Ben Bernanke and Kevin Warsh

Kevin Warsh writes in the Wall Street Journal, The New Malaise and How to End It.

I have contended that the Fed under Bernanke is committed to doing whatever it takes to stimulate the economy, but that any benefit of the Fed’s actions is undermined by the government’s fiscal  actions. This includes new laws, significantly more regulations, expected tax hikes and crippling uncertainty.

Excerpt:

Fiscal authorities should resist the temptation to increase government expenditures continually in order to compensate for shortfalls of private consumption and investment. A strict economic diet of fiscal austerity has greater appeal, a kind of penance owed for the excesses of the past. But root-canal economics also does not constitute optimal economic policy.

The U.S. would be better off with a third way: pro-growth economic policy. The U.S. and world economies urgently need stronger growth, and the adoption of pro-growth economic policies would strengthen incentives to invest in capital and labor over the horizon, paving the way for robust job-creation and higher living standards.

Pro-growth policies include reform of the tax code to make it simpler, more transparent and more conducive to long-term investment. These policies also include real regulatory reform so that firms—financial and otherwise—know the rules, and then succeed or fail. Regulators should be hostile to rent-seeking by the established, and hospitable to the companies whose names we do not know. Finally, the creep of trade protectionism is anathema to pro-growth policies. The U.S. should signal to the world that it is ready to resume leadership on trade.

The deleveraging by our households and businesses is not a pattern to be arrested, but good prudence to be celebrated. Larger, more liquid corporate balance sheets and higher personal saving rates are the reasonable and right responses to massive government dissaving and unpredictable government policies. The steep correction in housing markets, while painful, lays the foundation for recovery, far better than the countless programs that have sought to subsidize and temporize the inevitable repricing. It is these transitions in our market economy—and the adoption of pro-growth fiscal, regulatory and trade policies—that lay the essential groundwork for greater, more sustainable prosperity.

Monetary policy also has an important role to play. However, the Federal Reserve is not a repair shop for broken fiscal, trade or regulatory policies. Given what ails us, additional monetary policy measures are poor substitutes for more powerful pro-growth policies. The Fed can lose its hard-earned credibility—and monetary policy can lose its considerable sway—if its policies overpromise or under deliver.

From Thomas Sowell’s Intellectuals and Society

“In short, many things that the Federal Reserve, Congress and the two Presidents did (during the market crash of 1929) were counterproductive.  Given these multiple failures of government policy, it is by no means clear that it was the market economy which failed.  There is of course no way to re-run the stock market crash of 1929 and have the federal government let the market adjust on its own to see how that experiment would turn out.  The closest thing to such an experiment was the 1987 stock market crash, similar in size but not in duration to the 1929 collapse.  The Reagan administration did nothing, despite outrage in the media at the government’s failure to act.”

“What will it take to wake up the White House?” the New York Times asked, declaring that ‘the President abdicates leadership and courts disaster.”  Washington Post columnist Mary McGrory said that Reagan “has been singularly indifferent” to the country’s “current pain and confusion.”  The Financial Times of London said that President Reagan “appears to lack the capacity to handle adversity” and “nobody seems to be in charge.”  A former official of the Carter administration criticized President Reagan’s “silence and inaction” following the 1987 stock market crash and compare him unfavorably to President Franklin D. Roosevelt, whose “personal style and bold commands would be a tonic” in the current crisis.”

“The irony in this was that FDR presided over an economy with seven consecutive years of double-digit unemployment, while Regan’s policy of letting the market recover on its own, far from leading to another Great Depression, led instead to one of the country’s longest periods of sustained economic growth, low unemployment and low inflation, lasting twenty years.”

With the clarity of time we can look back at the brink of the collapse that hit us just prior to the last national election.  In the midst of the collapse we were stunned and angry, and tended to blame the party in power. Although the Democrats had controlled both houses of Congress since 2006, the disaster took its bigger toll on the Republicans.

While the roots of this collapse extend back through many administrations of both parties, it is important to know what did not cause this as well.

Some blamed the deficits, others blamed deregulation, but many just saw the main cause as unbridled greed.  I contend that while there were deficits, and there was greed, none of these played a critical role in fomenting this crisis.

As Thomas Sowell noted, blaming this crisis on greed is like blaming an airplane crash on gravity.  It is true but it doesn’t really explain anything. Worse if we just blame the undeniable then there is no need to examine human error, design flaws, or study ways to keep it from happening again.

Greed has been with us since the dawn of man. Why did it decide to show its ugly face in September of 2008? Greed is encumbered by the limits of a rational society and in a capitalist system it is encumbered by competition.  I may want to charge $2,000 a ton for steel, but competition keeps me from charging what I want, and even forces me to keep my payroll and expenses in line.

Our government tries to contain the fear of greed with regulations. If we are to blame greed we must face the failure of our regulations, or we may even need to face the possibility that our regulations fostered greedy behavior.  The second most common blame was the laissez faire attitude that had fostered deregulation of the financial markets.   Usually this is directed at the repeal of the Glass Steagal Act which separated lenders from investment banks. This law was repealed under The Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act of 1999, which was signed by President Clinton.

But other nations, notably Canada, also repealed similar legislation and they did not experience the financial crisis we did. But Canada also did not suspend prudent lending standards to force the spread of home ownership beyond its natural market.

Nor was deregulation the norm under George W Bush. In fact just the opposite was true.

Elliot Spitzer noted that we did not suffer from the lack of regulators or regulations. There were plenty to do the job, but they seem to lack the courage and the will to do the job.  We needed better regulations, not more of them.  In many cases the regulated industries such as Fannie Mae  (exempt from SEC and FDIC regulation) spent enormously on lobbyists and campaign contributions to thwart efforts to regulate them.  It was successful for them.

The biggest recipient of campaign contributions from AIG was Barak Obama. The biggest recipient of the PAC assembled by the largest mortgage lender for Fannie Mae, Country Wide Finance,  was Barak Obama. The largest recipient of campaign funds from Fannie Mae was ….. yes, Barak Obama. The second largest recipient in these three cases was Chris Dodd, Chairman of the Senate Banking Committee.

The deficits which seemed so irresponsible at the time now look like pocket change.  Deficits do matter but it depends how long they last, how large they are relative to GDP, prevailing interest rates, and what the deficits are spent on.  Personal debt spent on a house or investment equipment may seem prudent, the same debt spent on a boat or jewelry would not.

While the debt incurred under George Bush was arguably bad, it was not a critical factor in causing the meltdown.  We incurred controversial debts under Ronal Reagan and incurred little repercussion from the financial industry.

Bubbles are nothing new and may just be a part of the pricing mechanism. The Federal Reserve was created to bring stability to our financial system. It first test was the Great Depression of 1929, and it failed miserably.  Nearly 80 years later with the value of the dollar down 95% and in the middle of the worst financial crisis in our adult lives, we should ask if it is part of the problem.

Eliminating commonly perceived causes should help us focus on solutions that will work. If we delude ourselves into blaming greed, deficits, and individual demons we risk designing solutions that not only will not work, but will like make the problem worse

“Fannie and Freddie played the political game even more fiercely than their opponents, spending millions of dollars on armies of lobbyists on Capitol Hill. Each company was a revolving door for the powerful in Washington- both Republican and Democrat. Newt Gingrich and Ralph Reed, among others, worked as consultants for Fannie or Freddie; Rahm Emanuel was a board member of Freddie.”

“By the 1990’s, Fannie’s chief executive could boast, without much exaggeration, that “we are the equivalent of a Federal Reserve system for housing.”  At their pinnacle the two mortgage giants- neither of them and originator of loans- owned or guaranteed some 55 percent of the $11 trillion U.S. mortgage market.  Beginning in the 1980’s, the two companies also became important conduits for the business of mortgage- backed securities.  Wall Street loved the fees it collected from securitizing all kinds of debt, from car loans to credit card receivables, and Fannie’s and Freddie’s portfolio of mortgages were the biggest honeypot around.”

“But in 1999, under pressure from the Clinton administration, Fannie and Freddie began underwriting subprime mortgages. The move was presented in the press as a way to put  homes within the reach of countless Americans, but providing loans to people who wouldn’t ordinarily qualify for them was an inherently risky business.”

From Too Big To Fail by Andrew Ross Sorkin