Ben Bernanke has an editorial in the Washington Post that attempts to defend the Fed.  Here is my discussion of his editorial:

These matters are complex, and Congress is still in the midst of considering how best to reform financial regulation. I am concerned, however, that a number of the legislative proposals being circulated would significantly reduce the capacity of the Federal Reserve to perform its core functions. Notably, some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures are very much out of step with the global consensus on the appropriate role of central banks, and they would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution’s ability to foster financial stability and to promote economic recovery without inflation.

1) A fiat money system cannot control inflation without controlling credit.  Bank regulatory powers natively belong to the Fed as a result.  Rather than remove the regulation powers, give them to the Fed exclusively, so that we can watch them fail at the task without any charges of banks choosing their regulators.  There should only be one regulator of banks.  Let it be the Fed.

This is not to say the Fed has done a good job in the past.  Far from it.  But other regulators have failed as well.  Let’s have one regulator, so that we can assign blame when there is failure, and eliminate the errors in the long run.

2) Away from that, since Volcker and Martin, when has the Fed truly been independent?  When has it done something politically unpopular?  When has it done something that angered politicians?  Mr. Bernanke, your Fed has gone with the flow, and prostituted the credit of our nation to satisfy political ends, not protect the value of the currency.

The proposed measures are at least in part the product of public anger over the financial crisis and the government’s response, particularly the rescues of some individual financial firms. The government’s actions to avoid financial collapse last fall — as distasteful and unfair as some undoubtedly were — were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity, with profound consequences for our economy and society. (I know something about this, having spent my career prior to public service studying these issues.) My colleagues at the Federal Reserve and I were determined not to allow that to happen.

Moreover, looking to the future, we strongly support measures — including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system — to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is “too big to fail” — while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.

3) What the Fed did not do in the past it recommends now, that bankrupt institutions be taken through bankruptcy.  Duh, I recommended that many times in 2008.  There was no reason that any of the bailouts should have happened.  All we needed to do was follow existing law, and if no DIP lender showed up, the US Government could have played DIP lender, in order to liquidate the portions of complex institutions that were systematically important.

The Federal Reserve, like other regulators around the world, did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis. We have extensively reviewed our performance and moved aggressively to fix the problems.

4) There were regulators that did better, including Australia and Canada.

Working with other agencies, we have toughened our rules and oversight. We will be requiring banks to hold more capital and liquidity and to structure compensation packages in ways that limit excessive risk-taking. We are taking more explicit account of risks to the financial system as a whole.

We are also supplementing bank examination staffs with teams of economists, financial market specialists and other experts. This combination of expertise, a unique strength of the Fed, helped bring credibility and clarity to the “stress tests” of the banking system conducted in the spring. These tests were led by the Fed and marked a turning point in public confidence in the banking system.

5) Why should we believe that the Fed that did not use its powers to the full in the past, will do so in the future?  The Fed has had these experts available in the past, and did not use them.  What should make us think that they will be more successful in the future?  The failure to regulate properly is systematic.  There needs to be a change at the top of the Fed if it is to have a chance of regulating properly.

There is a strong case for a continued role for the Federal Reserve in bank supervision. Because of our role in making monetary policy, the Fed brings unparalleled economic and financial expertise to its oversight of banks, as demonstrated by the success of the stress tests.

This expertise is essential for supervising highly complex financial firms and for analyzing the interactions among key firms and markets. Our supervision is also informed by the grass-roots perspective derived from the Fed’s unique regional structure and our experience in supervising community banks. At the same time, our ability to make effective monetary policy and to promote financial stability depends vitally on the information, expertise and authorities we gain as bank supervisors, as demonstrated in episodes such as the 1987 stock market crash and the financial disruptions of Sept. 11, 2001, as well as by the crisis of the past two years.

6) 1987 and 2001 were failures, not successes.  No policy accommodation should have been given.  Would Martin or Volcker have done it?  Financial firms need to learn to run with more slack capital for disasters.  As for the present crisis, please take credit for the glut of liquidity provided 2001-2004.  The Fed is to blame for that.  The kid gets no credit for saying, “Ma, I broke the window,” when she saw him do it.

7) The Fed should regulate systemic risk, because it creates the systemic risk.  No other reason.  Make the Fed tighten policy when Debt/GDP goes above 200%.  We’re over 350% on that ratio now.  We need to save to bring down debt.

Of course, the ultimate goal of all our efforts is to restore and sustain economic prosperity. To support economic growth, the Fed has cut interest rates aggressively and provided further stimulus through lending and asset-purchase programs. Our ability to take such actions without engendering sharp increases in inflation depends heavily on our credibility and independence from short-term political pressures. Many studies have shown that countries whose central banks make monetary policy independently of such political influence have better economic performance, including lower inflation and interest rates.

Independent does not mean unaccountable. In its making of monetary policy, the Fed is highly transparent, providing detailed minutes of policy meetings and regular testimony before Congress, among other information. Our financial statements are public and audited by an outside accounting firm; we publish our balance sheet weekly; and we provide monthly reports with extensive information on all the temporary lending facilities developed during the crisis. Congress, through the Government Accountability Office, can and does audit all parts of our operations except for the monetary policy deliberations and actions covered by the 1978 exemption. The general repeal of that exemption would serve only to increase the perceived influence of Congress on monetary policy decisions, which would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation.

We have come a long way in our battle against the financial and economic crisis, but there is a long way to go. Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.

8) The Fed has been anything but independent.  An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.  A transparent Fed would have full transcripts published within a year, not five years.  Testimony before Congress is a joke, because Congressmen use it to play for their own advantage, rather than overseeing the Fed.

I repeat what I have said before — If we had truly independent central bank governors like Volcker, Martin and Eccles, the Fed could work.  The Fed needs to work, or we may as well go back to a gold standard.

Given the  lack of independence of the Fed over the past 23 years, additional Congressional oversight could not hurt much.  Better that the Fed should have tough men as leaders, willing to stand up to the politicians and say no, we won’t inflate.  If we can’t have that, bring back the gold standard.  Gold is impersonal, and bends to the whims of no one.  It is a friend to those that want something fixed to rely on.

We are also supplementing bank examination staffs with teams of economists, financial market specialists and other experts. This combination of expertise, a unique strength of the Fed, helped bring credibility and clarity to the “stress tests” of the banking system conducted in the spring. These tests were led by the Fed and marked a turning point in public confidence in the banking system.

When I was a grad student, I always felt weird about Keynes.  I grew up in a home that was not explicitly “free market” but was implicitly so.  My Dad was a small businessman and my Mom was a retail investor (as well as home manager).  My Dad’s business did well, but it had its share of hard times, including the depression of 1979-1982 in the Rust Belt, where many of his competitors did not survive.  He had to be a member of the local union and run a closed shop, but as an owner, he had no vote in union matters.

I worked for my Dad for two summers.  During one of them, when we went to get parts, the parts dealer said to me,”I’ve heard good things about you.  Even the union steward has heard about you.”  My face and my Dad’s face went white. I was not in the union. After an uncomfortable pause, he said, “Eeeaaah! Got you!” and he laughed.  Dad and I looked at each other, embarrassed but relieved.

My Mom, like Keynes, and like me, has beaten the stock market for most of her life.  There are excess profits available for wise investors, some of which stem from the foolishness of other investors.

Keynes was a fascinating man who understood asset markets well, but when trying to consider the economy in general, looked to what would work in the short run.  The author of Where Keynes Went Wrong points out repeatedly from Keynes’ writings his view that interest rates are almost always too high, and that interest rates should only rise when inflation is rising quickly.  Can lowering short term rates juice the economy.  Yes, in the short run, but in the longer run it fuels inflation and bubbles.

The strength of Where Keynes Went Wrong is that it spends a lot of time on what Keynes actually said, rather than the way Keynesianism developed into a branch of Macroeconomics, eventually becoming part of the dominant macroeconomic paradigm — the Neoclassical Synthesis.  I admit to being surrprised by many of the statements Keynes made — granted, the author is trying to prove Keynes wrong so he goes after what is least defensible.

The author dissects the errors of Keynes into a few main headings:

  • Lower interest rates are almost always better.
  • Growth comes through promoting consumption.
  • You can’t trust businessmen to do the right thing when it comes to capital allocation.
  • Government planning is superior to decentralized planning, because experts in government can allocate capital better than businessmen.
  • Crashes require government intervention.  Using the balance sheet of the government will have no long run negative impacts.
  • Markets do not self-correct.
  • Globalization is good, and the nations of the world can cooperate on creating a standard of value independent of gold.

For the most part, those are my words summarizing the author.  After going through what Keynes said, he then takes it apart point-by-point.  The author generally follows the Austrian school of economics, citing Mises, von Hayek, and Hazlitt.

After that, the book continues by taking on the rhetoric of Keynes, both oral and written.  He was one sharp man in being able to express himself — orally, there were few that could match him in debate.  In writing, where time is not so much of the esssence, there is more time for readers to take apart his arguments, and point out the fallacies.  The author points out much of the fallacies in how Keynes would argue his points.

The book finishes by pointing out the paradoxes involved in Keynesianism, e.g., in order to reflate a debt-ridden system, the government must lower rates and borrow yet more.  Also shows how beginning with manipulating the money supply leads to greater intervention in credit, banking, currency, and other economic policies over time, and why the politicians love the increase in power, even if they realize that the policies don’t work.

One surprise for me was how many ways Keynes suggested to intervene in a slump, and how many of them are being used today.

  • Rates down to zero.
  • Direct lending by the Fed.
  • Directing banks to make certain loans.
  • Bailouts.
  • Nationalizing critical companies.
  • Inflating the currency.

The idea of letting the economy contract in any way was foreign to Keynes.  He felt that a seemingly endless prosperity could be achieved through low interest rates.  Well, now we have low rates, and a mountain of debt — public and private, individual and corporate.  Welcome to the liquidity trap created by Keynesian meddling, together with the way our tax code encourages debt rather than equity finance.

I recommend the book; it is an eye-opener.  It makes me want to get some of Hazlitt’s books, and, read the whole of Keynes General Theory for myself.  The book that my professors once praised as a tour de force has holes in it, but better to read it all in context.


The book could have used a better editor.  Too many things get repeated too often.  The book also has two sets of endnotes, one for reference purposes, and one for expanded discussions.  The endnotes that were expanded discussions probably belonged in small type at the bottom of the page rather than as endnotes.  Many of the endnotes are quite good, and it is inconvenient to have to flip to the back to see them.

Also, on page 274, the author errs.  The risk to a business owner is higher after he borrows money.  The total risk of the business is not higher, but the risk to the equity owner is higher.  Whether that risk is double or not is another question.

There’s another error on page 328.  When I buy stock in the secondary market, I am putting my capital to work, but someone else is withdrawing capital from the market.  There is no net investment.  When I buy an IPO, not only do I put my money to work, but there is more investment in the economy (leaving aside the venture capitalists that are cashing out).  It is hard to say when investment in the economy is increased on net.

The table on page 330 is confusing.  The first row should have been set apart to show that GDP is not a government obligation.

Finally, I don’t think that Say’s Law (“Supply creates its own Demand.” Or in the modern parlance, “If you build it, they will come.”) is true, but neither is its converse (“Demand creates its own Supply”).  The two are interconnected, and either one can cause the other.  Markets are complex chaotic systems, and entrepreneurs sometimes produce goods that no one wants.  Similarly, when consumers discover a new product or service, that demand can help create a whole new industry.  Supply and demand go back and forth — the causality doesn’t go only one way.

Who would benefit from this book: Send it to your Congressman, send it to your Senator.  Make sure every member of the Fed gets one, and the fine folks at the Treasury as well.  Beyond that, think of your liberal friends who think of Keynes as a hero, and give them one.  After reading this, I want to add Keynes’ General Theory to the list of books the everyone cites, and no one reads.  (That list: The Bible, Origin of the Species, The Communist Manifesto)

If you want to buy it you can get it here: Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts.

Full disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.  Those that want to support me can enter Amazon through my site and buy stuff there.  Don’t buy what you don’t need for my sake.  I am doing fine.  But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.  Win-win.

Every one one us has limited bandwidth for analysis of data.  We pick and choose a few ideas that seem to work for us, and then stick with them.  That is often best, because good investors settle into investment methods that are consistent with their character.  But every now and then it is good to open things up and try to see whether the investment methods can be improved.

For those that use market indicators, this is the sort of book that will make one say, “What if?  What if I combine this market indicator with what I am doing now in my investing?”  In most cases, the answer will be “Um, that doesn’t seem to fit.”  But one good idea can pay for a book and then some.  All investment strategies have weaknesses, but often the weaknesses of one method can be complemented by another.  My favorite example is that as a value investor, I am almost always early.  I buy and sell too soon, and leave profits on the table.  Adding a momentum overlay can aid the value investor by delaying purchases of seemingly cheap stocks when the price is falling rapidly, and delaying sales of seemingly cheap stocks when the price is rising rapidly.

Looking outside your current circle of competence may yield some useful ideas, then.  But how do you know where you might look if you’re not aware that there might be indicators that you have never heard of?  Market Indicators delivers a bevy of indicators in the following areas:

  • Options-derived (VIX, put/call)
  • Volume and Price driven (Money flow, rate of change, 90% up/down days, and more)
  • Where the fast money invests (money in bull vs bear funds, sector fund sizes, and more)
  • Analyzing the likely motives of other classes of investors (margin balances, short interest, etc.)
  • Price Momentum and Mean-Reversion
  • Measuring asset classes and sectors using fundamental metrics  (Fed model, sector weightings, Q-ratio, etc.)
  • Investor sentiment surveys
  • How to use analyst opinions, if at all?
  • News reporting and reactions of stocks to news
  • Odd bits of news (CEO behavior, little things that indicate a qualitative change in the life of a company)
  • Insider buying and selling
  • Commodity market data (COT, etc.)
  • Bond market behavior (credit cycle, Fed moves, Credit Default Swaps, and more)
  • Changes in the capital structure (M&A, equity/debt issuance, etc.)
  • Monitoring the greats (13F filings)

No one can use all of these indicators.  You can probably only use a fraction of these indicators.  But being aware of how others view the market can widen your perspective, and help to reduce negative surprises on your part.


By its nature, since the book cuts across a wide number of areas in 216 short pages, you only get a taste of everything.  I liked this book, but there is room for a second book in this area — one of additional indicators passed over (I have a bunch!), or going into greater depth on the indicators covered.

Who will benefit from this book?

You have to have a quantitative bent, at least to the level of being willing to go out and collect simple data in order to benefit here.  Now, most serious investors do that, so I would say that serious investors can benefit from the “cook’s tour” of market indicators that this book gives, unless they are so serious that they know all of these indicators.  (Like me.)

If you would like to buy the book, you can buy it here: Market Indicators: The Best-Kept Secret to More Effective Trading and Investing.

Full disclosure: This book is unusual for me in two ways.  First, the author (not the PR flack) sent me a copy, with a nice handwritten letter thanking me for my blog and my assistance.  That is why there is the second reason.  Pages 80-81 summarize the longer argument made in my blog post, The Fed Model, where I take the so-called Fed model, and rederive it using the simple version of the Dividend Discount Model, giving a more robust model with reasonable theoretical underpinnings.

I earn a small commission from Amazon for anyone entering Amazon through my site, and buying anything there.  Your price does not rise from my commission.  Don’t buy anything you don’t want to buy if you want to reward me for my writing.  Only buy what you need if Amazon offers you the best deal.

There are always areas of excess in every market boom phase.  Dubai is an example of that.  Why can they build the tallest building, and construct islands in the Persian Gulf?  Cheap capital, riding on the oil boom, sent Dubai to incredible heights.  In an economic game of crack-the whip, Dubai is at the end of the line — they don’t have much energy production, but they have grandiose ideas that benefit if those with oil wealth decide to spend money nearby for fun, rather than abroad.

Now the Dubai government’s champion development corporation, Dubai World, faces bankruptcy.  Given the debt guarantees of the Dubai government, what happens?  Dubai is not big, and as part of the United Arab Emirates, is reliant on help from the other Emirates, particularly Abu Dhabi.  The worries are that there could be “contagion”-type effects that could affect the creditworthiness of related entities, particularly those that have lent to Dubai World.  Most of those are either UAE-related or European banks.  This isn’t a US issue, unless it becomes a big European issue — unlikely, but remember that European banks are more levered than US banks.  The US Dollar has been gaining on this news.

Secondary aftershocks would be entities similar to Dubai — other places in the world that have borrowed a lot in an attempt to grow rapidly.  Thus many emerging markets are getting hit in this mini-crisis.  What investors should remember is that in ordinary circumstances (peace, absence of famine, plague, or rampant socialism), the economy tends to grow at about 2%/year.  One can try to increase that by borrowing, and at the right opportunity that can be a winner.  But most of the time, huge increases in debt levels are eventually associated with default.  In a highly leveraged financial system where lenders are themselves indebted, defaults can cascade.  Also, as mentioned above suspicions get raised with similar entities for a different type of cascade.  A third aspect can involve a reduction in general willingness to take risk on the part of most investors.

Often at such a time, various government ministers/bureaucrats come forth and say, “There is nothing fundamentally wrong here.  All we need is to restore confidence.  This is not a solvency issue, it is a liquidity issue!”  Uh, maybe, but keep your hand on your wallet.  One has to examine how separable the various economic issues are.  Where contagion exists, it is like a massive arrangement of dominoes.  The more leverage on any entity, the taller that domino is.  The more leverage in the system, the more tightly the dominoes are spaced.  That arrangement can be stable for a time.  Stable, that is, until someone knocks over a key domino.

Now, most analysts are saying that this situation is contained, and after falling hard for the two prior days, European markets are rallying today, including financials.  Values for debts closely related to Dubai World have fallen hard, and S&P and Moody’s have downgraded them, and may declare the payment delay to be a default. (Also, with credit to Moody’s — they did downgrade many Dubai-related entities earlier this month.  Remember, with rating agencies, smart investors ignore the ratings, and look at what the analyst says.  The Moody’s analyst highlighted the lack of any explicit guarantees from Dubai.)

I would simply say be careful.  The total debts of Dubai-related entities are not clearly known, and the degree of willingness of friends and lenders to support them is unknown.  In the credit business, relying on the kindness of strangers is not a wise strategy.  The challenge is to see that in advance and avoid debt situations where informal reliance on third parties is a large part of the case for creditworthiness.  I would add that investors in junior debt issues, including Islamic pseudo-debt issues have to be cognizant of the lack of guarantees involved.  Study the prospectuses with care in such situations, and avoid risks that are less clear, particularly during bull markets, where the rewards for being correct are small.

Other selected articles on the mini-crisis:

I do a reflective piece every 100 posts, because I like to take a step back, and share my heart with those who read me.  It is fun for me writing this blog, even more than when I wrote for RealMoney.  Why better than RealMoney?  For what I liked to write, I did not feel that I fit well there.  One RealMoney editor told me, “You’re our most profitable columnist.”  Surprised, I asked how that could be.  The answer was simple.  I wrote lots of comments (no pay), and the articles I wrote were both high quality, and long lasting.  The half life of an average article at RealMoney is a day, if that.  My articles were perhaps a month or more.  And, as Cody (Willard) said (something like this) to me over dinner several years ago, “Many of your comments are better than the articles on the site.  I print them out and take them home so that I can think them over.”  I love Cody — a good friend.

Today’s piece is on Thanksgiving.  We all have  lot to be thankful for, but sometimes it is helpful to be prompted and consider all of the ways that we are blessed.

  • Your health could be worse.  A wide number of accidents/infections could have harmed you and did not.  I can count on two hands the close scrapes that could have killed me.
  • The food could be worse.  I don’t think that I have mentioned it before, but my hobby is cooking.  I am amazed at what supermarkets in the US offer today versus when I was a child.  The diversity is amazing, as are the places in the world that they come from.  It doesn’t hurt to have a large Asian market nearby.  (I am ready for my cooking event tomorrow — there will be 25 people here.)
  • The health of your children could be worse.  Two of my eight children nearly died while they were young.  Health for children across the world has improved dramatically over the last century.
  • Your economic situation could be worse.  Yes, there are problems, particularly today, but there have been markedly worse times and places to be alive in human history.  There are still dreadfully poor people in the world, but the lot of those worst off is still improving on average, though not everywhere.
  • Your national politics could be worse.  Compare the freedom of today against other eras.  In most places, the level of freedom is higher now than in most of history.  We complain about politics being nasty in the US, but hey, a close look at history would tell you that it has almost always been nasty.  And, when it has not been nasty, some of the worst results have occurred.  We do best with divided government in the US.
  • There could be more wars.  There are relatively few wars today, and what wars are going are relatively low intensity.

You name it — things could be worse, and across human history, things have been worse.  In most of the world. we would not want to go back to “Golden Eras” of the past.  They would be a step down (or more) from what we have today.

Against Complaining

The opposite of Thanksgiving is complaining.  I want to discourage complaining in a few areas.  First, if you are thankful, avoid complaining about government officials.  Complain about policies, fine.  It is proper to be principled; it is wrong to be acidic to those who hold an office, even if they hold a wrong opinion.  Basic respect must be maintained even with 180-degree disagreement.  The office means more than the person holding it that you disagree with.

There are many who are angry over the losses they have felt, and want restitution should it be available.  But with most things in life, most small-to-moderate losses aren’t recoverable.

There are those that are irascible, and complain no matter what.  They live to complain.  Time to repent, and gain a new perspective.  Yes, things aren’t what they ought to be.  When are they ever that way?  Grow up, and embrace what is good amid imperfection.

Avoid envy.  Yes, there are those who have it better than you, and they don’t deserve it.  Be happy for them; yes, they don’t deserve it, but neither do you.  There are people in developing countries as deserving as you that don’t have 10% of  what you do, and should they hate you?

No, they shouldn’t, and neither should you hate those who have done well in bad times.  Let the courts try those who have committed fraud.  There will always be those who get away, yet God will try them in the end, and find them wanting.

But truly, you don’t deserve what you have, and yet you have it.  It is time to be grateful.  We all have more than we deserve in a fallen world.

Toward God

Not that it is the most basic book of the Bible, but when we talk about thanksgiving, the book of Job is significant.  Read it if you get a chance.  It is the story of a wealthy, generous man who is put to the test.  Would he trust God if all of his riches were stripped away?  His two conclusions are that he needs a mediator, one who can go between God and man, and that no, his personal actions are nothing to God.  All that said, he trusted God, and God heard his prayers.  What more could one of us ask than to have God hear us?   (There is more that I could write about this, but it is beyond the scope of this blog.  All that said, what would a mediator be like, one that could relate to both God and man?  Who in history is like that?)


We have a lot to be grateful for, whoever we are, and whatever we are.  Grab hold of this, and be grateful to God on this day of Thanksgiving.  Your life will be richer when you give thanks to God for what you have, regardless of what others may have.

With this, I thank all of my readers around the world for reading me.  I don’t deserve your attention, and yet I appreciate it.  May the Lord Jesus Christ bless you amid the troubles that will afflict in 2010.


PS — you knew I was a Bible-believing Presbyterian Elder, didn’t you?  You didn’t?!  Well, aside from from my eight kids, and homeschooling, that is what I am.  Call me a Fundamentalist if you must, you will be partly right and partly wrong.  But my fundamental alliance is to Jesus Christ, who is still alive, and lives in his Church across the world.  Jesus is my Savior.

I love economic history books.  The book that I am reviewing tonight is different because unlike most economic history books, it is mainly empirical rather than mainly anecdotal.

Don’t get me wrong, one good anecdote can deliver more information than a carefully controlled study.  But more often, it is the careful studies that reveal more in their bloodless way.

This Time Is Different takes the reader through the last eight centuries of financial crises globally, subject to the prevalence of available data.  Data is more available recently, so the A.D. 21st, 20th, and 19th Centuries get more play than the more distant past.  Also, the developed West gets more coverage than the East.  This is to be expected.  It all depends on who writes down more.

Crises  have been far more common than the average economics textbook would suggest.  One of the first ideas to toss out of economics should  be that markets strongly tend toward equilibrium.  My own empirical research in the financial markets indicates that mean-reversion is there, but very weak.

The book has a wide number of disasters that it draws us through, namely inflation/debasement, currency crises, banking crises, and internal and external default.

Now, all of these crises tend to happen more frequently than the modern fat, dumb and happy Westerner would like.  Central banking has substituted fewer and larger crises for more and smaller ones.

Regardless, the chapters on sovereign defaults are worth the price of the book.  Will defaults be internal, external, or both?  A lot depends on how much debt will be compromised through default.  If a majority of debt is held externally, foreign creditors should be wary.

This book is needed now because many so-called scholars implicitly assume that the US Government could never default on its obligations.  Yes, it would be a horror, but leading nations in the world have defaulted before, and they will do so again.  It is the nature of mankind that it is so.  Promises happen in good times, and defaults happen in bad times.


The book is listed as 496 pages, but for non-academics the true length is more like 292 pages.

Also, I would suggest to the authors, that there are predictive variables that they have not considered regarding crises.  Two variables are growth in debt, and yield spreads.  Debt grows like kudzu or topsy prior to crises, and yield spreads are very small prior to crises.  As the crisis nears, debt growth slows, and spreads widen a little.


This book is not for everyone.  If you tire looking at tables, and prefer more discursive arguments giving anecdotes rather than facts, this book is not for you.

Who could benefit: if you want intellectual confidence that sovereign defaults /currency failures can happen even in the US (note we have had two so far, in addition to many other financial crises), this will give you confidence that you are not a nut.  If you want to educate one of your friends who thinks that such disasters are impossible, this is the book for him.  Just make sure he is willing to endure a semi-academic book.

If you want to buy the book, you can buy it here: This Time is Different: Eight Centuries of Financial Folly.

Full disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.  Those that want to support me can enter Amazon through my site and buy stuff there.  Don’t buy what you don’t need for my sake.  I am doing fine.  But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.  Win-win.

At the meeting of the eight bloggers and the US Treasury, one of the differences was whether the recovery was real or not.  The Treasury officials pointed to the financial markets, and the bloggers pointed at the real economy (unemployment and capacity utilization).

With T-bills near/below zero, I feel it is reasonable to trot out an old piece of mine about the last recession.  But I will quote most of it here:

I posted this on RealMoney on 5/6/2005, when everyone was screaming for the FOMC to stop raising rates because the “auto companies were dying.”


On Oct. 2, 2002, one week before the market was going to turn, the gloom was so thick you could cut it with a knife. What would blow up next?

A lot of heavily indebted companies are feeling weak, and the prices for their debt reflected it. I thought we were getting near a turning point; at least, I hoped so. But I knew what I was doing for lunch; I was going to the Baltimore Security Analysts’ Society meeting to listen to the head of the Richmond Fed, Al Broaddus, speak.

It was a very optimistic presentation, one that gave the picture that the Fed was in control, and don’t worry, we’ll pull the economy out of the ditch. When the Q&A time came up, I got to ask the second-to-last question. (For those with a Bloomberg terminal, you can hear Broaddus’s full response, but not my question, because I was in the back of the room.) My question (going from memory) went something like this:

I recognize that current Fed policy is stimulating the economy, but it seems to have impact in only the healthy areas of the economy, where credit spreads are tight, and stimulus really isn’t needed. It seems the Fed policy has almost no impact in areas where credit spreads are wide, and these are the places that need the stimulus. Is it possible for the Fed to provide stimulus to the areas of the economy that need it, and not to those that don’t?

It was a dumb question, one that I knew the answer to, but I was trying to make a point. All the liquidity in the world doesn’t matter if the areas that you want to stimulate have impaired balance sheets. He gave a good response, the only surviving portion of it I pulled off of Bloomberg: “There are very definite limits to what the Federal Reserve can do to affect the detailed spectrum of interest rates,” Broaddus said. People shouldn’t “expect too much from monetary policy” to steer the economy, he said.

When I got back to the office, I had a surprise. Treasury bonds had rallied fairly strongly, though corporates were weak as ever and stocks had fallen further. Then I checked the bond news to see what was up. Bloomberg had flashed a one-line alert that read something like, “Broaddus says don’t expect too much from monetary policy.” Taken out of context, Broaddus’s answer to my question had led to a small flight-to-safety move. Wonderful, not. Around the office, the team joked, “Next time you talk to a Fed Governor, let us know, so we can make some money off it?”

PS —  Before Broaddus answered, he said something to the effect of: “I’m glad the media is not here, because they always misunderstand the ability of the Fed to change things.”  A surprise to the Bloomberg, Baltimore Sun, and at least one other journalist who were there.


And now to the present application:

Why are commodities rising amid surplus conditions in storage?  Why is it reasonable to take over corporations when it is not reasonable to expand organically?  We are in a position where yields on short  Treasuries are nonexistent, investment grade and junk yields are low for corporates, and equities are rallying, but there is little growth, or some shrinkage in productive capacity.  Why?

The liquidity offered by the Fed is being used by speculators for financial positions, levering up relatively safe positions, rather than speculating on areas that are underwater, like housing and commercial real estate.  This is consistent with prior experience.  When the Fed does not allow a significant recession to occur, one proportionate to the amount of bad loans made, but comes to the rescue to reflate, what gets reflated is the healthy parts of the economy that absorb additional leverage, not the part that is impaired because they can’t benefit from low rates.  They have too much debt already relative to the true value of their assets.

That is why a booming stock market does not portend a good economy.  Banks aren’t lending to fund new growth.  They are lending to collapse capacity through takeovers.  ROE is rising from shrinking the equity base, not by increasing sales and profits.


There is another current application:

Why do we buy commodities as investments?  Is it that we fear inflation in the short or long run?  Is it that it is a proxy for future prices for consumption in retirement, so we are hedging the future price level in a dirty way?

Think about it.  How do you transfer present resources to the future?  Most consumable goods can’t be stored, or require significant cost for storage.  Services can’t be stored; elderly people can’t store up health care.

Storage occurs through building up productive capacity that will be wanted by other at a later date, such that they will want to trade current goods and services for your productive capacity.  Storage also occurs by purchasing goods that do keep their value, and then trading them for goods and services you need when the time come to consume.

That is how one preserves value over time, and it is not easy.  It will be even harder if there are such disruptions to the economy that markets that are virtual do not survive.  (I.e. paper promises are exchanged, but their is significant failure to deliver at maturity.)


In an environment where the government is playing such a large role in the economy, it is difficult to see how one can invest for the long term — when we are twisted between deflation and inflation, rational calculations are circumscribed, and simple judgments, such as buying out a competitor and shrinking the overall balance sheet are made.  In one sense, that is the rational thing.  Less capacity is needed.  But unemployment will rise.

That’s sad, but wage rates may be too high for some to be employed, given the lack of demand.  I view this as true in aggregate, but people that are aggressive in seeking employment are able to do much better.  I have seen it.  Even in a bad market, those that strive intelligently get hired.

Before I begin this evening, I would like to comment on my absence for the last week.  I gave a talk on Friday to the Southeastern Actuaries Conference.  I found myself behind the eight-ball, because of my many other projects, and so I had to block out the time to write and prepare the talk.

I’m going to turn the talk into a post, or a series of posts.  If you want to view the presentation before then, you can download it here (PPT PDF).  I needed more time; I wanted to do more with it – but you reach the end of your time, and you have to make your speech.  I didn’t feel well on the day I presented it; my throat was sore.  So, my apologies to any at SEAC who felt my talk was marginal.


One thing that came out of the SEAC meetings was an actuarial analysis of the health bill.  The presenter tried to be as neutral as possible, but the more he said, the more the actuaries I talked with said, “This bill doesn’t make sense.”  Now, I’m not a health actuary; I am a life and investments actuary by training.  Roughly 1/3rd of the audience were health actuaries, and 2/3rds were life actuaries.  The response was not, “This will hurt the industry.”  The response was more like, “This won’t work.  The costs are underestimated, and the taxes are overestimated.  This has real potential to mess up the good parts of the system, and be a very costly fix to the less generous parts of the system.  Taxes are front-ended, and costs are back-ended.  The analyses that show savings over ten years will show significant losses in the long run.

Among my pet peeves is that the bills are likely to do away with HSAs, which more than most health plan designs, gives real incentives to keep health care costs down.  If anything, moving away from first dollar coverage to catastrophic coverage would be a real incentive to keep down health costs.

I genuinely hope this does not pass Congress, and that nothing is done.  Then again, perhaps the Democrats want to commit political suicide.  Not that I like the Republicans much, but cramming through an ill-thought-out plan not favored by most Americans, can’t do much for their chances in 2010.


Secretary Geithner changed his view on why the AIG bailout was done.  He now says it was not over the derivatives counterparty, AIG Financial Products.  He probably says that because the government could have cut a better deal with creditors and did not, leaving the taxpayers on the hook.  Having thus bailed out Goldman, and other US and foreign investment banks that were due payments from AIG, the malodor of aiding investment banks in an opaque way is something the Treasury wants to lose.

So, now he claims it was to prevent systemic risk from failure of AIG’s operating insurance companies.  Now, I know that the life and mortgage insurance companies would have died, because of research I did in March and April of 2009.  But in September of 2008, no one was arguing about the insurance subsidiaries; it was all about AIG Financial Products.  No one was focusing on the weird losses from securities lending at the life subsidiaries of AIG.

Taking a step back, Insurance companies don’t produce systemic risk to the same degree that banks do.  First, the insurance industry is only one-third the size of the banking industry.  Second, insurance asset investment regulations are stricter for insurers than the bank regulations.  Third, the leverage isn’t as high, and the sources of profit are more diversified.  Finally, the liability structure is longer for most insurers, making “runs” less likely.

So, what would have happened if the Fed hadn’t come in and rescued AIG?

  • I recommended at the time that the government wall off the derivatives counterparty, and then analyze what the risks would be to the system as a whole if AIG did not pay on its derivative agreements in full.
  • The life and mortgage companies would have failed.  The mortgage companies would have added to the losses of Fannie and Freddie.  No state guaranty funds there.  The life companies might have passed $1-3 billion of losses to the state guaranty funds, hitting the life insurance industry when it was weak, but it would have killed few companies.
  • There were support clauses in many of AIG’s main P&C companies for some of the Life companies.  The P&C companies could have made good on those, and perhaps the state guaranty funds would have been clear.
  • Perhaps International Lease Finance or American General Finance would have been weak, but they would not have died immediately… and there would have been little systematic risk from any failure.
  • Common and preferred shareholders would have been wiped out, and maybe junior bondholders.  Senior bondholders might have been forced to compromise.

This isn’t good, but it is also not systematic risk.  After walling off AIGFP, there was no systemic risk from letting AIG fail.

Holding companies should never be bailed out.  There is no case for protecting them.  Operating subsidiaries are another thing; they are regulated for the good of consumers, ostensibly.

Ergo, I find the logic of the Treasury and Secretary Geithner wanting if he is claiming he was trying to avoid systemic risk in bailing out AIG, outside of AIGFP.  These arguments were not made in 2008, and in general, it is really difficult for an insurance company to generate systemic risk.  Systemic risk stems from short-funded financials, and in general, insurance companies do not fit that description.


This is just another reason why average Americans don’t trust the Fed.  But there are many reasons:

  • The Fed will not submit to full transparency of its actions.
  • They will not comply with legitimate FOIA requests.
  • They can’t be replaced by the people, but they have a big impact on the lives of the people.
  • Congress does a lousy job regulating them.
  • They acted high-handedly in bailing out entities like Bear Stearns and AIG that should have been put into bankruptcy.  Bailouts violate the sense of fairness that most Americans have.  Systemic risk could have been avoided without bailing them out in entire.

Is it any surprise then, the Congress, having done a lousy job of regulating the Fed and the Treasury, points the finger and blames those that they have been appointed to rule?  Alas, I see a lot of room for blame to go around, but few are willing to take it in DC.  There is no equivalent of Truman’s “The Buck Stops Here.”

In a bad environment like this, many governmental entities worry for their survival.  Good.  They should worry.  There is the outside possibility that things could change dramatically after the next election.  Perhaps ending the Fed won’t be a pipe dream then.  After all, the US did quite well without a central bank for most of its existence.

Imagine for a moment that you were approached by a very wealthy foundation, and they asked you to invest their money.  They offer a low asset-based fee, but the assets are so large that it looks like a dream to you.  Then they tell you the conditions:

  • We want this fund to last forever.
  • It must be able to deliver cash proceeds of 5% of assets each year.
  • We want it to generate a return that exceeds 7%/year over the long haul.
  • It must be able to do this through all environments, regardless of war, including civil war, socialism, famine, plague, etc.  This is the “forever fund.”
  • And if inflation becomes rampant, over 5%/year, you need to earn the inflation rate plus 2% at minimum.

You gulp, and say, “But sir, that’s impossible.  The need for current cash is at odds with a forever mandate.  Investing to earn the greater of 7% or 2% more than inflation is an unattainable goal.  Who can predict inflation?  Away from that, the record of investors during times of extreme societal stress is bad at best.”

He says, “Take it or leave it.  Those are the goals.”

You ask for a day to think about it, which he grants.  You sit back and think, “How can one assure wealth over generations?  I can’t prevent wars, plagues or famines.  I can’t even prevent domestic political change.  What do I do?”

Then it strikes you.  Divide the portfolio in two; one part is there for income and to provide liquidity, the other part is there to provide long-term gains.  Since the time horizon is very long term, aim for investments where the sustainable competitive advantage is high, and if possible, where a lot of money can be put to work.

Satisfied, you go to sleep, happy that the problem is solved, but as you dream, Warren Buffett stands in front of you as you accept the management contract.  When you wake up, you go sign the deal with the endowment sponsor, but wonder about Buffett.  You conclude that it was a bad burger you ate at the Dairy Queen the night before, and let the matter drop.


I thought about writing a negative article regarding Buffett’s purchase of Burlington Northern, but delayed about doing it.  I di not jump on the idea, partly out respect for Buffett.  I have been both an admirer and critic over the years, so I like to think I am even handed here.  Why should I criticize?  High valuation paid.  The free cash flow yield is low.

But Burlington Northern is very hard to replicate.  What would it cost to replicate their transport system?  A lot, and in this day of environmentalism, it might be impossible to replicate at any price.  Thus for one with the “forever fund” such an investment makes sense.  Personally, I would have bought utilities contiguous to my existing holdings, because the same conditions exist there.   Steady income plus inflation protection.

So, I don’t fault Buffett for buying Burlington Northern.  It makes sense with a very long term view.  There might have been better buys among utilities, but he has a lot of money to put to work.  He may mop up the utilities next year.  Or a cheap large energy company — oh, whoops, he sold that.

When you have a lot of money, the choices get tough.  The simple decision is to index, but you didn’t get a lot of money through indexing, so you want to do better.  At present, my view would be to buy utility shares and high quality stocks, which have not rallied much, and have defensive characteristics should the market fall.  In other eras, real estate might be the investment… but not now.

These companies provide value regardless of the economic circumstances; they are valuable even in bad times.  In really bad times, nothing is valuable.

From Bloomberg, I quote our Treasury Secretary:

“I believe deeply that it’s very important to the United States, to the economic health of the United States, that we maintain a strong dollar,” Geithner told reporters in Tokyo today.

Before I write, I can hear my friend Caroline Baum of Bloomberg gearing up her mental energies to say something like, “Again?  How many times can they say that with a straight face?”

If I wanted to create a strong dollar, what would I do?

  • I would have the Fed raise short-term rates.
  • I would reduce the creation of dollar claims by bringing the Federal budget into balance.

Neither of these are realities.  Thus the weak dollar.

But perhaps there is another way, and if you are reading me at the Treasury, please listen.  The idea is to make the countries that have acquired a lot of Dollar obligations realize that they are likely better off acquiring goods and services from the US now, rather than at a lower exchange rate later.

There is brinksmanship here, but when I was a bond trader, I could make it happen.  In the present context, there is no value to piling up more dollar obligations in exchange for goods today, unless one has a domestic political agenda to fulfill.

Now, with Japan and China, (and OPEC) both should be encouraged in this way.  Buy today, your dollars will likely buy less tomorrow.  That one action would restore balance to the global economy, as less business would be done on a credit basis across nations.

After that, the harder problem of dealing with structural US budget deficits becomes paramount.  What do you do with a government that has promised more than it can deliver?  The French Revolution comes to mind, but maybe we can do something more gentle.  The President addresses the nation, and tells the Baby Boomers that benefits from Medicare will be reduced.  It becomes a small medical needs and hospice program.  The nation can’t afford anything more, and if you were paying attention, you knew that.  Oh, and the foolish Part D, created by Bush gets eliminated, with no replacement.

As for Social Security, it becomes means-tested, and becomes an old age welfare program, complete with stigma.  “If you are receiving Social Security, you couldn’t have done that well.”

If we take actions like that, the US can survive.  Short of that, we face significant inflation, and a greater diminution of our living standards.

Until then, whoever is our Treasury Secretary will go around the world and say, “The US is committed to a strong dollar.”  And this is a valuable service.  We all need fairy tales to help us fall asleep easily at night, both here and abroad.