Given that, wouldn't one assume that when mistakes are made in high leverage situtation that the effects are likely to be very dramatic? I think less leverage would provide less opportunity for growth but might prove the saner course in the long haul.

I don't think these things because I understand economics (I don't) but because it seems to logically follow. Are we really sure that ever greater growth rates are on balance a good thing?

[jamzo]

seems as though ian macfarlane is a well=-educated economist with international experience as well as solid experience as a "professional financial regulator"

from wikipedia

Ian John Macfarlane AC (born 22 June 1946), Australian economist, and Governor of the Reserve Bank of Australia (RBA), Australia's central bank, from 1996 to September 17, 2006. He is also former Chairman of the Payments System Board of the Reserve Bank and Chairman of the Council of Financial Regulators.

Macfarlane was educated at Monash University, Melbourne, from which he received the Bachelor of Economics degree with first class honours in 1968, and the Master of Economics degree in 1971. He tutored in economics there before joining the RBA in 1970. From 1971–72 he worked at the Institute of Economics and Statistics at Oxford University. Following this, he then moved to the Organization for Economic Co-operation and Development in Paris, where he served until 1978, before returning to the RBA. He became head of the bank's Research Department in 1988, Assistant Governor (Economic) in 1990, Deputy Governor in 1992 and Governor in 1996.

On 21 May 2004 the Doctor of Science in Economics (D.Sc.Ec.) degree was conferred (honoris causea) upon Macfarlane by the University of Sydney at the Faculty of Economics and Business ceremony held at 2pm.

In January 2004 Macfarlane was awarded Australia's highest honour, Companion in the General Division of the Order of Australia (AC). He was honoured "for service to the stabilisation of the Australian financial system, to central banking, and to the operation of monetary and economic policy in both domestic and international spheres."

Macfarlane ended his term as Governor on September 17, 2006 after 10 years presiding over Australia's economic boom. He was replaced by Glenn Stevens. The Treasurer at that time, Peter Costello, said of Macfarlane: "Ian Macfarlane has been an exceptionally successful governor of the Reserve Bank ... And when history of the last 10 years is written, it will show as one of, if not the greatest periods of economic management in Australian history."[1] He is currently a director of Woolworths Limited,ANZ Bank and the Lowy Institute for International Policy.

[gaius marius]

If we look at the financial instability in the U.S. prior to the existence of the Fed, particularly once its powers were broadened after the Great Depression, there is little doubt that the Fed has promoted stability and confidence in the financial sector. No, the Fed isn't perfect, and it won't be able to prevent all instabilities with regulation or any other means, there will be good and bad times. But over the entire period the Fed has been in existence, financial markets have done fairly well, and with an effort to learn from our mistakes and update the Fed's regulatory authority to be consistent with modern financial markets, we can hope for relatively stable markets in the future.

mr thoma, i take exception here.

i think it's mildly revisionist to say that central banks have presided over a period of moderated economic volatility since 1913 or even since ww2. anyone who lived in the period between 1965 and 1982 knows otherwise -- in real terms, financial markets were devastated in the inflation which central banking abetted if not created during those years.

i do of course agree that, since 1982, there has been a wonderful moderation of economic turmoil in the west -- and further suggest that the unconscuious backward extrapolation of this recent period causes many to dilute the terror of the 1970s and draw the trend back to the last undeniable catastrophe.

but here i take a second exception -- one can attempt to correlate this period to the predominance of central banking, but is that causation? and, if it is causation, is it stable or unstable?

i would suggest to you that the moderation in economic instablility since the early 1980s does have a cause proximate to central banking -- but that it is best viewed in this graph. that is, central banking -- though not exclusively responsible -- is a key component in a systemic levering that has made the good times unusually good, the component which has intervened to prevent full-scale unwinds when they could have taken hold (from lesser and safer levels of leverage).

that is a illusory policy of economic stabilization which will work until it doesn't -- for it is inherently unstable, and if it is viewed today as a benefit of central banking it will likely too soon be viewed as its primary detriment as well.

[Winslow R.]

mark wrote: "[Let me add: Even if there are no vulnerabilities due to the existence of one or a few large firms that are too important too fail, it is still possible that a shock to the entire financial system could cause widespread losses and require the Fed to intervene to prevent a complete collapse. So we should also look for ways to prevent system-wide vulnerabilities due to the accumulation of risks that are common across firms. "

Any Fed rework should allow the Fed to stick to its macroeconomic objective, even during times of extreme distress that could lead to complete collapse. There should be no need for the Fed to target any particular part of the economy to keep it functioning, including any part of the financial sector.

New Fed tools should work through a broadly targeted mechanism to avoid encroaching on politically based fiscal policy. Politics (playing favorites, something the Fed has already mistakenly done) should play no part in how the Fed implements monetary policy if they wish to retain their 'independence'.

The Fed has the authority to implement a Fed Direct system that achieves all objectives. Fed Direct strengthens the Fed's ability to stabilize the economy while increasing the efficient allocation of funds. Also, Fed Direct reduces the inefficiencies associated with gains from the real economy being inordinately captured by a nonproductive financial sector. A Fed Direct system reduces the excessive leverage that led to the current crisis.

But you already know all that. Perhaps Ben does too.

[billy]

I trust our views are subject to the same standards of evidence that apply to all rational discourse. My view of how the efficiency of global capitalism has evolved over the decades as new evidence has appeared contradicts some earlier judgments and confirms others.

This is an outright lie.

What the economist cabal gives crooks like Greenspan is the luxury of "plausible deniability". Thus Greenspan can pretend that all of this was unforeseen.

If there were economists of principle, with integrity, they would have called Greenspan to the mat a long time ago, while this wreck was in the making.

How many MacFarlanes, Trichets or Issings did we see in this country? It hardly matters whether they are right or wrong, - but how many had the backbone?

It is a testament to the sycophancy and brown-nosing of the entire economic profession, to the Fed, that the most discerning analysis and questioning of the Fed racket has come from anonymous and not-so-famous bloggers - CR, Steve Waldman, Yves Smith and so on, rather than any of the storied academics.

Any economist who called the Fed out has been ridiculed by the Fed, their bootlickers in the media and academia.(Roubini, Dean Baker, Shiller for eg;)

Letting this rotten system collapse - this cabal of the Fed, academic economists, Wall Street pigmen and media pundits - would be worth every penny of the pain that comes with the collapse.

Do not let the prophesy of "apocalypse-if-the-system-is-not saved" from this cabal fool you. It is not the apocalypse, but the neutering of their well-oiled machine of looting that gives them the nightmares.

[acerimusdux]

"The dramatic fall in real long-term interest rates statistically explains, and is the most likely major cause of, real estate capitalisation rates"

While there is much need to discuss improved regulation, and regulatory failure may be the prime culprit here, rather than monetary policy, I'm also interested in the monetary policy debate.

Has it not occurred that real long-term interest rates falling globally might also be related to global monetary policy? Is it not possible that there are similar global effects, when most central banks globally have come to adopt similar methods and approaches?

Inflation targeting has been very successful, globally, at reducing inflation. Per the IMF Data Mapper, world inflation has fallen from 35.9% in 1992, to 14.4% in 1995, to 5% in 1999, and has been in the 3.5%-4% range since 2001.

Perhaps success in one area can lead to adverse consequences in others.

Overall, the global economy has been very strong. Developing economies began running current account surpluses around 2000, and real GDP growth since then has been explosive, in the 7-8% range for the developing world since 2002. So I'm not even convinced that our large current account deficit is really a problem, if it has been helping fuel a global boom.

As for asset bubbles, they seem to me in part a consequence of the strong currencies that have driven inflation lower. I wonder though, if global growth couldn't be even stronger if more were instead invested in that developing world in things like education, infrastructure, and productive capital assets.

[Winslow R.]

mark wrote: "a first step is, as noted above, to broaden our definition of what a bank is, and to broaden the Fed's regulatory authority over such institutions."

Redefining a bank as an entity that can leverage say 10x rather than 30x may provide a temporary fix, but long-term the limits to leverage are always circumvented. In a globalized world, ducking regulation will become increasingly easier.

The very structure of national currencies need to provide a balance to international trade. I am not a nationalist but neither am I an internationalist as I find the 'internationalist' agenda very destabilizing. Small international elites always seem to lose connection to the large national masses. In a globalized world it is so easy for the elite to remove themselves.

[kthomas]

Did Alan ever fudge at anything? One wonders.

[Spectator]

Well said, billy.

Greenspan's credibility is sinking fast. His latest excuse that all countries experienced the same excesses is hardly worth mocking. He seems to forget he was in charge of the world's reserve currency.

I wait for the day when the credibility of the economics establishment is in the same gutter as Greenspan's. We may not be far away.

[rufus]

Professor Thoma,
Forgive me for picking on your words, and for this contrite analysis. However at times I think we make things more complicated then they are:

"As a third step we need to ensure that no single financial institution, or no small set of institutions, can be so important that the entire economy is at risk if one or a few of them fail."

Should the Fed not also be subject to this precaution? Broader powers and broader scope means more concentration of risk associated with a singular strategy.

The obsession with 'Price Stabilization' is not natural. The effort applied to stymie all but the smallest shocks to the economy for the sake of the vaunted 2% inflation goal is a unilateral objective imposed by this 'important' agency, which we are now going to pay for. As the current regime tells us that we have to suffer the current mounting effects of inflation, for the sake of keeping the economy from stalling.

Yet again we've had our cake...just wondering when do we get to eat it?

[bakho]

Greenspan clearly does NOT understand regulation. What a blind spot.

[don]

Mark - Congratulations on some well-earned recognition.

Back in the Great Depression, countries engaged in competitive devaluations to export unemployment. Same thing is happening today, as china keeps its currency at about half the market value in order to keep up its exports. The U.S. Fed is causing the dollar to drop, but only as a side-effect of trying to spur domestic borrowing. But doesn't it strike anyone else as strange that our only response to the current malaise is is to spur borrowing when the country already has unsustainable excess demand?

[Lafayette]

gm: that is a illusory policy of economic stabilization which will work until it doesn't -- for it is inherently unstable

Life is "inherently unstable". What is your point?

The Fed improves with time, but the difference between pre-Fed and post-Fed -- in terms of Finance Market relative stability , has been night and day.

Let's not forget that the Great Depression occurred because the powers that be, at the time, felt that further tightening of credit, instead of its opposite, would "cure market sickness". In the face of a similar banking Credit Seizure, did they ever get that wrong!

We've come a long way ... but evidently we are still learning. As I have said repeatedly, "Do not blame the practice, blame the practitioners".

We have met the enemy and he is us. (Pogo by Walt Kelly)

[Winslow R.]

don wrote: " But doesn't it strike anyone else as strange that our only response to the current malaise is is to spur borrowing when the country already has unsustainable excess demand? "

This idea keeps popping up within posts but has yet to make it to the marquee (that I'm aware of). I recall a Martin Wolf article on the possibility that Malthusian restraints could totally destroy the democratic world order.

The dangers of living in a zero-sum world economy

"The optimists believe that economic growth can and will continue. The pessimists believe either that it will not do so or that it must not if we are to avoid the destruction of the environment. I think we have to try to marry what makes sense in these opposing visions. It is vital for hopes of peace and freedom that we sustain the positive-sum world economy. But it is no less vital to tackle the environmental and resource challenges the economy has thrown up. This is going to be hard. The condition for success is successful investment in human ingenuity. Without it, dark days will come. That has never been truer than it is today."

http://www.ft.com/cms/s/0/0447f562-ad85-11dc-9386-0000779fd2ac.html?nclick_check=1

[Lafayette]

Morality and capitalism

WR: I recall a Martin Wolf article on the possibility that Malthusian restraints could totally destroy the democratic world order.

Such Cassandra predictions constantly arise in debates such as ours.

Throughout the history of mankind, they have proved baseless as regards the human condition. Mankind always find a way around problems but rarely without casualties. For better or worse, we do make headway against total chaos within the world order.

All our griping is Shakespearean drama -- Much Ado About Nothing. We finger point in blogs, which never solves any given problem. It's just venting of mutual disgust.

America faces some pretty tough decisions regarding its future and we are in the midst of a presidential electioneering campaign that has become laughable. Does anybody really think any one of the current three candidates will change how America works (and, worse, does not work)?

If we want to end the mindless bent for riches that engulfs us, only marginal taxation will have the desired effect. And, what naive politician would propose raising taxes in an electoral debate? So, what should we expect from such a politician once elected? Miracles?

The problem, I find, is not as much in the mechanism as in ourselves. An excellent article appeared in the Economist (5th April edition) about educating the world towards understanding personal financing, titled "Getting it right on the money", from which comes this excerpt: “EVERYBODY wants it. Nobody understands it. Money is the great taboo. People just won't talk about it. And that is what leads you to subprime. Take the greed and the financial misrepresentation out of it, and the root of this crisis is massive levels of financial illiteracy.”

The present mess was born and bred in the US. It resulted in two kinds of greed; the first being predatory pricing of an uninformed clientele who believed they could get something-for-nothing and the second being the Finance Establishment that blithely packaged toxic-waste for profitable resale infecting virally the global investment community. With the artless collusion of rating agencies who blessed it as a "good deal".

If the above description is not a sign of collective moral lapse, then what is? Let's ask ourselves what set of moral imperatives could have allowed that financial beast out of its cage?

Or, was it simply lack of morality ingrained in unbridled capitalism? Methinks yes.

Are morality and capitalism at odd-ends? Only when we allow it.

[Lafayette]

Some interesting information from the article "Getting it right on the money" of the Economist (5th April) regarding the status of mortgages at the end of 4th quarter of 2007, from the Mortgage Bankers Association:

The four mortgage loan categories:

* Subprime, adjustable rate -- less than 10% of the total; with 42% foreclosures started

* Prime, adjustable rate -- 15% of total; 20% foreclosures started

* Prime, fixed rate -- 65% of total; 18% foreclosures started

* Subprime, fixed rate -- 6% of total; 12% foreclosures started

The bulk of mortgage lending is of the Prime, fixed or adjustable rate kind -- with around 20% in foreclosure. This rate of foreclosure is close to the double of its natural rate. Subprime is around 20% of the total, with more than 50% of the foreclosures.

So, where's the tsunami?

[Lafayette]

Article: Even with full authority to intervene, it is not credible that regulators would have been able to prevent the subprime debacle.

Literally true.

The Fed had no "Supervisory Oversight" mentality. Playing Tough Cop is not easy and takes not only expertise but a police mentality. Such mentality was quite beyond the Fed and its personnel more inclined towards posturing and mystical statements to Senate panels -- which throw media pundits into somersaults of joy deciphering.

So, yes, it is true enough that "it is not credible that regulators would have been able to prevent the subprime debacle". Thank you, Alan, for your probity. A bit late, however.

That does not mean, however, that the Fed should not have been exercising proper supervisory regulation, as its charter (perhaps arguably) gives it the authority to do.

The point is this: Greenspan had his own particular mindset as regards how markets should be supervised -- called Supervision Lite. The Board of Directors, which is mostly a sinecure for Finance Industry professionals, over the years, went right along with Greenspan's mentality because it suited the profit ambitions of the Finance Industry -- especially those who would benefit the most, its practitioners.

So, what have we learned? The Fed presidency and its Board are highly influenceable by the industry it is intended to oversee - an endemic problem throughout Washington, D.C. No Fed president should be allowed to overstay his/her welcome. Two terms and you go. And its Board should have a complexion of experience larger than the Finance Industry itself.

The Board needs likely less Finance Industry expertise (of the kind that let the subprime mess pass just under its collective nose) and more objective opinion exercised -- to arrive at a good balance. A bit of vigorous Board divisiveness would be evidently very healthy for the nation's financial health.

[rufus]

Kudos Lafayette! There is a certain prose to reading this:

"The present mess was born and bred in the US. It resulted in two kinds of greed; the first being predatory pricing of an uninformed clientele who believed they could get something-for-nothing and the second being the Finance Establishment that blithely packaged toxic-waste for profitable resale infecting virally the global investment community. With the artless collusion of rating agencies who blessed it as a "good deal"."

Very well stated...and I would have to agree with your thoughts on term limitations at the Fed. However, in attending a course taught by the head of R&D for the Dallas Fed (can't imagine them being ahead of the curve on anything at this point<<

says...

Kudos Lafayette! There is a certain prose to reading this:

"The present mess was born and bred in the US. It resulted in two kinds of greed; the first being predatory pricing of an uninformed clientele who believed they could get something-for-nothing and the second being the Finance Establishment that blithely packaged toxic-waste for profitable resale infecting virally the global investment community. With the artless collusion of rating agencies who blessed it as a "good deal"."

Very well stated...and I would have to agree with your thoughts on term limitations at the Fed. However, in attending a course taught by the head of R&D for the Dallas Fed (can't imagine them being ahead of the curve on anything at this point

says...

Apparently I've found the magic keys on the 'keypad'...my apologies.

Kudos Lafayette! There is a certain prose to reading this:

"The present mess was born and bred in the US. It resulted in two kinds of greed; the first being predatory pricing of an uninformed clientele who believed they could get something-for-nothing and the second being the Finance Establishment that blithely packaged toxic-waste for profitable resale infecting virally the global investment community. With the artless collusion of rating agencies who blessed it as a "good deal"."

Very well stated...and I would have to agree with your thoughts on term limitations at the Fed. However, in attending a course taught by the head of R&D for the Dallas Fed (can't imagine them being ahead of the curve on anything at this point, pessimistic…I know), the lecturer continually insisted that the Fed was charged with first the stabilization of the money supply, and therefore prices. The second commandment was striving for full employment (as filled as can be). I believe the Fed's charter is far less implicit than this. So maybe it is time to draft a constitution, complete with checks and balances for the Federal Reserve, and fully politicize the process via elections instead of appointments? Just seems to be a fire fighting approach to the current revision process...as in we'll cross that bridge when we come to it.

[Lafayette]

rufus: the lecturer continually insisted that the Fed was charged with first the stabilization of the money supply, and therefore prices.

Well, technically that person is correct. The above is what the Fed was chartered to do ... in 1913. We've come a way in a hundred years since then as a nation and finance as prime mover in the economy.

The Fed has to change if it wants to keep up with the times, and it is not so much a question of expertise but mentality. They still think they are bankers.

Railroads kept insisting they were in the rail-train business until the airlines and truckers taught them that they were in the transportation business. The Fed is having the same problem in discovering what its responsibilities should be beyond what their century old charter says the are.

(It is undergoing an .... uh, Identity Crisis. ;^)