Archive for the ‘Federal Reserve’ Category

A blinded Alan Blinder fails to see any Fed missteps in creating, anticipating or responding to the financial crisis

January 27th, 2009 No comments

In the January 24 New York Times, Alan S. Blinder, professor of economics and public affairs at Princeton and former vice chairman of the Federal Reserve, argues that our  worst postwar recession does not represent a fundamental failure of the American capitalist system, but is a result of a series of avoidable human errors.  Sounds balanced and reflective? Unfortunately, Blinder’s piece, “Six Errors on the Path to the Financial Crisis”, is remarkably shallow and myopic.

Despite purporting to explain, a la Richard Clarke after September 11, “why we failed and what … we need to do to ensure that nothing like that ever happens again”,  Blinder has deliberately omitted  “mistakes that became clear only in hindsight” and limited himself to mistakes “where prominent voices advocated a different course at the time”.  The most glaring omission?  Blinder has completely dodged mentioning the critical role of Fed chairman Alan Greenspan, who deliberately created the housing bubble as a favor to Pres. George Bush by lowering interest rates at the beginning of Bush’s first administration.  Similarly, Blinder fails to address any of the dangers in the Fed’s current inflationary and bubble-creating policies.

Blinder also barely scratches the surface in analyzing the factors that he does identify:

1.  “Wild Derivatives”:  Blinder suggests that derivatives should have been more closely regulated as requested by the CFTC in 1998.  Why not note that the supposed need for more regulation arose directly from the moral hazards for shareholders and managers created by prior regulatory interventions – the provision of deposit insurance to banks, the SEC’s attempts to require full financial disclosure from “public”, listed companies, and by the grant of limited liability itself?

2.  “Sky-High Leverage”:  Blinder rightly notes that a second error came in 2004, when the SEC let securities firms raise their leverage sharply.  But Blinder fails to cite any “prominent voices” who opposed the relaxation of leverage limits (which shot up from 12 to 1 to more like 33 to 1) – where was the Fed?  Further, his question – “What were the S.E.C. and the heads of the firms thinking?” – ignores the obvious:  the securities firms had recently gone private and so managing directors so were risking shareholders’ capital, not their own, and so had every incentive to to try to capture phenomenal profits – and bonuses – resulting from the bubble and made even more available through higher leverage, and let shareholders suffer the losses when the bubble burst.  The great political pull of Wall Street with the Bush administration, and particularly with former Treasury Secretary (and former Goldman Sachs head) Hank Paulson, has meant that US citizens as well as shareholders have been left holding the bag from Wall Street losses (with the exception of Lehman).

But the problem of moral hazard and disincentives was one the Fed was not only long aware, but itself contributed to, such as when it forced the massive bailout of hedge fund Long-term Capital Management.  Blinder himself in 2005, when commenting on a paper that discussed misincentives and systemic risks resulting from the disintermediation of banks and leverage of securities firms, specifically noted these malincentives – which were present not only for traders but for the funds and securities firms they worked for as well:

The way a lot of these funds operate, you can become richer than Croesus on the upside, and on the downside you just get your salary. These are extremely convex returns.

I’ve wondered for years why this is so. You don’t need to have public regulatory concerns to worry about it. Take the perspective from inside a big company. The traders don’t own the capital. The traders are taking all this risk and putting the company’s capital at enormous risk. I dont quite understand why the incentives are as they are.

I remember a discussion I had with-I won’t name him-one of the principals of the LTCM, while it was riding high. He agreed with me that the skewed incentives are a problem. But they weren’t solving it, obviously.

3.  The “Subprime Surge”:  Blinder blames the “insanity” of the rapid growth of subprime lending into a large and dangerous market on (1) “bank regulators [who] were asleep at the switch. Entranced by laissez faire-y tales, they ignored warnings from those like Edward M. Gramlich, then a Fed governor,” and (2) the argument that “many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator.”

For Blinder, every problem seems to one caused by either incompetent regulation or not enough of it.  Solution?  Easy!  Godlike regulators who have all powers needed and who never make mistakes.

And why not also blame politicians and Congress for the prominent roles of Fannie Mae and Freddie Mac in providing support to the subprime market by buying securitized subprime assets?

4.  “Fiddling on Foreclosures”:  Here Blinder is not blaming rising foreclosures for the financial crisis, but is blaming Congress and the Treasury (due to an excess of “Free-market ideology, denial and an unwillingness to commit taxpayer funds”) for failing to bail out those who took out loans beyond their means to repay them.  Are we better off, Mr. Binder, if our leaders shift all risks to taxpayers and the foreign nations that fund our deficits?

5.  “Letting Lehman Go”:  Says Blinder:  “After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.”  Blinder doesn’t  justify his conclusion, and how can he?  If the financial system is a house of cards, is bailing out every failing financial institution a cure, or simply a postponement of an inevitable reckoning?  Perhaps a lesson more fairly drawn is that the willingness of the Treasury and Fed to bail out some institutions but not others, pursuant to what is evidently and ad hoc and opaque process, paralyzes private decision-making.

6.  “TARP’s Detour”:  Blinder criticizes Paulson for using TARP funds to recapitalize failing firms rather than to revitalize markets by purchasing troubled assets.  But his real complaint is just that Paulson, having received the necessary God-like powers to through hundreds of billions around as he pleased, didn’t act in ways that Blinder would have.  Guess only Blinder should have received those God-like powers!

Blinder of course is right to note that our politicians and bureaucrats have screwed up the economy.  But he fails to see that it is intervention itself, and the massive shifting of risks that both result from and fuel it, that is the deep underlying problem.  The blind hubris displayed by his failure to direct any blame towards the Fed is ample testimony to his shallow and self-righteous perspective.  Blinder or the Fed asleep at the switch?  Never!  Give us more switches!