The Crisis Next Time: Role Of The Fed

The Federal Reserve is taking a victory lap (e.g., Ben Bernanke at Brookings, next Tuesday morning; no weblink yet available), and the emerging consensus is that its leadership has done a great job over the past 12 months.  But we should also take this opportunity to reflect on the longer run role of the Fed, both in the past decade or two and since its founding. 

Over on The New Republic website (and in the lastest hard copy), Peter Boone and I suggest that in the absence of effective financial regulation – i.e., both during the 1920s and again since 1990 – the Fed has operated in a manner that encourages the formation of sequential bubbles.  This destabilization of our financial system is not a minor matter; the damage caused – human, financial, social – is already enormous. 

And we are very far from being done. 

Don’t take my word for it. Lou Jiwei, the chairman of China’s sovereign wealth fund said recently, “It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”

By Simon Johnson

84 thoughts on “The Crisis Next Time: Role Of The Fed

  1. “Growth is a bubble when asset values do not reflect sustainable future profit streams.”

    Obvious problem being that we have no way of knowing what those future profit streams will be in the present. And that was the core of Minsky’s argument.

  2. I am growing increasingly wary of people assuming that the economic problem is over simply because the stock market is up 40% over the course of a few months (after having fallen over 50% from a much higher level).

    Unemployment is a huge and growing problem.

    Foreclosures and upside down mortgages are a huge and growing problem.

    Insolvent financial institutions (despite some hoking around with asset valuation regs, tax law, and capitalization regs) are still a problem.

    CRE is just starting to become a problem.

    State fiscal problems are still a problem.

    And last I checked, we still haven’t resolved Maiden Lane, AIG, Fannie, Freddie, etc.

  3. Bubbles are deniable until they pop.

    See my previous lists in the comments sections of this blog for “top 10 signs you’re in a bubble.”

    Here are some examples:

    * they publish a “dummies” and “complete idiots” guide to getting rich using the scam de jour.
    * P/E ratios clear 1000 in an industry that has never produced consistent profits.
    * Boosters are telling people there are no downside risks.

  4. I have a major issue with the arguments that assert we are deliberately creating a bubble to avoid dealing with the repercussions of our last bubble.

    The implicit assertion of this argument is that using monetary policy (e.g. monetary base expansion, low rates) to escape a deflationary spiral (which there is no doubt we briefly entered 9 months ago) is a “bad thing”. Immoral, unethical, impractical, short sighted, cowardly, and wrong.


    First, we’re better off with an expansionary monetary policy than an expansionary federal debt and a tight money policy (e.g. Reaganomics).

    Second, international currencies need to rebalance, and US expansion of the monetary base is part of that.

    Third, there is a quasi-moral presumption that government non-interference is inherently “natural” or “good”. The fact of the matter is that our entire international economy is unnatural. A pure human construct. It works only because there are so many artificial mechanisms propping it up, and one of those mechanisms is a constantly expanding money supply.

    Fourth, there is no world in which a 10% unemployment rate is socially optimal for anyone – not least of which is the federal government which needs to absorb huge tax revenue losses and then pay out massive subsidies to states and social insurance programs as a consequence. To the extent that monetary policy – or creating a “bubble” – avoids unnecessary waste of resources (and keeps the government solvent), this encourages more rapid re-allocation of resources to better ends. Economic “slack” on the scale we _would_ have if not for the “new bubble” is disastrous by any measure. And the impact on our currency is far less than it _would_ have been if the government kept a tight monetary policy while running ever greater deficits (until we inevitably default).

    The fact that we are creating a new “bubble” is NOT the issue. I suspect that many, many people complain about this new bubble because they WANT the current system to fail, not because they want to fix it. (I do not count SJ and JK in the crowd, but Liz Ann Sonders just coined a great phrase – “Anger at Optimism” – which accurately describes the sentiment. I’m not going to hold Sonders up as a hero, but that is one great phrase.)

    The real issue is that we haven’t fixed the deep structural problems in this country, and in the world economy. Dealing with these structural problems – energy, education, prison overcrowding, infrastructure, political influence, trade gaps, etc. – these are real and enduring problems. Using monetary policy (and some fiscal policy) to put idle resources to work solves only one problem – the problem of resources being unused. A lot of other problems come from this (unemployment has incredibly pernicious social consequences).

    So let’s not confuse the problem of putting idle resources to work, with the problems of fixing all our structural imbalances. I suspect that SJ and JK’s real concerns are that the US public and govt have such a short attention span (and are so vulnerable to special interest manipulation) that they can’t muster the political will to fix the problems unless we are in crisis.

    THAT is a fair point. But it’s a different one than complaining about the “new bubble”.

    The primary link, I think, is that

    There is such a thing as “good” and “bad” GDP growth – something that is literally impossible for modern economics to incorporate into its models. I would argue that the fundamental concept that is missing is “sustainability”, but not in the sense of the Green movement – rather in the simple sense of growth that does not come at the expense of future consumption.

  5. I am growing increasingly wary of people assuming that the economic problem is over

    Just increasingly wary? No one on this blog believes this for even a second.

  6. Second, international currencies need to rebalance, and US expansion of the monetary base is part of that.

    Are you trying to scare everyone Statsguy?

  7. I’m not disagreeing with you (I think), but the fact we are creating a bubble of economic activity that doesn’t address any social needs is the main objection and why we call it a bubble in the first place. If it was genuine quality economic activity, no one would call it a bubble.

  8. As a post script, I would note that the 1920s are not a “done deal” in terms of the Fed causing problems. Remember that the Fed and the other Lords of Finance were trying to manage huge global imbalances due to WWI hangover and the reparations from the Treaty of Versailles. There is also a prominent faction of economists that argues that the Great Depression should have been a severe recession, but for the excessively contractionary monetary policy of the Fed and other central banks.

  9. I would argue that preventing unemployment from peaking far above 10% is a genuine social need. Keeping the federal government out of insolvency is also a genuine social need.

    Please understand that I 90% agree with the basic argument of SJ and JK’s post above (an unregulated financial structure is going to get us back into bubble-trouble pretty darn fast).

    I’m entirely taking issue with the verbiage – that we are “fixing one bubble by creating a new bubble”. That verbiage directly feeds a specific economic and political agenda, and that agenda implies that we should have responded to the current crisis by embracing worldwide depression and calamity in order to “clear out the dead wood” and “rebuild on a strong foundation”. I don’t think these people honestly have a clue what they are really asking for.

  10. Krugman, Roubini and others were urging the government about a year ago to spend like crazy. The government spent about 1/5 of what they suggested, and now they seem to be satisfied. I still think they should have spent the other 4/5’s, and they will probably end up doing so soon one way or another.

    The idea that we need to “clear out the dead wood” to “rebuild on a strong foundation” was thoroughly discredited, as you mentioned, when we tried that during the great depression.

  11. You see nothing immoral about debasing the currency for the benefit of reckless gamblers who placed losing bets? What about the generation whose lifetime savings are now destroyed on a daily basis by the necessity of living on capital? As for your bugbear of ten percent unemployment, an artificial prop to asset values will sustain unemployment longer than anything else. What kind of recovery can we expect without real estate changing hands? We have created a liquidity trap, the very condition for which Keynes’ General Theory provides a clear remedy: fiscal stimulus. Monetary policy means money for banker speculation, nothing else.

  12. How do you figure the US government isn’t insolvent (or well on the way to being there) already?

    I expect that the crisis is nowhere near over. With the “stress tests” on the banks having passed only with unemployment at 8.5%, unemployment is approaching 10%. Couple that with the fact that there’s another round of ARM resets coming this winter, and suddenly things don’t look too hot. Regulations on the financial “innovations” that got us in to this mess are still non-existent. Government resources are already stretched about as far as they can go… if we have a relapse any time soon due to anymore financial “wizardry” (or the next round of resets already lumbering toward us like an angry bear), how will we survive it?

    Can we even be considered solvent with so little done to regulate the things that took us down, another round of loan failures in the offing, and less tax revenue coming in due to unemployment?

    I don’t mean to sound like Chicken Little at this point, but I really do think even cautious optimism at this phase is dangerously naive.

  13. This is comment on Simon’s article.

    J.P. didn’t “save the day”; he ran all the small banks out of business.

    Sound familiar?

  14. I am a pragmatist – and I do not value the moral win of punishing “reckless gamblers” more than the pragmatic win of avoiding worldwide collapse.

    10% employment is not a bugbear. Bugbears are fanciful hobgoblins out of folklore. 10% unemployment means catastrophe for millions of americans (and others), and long term social problems that will pass down through generations.

    Finally, you must be aware that even Krugman (the Keynesian champion Du Jour) concluded that fiscal policy alone does not escape liquidity traps without accompanying CREDIBLE expectations of monetary expansion. That was Krugman’s whole Japan’s Lost Decade argument. They spent themselves into a 100% of GDP debt hole while watching their economy contract for over 10 years precisely because conservative moralistic economists railed against using conventional monetary tools.

    Krugman’s current argument for fiscal policy is entirely the Zero Bound, but this argument is somewhat frail. He knows full well that the Zero Bound is an artificial limit. If you look at the last crisis, we did not reverse the bottom by passing the stimulus. We reversed the bottom by committing to quantitative easing. The timing is perfectly clear. Fiscal stimulus was useful to prevent structural dislocations during the bottom and help ease the suffering. But it did not turn the corner of this last recession, and it did not turn the corner of the Great Depression either.

    Your anti-inflation argument presumes that paying back the debt tomorrow (with heavy, deflated dollars) somehow is not harmful to people. The truth is that borrowing more money to sustain consumption (and having our children pay it off) primarily benefits the people who incurred the massive federal debt of the last 30 years. Doing this would create a massive intergenerational transfer of wealth – indeed, our current consuming generations have already done this.

    While I have always advocated a mix of monetary and fiscal policy, I lean more towards monetary policy because it’s generally more effective. And I believe the moral repercussions of robbing from our children to pay for our current generations to comfortably retire are far more hideous than devaluing saved dollars (which are frankly not worth what people think they are).

    If you want to talk about vulnerable populations, THE most vulnerable populations are those that cannot vote. The ONLY non-criminal citizens that can’t. Those under 18. And they are already starting to feel the impact of a consuming generation that wants to load them down with more debt to preserve their nominal savings. That is the real “morality” of currency integrity.

    That is the morality of a society that values giving the very best of everything to ourselves while failing to fully cover vaccinations for children…

  15. The US government is not insolvent because it does not owe money in foreign currencies, and it can print money. QED.

    TIPs are a modest risk, but they are a small share of overall federal obligations. The biggest real risk comes from imports with inelastic demand (notably, oil).

  16. Of course that’s one way to look at it. Another way is that the inflation caused by printing the money acts as a regressive tax on people who are just barely hanging on.

  17. I suppose I’m thinking “solvency” in our case is something along the lines of “Who will want our currency for transactions if we just pour it out like its water?”

    It’s going to be hard to buy oil and goods with paper that’s worth nothing, basically. At that point, I’d pretty much regard a country (and consequently its government) as insolvent. Have I got the definition just completely screwed up?

    An additional question: do we just count on the fact that everyone else is hurting (and printing money) as well to prop up the value of the dollar? Is every other country devaluing their local currency by madly printing it out and shoveling it in to blackholes like Wall Street and big banks?

  18. How about “Anger at Near-Sightedness”?

    The optimism you describe neutralizes the motivation for addressing the enduring problems. This means that all our current policies will amount to nothing more than postponing our reckoning, which we will no doubt greet with less fiscal flexibility.

  19. That’s what I think bondgirl. We’ve just bought ourselves some very expensive time, and proceeded to squander it.

  20. All right, as a pragmatist: would it not be more pragmatic to rebuild the country’s infrastructure while the Treasury can still borrow the money, rather than expanding the Fed balance sheet by absorbing GE commercial paper, reinflating top tier banks which turn around and reinflate hedge funds to create speculative booms in stocks, commodities, etc? Sooner or later the dollar will cease to be a reserve currency, or at least the only one. At that time your children or grandchildren will be in real trouble and the continued existence of CNBC cheerleading and propaganda may be a small comfort. Monetary policy gave us a 15% yield on 30 Treasuries as recently as 1981. Do we know this cannot happen again?

  21. Vis a vis the comments about burdening future generations with debt, one might note that during the neo-keynesian post-war years (e.g. from 2nd new deal [38]on) the broad policy was to encourage consumption, and to create the means by which a ‘new middle class’ could purchase houses, consumer goods, and post-secondary education cheaply. For my parents generation (adults in ’41) the single largest investment was the mortgage on a house. In contrast, the average college graduate has about !8,000 in debt and many students owe a great deal more, cripplingly more. We should also note that educational attainment in the U.S. is slipping – about a quarter of the age cohort of 18 year olds do not finish high school, and college graduation rates correlate uncomfortably with class. Social policy in the U.S. has dis-invested in human beings over the last 30 years. As I noted in another context (healthcare) the U.S. looks increasingly like the ‘developing world’ when measured on the human capabilities index (e.g. undp, v. Sen & Nussbaum). Not merely infant mortality rate down to 15th in the world, but across a range of criteria.In another index of willful destruction of the social fabric, federal support for primary and secondary education has declined by at least 30% over the same three decades. The burden has been displaced onto states and in turn, to localities with the not surprising result of citizens rebelling over ever escalating property taxes (one might note en passant, that local control over education translates into voting against the interests of children who, of course, don’t vote). Roughly half of all school buildings are now over 50 years in age – the end of their usable design life. One might go on and say the same about public infrastructure, and medical-pharmaceutical complex that passes for healthcare. Finally, we spend more on armaments than the next twelve national states combined. This is equivalent to burning federal revenues (v. Seymour Melman).
    Hence, whether the U.S. opts for another ‘bubble’ (likely whatever fed policy officially is) or something like it, we shall be in big, enduring trouble. And the terms of political discourse prevent any of this being seriously considered.

  22. Infrastructure is relatively slow investment, which inhibits the primary purpose of the stimulus–separate from the stabilization of large financial institutions.

  23. Professor Johnson wrote in his article that the next bubbles will be in certain developing countries in Asia and Latin America.

    Does anyone know which countries and which sectors?

  24. I’m in favor of a lot of the investments that were made in the stimulus bill, NOT because they were good stimulus, but because they were good investments.

    Fiscal deficits to sustain consumption are another story, and should be limited in scope and time to the degree that’s possible. But back in November, yes, they were very helpful – and we could have used more. We still need more, although it would be nice if the expenditures bought some real investments at the same time. So long as the fiscal “stimulus” was accompanied by monetary stimulus in the presence of deflationary expectations, yes – I favored fiscal action.

    Monetary policy in the pre-80s was not a policy of steady state monetary expansion, but of continuously accelerating monetary expansion. Which created heightened inflation expectations. Current policy (allegedly) targets steady state inflation of ~2%, and expectations are STILL under those targets in the near term. Long term, inflation expectations are driven largely by fear of fully monetizing the huge federal debt if expenses can’t be cut. So I would argue the best way to avoid long term inflation is by increasing short term inflation to moderate levels and focusing fiscal action on investments and structural improvement rather than consumption.

  25. (I’m not an economist – but a mechanical engineer well trained and practiced in Systems Engineering)

    It makes sense that the Fed hasn’t helped much as far as preventing bubble, but that strikes me as altogether far to simplistic a view (though that seams to be common in libertarian anti-fed circles). Surely some blame needs to be apportioned to the bankers (et al) who knowingly chase the “next big thing”, knowing that it will burst. There where some ties to that theory at the end of the linked article, but it wasn’t a very strong case in the body of the article. I also wonder what culpability politicians carry for this current financial system and economic mess. (Yes, legislation is sausage making and “democracy is the worse form of government – except for all the others” {Churchill?}) but still, where is the accountability for the pols?

  26. I’m sure you’ve been around the block enough times to know that it’s a never ending game of pass the buck.

  27. We need “moralistic economists” to prevent moral hazard. The US economy is now one giant moral hazard, with the financial industry the main driver of economic decay due to mispriced assets, commodity speculation, luring and wasting the best brains, short-sighted plunder of businesses (aka value extraction), etc. All of this would not be possible without Fed handouts to Wall Street.

    Everyone wants the government help people avoid suffering any consequences for their actions, with money they don’t have. This never ends well, even if it looks ok for a while.

    I wonder how many would make the conscious choice to avoid the pain now (possible depression), knowing it means an inevitable decay of the entire system if the bad actors are continually bailed out.

  28. Hi Mr StatsGuy,
    I think Prof Johnson’s short piece is bang on.
    I think that until the theory is able to mathematically represent what a bubble is, we’re subject to the forces of ‘nature’ that cause ’em!
    You may wish to reconsider your (I think) positive take on monetary matters since the theory does not link up how the various markets interplay – The stability of the dollar is not only determined by domestic inflation and or market forces:
    I am wondering if this is the start of a sell-off of the dollar internationally… Gosh – maybe I am that much older (you do write like someone with wisdom!) than you that I remember 1981 and everyone getting ‘hit’ with those 20 percent interest rates that were needed to stabilize the currency markets.
    I just think that the whole situation is still volatile than what can be currently predicted…

  29. My objection is that there are two clearly different roles the Fed has played – monetary, and regulatory.

    Professor Johnson has recognized these twin roles, and the degree to which combining them into a single institution is dangerous.

    My CHIEF objection, I suppose, boils down to this:

    We are conflating those two roles in this post. I firmly believe that the Fed’s action to halt deflation was entirely proper. This was the monetary role. Indeed, it was probably too late and nearly insufficient.

    The failure was not in the Fed’s monetary role, but in its regulatory role… which forced it to use its monetary powers to prevent systemic implosion.

    Baseline has made this argument – I am entirely objecting to the language around “fighting this bubble with another bubble” and so forth. Language which is primarily used by people who are attacking the Fed’s _monetary_ role.

    This is faulty, and dangerous, and makes Baseline’s views appear to fall into a particular camp where it (I hope) does not belong. Here are past statements of Baseline’s views that are better, IMHO:

  30. But do we really have to choose between pragmatism and morality here?

    Had we pursued the same fiscal and monetary policies as we have, could we not also have, while bailing out the failed institutions, wiped out their shareholders and trashed their senior management? Taking out the people at the helm of those institutions would, I think, have done a great deal to reduce the moral hazard.

    I have heard those very people claim that, of course, they are personally indispensable for solving the very problems they created. But beyond that unsubstantiated, self-serving claim, is there any real reason to think we would not be just as well off, nay, better off, with those people collecting unemployment and other people (less senior management promoted, other physicists and mathematicians recruited, and other Poincare’s out there not currently engaged in finance) running the finance industry’s show?

    I think we could have had our cake and eaten it, too, if the political will had been there.

  31. StatsGuy: “There is such a thing as “good” and “bad” GDP growth – something that is literally impossible for modern economics to incorporate into its models. I would argue that the fundamental concept that is missing is “sustainability”, but not in the sense of the Green movement – rather in the simple sense of growth that does not come at the expense of future consumption.”

    Modern economic thought is, IMO, hampered by a focus on maximizing current utility and unrealistically discounting the future. That is why I stress return on investment. You can’t invest tomorrow if you go broke today. And if you try to maximize today’s profit you take on too much risk (as a rule) of going broke. When too many people take on too much risk, a lot of them go broke. Bubble and crash.

    Greenspan warned in the past, and today, as well, about irrational exuberance, and predicted that we will have another financial crisis. I expect that he is right about that. But I disagree that they are inevitable.

    Decades old research indicates that people can learn to control their emotions and avoid bubbles and crashes. True, that has only been shown in games (simulations). But imagine a world in which people underwent such training in high school. The real world is different from a game, but such training does transfer. Remember when a Turkish airliner crashed when the rear door came off? An American pilot successfully landed his plane when the same thing happened, because, on his own initiative, he had trained in a simulator for just that emergency.

    Greenspan may have repented, but I think that he still does not get it. So we have had three centuries of recurrent financial crises. That does not make them inevitable. Maybe we just have not yet learned how to avoid them. But we do have a period of 50 years when we did avoid them in the U. S. During that time we had a Fed that was willing to take away the punch bowl. But shortly after we began to deregulate we had the S&L debacle. Is there no clue there? Yet we continued to deregulate while having bubble after bubble. No clues there?

    So here we have one of the world’s top economists saying, “Fact of life. Nothing to be done.” What would an engineer say? “We had a time between failure of 50 years. Can we make that 100?” :)

  32. My argument is not against the core ideas of the post above, which I think have been better expressed in previous Baseline posts. My argument is with accusing the Fed of creating new bubbles to avoid the consequences of old bubbles. That specific phrase is a rallying cry against the Federal reserve’s expansion of the money supply to counteract a clear deflationary trend at the beginning of the year.

    Permit me to note that the Fed has two critical roles:

    1) Keeping money supply/inflation on a stable trajectory

    2) Sharing regulatory power over financial institutions

    It has failed at the latter, rather spectacularly. But the “sequential bubbles” argument implicitly accuses the Fed of failing in its #1 role (monetary stability).

    The fact of the matter is that we do NOT have hyperinflation. The Fed’s monetary action post-September 08 was tardy and weak, and even now, near term inflation expectations are _still_ low.

    I don’t doubt that the Fed used its primary role (monetary policy) to cover for failing in its secondary role (regulator), and that long term this is perilous. But the solution is not to stop using monetary policy to prevent catastrophe – which is the chief objective of many in the anti-Fed-bubble-making camp.

    I think these previous posts are a better reflection of a more accurate argument that Baseline has made in the past:

  33. It’s probably harder to live without the technocrats than many think – the Bolsheviks proved that in their purge of the government bureucracy in 1917. And many current execs certainly fell from grace (with, admittedly, a comparatively soft landing).

    But you are right that we could have done better. Salary freezes, deferred compensation, clawbacks, windfall taxes, a few lawsuits… yes, we had that bit of grandstanding during the anti-AIG uprising. What did we get that yielded permanent reform?

  34. Re. the reported quote of Lou Jiwei, I just now realized something, perhaps the most important thing from this report:
    (1) This guy is surely one big shot: Lou Jiwei, the chairman of China’s sovereign wealth fund [$298B]
    (2) He rather clearly declared: “… Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. …”
    (3) This is a clear declaration, by someone expected to know, of market price manipulation by governments, either directly or via policy change!
    (4) In the case of the US stock market, I would claim that the following was too fast to result via policy change!
    On March 9, the Dow closed equal to its January 1966 average close, on a real basis. Zero change in the Dow’s consumer purchasing power over 43-plus years! See it here:

    Such made a blog:
    SIRENS? The nominal Dow low close 6547.05 on March 9 was followed by six up days (sum = +946.53), one down day of -7.01. Net rise 3/9/2009-4/17/2009 is +1584.28.
    (5) And remember this!

    Beyond reasonable doubt? Any way we can get this to a jury?

  35. Economists have only one guiding principle in institutional design. Efficiency. Any decent engineer would focus on system robustness and fault tolerance. [no more comments from me – I’m making a nuisance of myself now]

  36. This time the bubble that exploded was not a bubble that had been inflated so much by the Fed with low interest rates as by the credit rating agencies that with their AAAs channeled too much hot air into the bubbles. This of course does not mean that the Fed cannot set up the next bubble.

  37. I think it’s fair to say the Fed tightened too soon in the 1933-34 period.

    The bigger issue is the one Simon’s making in his TNR article — the banking sector has completely transformed a linear payout vis-a-vis its business decisions (good decisions = profits => higher comp vs. bad decisions = losses => lower or no comp + the possible loss of real wealth) into a publicly backed convex payout (good decisions = profits => higher comp vs bad decisions = losses = bailout => still-high comp, repeat ad infinitum). That is just a fact.

    The banks have done this by capturing the legislative and regulatory process, and by transforming their position at the center of the intermediation process into a position of control vs a utility-like function that allocates savings to investment. They realize they can lever themselves to an inordinate degree, to the point they cannot_be_allowed_to_fail because they will bring the rest of the system down with them.

    The most recent quarterly reports + balance-sheet information of these banks is most instructive. Without of the Fed, none of these firms would (or could) exist. Particularly in 4Q08-2Q09. All of these banks required the Fed to provide them liquidity, because their funding evaporated. Imagine that: Banks and Investment banks could not be funded. And they had no capital of their own to fall back on. Imagine that. Without the Fed they would have perished immediately. Imagine that.

    In the event, however, the banks were able to construct a conduit (AIG) that tunneled billions of dollars into their income statements, and followed it up with off-market tear-ups of AIG positions that tunneled billions more of tax-payer funds to their income statements. (Remember the US govt SEIZED AIG and paid all — as in 100% — of its debts and obligations.) In the history of the world, there has never been a more effective capture of the entire government apparatus than what we now see.

    This is not a discussion of the effectiveness of monetary policy vs fiscal policy. Or full-employment vs wasted resource. This Hank calling Lloyd multiple times a day on logged lines, and countless times on cell phone, talking about what it’s going to take to keep GS from blowing up. This is Jamie pounding the tom-toms to rally all the other fellow-travelers to stand up and push back.

    This is not a policy discussion — this is calling in all the favors owed and silences kept to ensure your bank gets to use the government’s balance sheet so you can make more money than you ever thought possible during the greatest crisis in 80 years. This about a few getting gloriously rich. Gloriously. Imagine: Your bank will pay out $20 billion in bonuses — an amount that would count as a major health-care spending or unemployment-extension program for the US Government because of the millions of people it would help. Imagine that.

    This complete capture isn’t a policy discussion. This cannot sustain itself. And that’s something to consider.

  38. See comment above to your earlier post. How many MMR shots would the $20 billion in bonuses that’s due to be paid out by just one bank (with a b) buy?

  39. We do have a way to know. We have had a way to know for the past 670 years. We simply are no longer doing a proper double-entry bookkeeping. A bubble is a Ponzi scheme. What bust comes when Peter can no longer support Paul’s excesses.We can forget about regulation and simply focus on a transparent bookkeeping framework that reports a full and honest story.

  40. While I’m not quite the financial brain a lot of other people on here are, I do know a shell game when I see one. Recent finance industry and government action have fit squarely in that role. “Staving off the inevitable”, “Buying time at sky high interest rates” and the obligatory “Rearranging deck chairs on the Titanic” are the thoughts that have run through my head a lot lately with regard to the policies and actions that will occur with such a quick “recovery”.

    I wholeheartedly agree with your prediction.

  41. “I think that until the theory is able to mathematically represent what a bubble is, we’re subject to the forces of ‘nature’ that cause ‘em!”

    Mathematics is not the tool to report a bubble. A bubble is not solved with probability theory. The bubble is a problem in double-entry bookkeeping. If a proper bookkeeping were being done the bubble would show up immediately. There is not the slightest mystery to a so called “bubble.”

  42. @StatsGuy

    Certainly we need the technocrats. But do we need these particular technocrats? Russia in 1917 was a backwards and largely illiterate country–once they purged the bureaucracy there were few people who could replace them functionally. But we have lots of quantitatively sophisticated people (ironically, many of them Russian immigrants) who could step into these roles now, do we not?

  43. Lots of food for thought. Don’t put the Fed in charge of regulating anything. They need the clear air in which to operate. It would actually be nice if we could fully isolate regulators from the regulated. Realistically, this won’t happen, but at least we need a somewhat substantial “firewall” to protect us from the abuse and abfuscation which seems to be the greatest creative financial product available. C’mon, folks, it’s like claiming that we can somehow reform our healthcare system and keep health insurance companies in business. No way, no how, just like keeping the megabanks in business. After a while, I begin to believe that the taxpayers of this country belong to a cult of masochists. We seem to continue to willingly pay taxes to leadership that has only its own interests (and those of its sycophantic oligarchs) at heart. Time to really put teeth in regulation. I say we start back in 1950, and calculate the salaries of todays bankers by giving them the same salaries, bonuses and retirement packages as were received by the bankers then, adjusted for inflation. I dare say, none would now be earning even a million a year, and probably much, much less.

  44. “Unemployment is a huge and growing problem.”

    … and the glossy magazines tell heart-breaking stories of “ruined” wealthies and even if they do it sneering at the billionaires down-sized to millionaires I have as yet to read an equally exciting story about the plight of the job-less – why???
    – is it only because it is beyond the capability of writers? or do we not yet want to face up to the fact that it can hit everybody?
    (so again where is the new Upton Sinclair or Emile Zola’s Germinal about miners I think which got me so very excited way back in the fifties)

  45. “Anger at Optimism”

    so that is going to be the new silencer for people who want to uphold solid book-keeping and other principles

    up to now my favourite was the put-down for anybody asking for more meticulous writing of new soft-ware to be “adverse to progress”

  46. “there’s always more to be printed”

    there are stories that they needed a wheel barrow to carry the money when they wanted to buy a bread

  47. “I am a pragmatist – and I do not value the moral win of punishing “reckless gamblers” more than the pragmatic win of avoiding worldwide collapse”

    that is always the argument which the “little ones” get told after the “big ones” blew it up
    – that’s the same argument that helped convicted Nazis to leave their prisons really fast because pragmatism demanded that the population stops being angry at the US de-nazification-procedures and stand firmly behind them against the SU. The argument seems totally valid even today but it remains disgusting just the same.

  48. Dan Palanza

    the problem with double entry book-keeping is that everybody can do it with just paper and pencil and that it shows up all those unpleasant facts which you can best hide via fancy computer programs whose basic assumptions almost everybody using them has forgotten long long ago or never known to start with.

    Can you even begin to imagine all the job markets which would take a hit If your “campaign” for proper non-fancy book keeping were successful

    found an article on the use of tokens in ancient ancient times from that French guy that you? recommended – fascinating stuff on how you can create security in transactions with very basic means.

    When I was young in the 60s there was the balance sheet, result of double entry bookkeeping and a thing called Gewinn- und Verlustrechnung (win and loss calculation) which explicitly was not considered book-keeping but cost control and considered to be a kind of appendix.
    Am I wrong in guessing that by now the cost control department has pushed the balance sheet department into a corner labeled “boring”?

  49. Bayard writes “It would actually be nice if we could fully isolate regulators from the regulated”

    As a sort of minimum minimorum you have to send the regulators off to a long vacation so that they can clear their heads. They have painted themselves in a corner and have no idea how they are going to get out of their current regulatory paradigms without it all coming apart. And yes you have to add to them outsiders who come from different parts of the economy because as is they are just an incestuous bunch of mutual admirers.

  50. “It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”


  51. I’d be interested to read anyone’s thoughts on Boyer’s paper, “Assessing the Impact of Fair Value on Financial Crises”

    This article challenges the notion that the reform of accounting principles in accordance with fair value would provide better information, and that more transparency would reinforce the resilience of the economy. Actually, fair value gives at each instant a seemingly relevant liquidation value, but obscures the value creation process by mixing present profit with unrealized capital gains and losses. This discrepancy increases with an increased degree of uncertainty, which is at odds with widely held beliefs about the efficiency of existing financial markets. Fair value introduces an accounting accelerator on top of the already present and typical financial accelerator. It extends to the entire economic system, the source of financial fragility typical of the 1990s. If fair value accounting is applied to banks, an extra volatility may be created unless a new wave of innovations introduces countervailing forces.

  52. But this is a straw man. Governments need to reflate the bubble. Better that than deflation, but still…

  53. It’s not the Fed, it’s the whole system — growth predicated on the continuous expansion of the finance, insurance and real estate sector.

  54. SG – I was talking about the potential for hyperinflation – (sorry – I think my note was unclear and the link too) – What may have started as an effort by the Fed to counteract deflation can transform into a crisis of inflation due to currency over-supply that the Fed has to scramble to control. It is not certain if it is happening now but one can’t help but question if the dollar sell-off in money markets may become another fire for the Fed to have to put out.
    It needs to be added – ‘…’81 saw people getting hit and others getting enriched by the double digit interest rates.’ There may be more leeway for the Fed given rates are so low now, but how the ‘wealth-redistribution-roulette’ that goes with trying moving from crisis to crisis, is to be seen.

  55. “Without of the Fed, none of these firms would (or could) exist. Particularly in 4Q08-2Q09. All of these banks required the Fed to provide them liquidity, because their funding evaporated. Imagine that: Banks and Investment banks could not be funded.”

    But that is precisely the reason the Fed exists – to be a bank of last resort. One could easily argue that quarterly reports reflect the fact that the Fed was doing the job it was built to do. And it did that job well.

    The _problem_ is that the Fed was required to do that job in the first place (aka, regulatory unravelling). SJ/JK’s point seems to be that we have grown reliant on using the Fed backstop, rather than fixing the problems which require tapping that (expensive) backstop. And that the cost of using the backstop is growing ever higher.

    But the “sequential bubbles” argument is one that is generally employed by people who object to the Fed’s _monetary_ function, which I would argue was correctly deployed (albeit late and weak).

    The implicit argument is that the moral hazard caused by the existence of the Fed backstop is the _single factor_ that is primarily CAUSING the crisis to begin with. AKA: the Fed is CAUSING the bubbles, not solving them. We are thus better off without the Fed.

    If the faction making this argument had won the day in October 08 – March 09, I cannot imagine the worldwide catastrophe. This faction is now triumphantly beating its chest, is _angry_ that the recession (might be) ending, and is using credible blogs like Baseline to make its case.

    By taking this line of attack, Baseline risks marginalizing itself. A more mainstream argument, and one which is more in tune with previous posts, would focus the line of attack on _splitting the Fed_. On the fact that the Fed’s heroic success at one mission was only required because it failed to catastrophically at its other mission. Yay for the Fed, but never again…

  56. I totally agree on inflation risks (I think “hyper” inflation is overblown, but I don’t consider 15% a year “hyper”…). I think the problem is gaining control over velocity, and the best way to achieve this is by phasing in high capital/asset ratios over time (which will keep down leverage). This is going to require a one time expansion of the monetary base (and injection of that base into the economy) to keep the total money supply from shrinking during the transition. It means moving slightly more toward a cash based (exogenous), rather than a debt based (endogenous) money supply. I’ve argued this more times than I can count.

  57. In the stock market, financial analysts often produce company valuations using the Discounted Cash Flow (DCF) method: they try to estimate the company’s future income and expenses, use these numbers to forecast future profits for the next few years, and then try to estimate the value – as of today – of this stream of future earnings. In bubble times, these estimates often reflect explosive rates of growth in the company’s income and profits, which justify high share prices.

    However, very seldom does it occur that someone actually attempts to sum up the projected income and profits from all these individual companies, and come up with an aggregate number – for example, saying that all the NYSE traded companies, combined, are expected to have sales of $10 trillion next year, and of $11 trillion in the year after that.

    Such aggregate estimates can probably be checked against macro-economic data and forecasts, and in bubble times the two would probably conflict very wildly. After all, even in good economic times, it is impossible for everybody’s sales to permanently grow at a real rate of 10% each year.

    In more globalized markets, e.g., commodities, the job of aggregation is made tougher because the forecasts have to be summed over many individual assets and countries. Still, in the information age, this may perhaps be doable.

    So, to summarize, one answer to the growth-vs-bubble question may be that when the micro-level forecasts (for individual shares) and the macro-level ones (for the entire economy) diverge too strongly – we may be in bubble territory.

  58. StatsGuy: 15% inflation = at least 15% interest rates= what would that add to the US public debt service? Another total health-sector?… That is when things get murky and ignorance is worth fortunes in bliss.

  59. Silke Said:
    “the problem with double entry book-keeping is that everybody can do it with just paper and pencil and that it shows up all those unpleasant facts which you can best hide via fancy computer programs whose basic assumptions almost everybody using them has forgotten long long ago or never known to start with.”

    This is true. But there is no reason not to program the proper system that ran large industries before computer came into play. Those books were keep in meticulous fashion.

    Silke Said:
    “Can you even begin to imagine all the job markets which would take a hit If your “campaign” for proper non-fancy book keeping were successful ”

    I believe it would be the reverse. Bookkeeping forces enterprise to generate value in support of profit. The physicist gamer will have to go back to Vegas, true, because double-entry does not support direct betting from the bank cash account.

    Silke Said:
    “found an article on the use of tokens in ancient ancient times from that French guy that you? recommended – fascinating stuff on how you can create security in transactions with very basic means.”

    Nice work. The author is a she. It demonstrates that accounting is what lead to civil cultures. Today the loss of accounting is leading us back into feudalism, and soon back into the dark ages.

    Silke Said:
    “When I was young in the 60s there was the balance sheet, result of double entry bookkeeping and a thing called Gewinn- und Verlustrechnung (win and loss calculation) which explicitly was not considered book-keeping but cost control and considered to be a kind of appendix.
    Am I wrong in guessing that by now the cost control department has pushed the balance sheet department into a corner labeled “boring”?”

    Today’s programmer does not even know that the option exists. I spent ten years looking for even a remote interest among software developers. There is none. They are mercenaries that write code for venture capitalists. I even met a guy who programmed the Ponzi Mortgage bonds for Bear Sterns. He did not have a clue of how double-entry bookkeeping works.

    When we talk of regulation on this list, there need be only one: That every federally supported bank must use a and report to the public a proper double-entry P&L and Balance sheet. With full audit capability. You will put half the nation back to work making handcuffs and other such paraphernalia.

  60. Dan Palanza

    “making handcuffs”
    oh what a tempting job opportunity that would be …

    But seriously,
    when I get these yearly reports for the few stocks I own they always have a balance sheet that looks like the one I learned to understand albeit for a very small company way back in the 60s.
    How do they arrive at this thing? and if that is not the result from “doppelte Buchführung” why is it allowed to look like it is?

    “He did not have a clue of how double-entry bookkeeping works.”
    The problem that the programmers are not required to be familiar with the intricacies of the work they write programs for is something I am always deploring. This is something no lawyer would tolerate in the translator of a contract.

    “Nice work. The author is a she”
    I seem to remember that despite the she-sounding name it is a he – I can’t check I threw the print-out away just remember dimly that I got a bit confused on the gender

  61. 15% inflation does not equal 15% interest on the entire federal debt – just the portion that is rolled over (which, unfortunately, has increased over time as the Treasury has shifted into shorter term securities to manage interest costs). Not that this is a good thing…

    Nor does 15% inflation equal _at least_ 15% interest. It’s quite possible to have an inverted yield curve (also not a good thing – usually means nasty recession coming).

    But I’m not arguing for 15%… I’m arguing for 2%, maybe 3-4% in the short run to recover lost ground and maintain long run price trajectory.

    It rather depends on the type of inflation, however. Wage driven inflation is better, since that drives federal revenue higher. Commodity import driven inflation is disastrous, since that costs jobs and does not drive income tax revenue.

    Re: MC Morley… I’m sorry for short-running the international finance arguments. Yes, risk of dollar flight does limit monetary action. I have argued that this is why the Fed did not loosen monetary policy in Summer of 08 – they perceived the commodity bubble (oil, in particular) as an effective run on the dollar, and which was an overwhelming fear of the Fed. I’ve also noted that a subsidized dollar-denominated interest rate (via the Fed) could trigger an anti-dollar carry trade (just like with the Yen) in the event of a stagnant US and an expectation of future devaluation. Indeed, we may already be seeing that, with the Fed subsidizing US and foreign banks to bid up the price of commodities in anticipation of a falling dollar. The key is to get it (devaluation) over with rapidly, so that expectations of future devaluation are limited – otherwise, you can drive a persistent carry trade and capital flight. But who knows what kind of shock that might cause to the system?

    Concomitant with devaluation, we need to demonstrate credible commitment to reduce the trade gap, which is largely fueled by govt. debt, commodities/import dependence, and a weak dollar. (Weakening the dollar helps trade gap in the longer term, but hurts in the short term – that’s the J curve effect. The current account depends on debt flows, so let’s pray we don’t develop a habit to borrow – either publicly or privately – in foreign currency.)

    But the Fed does not believe that the rest of the government can credibly commit to lower trade/govt deficits, and it still likes the idea of keeping the dollar as an international reserve currency (for all the grief that caused), so who knows what will happen. If I knew, I’d be rich.

  62. one more little item to mention – Mr. StatsGuy,
    I admire your dedication to the purity of economics and the hope that can be derived from neutral solutions. But now that I finally had a chance to read the article in the New Republic by Boone and Johnson, I am ever more convinced that a solution is going to have to be able to deal with political and social dynamics that have a strong-hold on the complex administrative structure producing policy decisions that support or generate bubbles. The bubble that is predicted by Boone and Johnson to happen due to financial flows between the US and developing nations is probably going to offset an inflationary bubble as mentioned earlier.

    Dan – Sounds like you might be aware of the discussions taking place to encourage change in accounting methods…? There was an item on this in July Economist issue (the date is on my misplaced copy) but I also found this reference: Of course it appears the same private-political interests will likely interfere with progress…
    p.s. Sorry to go back to this, but I do think that some math might be useful (in future) to better understand bubbles!

  63. SG – fyi – I wrote my last reply before reading your’s – which I plan on reading again since it’s full of food for thought! :)

  64. Stats Guy
    “Wage driven inflation is better, since that drives federal revenue higher.”

    On a more personal less abstract basis am I correct in assuming that wage driven inflation eats into the savings of retirees (i.e. mine)?
    If I am right then it is probably nothing but ausgleichende Gerechtigkeit=equalizing justice that us having high-lived for so long now get to take the greater hit.

  65. Yes we did
    but as for most of my working life wages not only kept up with inflation but exceeded it, public old age pensions, which are coupled to wages, did really fine, probably way too fine due to the creation of an overoptimistic formula – in theory pensions should of course fall, when wage earners incomes fall but as nobody can win elections by angering the seniors they blinked when the formula demanded cutting some years ago – they gave us instead a pause and this year of all years we got a raise – either the world is gaga or I am …

    – savings of the boring kind of course did badly during the years of ever increasing wages – Dalrymple, who I think might be your cup of tea, has some very interesting observations about when it all began to change and what all that change meant for “normal” people’s general attitude to money –

    – I’m not worried about me, it looks like I am to be the last age group who makes it through alright, but it makes me feel uncomfortable when dealing with juniors whose outlook seems to be so much worse than ours was – we were much much poorer at the start but it went up and up and up all the time

    – during my last years I could practically feel the apprentices I had thinking “how long is this Grufti (Gruft=tomb, vault, crypt – Grufti its inhabitant) going to keep this job out of reach for me” and then they got doubly cheated because by the time my job was available to them it had become labelled down to suitable for – yes – “hirnamputierte Knöpfchendrücker” with equivalent wages while during their waiting time for my job my easing out of the work-place was partly financed through taking money out of what should have been their social security pot – the only winner in the whole shamble were the big corporations who were helped in laying of old workers with quite a discount.

    so in short – through no fault of our own we did better by the seniors of our time than the juniors of today will be able to do by us. Let’s just hope that that will not seed more conflict

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