THE FED | Moral Hazard

Paul Volcker

Wall Street on Parade in recent years has been playing the role that the Pecora Committee played in 1933.

Ferdinand Pecora was hired as general counsel to the Senate Banking Committee to investigate the causes of the 1929 Crash. His hearings in 1933 revealed many practices that tilted the financial marketplace against small investors. He laid the groundwork of public opinion to ensure passage of the Securities Acts of 1933 and 1934.

In the process, the testimony that Pecora extracted injured the reputations of many Wall Street leaders and their friends. Some practices were illegal. Others were attacked with the benefit of hindsight, in the new light of the Crash of 1929. What seemed normal in 1929 had become unethical or unfair... and with the new laws would become illegal.

Today's installment of Wall Street on Parade by Pam Martens and Russ Martens looks at the Latin American financial crisis of the early 1980s and cites from the transcript of the FOMC meeting of June 30, 1982 to examine why the Fed approved a loan to Mexico of $700 million. Mexico owed U.S. banks $21.5 billion. The Fed bailed out Mexico to bail out the banks that had loaned money to Mexico.

In an interview published in the fall of 2013, Harvard Professor Martin Feldstein asked former Fed Chairman Paul Volcker whether the high interest rates of the early 1980s caused debt problems in emerging economies. Volcker responded that U.S. bank loans were of great concern to his predecessor as Fed Chairman in the 1970s:

Arthur Burns, to his credit, was the Paul Revere on this thing. He'd go around and make speeches: "This can't continue. ... We've got to do something about it." The borrowing continued until the winter [1981-82] when a couple of banks stopped lending. Mexico ran out of money. What do you do? [my emphasis]... The big US banks and some of the big foreign banks had more exposure to Latin America than they had capital. It wasn't something you could just say: "Okay, knock off the loans by 50 percent or something and everybody will be happy." They all would have been bust. You look for other approaches, and it took nearly a decade until Mr. Brady [Nicholas Brady, Treasury Secretary, 1988-1993] came along and settled them [Brady bonds replaced Latin American debt, paying lower rates or reducing the face value, but with greater certainty of repayment].  (Martin Feldstein, "An Interview with Paul Volcker, Journal of Economic Perspectives, 27:4, Fall 2013, pp. 112-113.)

Wall Street on Parade argues that the too-big-to-fail attitude, on view in 1982, was behind the Fed and Treasury response to the financial crisis of 2007-2009.

These issues go back to the earliest years of the Fed. Founded in 1913, the Fed published a statement of its policy intentions in 1924, in its Tenth Annual Report in 1924. It announced that it would seek to encourage "productive" loans and discourage "speculative" ones. As loans to purchase securities rose the following year, the Fed tightened money. Benjamin Strong in 1927 complained about the tightening. Concerns about productive lending were shelved that year in favor of expansionary monetary policy - the Fed purchased government securities to add to liquidity.

When the Fed tightened again in 1928, it created the disastrous crisis of 1929-30, and the expansion of 1927 was viewed as the root cause. When banks started to fail, the Fed often refused to lend to them. Not until April 1932 did it expand the money supply, and this ended by August. Julio Rotemberg, "Shifts in US Federal Reserve Goals and Tactics for Monetary Policy: A Role for Penitence?", Journal of Economic Perspectives, 27:4, Fall 2013, 67-69.

Thus a "too-big-to-fail" attitude emerged from the panics caused by a tough line on the banks in 1929-32, which was motivated by a reaction to the expansion of 1927. The "too-big-to-fail" idea creates moral hazard, as Wall Street on Parade notes. As long as that is not addressed, speculative lending will grow and the global financial structure remains shaky.

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Enough "Blood on the Streets"?

How low can the market go? In 1815, Nathan Rothschild said that the time to buy stocks was "when there is blood on the streets". Are we there yet?

The Great Depression lasted a decade but the Dow industrial index fell 89 percent from its high of 381 on September 3, 1929 to its low of 41 on July 8, 1932. The economy remained sour for the rest of the decade but the stock market picked up.

For the enthralling story of what happened during those years, I recommend chapters 17-20 of Liaquat Ahamed’s timely Lords of Finance: The Bankers Who Broke the World. I had the pleasure of listening to Liaquat talk at a recent evening event in New York City. He modestly disclaimed knowledge of the financial disasters that were going to happen and simply said that the Time magazine cover showing Robert Rubin, Larry Summers and Alan Greenspan with the caption “Committee to Save the World” suggested to him the idea for his book. The title reminded him of the name given to the top bankers working on global financial problems after World War I, “The Most Exclusive Club in the World.” The book studies the origins of the Great Depression that is clearly told by taking the different perspectives of the four leading actors of the period, the Lords of Finance -- Montagu Norman in the UK, Benjamin Strong at the New York Fed, Hjalmar Schacht in Germany and Emile Moreau in France.

Yesterday’s stock-market drop brings us to a cumulative decline that can only be compared with the 1930s. Fearful of today’s jobs report, investors drove the major U.S. stock averages down 4-7 percent. Jack McHugh has tallied from StockCharts.com how far down this took the markets from their peaks.

I think we can all agree that what ails our economy and markets is worse than anything since that awful time [the Great Depression], and the worst punishment Mr. Market has meted out since the 1930’s was a drop in the S&P 500 of just less than 50% (1974 & 2002).

The cumulative drop from their peaks (October 11, 2007 so far is:
Dow Jones Industrial Average — All Time High: 14,198. March 5 - Down 53.6% to 6594.
Standard & Poor’s 500 — All Time High: 1576. March 5 - Down 56.7% to 683.
Russell 2000 — All Time High: 856.50. March 5 - Down 59.2% to 349.45.
KBW Bank Index (BKX) — All Time High: 121.16. March 5 - Down 84.3% to 18.97.

Barry Ritholtz’s blog provides this list of Blue Clip penny and under-$10 stocks:
AIG (39 cents – less than it costs to mail a letter). Citigroup (98 cents). E*Trade (66 cents). Fannie Mae (39 cents). Freddie Mac (39 cents). Unisys (37 cents). Ford ($1.83). GM ($1.83). Las Vegas Sands ($1.97). MGM ($1.99). CIT ($2). Kodak ($2.50). Bank of America ($3.15). New York Times ($4.00). News Corp ($6.15). Xerox ($4.36). International Paper ($4.22). Alcoa ($5.55). GE ($6.75). Dow Chemical ($6.56). Wells Fargo ($7.95). Dell ($8.50).

In terms of timing, the Dow peaked before FDR came to office – before he was even elected. So the fears are lingering longer than they did then.

In what ways are markets and economies possibly worse off than in 1932?
- Expectations are higher because billions of people in the developing countries who were anticipating joining the global economy are seeing their hopes dashed. The 1930s effects were severe but were concentrated on the industrialized countries. The potential for instability in some countries is great and the proliferation of weapons makes this scarier than it would have been in the 1930s.

- The size of the credit overhang is much larger. The gold standard, for all of its faults in extending the distress in the 1929-33 period, kept a lid on the growth of credit. Today’s system has no natural limit to credit growth. Credit-market exposures today exceed GDP – in the United States by 50 percent, estimates Liaquat, in the UK by four times, and in Iceland by eight times GDP.

- In the world’s second-largest economy, Japan, the stock market has fallen 81 percent from its peak at the end of 1989. This 20-year decline raises questions about how quickly the world's current mess can be cleaned up.

DEPRESSION | Was the Fed the Cause? Or Property Speculation?

Friedman and Schwartz,
Monetary History of
 the U.S., 1963.

February 23, 2009–In the 1950s, the cause of the Great Depression was attributed simply to 1920s over-buying of real estate, with Florida as the poster state.

Subsequently, monetarist economists have put the blame on blunders by the Federal Reserve System, which was adrift after the death in 1928 of its able New York Bank President, Benjamin Strong.

Milton Friedman and Anna Schwartz demonstrated that the Fed was selling government securities instead of the more logical counter-deflationary action of buying them.

The Fed was therefore said to have taken liquidity out of the financial system and to have kept interest rates too high for recovery in the 1930s.

Making the Fed the culprit has contributed to a complacent feeling that the Fed knows so much now that the Depression couldn't happen again. The problems of the Japanese financial system since 1990 have been brushed off (e.g., by former Fed Governor Larry Meyer) as indicators that the Japanese response to a downturn was just too slow and too timid.

Polly Cleveland has recently reasserted the older version of the story, namely that the Depression was primarily a reaction to the 1920's real estate bubble. It began with the production of cars in 1899, which grew exponentially (with just a two-year interruption for World War I) until a peak of 4 million cars in 1929.

The auto suddenly opened up vast suburban and rural areas to housing. Developers—legitimate and bogus—leapt at the opportunity. Banks jumped in too, creating so-called "shoestring mortgages", effectively allowing property purchases on margin. Within a few years, tens of thousands of acres around major cities had been subdivided and sold. In rural areas, developers bought up farms, dug a pond, built a "clubhouse" and sold cheap "vacation" lots. As reported in Homer Hoyt's classic One Hundred Years of Land Values in Chicago, from 1918 to 1926, Chicago’s population increased 35 percent and land values rose 150 percent, or about 12 percent a year.

Land values tapered off in 1926, then fell. After 1929, home construction and car production collapsed. In Chicago, by 1933 land values had fallen some 70 percent overall; peripheral areas fell even more. U.S. auto production did not regain the 4 million level until 1949. Housing production did not pass the 1926 peak until 1950. Cleveland continues:

Around Detroit, more than 95 percent of recorded lots were vacant as of 1938. Nationally, the number of vacant lots rose to 20-30 million, compared with about 30 million occupied housing units. According to economic historian Alex Field, the barren subdivisions ringing the cities hindered the recovery of construction: Missing titles of defaulted owners and poor physical layout created de facto brownfields.

The real estate bubble helped set off and then worsen the Depression. Collapsing land values left people suddenly much poorer, so they cut spending. They also defaulted on mortgages, sticking the banks with "toxic" assets: liens on near-worthless property. The struggling banks in turn cut off lending even to good customers. Bank runs—panicky depositors withdrawing cash—further crippled the banking system.

Cleveland compares the innovation of the automobile with the innovation of collateralized debt obligations. Both started off innocently enough (securitization of housing debt was a good idea when properly monitored), but ended up setting off destructive real estate bubbles.

What we have found out is that the downside of the business cycle is not necessarily more under control than it was in the 1930s.

FINANCIAL CRISIS | Missing Minsky

Dec. 27, 2008–Martin Wolf, at FT.com, wrote on December 24 that Keynes offers us the best way to think about the financial crisis:

We are all Keynesians now. When Barack Obama takes office he will propose a gigantic fiscal stimulus package. Such packages are being offered by many other governments. Even Germany is being dragged, kicking and screaming, into this race. The ghost of John Maynard Keynes, the father of macroeconomics, has returned [and] that of his most interesting disciple, Hyman Minsky.

Hyman Minsky

I first heard Hy Minsky talk in the 1960s. His main message was:

1. Financial systems have a built-in tendency to euphoria. The financial market does not tend toward stability. The opposite is true. Bankers and other financial actors borrow more and more heavily, making the system increasingly vulnerable to panic. Lenders start after a scare by being conservative, hedging their bets. But eventually confidence returns and speculation takes hold again. Then investors get to the Ponzi phase – manic use of credit, a euphoria or bubble.

2. The credit cycle tends to manic, but ends with panic. The Ponzi phase continues until some investors exit with their profits, or the central bank raises interest rates to reduce investor euphoria, and then a financial institution runs into difficulty. The failure causes a bankers' panic. Turning points in the five stages of the cycle are called “Minsky moments”.

3. The system tends to instability and must be regulated. Fashions in monetary theory have moved from a belief that Keynesian sophisticates could “fine-tune” the economy, to fear that the Fed had lost control of the ability to contain inflation, to a belief that markets work best with minimal interference. Hy rejected all these ideas, preaching consistently about the need for regulation and the importance of leaning against the excesses of what Keynes called the animal spirits of investors.

Born in Chicago, Hy taught at Brown, Berkeley and Washington University (St. Louis). He died 12 years ago in Rhinebeck, 77 years old, near Bard College’s Levy Institute, which has a special interest in business cycles and treated Hy as a star in his last six years. Hy didn’t live to see how closely this year’s meltdowns would follow his predicted scenario, with the Lehman failure being one of several clear Minsky moments.

Former Fed Governor Laurence Meyer, who spoke in New York City last week, has said of Minsky: “few have influenced my thinking about economics more than Hy.” If Hy had been listened to, we would have seen less permissiveness, fewer NINJA (No Income, No Job nor Assets) mortgage loans and more aggressive Federal Reserve and SEC oversight over highly leveraged instruments and institutions.

Fed Chairman Alan Greenspan and then-Governor Ben Bernanke were anxious not to “pop the bubble” because (citing the Milton Friedman-Anna Schwartz history) that’s the mistake the Fed made in 1928 - after the guy who knew what he was doing, FRBNY chief Benjamin Strong, died of TB. The Fed was concerned not to stifle financial innovation, arguing that it is ready with new weapons in the event of an asset-destroying credit freeze.

This last theory is now being tested. The stakes are high, beyond an academic debate. Whatever side one takes, any sensible person should be rooting for the outgoing and incoming Fed-Treasury teams to succeed in restoring confidence and the flow of credit.