Transcript Global Crisis – Causes & Prescription

Global Financial Crisis : Causes &
Possible Cures—an Austrian Perspective
……. a presentation by R.Kuppanna , General Manager,
Kuwait India International Exchange Co.
March 15, 2010
Introduction
• Since mid-2008,
• Severe global economic downturn – mainly US
& Europe
• Stock markets plunged; companies folded;
economic fear, uncertainty, risk aversion
increased
• Extreme volatility across all markets: stocks,
currencies, commodities, real estate
Introduction
• Declining output, stagnant income, high
unemployment, low growth rates
• Financial system, worldwide, impaired; largescale failures of banks/institutions/corporates
(e.g. Merrill Lynch, Bear Stearns, Lehman
Brothers, Citicorp, AIG, Washington Mutual,
Countrywide Financial, Wachovia)
• Sovereign failures: Iceland; Greece, Italy,
Ireland, Portugal, Spain, UK in trouble
Introduction
• China in trouble??
• Other crises looming? - currency, credit cards,
commercial real-estate?
• Crisis: from US Housing Bubble (sub-prime)
• Repercussions beyond housing: secondary
mortgage markets, rating agencies, capital
markets, international markets etc. etc.
“When the money goes bad, everything goes bad”
Background
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Why did this happen?
Entire mortgage market (US) failing all at once?
How come this “cluster of errors”?
What is the root cause, if there is one?
Conventional wisdom: lack of regulation,
uncontrolled markets, greed of businessmen.
• Is it true? For this, we’ll have to look for explanations
not in the prevailing Keynesian orthodoxy but
elsewhere.
The Broken Window
Prime Cause
• Government policies primary cause of crisis
• Global economies: mixed, socialist, other variants of
interventionist
• Financial industry more government than private (in
the US and other countries too)
• Monetary system : fiat money and credit expansion
• Potential for limitless inflation and massive deflation
“Every step which leads from capitalism toward planning is
necessarily a step nearer to absolutism and dictatorship”
Dr. Ludwig von Mises (Omnipotent Government)
Residential Real Estate
• $600+ billion overinvestment in residential
real estate
• Too many houses, houses too big, houses in
wrong place.
• Should have invested in technology,
manufacturing capacity, agriculture,
education, etc.
How Did Overinvestment of this
Scale Occur
• Only government can make a mistake of this magnitude
possible
• Primary Sources of Problems
― Federal Reserve
― FDIC
― Housing Policy
― Freddie Mac / Fannie Mae
― SEC
“Abolish the Fed and then resign”, said Jim Rogers (on CNBC)
when asked what two things he’d do if he became Fed Chief
Cluster of Errors
• Businessmen not infallible; misjudgments result in
failure; closed down; no surprises
• When a great many businesses, all at once, suffer
losses or have to close, that should surprise us
• Why? Is it as Karl Marx says an “inherent feature” of
market economies?
• Here’s a clue
“interest rate coordinates production across time”
Cluster of Errors
• Lionel Robbins, British economist (first to use
expression ‘cluster of errors’ in 1934): “Why should
the leaders of business in the various industries
producing producers’ goods make errors of judgment
at the same time and in the same direction?”
Cluster of Errors
• Things consumers actually buy don’t suffer from
busts as much as do things produced in the higher
stages of production, farther removed from finished
consumer goods (i.e. capital goods)..
• F.A.Hayek, economics Nobel laureate(1974), of an
Austrian persuasion - - theory of the business cycle –
great explanatory power
“Is it not probable that disturbances affecting many lines of
industry at once will be found to have monetary causes”
Lionel Robbins ( The Great Depression ) , 1934
Business Cycle Theory
• Building on the work of economist Ludwig von
Mises, Hayek finds the root of the boom-bust
cycle in the central bank…the very institution
that postures as the protector of the economy.
• Theory
• Analogy of ‘home builder’ and ‘circus in town’
“The key economic activity that causes growth is not
consumer spending but production.” - Yaron Brook
Contra: Prevailing Viewpoint
“The remedy for the boom is not a higher rate
of interest but a lower rate of interest ! For
that may enable the so-called boom to last.
The right remedy for the trade cycle is not to
be found in abolishing booms and thus
keeping us permanently in a semi-slump; but
in abolishing slumps and keeping us
permanently in a quasi-boom.”
John Maynard Keynes
Government Policy As Causation
Federal Reserve
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Government owns monetary system
– Unlimited federal debt / print money / inflation
– Reduced capital requirements
– Perception of “no” risk
• Low savings rate
– Significant mismanagement of monetary policy
– Inverted yield curve
The Fed is like “ an arsonist watching a fire he set,
expressing amazement at how such an event could have
happened”…Economist Gerald O’Driscoll (former senior Fed
offical)
A Brief Aside
• Credit Expansion underlay:
> the recent housing bubble
> the stock market bubble of the late 1990s
> the earlier, long series of other booms/busts
> the Great Depression of 1929
> the earlier stock market boom of the 1920s
> bubbles of the 19th & 18th centuries, all the
way back to the Mississippi Bubble of 1719
“Those who cannot learn from history are doomed to repeat
it” - - George Santayana
Government Policy As Causation
FDIC Insurance
• Lack of market discipline
• Moral Hazard
• Examples: Indy Mac, WaMu, Countrywide
Government Policy As Causation
Housing Policy
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Increase home ownership above natural market rate
Tax policy
Affordable Housing / Subprime: NY Times 9/30/99
Freddie Mac / Fannie Mae: Government sponsored enterprises
– Would not exist in free market
– Leverage 1000 to 1
– $5 Trillion
– Government did have to “bailout” – implied guarantee
– Politics
Freddie / Fannie primary current cause of housing/financial problems
Belief that housing prices never fall: based on government policies
“The road to hell is paved with good intentions.” – F.A.Hayek
Fundamental Role of Financial
Intermediaries (Banks)
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Liquidity Issue
Enable individuals to invest for longer periods than
savers want to have their money invested: Pool Risk –
credit and liquidity
Borrow short / lend long: significant role in creating
economic growth
When they cannot sell assets financial institutions cannot
meet liquidity requirements
Bear Stearns: solvent but not liquid
– Not happened in many years
Fundamental Role of Financial
Intermediaries
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Leverage
Banks are leveraged 10 to 1
Investment banks leveraged 30 to 1
Federal Reserve has “encouraged” increased leverage to
fund government debt
SEC established capital rules for investment banks using
mathematical models
Pre-Fed banks leveraged 1 to 1
Even conservative banks had to leverage to be competitive
Another Failure of Government Policy
How Did Residential Real Estate Markets So
Significantly Impact Capital Markets
• Subprime mortgage crisis
• Failure of rating agencies: S&P / Moody's / Fitch:
Government sanctioned (SEC)
• Market could not evaluate risk: no liquidity
• Auction Rate Municipal Bond Market
• Ambac, MBIC – Insurance / mortgage and municipal
• S&P, Moody’s, Fitch rating of AMBAC, MBIC – not reliable
• Lack of liquidity / bonds not marketable at almost any price
How Government Policy Created
“Originate and Sell” Model
• Federal Reserve / FSLIC systematically destroyed thrift
industry
• “Originate and sell model” replaces “originate and hold”
• Freddie/Fannie drive many financial intermediaries out of
mortgage markets due to government guarantees on debt:
leverage 1000 to 1 – lower cost of capital
– Encourages banks to hold riskier mortgages
• Freddie/Fannie make “mortgage broker” origination
model viable – Brokers feed Countrywide/Washington
Mutual who feed Freddie/Fannie to meet “affordable
housing” goals to keep support in congress
Originate and Sell
• Perverse incentives for originations: sloppiness/fraud
• S&P, Moody’s, Fitch (government sanctioned) make huge
rating mistakes
• Investment bankers create financial “innovations” under
belief that Federal Reserve will keep risk in financial
markets low
• Investment bankers make irresponsible decisions based on
pragmatic thinking: i.e., short term: irrational/lacks
integrity/evasion/arrogance
Another Factor:
Misuse of Credit Instruments
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CDO / SIV / CDO2 (Double Leverage)
– Failure of rating agencies (S&P, Moody’s & Fitch): Government
sanctioned
– Investment banks hold risky “strips”
Credit Default Swaps (CDS)
– AIG
• Rating agencies
• Failed mathematical models
Investment banks “eat” each other: Bear Stearns?
State government pension plans / public university endowments invest in
hedge
funds who speculate in CDS and short stocks
Why Save AIG?
– Insurance subsidiaries safe
– To save Goldman? (crony capitalism or system risk?)
Misregulation: Not Deregulation
• Regulatory cost at all time high at peak of bubble (2005-2007)
– Sarbanes Oxley
– Patriot Act
• Irrational belief in “models”
– Wachovia as “Best Practices”
– BASEL/European banks
• Huge misdirection of management energy
• Bank Regulators pose major risk to residential construction
and development industry
– Talk one game / play another: unequal incentives for
regulators
Failure of Government Policy
SEC
• Sanctioning Rating Agencies
• BASEL rules for investment banks
– Significantly increased leverage
• Misregulation
– Sarbanes Oxley
– Meaningless, confusing, detailed disclosure
• Short sale rules: not enforced
• Ownership of accounting system
-- Reliance on rules instead of principles
– Fair Value
– Loan loss reserves
• Artificially created fluctuations in accounting results
Another Failure of Government Policy:
Fair Value Accounting
• New accounting rule: mark-to-market
• Does not work when there is no market:
― Inconsistent with law of supply and demand: must
be
willing buyer and willing seller
― Violates “going concern” concept
• Major Cause of systematic liquidity problem: Public
companies not purchasing economically valuable
assets because of accounting risk
• Fails to consider gains. Example: bank retail deposits
Fair Value Accounting
• Asset values should be based on projected cash flows, not
“fire sale” value
• If Fair Value Accounting applied in 1990 U.S. financial
system / economy would have failed
• If applied to all business in U.S. as applied to financial
intermediaries: 90% of U.S. businesses would be insolvent
given lack of liquidity in markets
• SEC (government agency) makes accounting rules: i.e.,
laws: primary supporters of Fair Value: State
Government and union pension plans
Fair Value Accounting
• Did Fair Value Accounting play a role in the crisis?
• Research : Two streams
> FVA provides information relevant to
investors ..messenger carrying bad news
> Undermines core of financial reporting
(difficult to verify, unreliable assumptions
provides management with too much
discretion; hence not a neutral or unbiased
messenger)
Fair Value Accounting
• FVA creates a circular dynamic in financial
reporting: markets provide inputs for
measurement, affecting reported earnings, and
then used by investors to assess firm’s market
value.
• Earnings volatility in line with market volatility,
fuelling investor apprehensions.
• FVA – allows managers to postpone day of
recognition; create distortions in
investors/regulators.
Market Corrections Are Not All Bad
• World is a better place to live with Countrywide
and WaMu out of business: misallocations of capital.
• Credit standards were far too loose at peak of bubble:
standards need to be tightened – Excessive leverage
• Saving rate needs to be increased
• Overinvestment in housing needs to be corrected:
less capital to housing: more to productive investment
• We needed a correction: natural market process:
creative destruction
• We did not need a panic: never would have had excesses and
misallocations of this magnitude without government policy
– We would have experienced minor corrections all along
“Panics” Are All Bad
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Action of Federal Reserve, Treasury, President and Congress
have created “panic”
– $700 billion: scary amount
– Inconsistency (Citi vs. Wachovia / Goldman vs. Lehman)
– Unpredictability
“Panics” negatively affect even the best run financial companies
and the overall economy
Even best run financial institutions had to compete against
risky institutions
Remember: Financial institutions borrow short and lend long:
– “Panic” creates liquidity risk for all
– Lending standards being too tight is destructive
– Self fulfilling spiral down
Deflation is extraordinarily destructive
Plight
• Current plight is result of credit expansion &
malinvestment it engenders
• Other consequences of credit expansion:
> encourages high debt & dangerous
leverage
> lower cash holdings relative to scale of
economic activity ( of firms)
Road to Recovery
• Answer stems from knowledge of credit
expansion and its consequences
• Contra the prevailing Keynesian view of
spending way through crisis
• A major misconception: It ignores that
fundamental problem is not insufficient
spending but insufficient capital (losses
caused by malinvestment)
Road to Recovery
• Ignores the fact that credit expansion has
brought about excessive debt / insufficient
cash
• Too little capital, too much debt, and not
enough cash are problems faced
• Essential , for recovery, to fix widespread
problems in the balance sheets of firms
Road to Recovery -- 100% Reserve
• Establish a 100% reserve system against
checking deposits (end credit expansion and
prevent deflation of money supply).
• Ideally, though, the reserve would be in gold
• That’s the ultimate, long-term solution
• Establish freedom of wage rates and prices to
fall…this to eliminate mass unemployment
Road to Recovery
• Would greatly enhance banks’ capital which
would be more than enough to cover
loan/investment losses and thus eliminate
government ownership & management of
banks
• Though, it can’t control the increase in papercurrency and paper-currency reserves
• This would require a 100%-gold-reserve
system
Road to Recovery
• Freedom of wage rates and prices to fall must
be established (repeal of pro-union and
minimum-wage laws)
• Educate public about the errors of the
Marxian exploitation theory…actual
knowledge of what determines wages and
standard of living to be explained
What Are Possible Cures
Long Term
• Most fundamental issue is the attack on capitalism / free
markets
– We do not have a free market in U.S.: mixed economy
– Financial system is primarily government owned: Federal
Reserve
– By far the primary causes of current financial crisis is
government policy, not market failure: Federal Reserve,
FDIC, Housing Policy, Freddie / Fannie, SEC, HUD
• Less regulation, not more
“Those who expect to reap the benefits of freedom, must
like men, undergo the fatigues of supporting it.”
Thomas Paine ( The Crisis Number IV )
What Are Possible Cures
Long Term
• Privatize / Liquidate Freddie/Fannie – After crisis: 2011
– Political risk / affordable housing
• Return to originate / hold for residential mortgages:
Do not attempt to salvage originate / sell model: Canada
– Reintermediate to banking system
– Do not “save” irrational competitors: mutual money funds
• Federal Reserve stripped of powers: one basic goal to grow
monetary supply at fixed rate (Milton Friedman – 3%)
– Do not manage in short run
• Consider market based monetary standard (gold)
– Federal Government owns monetary system: unlimited
federal debt
What Are Possible Cures
Long Term
• Raise capital requirements for bank (especially “start ups”)
– Reduce FDIC insurance back to $100,000
• Make it explicitly clear that Federal Reserve can not/will not
“save” non-banks
– If you buy GE’s commercial paper that is your risk
• Stop subsidies to housing (tax policy)
• Encourage productive investment – low/neutral tax rates:
tax consumption, not savings – increase productivity
• Free trade
What Are Possible Cures
Long Term
• Carefully and systematically privatize Medicare,
Social Security, and education
• Significantly cut cost of defense: By defending U.S. –
not “saving” world
• Encourage immigration of the productive and
hardworking; especially well educated
• Restore discipline to system
– Save more
– Spend less
Deepest Causes are Philosophical Different Than You May Think
• Altruism
– Affordable Housing
– Redistribute from productive to non-productive
– No one has a right to their own life
• Pragmatism
– Short term: What works: Subprime worked for several years
– Irrationality
– Lack of integrity
• “Free Lunch” Mentality
– Social Security
– Medicare
• Lack of Personal Responsibility
– Death of Democracies: Tyranny of Majority
Deepest Cure is Philosophical
• Life, Liberty, and the Pursuit of Happiness
– Right to your life and your happiness
– Personal responsibility
– No “free” lunches
• Demands and rewards rationality / self-discipline
• Pursuit of each individual’s long term rational self-interest in
the context of the “Trader Principle” – creating win/win
relationships
The Trader Principle
There is no conflict of interests among men who do
not desire the undeserved, who do not make
sacrifices nor accept them, who deal with one
another as traders, giving value for value.
The principle of trade is the only rational ethical
principle for all human relationships, personal and
social, private and public, spiritual and material. It is
the principle of justice.
-- Ayn Rand
Summing Up
Global Crisis - - Causes
• US Government’s Encouragement of Risky
Mortgages to “sub-prime” borrowers (Community
Reinvestment Act, Federal Housing Administration’s lowering of downpayment standards, Dept. of Housing & Urban Development’s pressure on
lending institutions)
• Freddie Mac & Fannie Mae grew to own or
guarantee about 50% of the $ 12 trillion
mortgage market.
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• All that is necessary for the triumph of evil is that good men
do nothing - - Edmund Burke
Global Crisis - - Causes
• Moral Hazard caused by Freddie/Fannie
• Cheap Money Policy of the Fed that
fueled these risky mortgages
(fed rates down from 6.25% to 1.75% in 2001; reduced
further to a low of 1% in mid-2003)
Global Crisis - - Consequences
• Riskier mortgages, irresponsible buying/lending of loans,
rising volumes, skyrocketing housing prices, price crash,
rising defaults, bankruptcies of major institutions,
cascading effects on other markets, global meltdown,
decline in income/savings, rising unemployment, risk
aversion, massive wealth destruction…
• Demand for more intervention, stimulus/bailouts and
more of the same disastrous policies
• Seeds for another, greater CRISIS
Your Choice
• From a state monopoly on money, to state guarantees of bank
liabilities, to state sponsorship of mortgages, to state
ownership of banks ---the progression in the past century has
been to move away from free markets toward socialist
banking.
• The welfare state and its main financier, the Federal Reserve,
are ultimately “justified” on the grounds that the government
has a moral duty to provide the needy with goods and
services – from education to health care/insurance to
mortgages.
• Think!! The choice between the alternatives is yours. So are
the consequences.
The Broken Window
• The art of economics consists in looking not
merely at the immediate but at the long
effects of any act or policy; it consists in
tracing the consequences of that policy not
merely for one group but for all groups –
Henry Hazlitt
THANK YOU