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Generational Dynamics Web Log for 7-Apr-08
Fed Chairman Ben Bernanke defends his Great Historic Experiment before Congress

Web Log - April, 2008

Fed Chairman Ben Bernanke defends his Great Historic Experiment before Congress

The Fed-led rescue of Bear Stearns last week was closely questioned by the Senate Committee on Banking, Housing, and Urban Affairs on Thursday.

The questioners wanted to know why Bear Stearns was "bailed out," when foreclosed homeowners have not been bailed out.

The response from Fed chairman Ben Bernanke made the following points:


Sen Jim Bunning, (R) Kentucky, questioning at Senate Banking Committee
Sen Jim Bunning, (R) Kentucky, questioning at Senate Banking Committee

What I found to be the most interesting interchange in the hearings occurred when the questioner was Republican senator Jim Bunning of Kentucky, and Fed chairman Ben Bernanke responded (my transcript):

"Bunning: How did we get to the point that the failure of one firm can get us to the edge of collapse - all our financial markets. We know that the Fed did not do their job in regulating lending practices, supervising the risks banks were taking on. But how do you let the entire financial system become so fragile that it cannot tolerate one failure?

Bernanke: Well, one response Senator, is that this has been a long time in the making. There was a substantial credit boom that peaked last summer. That credit boom, which was driven by international factors that I could go into if you like, involved substantial increase in risk-taking, a lot of financial innovation, some of which turned out not to work so well, deterioration in underwriting standards, and essentially a letting down of the guard.

Supervisors made many efforts to address these problems. We were not successful obviously in preventing the excesses.

Starting in August, triggered by, but not, I would say, fundamentally caused by the subprime crisis, there was a sudden rethinking of the amount of risk that people were willing to take, there was a major retrenchment in the markets.


Fed chairman Ben Bernanke, testifying at Senate Banking Committee
Fed chairman Ben Bernanke, testifying at Senate Banking Committee

Now, in contrast to last year when investors were willing to lend against quite risky assets, now even the safest assets find difficulty in getting financed. And so financial conditions have become much more fragile, much more uncertain. There's a great deal of distrust of counterparties, of the valuation of assets. And there's a very strong aversion of taking risk -- of even liquidity risk, as opposed to credit risk.

As I mentioned earlier, under more robust conditions, under more normal conditions, we might have come to a very different decision, with respect to Bear Stearns. We felt that, given the context, given the fact that financial conditions are already creating a slowdown in our economy, that the risk was too great."

Bernanke here exhibits the same things that I've criticized in him for years. This is the person considered the world's greatest expert in macroeconomics, but he obviously has no idea what's really going on.

My first major criticism of Bernanke came in September, 2004, in "Federal Reserve congratulates itself on jawboning policy," and discussed at greater length the next month.

Bernanke was expressing the view that economic problems can be solved or contained by the wording used in written statements issued by the Fed. Bernanke apparently believes that the Fed can use verbal statements, even misleading verbal statements, to affect the economy -- stock prices, interest rates (bond prices), and so forth -- in the long run!

I can't overstate how incredulous I was and am at these statements. To say that verbal statements are controlling, and underlying fundamentals are irrelevant, is a statement so na´ve that I'd expect it more from a teenager than from the Fed chairman.

As I've been pointing out for years, the fundamentals are that the 'real value' of the stock market is around Dow 5000, meaning that it's overpriced by roughly 250%. In addition, price/earnings ratios have been way above their historical averages since 1995, and so by the Principle of Mean Reversion, they'll have to far below average for a roughly equivalent period of time. As I've been saying since 2002, these fundamentals indicate that there must be a stock market crash to below Dow 4000, and that we're entering a new 1930s style Great Depression. In 2002, I estimated that this would probably happen in the 2006-2007 time frame. I thought we were close to it when the "credit crunch" triggered a worldwide financial crisis in August, 2007, and that crisis continues to this time, when a generational panic appears to be getting closer.

However, Bernanke continues to be completely unaware of these fundamentals. He doesn't explain what he means by "under more normal conditions," but he's clearly giving the impression that he means the time prior to August -- that is, the time of the credit bubble. That time was not normal, by any means.

Bernanke's "jawboning" policy, as explained in 2004, has been a total failure, obviously. The fundamentals have taken over. Does Bernanke believe that his jawboning concept is fundamentally wrong? Or does he believe that he simply hasn't been clever enough in his jawboning? He appears to believe the latter, and he certainly doesn't give any evidence that he understands the former.

Furthermore, as I wrote last year in "Ben Bernanke's Great Historic Experiment," and "Bernanke's historic experiment takes center stage," Bernanke is now putting into effect his master plan for avoiding another Great Depression. He is an expert on the 1930s Great Depression, and he has stated throughout his career that the 1930s Great Depression could have been avoided if the Fed had injected more liquidity into the financial system. This theory is based on a fundamental assumption that deflation is IMPOSSIBLE, because the central bank can prevent deflation by injecting liquidity. Bernanke held to that belief even in the 2000s, after almost a decade of deflation in the Japanese economy, following the Tokyo Stock Exchange's generational panic and crash that occurred in 1990.

Bernanke shows no evidence that he understands why this view is wrong, and how the credit bubble created tens or hundreds of trillions of dollars in new money that's now disappearing in the credit crunch, leading to a deflationary spiral.

Or maybe he has changed his views, and does understand this stuff now. Who knows? Maybe he's even read this web site. At any rate, he wouldn't want to say anything at this time, for fear of being identified throughout future history as the person who triggered the panic and the greatest financial disaster in world history.

There IS one thing that has changed about Bernanke: he's no longer The man without agony, which is how I described him in 2005. You can tell from his demeanor that he's FULL of agony these days.

Quite apart from Bernanke's lack of grasp of fundamentals, I was actually quite impressed with Bernanke's performance this week. He obviously had gotten almost no sleep at all, but still gave a very impressive political performance in front of the Senate committee.

The most important aspect of this political performance was his graceful refusal to take any political or ideological positions. He was asked several times to comment on the Administration's tax proposals, and his pointed response was always that tax policy is up to the Congress.

He even stared down Massachusetts senator Ted Kennedy, who came in for a few minutes to demand, in his usual fulminating style, tax recommendations from Bernanke. Bernanke refused, and Kennedy stomped off.

Rising star Timothy Geithner

Although Ben Bernanke was the star of the Senate hearing, the rising star was New York Federal Reserve President Timothy Geithner.


Timothy Geithner, New York Federal Reserve President, testifying at Senate Banking Committee
Timothy Geithner, New York Federal Reserve President, testifying at Senate Banking Committee

Geithner's grasp of fundamentals is no better than Bernanke's, but Geithner was able to promulgate his views very forcefully, staring down Senators, and sliding past inconsistencies very smoothly.

After Bernanke finished the testimony quoted above, Bunning asked if any of the other panelists had a different opinion. Geithner responded, leading to a confrontation between the two:

"Geithner: I don't have a different opinion, but let me just underscore -- in a market-oriented financial system, where people are free to fail, make mistakes, lose money, [[Bunning: I thought so]], make imprudent choices, any system designed that way is inherently vulnerable to the risk that a sharp loss of confidence in economic activity induces a dynamic, like we're experiencing now. This happens rarely, but it does happen. It happens across all different types of financial systems over time. But you're exactly right, and I think it is the critical objective for policy, the challenge for policy is to make the system strong enough so that it can withstand even the failure of large institutions.

But no system, in a situation this fragile, economically, is going to be able to withstand that easily, meaning withstand the risk of default by major debt easily.

What produced this is a very complicated mix of factors. I don't think anybody understands it yet. But we have to spend a lot of time and effort trying to figure out how to get a better handle on this stuff, and there's a lot of people who are going to be part of that, because it's very important that we try to make the system less vulnerable to this in the future.

Bunning: There were an awful lot of red flags. Not just in the last six weeks. Not just in the last month. But in a year or two before, that we were having some problems in our mortgage markets.

We were having mortgages made that shouldn't be made. That the mortgage brokers were soliciting people into mortgages that they couldn't afford, and finally they knew were doomed to failure. Nobody was watching the store, so it was eventually going to happen.

It just happened to be Bear Stearns who got a hold of all these things in one week. And the crisis occurred when everyone said, watch out for Bear Stearns because they're not going to wind up this week anywhere but in bankruptcy. I mean that's what they came and told the Fed. Am I wrong? Didn't they come and tell you that they were going to go belly up, and they asked for help?

Geithner: Senator, let me just step back for one sec, and go back a bit.

The people at this table, and the supervisors and regulators, took a lot of actions over several years to try to make the system less vulnerable to this kind of event.

Bunning: I'm sorry, I've been here too long to try to convince me of that.

Geithner: I'm not claiming to be trying to convince you, but I just want to ...

Bunning: You're not going to be able to convince me because the red flags have been waving long before you showed up at that table. [Q looked away in disgust, and there was a long pause.]

Geithner: Should I try ... Could I just go through a few important things for the record?

Bunning: Certainly, go ahead.

Geithner: We did, working with the SEC, and the other major supervisors, the other major institutions around the world, a series of very important things, beginning in 2004, in particular, focused on exactly the set of risks that are so pronounced today.

These things focused on strengthening ...

Bunning: The problems go before 2004.

Geithner: I, I ...

Bunning: It goes back to 2000, 2002, and on down.

Geithner: I'm not claiming that people were wise and all-knowing, or that we did everything that could have been done. But I just want to underscore the fact that we took a series of actions that tried to make the system more resilient to this kind of stress, and those things have made a lot of difference.

The system would have been more fragile without those things. As the Chairman said, they did not achieve enough traction in areas where we would have liked them to achieve more, and we are going to be very focused on how to deal with those things in the future, but it's going to require a very comprehensive effort, because we don't have the incentives in the system, aligned with ...

Bunning: You've talked me out of my time, but the biggest problem with that is that I get the last say. What's going to happen if a Merrill or a Lehman or someone like that is next?"

This question was left unanswered, although I would have loved to hear Geithner's answer. I doubt that he'd have any answer beyond "everything will be fine."

Shallow reasoning

All in all, this testimony shows what an incredibly shallow understanding of what's going on these people have. Geithner talks about stuff the Fed did since 2004, and Bunning replies (paraphrasing), "You're full of crap. This problem began in 2002. By 2004, it was already too late."

It's just incredible how shallow this reasoning is, although this is just a reflection of how shallow mainstream macroeconomics is.

Let's mention again that mainstream macroeconomics has not gotten anything right at least since 1995. It doesn't predict or explain the dot-com bubble of the late 1990s, it doesn't predict or explain the global collapse in interest rates in the early 2000s (Alan Greenspan's "conundrum"), and it certainly didn't predict anything that's going on now. Mainstream macroeconomics has been completely baffled by the credit crunch, since it began in August, and has no explanation other than Bernanke's, that there was "a sudden rethinking of the amount of risk that people were willing to take." Mainstream macroeconomics did not predict or explain when that "rethinking" occurred, other than Alan Greenspan laying the blame on animal spirits.

The fashionable explanation of what's happening today is that it was caused by Alan Greenspan, who lowered interest rates too much, causing the housing and credit bubbles and the subprime crisis.

This doesn't even make sense, as the housing and credit bubbles were worldwide, and occurred through Europe and Asia, even including China. Other than by pure guesswork and wishful thinking, there's no rational way to connect all these things together.

The housing bubble was caused by massive fraud throughout the entire financial and real estate industries, from top to bottom, whether it was homeowners lying on their applications, construction firms colluding with appraisers and brokers to get kickbacks by over-valuing homes, lenders who resold mortgages without checking any of the claims, lenders who adopted predatory lending practices, granting loans to people with no hope of making payments, investment banks that securitized loans based on the assumption that real estate prices would rise forever, ratings firms and monoline insurers that took fat fees to lie about these potentially worthless securities.

How is it possible that this rot, this blight, this depravity, this debauchery permeated EVERY financial institution at EVERY level, without almost any exception? This debauchery was caused by the Alan Greenspan's low Fed Funds rate? That simply doesn't make sense.

It's astonishing to me that these people at the Senate hearing argued whether the problem began in 2004 or 2001, and none of them even thought to consider the problem of the dot-com bubble of the late 1990s. Is it possible that these people are so clueless that they think that the dot-com bubble is totally unrelated to the credit bubble? Could they possibly believe that two major bubbles occurring in close succession have nothing to do with one another? Apparently so. The stupidity of these people is monumental.

And why did the dot-com bubble begin in 1995 rather than, say, 1990 or 2000? Did the Fed cause that too? That question wasn't even broached.

There's only one credible explanation for all of this: The Great Depression survivors all retired in the early 90s, and when the oblivious Boomers took over as senior managers, they ignored all those "old rules" about credit and created the dot-com bubble. Then, nihilistic Generation-X reached their 40s in the early 2000s, and created the fraudulent financial engineering models and structures that are disintegrating today around the world.

I think that it's funny that Alan Greenspan last year blamed the housing bubble on the fall of the Berlin Wall, and now he's blaming the credit crisis on "animal spirits." However, he did not cause and could not have caused, the problems we're seeing today. Those problems were caused by the massive corruption, depravity and debauchery that permeated every level of every institution of the financial industry. If this corruption had occurred in only a few institutions, then some other explanation might be possible; but the corruption was spread through EVERY financial institution, from top to bottom, and that can ONLY have a generational explanation.

Let's make a list of some of the major things that the people at the Senate hearing were completely clueless about:

How stability creates instability

Finally I want to return to two important sentences in Geithner's testimony:

"But I just want to underscore the fact that we took a series of actions [since 2004] that tried to make the system more resilient to this kind of stress, and those things have made a lot of difference. The system would have been more fragile without those things."

Well, if the system has become increasingly unstable since 2004, especially in the last year, then how could he claim that the system is more resilient?

When the credit crunch began last August, I really expected a major chain reaction and crisis within two or three months, as I wrote at the time. I've been amazed, since then, in watching the wide variety of awe-inspiring measures that the Fed has taken, often in conjunction with other central banks around the world, to stave off immediate disaster.

The problem is that none of these measures does anything to fix the problem (which can't be fixed anyway). Each of these measures is a stopgap that fixes one particular problem. Meanwhile, the entire system is degrading further each week, and each crisis is always worse than the preceding one. Eventually one of stopgap measures must fail.

Bernanke himself seemed to be hinting at this during the hearing when he expressed his own amazement at how quickly Bear Stearns melted down, from being a solid company on Wednesday, March 12, to be on the verge of bankruptcy 24 hours later.

It doesn't take much imagination to see that the same thing could happen in a more widespread manner, and could affect several financial firms simultaneously, with no hope of a "quick fix" as happened in the Bear Stearns case. Bunning hinted at this when he asked his final question: "What's going to happen if a Merrill or a Lehman or someone like that is next?"

This illustrates the principle of how stability breeds instability. Geithner claims that actions taken since 2004 have made the system less fragile, but all he's done is postpone the inevitable, almost certainly making the inevitable result worse.

At some point, the credit bubble had to burst. All the Fed can do is try to keep it from bursting right away.

Once again, I quote the following passage from John Kenneth Galbraith in his 1954 book, The Great Crash - 1929:

"A bubble can easily be punctured. But to incise it with a needle so that it subsides gradually is a task of no small delicacy. Among those who sensed what was happening in early 1929, there was some hope but no confidence that the boom could be made to subside. The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. Someone would certainly be blamed for the ultimate collapse when it came. There was no question whatever as to who would be blamed should the boom be deliberately deflated. (For nearly a decade the Federal Reserve authorities had been denying their responsibility for the deflation of 1920-21.) The eventual disaster also had the inestimable advantage of allowing a few more days, weeks, months of life. One may doubt if at any time in early 1929 the problem was ever framed in terms of quite such stark alternatives. But however disguised or evaded, these were the choices which haunted every serious conference on what to do about the market." (p. 25)

This is all that the hearing's about. There's one thing that I do wonder about: How many of the participants in this hearing understood what a farce it was, but were just playing along for political purposes, versus the rest, who were there because they actually believed that something useful was going on? Enquiring minds want to know.

There will be more hearings, and more proposed laws, and more regulations, and they'll all be as completely irrelevant as Thursday's meeting was.

It's obvious that these people have no idea what's going on, and that these meetings have only one purpose, as even the participants probably know: Determining who's going to be blamed for what happens.

Right now, the person most likely to be blamed is Ben Bernanke. He's the expert on macroeconomics in general, and on the 1930s Great Depression in particular. My guess is that he's not getting much sleep any of these days, and that he's probably going through a severe clinical depression (I'm not joking!).

However, his demeanor these days, and the aggressiveness of his actions as Fed chairman, are really quite impressive. He is pursuing his "Great Historic Experiment." It's completely failed so far, and has no chance of succeeding, but if he can pursue his Experiment convincingly enough, then when the axe falls, he may manage to have it land on Alan Greenspan's neck instead of his own. (7-Apr-08) Permanent Link
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