Friday, October 24, 2008

The Federal Government Is Not the Answer to Our Current Financial Mess

A few months ago I dropped couple of posts (here and here) about how our nation’s money policy is at the root of our current financial quagmire. I followed up in August with this post that suggested that the Fed needed competition. I recently ragged on the Fed even more and discussed the concept of competing currencies in more detail in this post and in comment #3 on the post.

Fed Chairman Alan Greenspan’s testimony before Congress the other day was a debacle. In effect he said, “Boy, I didn’t see this coming, but it’s OK to trust my judgment now.” He then went on to blame everyone except government and the Fed for our current economic mess. The Wall Street Journal says:
“The Fed's monetary policy apparently gets a pass. The media and Members of Congress will use Mr. Greenspan's testimony to impugn the very free market principles that the former Ayn Rand protégé has spent his life promoting. It was a painful spectacle to watch.”
The Journal, however, does a good job of showing how the Fed caused or helped cause two financial bubbles, both of which have now burst. “The original bubble was in housing prices and mortgage-related assets, which the Federal Reserve helped to create with its negative real interest rates from 2002 into 2005. This was Alan Greenspan's tragic mistake….”

Bubble number two came at the hands of Greenspan’s successor, current Fed Chair Ben Bernanke. The Journal has some charts depicting the oil bubble and the parallel euro-dollar exchange bubble that resulted from the Fed’s mishandling of the credit panic that ensued after the first bubble burst.

Instead of a solvency crisis, the Fed treated it like a liquidity crisis. They dropped interest rates drastically, injecting masses of new dollars into the system. This caused inflation, especially in oil and euros, as dollar holders worldwide dumped the shaky dollar for more stable instruments.

Coinciding with the run up in oil and foreign commodities was a run up in stock prices, as this chart shows. The chart also provides a good visual of the bursting of the bubble. What this means to you and me is that when our 401k funds looked great at the end of summer last year, they were really just overpriced. That problem has now been corrected. In fact, it has been overcorrected, as revealed by the tail end of the chart (and our 401k balances). The Journal says:
“Commodity prices have now fallen back to Earth, as the reality of global recession hits home and the Fed can't ease much further. Meanwhile, the euro has fallen from the stratosphere as Europe heads into recession and the dollar becomes a safer haven in a world of fear.”
But all is not well (as everyone is painfully aware). The second bursting bubble is impacting commodity prices worldwide. Emerging markets “such as Russia and the Persian Gulf countries” are being hit hard. And with the precedent of government bailouts now set, other industries such as auto manufacturing and ethanol production have lobbyists plying the Beltway crowd like sharks swimming in chum, looking for similar favors.

The bizarre thing is that most political movers and shakers seem completely oblivious to the real causes of the current crisis: federal meddling in housing markets and “Reckless monetary policy that did so much to create the credit mania and then compounded the felony with a commodity bubble and run on the dollar whose damage is now becoming apparent.”

I have heard and read many arguments in favor of strong central banks, such as this one and this one. Even many self-styled free market supporters have argued passionately for a strong central banking system. But in light of all of the mischief caused by our central bank of late, it’s difficult for me to swallow. FA Hayek’s observations seem much more appropriate at this juncture. He noted that government control of money has caused much worse problems than anything ever seen with private money.

As Alan Greenspan, Ben Bernanke, a host of financial gurus, big business types, and most of our federal politicians urge us to look to Washington DC for salvation from our financial woes, perhaps it would be wise to realize that these are the same people that caused the crisis in the first place. Looking to them for solutions is akin to an abused wife seeking a non-abusive relationship from her abusing husband.

In other words, now is the optimum time to be looking for financial solutions outside of the federal political class and its fellow travelers. Competing currencies anyone?


Jason The said...

In order to pin the blame on "federal meddling" one must completely ignore the irresponsibility of private lenders, who made up over 80% of the securities lending that created the crisis, and also the fact that the markets did not - at least in this case, obviously - self correct as free market thinkers tell us they will.

Scott Hinrichs said...

Who said that big finance was not fully complicit in this mess?

Scott Hinrichs said...

In fact, Fred Smith of FedEx has some interesting insights about this here. He notes that part of the problem is a tax structure that favors the finance sector and punishes manufacturing and other asset intensive businesses.

He also says, "Rather than in our business where you have to have a dollar of equity for, 10 cents or 15 cents of debt, it's exactly the opposite in the financial sector where you have one dollar of equity for 10, 25, 50 times risk. Things became so flipped upside down, the assets at these banks became the liabilities and the liabilities became the assets. These people were making these fantastic returns ... but in reality they weren't adding a lot of value. I have said time and again that there is a fundamental tendency in good times in the financial sector to over-leverage. Our national policies actively encouraged all this debt."