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Failed U. S. Monetary Policy

Despite its ongoing machinations with domestic interest rates and asset prices, in 2003 the Federal Reserve coincidentally arrived at equilibrium in the dollar’s value over the previous 15 years: $350/ounce of gold. The dollar’s value remained at equilibrium several months while the bank overnight lending rate was one percent and the ten-year Treasury yield was very respectable, under 4%. The Bush 2003 tax cuts were adopted in May, 2003, which allowed faster capital accumulation. U. S. economic growth gathered energy and took off, seeing its best times this decade until the Fed intervened.

The Fed caused the 2000-2002 crash in U. S. equity markets by producing a severely deflated dollar ($252/oz gold in 1999). After the brief interlude at dollar equilibrium in 2003, the Fed moved the dollar’s value in the opposite direction in June, 2004. The Fed slowed growth by hiking the funds rate, reducing demand for dollars, while injecting more liquidity. Particularly in the second year of rate hikes between June 2005 and June 2006, with the yield curve inverted, the U. S. dollar’s value plummeted. The dollar reached a post-1980 low of $735/oz in May, 2006.

In August, 2006, the FOMC finally stopped hiking the cost of bank credit, but maintained the severely inverted yield curve for another year. The inverted yield curve denied credit at reasonable, market-set rates to small and medium-sized business, retarding economic growth in those crucial segments of the diversified U. S. economy. The dollar strengthened to $615/oz. after the funds rate hikes were stopped. The FOMC eventually discontinued injecting net new liquidity in 2007, a second positive change by the Bernanke-led FOMC. But the long-inverted yield curve had already misallocated excessive liquidity to the long end of the curve. This policy error resulted in many private misjudgments in credit markets.

Lenders with access to funds at long rates pressed to put those funds into hands of borrowers at higher rates. With small and medium-size business growth shut down, much of the action went into sub-prime housing at low front-end adjustable rates. Easy-credit money also went to hedge funds and speculative investors. When those bad judgments began affecting confidence in commercial paper in mid-2007, FOMC’s bad monetary policy was felt in new ways by different players.

Misallocations of credit during the period of inverted yield curve and extreme excess liquidity caused stresses that threatened significant financial institutions. The FOMC reversed its field on the funds rate and moved towards a normalized yield curve. In August, 2007, the FOMC began historically sharp reductions in the overnight rate for inter-bank lending of reserves, reaching 3% in January, 2008. In addition, the Fed renewed about $50 billion in temporary funds during the second half of 2007 and began auctioning credit secured by permitted types of troubled collateral. The central bank’s responses did not restore confidence in its policy or in credit markets. The dollar fell to its lowest value in history during February, 2008, above $965/oz gold. The pitifully weak dollar speaks to failed U. S. monetary policy, and this failed policy overhangs the U. S. economy and financial markets in 2008.

Worsening U. S. Fiscal Policy

Since 2005, good U. S. fiscal policy (the Bush 2003 tax cuts) has been overrun by bad U. S. monetary policy. No matter how positive fiscal policy is, the Federal Reserve has tools and discretion to bring the economy to its knees, and has done so again. In its recent funds rate cuts, the Fed did not rescue the economy or contribute beneficially. The Fed simply reduced the harm it had been and is doing. The yield curve remains inverted, meaning that bank credit is priced above reasonable market value to much of U. S. main street.

The major difference in 2008 is that U. S. fiscal policy is measurably worse and set to get much worse than recent years. Congress just made the federal budget deficit $155 billion worse for no better reason than paying “walking around money” just prior to the November elections. Most deplorably, the $155 billion spent will be cited eventually as excuse enough to refuse further extension of current income tax rates.

U. S. GDP has grown almost 40% with current tax rates in place. That growth path is likely to be retraced if the economy is placed under the 2002 tax rates again. The 2008 elections get closer and extension of current tax rates appears less likely with each passing day. Financial markets fear that outcome, so 2008 will be volatile watching the threat of a sharp downside.

A Volcker 1980 Redux?

U. S. monetary policy is no better friend to financial markets than is fiscal policy, even during the Fed’s current rate-cutting mode. Chairman Bernanke’s FOMC may repeat Paul Volcker’s performance of 1980-1981. Recall those fabulous years when Carter-appointed chairman Volcker first poured liquidity into the economy in 1980 during President Carter’s re-election effort. Then, after President Reagan’s election became a foregone conclusion, Volcker turned to draining liquidity. The economy crashed into deflationary recession. That mindset seems still in place at the Fed. Already those who buy into the Fed’s mercantilist manipulation of interest rates and the dollar prescribe high rate hikes ahead, even while FOMC likely will move closer to a normal yield curve in the near term.

Combined with sun-setting of the Bush tax rates, this is not a pretty scenario. The year 2008 has worse macro-economic influences than any since 2002 and threatens to rival 1980.

Time for Policy Change

U. S. monetary policy has inflicted damage on Americans and other global economies for 37 years. Those with low income – sub-prime borrowers, laborers, the young, the old, working people of all levels – are hurt worst. How much more must they (and we) bear before this chaotic leap into mercantilist trade war via currency manipulation is ended? There is no “soft landing” able to cushion losses imposed on earning power by manipulated currencies. That earning power is being transferred daily to the captains of chaos who know how to profit from advance knowledge of central banking practices.

Inflation reality is this. The dollar has been devalued by about 65% during the past five years (worse than FDR’s devaluation in 1934, but with no announcement). Most of today’s devaluation remains to be reflected in U. S. and world prices. The Fed will soon have to face the price rises it calls inflation. Unless the Fed reforms policy, rising prices foretell manipulation of the funds rate higher, a significant recession and tumbling financial markets.

What the Fed should do is float the funds rate so the cost of bank credit can decline to market levels and economic growth can become robust again. This would create greater demand for dollars to invest in production, pulling down the price of gold as dollars become more valuable. Concurrently, the Fed should monitor liquidity, draining or adding by selling or buying Treasury securities to move the dollar’s value back to an announced target in the range of $450/oz to $500/oz of gold.

Please note this does NOT recommend the Fed manipulate the cost of bank credit higher to induce recession. So long as the dollar’s value relative to gold is moved to a proper and stable level, monetary inflation will not be a problem. Neither will the U. S. dollar’s status as the international reserve currency.

Ben Bernanke of course replaced Alan Greenspan at the Fed, and Greenspan cited Burns as one of his mentors in his autobiography, The Age of Turbulence. Like Burns, Greenspan understood the value of money measured in gold; acknowledging that he has "always harbored a nostalgia for the gold standard's inherent price stability."

Politics ultimately won out over dollar-price stability with Burns, and in order to keep his position as Fed Chair, Burns gave into political pressure for cheap money. When asked if the Fed was actually independent of Congress, Burns is said to have replied with some irony, “If we don’t do what the politicians want, we won’t be able to maintain our independence.” Just the same, Greenspan acknowledged about the gold standard that there is "no likelihood of its return" due to constant political pressures for cheap money.

Neither Burns’ nor Greenspan’s replacement had any notable orientation in fixed exchange rates, let alone money measured in gold. Indeed, in discussing the classical gold-standard era, Bernanke once asked without a hint of irony, "Why was there such a sharp contrast between the stability of the gold standard regime of the classical, pre-World War I period and the extreme instability associated with the interwar gold standard?"

According to William Greider’s Secrets of the Temple, Fed insiders frequently blamed Burns for the rising inflation experienced under his successor, Miller. Even though the price of gold rose nearly 50 percent on Miller’s watch, some thought he was the victim of excessive money growth from 1976 to 1977 that somehow didn’t register in the dollar’s value during the time in question. In much the same way, Greenspan is frequently targeted for criticism when the dollar’s decline is discussed today. Despite the fact that gold was trading in the $400 range when Fed funds was at 1 percent on his watch, the aforementioned low nominal rate is said to have caused the dollar’s collapse in the two years since he departed.

Not often discussed is that while the Federal Reserve is the sole originator of money, it is the Treasury’s job to communicate to the markets the proper level for the dollar. In this sense, Miller was ill-served by Michael Blumenthal, and present Treasury Secretary Henry Paulson is doing very little to help Bernanke’s cause. In Miller’s case, his time at the Fed was marked by frequent jawboning of the Japanese when it came to the value of the yen. Despite the yen’s rising strength against the dollar during ‘70s, Blumenthal decried yen “weakness” such that the dollar fell 42 percent against the yen eleven months into Miller’s term. It took a dollar-rescue package to stem the greenback’s decline.

While Blumenthal’s crutch was Japan, Paulson has frequently decried the allegedly weak Chinese yuan given his flawed belief that manipulation of paper currencies somehow opens markets. Paulson’s attempts to get China to revalue the yuan upward have been met by further declines in the dollar. Indeed, a dollar decline essentially accomplishes the same thing as a yuan revaluation; particularly if as China’s done, the “competing” currency is allowed to rise somewhat to partially avoid the inflationary result wrought by a peg to the falling dollar.

The problem for Bernanke is that unlike the briefly successful dollar rescue package during the Carter years, the Paulson Treasury has done nothing to rescue the greenback in recent times. Adhering to what is ultimately a non- policy of “markets” setting the dollar’s value, the latter is being ignored by the Treasury with the exception of occasional empty statements of the “strong dollar is in our interest” variety. With the Treasury not communicating a floor for the dollar, or better yet, a higher value in terms of gold or another currency, traders continue to sell it downward.

The comparison between Miller and Bernanke is perhaps greatest on the subject of inflation. Greider noted that when it came to inflation, Miller “was regarded as too complacent and too responsive to the Carter White House.” Just the same, despite a dollar that is at historical lows versus gold and other currencies, Bernanke’s Phillip's Curve orientation has him believing that projected slower growth in coming quarters will contain any inflation pressures. Though it’s said that Bernanke regarded the late Milton Friedman as his hero, apparently he missed the latter’s admonition that “inflation is always and everywhere a monetary phenomenon.” Worse, he channeled the White House last week with his remarkable contention that a silver lining to the dollar’s decline would be a lower trade deficit.

Miller ultimately left after 17 undistinguished months at the Fed, and while his replacement oversaw an even greater near-term decline in the dollar, and worse, a totally unnecessary recession purported as the cure for inflation, Paul Volcker ultimately returned to his fixed-exchange rate moorings in such a way that the Reagan Revolution was able to proceed. Sadly there’s no evidence at present that the Bush Administration will fix its mistake with Bernanke. Instead, the White House maintains an impressive ignorance when it comes to the dollar, and George Bush’s approval ratings (not to mention the Republicans’ electoral chances in November) continue to wither on the vine.

Whatever the electoral outcome in November, the dollar’s collapse suggests the markets would like a change at the Federal Reserve. The question now becomes one of politics. Though there are varying opinions on Paul Volcker, history credits Jimmy Carter for inserting him where Miller failed. Will George Bush get credit for correcting the Bernanke mistake, or will Ben Bernanke’s failures remain those of Bush; mistakes that Bush’s successor will almost surely have to correct.

Even many economists -- who should know better -- describe the present situation as an oversupply of unsold homes. True, there is about 10 months' supply of existing homes as opposed to four months' a few years ago. But the real problem is insufficient demand. There aren't more homes than there are Americans who want homes; that would be a true surplus. There's so much supply because many prospective customers can't buy at today's prices.

By definition, the "housing bubble" meant that home prices got too high. Easy credit, lax lending standards and panic buying raised them to foolish levels. Weak borrowers got loans. People with good credit borrowed too much. Speculators joined the circus.

Look at some numbers from the National Association of Realtors. From 2000 to 2006, median family income rose almost 14 percent, to $57,612. Over the same period, the median-priced existing home increased about 50 percent, to $221,900. By other indicators, the increase was even greater.

But home prices could not rise faster than incomes forever. Inevitably, the bust arrived. Credit standards have been tightened, and the (false) hope of perpetually rising home prices -- along with the possibility of always selling at a profit -- has evaporated. For many potential buyers, prices have to drop for housing to become affordable.

How much? No one really knows. There is no national housing market. Prices and family incomes vary by state, city and neighborhood. Prices rose faster in some areas (Los Angeles, Miami, Phoenix) than in others (Dallas, Detroit, Minneapolis). Some economists now expect an average national decline of about 20 percent. The Federal Reserve estimates that owner-occupied real estate is worth almost $21 trillion. A 20 percent reduction implies losses of about $4 trillion.

The largest part would be paper losses for homeowners: Values that rose spectacularly will now fall less spectacularly -- back to roughly 2004 levels; that's still 30 percent or so higher than in 2000. But hundreds of billions of dollars of other losses are already being suffered by builders (from the lower value of land and home inventories), mortgage lenders (from defaulting loans), speculators and homeowners (from lost homes). Mark Zandi of Moody's Economy.com estimates that mortgage defaults this year will exceed 2 million, up from 893,000 in 2006.

To be sure, all this weakens the economy. No one relishes evicting hundreds of thousands of families from their homes. Eroding real estate values make many consumers less willing to borrow and spend. Some economists fear a vicious downward spiral of home prices. More foreclosures depress prices, increasing foreclosures as people abandon houses where the mortgage exceeds the value. Losses to banks and other lenders rise, and they curb lending further. Particularly vulnerable would be Fannie Mae and Freddie Mac, the two government-sponsored housing lenders (their vulnerability emphasizes the need for Congress to pass legislation strengthening regulation of Fannie and Freddie).

Up to a point, there's a case for providing relief to some mortgage borrowers. In many cases, everyone would gain if lenders and borrowers renegotiated loan terms to reduce monthly payments. Losses to both would be less than if their homes went into foreclosure and were sold. The Treasury has organized voluntary efforts. Some measures being considered by Congress (for example: overhauling the Federal Housing Administration) might help. But other proposals -- particularly empowering bankruptcy judges to reduce mortgages unilaterally -- would perversely hurt the housing market by raising the cost of mortgage credit. Lenders would increase interest rates or down payments to compensate for the risk that a court might modify or nullify their loans.

The understandable impulse to minimize foreclosures should not be a pretext to prop up the housing market by rescuing too many strapped homeowners. Though cruel, foreclosures and falling home values have the virtue of bringing prices to a level where housing can escape its present stagnation. Helping today's homeowners makes little sense if it penalizes tomorrow's homeowners. An unstoppable free-fall of prices seems unlikely. Slumping home construction and sales have left much pent-up demand. What will release that demand are affordable prices

Economists are well used to considering one way in which globalisation can be undermined politically. The standard theory of international trade tells us that while trade may raise incomes generally, it produces both winners and losers. If the losers are sufficiently politically powerful, they may convince governments to impose protection. More importantly, history tells us that this is not just a theoretical curiosum, since this is exactly what happened in late 19th century Europe. For the first time in history, steamships and railroads made it possible to transport bulky commodities across oceans and continents, linking together regions of the world with very different endowments of land, labour and capital. Faced with an invasion of cheap grain from Russia and the New World, governments in France, Germany and other Continental countries caved in to the protectionist demands of their agrarian constituencies, raising agricultural tariffs significantly.2

Trade, War, and the World Economy

However, history also tells us that politics matters for globalisation in a far more fundamental way. The new steam technologies of the Industrial Revolution would never have had the effect that they did if they had not operated within the context of a stable geopolitical system within which the Royal Navy guaranteed the freedom of the seas for all; within which wars between the major European powers were relatively rare; and within which those same European powers used their military superiority to impose more or less open trade on most of Africa and Asia. With the outbreak of World War I, that geopolitical system was destroyed, and 19th century globalisation with it, despite the fact that technological progress continued unabated during the interwar period. And while in the rich countries of Western Europe and North America the post-1945 period saw a gradual reconstruction of open trading conditions, deglobalisation characterised much of the rest of the world until the 1980s thanks to the spread of communism and decolonisation, which themselves had their roots in the century's two world wars, and the intervening economic debacle.

Economists have typically shied away from considering such matters, regarding wars as 'exogenous' shocks to the system, or as departures from normality.3 The importance of war and peace for the international economic system is so evident, however, that it is now reflected in the title of a book which we have recently published on the history of international trade over the very long run.4 The ‘Power and Plenty’ of the book's title refers of course to the mutual dependence of trade and warfare during the Mercantilist era, when the links between commerce and violence were particularly explicit and clear. But great expansions of world trade were linked to conquest even earlier. The pax Britannica and pax Americana which provided the geopolitical stability underlying the globalisations of the 19th and late 20th centuries have their counterpart in the pax Mongolica of the 13th and 14th centuries, which produced an impressive integration of the Eurasian economy. The Muslim conquests, which unified a vast region stretching from India to the Atlantic, provide an earlier example, while the Iberian conquests of the 16th century provide an even more spectacular later one.

Lessons for the present

In the light of history, it would be foolish to assume that present day trends will automatically persist into the future. What sorts of challenges might arise to threaten 21st century globalisation? One striking feature of today's international economy is that, as in the 19th century, regions with very different factor endowments are being drawn into closer contact with each other, as what used to be known as the Third World opens up to the rich countries of the North. Will the modern day equivalents of the farmers of 19th century Europe, namely unskilled workers in the OECD, eventually press for and obtain a rolling back of trade liberalisation? The 2005 French referendum on the so-called European Constitution, when unskilled workers voted against what they saw as a pro-market, pro-globalisation accord, may serve as a straw in the wind in this regard.

Even more fundamentally, the continuation of a broadly liberal international trading environment will require that the geopolitical system adapt to the rise of China, India and other ”Third World” giants. In a historical context, this represents of course the restoration of the status quo ante, the end of a “Great Asymmetry” in international economic and political affairs caused by the Industrial Revolution, which was itself in large part a product of the interactions between early modern Europe and the rest of the world. But that is not to say that such an adjustment will be easy. The international system has historically done a pretty poor job of accommodating newcomers to the Great Power club. German unification and industrialisation during the late 19th century led to tensions with Britain and France over colonial and armament policy, while Japan's rise to regional prominence during the interwar period, and its search for secure sources of raw materials, ended in war against United States and its allies. Both precedents are worrying, in that similar questions are posed today, both in terms of the rights of emerging nations to rival the established powers’ military capabilities (notably with regard to nuclear weapons), and in terms of the strategic importance to countries like China of ready access to oil supplies and other natural resources.

The last point should cause us to reflect that, Cobden and Montesquieu notwithstanding, interdependence and trade do not necessarily guarantee peace. The world economy of the late 19th century was extremely interdependent, to the point where Norman Angell famously felt able to pronounce, on the eve of World War I, that major conflict was now unthinkable. Interdependence implies vulnerability, and vulnerability can lead to fear, with unpredictable consequences, as Anglo-German rivalry in the run-up to the Great War and Japanese reactions to the Great Depression and Smoot-Hawley both indicate.5

Impermanence appears to be the most enduring feature of the human condition, and if there is one lesson that we can safely learn from history, it is that history has not ended. Hopefully it will not repeat itself.

Footnotes

1 A notable recent expression of this view may be found in Mark Levinson’s The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger, Princeton University Press, 2006. On the other hand, the evidence presented by David Hummels on the evolution of transport costs during the late 20th century suggests that a far more nuanced view might be appropriate. See D. Hummels, "Transportation Costs and International Trade in the Second Era of Globalisation," Journal of Economic Perspectives 21:131-154.

2 K.H. O'Rourke and J.G. Williamson, Globalisation and History: The Evolution of a Nineteenth Century Atlantic Economy, MIT Press, 1999.

3 However, see P. Martin, T. Mayer and M. Thoenig, "Make Trade Not War?", CEPR Discussion Paper 5218; "Civil Wars and International Trade", CEPR Discussion Paper 6659; “Does globalisation pacify international relations?” 4 July 2007 Vox.

4 Power and Plenty: Trade, War, and the World Economy in the Second Millennium, Princeton University Press 2007.

5 On the links between the late 19th century international division of labour and Anglo-German military rivalry, see A. Offer, The First World War: An Agrarian Interpretation, Clarendon Press, 1989.

Americans have suffered an impressive devaluation of the dollar since 2001; one that has succeeded in eroding the value of their savings and investments. To hedge against this aforementioned devaluation, the citizenry correctly moved its capital into asset classes that do well when currencies decline; everything from gold to art to real estate. All three tend to rise when the dollar loses value, so as the dollar’s decline began in recent years, Americans re-directed their capital into less risky assets of the “real” variety.

For its tangible qualities, real estate is one of the least risky asset classes, and one that acts like a commodity in response to currency movements. And despite a great deal of commentary suggesting major declines in property prices, the Ofheo Index of home prices most recently registered a .29 percent year-over-year fall, while a more bearish indicator such as the Case-Shiller Index has shown a decline on the order of 10 percent.

Equity investors would kill for these kinds of “catastrophic” corrections, but when it comes to real estate, politicians and commentators from both sides of the ideological spectrum have fallen over each other to talk up various policy solutions (to be funded by taxpayers and investors alike) meant to save the property market. If we ignore for now the long-term negatives that invariably result from government involvement in private markets, any steps taken to prop up the real-estate market will harm an economy that many of these pundits already feel is weakening.

That is so because the major driver of the commodity/real estate boom in recent years was once again the falling dollar. When currencies move in either direction, there is a certain redistribution of wealth from one part of the economy to the other. When currencies decline, rather than an economic stimulant, there is as mentioned a “flight to the real,” which favors those long on earth assets as opposed to savings of the bank account and equity variety. Investors have of course witnessed this in recent years with the Dow and Nasdaq at levels seen back in 2001, while commodity assets have soared.

When the government seeks to prop up the property market despite these relatively miniscule price declines, it makes real estate even less risky in ways that harm the broader economy. This is true because we live in a world of limited capital. When the latter flows to unproductive earth assets, innovative entrepreneurs who create even greater wealth and jobs are left to scrounge for what is left.

That’s the case because all available capital is the product of savings. When essentials such as property are dear, and take up an even greater portion of our limited savings, there is less money to fund new ideas of what the late Warren Brookes termed the “economy of the mind.” As such, the productive sector of the economy suffers.

Looked at simply, when an individual saves or invests, that capital frequently finds its way to entrepreneurs and existing businesses that will use it to grow while employing increasing numbers of people. The savings fund growth and wages. Conversely, when capital is flowing into the earth, there is merely a transfer of wealth; from the buyer to the seller. Jobs are certainly created, but at the expense of those created within capital-intensive industries such as technology and software that regularly increase our productivity, and in doing so, attract even more capital to U.S. businesses. Money that flows into the earth is consumed, whereas money that flows into technology multiplies and enhances worldwide economic productivity.

If we forget home price appreciation, we can say that rising housing starts and increased home purchases are merely a symptom of a growing economy of the mind. When people prosper thanks to heavy investment in the Googles and Microsofts of the world, they have income that funds the purchases of homes. When monetary debasement leads to property-price booms, the very capital that creates a long-term stream of buyers is consumed instead, and buyers (as we’re witnessing now with rising jobless numbers) eventually disappear.

All of which leads us to the Fed’s alleged dollar conundrum. It is said that fixing our weak dollar would be catastrophic for our economy given the misbegotten belief that the U.S. economy must implode to root out inflation. That is incorrect.

A stronger dollar would undeniably reward today’s economy for reversing our long, inflationary decline. Will there be pain? No doubt there will be for those long on property, art and commodities. On the other hand, the stronger dollar will necessarily drive more investment into the riskier, metaphysical economy over the physical; meaning a strong dollar would be a boon for jobseekers in ways that will make “mortgage walks” less frequent all the while creating a new class of homebuyers eager to use a smaller portion of their savings to enter a more affordable housing market.

Identifying suspicious trading

We study four markets to track suspicious activity. First, we calibrate “normal time” stock volume, return, the volume of exchange traded call options, credit default swap (CDS) spreads, and bond spreads. Using this “normal time” econometric model, we extract daily abnormal activity for a three-month period prior to the bid date. Unusual levels of activity are captured by the maximum daily excess over normal levels for the five-day window preceding the bid and the aggregate of the daily excesses.

Who are the insiders?

We created three measures to count the number of debt participants, differentiating by the time when the debt was incurred and the status of the banks. The first and narrowest measure looks at syndicated facilities entered into within six months after the bid and counts only the lead banks. The second measure also counts the number of lead banks but uses a broader sample of bank facilities, looking at all syndicated facilities active on or six months after the date of the bid. The broadest definition includes all banks participating in all syndicated facilities active on or six months after the date of the bid, including non-bank investors such as hedge funds and other asset management institutions. Using the measure of lead banks only, the median is one equity buyer and 5 lead banks. Larger targets, measured by capitalisation, have more equity buyers and more lead banks involved.

How and why a proliferation of non-public information can leak out to a broad audience is best explained through a simple time line example. At the very initial stages, Firm A considering a bid for Firm Z will have a Commitment Letter from several banks who will become the lead banks if the deal progresses. When the tender offer is announced the names of the Lead banks will become public. Then when the deal is later agreed, the lead banks will go out into the market looking for junior partners to join the facility, including non-bank institutions. Once the syndication process is complete the loan can be actively traded. During this process, information is transferred amongst all these participants and their respective advisors.

But do more Insiders lead to more suspicious activity?

Regression analysis reveals that syndicate sizes explain our measures of abnormal trading activity. However, it appears that different insiders use their information only in their respective capital markets. The number of equity insiders is correlated with unusual stock price activity and option trading. Similarly, the number of lead LBO debt banks is correlated with suspicious activity in the debt markets. To be precise, there is no close relationship between the stock price activity and the number of banks involved in the debt element of the financing. Similarly there is no significant relationship between the credit market activity and the equity syndicate size. This is evidence of market segmentation in insider trading. Whilst the size of the bid premium (hence the payoff from insider trading) and a stock’s volatility and liquidity do have an impact on the results, the central theme that more insiders brings more insider trading prevails.

Conceptually, should more insiders lead to more insider trading? Competition amongst insiders should reveal information as price changes instantaneously if markets are frictionless, and beyond a few insiders, there should be little impact on the activity from additional insiders.3 It is the existence of barriers to competitive forces, such as wealth limitations, risk parameters and other exposure constraints as well as equity and debt market segregation, that creates imperfect competition between insiders and permits a larger number to exploit their information.

Enforcement needs

If insider trading has increased and is likely to be linked to the number of participants, then why have the enforcement regimes not retaliated? One issue could be that the regulators have not reacted promptly to the changing nature of how non-public information is disseminated in LBO deals. Indeed, in our research paper, we show theoretically that as the number of insiders increases, regulators should lower the threshold of abnormal trading activity beyond which they trigger an investigation. The problem is of course that detecting the symptoms of insider trading in the form of unusual price or spread activity is only the first step. Identifying the perpetrators is not straightforward given the lack of transparency, especially in the complex over-the-counter derivative markets. Furthermore, differentiating between legal hedging and trading and that derived from asymmetric information takes considerable resources. What is clear is that for any enforcement regime to be effective, it will need to be robust to the changing landscape – the increasingly cross-border dimensions of leveraged buyouts, the global location of their participants and hence their trading activity, and the growth in the use of over-the-counter instruments.

References

Acharya, V.V. and T. Johnson (2007), “More Insiders, More Insider Trading: Evidence from Private Equity Buyouts,” CEPR Discussion Paper 6622, December.

Holden, C. W., and A. Subrahmanyam (1992), “Long-lived Private Information and Imperfect Competition,” Journal of Finance, 47, 247–270.

Altman, E., 2007, “Global Debt Markets in 2007: New Paradigm or the Great Credit Bubble?," Journal of Applied Corporate Finance, 19, 1731.

Footnotes

1 See Altman (2007). Based on a sample of 178 US public-to-private deals of greater than $100 million in value in the period 2000-2006, the trend in activity and size is strikingly evident. In 2002 with just 15 observations the size of the 90th percentile was just short of $ 1.5 billion. By 2006 this was the median size from 64 observations (Acharya and Johnson, 2007).

2 See “Boom time for suspicious trades” by Victoria Kim and Brooke Masters, Financial Times, August 6th 2007. A May 2007 Bloomberg Markets “Insider Trading” study of the 17 biggest takeovers in the preceding year found that in the three days before the bid announcement, trading volume jumped 221% compared to the average for the prior 50 daysA Wall Street Journal study of December 2006 revealed unusual spikes in CDS fees ahead of 30 LBOs.

3 Holden and Subrahmanyam, 1992

Indeed, if specific locales or regions were truly weakened by high levels of pay, Silicon Valley and New York City would be ghost towns. But as evidenced by the high cost of living in both areas, salaries and wages are at nosebleed levels commensurate with those costs.

So why aren’t jobs rapidly exiting Manhattan and Menlo Park? The reason is that expensive labor is once again extremely cheap. Google presently has 17,000 employees, but its profits per employee are $247,000. Goldman Sachs has roughly 30,000 highly paid workers, but with profits of $16 billion last year, profits per employee worked out to $530,000. Judging by the high level of productivity on the coasts, companies there pay high nominal salaries that prove to be excellent bargains.

The problem for the Ohios and Michigans of the world is that many residents want to do that which is relatively cheap on a nominal, per-employee basis, but very expensive overall. The best example of this is General Motors. The average salary at GM is one that most on Wall Street wouldn’t bother to get out of bed for, but when we consider that GM regularly loses money, those low wages are very expensive.

Another example is Wal-Mart, the convenient whipping boy for lefty economists and labor activists seeking to reveal broad employee exploitation when it comes to hourly income. What’s missed is that compared to Goldman, Wal-Mart’s executives are ripped off on a per employee basis. Wal-Mart’s profits per employee work out to only $6,000, which exposes the lie about its executives enriching themselves on the backs of low-wage workers. On a per employee basis, Goldman Sachs is the true exploiter.

When we look overseas to China and India, wages over there are similarly expensive because they’re low. Economist Gregory Clark notes that in modern cotton textile factories in India, employees work “for as little as fifteen minutes of each hour they are at the workplace.” Much is made of heavy foreign investment flowing into Asia, but on a per person basis it’s very low given low levels of productivity.

Some would reply that if that’s the case, why not keep the outsourced jobs stateside? This doesn’t happen because with unemployment in the US still below historical norms, it would be too expensive to waste limited human capital on low wage, low value work. In short, workers in the Midwest haven’t been displaced by foreign trade; instead many want for work owing to their desire to remain in low-wage positions. Employers blanch because it would be too expensive to waste their labor on jobs that don’t pay very well.

The above is why the influx of cheap foreign goods is so essential to the health of the rustbelt. Beyond the simple truth that those struggling to make ends meet will see their money go further when goods are plentiful, the arrival of cheap goods is step one in a process that will free up previously consumed capital in favor of savings. Savings and investment fund wages, so if all Americans irrespective of geographical locale are able to save more, they’ll unwittingly be funding new entrepreneurial opportunities that will employ those eager to enhance their pay, and by extension, the value of their labor.

That’s why John McCain only gets it half right on trade. To his credit he’s not yet sold his political soul in favor of rethinking trade deals a la Clinton and Obama, but when he argues that “We’ve got to do a better job of taking care of those workers who have been displaced,” he’s misunderstanding why trade is so enriching to begin with. Cheap goods as mentioned free up limited capital for new industries, so when he proposes costly government programs meant to ease the alleged pain wrought by free exchange, he’s explicitly dipping into the very capital pool that leads to new jobs, and that exists thanks to trade.

So rather than wishing for higher tariffs to solve their problems, Midwesterners won’t get out of their economic rut until they realize the natural economic advantages that come with being English speaking and American; advantages that should have them seeking higher wage work that is less expensive to prospective employers. Free trade is not the cause of the Midwest’s economic malaise, but stationary work habits are.

Free trade is also in the balance, Malpass warns:

"There's more at stake in the dollar debate than a recession, inflation and a bear market. In the economic confusion created by the weak-dollar policy, presidential campaigners are blaming Nafta and free trade, not the weak-and-weaker dollar, for hard times."

But the level of misunderstanding about the dollar, the trade deficit, and the financial markets is almost as bad as ever. The demand-side worldview still dominates, even among conservative economists. Eminent scholars like Martin Feldstein , and John Taylor have been arguing for a “more competitive”—read, weak—dollar. Taylor calls the weak dollar the “silver lining” of the subprime mortgage crisis, instead of the cause of the crisis that it really is. Feldstein, meanwhile, misses the inflationary impact of a weak dollar by ignoring the time lags of monetary policy and currency changes.

The demand-side economy is a machine, where changes in big accounting aggregates cause other variables, like the dollar, to move in predictable fashion. The trade deficit thus forces the dollar to decline and “adjust” to mercifully relieve “imbalances.” Why the imbalances are bad they never quite say. Nor can they even define an “imbalance” in a highly integrated global economy. But in this view, currencies must shift so that every nation’s imports and exports more or less match. Relatively cheaper and rising exports can then compensate for more expensive and falling consumption of imports. The trade deficit goes poof.

Never mind the accuracy of this theory: As the dollar weakened these last half-dozen years, the trade deficit didn’t shrink. It boomed. Mostly because of surging imports of weak-dollar high-cost petroleum.

But even if the trade-deficit-is-bad-and-can-be-relieved-by-a-weak-dollar theory were correct, what do we get for it? Usually a recession. The U.S. last briefly “achieved” a trade surplus in the glorious recessions of 1990-91 and 1981-82. Consumption and business investment—and therefore imports—all plunged during these bad times, so the trade deficit very temporarily vanished. Unemployment and inflation were way up, and asset values and GDP were way down, but at least the trade deficit was vanquished. Congratulations.

Despite ubiquitous fear of the trade deficit, ask yourself: Have you ever heard a coherent, let alone convincing, case for why the trade deficit matters at all? Or why killing the economy in order to relieve this phantom burden is even remotely worth it? When monetary and fiscal policy got back on track and the economy rebounded after the '81-82 and '90-91 recessions, the trade deficit came back, and with a vengeance. When our economic prospects are bright, we import lots of capital—remember, foreign investment in America is a good thing—and when the economy is growing we buy lots of goods and energy, much of it imported.

That’s all the trade deficit has meant for 350 out of the last 400 years. The U.S. will continue to have a trade deficit as long as our wealth, growth, and demographic differentials vis-à-vis other nations persist. The trade gap is a good reflection of our prosperity gap.

Another point about the supposed need for currencies to adjust to effect a trade balance: Trade happens because each side wants what the other has. I'll trade you the fruit of my labor for the fruit of yours. It's a win-win transaction. I value what you have produced more than what I have produced. Let's trade. But if all currencies adjusted to relieve the “imbalances,” to unwind the “pressures,” to compensate for the differences and “disequilibria,” then there would be no trade at all. Movements, transactions—trade—only happens because there is a disequilibrium in the first place. But if it is the currencies that move, rather than the goods, services, assets, and information changing hands, then the transactions themselves become superfluous. If the value of money adjusts to wipe out the value of the good or asset, then why would I want what you have, and vice-versa? If the value of the transaction—and all the information—is consumed by the change in currency values, then there is no value in the exchange of the original good, service, asset, or idea.

Ignored in the overly formulaic effort to balance the books across contrived national borders is the damaging effect a weak dollar (or any quick change in the value of money) has on the price of every good, service, commodity, and asset across the world economy. And—on every decision of every investor, business, and entrepreneur. The trade-deficit hawks think mechanically. But the economy is about information—prices, uncertainty, forward-looking decisions, and surprising news and innovations, or what we call entropy. In Friday’s Wall Street Journal, Nobel economist Ned Phelps nicely summarized this information-not-mechanics worldview:

"In recent times, most economists have pretended that the economy is essentially predictable and understandable. Economic decision- and policy-making in the private and public sectors, the thinking goes, can be reduced to a science. Today we are seeing consequences of this conceit in the financial industries and central banking. "Financial engineering" and "rule-based" monetary policy, by considering uncertain knowledge to be certain knowledge, are taking us in a hazardous direction.

Predictability was not always the economic fashion. In the 1920s, Frank Knight at the University of Chicago viewed the capitalist economy as shot through with "unmeasurable" risks, which he called "uncertainty." John Maynard Keynes wrote of the consequences of Knightian uncertainty for rational action.

Friedrich Hayek began a movement to bring key points of uncertainty theory into the macroeconomics of employment—a modernist movement later resumed when Milton Friedman and I started the "micro foundations of macro" in the 1960s.

In the 1970s, though, a new school of neo-neoclassical economists proposed that the market economy, though noisy, was basically predictable. All the risks in the economy, it was claimed, are driven by purely random shocks—like coin throws—subject to known probabilities, and not by innovations whose uncertain effects cannot be predicted."

Recently, many others, like the trader-turned-academician Nassim Nicholas Taleb and the insightful writer Michael Lewis , have also exposed the fallacies of mechanical economics and statistically modeled finance. As Lewis writes, something is wrong with financial models when once-in-a-million-year-events happen every year.

Some of the weak-dollar inflation story is beginning to poke through, and news articles and even the President are now mentioning the dollar-oil-commodity link. Europe, Japan, the Mideast, and China are all consumed with weak-dollar worry and are urging behind the scenes the U.S. to take action. Yet the dollar continues its fall.

Wednesday night, in a little noticed interview with the Nightly Business Report, President Bush finally called for a stronger dollar :

Q: You mentioned that one of the reasons that’s driving up the price of oil is the dollar. You have said that you are for a strong dollar. Do we have a strong dollar now?

Bush: We have a dollar that’s adjusting, and I am for a strong dollar. One reason I am for a strong dollar is because I want, you know, people to — I think it helps deal with inflation. And you’re right, the weakening dollar has affected our capacity to be able to purchase energy. I mean, we’re dependent on energy from overseas. Our dollar doesn’t buy as many barrels of oil as it used to, and so therefore it’s more expensive for the American people. And that’s why I’m for a strong dollar; one reason.

But it was not clear just how firm or premeditated Bush's statement was. Then any hope his statement would get some attention was swamped by the announcement on Thursday of "Paul-box"—Treasury Secretary Paulson's new Sarbox-like mortgage and credit regulatory crackdown. Friday's news was dominated by the crisis at Bear Stearns, and in an interview with Lawrence Kudlow the President himself seemed to backtrack from his fleeting strong-dollar statement.

Nevertheless, Morgan Stanley on Friday said the odds of a currency intervention are rising fast. The Real Time Economics blog summarized the view of Morgan's Stephen Jen :

"First, the lower dollar is driving up commodity prices. “There is a vicious circle between (i) the falling dollar, (ii) rising commodity prices, (iii) the impression that inflation is high and rising in the world, (iv) the world having to remain vigilant on inflation by keeping interest rates high and currencies strong, and (v) the dollar falling as a result of this and a hyper-proactive Fed,” Mr. Jen writes. Perceptions of high inflation because of rising energy and food prices “also undermine the credibility of the Fed … further hurting the dollar.”

Second, at “these extreme levels,” the lower dollar is “starting to inflict serious damage to investor confidence … The excessive weakness of the dollar is starting to hurt the global equity markets and, more importantly, it is accelerating the quiet erosion of investor confidence in the dollar and dollar assets.” The U.S. is perceived to be devaluing its way to prosperity and the Treasury’s “strong dollar” mantra is no longer “taken seriously.” If a member country of the Gulf Cooperation Council decides to abandon its currency peg to the dollar, it could aggravate a “negative feedback loop” between the dollar and U.S. assets."

Inflation, capital outflows, huge asset price swings, modern-day bank runs, psychological impacts on investors and entrepreneurs—these effects of the weak dollar cannot be modeled in mechanical fashion.

This is why the value of money is not like any other product, whose value is set in the marketplace. They value of money in a floating rate environment where fine-tuning central banks print money cannot be “set by the market.” This is an illusion, and a dangerous one. Money is not a product or commodity. Money is an abstract concept—a measuring rod, a standard of value, a unit of account that must remain constant over time. Only then can workers and businesses, entrepreneurs and investors engage in meaningful trade, risk new money in forward-looking ventures, and lend and borrow money on reasonable terms. Movement in the value of money is not a helpful “adjustment” but harmful noise that impairs the transmission of all-important information. To achieve a dynamic and growing economy, you need an utterly undynamic, stone-cold unit of money. It is the information-rich creative spikes of entrepreneurship and profit that comprise all economic growth. Economic entropy thus requires a zero-entropy foundation. A high-entropy message requires a low-entropy carrier.

In this model, money is the carrier—the transmitter of information. The information itself—the positive entropy of economic growth—is the new ideas, ventures, products, services, technology, and profits that yield both steadily rising living standards and the occasional quantum leap to higher levels of economic life and lifespan.

Thus theory as well as experience argues for mostly stable exchange rates among nations.

The dollar derelicts have it backwards. In the end, high-entropy money yields a low-entropy, stone-cold economy.

Bret Swanson is a senior fellow and director of the Center for Global Innovation at The Progress & Freedom Foundation. The views expressed here are his own and do not necessarily reflect the views of PFF, its staff, or directors.

Bear Stearns is not the only big financial house in trouble. The potential for contagion is real and menacing. The real questions are: Which of the big banks will be next to fail? How many more banks will fail? Will the whole system turn to panic if Citigroup unwinds?

The quality of leadership provided by Citigroup CEO Vikram Pandit, and Robert Rubin, the man who chose him, is a major concern now that Citigroup has been forced to pour $1 billion into the hedge fund Pandit sold his employer. The Board at Citigroup seems hypnotized to be putting up with that maneuver.

We don’t want to return to Glass-Stegall but some of the large bank groups may have to be broken up. Citigroup tops the list. These firms are just not managed well and are too large and diverse to be managed effectively. The economy has been put at grave peril by the unwillingness of Pandit and other leaders of the Wall Street banks to reform what are clearly broken banking practices and a failing business model.

The Federal Reserve, to bolster liquidity, cut the primary credit rate charged primary dealers who borrow against securities at the Fed from 3.5 percent to 3.25 percent. Also, it increased maximum maturity for loans from 30 to 90 days. This should increase liquidity in the securities market a bit but will not address the primary systemic problems that make bank credit so difficult to obtain.

The Federal Reserve continues to bail out major financial institutions without imposing meaningful conditions to improve their conduct and performance. It is failing to require the reforms that have closed the bond market to banks, make the securitization of bank loans virtually impossible, and have greatly curtailed responsible lending to businesses by banks. In turn, the banks continue to impose onerous conditions on their customers. Many are sound businesses not responsible for the crisis the banks have created yet bear the primary burden.

Hence, the Federal Reserve continues to give aid to the irresponsible, while letting these same banks punish their customers.

Through today’s move, the Fed is trying to reassure financial markets that it stands ready to back up the banks but this is not likely to work. Treasury Secretary Henry Paulson and Federal Reserve Chairman Bernanke have reacted to events and consistently been behind the curve. Their leadership has been wholly lacking.

Today’s moves by the Federal Reserve are the desperate acts of failing men.

The threat of contagion and wholesale breakdown is on a scale of 1929 is real.

Yet, President Bush adopts the posture of Herbert Hoover telling us everything will work out soon. He looks more like a man whistling through the graveyard. Bernanke and Paulson look worse than that.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission

We saw this in the late ‘90s when the Fed’s failure to accommodate the capital gains cuts led to what many considered a deflationary dollar. As the dollar’s value drove commodities to modern lows, equities, including nascent Internet companies, were the big winners. With the dollar’s gold price well below its 10-year average, there was a rush away from the “real” into less tangible asset classes that promised greater returns than commodities crushed by the dollar.

But as is always the case, reality caught up to the money illusion. Companies new and old eventually collapsed under the weight of dollar debt that grew in real terms amidst a falling price level that was falling due to the rising dollar. Importantly, the companies that hit hard times, from Enron and Worldcom to eToys and Webvan, were allowed to fail.

Even though the various equity markets subsequently fell in ways that make today’s home-price moderation look positively tame by comparison, the federal government mostly stayed out of the way such that price discovery could occur, and capital could be redeployed such that the economy quickly recovered from what was an historically shallow recession. Better yet, those who ignored the gloom surrounding Internet companies at the market’s nadir made big money to the extent that they snapped up the various dotcom survivors at fire-sale prices.

Moving to September of 2001, the tragedy that was 9/11 set in motion the dollar’s escape from deflationary territory. With the world a much riskier place due to terror fears, the dollar price of gold began to rise in such a way that companies benefited from a reduction in their real debts. The latter moderation of dollar strength combined with the 2003 Bush tax cuts led to a rising economy and stock market by the spring of 2003.

The problem by 2003 was that neither the Bush Treasury nor the Greenspan Fed communicated to the markets any kind of desire for a stable dollar price. Worse, increased terror fears in concert with a Bush Administration that seemingly welcomed a weaker greenback (as evidenced by tariffs on steel/lumber/shrimp alongside a protectionist stance against China) turned the dollar reflation into an eventual dollar rout.

As the dollar weakened, a reverse of what happened in the late ‘90s occurred. The falling dollar led to what Von Mises referred to as a “flight into real goods.” Commodities are of course priced in dollars, and with the latter sagging, commodities, including housing, began an impressive run. Sure enough, an investment in property or gold since 2003 has handsomely outperformed the various equity indices over the same timeframe.

But just as investment can be distorted amidst a rising currency, the same can occur when the currency is losing value. Profits attract capital, and with housing and commodities on their aforementioned run, savers and equity investors lost out as capital was redeployed to the “real.” Furthermore, as Keynes pointed out, amidst devaluation the "practice of borrowing from banks is extended beyond what is normal."

The above is what we experienced in recent years, and much as markets eventually corrected for mal-investment in the equity sector during the strong-dollar equity boom, home prices have moderated in recent times as markets corrected for the money illusion wrought by a weak dollar. The problem today is that unlike what happened after the stock-market collapse earlier in the decade, the federal government is going out of its way to soften the economic impact.

This is remarkable on its face considering how little in percentage terms home prices have reversed compared to equities back in 2000-01. Worse, government efforts to slow the process by which markets achieve price discovery will necessarily push back the eventual recovery from our downturn. Left alone, markets would reprice housing possibly in a downward direction such that more capital could be redirected toward job-creating entrepreneurs.

When we also consider the sad collapse of Bear Stearns, the Federal Reserve’s attempts to cushion its fall will similarly retard the economic adjustments necessary for the economy to resume a productive path. Indeed, massive liquidation of assets made necessary by troubled times speeds the process by which properly priced assets settle into the hands of those who see value where others do not.

What’s clear is that taxpayer dollars are now being deployed to allegedly normalize the impact of the economy’s slowdown on consumers, homeowners, and now banks. The irony here is that economies are most reliant on capital to grow, but with politicians ever eager to access the money of others to show “compassion,” hundreds of billions of dollars will be siphoned away from the productive economy to fund the short-term and counterproductive desires of the political class.

All of which brings us to President Bush, Treasury Secretary Paulson and Federal Reserve Chairman Bernanke. Though all profess to having free-market leanings, they’ve crafted solutions that will slow the economy’s recovery through retardation of the price-discovery process. Worse, their solutions are the equivalent of a doctor performing plastic surgery on a patient in need of heart surgery. The dollar’s lurch downward in recent years to a high degree explains the dislocations we’re experiencing today, yet to a man, neither Bush nor Paulson nor Bernanke seems concerned in the least about the dollar’s fall.

They should be concerned. Due to its status as the world’s reserve currency whereby two out of three dollars are overseas, the greenback’s value is the most important price in the world. When it’s in freefall, investment distortions and the economic calamities of the likes we’ve witnessed always result. And just as the picture of Senator Reed Smoot and Representative Willis Hawley to this day is symbolic of a major legislative mistake (the Smoot-Hawley Tariff Act) that brought on a severe economic downturn, we can only wonder if history books in the future won’t frame Bush, Bernanke and Paulson as the architects of non-market solutions to economic problems that turned natural market corrections into something much worse.

In the past six months the central bank has reduced the policy rate by 300 basis points, and has also set up three separate facilities to provide liquidity to banks and securities firms in distress. The Office of Federal Housing Enterprise Oversight recently reduced the capital requirement for Fannie Mae and Freddie Mac from 30% to 20%, which should result in the injection of $200 billion into the market for mortgage-backed securities. Moreover, it is quite plausible that the Federal Government will take the final step and provide an explicit guarantee for Fannie and Freddie, thus in effect socializing the up to 80% of the mortgage market over the coming year.

What awaits the market going forward is equally unpleasant. The talks underway in Washington between Senate Finance Chairman Chris Dodd (D-CT) and House Financial Services Chairman Rep. Barney Frank (D-MA) appear to be organized around a bailout of both banks and homeowners to the tune of $400 billion. Had enough? No wait, it gets worse.

Over the horizon, the quid pro quo for the bailout of the domestic financial industry will be a significant step up in regulatory oversight by the Federal and State governments. The return of the regulators to domestic financial markets will stifle financial innovation and discourage reasonable assumptions of risk concomitant with globally active investment institutions. If little is done over the next few months, the era of unfettered freedom by U.S. financials will come to an end. Policy entrepreneurs in Washington already smell blood in the water and will be putting together an aggressive agenda that will seek to put real constraints on financial firms.

How far can it go? Perhaps, one should begin to think about the unthinkable. Want to see a return of Glass-Steagall? Seem far-fetched? Just wait till the backbenchers in Congress and the public gets a whiff of what the true price of the bailout will be. What may seem a bit outlandish today may not seem that far off the mark tomorrow.

The collapse of Bear Stearns and the response by Washington if not implemented properly may signal a turning point in the relationship between the market and the state. Twenty-five years of progress towards building a market based society where adjustments in prices and wages are the primary driver of changes in behavior is now at risk. The efficient allocation of scarce resources and capital in the pursuit of profits and prosperity will take a back seat to income redistribution. The late political scientist David Easton once defined politics as the “authoritative allocation of resources.” For many in our political establishment, that is an ideal state of not only political interaction, but also economic policy.

The Austrian political-economist Joseph Shumpeter often made the point that the public response to private financial crises was often worse than that which caused the conflagrations the first place. The more than one trillion dollars that our public institutions will put forward to stabilize the domestic financial system will require the Fed to push rates much higher in the aftermath of the crises to hedge against the inflation risks that will linger for years. Just as important, our political class will seek to satiate the current populist economic fad by re-instituting inefficient government mandates to quash risk-taking activity by banks and other financial institutions; mandates that will in turn diminish prospect for growth in the aftermath of the crises.

Our financial and public elite who otherwise might put up a vigorous intellectual and political struggle to preserve the progress made over the last quarter century are lost in an increasingly vain Beltway culture more concerned with ratings of an insignificant preacher and sex scandals rather than the first order concerns of the day. The primary question facing the country at this critical juncture is how to preserve the incentive to take risks in a context where market participants will be compelled to redistribute a static quantity of capital in a more equitable fashion rather than engage in the dynamic creation of wealth.

By the time Congress adjourns for its summer break roughly 90 days from now, much of what makes our domestic financial markets and the economy so attractive, may be put at risk. The initiatives favoring free trade, free capital flows and flexible currencies could be lost. One would have thought that the real risks over the horizon, in a tired and long election season, would have stimulated at least a modicum of debate about where all of this is leading. That is, if anybody is paying attention…. anyone?

Joseph Brusuelas is the Chief US Economist at IDEAglobal in Manhattan. The ideas expressed in the article are his own and do not represent those of the firm.

That politicians running for re-election in a slowing economy would applaud a temporary stimulus measure is unsurprising, but many economists were also supportive. For example, Edward Lazear, Chairman of the Council of Economic Advisors to President Bush, said that “permanent tax cuts are the best way to grow the economy in the long-run”, but that stimulus legislation was smart policy because “if we create growth right now, we’ll create a situation where the economy can grow further in the future.” Harvard’s Martin Feldstein echoed this sentiment, saying that the stimulus plan would help in “offsetting the risk of an economic downturn”.

Spending-leads-to-wealth is a distinctly Keynesian idea. Keynes held that when aggregate demand was insufficient in a period of unemployment and idle resources, government-led spending could increase demand, and via a “multiplier effect” across rounds of subsequent spending, return an economy to full employment. But this is not uncontroversial. Russell Roberts of George Mason University, for example, says the idea of a stimulus package is “like taking a bucket of water from the deep end of a pool and dumping it into the shallow end. If you can make the economy grow, why wait for bad times?” In other words, Roberts argues, stimulus spending will be ineffectual at best.

Let’s examine this at two levels. First, fundamentally, what causes economic growth? Secondly, to what degree are the drivers of GDP growth reflected in the February stimulus bill? This allows for honest appraisal of the bill’s efficacy.

I. What drives economic growth? Adam Smith made this question the centerpiece of his famous book in 1776, entitled An Enquiry into the Nature and Causes of the Wealth of Nations. Smith’s comprehensive answer, confirmed by David Hume and further elucidated by David Ricardo and John Stuart Mill, has been borne out in the centuries since. Modern economists would describe Smith’s book, and indeed the classical vision more broadly, as one highlighting the institutions which drive growth, summarized as follows:

• Private property and limited government – Smith was a keen student of John Locke, who eloquently enunciated a natural right to liberty and property, rooted in the very nature of man. For Smith, in fact, property and limited government were the cornerstones of a system of natural liberty, and a necessary condition for the advancement of civilization itself. From the vantage point of the economist, property implies private ownership of the means of production (capital), and limited government implies a regime of low taxation and regulation. With this institutional backdrop, in fact, proper incentives are in place to guarantee maximal economic growth via development of other necessary institutions undergirding a society based on liberty.

• Division of labor and exchange – Man, said Smith, has a propensity to “truck and barter”. Further, individuals develop specific skills and knowledge which are unique across society, and lead naturally to what became known, at a country-level, as Ricardo’s law of comparative advantage. In brief, comparative advantage mandates that each country should produce goods and services where there are cost advantages, and trade for those in which there is comparative inefficiency in production. Thus, a division of labor – and concomitantly, a division of knowledge – develops naturally in a free economy, and implies that trade and exchange between individuals (and eventually nations) also therefore ensues. The division of labor and knowledge leads to specialization and economies of scale in production, further enhancing the productivity of labor in an economy, and thus the profits of enterprise. Empirically, this has been borne out in the almost perfect correlation between increasing international trade and economic growth.

• Indirect exchange and money – Primitive trade consisted of direct exchange of goods, or barter. Over time, though, some goods such as gold became commonly accepted media of exchange, or money. Money permits far more efficient indirect exchange, because it avoids the barter requirement of a mutual coincidence of wants. A stable monetary unit also facilitates efficient economic calculation in terms of an accurate accounting of profit and loss; standardized pricing across markets for all goods; and, prospective forecasting and comparative cost analyses. Economists from Adam Smith to Hayek have thus affirmed the crucial role of monetary institutions in economic growth: stable money permits a radical intensification of the division of labor, widening markets wherever common money is used, and increasing productivity and profits from production and trade. Indirect exchange and the division of knowledge also lead to specialists in financial intermediation such as banks, which facilitate the allocation of capital to its most efficient uses.

• Saving and capital accumulation – Absent the fear of expropriation or confiscatory taxation, the institutions of private property and limited government foster strong motivating incentives for production and, in turn, allow for long term saving. Saving provides the fuel for investment, which in turn promotes the accumulation of capital. Capital formation is the primordial driver of wealth in an economy, because it increases output per unit of input, and is thus the primary source of growth in real wages to workers, and thus their living standards.

• Entrepreneurship and price discovery in competitive markets – Trade and exchange, aided by money, lead to the development of sophisticated markets in all goods and services, in which competitive behavior by buyers and sellers leads to efficient pricing of goods. Importantly, this pricing mechanism is activated by entrepreneurs who are present in every market; these are individuals who peer into an unknown future, accept risk of loss if they misapprehend the course of prices, and place bets on the future course of consumer desires by directing resources toward production yielding the hypothesized highest value. This process constitutes what Adam Smith referred to as the invisible hand – it promotes the optimal allocation of resources to their highest-valued uses, punishes (and hence minimizes) error due to mis-pricing, and leads to fulfillment of consumer priorities (e.g., higher prices accrue to those goods most demanded by consumers, drawing resources to their production).

These are the necessary and sufficient institutional conditions which guarantee maximal growth in an economy (Keynes himself would agree, differing only regarding the relative stability of a market economy and government’s role). Effective economic policy, both fiscal and monetary, thus consists in fully promoting this institutional mix.

II. Are these growth-promoting institutions reflected in the stimulus bill? Measured against the template described above, the stimulus bill appears irrelevant, if not harmful:

(1) Per above, stable money is crucial to facilitate trade, encourage entrepreneurial risk-taking, and engender accurate economic calculation. But some of the tax “rebate” funds will be borrowed in the current year, inflating credit levels (while at the same time crowding out private investment and expanding the fiscal deficit). At the margin, further pounding of the dollar distorts investment, discouraging both entrepreneurship and the capital formation so necessary to generate increases in output and real wages. In this respect the stimulus bill is unambiguously harmful.

(2) The tax “rebates” are not distributed pro rata to all tax-payers, but instead via a redistributive formula to lower and middle income recipients – some of whom will not have paid federal income taxes in 2007. By definition, this merely redistributes wealth from current and future taxpayers to current recipients. The GDP impact is thus neutral at best, and may be negative, when factoring in the transfer of real wealth away from job-creating producers. Similarly, businesses taking advantage of accelerated depreciation will spike up equipment-purchasing this year, but largely at the expense of next year – the kind of palliative measure which deepens recessions when they eventually arrive.

(3) Finally, the (Keynesian) proponents of the bill emphasize the need to increase spending, in order to increase consumption, and ultimately GDP. However, economic growth occurs because saving and capital accumulation increase, leading to intensified production and output, and thence to increasing real incomes. To say this differently, Mr. Lazear, the President’s chief economist, says increased spending will effectively engender increased output, which will “create a situation where the economy can grow further in the future”. This is sometimes known as “Keynes’ Law”, and is in fact the obverse of Say’s Law of Markets. Say’s Law states, correctly, that output, once created, affords buying power in other product markets to the “full extent of its own value.” The source of wealth, therefore, lies in production. Rather than vitiating Jean-Baptiste Say, Keynes could have learned from him: increasing consumption is an effect, not a cause, of economic growth.

To the non-economist, this is a subtle distinction, but much error has been spawned from the spectacular fallacy of Keynesian spending which, as Keynes himself erroneously wrote in 1943, has the capacity for “turning stones into bread.” In fact, policies which impel spending at the expense of saving are harmful to GDP growth just as surely as eating today’s seed corn hurts next year’s harvest.

On balance, then, those economists who endorse spending stimulus as marginally helpful or neutral have it wrong. Combined with the Federal Reserve’s abrogation of its responsibility to stabilize the dollar’s value, the lack of truly pro-growth fiscal policy only deepens the dislocations that will be corrected in the eventual recession. In a better world, Mr. Lazear would have followed his initial instinct, and advised the President to pursue permanent cuts in marginal income, capital gains, dividend, and corporate tax rates. Additionally, incipient protectionism needs to be thwarted, and the dollar stabilized. That this argument has not been made is but the latest example of the triumph of politics over economics.

John L. Chapman is an NRI Fellow at the American Enterprise Institute in Washington, D.C.

Not mentioned was that any perceived trade gains achieved through a weak dollar would be wholly illusory given that increased nominal profits would be wiped out by the weaker unit of account; in our case, the dollar. Inflation surely steals any benefits that supposedly result from devaluation.

Furthermore, the notion that we can export our way to growth is a myth driven by the view that paper money is itself wealth. Quite the contrary. Acquisition of fiat money is merely acquisition of a medium of exchange that allows U.S.-based companies and individuals to import the goods they desire in exchange for those exports. All trade in the end balances, so while we should embrace the truth that foreigners want what we produce, it’s rising imports that we should cheer as a symbol of economic growth. Rising imports are the signal that we’re being productive in ways that we’re receiving a lot in return for our productivity. We export so that we can import, so it’s the latter number that economists should concentrate on in order to divine our true level of economic health.

Consumption – 70 percent of economists polled in this month’s Wall Street Journal survey on the economy said the U.S. is in the midst of a recession. One factor cited was a 0.6% fall in retail sales. The article noted that the decline “reflects a sharp slowdown in consumer spending, which accounts for more than 70% of U.S. economic activity.”

The idea that consumption comprises 70% of our economic activity is frequently cited by economists and journalists as settled truth despite its obvious contradictions. Indeed, how can one consume without producing something first? It is through our wealth-producing labor that our consumption is enabled; consumption really a superfluous word obscuring the process by which we supply in order to demand. All consumption results from production, and to the extent that inheritance or borrowing from banks leads to consumption, that simply means someone else has supplied first so that we have access to money that allows us to consume.

Lastly, in concentrating on the macro calculations that constitute total consumption, economists miss out on how truly enervating rampant consumerism would be for our economy. If we as individuals spent all of our earnings without saving (see U.S. and England in the ‘70s), on an individual basis we would all be poor. Savings are the source of all wealth, and far from detracting from consumption, savings are banked or invested such that entrepreneurs and businesses can access the capital to build their job-creating businesses.

Home Mortgages as a Consumptive Medium – During the property boom of recent vintage, economists and commentators latched onto the idea that rising home prices were a source of economic growth. On CNN’s Glenn Beck Show last week, money manager Bill Fleckenstein said the economy was in trouble due to falling home prices. This is based on his belief that with many individuals lacking appreciated homes to borrow against for spending purposes, those same people will rein in their spending to the detriment of our economic health.

What Fleckenstein missed is that one man’s mortgage is another man’s savings. For someone to borrow in order to consume, there must exist a saver willing to put off current consumption in favor of spending at some time in the future. There’s no net consumption increase to speak of, plus when individuals access money in order to consume it, the latter siphons capital away from the economy’s more productive, job-creating sector.

England and the United States were mentioned above, and both countries experienced high levels of personal spending in the 1970s. Far from an economic stimulant, the heavy spending was the sad result of inflation and confiscatory capital gains rates that made most individuals unwilling to delay consumption. It was only when the barriers to saving were reduced in the ‘80s that people started holding on to more of their money; the savings an economic stimulant for increasing the base of investable capital in all manner of business ventures.

Rate Cuts a Replay of ‘That ‘70s Show’ - Many commentators (including this writer) have argued that the falling dollar is a blast to our unhappy and inflationary 1970s past. Still, there’s a lot of mythology concerning what happened thirty years ago.

Carnegie Mellon professor Allan Meltzer has said that the Fed’s current bias in favor of rate cuts “is a repeat of the mistakes of the 1970s.” The problem there is that the dollar’s greatest weakness in the early and late ‘70s occurred amidst Fed funds rate increases. In May of 1977 gold was trading at roughly $145/ounce with the Fed funds rate at 5.25 percent. By January of 1980, with the cash rate all the way up to 13.75 percent, gold reached what was then an all-time high of $850/ounce.

It’s also thrown around quite a bit that the Fed’s rate-cutting mirrors what happened to Japan in the ‘90s as the BOJ’s bank rate was driven all the way to zero. The major difference there is that as opposed to having an inflation problem, Japan suffered from deflation due to a strong yen that was wiping out debtors who faced rising real levels of debt amidst falling prices.

Our inflationary experience is quite the opposite, but for those who see low nominal cash rates as a signal of inflationary monetary policy, they would be wise to study Japan’s history. Not only did a zero bank rate fail to save Japan’s collapsing real estate industry, it also failed to moderate the yen’s rise.

Protectionist impulses stateside have it such that the yen will never weaken in any large sense versus the dollar, and just the same, it should be said that so long as the Bush administration, U.S. Treasury and the Federal Reserve all countenance and encourage a weaker greenback, no amount of rate hikes will reverse the latter’s descent. If we want a stronger dollar, credible comments in favor of such a move by our monetary authorities would accomplish what is desired in ways that rate increases never have; including from 2004-2006 when 425 basis points of rate increases occurred alongside a 60 percent decline in the dollar versus gold.

Rate Cuts Bail Out Investors in the Short-term – While there are varying views on the positive or negative effects of the Federal Reserve’s actions via the funds rate it sets, there’s a growing belief that rate cuts boost the markets in the near-term such that investors exposed to heavy losses can escape. That stocks have frequently rallied after rate-cut announcements have bolstered this flawed view.

The problem here is that in order for a seller to unload a position, there must also exist a buyer who thinks the securities being purchased have an upside. To believe that rate cuts weaken the economy while at the same time aiding heavily exposed investors is quite the paradox. Indeed, one would have to believe that the seller in every instance possesses information that the buyer is oblivious to. In short, if rate cuts are the market/economic negative that so many assume, this would be reflected in securities prices such that those eager to liquidate would face even greater losses. Instead, what market rallies in the aftermath of FOMC meetings tell us is that there are differing views in the great voting booth that is the stock market on the broad economic impact of Fed machinations. The Fed's agreement to cover J.P. Morgan's downside in its purchase of Bear Stearns constitutes a bailout. When it comes to rate cuts, bailouts they are not.

Negative Sentiment Can Be the Cause of Recessions – CNBC’s Maria Bartiromo has said that economies can essentially be talked into recession. Her view is that if it’s drilled into the heads of people that the economy is contracting, they’ll begin to believe it and will stop consuming. The notion that negative sentiment can induce recession fails on several counts.

First off, economies contract for the failure of economic actors to produce economic value that enables their consumption. What this means is that any negative economic sentiment would follow, rather than precede any economic slowdown.

Secondly, how do we as individuals respond to negative sentiment; the very sentiment that if true threatens our livelihoods? Rather than enervating, the fear of failure focuses us in such a way that we seek to enhance our productivity through taking less time off, spending our office time more productively, and generally doing whatever it takes to be productive such that we escape unemployment. Negative sentiment would if anything enhance our output for fear of failing in ways that would make us redundant to our employers.

If anything, we should say that excessive optimism is the driver of slowdowns, not pessimism. Indeed, it is when we feel good about our economic circumstances that we leave work earlier than usual, take more vacations, and to some degree consume our capital (while becoming lax in our investment disciplines) given the belief that the good times will continue.

And the above leads to the consumption fallacy that entrances so many of the economic and media elite. Always focused on how many cars people buy and vacations they take, mainstream thinkers forget that a failure to consume is a huge economic stimulant for the resulting savings very often flowing into new and existing business ventures that create jobs. Negative sentiment that might cause us to save is a boon for the economy for the pool of available investment capital increasing.

Assuming the economic picture worsens as so many suggest it will, one can rest assured that more in the way of fallacious economic assumptions will reveal themselves. That’s to be expected. Still, what’s rarely mentioned is that free markets don’t themselves cause economic slowdowns any more than rising economies and bull markets die of old age. Instead, they die due to legislative/government failure. In today’s case a falling dollar has created all sorts of economic dislocation that has harmed the broad economy, and generated myriad government “solutions.”

The better answer is for the federal government to get out of the way so that markets can clear, while allowing the productive sector of the economy to resume its growth path. In times like this, it's important to remember that the federal government only exists at the pleasure of taxpayers. And when it inserts itself into private commerce with taxpayer money, it slows down the all-important process by which markets adjust; its interventions consuming capital that if not taken from the private sector, would more likely find its way into the market economy in ways that would shorten the latter's recovery time.

While fostering a slowdown in economic activity through high, artificial rates for bank customers, the Federal Reserve injected additional liquidity through 2006 despite a fall in dollar demand brought about by slower growth. This revealed itself through the dollar's fall relative to gold. A sharply inverted yield curve confirmed that borrowers from banks could not get loans at rates near what the market deemed reasonable. Commercial paper and bond rates were very favorable by comparison, and monetary liquidity flowed to non-bank borrowers through innovative debt instruments designed in the financial markets. Those lenders and borrowers made credit decisions that were rational in devaluing currency conditions, but highly problematic with a stable or strengthening currency.

In 2007, the Federal Reserve stopped injecting new liquidity, but maintained the high cost of bank credit which disfavors smaller borrowers. By August, credit decisions made during the period of high liquidity became problematic, and the Fed began its series of fire drills designed to alleviate the crises arising in credit markets. In September, the FOMC began a series of reductions in the overnight interest rate (thus in bank credit costs), that continue to date, but which still leave the yield curve partially inverted and bank credit above market. Credit dislocations remain, economic growth is stifled, and the dollar’s value plumbs historic depths.

To its credit, the Federal Reserve’s actions appear designed to avoid adding permanently to the monetary base. New currency is being added temporarily as collateralized loans. New permanent liquidity may have to be added eventually, depending on the terms and outcome of the Bear Stearns transaction and any similar Fed undertakings. These are “mop-up” costs of salving crises caused by the central bank’s strident devaluation of the dollar during 2004-2007.

Almost all economists desiring a stronger, stable dollar hold the mistaken view that a higher overnight funds rate will provide it. They are just as much in error as are Keynesians who urge (and persuade) the Federal Reserve to devalue as the path to a positive current account balance. Keynesians are sorely wrong in asserting that a current account surplus is mandatory, or even necessarily desirable in America’s quest for prosperity. All who espouse central bank manipulation of interest rates (whether higher or lower) lend aid and comfort to the use of currency as a weapon of trade war, and to central planning of bank credit costs and asset prices.

Defective U. S. monetary policy has caused serious dislocations in the credit markets, distrust of credit quality and distrust of the dollar. None of these three serious concerns will be resolved, and certainly not for the long term, without reforming monetary policy. The Federal Reserve is not the cavalry riding to rescue private wagon trains in trouble of their own making. Crises addressed by the Fed are of the Fed’s making. Chairman Bernanke has steered the Federal Reserve into a role of investment banker of last resort, a high risk business whose prospective losses will be paid by further devaluation of the peoples' money.

Orthodox Keynesian theorists see dollar devaluation as a good thing, yet paradoxically argue price inflation is bad and ought to be fought with higher interest rates and higher unemployment. Dollar devaluation makes price increases inevitable, and unemployment is merely one mechanism for lowering the standard of living. Keynesian doctrine guiding the Federal Reserve may get the economy through this federal election year without catastrophe, but it is incapable of producing a good outcome over the longer term.

President Bush needs better economic advice. Someone should tell him he can issue an executive order requiring the Federal Reserve to allow markets to set the overnight funds rate, while at the same time requiring our central bank to target $500/oz. gold as the dollar’s value. Otherwise, after November 4, high inflation, high interest rates and economic recession will tarnish the legacy of his originally successful 2003 tax cuts.

All three candidates seem legitimately concerned about the poor, but is eradicating poverty in what is for the most part an economically free country a truly compassionate idea? No doubt if they were campaigning in the slums of La Paz or Port-au-Prince, their words would have meaning. Where there’s little economic freedom, poverty is surely rampant due to the aforementioned lack of freedom.

But in the United States it would be hard to make the same argument. What we find here is that the poor and rich are very much a moving target. According to a November 2007 Treasury Department study, individual income mobility was considerable from 1996-2005, with “roughly half of taxpayers who began in the bottom quintile moving up to a higher income group within 10 years.”

What the Treasury study shows is that misleading measures of average income statistics aside, individual Americans who are poor rarely remain that way. And if they do, their depleted existence is frequently a function of their own mistakes. So when we consider poverty in what is a very mobile country, we have to ask if there existed a magic program to erase it, would it be worth it? Likely not.

In what is an economically free country, stamping out poverty would be tantamount to voiding a highly compassionate market signal that tells us we’re doing something wrong. Simply put, without the reality that is poverty we’d have no way of knowing we were failing.

The poverty signal in the U.S. tells us to change geographical locales, to change our chosen line of work, and if we’re lazy, to work harder. Fear of poverty in a free country is what makes the prolific spender more parsimonious, the late sleeper an early riser, and the heavy drinker a teetotaler so as to show up to work clear-headed and energetic.

For the difficult-to-employ, the near-term poverty that often results from joblessness offers up lessons on what and what not to do once future employment is secured. As painful as job loss is, the fear of “what’s next” focuses us in such a way that we gradually cut down on the mistakes that put us out of work to begin with.

When we consider consumer products, from the Edsel to New Coke to the Newton, the market failure of all three was a strong signal from their customers that Ford, Coca-Cola and Apple Computer needed to make changes. For successful companies, the ability to fail is what fuels future success for the lessons learned. It is past business failures that provide today’s and tomorrow’s CEOs with a template showing what and what does not work.

It could also be said that fear of the joblessness that might result from bankruptcy or a takeover is what keeps executives and employees innovating, and working harder than they might. Failure, and the looming joblessness that it often foretells concentrates our actions very effectively.

Looking at the Internet implosion in 2000, awful as it was, it was useful in the sense that investors will forever have seared on their brains the need to diversify in terms of asset class, companies and level of risk. Investors will surely make mistakes in the future, but the fact that they were allowed to fail means that they’ll navigate the next bull market far more wisely.

All of which brings us to the present difficulties in the real estate market. In this case the federal government is seeking to cushion failure, to try and soften the sometimes sharp edges of capitalism to save homeowners and mortgage investors alike. What a shame. Just as government handouts to the poor often delay the process whereby they fix what they’re doing wrong, if the housing and mortgage markets are saved on the backs of taxpayers, no lessons will be learned. That politicians are presently trying to blunt the truth offered by market signals makes it a near certainty that more investment mistakes will be made in the housing sector down the line.

It’s paradoxical, but the happy truth is that poverty and all forms of economic failure are every bit as much a fact-of-life in the United States as wealth is. Indeed, it is because we can fail so spectacularly here that we’re also able to achieve so much.

Ultimately, wealth and poverty are two sides of the same coin; both essential market indicators in the way that consumer prices are. And if the federal government tries to protect us from the downside of free markets, it will surely rob us of the economic signals that tell us how to become rich.

The present financial crisis poses two main questions: whether it is similar to past crises and how central banks should intervene to preserve the stability of the system.

The current financial turmoil seems extraordinary because it has unexpectedly affected the heart of the functioning of our sophisticated money markets. Despite the Northern Rock episode, the main contours of the current crisis seem very distant from scenes of crises past where newspapers were covered with photos of depositors queuing to withdraw their money during a panic. Yet this crisis is just a modern-market form of a traditional banking crisis.

An old-fashioned bank run happened if enough people tried to withdraw their funds from a bank; even if the bank was solvent, it might not be able to meet all the withdrawals and thus the fear of bank failure could become a self-fulfilling prophecy. In the current crisis, participants in the interbank market take the place of long queues of withdrawers. They have stopped extending credit to other banks that they suspect to have been contaminated by the subprime loans and which therefore may face solvency problems. The commercial bond market and structured investment vehicles are facing similar trouble.

Both the old and new forms of crisis have at their heart a coordination problem. In the current one, participants in the interbank market and in the commercial bond market do not renew their credit because of fear others will not either. Witness the demise of the investment bank Bear Stearns at the heart of the dealing on structured vehicles.

In reaction, central banks have intervened massively, injecting liquidity and allowing banks to access fresh cash at the discount window in exchange for collateral that includes the illiquid packages of mortgage obligations. Have central banks done the right thing or are they provoking the next wave of excessive risk taking by bailing out banks and markets? Is monetary policy the only tool available for the central bank to address the market crisis?
Bagehot’s wisdom

Bagehot advocated in 1873 that a Lender of Last Resort in a crisis should lend at a penalty rate to solvent but illiquid banks that have adequate collateral. The doctrine has been criticised as having no place in our modern interbank market, but this is wrong. Bagehot’s prescription aims to eliminate the coordination problem of investors at the base of the crisis. It is still a useful guide for action when the interbank market stalls.1 It makes clear that discount-window lending to entities in need may be necessary in a crisis.

Bagehot's doctrine, however, is easy to state and hard to apply. It requires the central bank to distinguish between institutions that are insolvent and those that are merely illiquid. It also requires them to assess the collateral offered. Central banks, because of information limitations, are bound to make mistakes, losing face and money in the process. This doesn’t mean they should not try.
Poor collateral versus massive liquidity

The collateral should be valued under “normal circumstances”, that is, in a situation where the coordination failure of investors does not occur. This involves a judgment call in which the central bank values the illiquid assets. A central bank that only takes high quality collateral will be safe, but will have to inject much more liquidity and/or set lower interest rates to stabilise the market. This may fuel future speculative behavior. Some of this may have happened in the Greenspan era, in the aftermath of the crisis in Russia and LTCM, and after the crash of the technological bubble. The ECB and the Federal Reserve have accepted now partially illiquid collateral that the market would not. This seems appropriate and releases pressure to lower interest rates to solve the problem, something that should be done only if there are signs of deterioration in the real economy. The problem is that central banks are extending the lender of last resort facility outside the realm of traditional banks to entities, like Bear Stearns, that they do not supervise and, therefore, over which they do not have first hand information. How does the Fed know whether Bear Stearns or other similar institutions are solvent? It seems that the Fed is not following Bagehot’s doctrine here.

Finally, if banks and investors are bailed out now, why should they be careful next time? This is the moral hazard problem: help to the market that is optimal once the crisis starts has perverse effects in the incentives of market players at the investment stage. The issue is that only when the moral hazard problem is moderate does it pay to eliminate completely the coordination failure of investors with central bank help. When the moral hazard problem is severe, a certain degree of coordination failure of investors - that is, allowing some crises - is optimal to maintain discipline when investing and, amending Bagehot, some barely solvent institutions should not be helped.

Therefore, a key question to assess the future consequences of current central bank policy is whether the subprime mortgage crisis arises in the context of a moderate or a severe underlying moral hazard problem. The important extent of asymmetric information in this market points to a severe problem. Be as it may, this issue will determine whether current help will plug the hole for good,or only temporarily to make a larger one in the future. The challenge for central banks is to find the right balance between preserving current stability and imposing discipline for the future. Bagehot’s doctrine is still a reference today.
Footnotes

1 See X. Vives and J.C. Rochet (2004)”Coordination Failures and the Lender of Last Resort: Was Bagehot Right after all?” Journal of the European Economic Association (www.eeassoc.org/jeea/)

Xavier Vives is a Professor of economics and finance at IESE Business School; Editor of the Journal of the European Economic Association; member of the EU’s Economic Advisory Group on Competition Policy; CEPR Research Fellow