On October 15, Chairman Ben Bernanke delivered a lecture to
the Economic Club of New York, titled, "Stabilizing the Financial
Markets and the Economy."
I am sure the title resonated to members of the Economic
Club of New York, who saw the Dow Jones Industrial Average fall
another 733 points before the day was over.
He began his speech with these inspiring words:
I will focus today on the economic and financial
challenges we face and why I believe we are well
positioned to move forward.
I am reminded of Mort Sahl's comedy album in 1958: "The
Future Lies Ahead." Yes, it does.
I, for one, have no desire to be well positioned to move
The problems now evident in the markets and in the
economy are large and complex, but, in my judgment, our
government now has the tools it needs to confront and
Does he mean that only now does the government have the
tools? Is he saying that for the last sixty years, Keynesian
economists, Chairmen of the Federal Reserve System, and
Secretaries of the Treasury did not have these tools? They said
they did. Were they wrong?
The government has always had the tools by which it has
dealt with the crisis over the last six weeks: taxation,
inflation, and blarney.
It would have been polite of Dr. Bernanke to tell us about
these "large and complex" problems. He didn't. He gave no
indication of a looming crisis so large that it would bring the
international capital markets to gridlock, i.e., "frozen."
Actually, the capital markets were not frozen. I was offered a
30-year fixed-interest mortgage for 5.7% two weeks ago, with 10%
down. Prevailing interest rates revealed no evidence of freezing
up, according to free market economist Robert Higgs.
But without the hoopla about frozen markets, politicians around
the world would not have capitulated to an increase of government
debt of something in the range of $4 trillion in one month.
Our strategy will continue to evolve and be refined as
we adapt to new developments and the inevitable
"Evolve." "Be refined." Translation: "Making this up as we
But we will not stand down until we have achieved our
goals of repairing and reforming our financial system
and restoring prosperity.
"Restoring prosperity." Yes. Yet somehow I do not recall
that Dr. Bernanke, President Bush, or Henry Paulson ever admitted
before that we had lost our prosperity. As I recall -- I am
getting older -- they all insisted repeatedly that there was no
recession at all.
As in all past crises, at the root of the problem is a
loss of confidence by investors and the public in the
strength of key financial institutions and markets.
A lack of confidence is a symptom of the crises, but the
question arises: What was the basis of this loss of confidence?
He avoids the answer: a looming recession in the real economy.
The possibility of such a recession was denied by all policy-
makers until about six weeks ago.
The crisis will end when comprehensive responses by
political and financial leaders restore that trust,
bringing investors back into the market and allowing
the normal business of extending credit to households
and firms to resume.
This is the Party Line, all over the West: the crisis stems
from the financial system. A bailout of the financial system by
taxpayers is the only workable solution. No one has suggested
that the crisis was engineered by Alan Greenspan's policies of
loose money, and the bankers' faith that the government would
bail out the system in a crisis -- which is exactly what the
government is attempting to do.
In that regard, we are, in one respect at least, better
off than those who dealt with earlier financial crises:
Generally, during past crises, broad-based government
engagement came late, usually at a point at which most
financial institutions were insolvent or nearly so.
What would Dr. Bernanke call the Bear Stearns fire sale in
March? What would he call the Office of Thrift Supervision's
seizure of Washington Mutual on September 15? What would he call
the bankruptcy of Lehman Brothers on September 15? That was the
largest bankruptcy in American history, dwarfing Enron: half a
trillion dollars. The value of its bonds was recently settled at
less than 9 cents on the dollar.
Waiting too long to respond has usually led to much
greater direct costs of the intervention itself and,
more importantly, magnified the painful effects of
financial turmoil on households and businesses. That is
not the situation we face today.
It isn't? It surely looks as though it is. The recession
has not played out. That was the message sent by the stock
market before the day was over.
Fortunately, the Congress and the Administration have
acted at a time when the great majority of financial
institutions, though stressed by highly volatile and
difficult market conditions, remain strong and capable
of fulfilling their critical function of providing new
credit for our economy.
Substitute the words "fiat money" for "new credit," and you
have the Federal Reserve's solution. It was Greenspan's solution
in the 22% stick market meltdown in October 1987. It was his
solution in 1999. It was his solution after 9-11. Each time, it
has created asset bubbles.
This prompt and decisive action by our political
leaders will allow us to restore more normal market
functioning much more quickly and at lower ultimate
cost than would otherwise have been the case. Moreover,
we are seeing not just a national response but a global
response to the crisis, commensurate with its global
In short, politicians have put taxpayers on the hook for at
least $4 trillion in just six weeks.
What caused this? Federal Reserve policy under Greenspan?
This was never mentioned. It was world confidence in the United
Large inflows of capital into the United States and
other countries stimulated a reaching for yield, an
underpricing of risk, excessive leverage, and the
development of complex and opaque financial instruments
that seemed to work well during the credit boom but
have been shown to be fragile under stress.
But what was the source of these large inflows of capital?
The capital fairy, perhaps? No? Actually, a team of
capital fairies. One capital fairy is the People's Bank of
China, which inflates at 20% per annum. It buys U.S. Treasury
debt. Another is Russia, whose oil exports have blessed the
central bank with half a trillion in foreign exchange reserves.
But China and Russia are still buying Western governments'
debt. So, what happened? Why did the West's financial system go
The Austrian theory of the business cycle tells us. As I
have been writing since early 2007, Greenspan's policy of
monetary inflation was followed by Bernanke's policy of tight
money. The Austrian theory of the business cycle teaches that
this reduction in monetary inflation creates a recession. That
was why I began predicting recession in 2007. That was why Dr.
Kurt Richebacher predicted a monumental financial crisis around
the world. He predicted this for six years, 2001 to 2007. He
died in August 2007, as the first stage of the crisis revealed
The unwinding of these developments, including a sharp
deleveraging and a headlong retreat from credit risk,
led to highly strained conditions in financial markets
and a tightening of credit that has hamstrung economic
This is exactly what Richebacher had predicted, based on the
Austrian theory of the business cycle.
The important thing from the point of view of the men in
charge, who did not see this coming and who denied that it was a
crisis until the government, without Congress's approval,
nationalized the American mortgage market by nationalizing Fannie
Mae and Freddy Mac on September 7, is to make it look as though
the government has a handle on all this.
The Federal Reserve responded to these developments in
two broad ways. First, following classic tenets of
central banking, the Fed has provided large amounts of
liquidity to the financial system to cushion the
effects of tight conditions in short-term funding
In other words, it returned to Greenspan's policies of fiat
money. You can see the chart here:
Second, to reduce the downside risks to growth
emanating from the tightening of credit, the Fed, in a
series of moves that began last September, has
significantly lowered its target for the federal funds
The FED lowered its target because the T-bill rate fell to
.03% in September, indicating total panic in the capital markets.
Banks would not lend to each other, so the FED made fiat money
available for them.
We will continue to use all the tools at our disposal
to improve market functioning and liquidity, to reduce
pressures in key credit and funding markets, and to
complement the steps the Treasury and foreign
governments will be taking to strengthen the financial
What tools? Inflation and asset swapping. The FED swaps T-
bills for bonds that banks and finance agencies hold that have no
market, despite their AAA-rating. The banks then tell the
regulators that these Treasury assets, borrowed for 30 days (but
renewable forever) constitute their capital. "Look at all this
rock-solid Treasury paper. We're solvent.!" It is a massive
charade that the whole world understands is a charade.
On this charade the recovery of the world economy is
supposedly secure -- until the FED runs out of Treasury debt to
swap. A chart of its reserves is here.
With the exception of Austrian School economists, who reject
government interference -- before the crisis and also after --
all other schools of economic opinion abandon their commitment to
free market solutions as soon as a credit crisis threatens the
stock market. In 1970, Leonard E. Read of the Foundation for
Economic Education, wrote an essay, "Sinking in a Sea of Buts."
He was referring to this statement, "I believe in the free
market, but. . . ."
Dr. Bernanke is a typical but-man.
The Federal Reserve believes that, whenever possible,
the difficulties experienced by firms in financial
distress should be addressed through private-sector
arrangements--for example, by raising new equity
capital, as many firms have done; by negotiations
leading to a merger or acquisition; or by an orderly
wind-down. Government assistance should be provided
with the greatest reluctance and only when the
stability of the financial system, and thus the health
of the broader economy, is at risk.
I love this: "greatest reluctance." That's what I have
observed of the government over the last half century: great
reluctance to interfere, to tax, and to inflate. Maybe you
noticed that, too.
In those cases when financial stability is broadly
threatened, however, intervention to protect the public
interest is not only justified but must be undertaken
forcefully and without hesitation.
Translation: "Whenever the solvency of large New York City
banks (or Bank of America) is threatened, the Federal Reserve
System intervenes. This has been true since 1914."
Importantly, the financial rescue legislation, which I
will discuss later, will give us better choices. In the
future, the Treasury will have greater resources
available to prevent the failure of a financial
institution when such a failure would pose unacceptable
risks to the financial system as a whole.
Translation: "Until the Treasury spends the $700 billion,
which will not take too long, we have got this under control.
When the Treasury burns through the first $700 billion, it will
be back to Congress for more. It will get it, because the 2008
elections will be behind us, so Congress will not even pretend to
resist." With respect to the Treasury's access to more money,
see this. It explains Bernanke's confidence.
If the crisis originated with flows of capital coming into
our capital markets -- his argument -- and if Asian and Russian
central banks were the primary sources of this credit -- my
argument -- then what we need is a free market program to block
this from ever happening again. The FED has now adopted a policy
where the United States, as the world's leading debtor nation (an
$800 billion a year balance of payments deficit) will lend newly
created dollars to European central banks, so that they can lend
to American banks and brokerage houses operating abroad.
Indeed, this week we agreed to extend unlimited dollar
funding to the European Central Bank, the Bank of
England, the Bank of Japan, and the Swiss National
Bank. These agreements enable foreign central banks to
provide dollars to financial institutions in their
jurisdictions, which helps improve the functioning of
dollar funding markets globally and relieve pressures
on U.S. funding markets. It bears noting that these
arrangements carry no risk to the U.S. taxpayer, as our
loans are to the foreign central banks themselves, who
take responsibility for the extension of dollar credit
within their jurisdictions.
No risk to the taxpayer? Why, it's the capital fairy again.
The FED creates money to lend, which creates worldwide dollar
inflation, and the taxpayer does not bear the costs. Isn't
central banking creative?
The expansion of Federal Reserve lending is helping
financial firms cope with reduced access to their usual
sources of funding and thus is supporting their lending
to nonfinancial firms and households. Nonetheless, the
intensification of the financial crisis over the past
month or so made clear that a more powerful,
comprehensive approach involving the fiscal authorities
was needed to address these problems more effectively.
On that basis, the Administration, with the support of
the Federal Reserve, asked the Congress for a new
program aimed at stabilizing our financial markets.
Translation: "The FED in September pumped in new money at an
annual rate of 132% (adjusted monetary base). This could not go
on without destroying the dollar. So, the Treasury got Congress
to borrow money to bail out the financial industry. This way,
the FED can back off the printing press."
Second, the Treasury will use some of the resources
provided under the bill to purchase troubled assets
from banks and other financial institutions, in most
cases using market-based mechanisms.
Market-based mechanisms? What market-based mechanisms? We
have seen the nationalization of the mortgage market. We have
seen an enormous increase in government debt.
Mortgage-related assets, including mortgage-backed
securities and whole loans, will be the focus of the
program, although the law permits flexibility in the
types of assets purchased as needed to promote
"Flexibility in the type of assets purchased" means
"anything that large New York City banks want to palm off on the
Unclogging the markets for mortgage-related assets
should put banks and other institutions in a better
position to raise capital from the private sector and
increase the willingness of counterparties to engage.
With time, the provision of equity capital to the
banking system and the purchase of troubled assets will
help credit flow more freely, thus supporting economic
Translation: "When the banks stick taxpayers with toxic
debt, private investors will start buying bank stock again . . .
especially since the Treasury will also be buying bank stock, as
Paulson has announced."
These measures will lead to a much stronger financial
system over time, but steps are also necessary to
address the immediate problem of lack of trust and
Translation: "The economy is still heading into the tank,
despite fiat money, asset swaps, and the $700 billion bailout.
Lack of trust and confidence are with us still."
I would like to stress once again that the taxpayers'
interests were very much in our minds and those of the
Congress when these programs were designed.
Translation: "Ho, ho, ho. And, I might add, ha, ha, ha."
In the case of the TARP program, the funds allocated
are not simple expenditures, but rather acquisitions of
assets or equity positions, which the Treasury will be
able to sell or redeem down the road. Indeed, it is
possible that taxpayers could turn a profit from the
program, although, given the great uncertainties, no
assurances can be provided.
Taxpayers could turn a profit. "No assurances can be
provided." He's got that right! If there is any profit to be
turned, Congress will allocate it for more pork. That $700
billion is gone forever. But still the charade goes on.
Stabilization of the financial markets is a critical
first step, but even if they stabilize as we hope they
will, broader economic recovery will not happen right
away. Economic activity had been decelerating even
before the recent intensification of the crisis.
Translation: "A recession is coming, and it is going to be a
Ultimately, the trajectory of economic activity beyond
the next few quarters will depend greatly on the extent
to which financial and credit markets return to more
Translation: "If Main Street suffers, Main Street will be
compelled by Congress to bail out Wall Street . . . again."
I have laid out for you today an extraordinary series
of actions taken by policymakers throughout our
government and around the globe. Americans can be
confident that every resource is being brought to bear
to address the current crisis: historical
understanding, technical expertise, economic analysis,
financial insight, and political leadership.
Translation: "It is business as usual: inflate, tax, and
juggle the books."
I am not suggesting the way forward will be easy, but I
strongly believe that we now have the tools we need to
respond with the necessary force to these challenges.
The tools have not changed. The rhetoric has changed. In
short, it's lipstick on the pig. Again.
Although much work remains and more difficulties surely
lie ahead, I remain confident that the American
economy, with its great intrinsic vitality and aided by
the measures now available, will emerge from this
period with renewed vigor.
Translation: "Deficits don't matter."
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