17 November 2008

The Only Cure for a Bubble...

I commend Judy Shelton for her insightful op-ed piece, “Stable Money is Key - How the G-20 can rebuild the ‘capitalism of the future.’” It was published in this morning’s Wall Street Journal, a day ahead of “The G20 Summit on Financial Markets and the World Economy.” As Ms. Shelton noted: “One thing is guaranteed: Most attendees will take the view that Wall Street greed and inadequate regulatory oversight by U.S. authorities caused the global financial crisis -- never mind that their own regulatory agencies missed the boat and that their own governments eagerly bought up Fannie Mae and Freddie Mac securities for the higher yield over Treasurys.”

She continues: “At the bottom of the world financial crisis is international monetary disorder. Ever since the post-World War II Bretton Woods system -- anchored by a gold-convertible dollar -- ended in August 1971, the cause of free trade has been compromised by sovereign monetary-policy indulgence. Today, a soupy mix of currencies sloshes investment capital around the world, channeling it into stagnant pools while productive endeavor is left high and dry… If we are to ‘build together the capitalism of the future,’ as Mr. Sarkozy puts it, the world needs sound money. Does that mean going back to a gold standard, or gold-based international monetary system? Perhaps so; it’s hard to imagine a more universally accepted standard of value.”

As much as I find the notion of sound money and a new gold standard international monetary regime appealing, neither will be part of any solution coming out of Washington or the G20 this weekend or anytime soon. Fundamentally, our nation has only a sliver of bullion available to back tens of trillions in financial claims that are the crumbly bedrock for the entire global financial system. But this is a moot point. The world may today disagree somewhat on how to parcel out blame for international monetary disorder, resulting in the worst financial crisis since the Great Depression, but there exists a consensus that concerted reflationary measures are the only possible solution.

There is little prospect that the direction of global policymaking will engender the return of stability anytime soon. As Ms. Shelton adeptly notes, “In the absence of a rational monetary system, investment responds to the perverse incentives of paper profits. Meanwhile, price signals in the global marketplace are hopelessly distorted.” To be sure, the market pricing distortions that for years empowered Wall Street finance and the GSEs these days ensure that the U.S. Treasury borrows and spends in egregious excess.

I think often of the great economist Dr. Kurt Richebacher. My analytical framework was over the years heavily influenced by his writings and mentoring. He would always say, “The only cure for a Bubble is to prevent it from developing.” Today’s crisis confirms the brilliance of Dr. Richebacher’s work. At the other end of the spectrum, conventional economic doctrine is revealed as shallow and fatefully flawed.

I have repeatedly pointed to Milton Friedman’s analyses of the causes behind the Great Depression as the keystone for our nation’s deeply flawed economic perspective. By the 1960s’, there was an eagerness to cast blame for the Depression on policy mistakes made in 1929 and subsequent to the crash. The depression, it was determined, was not due to any weaknesses or vulnerabilities associated with the Credit system or market pricing mechanisms. Instead, the 1920s were conveniently recast as the “golden age of Capitalism.” Over the years, Dr. Bernanke has repeatedly excoriated the “Bubble poppers” for their principal role in instigating the thirties downturn.

Those of us who have studied the nature of the financial and economic maladjustments engendered during the rampant Credit excesses leading up to the ’29 crash take serious exception. Indeed, the Friedman/Bernanke/conventional view of that historical Bubble and bust has been a most dangerous case of historical revisionism and flawed analysis. I am more interested today in working to change failed economics than fingering blame for the crisis on our public servants working desperately to avert collapse.

It is in this spirit that I am compelled to defend Hank Paulson and his team at Treasury. The severity of today’s crisis is not the result of policies – good, bad or otherwise – implemented over the past few months. The greatest Bubble in the history of mankind – nurtured by decades of flawed economics, flawed finance, flawed policymaking and irresponsible behavior throughout – is bursting, and there is little our authorities can do about it. Everyone was content during the boom to buy into the notion of all-powerful Fed reflation and Washington stimulus. We must now come to grips with the reality that the entire framework advocating post-Bubble “mopping up” strategies was specious.

Secretary Paulson has been criticized for “making up the rules as he goes along.” Well, there is no rulebook for resolving this crisis. His policymaking has been faulted – perhaps not undeservingly – for lacking transparency. Yet a more substantive policy issue goes back 15 years: regulators looked the other way and didn’t demand any transparency as the leveraged speculating community borrowed trillions and accumulated massive holdings. Paulsen and Bernanke likely believed that an unprecedented $700 billion government program to acquire securities would provide the backstop bid to help restore market confidence, securities prices, and lending throughout the economy. It simply didn’t work. Yet the system was headed toward collapsed had they not moved aggressively.

The Treasury, Fed, and the marketplace now appreciate that the system faces a multi-Trillion dollar de-leveraging problem - not to mention the issue of new Credit creation necessary to avert economic collapse. The focus has, rightly, turned away from the issue of impaired securities markets to a primary focus on stimulating lending. The hope now is that the economy will receive a much bigger bang for $700 billion bucks if it is used to recapitalize the financial system rather than to acquire securities from distressed sellers. With the securitization markets now essentially lost causes, the last hope rests with a recapitalized and, supposedly, resurgent banking system. The expectation is that $700 billion of additional capital can be multiplied into the Trillions of new loans vital to bolstering the economy going forward. It’s not Paulson’s fault if it doesn’t work.

We are witnessing policymaking out of desperation. Treasury has very limited time and few alternatives, while it confronts dire problems. It has become popular to point out that the marketplace has lost confidence in Mr. Paulson and his team. I believe, however, that it is more aptly stated that the market has lost faith in the prospect of policymaking generally having much influence on developments. This is a consequence, as Ms. Shelton reminds us, of upwards of forty years of “monetary policy indulgence.” Regrettably, G20 policymakers will this weekend focus efforts on global stimulus and pay only lip service to monetary system reform.

Fundamentally, individual participant discipline is the nucleus of any stable international monetary regime, whether it is the classic gold standard approach or a Bretton Woods system type of arrangement. The global abandonment of any semblance of monetary or fiscal discipline is a hallmark of this extraordinary period of bursting Bubbles. Stable “money” may be the key – but it’s also nowhere to be seen.
credit bubble

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