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.


  • Scott M says:

    David, a typically excellent piece. What lies ahead, in your view? I tend toward the Japanese scenario, dead men walking, that runs for a couple of years, followed by a wicked inflation as our govt runs out of policy ammo and our reliance on outside financing for the debt is laid bare. in the meantime i am hard-pressed to see how we lay on any real growth, what with falling financial and RE prices.

  • Eric says:

    Looking at your recent buy list, the action in Terex this past couple of weeks was remarkable. Down to the $12s from the $20s in just a few days. And it was in the $80s last year. (I don’t have a position.) I bring it up not for advice but because it seems to embody the whole situation. They do carry debt like pretty much all capital goods firms. But they aren’t reckless about it. They grew by acquisition and benefited disproportionately from artificially higher purchasing power around the world, but they strike me as responsibly managed and straightforward. And here they are, one of the most prominent machinery firms in the world, with a market cap that’s barely over $1 billion. Heck, at this price, a super-richie could buy himself a whole company of life-sized Tonka toys for a small piece of his personal fortune — and he wouldn’t exactly be on the hook for much more in debt either. It might sound weird, but explain Terex’s situation and fate, and I think it may go a long way in getting a beat on the whole situation.

  • Terry says:

    Bernanke per se aside, I don’t think our government–Treasury and Fed–has enough money (or enough debt potential while sustaining our debt rating) to bailout/rescue the US financial sector. Same for the other OECD governments and their financial sectors.

    As a result, I think the policy idea of injecting capital or buying bad debts or lending to endangered banks & insurance companies is doomed to fail in creating liquidity. The deleveraging requirement is far larger than the government’s ability to absorb those losses while increasing liquidity through the banks. I think some of the financials are too big to RESCUE.

    I have been thinking about an alternative approach, which is probably full of holes, but may be worth considering (if smart people can figure out how to fill the holes). It entails two steps:

    1. The US and other governments stop providing any financial support to financial institutions that are suffering because of their overzealous use of highly-leveraged securitization. So, it would be OK to help PNC take over NCC as has just occurred, but no more funds would go to the Wall Street crew.

    2. Have the Fed and Treasury assume the normal business functions of banks, dealing directly with the private sector. The could provide credit, take in deposits, and do things that normal banks do using their balance sheets and the balance of the $700B Congress has allowed Treasury to spend. They should do this in a way that doesn’t undermine healthy commercial banks (such as PNC), but enables taxpayer money to actually reach those in the private sector who need it (businesses and consumers) and, thus, keep the “real” economy moving (if not thriving). The Fed’s new CPFF is probably hte first such step in this direction. Certainly there are enough laid off private sector banking types to staff USG efforts.

    The key consequence is that the highly leveraged banks would eat up each other. A few would survive in a much diminished capacity. As they deleverage, they would be permitted to participate in regular commercial banking operations (if they could), but they would be banned from securitizing assets. In short, they would be forced to act like a bank, not a Ponzi scheme.

    The point of this exercise is that it is more important to save the economy with the limited resources the USG & other governments have available than it is to save the major banks and insurance companies (and GE, GM (GMAC), etc). Moreover, I suspect that there is a better chance for the taxpayers would see their money returned than dumping into the black hole of bank balance sheets.

    At some point, the USG would ease out of its role as the financial sector is able to do without the extra involvement. My guess is that the way to do this would involve raising loan interest rates while lowering them on deposits so commercial banks look more attractive. Certainly there must be other ways as well.

    I can feel the breeze of Keynes spinning in his grave. But I’m certain that throwing more money at banks in any form will NOT lead us out of this financial crisis and deep recession.

    I would welcome thoughtful comments on this by anyone.

  • David,

    What would your policy prescriptions be at this point?


    “They should do this in a way that doesn’t undermine healthy commercial banks (such as PNC), but enables taxpayer money to actually reach those in the private sector who need it…”

    I can’t see how the government could compete with commercial banks directly without undermining the healthy ones. I think the problem with expecting banks to lend more in this environment is that the interest rates banks are allowed to charge may not be high enough to compensate them for the risk they’d be taking on. Perhaps there are other ways the government could increase liquidity in the real economy, perhaps by channeling funds through non-traditional lenders.

  • Chris says:

    David, are you not contradicting yourself here? First you criticize Bernanke for not doing enough, but later you state that the right course would be a new bankruptcy regime for failing institutions. I find it amazing that 7 months after Bear Stearns’ failure there is still no framework for dealing with the situation. Nothing has even been proposed, except giving the Treasure $750 billion to buy umm, assets, wait, no, umm, preferred stock in, umm, banks, yeah, important ones. Is it any wonder the markets aren’t reassured?

    And who is to blame? Paulson for one. It seems like he can’t get out of his Investment banker mode. Say… Goldman has bad assets and can’t lend? I’ll fix that, just buy em from GS. That’s not going to pass muster? I’ll give em a cheap loan.

    Bernanke in my view is doing the right thing. I believe that you David have published about the Fed’s balance sheet, surely you have noticed the extra $600Bln of slime that appeared in the September to October time frame? The Fed absorbed in 30 days almost enough assets to match the entire Paulson plan, or at least Paulson I. So I conclude that BB is both flexible and accomplished what he wanted without the fanfare.

    I think what you are suggesting is that there is an absence of leadership in Washington. No argument from me. Paulson clearly lacks vision and political savvy. Bush is AWOL again. I would like to point out the last major bank crisis, the S&L crisis of the late 80s, required leadership from both the congress and the executive branch. Volcker did not emerge one day, and rip open his shirt to reveal a big “S” on his unitard. Cut Bernanke some slack. He clearly doesn’t have the leadership skills of a Volcker, which is unfortunate, but he is bright and creative, and god knows where we would be right now without some very skillful and deft improvisation from the Fed.