Econ-Fin News Dec 1 2008 - Bernanke's Laissez Faire Dissected

Economics and Finance News - Dec 1, 2008

Bernanke and Paulson talk about the financial collapse
John Cassidy has a lengthy article in The New Yorker today which includes some excellent insights into U.S. Federal Reserve chairman Ben Bernanke and his miserable handling of the financial collapse, including, so far as I know, the first public discussion of an August 2007 meeting in Jackson Hole, Wyoming in which the Fed’s initial approach was discussed and decided by Bernanke and a small group of top advisers.

First, Cassidy provides some interesting details on how Bernanke became Fed chairman,

“I always thought that Ben would stay in academia,” Mark Gertler, an economist at New York University who has known Bernanke well since 1979, told me. “But two things happened.”

In 1996, Bernanke became chairman of the Princeton economics department, a job many professors regard as a dull administrative diversion from their real work. Bernanke, however, embraced the chairmanship, staying on for two three-year terms. Under his stewardship, the department launched new programs and hired leading scholars, among them Paul Krugman, whom Bernanke wooed personally. Bernanke also bridged a long-standing departmental divide between theorists and applied researchers, in part by raising enough money so that the two sides could coexist peaceably, and by engaging in diplomacy. “Ben is very good at respecting minority opinion and giving people the feeling they have been heard in the debate even if they get outvoted,” Alan Blinder said.

The other event that changed Bernanke’s career occurred in the summer of 1999, at the height of the Internet stock boom, when he and Gertler were invited to present a paper at an annual policy conference organized by the Federal Reserve Bank of Kansas City. The topic of the conference—which takes place at a resort in Jackson Hole, Wyoming—was New Challenges for Monetary Policy. Then, as now, there was vigorous debate among economists about whether central banks should raise interest rates to counter speculative bubbles. By increasing the cost of borrowing, the Fed, at least in theory, can restrain speculative activity and prevent the prices of assets such as stocks and real estate from rising excessively.

Bernanke and Gertler argued that the Fed should ignore bubbles and stick to its traditional policy of controlling inflation. If a bubble inflated and burst of its own accord, they said, the Fed could always bring down rates to alleviate damage to the broader economy. To support their case, they presented a series of computer simulations, which appeared to show that a policy of targeting inflation stabilized the economy more effectively than one that targeted bubbles. The presentation got a mixed reception. Henry Kaufman, a well-known Wall Street economist, said that it would be irresponsible for the Fed to ignore rampant speculation. Rudi Dornbusch, an M.I.T. professor (who has since died), pointed out that Bernanke and Gertler had overlooked the possibility that credit could dry up after a bubble burst, and that such a development could have serious effects on the economy. But Greenspan was more supportive. “He didn’t say anything during the session,” Gertler recalled. “But after it was over he walked by and said, as quietly as he could, ‘You know, I agree with you.’ That had us in seventh heaven.”

This, of course, is not just more damning evidence against Greenspan, but more importantly, that the financial disaster is the result of deliberate policy choices that were made even before the Bush Jr. regime--and that those policy choices were widely discussed and approved by a majority of the economics profession and financial community despite extremely prescient criticism by major figures. Thus, the financial disaster is a general social failure by society’s elites, and society’s acceptance of the wrong-headed thinking of those elites.

It’s not like this is the first time a society has had this debate, either. In the 1920s, the fundamental insight by John Maynard Keynes was that market mechanisms were incapable of distinguishing between “enterprise” and “speculation.” That’s why financial markets eventually devolve into little more than gambling casinos. Keynes was quite explicit in calling for the “euthanasia of the rentier” and the “socialization of investment”. The Austrian school of van Hayek and von Mises glosses over the “enterprise” versus “speculation” problem with its argument that “useless consumption” is fostered by fiat money and lax monetary policy, placing the onus of financial calamity squarely on the shoulders of government authority while ignoring entirely the role of what essentially becomes predatory finance that much prefers making money through rent, speculation, and usury.

And the debate continued, with Greenspan, Bernanke, and U.S. policy makers clinging to their laissez faire thinking despite the occasional Cassandra. In fact, they devised reasons to explain away the mounting evidence that there were systemic financial imbalances accumulating.

In October, 2002, a few months after joining the Fed, [Bernanke] gave a speech to the National Association for Business Economics, in which he said, “First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.” In other words, it is difficult to distinguish a rise in asset prices that is justified by a strong economy from one based merely on speculation, and raising rates in order to puncture a bubble can bring on a recession. Greenspan had made essentially this argument during the dot-com era and reiterated it during the real-estate boom.

As house prices soared, many Americans took out home-equity loans to finance their spending. The personal savings rate dipped below zero, and the trade deficit, which the United States financed by borrowing heavily from abroad, expanded greatly. Some experts warned that the economy was on an unsustainable course; Bernanke disagreed. In a much discussed speech in March, 2005, he argued that the main source of imbalance in the global economy was not excess spending at home but, rather, excess saving in China and other developing countries, where consumption was artificially low. Lax American policy was helping to mop up a “global savings glut.”

“Bernanke provided the intellectual justification for the Fed’s hands-off approach to asset bubbles,” Stephen S. Roach, the chairman of Morgan Stanley Asia, who was among the economists urging the Fed to adjust its policy, told me. “He also played a key role in the development of the ‘global savings glut’ theory, which the Fed used as a very convenient excuse to say we are doing the world a big favor in maintaining demand. In retrospect, we didn’t have a global savings glut—we had an American consumption glut. In both of those cases, Bernanke was complicit in massive policy blunders on the part of the Fed.”

Another expert who dissented from the Greenspan-Bernanke line was William White, the former economics adviser at the Bank for International Settlements, a publicly funded organization based in Basel, Switzerland, which serves as a central bank for central banks. In 2003, White and a colleague, Claudio Borio, attended the annual conference in Jackson Hole, where they argued that policymakers needed to take greater account of asset prices and credit expansion in setting interest rates, and that if a bubble appeared to be developing they ought to “lean against the wind”—raise rates. The audience, which included Greenspan and Bernanke, responded coolly. “Ben Bernanke really believes that it is impossible to lean against the wind on the way up and that it is possible to clean up the mess afterwards,” White told me recently. “Both of these propositions are unproven.”

It was, in fact, Bernanke’s clinging to laissez faire ideas that he was selected to advise Bush Jr.

As chairman of the Council of Economic Advisers, Bernanke was expected to act as a public spokesman on economic matters. In August, 2005, after briefing President Bush at his ranch in Crawford, Texas, he met with the White House press corps. “Did the housing bubble come up at your meeting?” a reporter asked. “And how concerned are you about it?”

Bernanke affirmed that it had and said, “I think it is important to point out that house prices are being supported in very large part by very strong fundamentals. . . . We have lots of jobs, employment, high incomes, very low mortgage rates, growing population, and shortages of land and housing in many areas. And those supply-and-demand factors are a big reason why house prices have risen as much as they have.”


the White House economics team was searching for market-friendly policy proposals, and Bernanke was happy to contribute. On the flight from Crawford to Washington, D.C., he and Hennessey discussed replacing tax subsidies to employer-based health-insurance plans with a fixed tax credit or deduction that families could use to buy their own coverage. In Washington, they continued to develop the idea, which proved popular with economic conservatives, though some experts have said it would lead to a dramatic drop in employer-provided health plans. “It’s what we proposed, and it’s what John McCain proposed,” Al Hubbard said. “If we can keep health care in the private sector, it is what eventually will happen. Ben and Keith are the guys who came up with it.”


Bernanke hadn’t said much about regulation before being nominated as the Fed chairman. Once in office, he generally adhered to Greenspan’s laissez-faire approach. In May, 2006, he rejected calls for direct regulation of hedge funds, saying that such a move would “stifle innovation.” The following month, in a speech on bank supervision, he expressed support for allowing banks, rather than government officials, to determine how much risk they could take on, using complicated mathematical models of their own devising—a policy that had been in place for a number of years. “The ongoing work on this framework has already led large, complex banking organizations to improve their systems for identifying, measuring, and managing their risks,” Bernanke said.

The first prick in the housing bubble actually began to appear in the last half of 2006. Sales of new homes began to slow, and in the hottest markets, such as New York, San Francisco, and Washington DC, median sale prices halted their dizzying climb. Even worse, since the early years of the decade, the big Wall Street firms had muscled aside traditional sub-prime lenders like Countryside and grabbed most of the business for themselves, flooding America with undocumented and variable rate mortgages that can only be honestly described as predatory. Some of the shakiest ARMs from previous years had already begun to reset, and default rates were beginning to rise sharply.

It was at this point that the government could have choked the financial crises in their infancy, by intervening strongly into the “free market,” recognizing these predatory mortgage contracts for what they were, and invalidating them, or at the very least forcing the banking and financial system to rewrite the terms to keep people in their homes. Amazingly, no one except outside critics saw that by doing so, people would be able to continue servicing those contracts, and the banks and financial firms could thus avoid having to write them off as a total loss.

Bernanke now realized that the subprime crisis posed a grave threat to some of the country’s biggest financial institutions and that Greenspan-era policies were insufficient to contain it. In the third week of August [2007], he made his second visit as head of the Fed to Jackson Hole, where he invited some of his senior colleagues to join him in a brainstorming session. “What’s going on and what do we need to do?” he asked. “What tools have we got and what tools do we need?”

The participants included Don Kohn; Kevin Warsh; Brian Madigan, the head of monetary affairs at the Fed; Tim Geithner, the head of the New York Fed; and Bill Dudley, who runs the markets desk at the New York Fed. The men agreed that the financial system was facing what is known as a “liquidity crisis.” Banks, fearful of lending money to financial institutions that might turn out to be in trouble, were starting to hoard their capital. If this situation persisted, businesses and consumers might be unable to obtain the loans they needed in order to spend money and keep the economy afloat.


Kohn proposed a potential solution. Before the turn of the millennium, he recalled, worries about widespread computer failures had prompted many financial institutions to hoard capital. The Fed, determined to keep money flowing in the event of a crisis, had developed several ideas, including auctioning Fed loans and setting up currency swaps with central banks abroad, to enable cash-strapped foreign banks to lend in dollars. Y2K had transpired without incident, and none of the ideas had been tested. Kohn suggested that the Fed revisit them now.

Versions of the Y2K proposals became the second part of the Bernanke doctrine—its most radical component. Over fifteen months, beginning in August, 2007, the Fed, through various novel programs known by their initials, such as T.A.F., T.S.L.F., and P.D.C.F., lent more than a trillion dollars to dozens of institutions. One program, T.A.F., allowed banks and investment firms to compete in auctions for fixed amounts of Fed funding, while T.S.L.F. enabled firms to swap bad mortgage securities for safe Treasury bonds. The programs, which have received little public attention, were supposed to be temporary, but they have been greatly expanded and remain in effect. “It’s a completely new set of liquidity tools that fit the new needs, given the turmoil in the financial markets,” Kevin Warsh, the Fed governor, said. “We have basically substituted our balance sheet for the balance sheet of financial institutions, large and small, troubled and healthy, for a time. Without these credit facilities, things would have been a lot worse. We’d have a lot more banks needing to be resolved, unwound, or rescued, and we would have run out of buyers before we ran out of sellers.”

And so we are where we are, and the fundamental problems still are not being addressed. What the economists and financial wizards who got us into this mess say is the fundamental problem – the collapse of the residential real estate market – continues, as policy-makers cling to laissez faire and reject, for example, using $25 billion of the original $700 billion rescue plan to help homeowners.

But more fundamentally, and more importantly, we still have financial markets that are simply unable, as Keynes pointed out, to reward enterprise but not speculation.

U.S. bankruptcy judge lets loose in the Washington Post
It is not often that a sitting judge is angry enough to take public pen in hand and bring a case before the public. Judge Rich Leonard of the U.S. Bankruptcy Court in the Eastern District of North Carolina wrote in the Washington Post on Friday that the bankruptcy laws are perversely skewed against homeowners.

Homeowners are the only ones who cannot modify the terms of their secured debts in bankruptcy. Corporate America flocks to bankruptcy courts to do precisely this -- to restructure and reamortize loans whose conditions they find onerous or can no longer meet. Airlines are still flying and auto parts makers still operating because they have used this powerful tool of the bankruptcy process. Lehman Brothers will surely invoke it. But when the bankruptcy code was adopted in 1979, the mortgage industry persuaded Congress that its market was so tightly regulated and conservatively run that it should be exempted from the general bankruptcy rules permitting modification.

For more than a year, a number of legislators, academics and judges have advocated removing this ban on home mortgage modification to help stem the increasing number of foreclosures. I have twice participated in briefing sessions organized by the House Judiciary Committee, where I was lectured by lobbyists for the mortgage industry about the sanctity of contracts. I have listened to their high-priced lawyers make fallacious constitutional arguments based on discredited cases from the 1930s. (This is, incidentally, an industry that is not particularly concerned about its own contractual obligations as it tries, through various Treasury-aided programs, to stay afloat.)

Usury laws. Bring back the usury laws! Repeal the Depository Institutions Deregulation and Monetary Control Act of 1980 and bring back the usury laws!

Compiling a list of Cassandras
Two weeks ago, Queen Elizabeth visited the London School of Economics and discomfited everyone by asking about the financial collapse: “If these things were so large, how come everyone missed them?”

One wishes the economics profession were being so honest to ask themselves the same question.

This past weekend, Kevin Drum

asked for names of people who had given early warning of the global financial meltdown. Not just people who foresaw the housing bubble, mind you, but people who figured out some of the other problems that made a bursting housing bubble into a worldwide catastrophe and were banging the drums about them. Unfortunately, nearly all the answers came in one of three buckets: (a) Nouriel Roubini, (b) people warning about the housing bubble, or (c) people writing in 2006 or 2007.

However, there were a few plausible suggestions for analysts whose warnings went beyond the housing bubble and who did it earlier than 2006, including Peter Schiff, Tanta at Calculated Risk, Mish at Global Economic Analysis, Doug Noland at PrudentBear, and Brad Setser. Martin Wolf provides a few more possibilities here. I don't know enough about their early work to say for sure that these folks were all early and accurate critics of more than just the housing bubble, but they seem to be likely suspects.

First, a sad note, 47-year old Doris “Tanta” Dungey, who blogged on Calculated Risk, passed away early Sunday morning. She was able to blog only because her terminal cancer was held at bay the past few years. Our thoughts and prayers go out to her family and colleagues. She will surely be missed.

Drum modified his criteria and asked his readers to try again, and there has been an outpouring of suggestions. It is a scandal that none of these people are showing up on the lists of selected and proposed Obama economic advisers and officials. So, it might be a good idea to maintain and expand this list, because I strongly suspect that in a year or two, President Obama is going to desperately looking for fresh economic advice.

Here is a compilation of some of the comments solicited by Kevin Drum:

Mish at Global Economic Analysis.

The Housing Bubble Blog got a lot of it right too....

Doug Noland at PrudentBear has been writing passionately about all of this for five years. Also, Brad Setser.

Robert Schiller

Michael Hudson

Eric Janszen

Doug Henwood

Keith at, now found at He has been tracking the cycle from unfounded exuberance to denial and panic for years.

All the staff at Prudent Bear and The Daily Reckoning; Stephen Roach, who was chief economist at Morgan Stanley until his pronouncements were deemed too negative; David Roche at Independent Strategy in London; Jim Walker of CLSA in Hong Kong; Marc Faber in Hong Kong; Hugh Hendry of Eclectica in London; Philip Manduca, Titanium Capital in London.
Jim Kunstler has been on all of this like white on rice. Also: Herman Daly, Wendell Berry, Bill McKibben, Thomas Frank

. . . if you'd been a regular reader of the CATO Institute, the Heritage Foundation, the Mises Insitute, Mish's blog, Grant's Interest Rate Observe, and Calculated Risk, you would have been up to speed on a half dozen of the most important building blocks of the current crisis, including the most important of these, Fed policy and the Fannie Mae / subprime regulatory disaster. [NOTE – see my discussion above of the Austrian schools’ refusal to deal with the enterprise versus speculation problem identified by Keynes.]

Add Peter Schiff to the list.

Kevin Phillips generally got it correct: Housing bubble isn't the's declining middle class income and 'financialization' that's the problem. Too much debt and giving money to the upper one percent

Peter Schiff, Marc Faber, Jimmy Rogers, in addition to Nouriel Roubini and many other analysts, predicted the collapse of the housing bubble and the financial system two years ago. All of them publish well-read financial newsletters. It's inconceivable that the likes of Robert Rubin didn't know about these predictions and the reasons why they were made.
Here's the link to a clip of Peter Schiff appearing on various Fox financial programs, making his predictions and being ridiculed for it:

In 1999 (!), Senator Byron Dorgan (D - North Dakota) made a courageous stand AGAINST the repeal of the Glass-Steagal act. Watch the video of his arguments in that debate here, with the sharper eyesight we have now it's prophetic:

Another commenter noted that London Financial Times columnist Martin Wolf lists a number of economists/analysts who got parts of this right":

"In my gallery of heroes are Avinash Persaud, who told us early and often that the risk-management models on which regulators foolishly relied were absurd individually and lethal collectively, a point also made by John Eatwell; Kenneth Rogoff, who warned of the US external deficit; Wynne Godley, who warned no less powerfully of the domestic financial imbalances associated with those external imbalances; Charles Dumas and Brian Reading of Lombard Street Research, who warned of the global imbalances; Roger Bootle of Capital Economics, who pointed out the fantasy of believing that we could become rich by selling second-hand houses to one another at ever more exorbitant prices; Raghuram Rajan of Chicago Business School, who identified the frailty of the new financial capitalism; Bernard Connolly of AIG, who warned of the ongoing “Ponzi game” and George Magnus of UBS, who foretold the consequent “Minsky moment”; Stephen King of HSBC, who argued that US growth was built on sand; Andrew Smithers of Smithers and Co and Martin Weale of the National Institute, who told us that UK fiscal policy was far too loose; Bill White of the Bank for International Settlements who insisted again and again that monetary policy should not ignore asset prices and associated credit explosions; and Nouriel Roubini, of course, who was Dr Doom before almost anybody else."

Your humble correspondent believes that these names should be at the top of the list of cassandras: Dean Baker, Thomas Palley, Robert Kuttner, and Stirling Newberry.

Excellent Quote of the Day
Hat tip to Youffraita, commenting on Daily Kos Sunday:

One function of the income gap is that the people at the top of the heap have a hard time even seeing those at the bottom. They practically need a telescope. -- Molly Ivins




Great post...even though it tends to indicate that with Mr. Helicopter in charge we are truly doomed.

I'm ready to 'restructure' my home loan. Guess I'll read up on American Airlines.

'When you see a rattlesnake poised to strike, you do not wait until he has struck to crush him.'

Austrian School

Please get rid of the Austrian School Of Economics. They have done nothing but ruin this country-for some damned reason we have more of them than Austria does! Bring back John Maynard Keynes!!

The funny thing is

If any moral person had actually read von Mises, it's pretty damned obvious right from the start that the Austrian School is based on eugenics and accelerated evolution- they actually consider depressions to be a *good* thing because it gets rid of "inefficient" businesses.

Never mind that's the same bankrupt morality of anti-semitism.....

Maximum jobs, not maximum profits.