“As part of my efforts to understand the true root-causes of the financial crisis, I have read many books and articles including Ron Paul’s book ‘End the Fed’. Because of my experiences, the views expressed by Mr. Paul in this book resonated with me and I am working to learn more about this subject. Like Mr. Paul and many others, I do not believe it is possible for hundreds of millions of independent human interactions in a truly free and fair marketplace to cause a global financial and economic crisis. A global crisis requires central planning and coordination. It defies logic that independent, private bankers and other financial firms who compete with each other and/or operate in vastly different countries around the world, would coordinate their strategic and tactical business decisions unless directed to by government rules and regulations. Does it make any sense that nearly every major private bank in the developed world was ‘reckless’ and ‘greedy’ at the same time? It doesn’t to me. From all of my study and research, I believe that well-intended government intervention, including by central banks like our Federal Reserve, was the key factor in causing the global financial crisis. Ask yourself this simple question: Why if the Fed now has the power to save us from a second Great Depression (and re-inflate real estate, the stock market and other asset bubbles in the process), do they claim they had little to no power to cause one in the first place? That doesn’t make much sense, does it?” Mike Perry, former Chairman and Chief Executive Officer

Key Excerpts written by Ron Paul in the Forward to “The DAO of Capital”, 2013

“Before discovering the Austrian School (economists Mises, Nobel laureate Hayek, Rothbard, etc.), I did not fully understand the process of how free markets work. The Austrians illustrated for me the benefit of free market economies relative to interventionist, centrally planned economies. The more I read, the clearer it became to me that this was how truly free individuals living in a truly free society should interact with one another. Austrian economists were also arguing for free markets at a time when the majority of intellectuals were praising collectivism and socialism.

As economist Ralph Raico wrote:

‘Classical liberalism….which we shall call here simply liberalism….is based on the conception of civil society as, by and large, self-regulating when its members are free to act within very wide bounds of their individual rights. Among these, the rights to private property, including the freedom of contract and free disposition of one’s own labor, is given a very high priority….Austrian economics is the name given to the should….(that) has often been linked….both by adherents and opponents…to the liberal doctrine.’

I have always turned to Mises’s wise words whenever the world (and economics in particular) seemed most insane: ‘No one should expect any logical argument or any experience could shake the almost religious fervor for those who believe in salvation through spending and credit expansion.’ The core of the Austrian School is the unpredictability of human action and the enormous influence individual choice wields in how economics work. It recognizes the subjectivity of value, the role of the entrepreneur, and the pursuit of capital creation to advance society itself. These truths are as essential to grasp today, and perhaps more so, as they were when the school first emerged in the mid-nineteenth century.

As an adherent of the Austrian School, I have been frustrated by constantly being forced to watch what the centralizers and government planners have been doing to our economy….contriving recipe after recipe for disaster. We must understand that markets are naturally resilient.

Rather than calming the markets by their actions, central bankers create ever-mounting levels of distortion. Grasping at straws, they believe that flooding the world with money will somehow solve the very problems that such interventionism created in the first place.

People deserve better than this. Let capitalism function as it should without the manipulation of bureaucrats. As a doctor who practiced for a total of nearly 35 years, I abided by the “Hippocratic Oath” that charged me to do no harm and not get in the way of the body’s natural ability to heal itself. The government must do the same and allow market’s natural homeostatic process to work.

Our rights of free speech, assembly, religion, petition, and privacy remain essentially intact. But before our rights are lost, we must change the policies born of decades of government interventionism.

I have always believed deeply that the Founding Fathers got it right…certainly more so than their successors, who have worked feverishly against individual rights since the day our Constitution was ratified. Our nation was founded on the value of liberty, and I have never need to be convinced of the merits of individual freedom. Other forces challenged my natural instincts toward freedom…an education establishment, the media, and government. They constantly preached that we need government to protect us from virtually everything, including ourselves. But I never wavered in my conviction that only an unhampered market is consonant with individual liberty.

This liberty goes hand in hand with sound money, a concept that is fundamental to Austrian economics. Mainstream economists continue to downplay or dismiss its importance. The continual and never-ending bad results of these dominant economic ‘experts’ speak for themselves. Money, according to Mises, must originate in the market as a useful commodity in order for it to function properly. The most important role money plays is that of a medium of exchange. It also serves as a measurement and store of value. Unfortunately, politicians hold the conviction that money growth gives us economic growth. They are blind to the fact that government cannot create anything. Government cannot make man richer, but it can make him poorer. It is extremely naïve to think otherwise.

The Federal Reserve can intervene in the market and meddle with interest rates, but ultimately it cannot escape the immutable nature of free market economics. Politicians may warp a monetary system to their liking but they cannot repeal economic laws that determine the nature of money. As I have said in the past and stand by today, distortion and corruption through monopoly control can benefit the few at the expense of the many for long periods of time, but eventually the irrefutable laws of nature will win. Free choice in the market is the only way economic calculations can come about.

Money had always been viewed as neutral. The supply of money was not thought to play a critical part in determining specific prices. Rather, it was accepted as fact that the price of a product depended only on the supply and demand of the goods sold. This was tacitly accepted by even the early Austrian economists, but it took Mises to prove the nonneutrality of money. As he wrote in his masterful book, ‘Human Action’:

‘As money can never be neutral and stable in purchasing power, a government’s plan concerning the determination of the quantity can never be impartial and fair to all members of society. Whatever a government does in the pursuit of its aims to influence the height of purchasing power depends necessarily upon the ruler’s personal value judgments. It always furthers the interest of some groups of peoples at the expense of other groups. It never serves what is called the common wheel or the public welfare.’

To tamper with a nation’s money is to tamper with every economic aspect of people’s lives: earnings, savings, how much one pays in nominal terms for every purchase made. When money is manipulated at will by politicians, it always leads to chaos, unemployment, and political upheaval. For this reason it is imperative that we identify a money that cannot be a abused, that prohibits inflation, and allows responsible working citizens to prosper.

As “The Dao of Capital” clearly shows, with an inflating fiat currency, capital investment in a market economy becomes very difficult.

As money is destroyed, there is an increase in government power and interference in the markets to attempt to maintain order. Government officials throughout history have refused to admit that economic planning does not work until it’s too late. And then when government’s have tried to compensate for ‘printing too much money’ it has only made things worse. This should sound all too familiar to Americans concerning the functions of the Federal Reserve.

Ironically, there is a consensus in America against government price controls in favor of free markets, until it comes to the most important price of all…the price of time, or interest rates. This is how the government controls the value of money. Through this price control, the government distorts the market’s elaborate coordinating function between consumers and producers. Thanks to the work of the Austrian economists, we know that the loss of this coordination gives us boom and bust cycles….due solely to the manipulation of the supply of money and credit by the central bank. Therefore, the rate of unemployment and the general standard of living are all a reflection in large part of the monetary policy a nation pursues.

Mises understood how money becomes as much a political issue as and economic one. His insights helped me oppose excuses for deficits coming from both the left and the right. Regardless of their rhetoric, both factions depend on a fiat money system and inflation to continue government financing while serving their respective special interests.

The Austrians explained thoroughly why government intervention is the enemy and why individual liberty is the key to realizing true freedom.

The phrase ‘Austrian economics’ is not something I ever expected to come into widespread use. But since 2008, it has permeated our political vocabulary at a popular level….It has given me tremendous pride to see the thousands of young people who come to my rallies, a reflection of how the youth of America are embracing freedom, economic and otherwise.”

Excerpt from Yahoo Finance’s “The Daily Ticker” Interview with Jim Grant, September 27, 2013:

Jim Grant: “The Fed believes that it is in charge. That it is Atlas with the weight of the world on its shoulders. This speaks to another risk. The Fed, as somebody once said to Alan Greenspan, how can you protect against systemic risk when you are systemic risk?  So, the Fed in good measure is the source of risk. It suppresses money market rates. It muscles around the yield curve. It talks up the stock market.  It does everything except let the price discovery mechanism do the work. So we are increasingly in a regime of price administration rather the price discovery.”

The Daily Ticker Interviewer: “And they don’t want to give it up?”

Jim Grant: “They do not…See, they claim they are data driven; not telling us, not reminding us that this data is subject to enormous revisions.”

Full video is available at Yahoo Finance: http://finance.yahoo.com/blogs/daily-ticker/no-fed-taper-jim-grant-131604213.html

Mr. Bernanke: “Even if you believe that the Fed’s monetary policy was a contributor to the bubbles, it should be noted that even people who are most critical of the Fed’s policy acknowledged that it was only….it was not a large mistake. It was a percentage point or two relative to, say, what the Taylor rule, which is the standard measure of interest rate policy is…if you have a situation where a relatively small mistake…if it was a mistake, I’m just accepting that hypothesis…leads to the biggest financial crisis since World War II, I mean, what does that say?”

Mr. Taylor (“of the Taylor Rule”): “Figure 1 shows that the actual interest-rate decisions fell well below what historical experience would suggest policy should be. It thus provides an empirical measure that monetary policy was too easy during this period (2002 – 2005), or too ‘loose fitting’, as the ‘The Economist’ puts it. This deviation from the Taylor rule was unusually large; no greater or more persistent deviation of actual Fed policy had been seen since the turbulent days of the 1970s.”

“Who is right here? Mr. Taylor’s arguments make sense to me and are backed by empirical data. Mr. Bernanke’s comments to the FCIC are not under oath and while I found them to be generally very forthcoming and accurate, I have noted on this blog I felt his FCIC comments re. Fed monetary policy/interest rates were not. I believe they were designed to protect the Fed. Read the excerpts below from Mr. Taylor’s book and from Mr. Bernanke’s 2009 conversation with the FCIC below and decide for yourself. Mr. Taylor’s book has been lauded by famed monetary economist Anna Schwartz, and former Secretary of Treasury; State, and Labor George P. Shultz.” Mike Perry, former Chairman and CEO IndyMac Bank

Key Excerpts from John B. Taylor’s “Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (John B. Taylor is a Senior Fellow at the Hoover Institution and Professor of Economics at Stanford University):

 “What caused the financial crisis? What prolonged it? What worsened it dramatically more than a year after it began? Rarely in economics is there a single answer to such questions, but the empirical research I present in this book strongly suggests that specific government actions and interventions should be first on the list of answers to all three.”

What Caused the Financial Crisis

“I begin by showing that monetary excesses (Fed policies) were the main cause of that boom and the resulting bust.”

“Figure 1 shows that the actual interest-rate decisions fell well below what historical experience would suggest policy should be. It thus provides an empirical measure that monetary policy was too easy during this period (2002 – 2005), or too ‘loose fitting’, as the ‘The Economist’ puts it. This deviation from the Taylor rule was unusually large; no greater or more persistent deviation of actual Fed policy had been seen since the turbulent days of the 1970s.”

“The unusually low interest-rate decisions were, of course, made with careful consideration by monetary policy makers. One could interpret them as purposeful deviations from ‘regular’ interest-rate settings….Those actions were thus essentially discretionary government interventions in that they deviated from the regular way of conducting policy in order to address a specific problem, in particular the fear of deflation, as had occurred in Japan in the 1990s.”

“In presenting this chart to the central bankers in Jackson Hole in the later summer of 2007, I argued that this extra-easy policy accelerated the housing boom and thereby ultimately led to the housing bust. Others made similar arguments. The Economist magazine wrote, in the issue then on the newsstands, ‘by slashing interest rates (by more than the Taylor rule prescribed) the Fed encouraged a house-price boom. To support the argument empirically, I provided statistical evidence showing that the interest-rate deviation in Figure 1 could plausibly bring about a housing boom….In this way I provided empirical proof that monetary policy was a key cause of the boom and hence the bust and the crisis.”

“Although the housing boom was the most noticeable effect of the monetary excesses, the effects could also be seen in more gradually rising overall prices: inflation based on the CPI average 3.2 percent annually during the past five years, well above the 2 percent target.”

“The more systemic monetary policy followed during the Great Moderation had the advantages of keeping both the overall economy stable and the inflation rate low.”

“Some argue that the low interest rates in 2002-4 were caused by global factors beyond the control of the monetary authorities. If so, then interest-rate decisions by the monetary authorities were not the major factor causing the boom…..It argues that there was an excess of world saving…a global saving glut…..that pushed interest rates down in the United States and other countries. The main problem with this explanation is that there is no actual evidence of a global savings glut….As implied by simple global accounting, there is no global gap between saving and investment.”

“Nevertheless there are possible global connections to keep track of when assessing the root cause of the crisis. Most important is evidence that interest rates at several other central banks also deviated from what historical regularities, as described by the Taylor rule, would predict. Even more striking is that housing booms were largest where the deviations from the rule were the largest….The country with the largest deviation from the rule, Spain, had the biggest housing boom, measured by the change in housing investment as a share of GDP.”

“One important question, with implications for reforming the international financial system, is whether the low interest rates at other central banks were influenced by the decisions in the United States or represented an interaction among central banks that caused global short-term rates to be lower than they otherwise would have been…..Figure 5 shows how much of the ECB’s interest-rate decisions could be explained by the Fed’s interest-rate decisions. It appears a good fraction can be explained this way…By this measure, the ECB interest rate was as much as 2 percentage points too low during this period. The smoother line shows that a good fraction of the deviation can be ‘explained’ by the federal funds rate in the United States….Indeed it is difficult to distinguish statistically between the ECB following the Fed and the Fed following the ECB..”

Monetary Interaction with the Subprime Mortgage Problem

 “A sharp boom and bust in the housing markets would be expected to affect the financial markets, as falling housing prices led to delinquencies and foreclosures. Those effects were amplified by several complicating factors, including the use of subprime mortgages, especially the adjust-rate variety, with led to excessive risk taking. In the United States such risk taking was encouraged by government programs designed to promote home ownership, a worthwhile goal but overdone in retrospect.”

“During 2003-5, when short-term interest rates were still unusually low, the number of adjustable-rate mortgages (ARMs) rose to about one-third of total mortgages and remained at that high level for an unusually long time. This made borrowing attractive and brought more people into the housing markets, further bidding up housing prices.”

“It is important to note, however, that the excessive risk taking and the low-interest monetary policy decisions are connected…Observe in Figure 6 how delinquency rates and foreclosure rates were inversely related to housing price inflation during this period. In the years of rapidly rising housing prices, delinquency and foreclosure rates declined rapidly. The benefits to holding onto a house, perhaps by working longer hours to make the payments, are higher when the price of the house is rapidly rising. When prices are falling, the incentives to make payments are much less and turn negative if the price of the house falls below the value of the mortgage. Hence, delinquencies and foreclosures rise.”

“Mortgage underwriting procedures are supposed to taking into account actual foreclosure rates and delinquency rates in cross-section data. These procedures, however, would have been overly optimistic during the period when prices were rising….Thus, there is an interaction between the monetary excesses and risk-taking excesses. This illustrates how unintended things can happen when policy deviates from the norm.”

“In this case, the rapidly rising housing prices and the resulting low delinquency rates likely threw the underwriting programs off track….”

More Complications: Complex Securitization, Fannie, and Freddie

“These problems were amplified because adjustable-rate subprime and other mortgages were packed into mortgage-backed securities of great complexity. The rating agencies underestimated the risk of these securities because of a lack of competition, poor accountability, or, most likely, and inherent difficulty in assessing risk due to the complexity.”

“The risk in the balance sheets of financial institutions has been at the heart of the financial crisis from the beginning.”

“In the United States other government actions were at play. The government-sponsored agencies Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage-backed securities, including those formed with risky subprime mortgages. Although legislation, such as the Federal Housing Enterprise Regulatory Reform Act of 2005, was proposed to control those excesses, it was not passed into law. Thus the actions of those agencies should be added to the list of government interventions that were part of the problem.”

Monetary Policy Excerpts from Chairman of the Federal Reserve Ben Bernanke’s Closed Session on November 17, 2009, before the Financial Crisis Inquiry Commission:

Mr. Bernanke: “The third explanation, which I’m sure you’ll investigate, has to do with monetary policy in 2003, 2004, 2005. Interest rates were down to 1 percent during that period for the reasons having to do with both the slow recovery from the recession and because of concerns about deflation at the time.”

Mr. Bernanke: “Some have argued…and I’m sure you’ll look at it…that those low rates contributed to the risk-taking….I think there are a lot of different components of this issue….if I could just sort of illustrate why there are a number of different questions to be looked at. The first question is, was, in fact, this policy (monetary) the cause or a major cause? And as I have said, there are some alternative hypothesis, like the saving glut and some other things. A second question is, if it was a cause, you know, was it a knowable problem? Was the Fed doing the best it could give the information it had, or was it neglecting information it should have used?…And related to that is the general issue, which has become very hot in monetary circles, which is, should monetary policy be used to try to know down bubbles or not?”

Mr. Bernanke: “Even if you believe that the Fed’s monetary policy was a contributor to the bubbles, it should be noted that even people who are most critical of the Fed’s policy acknowledged that it was only….it was not a large mistake. It was a percentage point or two relative to, say, what the Taylor rule, which is the standard measure of interest rate policy is…if you have a situation where a relatively small mistake…if it was a mistake, I’m just accepting that hypothesis…leads to the biggest financial crisis since World War II, I mean, what does that say? They say that the system itself was inherently unstable and that a relatively small shock was enough to knock it off the pedestal.”

Mr. Bernanke: “I think the Fed…the Fed made some mistakes. But I think the current attitude in Congress that somehow the Fed is now the scapegoat, I think that’s quite unfair. The Fed, I don’t think that our interest-rate policy was a big source of the problem, both because I don’t think it was obviously the wrong policy, and also because, again, as I said, if the system hadn’t been incredibly fragile, you know, it wouldn’t have caused anything.”

As part of my defense efforts, I read the transcript (attached below) of Ben Bernanke’s 2009 closed session before the Financial Crisis Inquiry Commission when it was made available to the public in early 2011. I recently completed a re-read of this important document. As Chairman of the Federal Reserve, during the crisis and to this day, he is our top banker and monetary economist. I would encourage you to read his transcript or the excerpts I have provided below. Mr. Bernanke’s statements and opinions to the FCIC that day make clear that the majority report’s lead finding: “We conclude this financial crisis was avoidable”, cannot possibly be true. Is this the reason that the minority members of the FCIC refused to sign this report and issued two of their own instead? Probably.

Commissioner Thompson: “So no calamity of this magnitude occurs without some early signals that something’s wrong…what were the signals? Why did we..and had we acted on them might we have averted the disaster?”

Mr. Bernanke: “Well, I don’t know, I have to think about that.”

I believe Mr. Bernanke’s testimony is very forthcoming and accurate, with the possible exception of his downplaying the role of the Fed’s monetary policy/low interest rates in fueling risk-taking and the housing bubble. Mr. Bernanke makes clear that he and former Federal Reserve Chairman Alan Greenspan are in agreement on two important points: 1) that macroeconomic events beyond any individual person or firms control were the primary cause of the global financial crisis (“A hypothesis I have advocated is called The Global Savings Glut”), and 2) while there were various signs or concerns, the crisis could not have been (and was not) anticipated even by the best economic and banking experts (“I fully admit I did not forecast this crisis”, “I can point to a number of different things various people said, I don’t know of anybody who really anticipated this…”, “I think instead of relying in the future on particularly perspacious financial geniuses who identify problems accurately in advance, I think we just need to have a more systemic government make an attempt to look at the possible problems”, see more statements like these from Mr. Bernanke below). Therefore, if it could not have been anticipated, it could not have been prevented.

Mr. Bernanke also makes clear that this was not a U.S. mortgage or subprime mortgage crisis, but a much larger global economic event. (“It wasn’t subprime mortgage per se. Subprime mortgages were just the trigger that set off a whole bunch of other bombs.”)

Key Excerpts from Chairman of the Federal Reserve Ben Bernanke’s November 17, 2009, Closed Session before the Financial Crisis Inquiry Commission (quotes are from Mr. Bernanke, unless otherwise noted):

“A second hypothesis, which I have advocated….is what’s called the global savings glut. And the idea here basically is that after the Asian crisis in the nineties, many developing emerging-market economies became capital exporters rather than capital importers….All those things created large capital inflows into the Western industrial countries, notably the United States. It’s a common observation in the context of emerging-market financial crises that they’re often preceded by large capital inflows from abroad and that the problem is that the local banking system can’t handle the massive inflow of capital. So by analogy, sort of a similar story may have happened in the United States…”

“The third explanation, which I’m sure you’ll investigate, has to do with monetary policy in 2003, 2004, 2005. Interest rates were down to 1 percent during that period for the reasons having to do with both the slow recovery from the recession and because of concerns about deflation at the time. Some have argued…and I’m sure you’ll look at it…that those low rates contributed to the risk-taking…”

“…Treasury took over Fannie and Freddie. We felt at that point, you know, the implicit guarantee of the government on all of Fannie and Freddie’s MBS and debt was there, and this was so globally held in such large amounts, that the loss of confidence in that would have basically been a huge problem for the stability of the financial system…The Fed was concerned about the GSEs and their capitalization and their financing for a long time. Chairman Greenspan testified about that way back in…you, 15 years. So we were right on that one.”

“When the subprime mortgages began to go bad, a number of us, like myself and Paulson, we’re wrong in saying that it was a contained problem.”

“As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the great depression. If you look at the firms that came under pressure in that period…only one…was not in serious risk of failure. So out of maybe 13…13 of the most important financial institutions in the United States. 12 were at risk of failure within a period of a week or two…And the fact is that globally, somewhere on the order of 15 to 18 major firms were bailed out, rescued, saved by their governments in Europe and in the UK. So it was very much a global phenomenon.”

Commissioner Holtz-Eakin: “…no one could understand basically the panic in the tri-party repo. That run on the repo market is really what drove the spreading of the crisis. Would anyone have been able to able to anticipate that? You didn’t seem to.”

Mr. Bernanke: “No. So maybe not. Maybe not. I mean, I think a thorough review of the system would have identified this as a critical piece of the infrastructure…But it’s possible that it might not have been identified specifically. But, of course that was then, this is now. We now have the benefit of the crisis. You’re absolutely right, I mean, there is no guarantee that a macroprudential approach will identify every possible crisis.”

“The reform will be a failure if we could not contemplate the failure of Goldman Sachs. That is, there needs to be a system by which Goldman Sachs will go bankrupt and its creditors could lose money. If we don’t have that, then we might as well treat them as a utility, because that’s what they are.”

“So if we want them to be a free capitalist company, they have to be able to fail.”

“I fully admit that I did not forecast this crisis. And in defenses, for what it’s worth, is that again, if you just thought about this as a subprime mortgage crisis…I mean, clearly you want to understand why subprime mortgages did what they did and why they were such a problem and so on. But it wasn’t subprime mortgages per se.  Subprime mortgages were just the trigger that set off a whole bunch of other bombs.”

Vice Chair Thomas: “The perfect storm of all these.”

Mr. Bernanke: “And it’s a perfect storm, is what it was…I would do…a narrative and sort of say, how did these things interact with each other to create the perfect storm…So these connections are very complex, and the only way to do it is to understand the main threads and then try to tell a narrative.”

Vice Chair Thomas: “I find it’s fairly easy after the facts.”

Mr. Bernanke: “Well, after the facts, yes.”

Commissioner Born: “You’ve talked a lot about the need for a systemic risk supervisor and the need to understand the exposures of big institutions and the interconnectedness…I mean, nobody really, totally saw the problems with securitization or OTC derivatives.”

Mr. Bernanke: “Right. So..I actually gave a speech about that. So financial innovation we all thought was great…most people thought it was a great thing…You know there was a lot of people who argued that subprime mortgages were a big innovation, that they allowed people who couldn’t otherwise afford homes, to get homes, and your know it was a wonderful thing. So clearly, you know, people didn’t understand the vulnerability of say, 3/27 ARMs to a downturn in housing prices, for example. So, I guess what I would…this goes back to my answer to Doug, which is that I do not think there is any foolproof way to avoid financial crisis in the future…”

Commissioner Thompson: “So no calamity of this magnitude occurs without some early signals that something’s wrong…what were the signals? Why did we..and had we acted on them might we have averted the disaster?”

Mr. Bernanke: “Well, I don’t know, I have to think about that.”

“I think there were people saying…including people at the Fed…saying, in the year before the crisis, that risk was being underpriced, that spreads were very narrow, that markets seemed ebullient, that liquidity was, in some sense excessive. There were..you know, the way I would put it is, I think there were people…not necessarily the same people…identifying parts of the problem..But I think notwithstanding the claims of one or two people out there who are now sort of making a living on the fact they, quote “anticipated the crisis”, I would still say the interaction of these things, the “perfect storm” aspect was so complicated and large, that I was certainly not aware, for what it’s worth..and it could be just my deficiency…but I was not aware of any kind of comprehensive warning…in this blogosphere we live in now…at any given moment, there are people identifying 19 different problems, crises.”

Vice Chair Thomas: “And they may be right at some point.”

Mr. Bernanke: “And this is the thing, one of them is probably right, but you don’t know who in advance…I would be very skeptical…So people that, quote, identify a problem, but they don’t get the timing or magnitude right. So I welcome your…you know attempts to unravel this…So, while I can point to a number of different thing various people said, I don’t know of anybody who really anticipated this”

Commissioner Thompson: “So there were no actionable signals?”

Mr. Bernanke: “Possibly, yes. So I think rather than saying, you know….obviously some folks are going to come out looking bad or whatever based on what they saw or didn’t see. But I think instead of relying on the future on particularly perspacious financial geniuses who identify these problems accurately in advance, I think we just need to have a more systemic government or whatever structure that will at least make an attempt to look at the possible problems..”

“I think the Fed…the Fed made some mistakes. But I think the current attitude in Congress that somehow the Fed is now the scapegoat, I think that’s quite unfair. The Fed, I don’t think that our interest-rate policy was a big source of the problem…”

Vice Chair Thomas: “One of the main points you mentioned was the global savings glut. I mean, you know, you’re watching the monetary drop, we used to watch our fiscal drop. Now here was this…was somebody accounting for it, somebody examining the profile and sovereign funds and the rest. Was there any real collection of the amount of money coming in, where we were turning little, bitty dials, and there was this hose coming in from the private sectors.”

Mr. Bernanke: “We knew all those numbers, of course. But a lot of smart people….and you asked the question about anticipation, people like Paul Volcker and others thought it was going to cause a crisis. But they got it wrong. They thought it was going to cause a dollar crash. It didn’t do that. It caused a different kind of crisis. Just another example of how difficult it is to predict.”

“Let me make one observation from my own experience, which is one of the things that my historical studies has helped me with this, recognizing that politics is part of the dynamics of a financial crisis. In the 1930s, after the crisis got bad, then they had these Pecora hearings, where they were…J.P. Morgan got…the midget sat on his lap and all kinds of funny things happened. But it’s sort of predictable that there’s going to be a political reaction…But it’s true the politics have been bad…the politics has been so poisonous…”

More Excerpts from Chairman of the Federal Reserve Ben Bernanke’s November 17, 2009, Closed Session before the Financial Crisis Inquiry Commission:

Chair Angelides: “…we wanted to ask you to come by today to give use your perspective on the crisis, the causes.”

Mr. Bernanke: “One general area you’re going to want to look at is the macroeconomic context, the macroeconomic background that led to the risk-taking and so on of the crisis…So why did risk-taking increase? One hypothesis is the so-called great moderation. In a way, this suggests that monetary and fiscal policy were too successful during the eighties and nineties in creating a very stable environment, low inflation. And that it was that sense of excessive security that led to risk-taking. That’s one hypothesis. A second hypothesis, which I have advocated in a number of speeches…is what’s called the global savings glut. And the idea here basically is that after the Asian crisis in the nineties, many developing emerging-market economies became capital exporters rather than capital importers….All those things created large capital inflows into the Western industrial countries, notably the United States. It’s a common observation in the context of emerging-market financial crises that they’re often preceded by large capital inflows from abroad and that the problem is that the local banking system can’t handle the massive inflow of capital. So by analogy, sort of a similar story may have happened in the United States…People…have argued that the emerging markets were looking for high-quality, safe assets, like Treasuries, for example….And that, indeed, once there became a sort of shortage of Treasuries, that there was strong incentives to U.S. financial institutions to create, quote, “safe assets.” And that’s where the securitized AAA credit assets came from. The third explanation, which I’m sure you’ll investigate, has to do with monetary policy in 2003, 2004, 2005. Interest rates were down to 1 percent during that period for the reasons having to do with both the slow recovery from the recession and because of concerns about deflation at the time. Some have argued…and I’m sure you’ll look at it…that those low rates contributed to the risk-taking….I think there are a lot of different components of this issue….if I could just sort of illustrate why there are a number of different questions to be looked at. The first question is, was, in fact, this policy (monetary) the cause or a major cause? And as I have said, there are some alternative hypothesis, like the saving glut and some other things. A second question is, if it was a cause, you know, was it a knowable problem? Was the Fed doing the best it could give the information it had, or was it neglecting information it should have used?…And related to that is the general issue, which has become very hot in monetary circles, which is, should monetary policy be used to try to know down bubbles or not?…Even if you believe that the Fed’s monetary policy was a contributor to the bubbles, it should be noted that even people who are most critical of the Fed’s policy acknowledged that it was only….it was not a large mistake. It was a percentage point or two relative to, say, what the Taylor rule, which is the standard measure of interest rate policy is…if you have a situation where a relatively small mistake…if it was a mistake, I’m just accepting that hypothesis…leads to the biggest financial crisis since World War II, I mean, what does that say? They say that the system itself was inherently unstable and that a relatively small shock was enough to knock it off the pedestal.”

Mr. Bernanke: “A second are, I’ll call the “shadow banking system”. I’m sure you’ll look in detail at housing finance, at the GSEs, at subprime mortgages…The Fed was concerned about the GSEs and their capitalization and their financing for a long time. Chairman Greenspan testified about that way back in…you, 15 years. So we were right on that one.”

Mr. Bernanke: “But, you know, we’ve acknowledged that we didn’t do enough to prevent the subprime lending crisis, in particular, since we had authority to put some rules against some of the practices that occurred. What I’d like to call your attention to is the broader phenomenon of the so-called shadow banking system, which subprime mortgages were only one type of asset which were bundled together into securities, and then these securities were then sold through various legal off-balance sheet type mechanisms to investors, usually with AAA ratings from the credit rating agencies.”

Mr. Bernanke: “When the subprime mortgages began to go bad, a number of us, like myself and Paulson, we’re wrong in saying that this was a contained problem. And the reason we were wrong was that the subprime mortgage themselves were a pretty small asset class. You know, the stock market goes up and down every day more than the entire value of the subprime mortgages in the country. But what created contagion, or one of the things that created contagion, was that subprime mortgages were entangled in these huge securitized pools, so they started to take losses and in some cases, the credit-rating agencies, which had done a bad job basically of rating them began to downgrade them. And once there was fear that these securitized credit instruments were not perfectly safe, then it was just like an old-fashioned bank run…..Of course, again, flaws in the securitization process. I’m sure you’ll want to look at the credit-rating agencies.”

Mr. Bernanke: “A third category of topics has to do with regulation…One is gaps in coverage. AIG is a great example….Another example is the investment banks, which were a huge problem, of course….Number two, I would mention is capital and liquidity. You know, was the Basel framework adequate? I think one of the things that struck me the most about this, though, was liquidity…For example, runs in the tri-party repo market, where what we used to think was very stable funding, which is funding through repurchase agreements where the investment banks would put out, asset overnight and use that as collateral, they thought that was a pretty much foolproof form of short-term funding. But in a crisis where people began to doubt the liquidity or the value of those assets, the haircuts went up and you got into a vicious cycle which led to Bear Stearns collapse and was important in the Lehman collapse as well. And finally…”too big to fail”, you’re going to look at that, I’m sure, in great detail. You know, why did the firms become so big? Why did they become so interconnected?”

Mr. Bernanke: “Another aspect of supervision is the lack of what has become known as “macroprudential” or “systemic” supervision. There was too much focus on individual firms…The Fed is currently revamping its supervision to take into account more macroprudential types of oversight.”

Mr. Bernanke: “I think the issue of the shadow banking system is very important and the role of the maturity transformation, the fact of the use of the short-term financing is something the focus on, say, subprime lending might miss, and I think you need to think about that. And I think that really was a very important element in the crisis, as was liquidity problems associated with…you know, Lehman and Bear Stearns and so on. So those are some things you might otherwise perhaps miss.”

Mr. Bernanke: “What we were seeing at that time was exactly this cycle of worsening haircuts, that is, where the financing…so that Bear Stearns was the weakest of the six or five investment banks. The investment banks relied on this repurchase agreement, overnight tri-party repo financing model. And this is when that model was really beginning to break down. And as the fear increased, the lenders, via the tri-party repo market and other short-term lending markets, again, began to demand larger and larger haircuts, premiums, which was making it more and more difficult for the financial firms to finance themselves and creating more and more liquidity pressure on them. And it was heading sort of to a black hole. Considered at the time of Bear Stearns…was that the collapse of Bear Stearns might bring down the entire repo market, the entire tri-party repo market, which was the source of financing for all the investment banks and many other institutions as well. Because if it collapsed, what would happen would be that the short-term overnight lenders would find themselves in possession of collateral, which they would then try to dump on the market. You would have a big crunch in asset prices. And probably what would have happened would…our fear at least…was the tri-party repo market would have frozen up. That would have led to huge financing problems for other investment banks and other firms; and we might have had a broader financial crisis….And, you know, following the (Bear) rescue, the markets did improve quite a bit. Then we had for a number of months a considerable increased stability in funding markets.”

Mr. Bernanke: “Subsequently, of course we didn’t mention Fannie and Freddie, but Treasury took over Fannie and Freddie. We felt at that point, you know, that the implicit guarantee of the government on all of Fannie and Freddie’s MBS and debt was there, and that this was so globally held in such large amounts, that the loss of confidence in that would have basically been a huge problem for the stability of the financial system.”

Mr. Bernanke: “As a scholar of the Great Depresssion, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression. If you look at the firms that came under pressure in that period…only one…was not in serious risk of failure. So out of maybe 13…13 of the most important financial institutions in the United States. 12 were at risk of failure within a period of a week or two…And the fact is that globally, somewhere in the order of 15 to 18 major firms were bailed out, rescued, saved by their governments in Europe and in the UK. So it was very much a global phenomenon…”

Mr. Bernanke: “We knew…we were very sure that the collapse of Lehman would be catastrophic…It would probably bring the short-term money markets into crisis, which we didn’t fully anticipate; but, of course, in the end it did bring the commercial paper market and the money market mutual funds under pressure…We could not (save it). We did not have the legal authority to save it…Two days later, AIG, again, we felt that its failure would threaten the stability of the global financial system. Among other things, they had as counterparties many of the world’s largest bank financial institutions, many of the world’s largest banks…Now, why AIG and not Lehman?…So we were able to…we made a loan…we didn’t put capital in (to AIG), we made a loan against the assets of the entire company. In the case of Lehman Brothers, there was just a huge hole. I mean, they were insolvent and they had a thirty-to forty billion hole in their capital structure.”

Vice Chair Thomas: “And you wouldn’t have done it, anyway.” (bailing out Lehman’s hole)

Mr. Bernanke: “That’s right. And it would have been a bad decision, anyway because we had so much…so many other firms already on the brink, coming down the pike.”

Mr. Bernanke: “First, is that “viewed too big to fail” is a very, very serious problem, and one that was much bigger than was expected. And I think it’s absolutely critical that if we do only one thing in financial reform, it is to get rid of that problem. It has to be possible for firms to fail. But in the context of the financial crisis last Fall, it was our judgment, which was…in my opinion, was vindicated by subsequent events, that the collapse of one of these firms would have had very serious effects, not only on other financial firms but on the whole economy.”

Mr. Bernanke: “And I would just point out as evidence that prior to Lehman’s failure, the CDS spreads were blowing out, that everybody…every creditor was running to pull their money out of Lehman. The stock prices was plummeting. This doesn’t sound like a situation where people thought that Lehman was going to be protected. There was truly a lot of uncertainty, a lot of fear that Lehman would not be protected. And, in fact, it was that very fear and uncertainty that forced us into the situation in the first place.”

Mr. Bernanke: “…secondly, that I think the events have vindicated the view that, while it was an extraordinarily unpleasant situation and one where we shouldn’t have been in the first place, the failure of those firms, particularly Lehman, created a huge amount of chaos in the financial system which spilled over to a very sharp decline in economic activity around the world.”

Commissioner Holtz-Eakin: “But one of these…I just want to understand this…is that no one could understand basically the panic in the tri-party repo. That the run on the repo market really is what drove the spreading of the crisis. Would anyone have been able to anticipate that? You didn’t see to.”

Mr. Bernanke: “No. So maybe not. Maybe not. I mean, I think a thorough review of the system would have identified this as a critical piece of infrastructure that required careful attention. But it’s possible that it might not have been identified specifically. But, of course, that was then, this is now.”

Commissioner Holtz-Eakin: Right.

Mr. Bernanke: “We now have the benefit of the crisis. You’re absolutely right, I mean, that there’s no guarantee that a macroprudential approach will identify every possible crisis. But clearly, where we can we want to strengthen the system, we want to create as many ways of identifying problems as possible.”

Commissioner Georgiou: “Back in last September, when you created…you began to supervise Goldman Sachs as a single bank holding company at the Fed. Do you regard that as a temporary condition or a permanent one?…How long will they have access to the Fed window and so forth, since it’s an institution that will be regarded as so large to be required to be protected forever?”

Mr. Bernanke: “So first of all, under current law, Goldman Sachs is a bank holding company so under current law, the Fed is the umbrella supervisor of Goldman Sachs….You used the word “protection”. My view is that, going forward, that the firms are systemically critical…and Goldman Sachs is one of them…should, on the one hand, receive tougher, more comprehensive oversight than other firms. Because not only are they…not only do we need to protect them themselves, but because of the damage they would do to the broader system if they collapsed. Morever, tougher, more comprehensive oversight, including higher capital and liquidity requirements and so on makes it less attractive to be big….And there would be and incentive to shrink if, in fact, you could escape some of the intrusive oversight.”

Mr. Bernanke: “The other part, though…and again, I just want to say this as strongly as possible…the reform will be a failure if we could not contemplate the failure of Goldman Sachs. That is, there needs to be a system by which Goldman Sachs will go bankrupt and Goldman Sachs’ creditors could lose money. If we don’t have that, then we might has well treat them as a utility, because that’s what they are.”

Mr. Bernanke: “So if we want them to be a free capitalist company, they have to be able to fail.”

Vice Chair Thomas: “Downsize.”

Mr. Bernanke: “We don’t have….there are many ways to do it. You can downsize them, many things…”

Vice Chair Thomas: “I think one of the things that happened, especially with AIG…and I’m just judging the way people talk to me…they were absolutely shocked when you put money into AIG and it’s like a bucket, and where the money flowed, all these European folks and the rest of it really brought home, I think, for some folks for the first time how interdependent we are.”

Mr. Bernanke: “No, I think Europeans and the British, in particular, are quite taken by the severity of the crisis, and they recognize that some of the problems were homegrown as well as imported from the U.S. I would have to say that, broadly speaking, financial regulation is one of those areas where there’s more international cooperation than in almost any other are of regulation. You know, we regularly go to Basel, they talk of the Basel Capital Committee, and they have many other subcommittees and various other types, and there’s called the Financial Stability Board, which is a body that brings together the regulators and the central bankers around the world. So there’s a lot of standard-setting and rules and so on which are set up on an international basis.”

Mr. Bernanke: “If we can’t do that, then what may happen is that we may go to a world where the large companies are required to separately capitalize their subsidiaries in each country. For example, Citigroup owns Banamex, which is a big Mexican bank. Under the kind of provision I am thinking of, Banamex would have to have its own capital, its own liquidity. And so if there was a failure, Banamex itself could stand on its own and the Mexican government would worry about Banamex, and we would worry about the rest of Citigroup. Now, that would actually greatly simplify the process of bringing down and closing a global company.”

Mr. Bernanke: “The only way, what gave financial products its AAA rating was the full faith and credit, essentially of the whole AIG company. There is no way to say that financial products is bankrupt without bringing down the whole company, and that was the dilemma.”

Mr. Bernanke: “I think, unfortunately for you, it’s the latter.”

Chair Angelides: “The latter being?”

Mr. Bernanke: “The integration, the interaction of all these different factors. So one of the reasons…so, again, I fully admit that I did not forecast this crisis. And in defense, for what it’s worth, is that, again, if you just thought about this as a subprime mortgage crisis…I mean, clearly, you want to understand why subprime mortgages did what they did and why they were such a problem and so on. But it wasn’t subprime mortgages per se. Subprime mortgages were just the trigger that set off a whole bunch of other bombs.”

Vice Chair Thomas: “The perfect storm of all these.”

Mr. Bernanke: “And it’s a perfect storm, is what it was. And then having laid out how each of these areas involved, and what the main forces were, then if were doing it, I would then sort of do a kind of a narrative and sort of say, how did these things interact with each other to create the perfect storm? And I think unless you identify it, there’s no single simple thread, linear thread, that will let you do it….so in our case, what’s the connection between Lehman Brothers and General Motors? Lehman Brothers’ failure meant that commercial paper that they used to finance went bad, which meant that the reserve fund which held the Lehman commercial paper broke the buck, which there was a run in the money market mutual funds, which meant the commercial paper market spiked, which was a problem for General Motors. So these connections are very complex, and the only way to do it is to understand the main threads and then try to tell the narrative.”

Vice Chair Thomas: “I find it’s fairly easy after the facts.”

Mr. Bernanke: “Well, after the facts, yes.”

Chair Angelides: “To what extent do these come together in certain mega-institutions…these threads?”

Mr. Bernanke: “Well, I mean, clearly, the mega-institutions were the focus of the crisis. I mean, that’s not a necessary thing. We’ve had other crises, like the savings and loan.

Chair Angelides: “But in this one.”

Mr. Bernanke: “In this one…I’m saying, but in this one, mega-institutions were, in some sense, the heart of the crisis. And all the things I’m talking about, one way or another impacted on their stability and the stability of the system. So were things like over-the-counter derivatives trading and things of that sort, which reflect interactions between firms. There were some medium-sized firms that were involved, the IndyMacs and the WaMus and things like that. But basically, it was the complexity of large firms. And think of it as…and, again, it was our…but it was part of our problem, that we were looking at this firm (in the Fall of 2008) and saying, “Citigroup is not a very strong firm, but it’s only one firm and the others are okay”, but not recognizing that’s sort of like saying, “Well, four out of your five heart ventricles are fine, and the fifth is lousy”. They’re all interconnected, they all connect to each other; and therefore, the failure of one brings the others down.”

Mr. Bernanke: “So by definition, a systemically critical firm is one whose failure would create broad problems for the financial system and the economy…One would be size and, therefore, the number of counterparties and creditors and so on that it has…Another element with the word that comes up a lot is interconnectedness…Bear Stearns, which is not that big a firm, our view on why it was important to save it…was that because it was so essentially involved in this critical repo financing market, that its failure would have brought down that market, which would have had implications for other firms…Another example is AIG…well, so AIG is big. But I’ll give you a smaller one, like some of these companies that were mortgage insurers, which are pretty small companies. But, you know, their failure required by accounting rules would have forced the markdowns…serious markdowns of many of their counterparties who had use them to insure their mortgage positions, for example. So they were connected to a large number of other firms…so size, inteconnectednes…And then the third would be provision of critical services, like the J.P. Morgan example (co-running the tri-party market)…So companies that either are closely tied to or perform critical market functions, like exchanges or clearinghouses, are also very important. Another criterion that’s been used by some scholars is (market/price) correlation…”

Commissioner Hennessey: “To the extent that there were specific problems over the last couple of years, were they just in CDS…I’m sorry, within those universe of derivatives, was it CDS and asset-backed securities, or were there broader problems or problems with other subsets of the derivative world?”

Mr. Bernanke: “I think the biggest problems were in those two categories you mentioned.”

Vice Chair Thomas: “…why was it (the OTC CDS market) expanding rapidly? Because there was no tent to put it under?”

Mr. Bernanke: “Well, it’s actually a…from a finance theory point of view, it’s actually a very clever instrument.”

Vice Chair Thomas: “Oh, yeah?”

Mr. Bernanke: “What it does, it allows you very cheaply and efficiently to insure yourself against the credit risk of a particular firm or even an index of firms.”

Vice Chair Thomas: “Give me…in theory? In theory or in reality?”

Mr. Bernanke: “Well, in reality, if you use them right…More generally, you know, it’s kind of expensive to buy and sell corporate bonds. You can buy it…it’s much cheaper to buy and sell CDS, which have the same risk…So it’s a very…in principle, it’s a very efficient instrument.”

Vice Chair Thomas: “And, therefore, used by a lot of people very quickly.”

Mr. Bernanke: “Used by people, and grew very, very quickly. And became…frankly, the regulators probably didn’t help here. Because in the sort of capital regulation of banks, to the extent that banks can show that they have hedged their risks, they can hold less capital…the other problem here, besides just the primitiveness of this system in which they cleared and settled, was that the counterparty risk wasn’t taken into account. So people who lost…you know, you could lose money because you took a bad position…but you could also lose money because you made that bet with AIG and they couldn’t pay off.”

Commissioner Born: “…you’ve talked a lot…about the need for a systemic risk supervisor and the need to understand the exposures of big institutions and their interconnectedness…I mean, nobody really, totally saw the problems with securitization or OTC derivatives.”

Mr. Bernanke: “Right. So…I actually gave a speech about that. So financial innovation we all thought was a great thing…or maybe we didn’t think it, but most people thought it was a great thing. But it obviously had a downside, which like any other invention, it can blow up if it hasn’t been safety-tested sufficiently. And that clearly turned out to be an issue in the consumer level, for example. You know, there was a lot of…there are a lot of people who argued that subprime mortgages were a big innovation, that they allowed people who couldn’t otherwise afford homes, to get homes; and, you know, it was a wonderful thing. So clearly, you know, people didn’t understand the vulnerability of, say, 3/27 ARMs to a downturn in house prices, for example. So, I guess what I would…this goes back to my answer to Doug, which is that I do not think there’s any foolproof way to avoid financial crisis in the future, although we could do all we can to make them smaller and less damaging…I don’t want to be too prescriptive here…but where, say, a consumer agency could look at new consumer products and sort of look at them, anyway, where regulators would look at big innovations in types of financial products, financial instruments. And not so much to be…I don’t necessarily mean to say that the regulator would say, “You can’t do this one”…So, yes, I think we need to have a somewhat more balanced view about the effects of financial innovation, that there are times when it can be dangerous. And, again, while, without promising, by any means, that we can identify all the problems, at least some attempt to look at things and road-test them and look at how they interact with other markets and ask some hard questions, would be at least a step in the right direction.”

Commissioner Thompson: “So no calamity of this magnitude occurs without there being some early signals that something’s going wrong. In the case of this calamity, what were the signals? Why did we…and had we acted on them, might we have averted the disaster?”

Mr. Bernanke: “Well, I don’t know, I have to think about that.”

Mr, Bernanke: “I think there were people…there were people saying…including people at the Fed but others as well…saying, in the year before the crisis, that risk was being underpriced, that spreads were very narrow, that markets seemed ebullient, that liquidity was, in some sense, excessive. There were…you know, the way I would put it is, I think there were people…not necessarily the same people…identifying various parts of the problem…But I think notwithstanding the claims of one or two people out there who are not sort of living on the fact that they, quote, “anticipated the crisis”, I would still say that the interaction of these things, the “perfect storm” aspect was so complicated and large, that I was certainly not aware, for what it’s worth…and it could be just my deficiency…but I was not aware of any kind of comprehensive warning……in this blogoshphere we live in now…at any given moment, there are people identifying 19 different problems, crises.”

Vice Chair Thomas: “And they may be right at some point.”

Mr. Bernanke: “And this is the thing, one of them is probably right, but you don’t know who in advance….I would be very skeptical…there are people like…you know, even…take somebody like Robert Shiller who is now pretty famous for identifying the stock market and the house bubbles; right? A great economist. I have great admiration for him. He’s a very serious guy. But he identified the stock market crash when the Dow was at 7,000. So it went a lot further after that. And he was pretty open-minded in 2002, 2003, whether there was a housing bubble or not…So people that, quote, identify a problem, but they don’t get the timing and magnitude right. So I welcome your…you know attempts to unravel this…So while I can point to a number of different things various people said, I don’t know of anybody who really anticipated the…”

Commissioner Thompson: “So there were no actionable signals?”

Mr. Bernanke: “Well, no, I don’t think that’s true. I mean, I think….well, it’s always a question of legal perspective, if you’re trying to figure out intent, and da, da, da, what did you know and when did you know it. It may be that very few people fully appreciated the risks of subprimed lending in 2001 or 2002. If we had been smarter or more systematic, we might have identified them? Possibly, yes. So I think rather than saying, you know…obviously some folks are going to come out looking bad or whatever base on what they saw or didn’t see. But I think instead of relying on the future on particularly perspicacious financial geniuses who identify these problems accurately in advance, I think we just need to have a more systemic government or whatever structure that will at least make an attempt to look at the possible problems and”

Chair Angelides: “So what you said earlier, J.P. Morgan out of 13 was in a different position Was there something that they saw or did that was definitively different in terms of market practices as an institution?”

Mr. Bernanke: “So J.P. Morgan was never under pressure, to my knowledge. Goldman Sachs, I would say also protected themselves quite well on the whole. They had a lot of capital, a lot of liquidity. But being in the investment banking category rather than the commercial banking category, when the huge funding crisis hit all he investment banks, even Goldman Sachs, we thought there was a real chance that they would go under.”

Commissioner Holtz-Eakin: “I want to ask…sort of just address this narrative, the Fed/Treasury policy and these actions that made this worse. And I think you know this story: Rates too low for too long, creating a housing bubble, failure for supervision oversights, standards on mortgage origination, misdiagnosing counterparty risk, lack of transparency and liquidity problems, the notion that post-Lehman credits were in fact tightening, markets recovering, and the TARP requests comes, and then things explode. How do you respond to that?”

Vice Chair Thomas: “Just a conspiracy ball of wax.”

Mr. Bernanke: “I think the Fed…the Fed made some mistakes. But I think the current attitude in Congress that somehow the Fed is now the scapegoat, I think that’s quite unfair. The Fed, I don’t think that our interest-rate policy was a big source of the problem, both because I don’t think it was obviously the wrong policy, and also because, again, as I said, if the system hadn’t been incredibly fragile, you know, it wouldn’t have caused anything. We are, to some extent, culpable for not doing the subprime mortgage regulation. Supervisions: We did a relatively good job on supervision. If you look at the companies that failed…”

Mr. Bernanke: “I know there are people, probably even on this commission, who believe that Lehman could have been allowed to fail without…or Bear Stearns…without real consequences. I don’t believe that myself. I base it on historical knowledge, and I base it on our detailed analysis of the individual markets and interactions…Looking at AIG, I thought myself…and I believe now…that if we let it fail, that the probability was 80 percent that we would have a second depression. Suppose it was 5 percent…How much would you pay to avert a 5 percent chance of a second depression? $5 billion? That’s probably what we will end up paying. So I think that those are the right decisions to make, and we did the best we could given the limited powers we had.”

Mr. Bernanke: “So a mixed record, but I think we played important roles in saving the situation. And I hope we’ll play an important role in trying to get an improvement in our structure so that in the future we won’t have a problem.”

Vice Chair Thomas: “One of the main points you mentioned was the global savings plan (Bernanke’s term was Global Savings Glut). I mean, you know, you’re watching your monetary drop, we used to watch our fiscal drop. Now, here was this…somebody was accounting for it, somebody was examining the profile and sovereign funds and the rest. Was there any real collection of the amount of money coming in, where we were turning little, bitty dials, and there was a hose coming in from the private sectors…”

Mr. Bernanke: “We knew all those numbers, of course. But a lot of smart people…and you asked the question about anticipation, people like Paul Volcker and others thought it was going to cause a crisis. But they got it wrong. They thought it was going to cause a dollar crash. It didn’t do that. It caused a different kind of crisis. Just another example of how difficult it is to predict.”

Commissioner Georgiou: “The dollar crash is just slower…”

Mr. Bernanke: “Well, it hasn’t happened yet, but it didn’t happen in the early part of this decade….Which is what Volcker at one point said there was a 75 percent chance of a dollar crash within two years, whatever. So he’s been proven wrong on that.”

Vice Chair Thomas: “But that was the dials that he had, in the structure that he was looking at.”

Mr. Bernanke: “But essentially right. The example I would give, would have been the silo mentality of the regulators, that I’m looking at this company, I don’t care about the counterparties, I don’t care about the markets they’re involved in. I’m not thinking about…there’s a difference between…if there’s a common exposure across the whole system and that goes bad, that has a much different implication than if it’s an uncorrelated risk across the system. But for an individual regulator looking at one company, they don’t distinguish between those two, but it’s a critical distinction. That’s why you need some kind of interaction among the regulators.”

Vice Chair Thomas: “Or a bigger, comprehensive, more-umbrella regulatory structure.”

Mr. Bernanke: “Right…well, macroprudential….So I would prefer having a systemic risk council which is responsible for the overall system and looks for emerging risks ad coordinates and shares information, et cetera. But underneath that, you’ve got specialists.”

Mr. Bernanke: “So, of course, and again this is where the Fed and the communication has failed, is that the public still thinks that “Wall Street” was bailed out. We weren’t bailed out.” The reason we bailed out Wall Street….I hate that terminology…but the reason we did it was to avoid a collapse of the broad system, and so on. So the critical thing…the first important achievement was to prevent the meltdown of the global financial system, which we did, in the fall and early into this year. Given that we did that and the financial markets are improving, the credit situation is, broadly speaking, is improving slowly. It’s still tough. It’s better, certainly, for larger firms than it is for smaller firms.”

Mr. Bernanke: “But let me make one observation from my own experience, which is one of the things that my historical studies has helped me with this, recognize the politics is part of the dynamics of a financial crisis. In the 1930s, after the crisis got bad, then they had these Pecora hearings, where they were…J.P. Morgan got…the midget sat on his lap and all kinds of funny things happened. But it’s sort of predictable that there’s going to be a political reaction. And Sheila Bair said yesterday that she thought that TARP was a mistake completely because of the bad politics that have come from it. I don’t think that’s true because the alternative would have been to let the system collapse, which is not what we wanted to do. But it’s true that the politics have been bad…Unfortunately, the politics has been so poisonous….you know, both at the congressional level but also at the local level, where people have accused bankers of taking TARP money, all kinds of horrible things…that the general response of bankers has been to give the money back as fast as they can; or if they have to keep it for some reason, not to base any lending on it.”

Mr. Bernanke: “But I will say that there are other things, like the Fed’s TALF program…actually, in my defense, I should have mentioned a lot of other things we did to protect the asset-backed securities market, the commercial paper market, money market mutual funds, et cetera, et cetera, and our monetary policy…And the unique aspect of this crisis, which was the capital injections, did stabilize the system. And now, a great, good sign is that banks are raising large amounts of private capital and paying back the government capital. That’s a good sign.”

Attachment:

United States of America, Financial Crisis Inquiry Commission
Closed Session
Ben Bernanke, Chairman of the Federal Reserve
November 17, 2009

Below is an email that I wrote my defense attorneys in December 2010 that comments on the Minority Report of the Financial Crisis Inquiry Commission (attached below), which I believe is less political and more accurate than the Majority Report. Both the current Federal Reserve Chairman Ben Bernanke’s FCIC testimony and former Federal Reserve Chairman Alan Greenspan’s paper “The Crisis” are more in alignment with this report than the majority report.

For example, both Bernanke and Greenspan saw the crisis being caused primarily by global macroeconomic issues and both admitted that they and the Federal Reserve System (our government’s top banking, monetary and macroeconomic experts) did not foresee the financial crisis coming and that they didn’t think, even with the benefit of hindsight, that there was any “foolproof” way to avoid a crisis in the future. And yet the January 2011 Financial Crisis Inquiry Commission Majority Report stated:

“We conclude this financial crisis was avoidable”

I believe this majority report was a political “whitewash” on the part of the Administration and government bureaucrats. Well-intentioned politicians and government couldn’t be the key cause of the financial crisis when easy scapegoats existed in “bankers”, “Wall Street”, “recklessness”, “greed”, and “inadequate disclosure”. And their brethren in the government’s enforcement bureaucracy (FDIC, SEC, etc.) and the private plaintiff’s bar could effectively squelch most of these individuals and firms from speaking the truth. Thank goodness that minority members of the FCIC did not agree, refused to sign the majority report, and produced a less political and more accurate account of the financial crisis.

My December 2010 email to My Defense Attorney’s Re. The Financial Crisis Commission Minority Report:

This document, in my view, explains accurately and succinctly what happened and dovetails with my comments to you.

It also shows that what we did at Indymac…was a prudent part of the financial system at the time.

It never mentions fraudulent or non-transparent securities disclosures or negligent business decisions as a cause of the crisis or Indymac’s failure (we are briefly noted).

It would be defense exhibit A in both the securities litigation cases, as well as other cases (it even touches on the solvency issue…and makes our case for the fact that Indymac was solvent right up to it bank run…see quote below). Mike

Here some key excerpts:

“You get in much more trouble in investments with a sound premise than a bad premise because the bad premise you recognize immediately does not make sense…a home is a sound investment.” Warren Buffett in his testimony to the commission

“In retrospect, however, it is clear that lenders…including the government, which held the credit risk on most of the subprime and other weak mortgages outstanding…were not requiring big enough returns to compensate for the risk they were taking. The real risk of a mortgage investment became delinked from the premium demanded by investors to make a loan. Why? For one, investors shared the same mindset as borrowers, entice by the belief that home prices would never fall on a national scale. Further, the returns on investments thought to be comparably safe yielding far less than mortgage-related investments.”

“The government has always supported homeownership. But trying to get something for nothing…to subsidize homeownership without increasing the budget deficit…was a recipe for a crisis. The government, in effect, encouraged the GSEs to run two enormous monocline hedge funds that invested exclusively in mortgages and were implicitly backed by the U.S. taxpayer.”

“The GSEs were not the only means by which the government supported the financing of high-risk mortgages. Through the GSEs, FHA loans, VA loans, the FHLBs, and CRA, among other programs, the government subsidized and, in some cases, mandated the extension of credit to high-risk borrowers, propagating risks for financial firms, the mortgage market, taxpayers, and ultimately the financial system.”

“If the financial firm does not have enough cash on hand, then it will have to sell assets into a depressed market. Liquidity risks can quickly evolve into solvency concerns once a run begins. A striking conclusion we drew from the FCIC’s work is the extent to which these liquidity risks proved to be systemically underappreciated.”

“So, that is what you prepare for (a storm). But this was not a normal storm. It was, to quote Goldman Sachs CEO “a hurricane”.

“Put simply, the risk of a housing collapse was simply not appreciated. Not by homeowners, not by investors, not by banks, not by rating agencies, and not by regulators.”

“Because of the perceived safety of highly rated MBS and CDOs, firms held minuscule capital against the probability of loss.”

“Leverage and maturity mismatch are not bad things…the financial system and the economy as a whole need them to operate…leverage and maturity transformation are, to a large extent what banks do, but both of these factors create fragility.”

“But once investors get spooked, and a run begins, there is nothing that a financial firm can do except try to regain the market’s confidence.”

“Following the successive collapses of Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, and American International Group (AIG), what had begun in the second half of 2007 as a run on those firms that the market identified as having large mortgage exposures and acute liquidity risks exploded into a generalized market panic. Depository institution had failed. Investment banks had failed…”

“The panic had spread to the widest corners of the financial system. Thrifts IndyMac and Washington Mutual failed…”

“The panic ended when confidence returned…by acting as a lender of last resort…that is, a counterparty willing to make secured loans when no one else will…the government played a key role in preventing runs on otherwise strong firms…the passage of the Troubles Asset Relief Porgram helped restore confidence as well. The government’s commitment to stand behind financial firms, combined with capital injections, and a guarantee of bank debt, helped moderate the panic and stabilize financial markets.”

“These were the best of a series of bad options, and policymakers had extremely limited information to work with. While we believe that the government deserves quite a lot of the blame for getting our financial system and our nation into trouble in the first place, we applaud the quick and decisive actions taken by our nation’s leaders during the panic.”

“The historical record is rich with examples of the prolonged and devastating economic impact of financial crises.”

“In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies in advanced economies aimed at mitigating the downturn (and not the costs of bailing out or recapitalizing the banking system).”

“Reinhart and Rogoff also find that financial crises often precede sovereign debt crises, give the rapid increase in public debt.”

“In their panoramic study of financial crises and the debt crises that follow, Reinhart and Rogoff identify perhaps the four most dangerous words expressed by investors, regulators, and policymakers before the crash: “This time is different”. We could not agree more. We caution our nation’s leaders to learn the appropriate lessons from history and take seriously the need to reduce our federal deficit.”

REPUBLICAN COMMISSIONERS ON THE FINANCIAL CRISIS INQUIRY COMMISSION
FINANCIAL CRISIS PRIMER QUESTIONS AND ANSWERS ON THE CAUSES OF THE FINANCIAL CRISIS
Delivered as required by P.L. 111-21: The Fraud Enforcement and Recovery Act of 2009
December 15, 2010

“We conclude this financial crisis was avoidable.” From the Majority Opinion of the Financial Crisis Inquiry Commission Report, January 2011

Again, this is an older, but I believe important document if you are trying to understand the true, root-causes of the financial crisis, which is not the government’s view (parroted by the press to become ‘conventional wisdom’), that it was caused by reckless and greedy bankers and Wall Street and poor government regulation.

Alan Greenspan, the former Federal Reserve Chairman, wrote his paper “The Crisis” (attached below) in February of 2010 and I read it the time and provided my defense attorneys with the analysis and important excerpts below. I did post “The Crisis” in the FDIC section of my blog when it was launched in the Fall of 2011, but my attorney’s advised me not to provide any of my commentary (or key excerpts) given pending and threatened litigation against me at the time.

I am providing this now, so that a more accurate understanding of the true-root causes of the financial crisis may be known. I think the government, and the majority opinion of the Financial Crisis Commission were wrong: blaming reckless and greedy bankers, Wall Street, and poor government regulation. Greenspan in this paper, Bernanke in FCIC testimony (which is now public), and the Minority Report of The Financial Crisis Inquiry Commission (and many others, some of whom I have posted on this blog) in my view refute this ‘conventional wisdom’. Read my excerpts and commentary and the detailed testimony or papers and decide for yourself.

 Here are just a few Greenspan excerpts of the excerpts:

 “…analyst’s ability to time the onset of deflation (a bubble bursting) has proved illusive.”

“…we had to rely on an international ‘invisible hand’ to bring equilibrium to such undecipherable markets. The high level of market liquidity (erroneously) appeared to confirm that the system was working.”

 “Central Banks have chosen to set Bank capital and reserve standards that exclude once or twice in a Century crisis.”

 “Is the current crisis a 100 year flood? It is the most severe global financial crisis ever.”

 “The current crisis has demonstrated that neither bank regulators, nor anyone else, can consistently and accurately forecast whether…mortgages will turn toxic, or to what degree…or whether a tranche of a CDO will default…or even if the financial system as a whole will seize up. A large fraction of such difficult forecasts will invariably be proved wrong.”

 “Could the breakdown that so devastated global financial markets have been prevented? Given inappropriately low financial intermediary capital (excessive leverage) and two decades of unrelenting prosperity, low inflation, and low long-term interest rates, I very much doubt it.”

“Given history, we (the Fed) believed that any decline in home prices would be gradual. Destabilizing debt problems were not perceived to arise under these conditions.”

My full email to my defense attorneys in March 2010:

I quickly read through Greenspan’s paper last night after you sent it to me.

I thought his central theme was pretty accurate.

“Financial intermediation tried to function on too thin a layer of capital, owing to a misreading of the degree of risk embedded in ever-more complex financial products and markets.”

I also thought his assessment….that the roots of the financial crisis being the result of 500 million additional relatively well-educated (now a total 800 million worldwide) people being freed to work productively with developed world tools (as a result of the end of the Cold War) and their productivity and incomes (without any system of credit or culture to spend) resulted in a global savings glut in Developing Countries at the same time there was a shortfall of investment in Developed Countries, resulting in long-term Global rates moving to historically low levels and fueling a housing bubble in 20 developed Nations…..was both elegant and mostly correct. While later on, he notes that nonconforming home loans in the USA made the bubble worse….this does not bear out with his evidence that “USA price gains at peak were no more than the Global peak average”…and clearly even if he was correct, the dramatic increase in nonconforming lending was really more a symptom of global savings glut and low rates. The following sentences by him summarize: “Asset prices, particularly house prices, accordingly move dramatically higher in the 20 developed Nations. Geopolitical events led to the fall in rates and in turn, with lag, in an unsustainable boom in house prices globally.”

I do think he is wrong that the Fed’s short-term interest rate policies during this time were not a factor. Short-term interest rates….which is primarily the Fed’s view on inflation and the economy can have a serious impact on investors in long-term bonds. In addition, with short-term rates so low and Greenspan telling everyone they would be smarter to utilized ARM loans….the ARM market share expanded dramatically and these consumers/buyers were not using a long-term fixed rate to determine their cost of funds and the price they would pay for the home. Lastly, and most importantly, because of these low short and long-term interest rates…investors went seeking yield and to do so meant seeking additional risk….this, combined with the Fed never allowing the normal business cycle to occur, (an inadequate ratings and capital requirements from government rating agencies and regulators) caused investors to bid the risk premium to an unsustainably low level. Remember, there are many, many short-term tranches of debt that are created from a mortgage securitization structure (due to prepayment speeds)….these were priced off short-term rates set by the Fed. So, I think the Fed’s short-term interest rate policies had a huge impact on fostering the bubble (and causing investors to chase yield/risk) not just in housing but in all sorts of other investments (just look at the public and university pension funds and the kinds of nutty and illiquid investments they got involved in).

He notes that the private sector and government regulators and rating agencies failed because their models did not incorporate a Black Swan-type (once or twice in 100 years) event in them and that it is impossible to accurately forecast or predict events like this occurring and because the benign economic environment and low rates of the last 20+ years lulled everyone into more and more risk taking. The Fed believed that home price declines, if they occurred at all, would be gradual and not destabilizing.

He also in a footnote makes an argument against making our mortgage system safer for creditors/investors/banks…..by making it more conservative. He says this will make home ownership only available to the affluent. Basically, he justifies our business model….even alluding to the fact that subprime lending is needed (as we discussed, more than one Fed Governor has said this and one recent one personally told me this at a Fed dinner). There is a great quote below on the fact that no one could predict when a subprime loan or a tranche in a CDO could become toxic.

He also said that this event is not only a Black Swan (a once or twice in 100 year event), but the worst global financial crisis ever (including the Great Depression…which was a bigger economic crisis, but not financial crisis). In addition, he notes that Central Banks have deliberately established a private financial system that does not maintain adequate capital levels for this type of crisis and therefore sovereign governments must temporarily come to the rescue.

Lastly, he does not believe this event could have been prevented given the macroeconomic conditions that persisted for decades.

So, US home lenders like Indymac did not cause a housing bubble…global macroeconomic factors did. This was the worst financial crisis in history….centered in housing and mortgages….and the Central Banks deliberately structured a private financial system with capital levels inadequate to withstand this type of event without sovereign assistance. Indymac received no help (and in fact received inappropriate disclosures by an elected official….the press had to sue the Fed to get the names of banks who previously borrowed from them, because the Fed was so worried it might cause a bank run or other adverse conditions for an institution) and so it did not survive. This event was rapid, and with a harsh and major down move, and could not be predicted (Greenspan’s words but I agree). Therefore, where is the banking negligence and where is the securities fraud? There is none. mike

Here are some other excerpts that I thought were important:

“Almost all market participants of my acquaintance were aware of the growing risks, but also cognizant that risk had remained underpriced for years.”

“Financial firms were extremely fearful that should they retrench to soon they would almost surely lose market share, perhaps irretrievably.”

Greenspan buried some important things in his footnotes (often a Mea Culpa):

Footnote 16:

“Failing to anticipate the length and depth of emerging bubbles should not have come as a surprise. Though we like to pretend otherwise, policymakers, and indeed forecasters in general, are doing exceptionally well if we can get projections essentially right 70% of the time. But that means we get it wrong 30% of the time. In 18 ½ years at the Fed, I certainly had my share of the latter.”

 “The financial firms risked being able to anticipate the onset of crisis in time to retrench. They were mistaken.”

“Eschewing all objective risk is not consistent with life.”

“…analysts’ ability to time the onset of deflation (a bubble bursting) has proved illusive.”

 “Bubbles with higher debt leverage (mortgages) in the financial sector are a bigger risk.”

“The 1987 stock market crash and the dot com bubble bust led the Fed and sophisticated investors to believe another bubble would not have a big impact.”

 “An inordinately large part of investment management subordinated to ‘safe harbor’ risk designations of the credit rating agencies…government-sanctioned ratings organizations.”

 “Credit rating agencies were no more adept at anticipating the onset of the crisis than the investment community at large.”

 Footnote 23 Mea Culpa and Excuse:

 “I often argued that because of the complexity, we had to rely on an international ‘invisible hand’ to bring equilibrium to such undecipherable markets. The high level of market liquidity (erroneously) appeared to confirm that the system was working.”

 “A financial intermediary cannot profitably operate without risk.”

“Financial intermediaries therefore have no choice but to operate with leverage and accept the risk that entails.”

“There is always some risk that cannot be covered by Bank capital.”

“Central Banks have chosen to set Bank capital and reserve standards that exclude once or twice in a Century crisis.”

“Is the current crisis a 100 year flood?”

“It is the most severe global financial crisis ever.”

“I assume, with hope more than knowledge, that was (the current crisis) indeed the extreme of possible financial crisis that could be experienced by a market economy.”

“Designated pools of self amortizing home mortgages are the safest of private investments.”

“Because financial intermediation requires significant leverage to be profitable, risks, sometimes large risk, are inherent to this indispensable process. And on very rare occasions, it will bring down and may require the temporary substitution of sovereign credit for private capital.”

 “Facing prices that are too low (too low a cost of capital), systemically important firms will take on too much risk.”

“Businesses that are based out of having competitive market and cost of funds advantages, but not efficiency advantages, over firms not thought to be systemically important.”

“The current crisis has demonstrated that neither bank regulators, nor anyone else, can consistently and accurately forecast whether, for example, subprime mortgages will turn toxic, or to what degree, or whether a particular tranche of a CDO will default, or even if the financial system as a whole will seize up. A large fraction of such difficult forecasts will invariably be proved wrong.”

Footnote 58 (Greenspan now changes his mind and admits “you can see bubbles”):

“There has been confusion on the issue, to which I may have been a party. With rare exceptions it has proved impossible to identify the point at which a bubble will burst, but its emergence and development is visible in credit spreads.”

“Indeed, these developments reinforce a truth of a key lesson from our banking history….that private counterparty supervision remains the first line of regulatory defense. Regrettably, that first line of defense failed.”

 “But in retrospect, it appears that the decision to buy homes preceded the decision of how to finance the products.”

“Market demand obviously did not need ARM financing to elevate home prices during the last 2 years of the expanding bubble.”

“Could the breakdown that so devastated global financial markets have been prevented? Given inappropriately low financial intermediary capital (excessive leverage) and two decades of virtual unrelenting prosperity, low inflation, and low long-term interest rates, I very much doubt it.”

 Footnote 72:

“Tight regulations on mortgage lending, for example, down payment requirements of 30% or more, the removal of the mortgage interest deduction, and eliminating home mortgage non-recourse provisions would surely severely dampen enthusiasm for homeownership. But that would delimit home ownership to the affluent, unless low and moderate income ownership were fully subsidized by the government. Since January 2008, the subprime origination market has virtually disappeared. How will HUD’s affordable housing goals be achieve in the future?”

“Given history, we (the Fed) believed that any decline in home prices would be gradual. Destabilizing debt problems were not perceived to arise under these conditions.”

ALAN GREENSPAN, Greenspan Associates, The Crisis

The April 2009 WSJ OpEd entitled: “From Bubble to Depression?” on the U.S. housing bubble and bust and the financial crisis is old, but a great one that I have never shared publicly because it came out during a period in which my speech was squelched (due to government investigations and pending or threatened litigation against me). It is short and I believe a simple, accurate and truthful account of some of the causes of the crisis and despite it being very early after the 2008 crisis, I believe it stands the test of time. It was co-written by researcher Steven Gjerstad and Nobel Prize winning economist Vernon L. Smith.

The full article is attached below, but I have taken out key excerpts and then provided what I believe is important commentary for each of these key excerpts. I believe the ‘conventional wisdom’ about the true root-causes of this crisis (greedy and reckless bankers, Wall Street, and poor regulation) is wrong, and that it is my duty, given my knowledge and experience, to help get the right diagnosis out there, so that the right “cures” can be taken.

“Bubbles have been frequent in economic history, and they occur in the laboratories of experimental economics under conditions which….when first studied in the 1980s…were considered so transparent that bubbles would not be observed.”

“We economists were wrong: Even when traders in an asset market know the value of the asset, bubbles form dependably. Bubbles can arise when some agents buy not on fundamental value, but on price trend or momentum. If momentum traders have more liquidity, they can sustain a bubble longer.”

(“This is right, in my view. The U.S. housing bubble and bust, which occurred in many developed countries, was not caused by misleading, omitted or fraudulent investor disclosures by public securities issuers. The government and private plaintiffs have proven almost nothing against anyone, while strong-arming ‘no admission or denial’ settlements from many. After five years, the legal results support this article’s economic view about bubbles and busts and not the view that disclosures had anything to do with the bubble and bust or the financial crisis.” Mike Perry)

“…the largest one (housing bubble) in U.S. history started in 1997, probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000. Rising values in an asset market draw investor attention; the early stages of the housing bubble had this usual, self-reinforcing feature.”

(“Again, this is right in my view. The start of the bubble had little or nothing to do with home lenders ‘relaxing’ lending standards. It had to do with rising incomes and well-intended government tax policies that encouraged significant speculation in single family real estate; a point I have raised many times and few have identified as a key cause of the bubble.” Mike Perry)

“The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership…”

(“Again, I agree. Banks and mortgage lenders didn’t cause our housing bubble, they only responded to it. It was started by macroeconomic events and well-intended government/FED intervention. It was clear that the government and the FED wanted housing to be the ‘horse’ that took the country out of the dot-com collapse.” Mike Perry)

“Lenders and investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and incomes. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.”

(“That’s about right. Although Greenspan made clear as late as 2005 that he didn’t think the housing market was a speculative bubble and said that home prices had not declined on a nationwide-basis since the Great Depression, because they tended to rise at CPI+, and everyone knew the FED was committed to preventing another depression. Also, the key party responsible in the above chain is investors. These were sophisticated institutional investors buying these bonds all around the world. I offer as proof that they were the key control point, that when they stopped buying the securities; the home loans backing them immediately stopped getting made.” Mike Perry)

“The price decline started in 2006. Then policies designed to promote the American dream instead produced a nightmare. Trillions of dollars of mortgages, written to buyers with slender equity, started a wave of delinquencies and defaults. Borrowers’ losses were limited to their small down payments; hence, the lion’s share of the losses were transmitted into the financial system and it collapsed.”

(“That’s about right. The American dream policies were those of our well-intended government, happily supported by the private sector. Many borrowers who lost their jobs in the crisis were true victims, but many other borrowers were not victims at all; they had put little to no money down or they had pulled all their cash out of their homes through ‘serial refinancing’; effectively selling their home at the peak of the market to the bank or mortgage debt investors. I think these statements also put the lie to the fact the idea that banks knowingly took on too much risk; why would they rationally do that and risk their reputations and careers? That argument makes no sense to me or any other current or former banker.” Mike Perry)

“During the 1976-79 and 1986-89 housing prices bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, ‘leaning against the wind,’ helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the feds-fund rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.”

(“Again, this is well before nonconforming lending really kicked into gear; proving that this type of lending was a reaction to the bubble started by macroeconomic events and well-intended government policy. Stanford and Hoover Institute economist John Taylor has argued strongly that the FED’s monetary policy was a key contributor to the housing bubble and bust and financial crisis and these authors and many others do the same. How long is it going to take the Fed to apologize for being a major cause of this crisis? They didn’t admit and apologize for their role in the Great Depression until Chairman Bernanke did it for them!” Mike Perry)

“Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus…”

(“That’s right, but it was macro and government policy that led the way. It was clear that our economy needed another ‘horse to ride’ after the dot-com bubble burst and the government and the FED pushed housing to the hilt and the industry was only too happy to respond. But clearly, the story that nonconforming lending and/or reckless lenders caused the bubble and bust is wrong. Lending standards relaxed as a response to the housing bubble and the fact that the FED managed the economy so that we rarely had business cycles; an unintended consequence of this is that lenders had no opportunity to tighten credit standards, as they would with small economic downturns. Also, this narrative of blaming reckless home lending for the bubble doesn’t hold up when you consider that housing bubbles and busts occurred in nearly every developed economy in the world; and most did not have nonconforming loans and/or securitization.” Mike Perry)

“With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 along, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since ‘owners’ equivalent rent’ is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.”

(“I thought the same thing and discussed this issue with an IndyMac independent director, who was an economist and had served as a Federal Reserve Board Governor. He didn’t have a good explanation and I have never seen this discussed before by any other monetary economist, but clearly I think these guys are right. The FED was dramatically understating real inflation and therefore had monetary policies in place that were way over-stimulating the economy and in particular housing. If they were in the private sector, this intentional decision to mis-calculate and under report real inflation would be considered gross negligence and/or securities fraud. Recently, I read ‘The Great Degeneration’ by financial historian Niall Ferguson and he raised this same issue: ‘Thirdly, central banks…led by the Federal Reserve…evolved a peculiarly lopsided doctrine of monetary policy, with taught that they should intervene by cutting rates if asset prices abruptly fell, but should not intervene if they rose rapidly, so long as the rise did not affect public expectations of something called ‘core’ inflation, which excluded changes in the prices of food and energy and wholly failed to capture the bubble in housing prices. The colloquial term for this approach is the ‘Greenspan, later Bernanke, Put’, which implied the Fed would intervene to prop up the U.S. equity market, but would not intervene to deflate an asset bubble. The Fed was supposed to care only about consumer-price inflation, and for some obscure reason not about house-price inflation.” Mike Perry)

“With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off…As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued.”

(“And I was investigated and sued and Ben Bernanke was reappointed Chairman of the Fed?” Mike Perry)

“At the end of February 2007, the cost of $10 million of insurance on the AAA-rated portion of a mortgage-backed security was still only $68,000 plus a $9,000 annual premium. Housing market conditions deteriorated further in the first half of 2007 (based on the Case-Shiller home price models)…Startling developments began to unfold that month (July 2007). Between July 9 and August 3, 2007, the cost of insuring AAA MBS went from $50,000 upfront to over $900,000 upfront (plus the annual premium). Once the cost of insuring new mortgage-backed securities skyrocketed, mortgage financing from MBS rapidly declined.”

(“First, as I said earlier, this proves that it was not the mortgage lenders who dictated private mortgage lending guidelines, but the secondary market for private MBS, the insurers, and the rating agencies. Importantly, this puts the lie to the FDIC’s negligence allegations against me in their $600 million frivolous civil lawsuit; I denied their allegations in the Dec 2012 settlement. I was already dramatically cutting IndyMac’s loan volumes and closing lending units, but the FDIC didn’t think that was enough. They thought I should have been omniscient and cut $10 billion more in loan volumes between April and October 2007. But you can see from these objective prices for insurance for private label MBS that there was little concern in February 2007, things got a little worse in the private MBS market in March 2007, but then recovered by the summer of 2007. We even did a big $500 million bank capital raise in May 2007, with sophisticated institutional investors, and there was even less concern as late as July 2007; as the insurance prices noted above evidence. And frankly, while this article uses the Case-Shiller price data and this index has become the ‘gold standard’ post-crisis it was not widely used by Fannie, Freddie, FHA, or the mortgage industry at the time; the government produced their own home price index (OFHEO’s Home Price Index, which determined the conforming loan limit annually) and my recollection is it wasn’t showing much if any home price decline in mid-2007. My recollection was the real change occurred during this July 2007 period when the Bear Stearns mortgage funds blew up and Countrywide had a major bank run and had to firesell themselves to BofA. After that, the private MBS market collapsed and has never really recovered to this day and consumer demand for new homes (from builders) also collapsed and while it has recovered some, it is still to this day at historically low levels. Think about it. In the first half of 2007, I was prudently cutting billions in loan volume and closing lending divisions and raising $500 million of bank capital, all before July 2007. And after Bear and Countrywide and the private MBS market collapsed, I converted IndyMac to a conforming (Fannie/Freddie) and government (FHA/VA) lender in a roughly 90-day period and raised an additional $175 million or so of bank capital. I wasn’t omniscient, but neither was the marketplace and our ‘economic experts’ like Bernanke and the Fed. And I certainly was not a negligent banker who deserved to have a lifetime banking ban forced upon him by the FDIC. My actions in 2007 and 2008 were the exact opposite of negligent and to this day and with the benefit of hindsight I am confident that I did everything right and appropriate and am proud of my efforts. The events of this period were frankly beyond any individual or firm’s control.” Mike Perry)

“The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and monetary contraction caused the decline of the banking system both seem inadequate….What we have offered in our discussion of this crisis is the back story to Mr. Bernanke’s analysis of the Depression. Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we’re witnessing the second great consumer debt crash, the end of a massive consumption binge.”

(“It’s unbelievable to me that ‘conventional wisdom’ is so sure they have gotten the diagnosis of this current crisis correct: reckless and greedy bankers, mortgage lenders, Wall Street, and inadequate government regulation of them. And yet, the above statements, which I agree with, show that the ‘conventional wisdom’ about The Great Depression is probably wrong and that Bernanke, an ‘expert’ on the Great Depression and the Fed’s actions during it, believed this conventional wisdom and acted wrongly in this current crisis, as a result. I think given my knowledge and experience and study post-crisis, it is my duty to speak up and make the case that this ‘conventional wisdom’ is not correct. Because if we don’t have the right diagnosis, we won’t seek the right cures and that will hurt all Americans, as it has. Please read this article by Mr. Gjerstad and Mr. Smith. They are right and I have tried to highlight other very smart people on my blog who make similar points about the true underlying causes of the financial crisis.” Mike Perry)

OPINION
April 6, 2009

From Bubble to Depression?

By STEVEN GJERSTAD

and VERNON L. SMITH

Bubbles have been frequent in economic history, and they occur in the laboratories of experimental economics under conditions which — when first studied in the 1980s — were considered so transparent that bubbles would not be observed.

We economists were wrong: Even when traders in an asset market know the value of the asset, bubbles form dependably. Bubbles can arise when some agents buy not on fundamental value, but on price trend or momentum. If momentum traders have more liquidity, they can sustain a bubble longer.

But what sparks bubbles? Why does one large asset bubble — like our dot-com bubble — do no damage to the financial system while another one leads to its collapse? Key characteristics of housing markets — momentum trading, liquidity, price-tier movements, and high-margin purchases — combine to provide a fairly complete, simple description of the housing bubble collapse, and how it engulfed the financial system and then the wider economy.

In just the past 40 years there were two other housing bubbles, with peaks in 1979 and 1989, but the largest one in U.S. history started in 1997, probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000. Rising values in an asset market draw investor attention; the early stages of the housing bubble had this usual, self-reinforcing feature.

The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.

But housing expenditures in the U.S. and most of the developed world have historically taken about 30% of household income. If housing prices more than double in a seven-year period without a commensurate increase in income, eventually something has to give. When subprime lending, the interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARM were no longer able to sustain the flow of new buyers, the inevitable crash could no longer be delayed.

The price decline started in 2006. Then policies designed to promote the American dream instead produced a nightmare. Trillions of dollars of mortgages, written to buyers with slender equity, started a wave of delinquencies and defaults. Borrowers’ losses were limited to their small down payments; hence, the lion’s share of the losses was transmitted into the financial system and it collapsed.

During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, “leaning against the wind,” helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.

Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years — from $1.05 trillion in 2000 to $3.95 trillion in 2003!

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.

How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since “owners’ equivalent rent” is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off. As measured by the Case-Shiller 10 city index, the accumulated inflation in home-ownership costs between January 1999 and June 2006 was 151%, but the CPI measured a mere 23% increase. As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued. Even after the Fed began to slowly raise the fed-funds rate in May 2004, the average rate remained low and the bubble continued to inflate for two more years.

The unraveling of the bubble is in many ways the most fascinating part of the story, and the most painful reality we are now experiencing. The median price of existing homes had fallen from $230,000 in July to $217,300 in November 2006. By the beginning of 2007, in 17 of the 20 cities in the Case-Shiller index, prices were falling. Serious price declines had not yet begun, but the warning signs were there for alert observers.

Kate Kelly, writing in this newspaper (Dec. 14, 2007), tells the story of how Goldman Sachs avoided the fate of many of the other investment banks that packaged mortgages into securities. Goldman loaded up on the Markit ABX index of credit default swaps between early December 2006 and late February 2007, as their price dropped from 97.70 on Dec. 4 to under 64 by Feb. 27. But the market was not yet in free-fall: The insurance on AAA-rated parts of the mortgage-backed securities (MBS) remained inexpensive. By mid-summer 2007, concern spread to the AAA-rated tranches of MBS.

At the end of February 2007, the cost of $10 million of insurance on the AAA-rated portion of a mortgage-backed security was still only $68,000 plus a $9,000 annual premium. Housing-market conditions deteriorated further in the first half of 2007. Case-Shiller tiered price sequences in Los Angeles, San Francisco, San Diego and Miami all show serious declines by the summer of 2007. Prices in the low-price tier in San Francisco were down almost 13% from their peak by July 2007; in San Diego they were off 10% by July 2007. Startling developments began to unfold that month. Between July 9 and Aug. 3, 2007, the cost of insuring AAA MBS tranches went from $50,000 upfront plus a $9,000 annual premium for $10 million of insurance to over $900,000 upfront (plus the annual premium).

Once the cost of insuring new mortgage-backed securities skyrocketed, mortgage financing from MBS rapidly declined. Subprime originations plummeted from $160 billion in the third quarter of 2006 to $28 billion in the third quarter of 2007. Mortgage-backed security issuance fell comparably, from $483 billion in all of 2006 to only $30.7 billion in the third quarter of 2007. Other measures of new loan originations were falling at the same time. The liquidity that generated the housing market bubble was evaporating.

Trouble quickly spread from the cost of insuring mortgage-backed securities to problems with credit markets generally, as the spread between short-term U.S. Treasury debt and the LIBOR rate increased to 2.40% from 0.44% between Aug. 8 and Aug. 20, 2007. Since U.S. Treasury debt is generally considered secure, but a bank’s loans to another bank carry some risk of default, the spread between these rates serves as an indicator of perceived risk in financial markets.

In one city after another, prices of homes in the low-price tier appreciated the most and then fell the most; prices in the high-priced tier appreciated least and fell the least. The price index graphs for Los Angeles, San Francisco, San Diego and Miami show that in all of these cities, prices in the low-price tier have fallen between 50% and 57%. Moreover, housing prices have continually declined in every market in the Case-Shiller index. According to First American CoreLogic, 10.5 million households had negative or near negative equity in December 2008. When housing prices turned down, many borrowers with low income and few assets other than their slender home equity faced foreclosure. The remaining losses had to be absorbed by the financial system. Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets.

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury.

In an important paper in 1983, Ben Bernanke argued that during the Depression, severe damage to the financial system impeded its ability to perform its economic role of lending to households for durable goods consumption and to firms for production and trade. We are seeing this process playing out now as loan funds for automobile purchases have withered. Auto sales fell 41% between February 2008 and February 2009. Retail and labor markets too are now part of the collateral damage from the housing debacle. Housing peaked in early 2006. Losses from the mortgage market began to infect the financial system in 2006; asset prices in that sector began to decline at the end of 2006. Meanwhile, equities and the broader economy were performing well, but as the financial sector deteriorated, its problems blindsided the rest of the economy.

The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression. Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth.

The Great Depression has been attributed to excessive speculation on Wall Street, especially between the spring of 1927 and the fall of 1929. Had the difficulties of the banking system been caused by losses on brokers’ loans for margin purchases in 1929, the results should have been felt in the banks immediately after the stock market crash. But the banking system did not show serious strains until the fall of 1930.

Bank earnings reached a record $729 million in 1929. Yet bank exposures to real estate were substantial; as the decline in real estate prices accelerated, foreclosures wiped out banks by the thousands. Had the mounting difficulties of the banks and the final collapse of the banking system in the “Bank Holiday” in March 1933 been caused by contraction of the money supply, as Milton Friedman and Anna Schwartz argued, then the massive injections of liquidity over the past 18 months should have averted the collapse of the financial market during this current crisis.

The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate. It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt — especially mortgage debt — that was transmitted into the financial sector during a sharp downturn.

What we’ve offered in our discussion of this crisis is the back story to Mr. Bernanke’s analysis of the Depression. Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we’re witnessing the second great consumer debt crash, the end of a massive consumption binge.

Mr. Gjerstad is a visiting research associate at Chapman University. Mr. Smith is a professor of economics at Chapman University and the 2002 Nobel Laureate in Economics.

Excerpts from September 19, 2013 LA Times article: “Five Years After The Meltdown: MBA Schools learn, teach new lesson” The financial crisis spurs soul-searching and beefed-up courses on ethics and risks

“It’s all part of an effort to combat the mantra that has become central to business culture over the last few decades: the single-minded pursuit of shareholder value. A case in point could be the subprime mortgage deals that propelled the crisis. Mortgage brokers and Wall Street Traders earned big bucks selling faulty loans and packing them into…it turned out…worthless investments. Their goals was to make as much as possible.”

“’That goes to the heart of the problem,’ said Jeffery Smith of the University of Redlands, who is a visiting professor at DePauw University in Indiana this year. ‘They weren’t rewarded on the basis of whether or not these products and services actually produced wealth for society as a whole.’”

“Is this Redlands professor right? Is the whole tenor of this LA Times article, that business ethics lapses and greed were the cause of the financial crisis, right? I don’t think so. How would we then make every day decisions, especially economic/business decisions? On the greater good for society as a whole? Who’s view? I was taught that our capitalistic system only works properly if we pursue our own self-interests (subject to complying with all laws and regulations). It’s for our government and our religious/civic/charitable organizations to fill in were our free market capitalistic system falls down. I still think that’s right. And what’s greed? Isn’t it greedy to want your kids to go to Stanford and do everything possible to make that happen. You went to Stanford. Why not let some other family have a chance? Is it greedy to want your college alma mater to win the BCS championship every year? Shouldn’t you let someone else win for a change? I bet the Alabama faithful don’t think so? What amount of wealth accumulation is greedy and what is not? I think the financial crisis was caused by many factors, including well-intended government distortions of the financial, mortgage, and housing markets, global macroeconomic factors, economic uncertainty, and investor exuberance for all types of assets. I don’t think it was caused by greed (because that is always present in our system and needs to be) or by fraud.” Michael Perry, September 19, 2013

Excerpt from NY Times, September 10, 2013, “Embracing Wynne Godley an Economist Who Modeled the Crisis”:

“Mainstream (economic) models assume that, as individuals maximize their self-interest, markets move the economy to equilibrium.”

Excerpt on Capitalism and Greed from Feb. 11, 1979 Phil Donahue Interview of Nobel prize economist and Presidential Medal of Freedom recipient Milton Friedman:

Phil Donohue: “When you see around the globe the mal-distribution of wealth, the desperate plight of millions of people in underdeveloped countries, when you see so few haves and so many have-nots, when you see the greed and the concentration of power, did you ever have a moment of doubt about capitalism? And whether greed is a good idea to run on?”

Milton Friedman: “Well first of all tell me, is there some society you know that doesn’t run on greed? You think Russia doesn’t run on greed? You think China doesn’t run on greed? What is greed? Of course none of us are greedy. It’s only the other fella that’s greedy. The world runs on individuals pursuing their separate interests. The greatest achievements of civilization have not come from government bureaus. Einstein didn’t construct his theory under order from a bureaucrat. Henry Ford didn’t revolutionize the automobile industry that way. In the only cases in which the masses have escaped from the kind of grinding poverty that you are talking about, the only cases in recorded history are where they have had capitalism and largely free trade. If you want to know where the masses are worst off, it’s exactly in the kind of societies that depart from that. So that the record of history is absolutely crystal clear, there is no alternative way, so far discovered, of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system.”

Phil Donohue: “Seems to reward not virtue as much as the ability to manipulate the system.”

Milton Friedman:  “And what does reward virtue? You think the Communist commissar rewards virtue? You think a Hitler rewards virtue? Do you think… American presidents reward virtue? Do they choose their appointees on the basis of the virtue of the people appointed or on the basis of political clout? Is it really true that political self-interest is nobler somehow than economic self-interest? You know I think you are taking a lot of things for granted. And just tell me where in the world you find these angels that are going to organize society for us? Well, I don’t even trust you to do that.”

Key Excerpts from Niall Ferguson’s 2013 book, “The Great Degeneration: How Institutions Decay and Economies Die”:

“You cannot blame all of this on deleveraging. In the United States, the wider debate is about globalization, technology change, education, and fiscal policy.”

“The first draft of the history of the financial crisis is in, and here is what it says: deregulation is to blame. Unfettered after 1980, financial markets ran amok, banks blew up and then had to be bailed out. Now they must be fettered once again. As will become clear, it is not my purpose to whitewash bankers. But I do believe this story is mostly wrong.”

“Because legislators and regulators acted with an almost complete disregard for the law of unintended consequences, they inadvertently helped to inflate a real estate bubble in countries all over the developed world.”

“Think of it this way. The regulatory frameworks of the post-1980 period encouraged banks to increase their balance sheets relative to their capital. This happened in all kinds of different countries, in Germany and Spain as much as the United States. (We really cannot blame Ronald Reagan for what happened in Berlin and Madrid.) When property-backed assets fell in price, banks were threatened with insolvency. When short-term funding dried up, they were threatened with illiquidity. The authorities found they had to choose between a Great Depression scenario of massive bank failures or bailing the banks out. They bailed them out. Chastened by ungrateful voters (who still do not appreciate how much worse things could have got if the ‘too big’ had actually failed), the legislators now draw up statutes designed to avoid future bailouts.”

“Countries arrive at the stationary state, as Adam Smith argued, when their ‘laws and institutions’ degenerate to the point that elite rent-seeking dominates the economic and political process. I have tried to suggest that this is the case in important parts of the Western world today. Public debt…stated and implicit….had become a way for the older generation to live at the expense of the young and unborn. Regulation has become dysfunctional to the point of increasing fragility of the system. Lawyers, who can be revolutionaries in a dynamic society, become parasites in a stationary one. And civil society withers into a mere no man’s land between corporate interests and big government. Taken together, these are the things I refer to as the Great Degeneration.”

More Excerpts from Niall Ferguson’s 2013 book, “The Great Degeneration: How Institutions Decay and Economies Die”:

Jacket Cover

“What causes rich countries to lose their way? Symptoms of decline are all around us today: slowing growth, crushing debts, increasing inequality, aging populations, antisocial behavior. But what exactly has gone wrong?”

“Niall Ferguson argues in The Great Degeneration, is that our institutions…the intricate frameworks within which society can flourish or fail….are degenerating.”

“Representative government, the free market, the rule of law and civil society…these are the four pillars of our way of life. It was these institutions, rather than any geographical or climatic advantages, that set the West on the path to prosperity and security. In our time, however, these institutions have deteriorated in disturbing ways.”

“Our democracies have broken the contract between generations by heaping IOUs on our children and grandchildren. Our markets are hindered by overcomplex regulations that debilitate the political and economic processes, they were created to support; the rule of law has become the rule of lawyers. And civil society has degenerated into uncivil society, where we lazily expect all of our problems to be solved by the state.”

“It is institutional degeneration, in other words, that lies behind economic stagnation and the geopolitical decline that comes with it.”

Introduction

“The voguish explanation for the Western slowdown is ‘deleveraging’: the painful process of debt reduction (or balance sheet repair). Certainly, there are few precedents for the scale of debt in the West today. This is only the second time in American history that combined public and private debt has exceeded 250 per cent of GDP. In a survey of fifty countries, the McKinsey Global Institute identifies forty-five episodes of deleveraging since 1930. In only eight was the initial debt/GDP ratio above 250 percent, as it is today not only in the U.S. but also in all of the major English-speaking countries (including Australia and Canada), all the major continental European countries (including Germany), plus Japan and South Korea.”

“The deleveraging argument is that households and banks are struggling to reduce their debts, having gambled foolishly on ever rising property prices. But as people have sought to spend less and save more, aggregate demand has slumped. To prevent this process from generating a lethal debt deflation, governments and central banks have stepped in with fiscal and monetary stimulus unparalleled in time of peace. Public sector deficits have help mitigate the contraction, but they risk transforming a crisis of excess private debt into a crisis of excess public debt. In the same way, the expansion of central bank balance sheets (the monetary base), prevented a cascade of bank failures, but now appears to have diminishing returns in terms of reflation and growth.”

“Yet more is going on here than just deleveraging.”

“You cannot blame all of this on deleveraging. In the United States, the wider debate is about globalization, technology change, education, and fiscal policy.”

“The crisis of public finance is not uniquely American. Japan, Greece, Italy, Ireland, and Portugal are also members of the club of countries with public debts in excess of 100 percent of GDP.”

“Only by historical methods can we explain why, over the past thirty years, so many countries created forms of debt that, by design, cannot be inflated away; and why, as a result, the next generation will be saddled for life with liabilities incurred by their parents and grandparents.”

“In the same way, it is easy to explain why the financial crisis was caused by excessively large and leveraged financial institutions, but much harder to explain why, after more than four years of debate, the problem of ‘too big to fail’ banks has not been solved.”

“Today, a mere ten highly diversified financial institutions are responsible for three-quarters of total financial assets under management in the United States. Yet the country’s largest banks are at least $50 billion short of meeting new capital requirements under the new Basel III accords governing bank capital adequacy. Again, only a political and historical approach can explain why Western politicians today call simultaneously for banks to lend more money and for them to shrink their balance sheets.”

“Why is it now a hundred times more expensive to bring a new medicine to market than it was sixty years ago…Why would the FDA probably prohibit table salt if it were put forward as a new pharmacological product? Why, to give another suggestive example, did it take an American journalist sixty-five days to get official permission (including, after a wait of up to five weeks, a Food Protection Certificate) top open a lemonade stand in New York City?…This is the kind of debilitating red tape that development economists often blame for poverty in Africa or Latin America.”

“The Four Black Boxes”

“To demonstrate that Western institutions have indeed degenerated, I am going to have to open up some long-sealed black boxes.”

“The first is the on labeled ‘democracy’. The second is labeled ‘capitalism’. The third is ‘the rule of law’. And the fourth is ‘civil society’. Together, they are the key components of our civilization.”

The Human Hive

“Most commentators who address this question tend to concern themselves with phenomena like excessive debt, mismanaged banks, and widening inequality. To my mind, however, these are nothing more than symptoms of an underlying institutional malaise: an Inglorious Revolution, if you like, which is undoing the achievements of half a millennium of Western institutional evolution.”

“A second problem is that today’s Western democracies now play such a large part in redistributing income that politicians who argue for cutting expenditures nearly always run into the well-organized opposition for one or both of two groups: recipients of public sector pay and recipients of government benefits.”

“But I believe there is a way of making such leadership more likely to succeed, and that is to alter the way in which governments account for their finances. The present system is, to put it bluntly, fraudulent. There are no regular published and accurate official balance sheets. Huge liabilities are simply hidden from view. Not even current income and expenditure statements can be relied upon. No legitimate business could possibly carry on in this fashion. The last corporation to publish financial statements this misleading was Enron.”

“There is in fact a better way. Public sector balance sheets can and should be drawn up so that liabilities of governments can be compared with their assets. That would help clarify the differences between deficits to finance investment and deficits to finance current consumption. Government should also follow the lead of business and adopt Generally Accepted Accounting Principles. And above all, generational accounts should be prepared on a regular basis to make absolutely cleare the inter generational implications of current policy.”

“As our economic difficulties have worsened, we voters have struggled to find appropriate scapegoats. We blame the politicians whose hard lot it is to bring public finances under control. But we also like to blame bankers and financial markets, as if their reckless lending were to blame for our reckless borrowing. We bay for tougher regulation, though not of ourselves.”

The Darwinian Economy

“The first draft of the history of the financial crisis is in, and here is what it says: deregulation is to blame. Unfettered after 1980, financial markets ran amok, banks blew up and then had to be bailed out. Now they must be fettered once again.”

“As will become clear, it is not my purpose to whitewash bankers. But I do believe this story is mostly wrong. For one thing, it is hard to think of a major event in the U.S. crisis….beginning with the failure of Bear Stearns and Lehman Brothers….that could not equally well have happened with Glass-Steagall still in force.”

“For another, the claim that economic performance for the U.S. economy before Ronald Reagan was superior to what followed because of the tighter controls on banks before 1980 is simply laughable. Productivity certainly grew faster between 1950 and 1979 than between 1980 and 2009. But it grew faster in the 1980s and 1990s than in the 1970s. And it consistently grew faster than in Canada after 1979…..I could triumphantly point out that Canada retained a far more tightly regulated banking system than the U.S…and as a result lagged behind in terms of productivity.”

“To a British reader, if not to an American, there is something especially implausible about the story that regulated financial markets were responsible for rapid growth, while deregulation caused crisis…..Yet there was anything but ‘spectacular economic progress’ in this era of financial regulation. On the contrary, the 1970s were arguably Britain’s most financially disastrous decade since the 1820s, witnessing not only a major banking crisis, but also a stock market crash, a real estate bubble and bust, and double-digit inflation, all rounded off by the arrival of the International Monetary Fund in 1976….the lesson of the 1970s (in Britain) is not that deregulation is bad, but that bad regulation is bad, especially in the context of bad monetary and fiscal policy. And I believe the same can be said of our crisis, too.”

“The financial crisis that began in 2007 had its origins precisely in over-complex regulation.”

“First, the executives of large publicly owned banks were strongly incentivized to ‘maximize shareholder value’….All over the Western world, balance sheets grew to dizzying sizes relative to bank equity. How was this possible? The answer is that it was expressly permitted by regulation. To be precise, the Basel Committee on Banking Supervision’s 1998 Accord allowed very large quantities of assets to be held by banks relative to their capital, provided these assets were classified as low risk…for example, government bonds.”

“Secondly….In practice risk weightings came to be based on the ratings given to securities….and, later to structured financial products…by the private rating agencies.”

“Thirdly, central banks…led by the Federal Reserve….evolved a peculiarly lopsided doctrine of monetary policy, with taught that they should intervene by cutting rates if asset prices abruptly fell, but should not intervene if they rose rapidly, so long as the rise did not affect public expectations of something called ‘core” inflation (which excluded changes in the prices of food and energy and wholly failed to capture the bubble in housing prices). The colloquial term for this approach is the ‘Greenspan (later Bernanke) Put’, which implied the Fed would intervene to prop up the U.S. equity market, but would not intervene to deflate an asset bubble. The Fed was supposed to care only about consumer-price inflation, and for some obscure reason not about house-price inflation.”

“Fourthly, the U.S. Congress passed legislation designed to increase the percentage of lower-income families…especially minority families….that owned their own homes. The mortgage market was highly distorted by the ‘government sponsored entities’ Fannie Mae and Freddie Mac. Both parties viewed this as desirable social and political reasons. Neither considered that, from a financial point of view, they were encouraging low-income households to place large, leveraged, unhedged and unidirectional bets on the U.S. housing market.”

“A final layer of market distortion was provided by the Chinese government, which spent literally trillions of dollars’ worth of its own currency to prevent it from appreciating relative to the dollar…Nor were the Chinese the only ones who chose to plough their current account surpluses into dollars. The secondary and unintended consequence was to provide the United States with a vast credit line. Because much of what the surplus countries bought was U.S. government or government agency debt, the yields on these securities were artificially held low. Because mortgage rates are closely linked to Treasury yields…..thus it helped further to inflate an already bubbling property market.”

“The only chapter in this history that really fits the ‘blame deregulation’ thesis is the non-regulation of the markets in derivatives such as credit default swaps……However, I do not believe this can be seen as a primary cause of the crisis. Banks were the key to the crisis, and the banks were regulated.”

“The issue is whether or not additional regulation of the sort that is currently being devised and implemented can improve matters by reducing the frequency or magnitude of future financial crises. I think it is highly unlikely. Indeed, I would go further. I think the new regulations may have precisely the opposite effect. The problem we are dealing with here is not inherent in financial innovation. It is inherent in financial regulation.”

“Because legislators and regulators acted with an almost complete disregard for the law of unintended consequences, they inadvertently helped to inflate a real estate bubble in countries all over the developed world.”

“Today, it seems to me, the balance of opinion favours complexity over simplicity; rules over discretion; codes of compliance over individual and corporate responsibility. I believe this approach is based on a flawed understanding of how financial markets work.”

“I believe excessively complex regulation is the disease of which it pretends to be the cure.”

“As I have suggested, it was the most-regulated institutions in the financial system that were in fact the most disaster-prone: big banks on both sides of the Atlantic, not hedge funds. It is more than a little convenient for America’s political class to have the crisis blamed on deregulation and the resulting excess of bankers. Not only does that neatly pass the buck it also creates justification for more regulation.”

“Under the Basel III Framework for bank capital standards, which is due to come into force between 2013 and the end of 2018, the world’s twenty-nine largest global banks will need to raise an additional $566 billion in new capital or shed around $5.5 trillion in assets. According to the rating agency Fitch, this implies a 23 percent increase relative to the capital the banks had at the end of 2011. It is quite true that big banks became under-capitalized….or excessively leveraged if you prefer the term…after 1980. But it is far from clear how forcing banks to hold more capital or make fewer loans can be compatible with the goal of sustained economic recovery, without which financial stability is very unlikely to return to the U.S., much less Europe.”

“Lurking inside every such regulation is the universal law of unintended consequences.”

“One of the many new features of Basel III is a requirement for banks to build up capital in good times, so as to have a buffer in bad times. This innovation was widely hailed some years ago when it was introduced by Spanish bank regulators. Enough said.”

“The editor of the Economist Walter Bagehot was only one of many Victorian contemporaries who drew the parallel back from Darwin’s theory of evolution to the economy. As he once observed: ‘The rough and vulgar structure of English commerce is the secret of its life; for it contains the ‘propensity to variation’, which, in the social and the animal kingdom, is the principle of progress.’”

“The Great Depression of the 1930s and the Great Inflation of the 1970s stand out as times of major discontinuity, with the ‘mass extinctions” such as the bank panics of the 1930s and the Savings and Loans failures of the 1980s. A comparably large disruption has clearly happened in our time. But where are the mass extinctions? The dinosaurs still roam the financial world.”

“The answer is that, whereas evolution in biology takes place in the pitiless natural environment, evolution in finance occurs within a regulatory framework where….to adapt a phrase from anti-Darwinian creationists….’intelligent design’ plays a part. But just how intelligent is this design? The answer is: not intelligent enough to second-guess the evolutionary process. In fact, stupid enough to make a fragile system even more fragile.”

“Think of it this way. The regulatory frameworks of the post-1980 period encouraged banks to increase their balance sheets relative to their capital. This happened in all kinds of different countries, in Germany and Spain as much as the United States. (We really cannot blame Ronald Reagan for what happened in Berlin and Madrid.) When property-backed assets fell in price, banks were threatened with insolvency. When short-term funding dried up, they were threatened with illiquidity. The authorities found they had to choose between a Great Depression scenario of massive bank failures or bailing the banks out. They bailed them out. Chastened by ungrateful voters (who still do not appreciate how much worse things could have got if the ‘too big’ had actually failed), the legislators now draw up statutes designed to avoid future bailouts.”

“Another and related way of thinking about the financial system is as a highly complex system, made up of a very large number of interacting components that are asymmetrically organized in a network. This network operates somewhere between order and disorder….on ‘the edge of chaos’. Such complex systems can appear to operate quite smoothly for some time, apparently in equilibrium, in reality constantly adapting as positive feedback loops operate. But there comes a moment when they ‘go critical’. A slight perturbation can set off a ‘phase transition’ from a benign equilibrium to a crisis. This is especially common where the network nodes are ‘tightly coupled’. When the interrelatedness of a network increases, conflicting constraints can quickly produce a ‘complexity catastrophe’.”

“All complex systems in the natural world….from termite hills to large forests to the human nervous system….share certain characteristics. A small input to such a system can produce huge, unanticipated changes. Causal relationships are often non-linear. Indeed, some theorists would go so far as to say that certain complex systems are wholly non-deterministic, meaning that it is next to impossible to make predictions about their future behavior based on past data…..It turns out that financial crises are much the same.”

“As heterodox economists like W. Brian Arthur have been arguing for years, a complex economy is characterized by the interaction of dispersed agents, a lack of central control, multiple levels of organization, continual adaptation, incessant creation of new market niches and no general equilibrium.”

“Viewed in this light, as Andrew Haldane of the Bank of England has argued, Wall Street and the City of London are parts of one of the most complex systems that humans beings have ever made. And the combination of concentration, interbank lending, financial innovation, and technological acceleration makes it a system especially prone to crash.”

“Once again, however, the difference between the natural world and the financial world is the role of regulation. Regulation is supposed to reduce the number and size of financial forest fires. And yet, as we have seen, it can quite easily have the opposite effect….The point is that regulation should be designed to heighten anti-fragility. But the regulation we are contemplating today does the opposite: because of its very complexity….and often contradictory objectives…it is pro-fragile.”

“Over-complicated regulation can indeed be the disease of which it purports to be the cure.”

“Just as the planners of the old Soviet system could never hope to direct a modern economy in all its complexity for reasons long ago explained by Friedrich Hayek and Janos Kornai, so the regulators of the post-crisis world are doomed to fail in their efforts to make the global financial system crisis-free. They can never know enough to manage such a complex system. They will only ever learn from the last crisis how to make the next one.”

The Landscape of Law

“I believe this gives an invaluable insight into the authentically evolutionary character of the common law system. It was this, rather than any specific functional difference in the treatment of investors or creditors, that gave the English system and its relatives around the world an advantage in terms of economic development.”

“First (threat), we must post the familiar question about how far our civil liberties have been eroded by the national security state…a process that in fact dates back almost a hundred years to the outbreak of the First World War….”

“A second threat is the very obvious on posed by the intrusion of European law….with its civil law character….into the English legal system…This may be considered Napoleon’s revenge: a creeping ‘Frenchification’ of the common law.”

“A third threat is the growing complexity (and sloppiness) of statute law, a grave problem on both sides of the Atlantic as the mania for elaborate regulation spreads through the political class.”

“I agree with the American legal critic Philip K. Howard that we need a ‘legal spring cleaning” of obsolete legislation and routine inclusion of ‘sunset provisions’ (expiry dates) in new laws. We must also seek to persuade legislators that there role is not to write an ‘instructions manual’ for the economy that covers every eventuality, right down to the remotest imaginable risk to our health and safety.”

“A fourth threat….especially apparent in the United States….is the mounting cost of the law. By this I do not mean the $94.5 billion a year the U.S. federal government spends on law making, law interpretation, and law enforcement…It is the cost of the consequences of their work that is truly alarming: an estimated $1.75 trillion a year, according to a report commissioned by the U.S. Small Business Administration, in additional business costs arising from compliance with regulations. On top of that are the $865 billion in costs arising from the U.S. system of tort law, which gives litigants far greater opportunities than in England to seek damages for any ‘wrongful act, damage, or injury done willfully, negligently, or in circumstances involving strict liability, but not involving breach of contract, for which a civil suit can be brought.’”

“….the tort system costs a sum ‘equivalent to an eight percent tax on consumption or thirteen percent tax on wages. The direct costs arising from a staggering 7,800 new cases a day were equivalent to more than 2.2 percent of U.S. GDP in 2003, double the equivalent figure in any other developed economy, with the exception of Italy.”

“…my own personal experience tells a similar story: merely setting up a new business in New England involved significantly more lawyers and much more in legal fees than doing so in England.”

“Experts on economic competitiveness…..define the term to included the ability of the government to pass effective laws; the protection of physical and intellectual property rights and lack of corruption; the efficiency of the legal framework, including modest costs and swift adjudication; the ease of setting up a new business; and effective and predictable regulations. It is startling to find how poorly the United States now fares when judged by these criteria.”

“(Harvard Professors) asked HBS alumni about 607 instances of decisions on whether or not to offshore operations. The United States retained the business in just ninety-six cases (16 percent) and lost it in all the rest.”

“Evidence that the United States is suffering some kind of institutional loss of competitiveness can be found not only (in this work) but in the World Economic Forum’s annual Global Competitiveness Index, and in particular, the Executive Opinion Survey….The survey includes fifteen measures of the rule of law, ranging from the protection of private property rights to the policing of corruption and the control of organized crime. It is an astonishing yet scarcely acknowledged fact that on no fewer than fifteen out of fifteen counts, the United States now fares markedly worse than Hong Kong. Taiwan outranks the U.S. in nine out of fifteen…..Indeed, the United States makes the global top twenty in only one area. On every other count, its reputation is shockingly bad.”

“The World Justice Project’s Rule of Law 2011 index ranks the United States twenty-first out of sixty-six in terms of access to civil justice, nineteenth for fundamental rights, sixteenth for the limiting of government powers, fifteenth for regulator enforcement, and twelfth for the openness of government…”

“..the World Bank’s indicators on World Governance, suggest that since 1996 the United States has suffered a decline in the quality of its governance in four different dimensions: government accountability and effectiveness, regulatory quality and control of corruption. Compared with Germany and Hong Kong, the U.S. is manifestly slipping behind. This is a remarkable phenomenon. Even more remarkable is that it is happening almost unnoticed by Americans.”

“…the rule of law, broadly defined, is deteriorating in the United States…..All over the developing world, countries are seizing the opportunity to improve their chances of attracting foreign and domestic investment and raising the growth rate by reforming their legal and administrative systems. The World Bank now does a very good job of keeping tabs on the progress of such reforms.”

“Another approach I have taken is to look at the IFC’s ‘Doing Business’ reports since 2006 to see which developing countries have seen the biggest reduction in the number of days it takes to complete seven procedures: starting a business, getting a construction permit, registering a property, paying taxes, importing goods, exporting and enforcing contracts.”

“Mancur Olson used to argue that, over time, all political systems are likely to succumb to sclerosis, mainly because of rent-seeking activities by organized interest groups. Perhaps that is what we see at work in the United States today.”

“Americans could once boast proudly that their system set the benchmark for the world; the United States WAS the rule of law. But now what we see is the rule of LAWYERS, which is something different. It is no coincidence that lawyers are so over-represented in the U.S. Congress.”

“Olson also argued that it can require an external shock….like a lost war….to sweep away the stifling residues of cronyism and corruption, and allow the rule of law in Bingham’s and Dworkin’s senses of the term to be re-established. It must fervently be hoped that the United States can avoid such a painful form of therapy. But how is the system to be reformed if, as I have argued, there is so much that is rotten within it: in the legislature, in the regulatory agencies, in the legal system itself?”

“The answer, as I shall argue in the next and final chapter is that reform….must come from outside the realm of public institutions. It must come, in short, from us: the citizens.”

Civil and Uncivil Societies

“My Welsh experience taught me the power of the voluntary association as an institution. Together, spontaneously, without any public sector involvement, without any profit motive, without any legal obligation or power, we had turned a depressing dumping ground back into a beauty spot. And every time I wonder down for a swim, I ask myself: how many other problems could be solved in this simple and yet satisfying way?”

“In this final chapter, I want to unlock the black box labeled ‘civil society’. I want to ask how far it is possible for a truly free nation to flourish in the absence of the kind of vibrant civil society we used to take for granted. I want to suggest that the opposite of civil society is uncivil society, where even the problem of anti-social behavior has become a problem for the state. And I want to cast doubt on the idea that the new social networks of the internet are in any sense a substitute for the real networks of the sort that helped me clear my local beach.”

“’America is, among the countries of the world,’ declared Alexis de Tocqueville in the first book of his Democracy in America: the one where they have taken the most advantage of association and where they have applied that powerful mode of action to a greater diversity of objects. Independent of the permanent associations created by law under the names of townships, cities, and counties, there is a multitude of others that owe their birth and development only to individual will. The inhabitant of the United States learns from birth that he must rely on himself to struggle against the evils and obstacles of life: he has only a defiant and restive regard for social authority and he appeals to its authority only when he cannot do without it…In the United States, they associate for the goals of public security, of commerce and industry, of morality and religion. There is nothing the human will despairs of attaining by the free action of the collective power of individuals.’”

“Tocqueville saw America’s political associations as an indispensible counterweight to the tyranny of the majority in modern democracy. But it was the non-political associations that really fascinated him: ‘Americans of all ages, all conditions, all minds constantly unite. Not only do they have commercial and industrial associations in which all take part, but they also have a thousand other kinds: religious, moral, grave, futile, very general and very particular, immense and very small; Americans use associations to give fetes, to found seminaries, to build inns, to raise churches, to distribute books, to send missionaries to the antipodes; in this manner they create hospitals, prisons, schools,. Finally, if it is a question of bringing to light a truth or developing a sentiment with the support of a great example, they associate.’”

“…organizations like the Elks, the Moose, the Rotarians and indeed the my friends the Lions…which once did so much to bring together Americans of different income groups and classes….are in decline in the United States. In a similar vein, Charles Murray’s superb 2012 book Coming Apart makes the argument that the breakdown of both religious and secular associational life in working-class communities is one of the key drivers of social immobility and widening inequality in the United States today.”

“If the decline of American civil society is so far advanced, what hope is there for Europeans?”

“The implementation of Beveridge’s recommendation for a centrally administered system of national insurance and healthcare radically altered the role of many British ‘friendly societies’, either turning them into agencies of government welfare or rendering them obsolete.”

“What is happening? For Putnam, it is primarily technology…first television, then the internet….that has been the death of traditional associational life in America. But I take a different view. Facebook and its ilk create social networks that are huge but weak.”

“It is not technology that has hollowed out civil society. It is something Tocqueville himself anticipated, in what is perhaps the most powerful passage in Democracy in America. Here he vividly imagines a future society in which associational life had died: ‘I see an innumerable crowd of like and equal men who revolve on themselves without repose, procuring the small and vulgar pleasures with which they fill their souls. Each of them, withdrawn and apart, is like a stranger to the destiny of all others: his children and his particular friends form the whole human species for him; as for dwelling with his fellow citizens, he is beside them, but he does not see them; he touches them an does not feel them; he exists only in himself and for himself alone….Above these and immense and tutelary power is elevated, which alone takes charge of assuring their enjoyments and watching over their fate. It is absolute, detailed, regular, far-seeing, and mild. It would resemble paternal power if, like that, it had for its object to prepare men for manhood; but on the contrary, it seeks only to keep them fixed irrevocably in childhood…Thus, after taking each individual by turns in its powerful hands and kneading him as it likes, the sovereign extends its arms over society as a whole; it covers its surface with a network of small, complicated, painstaking, uniform rules through which most original minds and most vigorous souls cannot clear a way to surpass the crowd; it does not break wills, but it softens them, and directs them; it rarely forces one to act, but it constantly opposes itself to one’s acting; it does not tyrannize, it hinders, compromises, enervates, extinguishes, dazes, and finally reduces each nation to being nothing more than a herd of timid and industrious animals of which the government is the shepherd.’”

“Tocqueville was surely right. Not technology, but the state….with its seductive promise of ‘security from the cradle to the grave’….was the real enemy of civil society.”

“Even as he wrote, he recorded and condemned the first attempts to have ‘a government,…take the place of some of the greatest American associations’. ‘But what political power would ever be in a state to suffice for the innumerable multitude of small undertakings that American citizens execute every day with the aid of association?……The more it puts itself in the place of associations, the more particular persons, losing the idea of associating with each other, will need to come to their aid….The morality and intelligence of a democratic people would risk no fewer dangers than its business and its industry if the government came to take the place of associations everywhere. Sentiments and ideas renew themselves, the heart is enlarged, and the human mind is developed only by the reciprocal action of men upon one another.’”

“…I elicited gasps of horror when I uttered the following words: in my opinion, the best institutions in the British Isles today are the independent schools. (Needless to say, those who gasped loudest had all attended such schools.)”

“But we need to recognize the limits of public monopolies in education, especially for societies that have long ago achieved mass literacy. The problem is that public monopoly providers of education suffer from the same problems that afflict monopoly providers of anything: quality declines because of lack of competition and the creeping power of vested ‘producer’ interests. We also need to acknowledge, no matter what our ideological prejudices, that there is a good reason why private educational institutions play a crucial role in setting and raising educational standards all over the world.”

“A mix of public and private institutions with meaningful competition favours excellence. That is why American universities (which operate within an increasingly global competitive system) are the best in the world….twenty-two out of the world’s top thirty….while American high schools (in a localized monopoly system) are generally rather bad…”

“Would Harvard be Harvard if it had at some point been nationalized by the State of Massachusetts or the federal government? You know the answer.”

“All over the world, smart countries are moving away from the outdated model of state education monopolies and allowing civil society back into education, where it belongs.”

“..Sweden and Denmark have been pioneers of educational reform. Thanks to a bold scheme of decentralization and vouchers, the number of independent schools has soared in Sweden. Denmark’s ‘free’ schools are independently run and receive a government grant per pupil, but are able to charge fees and raise funds in other ways if they can justify doing so in terms of results.”

“Today in the U.S., there are more than 2,000 charter schools…like English academies, publicly funded but independently run…bringing choice in education to around 2 million families in some of the country’s poorest urban areas. Organizations like Success Academy have had to endure vilification and intimidation from the U.S. teachers’ unions precisely because the higher standards at their charter schools pose such a threat to the status quo of under-performance and under-achievement. In New York City’s public schools, 62 percent of third, fourth, and fifth graders passed their math exams last year. The latest figure at Harlem Success Academy was 99 percent. For science it was 100 percent. And this is not because the charter schools cherry-pick the best students or attract the most motivated parents. Students are admitted to Harlem Success by lottery. They do better because the school is both accountable and autonomous.”

“If you want to know one of the reasons why Asian teenagers do so much better than their British and American peers in standardized tests, it is this: private schools educate more than a quarter of the pupils in Macao, Hong Kong, South Korea, Taiwan, and Japan. The average PISA score for those places is 10 percent higher than for the UK or US.”

“The education revolution of the twentieth century was that basic education became available to most people in democracies. The education revolution of the twenty-first century will be that good education will become available to an increasing proportion of children. If you are aginst that, you are the true elitist: you are the one who wants to keep poor kids in lousy schools.”

“The larger story I am telling, using education as the example, is that over the past fifty years governments encroached too far on the realm of civil society.”

“Like Tocqueville, I believe that spontaneous local activism by citizens is better than central state action not just in terms of results, but more importantly in terms of its effect on us as citizens. For true citizenship is not just about voting, earning and staying on the right side of the law. It is also about participating in the ‘troop’….the wider group beyond our families…which is precisely where we learn how to develop and enforce rules of conduct: in short, to govern ourselves. To educate our children. To care for the helpless. To fight crime. To keep the streets clean.”

“It will be clear by now that I am much more sympathetic than these gentlemen to the idea that our society…and indeed most societies…would benefit from more private initiative and less dependence on the state. If that is now a conservative position, so be it. Once, it was considered the essence of true liberalism.”

Conclusion

“I have represented the crisis of public debt, the single biggest problem facing Western politics, as a symptom of the betrayal of future generations: a breach of Edmund Burke’s social contract between the present and future.”

“I have suggested that the attempt to use complex regulation to avert future financial crises is based on a profound misunderstanding of the way a market economy works..”

“I have warned that the rule of law, so crucial to the operation of both democracy and capitalism, is in danger of degenerating into the rule of lawyers….”

“And finally, I have proposed that our once vibrant civil society is in a state of decay, not so much because of technology, but because of the excessive pretensions of the state….”

“We humans live in a complex matrix of institutions. There is government. There is the market. There is the law. And there is civil society….this matrix worked astonishingly well, with each set of institutions complementing and reinforcing the rest. That, I believe was the key to Western success in the eighteenth, nineteenth, and twentieth centuries. But the institutions in our times our out of joint.”

“You Didn’t Build That”

“Countries arrive at the stationary state, as Adam Smith argued, when their ‘laws and institutions’ degenerate to the point that elite rent-seeking dominates the economic and political process. I have tried to suggest that this is the case in important parts of the Western world today. Public debt…stated and implicit….had become a way for the older generation to live at the expense of the young and unborn. Regulation has become dysfunctional to the point of increasing fragility of the system. Lawyers, who can be revolutionaries in a dynamic society, become parasites in a stationary one. And civil society withers into a mere no man’s land between corporate interests and big government. Taken together, these are the things I refer to as the Great Degeneration.”

“On July 13, 2012, as I was completing this book, the President of the United States gave a speech that neatly illustrated the point: ‘If you were successful, somebody along the line gave you some help. There was a great teacher somewhere in your life. Somebody helped to create this unbelievable American system that we have that allowed you to thrive. Somebody invested in the roads and bridges. If you’ve got a business….you didn’t build that. Somebody else made that happen. The Internet didn’t get invented on its own. Government research created the Internet so that all the companies could make money off the Internet…..There are some things, just like fighting fires, we don’t do on our own….So we say to ourselves, ever since the founding of this country, you know what, there are some things we do better together. That’s how we funded the GI Bill. That’s how we created the middle class. That’s how we built the Golden Gate Bridge or the Hoover Dam. That’s how we invented the Internet. That’s how a man was sent to the moon.’”

“This surely is the authentic voice of the stationary state: the chief mandarin, addressing his distant subjects in the provinces. It is not that the implied interdependence of the private sector and the state is wrong. It is the overstatement of the case that is disquieting, as if it took government to build every small business or, indeed, to ‘create the middle class’. Also striking is the conspicuous absence from the speech of any future project comparable with those cited from the past (the Manhattan Project would have been an even better example, but presumably it is not politically correct).”

“In the same way, President Obama’s second inaugural address suggested that the appropriate yardstick for an effective government was ‘whether it helps families find decent wage, care they can afford, a retirement that is dignified’. By contrast, ‘without a watchful eye, the market can spin out of control’. The words ‘debt’ and ‘deficit’ were not mentioned. The dangers of excessive regulation and litigation were ignored. And civil society scarcely featured at all, as if the hallowed phrase ‘we the people’ is now synonymous with ‘the government’.”

“It is bad enough to see state capitalism touted as an economic model by the Chinese Communist Party. But to hear it deployed by the President of the United States as a rhetorical trope nearly devoid of practical content makes this writer, for one, pine for the glad, confident morning of 1989….when it really seemed the West had won, and a great regeneration had begun.”