NOT Born and Bred in the Briar Patch

Originally, I was not a fan of Bernanke, but the more I read about him, the more I liked him.  Still, my main fear that I wrote about at RealMoney at the time of his nomination has largely been realized in my mind.

David Merkel
Why I Don’t Like Bernanke as Fed Chairman
10/24/2005 12:09 PM EDT

From my post on April 4th:

“I’m not crazy about Ben Bernanke being selected chairman of the Bush administration’s Council of Economic Advisers. This is not because I think he’ll do a bad job there; odds are, he’ll do fine. It’s kind of a nothing job, anyway. I just suspect that this is a stepping stone to becoming the next Fed chairman. Bernanke is too much of a dove on inflation for me, and too seemingly certain of his own opinions. If we have very placid economic conditions, he could do fine as Fed chairman. If we have crisis conditions, the last thing I want is a dovish idealist as Fed chairman.”

Greenspan was more of a political operative than an academic, and as such, fairly pragmatic as he threw liquidity at every crisis, creating a climate of moral hazard. Investors lose fear of loss, because monetary policy will bail them out in a crisis.

Academics think they understand how monetary policy affects the economy, and in my opinion, have a higher degree of confidence in their views than say, a banker in a similar position would. When models of the world are imperfect, a false certainty can do a lot of damage. Bernanke is a bright guy, but bright doesn’t mean right.

Position: None

Bernanke spent a lot of time studying the Great Depression as a grad student, and I did not.  As an academic, there is the bias that says, “Yes, but we have learned from the past, and know what to do next time.  We have the game plan to fight Depression II set.”

I think the wrong lessons were learned by Dr. Bernanke, and many academic macroeconomists.  They look at the ineffective remedies at the time: negative monetary growth, Smoot-Hawley, and lack of stimulus, and they conclude that if they can stimulate a lot more, they can avoid Depression II.

Depressions occur because market actors take on too much debt, including financial institutions, and at the tipping point, cash flow proves insufficient to service the debt, starting a self-reinforcing bust cycle going the opposite direction of the prior self-reinforcing boom.  Once the self-reinforcing bust starts, I’m sorry, but there is little that can be done.  Liquidation of bad debts must happen to clear the system.  In the absence of that, we can have a Japan-style scenario where rates go to zero, and we stay in a funk, or we could inflate the mess away, harming savers and pensioners.

The boom-bust cycle is normal to Capitalism and should be enjoyed, rather than avoided by policymakers.  A lot of smaller busts are better than one big bust when national debt to GDP levels are at record levels.

At this point, stimulus merely slows down the inevitable.  We aren’t liquidating debts as much as transferring them to the government.

I am waiting for the first Treasury auction failure.  They won’t call it a failure, and they may reschedule it.  When that happens, we will have a statement that shifting private debts to the US Government is not appreciated by the creditors of the government.

We also could have semi-failures, where the market clearing rate at the auction is well above the average bid.  A few of those, and the yield curve could be at record wide levels.

I view the Federal Reserve and Treasury as being a bunch of amateurs here.  That’s not an insult.  Take me, James Grant, or any number of bright critics of the Fed and Treasury, and if they were in charge now, they would be amateurs also.  There is nothing in their training that prepares them for dealing with the credit equivalent of nuclear winter.  Nor should there be.  These abnormal periods happen every 40-80 years whether we like it or not, once we forget the lessons of building up too much leverage under a fiat money system.

Should they be blamed for not bailing out Lehman?  That was the inflection point for this crisis as it is manifesting now.  Yes and no.  Yes, since they took it upon themselves to be the guardians of the whole financial system.  Yes, since they bailed out Bear and AIG, two institutions that they had no business bailing out.  Both were bailed out for reasons relating to systemic risk, and both were politically unpopular.  But though Lehman may have posed less systemic risk than AIG, it certainly posed more risk than Bear.  Yes, because they jolted expectations.  No, because they couldn’t have known the full chain of events that allowing Lehman to fail would touch off.

A hidden cost here is that activism begets more activism, or, at least, a demand for more activism.  If the Federal Government and the Fed are now the lenders of first resort, it is no surprise that many will come-a-beggin’.  Once you are willing to lend to support one critical area of the economy, my but many areas will deem themselves critical as well.  Where does it stop?  At this point, I think it might have been better to let Bear, Fannie, Freddie, and AIG fail, but with some sort of expedited bankruptcy process that quickly disposes of equity rights, and converts all debt claims into varying degrees of new equity.  This extinguishes debt claims, and accelerates the healing of the economy.  This would be true reform.

Looking Forward

Now, suppose for a moment that the monetary and fiscal stimulus programs work in the short-run, and bring down rates.  What happens when the Fed tries to exit?  My guess is that they can’t exit.  In paying interest on reserves, the Fed is slowly replacing the Fed funds market with its own lending.  If the Fed leaves, the crisis reappears.  But even apart from that, the government ends up with more debt, and that has to be serviced in some way.

In providing guarantees to money market funds, buying top-rated CP, and helping financial firms finance paper of varying quality, the Fed replaces markets that ceased to function for a time.  The Fed sets yields and prices for credit, but with little to guide their decisionmaking.  Set the price too high, and there are few takers.  Too low, and there are many takers.  Beyond that, with so many programs, what is a bureaucrat to do to figure out which programs are offering the most relief?  I’ll tell you, it is not possible to figure that out.  The money going out is certain, but the benefits are not.

Now, as Greenspan mumbles, wondering about how this crisis could have come about, those of us that are more aware (or intellectually honest), look at the increase in total debt levels and say, “It’s pretty amazing that the system held together for so long.”  It’s an ugly situation, but it is worth asking whether the current actions of our government might harm the future well-being of our nation.

It’s almost never a good idea to sacrifice freedom for security.  But the Federal Reserve has done that.  They are now tied to the Treasury Department, and any policy independence they had is gone.  Book-smart Bernanke has been co-opted by the street-smart Paulson.  Bernanke is a bright guy, but he was not “Born and bred in the briar patch,” as was Paulson, who learned the ropes on Wall Street.  (Do I have to say that Wall Street produces harder characters than academia?  No?  Good.)

In this case though, we are beyond normal, even for seasoned veterans of Wall Street.  There are no comparables any more.  This is more severe per unit time than 1973-4 or 2000-2.  Only the Great Depression remains as a benchmark, and that era grins at us as we think we can beat the process of delevering through government action, of which they had much.

I’m not grinning here.  We are looking at tough times.  May the Lord help us.