WHAT’S A FREE MARKETEER TO THINK? Volume 6
Nearly a dozen days ago now, and in response to our nation’s financial emergency, I invited think tank and other colleagues from around Minnesota and the nation to address the question: “What’s a free marketeer to think?” What follows is installment Number Six of the ongoing series: three new columns, bringing the running total to 23. Please note they were all written before the House of Representatives passed, and President Bush signed, legislation earlier today aimed at alleviating crisis.
I extend my thanks this time around to American Experiment’s Peter J. Nelson; Robert P. Murphy of the Pacific Research Institute in California; and Matthew J. Brouillette of the Commonwealth Foundation in Pennsylvania.
The Center will continue publishing varied and provocative pieces like these as we receive them through next week.
Many thanks, I welcome your comments – and whether today’s actions in Washington have calmed you down a bit or agitated you even more, may you have a good weekend.
Found & President
Center of the American Experiment
The 2000s in Retrospect
By Peter J. Nelson
Way back in January 1997, Paul Volcker, chairman of the Federal Reserve from 1979 to 1987, led an FDIC-sponsored panel discussion on the 1980s banking crisis with Carter H. Golembe, the head of a banking research and consulting firm until 1989; William M. Isaac, chairman of the FDIC from 1981 to 1985; and John G. Medlin Jr., CEO of Wachovia Corporation from 1976 to 1993.
In his introduction, Volcker complained that the title, “The 1980s in Retrospect,” instead should have read “Lessons for the Future.” The panelists indeed offered lessons for the future — most of which have been ignored. Many of the lessons would seem grist for a panel discussion in 2017 or thereabouts about the 2000s in retrospect. But the first decade of the century is still not over and maybe some of the lessons can be applied to our current crisis, most notably in regards to the current debate over marked-to-market accounting. (“Marked-to-market” accounting rules force banks to use the current market value of their mortgage-backed securities on their balance sheets, which critics complain sets values too low because it neglects long-term returns.)
The following quotes speak for themselves:
Carter Golembe. “[T]he [FDIC] crossed its own Rubicon in 1972 with a loan to the first billion-dollar bank to face failure [the Bank of the Commonwealth in Detroit], offering as justification, among other reasons, ‘the effect its closing might have had on public confidence in the nation’s banking system.’ This was the beginning of the present ‘too-big-to-fail’ program, although the FDIC had in fact long been following a policy of attempting to treat every bank in difficulty, regardless of size, as ‘too-big-to-fail.’”
Paul Volcker. “I agree with [the decision for the FDIC to assist in keeping Continental bank open.] . . . . But, in fact, it had a big effect — that was the precursor of a lot of protection that happened afterwards. I can remember looking at television when I was out of office in 1990 and 1991 and 1992 — and it would be in the press every day — that so-and-so bank or savings and loan was close to insolvent and failing, and nobody seemed to care. Even when you had headlines about the weakness of an institution no depositors moved their money because they had been convinced that the government was going to take care of everything, so you had no market discipline. It drives the lesson that has been described here over and over again. How do you get some balance between the rescue and retaining some discipline? I don’t know whether we yet have the right answer.”
2. The FDIC
Bill Isaac. “I don’t think [the FDIC] should be in the regulatory business. I was willing to give up the FDIC’s regulatory powers when the Bush Task Force was deliberating these issues. I don’t believe it matters to the FDIC whether a bank opens a new branch or not, and I don’t think it matters to the FDIC whether a bank is in compliance with [the Community Reinvestment Act] and other such things. I don’t believe that the FDIC ought to be dealing with anti-trust issues on mergers and the like. I believe firmly that this agency needs to be focused on the forest, not the trees.”
Carter Golembe. “[N]ot all deposit insurance systems in this country have relied on an insurance fund. The two most successful, in Indiana and Ohio — 30 or 40 years in each case — before the Civil War were the most successful insurance we ever had. They did not rely on a deposit insurance fund. They relied on cross guarantee by the banks — Indiana, for example, did not have a bank failure in 35 years.”
3. Increasing the FDIC’s deposit insurance limit
Bill Isaacs. “One of the ideas that we thought made a lot of sense was the subordinated debt idea. We wouldn’t necessarily increase capital requirements, but we would mandate that some portion of it be in subordinated debt so that you would have sophisticated creditors overseeing banks and deciding who could get subordinated debt at what price and who couldn’t. I thought it made a lot of sense at the time. The reason why we thought it was an interesting idea was because we thought that other changes to the deposit insurance system were not in the political cards. It was unlikely that Congress, having increased the deposit insurance limit to $100,000 two years earlier, would reduce the deposit insurance limit below $100,000 again. So, why not go ahead and concede defeat on depositor discipline and try to impose it through sophisticated creditor discipline. I think it made sense at the time, and I think it still could make sense today.”
4. Bundling mortgages
John Medlin. “Also, and it is probably more popular now than back in the ‘80s, problems can arise from syndication or selling out pieces of loans, where the syndicator takes a nice fee for putting it together, but sells it off and keeps very little risk. A ‘syndication’ is sometimes characterized as a transfer of risk from someone who lacks courage to someone who lacks knowledge. There is an enormous amount of that going on today; most smaller banks do not have the capability to assess the syndicated risks they are putting on their books.”
[Note: “Syndicating loans” is different than “bundling subprime mortgages,” but they share very similar shortcomings: The originator of the loan generally does not own the loan, which makes Medlin’s comment quite relevant to the current crisis.]
5. Marked-to-market accounting standards
Paul Volcker. “I think, pushed to an extreme, [marked-to-market] is nonsense for a bank. The idea that we have to be so precise about marked-to-market accounting for an institution that is supposed to take liquid funds and transform it into something longer, while we tolerate enormous uncertainties in accounting on other parts of the balance sheet and in industry generally, doesn’t make sense to me. An accounting profession that will tolerate company after company taking large accounting losses for prospective events or to account for past losses that didn’t appear on the balance sheet the day before, and doesn’t blink an eyelash, shouldn’t worry too much about marked-to-market accounting, in my opinion.”
Bill Isaacs. “But if we had marked-to-market accounting back in that period, and if we had wanted to, we could have closed every savings bank in the country at a cost to the FDIC of tens of billions of dollars. That is what the numbers were. We had it documented in the savings bank task force. So, we could have shut them all down, marked-to-market, and spent tens of billions of dollars. I say the social cost of that would have been inordinately high.”
Bill Isaacs. “But I think doing everything by the numbers without discretion is a mistake. People keep on pushing for marked-to-market accounting, prompt corrective action and the like, and the next time we have an ag-bank crisis or a savings bank crisis or an LDC debt crisis, I think we are going to regret we have those laws on the books. I think it is going to tie the regulators’ hands in a way that is going to precipitate a crisis, that could otherwise be avoided.”
John Medlin. “Market value accounting — it has its virtues, but at the same time, it is a problem in times of stress when you have to market at the worst possible condition when if you could disguise it for awhile, things would be okay.”
6. Big picture lessons
John Medlin. “We’ve talked a lot about public policies and to boil the problem down in a [two-part] one-liner: What we had, and to some extent what we still have, is the democratization of credit; the democratization and liberalization of credit to everyone, cheaper credit, more liberal credit. But in the final analysis, the socialization of the risks underlying that credit falls ultimately back on the people. We have some other things like that — we have Medicare and we have Social Security which are actuarially unsound and ultimately will cause problems and deposit insurance is not a problem as long as times are good. It is only when we have unusual times like the ‘80s that it becomes a problem.”
John Medlin. “Management practices — banking can’t blame public policy, can’t blame the economy really for its problems. It can blame itself for failing to exercise proper private sector disciplines. We should have learned to expect public policies not to be very smart; in most times, very politically driven, very expediently driven. In the management side of this equation, we had competition in laxity. Unfortunately the dumbest and weakest competitors in the marketplace set the basic standards of pricing and credit terms.”
Bill Isaac. “When you have a massive collapse of the real estate industry like we had on the heels of the S&L crisis and the tax law changes and everything else, you’re going to have some bank failures. You can’t prevent that. All you can do is try to contain them and spot some of the trends before they get too far out. I also think it is a regulator’s job to lean against whatever wind is blowing at the time. If everybody is doing really well and they are putting on a bunch of loans in real estate, that is the time to be saying, I wonder why they are putting on all those loans in real estate — maybe we ought to be taking a much closer look at it. That is very tough to do — to go into a major bank before it has obvious problems and say, you guys are making a lot of real estate loans and we are really worried about it and we think you ought to slow down.”
John Medlin. “I think our greatest lesson from the ‘80s would be complacency, and probably our greatest risk today is complacency. Everything is wonderful; the economy is wonderful; public policies have gotten better in many respects, but have managements learned their lessons?”
For the full text of this prescient panel discussion, see http://www.fdic.gov/bank/historical/history/vol2.html
Peter J. Nelson is a policy fellow with Center of the American Experiment.
Let Entrepreneurs Fix the Problem Government Made
By Robert P. Murphy
As the financial crisis intensifies, we hear ever more claims that emergency times justify government measures unthinkable a mere 14 months ago. Even some libertarians, who would cry foul if a third world dictator nationalized an industry, are calling for the government to take equity positions in major financial institutions.
Worst of all, an ostensibly conservative Republican administration is seeking to subordinate the capital markets to the whims of one man, Henry Paulson. In this Orwellian climate, genuine free marketeers need to take a deep breath and remember their principles.
Economic theory and historical practice have demonstrated beyond any doubt that decentralized free markets outperform centrally planned economies. Beyond the issues of incentives and corruption, there is the knowledge problem stressed by Friedrich Hayek: it is no use searching for just the right experts to put in charge of running entire industries, because such omniscient people do not exist. Only in an open, competitive marketplace can rival firms discover the cheapest ways to deliver superior products and services to consumers. Businesspeople make mistakes all the time, but the profit-and-loss test weeds out the bad entrepreneurs and allows the successful ones to gain more influence.
Many, if not most, policy analysts would agree that capitalism is a better social arrangement than socialism, and that free markets provide sustained economic growth showering prosperity on all citizens. Yet for some inexplicable reason, many of these same analysts lose all faith in the power of markets during times of crisis. All of a sudden, even many cynical right-wingers – let alone the liberals – believe that 535 people in Washington D.C. know better than legions of financial professionals in New York and Chicago. Yet this is just one of many contradictions in our current crisis.
For example, we are told that the housing boom was caused by cheap credit and lax oversight, where greedy lenders made it too easy for unqualified applicants to receive loans. But at the same time, we are told the limits on Fannie and Freddie, as well as the FDIC, must be relaxed, and that taxpayers must spend $700 billion in order to “unfreeze” the credit markets; that is, to get easy credit flowing to borrowers as it has been in the recent past.
We are told that the government must enact bold measures, lest we relive the Great Depression. Yet at the same time, we are told that the measures we need to take are precisely those adopted by Franklin Roosevelt in the 1930s. Indeed, this is why so many news articles over the last year have included variations of the phrase, “a government power not used since the New Deal.”
Prior to the Great Depression, economic downturns in the United States were relatively quick, typically lasting 18 months or so. The worst was the depression starting in 1893, which lingered four or five years, depending on the economic historian. It was under the New Deal – when the federal government adopted unprecedented measures to prevent business failures and to prop up wages – that a sharp initial downturn endured for a decade. When Roosevelt took office in 1933, unemployment stood at a staggering 24.9 percent. And yet, despite claims that Roosevelt “got us out of the Depression,” the unemployment rate was still 19 percent five years later in 1938.
Poor government policies, including very low-interest rates and efforts to promote mortgages for unqualified applicants, contributed to the housing boom of the mid-2000s. And after the government contributed to the problem, its efforts to fix things are even worse. For example, hundreds of billions in corporate welfare to bail out overleveraged financial institutions will only ensure that they take unwarranted risks in the future as well.
Resources were misallocated during the credit bubble, and the economy needs a period of liquidation before its normal growth can resume. Policy analysts, above all those who claim to support the free market, should tell the government to stop meddling with the correction and instead let private-sector entrepreneurs fix the mess that the politicians made.
Robert P. Murphy is a Senior Fellow in Business and Economic Studies at the California-based Pacific Research Institute and author of The Politically Incorrect Guide to Capitalism (Regnery 2007).
Marx was Right (Groucho, that is)
Matthew J. Brouillette
Washington’s response to the current financial trouble is affirming Groucho Marx’s definition of “politics”: “The art of looking for trouble, finding it everywhere, diagnosing it incorrectly, and applying the wrong remedies.”
To be sure, we are in a financial mess. Too many banks lent money to credit-risky consumers they shouldn’t have lent money to, and too many consumers borrowed more money than they could afford to borrow. But the remedies being proffered by our politicians will likely miss the mark, once again.
Why? The very people who created our current problems think they can now solve it by doing more of the same. Indeed, politicians who have consistently used the heavy hand of government in our economy are claiming that more government intervention and manipulation of the market is the solution. They want us to believe that throwing more gasoline on a fire will put out the flames.
The reality that most in Washington, D.C. refuse to acknowledge is that our current financial woes are a direct result of the federal government’s encouragement and financial backing of poor lending practices. Through a variety of political decisions by both Democrats and Republicans – including loose monetary policy, the Community Revitalization Act which forced banks to loan to credit risks, and using Fannie Mae and Freddie Mac to encourage subprime loans – the fundamental cause of the current crisis has been government created.
It is equally important to recognize that our market economy is not to blame for this mess. Many politicians, like House Speaker Nancy Pelosi, have erroneously focused their criticism on capitalism, claiming that the problem is the result of “no regulation, no supervision, no discipline.” Although such rhetoric may sell on the campaign trail, it denies the fact that the current trouble is occurring in one of the most heavily regulated and supervised sectors of the financial industry. Indeed, Fannie Mae and Freddie Mac couldn’t have been any more of a government regulated and supervised entity, yet it still collapsed.
But instead of allowing the banks who made bad decisions to fail and consumers who borrowed more than they could afford to take personal responsibility, politicians will further distort the economy. It will be the fiscally prudent banks that will eventually be over-regulated and the credit-worthy consumers who will ultimately pay the price.
There is no pain-free choice. The choice isn’t about whether or not we will experience some financial tragedies, but whether or not we believe that the same government actors who significantly contributed to the problems we face today can actually come up with the solution. Chances are they won’t.
We must recognize that comparisons to the Great Depression are greatly exaggerated. As Allan Reynolds of the Cato Institute points out, “we have had little more than a dozen bank failures this year compared with more than 5,000 in the 1930s, and nearly 3,000 in the 1980s.” Even more important is that the failure of those banks occurred after government “did something” – namely, increased taxes, increased tariffs, and created the Reconstruction Finance Corporation.
The only appropriate analogy to the events before and after the October 1930 collapse is that President Bush, like President Hoover, plans to heavily intervene in the economy. Bush, like Hoover, is criticized as having been a hands-off, market-oriented, do-nothing president. But the historical record has shown that both presidents have been strong government interventionists rather than free market advocates.
Politicians have a horrible track record of being effective economic planners. We shouldn’t allow government to spread losses to the rest of the economy.
What, then, should government do?
The answer is to embrace free-market solutions and allow the market to ferret out the bad actors and the bad debt in the marketplace. There are a number of proposals that would do this, including altering current accounting regulations such as “mark-to-market,” lowering taxes on investments, and privatizing Fannie Mae and Freddie Mac. These are a few policy changes where government can “do something” without doing damage.
Unfortunately, panicked politicians are running away from these solutions. They are instead proving Groucho Marx was right by incorrectly diagnosing the problem and applying the wrong remedies.
Matthew J. Brouillette is president and CEO of the Commonwealth Foundation in Harrisburg, Pennsylvania.