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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The Great Recession

In his NY Times column today, "Bad News, and More Bad News," Clark Hoyt responds to mail that complains of the NY Times writing too much about bad news. He says: "A newspaper's responsibility is not to be an economic cheerleader, but to maintain a level head and help put the world in perspective for readers.

The theme of Mr. Hoyt's column can't be repeated too often, but I have a problem with the sentence that the Public Editor attributes to Times business columnist David Leonhardt:

"[A]s bad as things are, they are still not as bad as the recession of 1982, let alone the Great Depression."

Does Mr. Leonhardt still say that? If so, I would respond that his comparison between today and 1982, which he based on job-market data, is a case of apples and oranges. The reason for the recession that produced high unemployment in 1982 was Fed Chairman Paul Volcker's brave determination to break the back of inflation. In the process he allowed interest rates to soar.

The 1980-82 recession was painful, but recovery was entirely within the control of the Fed, which simply had to ease credit.

Continuing credit problems today are not the deliberate creation of the Fed, which has--on the contrary--eased the target fed funds interest rate down to the "zero bound". To say that 1982 was worse is like someone suffering an angina attack saying that his heart was worse off right after his triple-bypass operation. Not so, because the surgeons then had the situation under control.

A consensus is growing that this recession is the worst downturn since the Great Depression. It's global. it looks only at U.S. data and misses the full extent of the devastation from the credit freeze. The IMF’s Dominique Strauss-Kahn, said on March 10: "I think that we can now say that we've entered a Great Recession."

Prior uses of the term "Great Recession" (which was applied to earlier recessions) have been collected by Catherine Rampell of the NY Times using Nexis and were quoted by World Wide Words. WWW does not mention the prominent March 1 NY Times Op-Ed by economic historian Niall Ferguson.

On December 5, 2008 the U.S. Federal News Service reported: "Some economists are already calling this 'the Great Recession' because they fear it may be longer and deeper than any recession in recent history." As early as April 2008, Former Wall Street Journal writer Jesse Eisinger predicted in Portfolio that: "The next president will take office during what may well come to be known as the Great Recession."

One year ago, in March 2008, I contributed three posts for HuffPost about the Bankers' Panic of 2008. I was focused on regulatory shortcomings and what could be done about them, rather than the likely economic consequences.

A March 10, 2009 poll reports that 53 percent of respondents say the United States is at least somewhat likely to enter a 1930’s-like Depression within the next few years. The Rasmussen Reports national telephone survey found that 39 percent think this outcome is unlikely. The latest results are more pessimistic than those found in early January, when 44 percent said a 1930’s-like Depression was likely. It will be a big challenge to restore positive “animal spirits”. But the poll may be a sign of “blood is in the streets” –- Main Street as well as Wall Street.