Loose Monetary Policy Fueled Bubbles

Low interest rates, especially negative real interest rates create excessive risk taking because people are forced to reach for yield in order just to stay even with inflation. Look at the situation today and back in the early 2000's with the FED Funds set at 1%. The typical definition for the risk-free rate is the 90 day Treasury bill which closely follows the FED Funds rate. With inflation above 1%, anyone who wanted a safe return would have to guarantee themselves a loss. The only way to keep up with inflation and keep purchasing power is to make riskier investments.

Banks are not the only ones that benefit from low FED Funds rates. Corporate bonds and other financial instruments (such as mortgage bonds) are also affected and receive lower rates too. The higher the quality of the bond, the lower the spread between Treasuries and the bond. Today, highly rated and highly "safe" companies such as Microsoft are able to sell their five year bonds at below inflation. Once again, the investor has to reach for yield in order not to guarantee himself a loss.

Where to go? Humm, junk bonds offered around 7%, and back in the bubble, people couldn't get enough of those bonds. There was so much demand that artificial junk and subprime mortgage bonds were created. That's right, artificial bonds made from credit default swaps simulated the junk and subprime bonds because not enough real subprime and junk bonds were available. Do we see something here? There was so much demand for subprime "high" yielding debt that mortgage brokers were pulling in jobless people and giving them money to buy a home. That is people could get cash out in addition to owning the home!

There was no conspiracy, these loans were widely known and discussed because they were referred to as NINJA loans, no income, no job loans and that name itself should have been enough for any regulator or investor to understand what they were getting into.

Yes there is definitely a psychological side as well. People stopped pouring money into stocks after the tech crash and people are much more risk-adverse today, even willing to accept 0.01% on T-bills which is a guaranteed loss of more than 3% a year with inflation where it is. But I hope that you see how low interest rates create speculation because people are FORCED to take risks that they wouldn't otherwise to protect their savings and assets from being destroyed by inflation. Many people would have been happy getting 5% in a riskless T-bill, which is why the bubble popped right around the time the FED raised FED Funds to 5.25%. It's a complicated system with many feedback loops, but there is no question that loose monetary policy was at the center of the mess.

Argument Against Modern Monetary Theory and the New Keynesians

Can the FED can print all the money it wants to? Not without bad consequences, the ultimate being a Zimbabwe-like collapse of the monetary system.

What is missing from the discussion that of confidence. For the dollar to be an unit of account and store of value, society needs to have confidence that the numbers aren't being fudged, that whatever savings I've built up, my delayed consumption, isn't being manipulated.

Proponents of MMT and New Keynesian economics have pointed out that the government doesn't even need to issue bonds, it could just give itself dollars and spend up to the point where it can purchase 100% of the goods and services offered in the economy. Actually it can't, the monetary system would collapse well before the 100% and people would stop accepting dollars as money because they would have lost confidence in it as a fair and accurate unit of measurement. If even a dictatorship like Zimbabwe isn't able to compel its citizens to accept and use their worthless unit of account, I doubt the US Govt. would be able to.

The reason the government issues bonds at all (that is borrow) is to provide an open and transparent account and to assure the public that the dollar remains a good and fair measurement of the future consumption that they have saved. People want to know that, if they have saved $5 and that can purchase a sandwich at a fast food chain, they will wake up tomorrow and still have a sandwich "due to them" whenever they want it in the future. If they wake up and the $5 in their bank account can't buy them a sandwich anymore, then they know they've been had. Add expected inflation into the mix if you want a more accurate explanation.

When the government borrows money, the public knows that either future government spending will have to decrease, allowing the public to consume more (purchasing bonds is a way to delay consumption to the future), or the public will give up that future consumption in the form of higher taxes. Taxes are very visible and politicians are reluctant to raise taxes without implied consent from the public.

The FED printing money on the other hand, is a stealth tax that is not transparent and is not accounted for. At least with open market operations we can see how much the FED has printed, but as an independent agency that is not directly elected, the people have limited means to control the actions of the FED. No taxation without representation! That's a notion fundamental to our ethos. There are many reasons why FED printing of money and uncontrolled government money creation should be avoided.

Only under a communist dictatorship with an iron grip over society tighter than even Stalin was able to achieve, could government create money like the MMT/New Keynesians advocate. If I have $30000 in my bank account and the government all of a sudden types in $1,000,000,000,000 and posts it to their own account, I know all I've worked for my entire life amounts to nothing. Perhaps this gives a clue as to why people are so pissed off right now and are electing "extremists" like Rand Paul, who seem to understand better than the MMT folks.

Paulson Deserves Praise

Paulson should be commended for making the right moves to get us out of the crisis. Each time, he was ahead of the curve, he asked Congress for TARP before the crisis actually hit the entire financial system, but Congress took its sweet time debating for a week and then voted no. He asked for a lot of new powers, but did it in many increments because there was just no way Congress would consent to authorize all that he knew he would need, at once.

People criticize him for not rescuing Lehman, but don't take into consideration the political impossibility of bailing out both AIG and Lehman at the time. Only after things got worse and people saw the effects of the crisis were they willing to concede that Paulson needed all that power and money.

I say this with all honesty, it's really too bad that people always have conspiracy theories and look through a political filter. Paulson should be thanked for taking the personal abuse and for putting his ego aside and begging Pelosi on his knees, to authorize TARP because he knew that a failure to authorize would destroy the US financial system and cause another depression.

A less competent would not have come up with TARP and understood that he needed a "bazooka", though it was politically impossible to ask for several trillion all at once. A less competent person would have been frozen in fear and asked too little or waited for the crisis to force a move, rather than try and move ahead of the crisis.

For the critics, I ask what he should have done instead? Let's put impossible demands, like prevent the crisis, aside, since he's isn't God and he didn't arrive at Treasury until the bubble was already in full bloom.

Sometimes it saddens me to see so many people so unreasonable and with such a distorted view. If it's on an event that really doesn't matter, then I just shrug it off, but this was a genuine moment where we could have fallen off of a cliff into disaster. That this man is not getting any credit for saving us from another great depression is simply unfair. Was he perfect, no, but he was about as perfect as you can be without the benefit of hindsight and in a crisis without precedence. Give the man the recognition he deserves.

Where Was the Inflation? Right In Front of Your Nose!

I think we need to seriously reconsider the basket of goods used to measure inflation. Intermediate and manufactured goods are becoming cheaper thanks to emerging countries like China and Vietnam. We are in an era of greater manufacturing productivity being passed on in the form of lower costs for manufactured items. So we will not see inflation in this era as long as we measure inflation primarily through manufactured goods.

Commodity, energy, and asset prices, on the other hand, don't benefit from lower cost manufacturing. If the Fed is using inflation as an indicator of whether monetary policy is too tight or too loose, they must understand that the manufactured item category will give them a lower inflation rate than normal thus fooling them into thinking monetary policy is tighter than it is. The Fed should look at inflation ex manufactured items or at least adjust for the China effect that skews the inflation numbers. They are treating current CPI numbers as if they were the same as CPI in the 1980's or 1990's, but the era has changed.

I believe this is why the Fed has adopted a monetary policy far far too loose, because they are being tricked by a natural deflation in manufactured goods due to the entry of China and other emerging markets. If they adjust for these factors, they would see that inflation was out of control in the 2000's, but unfortunately, they did the opposite. Instead of paying attention to food, energy, and asset price inflation and ignoring manufactured goods, they used the CPI ex food and energy as their main measure of inflation. How stupid! Furthermore, a change in the housing component of CPI to owner equivalent rent removed housing asset prices from CPI and replaced it with a non-asset alternative. No wonder they haven't been able to pick up inflation, they've removed everything that can rise in price from the CPI!

Now if someone like me can see this, why are Fed members still scratching their heads over the lack of inflation? It should be obvious by now, and I'm going to give Bernanke the benefit of doubt when he says that he will be alert to inflation and raise rates quicker than the Fed did in the past. So the real key is how commodity, energy, and asset prices behave. Oil and gold are already at elevated levels, the stock market has recovered. Should we see food prices skyrocket as they did during the bubble and oil go back to 100, we will know that inflation is back and out of control again. But should the Fed continue to be clueless and look at CPI ex food and energy, then they will never see the signs of loose credit and they'll never get why their policies are causing bubble after bubble.

Fundamental Causes of the Financial Crisis

As I've learned recently, capital requirements (as in Tier I capital, etc.) are the only limit to lending by banks. But the use of SIVs and off balance sheet subsidiaries allowed banks to escape the capital requirements imposed on them. Even without the SIVs, a "well-capitalized" bank only needs a tier 1 ratio of around 8%!

The capital requirement for Fannie, and other GSEs were even lower at around 3%. Back in 2002-4 when Fannie had an accounting scandal, Congress had a chance to reform and limit the outrageous size of the GSEs, but of course this was defeated. Meanwhile Bush pushed for lower down payment requirements and government subsidies to make housing "affordable for all".

The crisis is almost totally due to bad loans, or loans that are underwater. Had the standard 20% down payment been in place, it would have been hard for the majority of the populace to engage in the bubble. Bubbles can only happen when the mainstream populace participates. The 20% equity would have also cushioned the banks from the majority of losses in my opinion as the peak would have been lower to begin with.

Interestingly enough, we're not the only ones with a housing induced crisis. Australia and Spain are only some of the many other nations that similarly experienced a housing bubble. This leads me to the belief that there is a systematic problem within the global financial network. The problem is that bank lending is not constrained adequately. Furthermore, the low interest rate environment does NOT translate into commodity or consumer good inflation thanks to what the modern financial system has developed into, which is a credit based system.

In this new system, firms or agents first identify an investment opportunity (it can be to build a factory or buy an income producing asset that will generate a greater return than the cost of the loan). Banks then lend to the firm or agent. Notice that the identification of the investment opportunity is step number one, not the lending. With a low interest rate environment, the hurdle to clear for a profitable investment is much lower. Borrowers then borrow to acquire assets. I believe this is why we saw asset and commodity inflation but no inflation in goods and services tracked by the CPI. Firms and agents aren't borrowing to consume, they are borrowing to acquire income assets or building a factory (or store) that produces consumer goods and services to sell at a profit. The new production that comes online keeps prices for consumer goods and services down, but the means of production get bid up. The lower the interest rate, the lower the threshold yield needed for a firm or agent to borrow to acquire or build.

I don't think people understand this new system of finance. This is why people are constantly looking for inflation (as measured by CPI) but finding none except in asset prices (which aren't included in CPI) and can't see the connection between the FED's loose monetary policy and the various bubbles (all asset bubbles) that have popped up. In sum, I identify lax leverage limits and the low interest rate environment established by the various central banks as the underlying causes of the crisis.

Observations on Bubbles

Bubbles are only obvious after the fact. I thought there was a housing bubble, but I also thought we had a bond bubble too when 30-year Treasury bonds were near 5%. It could be that the bond bubble is still ongoing and will pop soon, or next year, or not at all. Gold is another case. I don't think there is a bubble in gold, the heightened attention paid to it reflects the unease people feel towards the ballooning balance sheets of central banks and the unsupportable budget deficits of certain nations. Yet there are others who think gold is pretty much worthless outside its value for industrial purposes. Is gold in a bubble right now? Too hard to say. Should gold drop to $450 then it becomes obvious and we can look back at the gold bubble and blast the idiots who couldn't see something so obvious. Stock market P/E has been higher than average and in bubble mode since the early 90's, yet even after this meltdown we're way higher.

What I think we need to focus on are the types of events or bubbles that can bring down the financial system. This has to do with leverage and allowable risks to our banks. The dot com bubble hurt, but wasn't as damaging as this crisis because banks didn't stand a chance of going under, they were not exposed enough to the bubble to cause a financial system meltdown. However banks are tied to real estate in a much great fashion, here is where a bubble can do great harm.

In the future, we have to make sure leveraged firms don't have their eggs in one basket and that not all firms that are leveraged are exposed to the same risks. Should all banks start lending out cheap money for margin accounts tied to gold, then the price of gold would have a great impact and could cause a crisis like this one. It's the banks and the leverage that is the problem. If we can eliminate the risk of many banks going under at the same time, then we've solved the problem, crises will no longer be as severe as this one.

Large banks should have higher capital requirements, and lower leverage allowances. Smaller banks will have looser requirements, but the regulator needs to see if they are all betting on the same thing and if that poses a danger to the entire system should the bet turn out badly.

Almost forgot, bubbles are almost always the result of easy credit. Bubbles can't form without credit, in every case I can think of, credit was the hidden accomplice, perhaps even the mastermind that causes bubbles. No credit, not enough "fuel" for a bubble to develop. I think we're seeing a lot more bubbles recently because the FED just will not allow credit to contract, they keep on trying to reinflate the bubble, even now there are calls for more loans and credit to be made available. I think the FED's monetary policy is severely flawed, the default rate in normal times is too low and they refuse to tighten until its too late due to pressure to allow good economic times to continue (the economy is always referred to as bad, no matter what, even when we had below 5% unemployment in order to create pressure for more rate cuts). The FED has to break the cycle or we'll have another bubble shortly, the aftermath of reflating the housing bubble.