Thursday, March 25, 2010

Government Authorities are Looking Out for Themselves – As Should Everyone

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

"China in Midst of 'Greatest Bubble in History'", Bloomberg told readers on March 17, 2010. That was the opinion of certain experts interviewed by the news service. One expert held the opposite view: "'People making comments about bubbles possibly don't have all the facts,' HSBC Holdings Plc Chief Executive Officer Michael Georghegan said in Shanghai today. Regulators are in control of the banking industry, and have the ability to curb lending as needed, he said."

Aside from the bubble question (which the experts answered), it is the rationale behind Georghegan's chipper comment that deserves attention. "Regulators are in control" seems low on the list to assure clientele. Even though Georghegan is persuaded, investors should be skeptical. What follows is a review of instances when trusted regulators were a good reason to panic.

On September 4, 1929, Roger Babson advised a gathering in Wellesley, Massachusetts to "pay up their loans and avoid margin speculation at this time because a 'crash' of the stock market was inevitable." This was the New York Times summary in its September 6 edition under the headline "Babson Predicts 'Crash' in Stocks."

Forever known as the "Babson Break," stocks fell 3% after the ticker relayed Babson's warning. This was two days after the Dow Jones Industrial Average peaked at 381, which would remain the top until 1954. The Times quoted the most celebrated economist of the time, Irving Fisher: "Stock prices are not too high and Wall Street will not experience anything in the nature of a crash." The persistence of celebrated economists to miss monumental shifts is, or should be, expected.

Alexander D. Noyes, sometimes called the "dean of American financial journalism," cautioned Times' readers that Babson's counsel might be outdated. There are "numerous other considerations now which must nowadays modify ideas about the future. One is the power and protective resources of the Federal Reserve."

There were some inside the Fed who thought differently. In 1928, Carl Snyder of the New York Fed wrote: "Owing to the abundance of credit, in excess of what appears to be about the maximum possible growth of trade, there came a heavy expansion of bank investment.... [P]artly in consequence of the abundant credit, [we have seen what] appears to be the greatest building boom which this country has known in 60 years..."

By the fall of 1929, plans were or had been drawn for five buildings ranging in height from 80 to 150 stories in New York. The "protective resources of the Fed" were no better (or worse) in 1929 than in 2008.

Investors are better off trusting their own judgment than the motivations of government authorities. In the same September 6, 1929, "Babson Break" edition of the Times, a column with the title "Action by Board Doubted" reported the "total of broker's loans by member banks of the Federal Reserve System took another jump... [to] a new peak of $6,354,000,000. Treasury officials indicated that they did not expect any radical step by the Federal Reserve Board at this time to curb the speculative movement."

This instance of an inflated stock market accompanied by a blank stare from the government is known, in contemporary parlance, as the "Greenspan Put," now superseded by the "Bernanke Put." Speculators, in 2010, as in 1929, must decide whether the "power and protective resources of the Federal Reserve" have put a floor on the stock market's price even though it was (and is) floating on borrowed money.

Such calculations aside, there was another story in the Times' "Babson Break" issue that warned the mind of the market was that of the village idiot. The article, "Brokerage Office Set Up On Pebble Beach Golf Course," reported: "Golf enthusiasts who are following the course of the national amateur championship at Pebble Beach, Cal., may watch the stock market while keeping up with the play. A temporary brokerage office, housed in a tent...has been established by the firm of E.F. Hutton & Co.... The temporary office has had a lively bit of business from the crowd following the players and from some of the players, too, many of whom are ardent followers of market quotations."

In 1966, when the Federal Reserve was ceding monetary policy to the Johnson administration, the business editor of the New York Times calmed readers: "Luckily, the Government has the ability and the wisdom not to let inflation break into a gallop as has happened recently in other countries." The inflation rate was 3.3% at the time and rose to 6.1% in 1969. The Times, in its high-minded trust of Washington, did not stoop to consider the authorities might be looking after their own interests. Secretary of Defense Robert McNamara was lying about the financial burden of Vietnam, where the troops deployed were to double (from 184,000) in 1966. The Johnson administration would not consider a major tax increase and the budget deficit rose from $1 billion in 1965 to $25 billion in 1968.

As every schoolchild knows, political independence of the Federal Reserve does not include its unstated mandate to plug Treasury deficits. In late 1965, Federal Reserve Chairman William McChesney Martin had told the Federal Reserve Open Market Committee "I cannot believe that all periods of prosperity float on constantly rising levels of credit or that one can ignore credit quality." Martin's intentions may have been parsimonious, but McNamara's War demanded expansion. Bank credit rose at a 7.2% rate in December 1965 and by 15% in April 1966. At Martin's 1970 White House farewell dinner, he told the assembled: "We are in the wildest inflation since the Civil War."

As goes inflation, so go bonds. Americans who trusted the "ability and wisdom" of the Federal Reserve were scarred. In 1969, Institutional Investor published a front cover story, "The Death of Bonds." Prices of long-term Treasuries fell 14% from the end of 1966 to 1969. Stock investors wished they hadn't. After rising for 17 years, the Dow Jones Industrial Average reached a peak of 995 on February 9, 1966. The Dow was 777 on August 12, 1982. These numbers do not reflect inflation's toll on purchasing power. Consumer prices tripled over the 16-year period.

This brings us to the present and to a regular columnist in the New York Times, Greg Mankiw, professor of Economics at Harvard University, past chairman of President George W. Bush's Counsel of Economic Advisers, and so on. On December 23, 2007, Mankiw outdid Irving Fisher: "The truth is the current Fed governors, together with their crack staff of Ph.D. economists and market analysts, are as close to an economic dream team, as we are ever likely to see.... The best Congress can do now is to let the Bernanke bunch do its job."

The Federal Reserve governors had spent 2007 in a daze; 2008 would show their policy was to panic, overreact to meltdowns the Fed had fostered, and disguise their market manipulations.

Anti-authoritarianism is often simple common sense. Returning to China, the country suffered one of the worst inflations of the twentieth century during the 1930s and 1940s. (In good measure, this was inflicted by the United States. See "America's Beggar-Thy-Neighbor Policy" under "Articles" on the website.)

The Chinese press, controlled by Chinese Communists in 1949, blamed inflation on "Kuomintang agents" and "unscrupulous speculators." (It never changes.) Prices for necessities - rice, bean oil, firewood, soap - were rising daily when the Communists demanded trade be conducted in the new People's Bank note. In June 1949, a New York Times correspondent spoke to a merchant in Nanking who would not touch the paper currency: "Communist currency may be backed by rice, but you can't hold rice. It spoils. A gold bar is always a gold bar."

Frederick Sheehan writes a blog at

Friday, March 12, 2010

Municipal Deflation: Consequences of the Greatest Speculation

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

"The financial difficulties of local governments in consequence both of the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue system concentrated so heavily upon real estate...."

-Herbert D. Simpson, Meeting of the American Economic Association, 1933

On March 10, 2010, the Kansas City Missouri School Board voted to close nearly half its schools (28 of 58). On the same day, Illinois Governor Pat Quinn warned that if the state income tax is not raised by 1%, education will face "draconian cuts."

To employ the most hackneyed metaphor of the recent financial meltdown, we are only in the first inning of municipal deflation in the United States. This has not gained much attention in the recovery vs. recession debate. Yet, states and municipalities spend around twice as much money as the federal government. (Since only the federal government can print money, this comparison may have changed in the last year.) The gap between tax receipts and spending is forcing big changes in Missouri and Illinois, though it is probable these cuts are miniscule in comparison to what is ahead. A recovery is expected in tax receipts by those who think the economy is rebounding, but in fact the broad swath of municipalities will suffer deeper reductions in tax receipts for a long time to come. (Municipalities - cities and towns - receive most of their revenue from real estate taxes. State revenues are skewed towards income, corporate, and sales taxes.)

The Great Depression taught this lesson but it was tossed in some ash heap of history. Revered economists are particularly immune to events that contradict their theories. In the 1938 Alfred Hitchcock movie, The Lady Vanishes, the mistaken psychiatrist is told: "You must think of a fresh theory." Doctor Hartz responds: "It is not necessary. My theory was perfectly good. The facts were misleading."

Doctor Hartz had a sound reason not to change his theory since reconsideration may have precluded his intent to murder his victim. In a similar vein, intended or not, Federal Reserve Governor Frederic Mishkin espoused a murderous theory that has claimed many victims: "To begin with, the bursting of asset price bubbles often does not lead to financial instability....There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability.... In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble." This prediction was made in January 2007 before the Forecaster's Club of New York. (Novelists shy from such parody.)

Current theories and books written about the Depression do not dwell on the 1920s real estate boom. Real estate lending in the 1920s might rival the recent debacle, in form if not degree. There was a flight to the suburbs. The building balloon included houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury "Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program...."

This was speculative building on a grand scale, as Professor Herbert D. Simpson of Northwestern University informed the Forty-Fifth Annual Meeting of the American Economic Association in 1933: "Throughout this period there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate 'speculation' carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29."

In The Crash and Its Aftermath, A History of Securities Markets in the United States, 1929-1933, Barrie Wigmore wrote: "Municipal governments were expected to be an active countervailing force in the anticipated business downturn after the Crash. However, many municipalities were not in a position financially to bear the twin burdens of unemployment relief and capital construction...." It is easy to see why. Municipalities were spending because tax receipts rose. Since tax receipts rose, local governments could leverage growth through bond issues. Outstanding municipal bond debt doubled in the 1920s. Over the same period, federal government debt fell by 30%.

With nothing learned, states and municipalities borrowed $23 billion in 2000 and $215 billion in 2007. One reason credit rained on bubbly school committees was the ever-rising revenue stream from real estate taxes: receipts increased from $254 billion in 2000 to $421 billion in 2008.

Federal Reserve Governor Frederic Mishkin dismissed the body blows of real-estate bubbles, but A.M. Hillhouse, author of Municipal Bonds: A Century of Experience, wrote in 1936: "[T]he major portion of overbonding by municipalities arises out of real estate booms.... The prize crop of boom bond troubles of all time came with the collapse of the Florida real estate speculation in 1926." In consequence, the property tax in West Palm Beach, Florida was raised to 42.5% of assessed value. This effort to balance the books failed.

At the 1933 meeting of the American Economic Association, Simpson was not a happy professor: "During this period of prosperity, real estate taxes were paid with little complaint.... [U]nder these conditions, public expenditures expanded and taxes were increased without protest.... The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale."

Simpson delivered his paper at the bottom of the Depression but the number of beleaguered municipalities kept rising until 1935, when there were at least 3,252 municipal issues in default. There are at least three reasons to think current municipal problems will be worse. First, the latest real estate bubble has probably been much bigger and more leveraged than in the 1920s. Second, expenses are not as easy to cut. The earlier retrenchment was not hamstrung by bloated government retiree pension and health benefits. Third, property assessments lag current prices. This promises to be a fierce battle. Towns want to hold the status quo so are in no hurry to tax properties at falling market values; residents do not want to fund comfortable teacher retirements when they are wondering what happened to their own pension plans.

At the One Hundred Twenty-First Annual Meeting of the American Economic Association in 2009, Professor Frederic Mishkin (who has departed the Fed and returned to Columbia University) contributed a paper, "Is Monetary Policy Effective During Financial Crises?" Whatever he had to say, may it gather dust as the world learns the lessons taught and discarded by Professor Herbert D. Simpson.

Tuesday, March 9, 2010

From the Greenspan Put to the Kohn Put: Our Brilliant Central Bankers

Federal Reserve Vice Chairman Donald Kohn announced his retirement on March 1, 2010. In his obligatory lament, Federal Reserve Chairman Ben S. Bernanke was half right: "The Federal Reserve and the country owe a tremendous debt of gratitude to Don Kohn." What is good for the Fed is generally not good for the country. The influence of Donald Kohn supports this view.

A rarity, Kohn rose through the ranks of the Federal Reserve System. After 32 years of grunt work, he was named a Federal Reserve governor in 2002 and assigned the vice chairmanship in 2006. He participated in Federal Reserve Open Market Committee (FOMC) meetings long before his governorship. He had been a staff economist (Director of Monetary Affairs) and Secretary at FOMC meetings.

Donald Kohn will be smothered in praise from now until his June retirement. The media will quote celebrity economists who will deify the celebrity vice chairman. Alan Greenspan was "the greatest central banker who ever lived," according to former Federal Reserve Vice Chairman Alan Blinder at a 2005 conference. These farewell hosannas are necessarily vague and meaningless, as was the March 6, 2010, appraisal of Kohn in the Economist: "Mr. Kohn is widely considered one of the most experienced and thoughtful central bankers in the world." Given the worldwide failure of central bankers, this may well be true, so a critique of Kohn's brilliance is necessarily specific.

October 15, 1998: Fanning the Greenspan Put

The FOMC held a conference call on October 15, 1998. This remains the most infamous FOMC discussion on record. It was held shortly after Wall Street paid over $3 billion to bail out Long-Term Capital Management (LTCM), a hedge fund. The Nasdaq Composite Index fell 20% from mid-July to mid-October. It had boomed for the past three-and-one-half years (a 160% return), but the Fed decided a hiatus would not do.

In the wake of the conference call, the Fed announced a surprise rate cut at 3:14 p.m. The bond market had already closed for the day, stock-option contracts expired the next day, and investors panicked. A frenzy of buying pushed the S&P 500 futures up 5% in five minutes. The Nasdaq Composite rose from 1,540 on October 14, 1998 to 4,069 on December 31, 1999.

Donald Kohn's contribution, as Secretary of the FOMC, was to announce at the meeting's conclusion: "We are not constrained by the practice followed after regularly scheduled FOMC meetings where the release time is set for 2:15 p.m. We will try to move through the process of preparing the press release as rapidly as possible."

It was after this surprise rate cut that the "Greenspan Put" came into common use. A put option is bought by investors to limit losses when the market falls. Now, instead of buying protection, the Greenspan Put inspired such confidence that speculators replicated the borrowing and leveraging of LTCM. Kohn's faux pas, if that is what it was, served the interests of the Fed but not those of the American people. Around $5 trillion was lost by investors after the Greenspan Stock-Market Put failed in 2000.

Joining the Inflation Targeting Team

The Fed's deflation team was beefed up on August 5, 2002. Both Ben Bernanke and Donald Kohn were appointed as Fed governors, and to the FOMC. Bernanke had devoted his adulthood to inflationary economics. His book, which he wrote with three other economists, Inflation Targeting: Lessons from the International Experience made clear that an economy should always be inflating.

At Bernanke's first FOMC meeting (August 13, 2002), it was the other newcomer, Donald Kohn who sounded as if he was reading from Bernanke's book: "I don't see a zero real rate as a natural bound for monetary policy." He not only was unconcerned about real rates below zero, Kohn stated the opposite case: [I]nflation is already as low as I would like to see it go." He intimated that real rates were already below zero (when inflation exceeds the borrowing rate), and stated a desire for even lower real rates.

This was an about face. At the May 2002, Donald Kohn, speaking as a staff economist, had warned the committee it would soon need to address a fed funds rate hike from "its currently unsustainably low level." He also told the FOMC the fed funds rate "will have to be tightened at some point to forestall increasing inflationary pressures."

Donald Kohn has been an asset inflator since his coming out party at the August 2002 meeting. Although (the current) Chairman Bernanke has led the charge against deflation at all costs, Donald Kohn has been a loyal sidekick.

The FOMC had started cutting the fed funds rate in 2001 and did so until 2003, when it stopped at 1.0%. There are few precedents to a 1.0% borrowing rate. When we sift through the wreckage in future years, the zero-percent school will deserve a healthy portion of the blame.

"[H]ouseholds Have Bought More and Larger Houses and Cars, Have Taken on More Debt..."

Ignorance will not be an excuse. Donald Kohn knew what he was doing. After the Greenspan Stock-Market Put had failed, the FOMC instituted the Greenspan Home-Equity, Cash-Out Put. On April 1, 2004, Kohn spoke at Widener College in Chester, Pennsylvania. He opened by reminding his audience of the gratitude it owed the Federal Reserve: "Starting in January of 2001, the Federal Reserve moved to counter [the weak economy] by lowering the funds rate.... This prompt and aggressive action undoubtedly served to limit the decline in economic activity, and, in fact, the recent recession was one of the mildest on record." Attendees among the cohort that had lost the $5 trillion may not have appreciated this P.R. stunt.

Kohn acknowledged there were dissenters to the Fed's current 1.0% fed funds rate: "[S]ome observers have been calling for the Federal Reserve to begin the tightening process sooner rather than later." They were concerned "that the Federal Reserve, by keeping the funds rate so low and signaling that it is likely to stay low for a while, is sowing the seeds for different kinds of future problems. In particular, these critics worry that a continued environment of low interest rates is giving rise to economic imbalances - excessive indebtedness, and elevated prices of houses, equities, and bonds - that in the longer run will come back to haunt us."

Since the financial meltdown, the Fed has recited from its handbook: "No one saw it coming." The credit crash in 2007 had been widely anticipated and in all its severity. The question was not "if," but "when." The media quotes the Fed without correction, and so, Ben Bernanke was recently awarded another term as chairman.

Kohn dismissed concerns before the Pennsylvania college audience: "[H]ouseholds have bought more and larger houses and cars, have taken on more debt, and generally have spent more than would have been the case if interest rates had been higher.... [T]hese developments... are by-and-large the intended and logical consequences of the Federal Reserve's efforts to reduce economic slack through low interest rates."

Should there be credit "adjustments", Kohn assured his audience: "Commercial banks remain highly profitable and well capitalized...." They were only well capitalized as long as they remained highly profitable.

Of course, Kohn praised the Fed's regulatory vigilance: "Banking supervisors at the Federal Reserve, for example, in the course of the ongoing examination process, have been paying close attention to the sorts of vulnerabilities we have reviewed and have been discussing these risks with the commercial banks they oversee."

Regulation: "It's a Very Hard Sell to the Banks."

On March 4, 2008, Vice Chairman Kohn testified before the Senate Banking Committee about the "Condition of the U.S. Banking System." He made an honest admission: "I don't know that we fully appreciated all the risks out there." He also made a self-serving claim: "I'm not sure anybody did, to be perfectly honest."

Kohn was among the slow minded. In October 2007, Kohn had predicted that once "we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment."

At the March 2008 hearing, Kohn acknowledged that banks had not priced certain risks appropriately, but "It's a very hard sell to the banks." Senator Richard Shelby, a member of the committee, was not amused: "It's a hard sell to the banks, yes, but you are the supervisor of all the bank holding companies, and you are also the central bank.... So you have not just a little bit of power, but a lot of power." Shelby asked Kohn if the Fed "was afraid of the banks they regulate." Kohn responded in the negative. If this was true, a classroom of rookie bank tellers would have done - and would do - a better job supervising the banks.

Donald Kohn was talking through his hat on September 9, 2009. Again, selling the virtues of the Fed, he claimed the Fed's myriad bailouts (not his description) over the past year had followed the "precepts derived from the work of Walter Bagehot [author of Lombard Street, a central-banking blueprint from Queen Victoria's time.] Those precepts hold that central banks can and should ameliorate financial crises by providing ample credit to a wide set of borrowers, as long as the borrowers are solvent, the loans are provided against good collateral, and a penalty rate is charged." [Italics added]

Bagehot's precepts were stated correctly but Fed practices contradicted the Victorian author. Kohn betrayed a complete ignorance of what the Fed was doing. Kohn and Company had provided loans against collateral that was so damaged it was necessary for the Fed to buy it from the banks and hide it from the public on its own books. We still do not know what the Fed bought and this is probably the main reason the central bank is resisting an audit. As for charging a "penalty rate," the Fed has charged a negative real rate of interest (below the rate of inflation). A double-digit interest rate would meet Bagehot's requirement.

The Kohn Put: Inducing "Savers to Diversify into Riskier Assets"

This past fall, the Kohn Put was announced. Maybe because he was speaking to the choir - at a Federal Reserve conference - he explicitly stated the Fed's grand plan. "[R]ecently the improvement, in risk appetites and financial conditions, in part responding to actions by the Federal Reserve and other authorities, has been a critical factor in allowing the economy to begin to move higher after a very deep recession.... Low market interest rates should continue to induce savers to diversify into riskier assets, which would contribute to a further reversal in the flight to liquidity and safety that has characterized the past few years."

In other words, the Federal Reserve is attempting to rescue itself as it did in 1998 and in 2002. Afraid the LTCM failure would cause financial institutions to freeze, the October 15 Greenspan Put inflated confidence and the stock market. In 2002, Federal Reserve governors, in speech after speech, terrorized Americans into believing it had to lift prices or the United States would suffer another Great Depression. This was the rationale for the 1% fed funds rate, the means by which the Fed inflated another asset bubble, the mortgage market, to compensate for its earlier mistake. And now, with the housing market and economy in despair, Kohn has announced the Fed's zero percent interest-rate policy will induce savers into the stock market and the already inflated municipal and federal government bond markets.

Presidential adviser Larry Summers and Secretary of the Treasury Tim Geithner are leading the search for Donald Kohn's replacement. We can be sure this pair of insiders will identify a candidate who will serve the Federal Reserve first and the American people last.