The Assault on Free Markets

Those blindsided by the recent financial meltdown are now loudly blaming the free market for its failure to police its own excesses, and are calling for greater regulation to prevent future disasters. But for those who clearly observed the problems developing (in high definition slow motion) the blame can be directed squarely at the policies of the Greenspan/Bernanke Federal Reserve. As has been the case countless times in history, the free market will now pay the price for government incompetence.

In Senate hearings this week, all parties involved completely ignored the Fed's own culpability in igniting the speculative fever. It's as if a senior prom had turned into a wild bacchanalia, and angry parents now question why the chaperones failed to notice the disrobing or why the DJ played provocative music, all the while ignoring the bearded gentleman pouring grain alcohol into the punch bowl.

A perfect illustration of the Fed's failure to take responsibility can be found in Bernanke's explanations regarding inflation, which he solely attributes to the effects of the rapid increase in global commodity prices. He failed to mention that commodity prices are rising as a direct consequence of his monetary policy, which is debasing not just the U.S. dollar, but currencies around the world. Rather than accepting the blame for creating inflation, Bernanke is shifting the blame to the free market. The Senators are happy to let him get away with it as it provides more evidence to support the "need " for more government to save the economy from the disastrous effects of unbridled capitalism.

When asked how we got into this mess, Bernanke replied that our problems resulted from an excessive credit bubble characterized by aggressive leverage, reckless lending, and extreme risk taking. Absent from his explanation was the Fed's role in irresponsibly setting interest rates below market levels, which mispriced risk, got the party started and kept it raging into the wee hours of the morning. The expressed goal of the Fed for much of this decade was, and is, to encourage and facilitate borrowing and lending.

During his testimony, Bernanke continued to claim that Bear Steams was not bailed out as shareholders only received about $10 per share. Of course, $10 is better than zero, which is what they surely would have received if the Fed hadn't thrown taxpayer money around. What about Bear's creditors though? Although the collapse of Bear Stearns would have cost bond holders dearly, the bailout essentially makes them whole. Here again, the Fed creates even greater moral hazards by encouraging excessive risk taking. By bailing out lenders who extend excessive credit, the Fed simply invites more of that behavior. The free market must be allowed to properly price risk. Lenders need to know that when they lend money, whether to highly leveraged investment banks and hedge funds, or to over-stretched homebuyers or credit card users, they risk not getting paid back. By interfering with this process the Fed simply guarantees more losses and even bigger bailouts in the future.

Also, leveraged speculators need to know that it is not "heads they win, tails the taxpayers lose". Wall Street executives amassed fortunes by making extremely risky bets. Now that those bets have soured, why is it taxpayers that have to swallow the losses? Wall Street billionaires earn their bucks on the backs of the middle class, who made little on the way up, but foot the entire bill on the way down.

While Bernanke talked about the underlying strength of our economy, he claimed necessity in saving Bear Stearns from bankruptcy as it would have brought down our entire financial system. How sound can our economy be if the failure of one investment bank could topple it? Does this now mean that no more major banks or brokerage firms will be allowed to fail? Since we routinely accused Japan of practicing "crony capitalism" what do you suppose we should call our version?

Not to be outdone in rewarding reckless behavior, earlier in the week Congress passed $15 billion in tax breaks for homebuilders, who had made their fortunes overbuilding during the bubble and unloading their shares to a gullible public. By threatening to hold back on their political contributions, these same homebuilders are awarded still more billions. The last ones we should be subsidizing are homebuilders. After all, the last thing we need right now is more homes.

The legislation also contained a provision that offers generous tax credits to individuals who buy homes out of foreclosure. While this is billed as a benefit to homebuyers, it is just another hand out to lenders, as those qualifying for the tax breaks will simply pay more at auctions as the tax breaks subsidize higher bids. The real winners are the creditors who get more in foreclosure than would have been the case had buyers not had their bids subsidized by the government.

Of course, for all the talk about taxpayer bailouts, none of the senators bothered to mention that, for the moment, no tax increases are actually on the table. Instead, the bailouts are being financed by savers, pensioners, wage earners, investors and the elderly on fixed incomes, who all suffer staggering increases in their costs of living, as the Fed uses inflation to rob Main Street to pay off Wall Street.

Does this now mean that no more major banks or brokerage firms will be allowed to fail? Since we routinely accused Japan of practicing "crony capitalism" what do you suppose we should call our version?

this is the unspoken implication.

On the other hand, there was a sort of chastisement in the Bear episode. Bear was "bailed out" with regard to its counterparty obligations. But the firm's equity nearly disappeared. It's not as if they got off scot-free and there were no untoward consequences. In reality, Bear was not bailed out. The market was. Bear is being picked clean.

If Jamie Dimon didn't get some kind of immunity from the ocean of shareholder suits that are probably ramping up, he may rue the day he did it.

OK, if you want to make the anti-fed argument, that’s fine with me... I don’t think it’s a point I misse but a point I’m ignoring. We both know that a change like that isn’t going to happen today if ever. And even if it were implemented tomorrow, it still won’t stop the boom bust cycle.

I strongly suspect that you’re trying to use this sword to slay the same dragon you always fight, but that strikes me as futile. you’re mistaking “identification of the problem” with trying to provide an ongoing solution.

My solution on the other hand will do a great deal to address the boom-bust cycle that comes from asset bubbles, and will do so with a policy change that is small and achievable.

I'm making an anti-creditbubble argument. If the Fed did its job we wouldn't have $47T in credit (on the books) for a $14T economy. We require $6 in credit for a $1 growth in GDP. The Fed has brought us well past the point of credit sustainability which leaves us no choice but to do the writeoffs and take the lumps. The Fed will have to do more of BSC type transactions: buying bad securities and sticking them in new LLCs that it creates so they can be sold later (or never). That is monetization and of course it is inflationary, but it is much better to get that over with than to try to expand the credit bubble even more.

What financial wizards don't realize is that boom/bust is easily fixed if it stays in the nonfinancial world. My friends can start new business that are not housing related provided there is no credit contraction. But we are doomed to a credit contraction because of the previous loose credit policies. All Bernanke is doing now by lowering rates now is creating the next credit contraction later (if he is successful now) or creating needless inflation now (if he is not).

Asset bubbles come from credit bubbles, until you understand that, you aren't going to solve anything.

Well to be perfectly honest, I'm not sure you know what it is you're arguing against and what you're not.

You say rates should be set by market forces but you complain about the effect of the “carry trade” which is a market force. I describe a simple solution for a purely market phenomenon and you respond by saying that a better solution is to find some way (a way you don't specify) to solve an economic policy problem by keeping it in a “nonfinancial world”. You ignore the fact that I'm not talking about that part of the problem at all.

I think it's pretty clear that you know who it is you think is the villain in this circumstance, and I think it's hard for you to get past the idea that I'm culpable in some way because of my choice of careers. But the truth is, I don't think you've actually read my piece at all, or if you did, then I guess you didn't understand it. I'm talking about solving one kind of problem, and you're talking about addressing a completely different one. Your insistence that they are really the same and that your claim that I don't understand the connection are unfounded.

You're clearly a smart guy (please excuse the gender assumption) but you're talking only about the causes of the last problem, while I'm talking about preventing the next one.

What's worse is that you don't seem to understand enough about financial markets as they are now to know that without a change like the one I'm proposing, your solution can't be had without catastrophic effects to overall economy. When a crisis like this occurs, the Fed see’s itself as having it's hands tied. They see themselves as doing what must be done to avoid economic catastrophe. The thinking is that you can't do anything about inflation by putting some high percentage of Americans out of work.

But if a solution like mine was implemented, we take the crisis out of the equation which would free up the fed to take a longer term view and do more of what you would like them to do. And eventually (not quickly as you seem to well know... but eventually) address the very issues you complain about.

Either way though, I think it's pretty clear that we're not speaking the same language.

Thanks for the compliments and your assumptions about me are correct. The one point of yours I agree on is the pain of undoing the credit bubble. I am fully aware of that and the fact that we have undone perhaps 1T out of 47T with significant pain is not lost on me. I am not accusing Greenspan of villainy nor criticizing your choice of careers. I think Greenspan was very foolish and arrogant, but not malicious. The Fed (and Bernanke) are good people trying to do the best they can for a difficult situation. They are looking for the most cost effective solution for buying bad debt (30B is a good deal for the amount BSC had), but they are also kicking the can by trying to roll the debt with lower rates. That is their flaw.

The problem of growing the credit bubble to solve a credit contraction does not solve anything. Your solution for the asset bubble which is created from the credit bubble does not solve any problem, it will merely result in shifting the bubble into a wide range of assets. Asset bubbles as we would both agree are very psychological and there is no doubt that the housing bubble had that element in Phoenix, Miami, Las Vegas. People in those places argued that their location was different, everyone wanted to move there, or ocean front was limited, or there was a huge population growth for some other reason.

The problem with pinning all the blame on the psychology is that it largely doesn't happen without credit. It's basically an easy come easy go situation. It is too easy to get leverage and flip. Your solution would presumably dampen the bubble in particular places, but would not slow it overall. The same availability or glut of credit will have the same effect, just more spread out.

On two other points, the carry trade is the market response to artificially low short term rates. It borrows short and lends long which means there is a problem somewhere (either short rates are too low or long rates anticipating inflation are too high). On the nonfinancial world, my friends in the housing business would like to start new businesses but cannot get a loan of any sort to do so. It doesn't matter what the Fed sets rates to, it won't help them at all. The problem is essentially that I am unwilling to loan them my money for the long run while they get going because I know the Fed is inflating right now, so I speculate in short assets instead. I don't like to do that, but the Fed has given me no choice.

You’re still talking about a monetary policy issue, while I’m talking about a markets issue. It’s apples and oranges. We cannot address the long term problem that you have identified while the short term problem that I’ve identified continues to make the long term problem worse. But if we were to implement my solution we would prevent the next “emergency” where the Fed would be forced to forget it’s long term goals... again. It would then free them up to address the long term monetary policty issue.

Fed uses inflation to rob Main Street to pay off Wall Street-This is the reason why Wall-Street is generally hated (along with the Federal Govt in WaD.C.)because the bankers are only interested in the bankers. The FED is a Monster- and the leadership should be tried as TRAITORS to this nation!!

Sadly many times people think of solutions they just turn to more government/regulation rather than freedom and de-regulation: Know the problem-People don’t like to take Personal Responsibility anymore..

Your solution would in no way prevent any emergency. The current debt contraction emergency was brought about by excessive credit lowering the spreads of upper truanches of junk debt to a couple of basis points over treasuries. That is credit market insanity and it doesn't matter how much information people have or share about the end of the asset bubble. If anything, your proposal would make the race for the exits even more extreme triggered by a broader market excess rather than a few focused areas.

Here's a simple example: I am offered zero downpayment, zero interest, deferred principle financing on whatever I want. As long as I am early to the party I am fine. With your proposal I would be notified in advance when the party is going to end. That means I am also informed that the party has started so I can jump on it even earlier. I am also more likely to make the decision to go for it because I have less uncertainty about when to cash in. In short, the bubbles would be steeper and the crashes would be much faster and thus take down more unrelated markets.

Actually your just wrong about that and the example I mention in the essay demonstrates it. I’ve spent 20 years studying these market phenomenon, and I know as much about it as anyone alive.

Asset bubbles don’t occur just because of low rates or cheap money. It’s a behavioral phenomenon specific to publicly traded markets. If my suggestion were implemented we would never see a situation where credit spreads got so tight because it would impossible to build a large enough consensus about future expectations to drive them there.

But I confess that one would really need to know an awful lot about how markets actually work to understand that at a glance.

If you’d like to learn something about it try reading “Knowledge and Decision” by Thomas Sowell, and the book I mentioned in the essay is also very good.

I agree. Bernanke has done well considering his options are limited. Now the Fed should stop any other bailouts, and printing of trillions to cover legalized gambling in the derivitives. The American people minus the top 3% will wake up on day to hear news about Central Bank collapse and make runs on the banks, only to find the dollars are worth about 1/10 of their value. Heads are going to roll. I say, let the truth be shouted from the rooftops so the pain and responsible steps are taken in energy independence and fiscal responsibility begin so we can someday get back to what America was all about. Right now, this isn’t my nation anymore. It’s owned by the EU, Arabs, lobbyists and our politicians whom are VERY un-American.

If I’m as smart as you say I am, how come I don’t see your example? I think the essay demonstrates that going long in natural gas while JP Morgan is going short will put a company out of business. I agree that the asset bubble is behavioral, but it is a result of the low spreads, not the cause. The spreads were lowered as people chased yield to the point of insanity, buying traunches of junk with a fake “AAA” rating insured with fake insurance. That kind of excess can only occur from the credit excesses, and it drives the asset bubble. Your notion of future expectations depends on the reality (or nonreality) of the asset pricing. That is good and will help dampen the bubble in the extreme situations. But my expectations are based on the Fed lowering short term rates, and eventually the Fed jiggering longer yields lower. That’s what ultimately drives the tight yields.

No ... you're just mistaking cause and effect. The only thing that ever moves prices is a buyer or a seller... when they buy or sell. Low spreads don't cause themselves, they occur when there are more sellers of volatility than there are buyers, or in the case of an asset bubble, if there are no buyers of volatilty at all.

In other words...making cheap money available only turns into an asset bubble if everyone does the same thing with it. And the reason everyone has done the same thing (favored the short volatility trade which then tightened spreads) was because it was impossible given public information, to form an opinion about the long volatility trade. But the suggestion I point to would change that. It would make it possible for sophisticated professionals to form an opinion (build a probability distribution) about the likelihood of a spike in volatility. And so long as there is enough people out there saying “today is the day it all falls down”, the crisis will never occur because they will be there to provide a bid when it does. Instead the money goes from one participant to the other rather than just driving bids to zero.

The Amaranth collapse was larger than LTCM but there was no need for a bailout. They didn't just go long NatGas like you say, it was a complex spread position identical in risk terms to the circumstance we're discussing. It was the same thing... the only difference was that there was no collapse of asset values because other market participants were there with long volatility exposure and were willing to provide a bid. That could be our model going forward if we made this one simple change. I don't think this can be explained any more plainly than that. At this point, it's really on you... if you still don't understand what I'm talking about I'll be happy to reccomend other reading material, but this is how markets actually work whether it matches your understanding or not.

Your best explanation yet. But I still disagree with your conclusion. The opinion of the "long volatility" trade was utterly obvious. Most of us saying there is a credit bubble now, were saying it in 2005. My personal posts here pointed out the absurd lending practices and subsequent asset bubble. I didn't get into the cause and effect then because I didn't know enough about it. Now I know that the demand for overrated traunches came from several factors, the main one being carry trade from low short term rates. It was trivial to borrow at 2 or 3 percent and buy longer duration securities with whatever yield was available at "AAA" (which were based on ludicrous assumptions). That is what drives down spreads, not the asset bubble, or lack of knowledge of the bubble or anything else to do with the asset bubble.

The implication that "volatility" or risk is somehow involved in all of this is about as ludicrous as the fake "AAA" ratings and fake insurance on the "AAA" ratings. The market has discovered that fraud and has now priced accordingly, but your plan will not prevent such malarky in the future.

Actually it will... you just don’t understand how those investment decisions are made. You don’t get what professional money managers actually do for a living. That’s OK of course, it’s no reflection on you that you don’t. You have some other job that I probably don’t know all that much about (certainly not as much as you), but it’s pretty clear that it’s a mistake to assume that you know enough to understand the consequences of what I’m talking about.

If the long vol trade was so obvious to you, then you’d be a billionaire right now, and you’re not. The fact that it would blow up eventually was obvious to everyone, but no one could forecast when it would blow up. My proposal would make that forecast possible for those who do this for a living. And that would prevent the market crisis by “creating” liquidity at the most crucial time. Assets will still fall and rise, market volatility will still be present, just like it was during the Amaranth collapse, but it won’t be a broader market crisis.

I’m sorry to put it so bluntly, but the fact that you don’t understand it doesn’t mean it won’t work... it only that you don’t understand it.

My career has been productive enough to satisfy me, no need for the “billionaire” argument. The fact that nobody could decide when a 47T credit to 14T income would blow up is completely irrelevant. The “crucial” liquidity from the other side of the asset bubble will not pay those debts. No money from the other side of the trade (e.g JPM in the Amaranth case) is going to go into the stream of income need to sustain the securities and keep them solvent, never mind worthy of a “AAA” rating. Creating liquidity at the “crucial” time last summer would have been as effective as the Fed liquidity was back then. There’s no way out of a credit bubble other than credit contraction. Your attempt to sustain it and kick the can only makes it crash from a high point later.

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