In How libertarian dogma led the Fed astray Henry Kaufman launches into tirade against the “Libertarian Fed” and the “prevailing economic libertarianism”. I have a question for Kaufman:

Since When is Constant Meddling in the Markets a Sign of Libertarianism?

The idea that Greenspan or the Fed is Libertarian is absurd.

Greenspan never left the markets alone. At every crisis (real or imaginary) Greenspan slashed interest rates. Here are two prime examples: In 1999 the Fed threw money at non-existent problems such as the Y2K scare. That policy decision helped fuel the Dot-Com bubble. When the Dot-Com bubble burst Greenspan stepped on the gas in 2001-2002 to bail out banks at risk because of poor loans to both Latin America and the internet companies. That policy decision fueled a massive housing bubble not just in the US but worldwide.

Every step of the way, the Greenspan and Bernanke Fed micro-mismanaged interest rates as if they knew better than the free market where rates should be. The reality is the Fed does not know where interest rates should be only the free market knows.

Fed Uncertainty Principle

When it comes to interest rate policy, some think the Fed simply follows the markets. If that is the case, why do we need the Fed?

In actual practice, the Fed neither leads nor follows the market. However, the Fed does massively distort the market, a perfectly valid reason we do not need the Fed. For a complete discussion of this idea, please read the Fed Uncertainty Principle.

Bully Pulpit Silliness

Kaufman goes on with numerous anti-Libertarian rants including a discussion of how “adherence to economic libertarianism inhibited the Fed from using the bully pulpit or moral suasion to constrain market excesses.”

Please! Kaufman wants the Fed to get on the bully pulpit (as if that does a damn thing) when 18 months ago the Bernanke Fed did not think the housing crisis would spillover into the real economy. Hells bells, slashing interest rates to 0% and throwing trillions of dollars at problems did not do a thing to contain the crisis yet we are somehow supposed to believe that better use of a bully pulpit could have prevented this crisis?

Fannie Mae and Freddie Mac

Many right now are arguing for regulation of Fannie Mae and Freddie Mac. The idea is preposterous. There is virtually no need to regulate Fannie and Freddie for the simple reason that Fannie Mae and Freddie Mac should not even exist.

The first thing any regulator in his right mind would do to Fannie and Freddie is to shut them down on account of systemic risk. Instead, in order to get “credit flowing” Congress is throwing $trillions of taxpayer dollars down a black hole and upping the amount of dollars that Fannie and Freddie can lend. So much for regulators acting responsibly even when we know Fannie and Freddie are excessively leveraged and making risky loans.

Rating Agency Madness

Please consider the rating agency problem where the agencies rated the most ridiculous garbage AAA. Was this due to lack of regulation? Of course not.

The rating problem stems from regulation by the SEC that mandated all debt be rated. Prior to that regulatory change by the SEC, corporations buying debt paid rating agencies for their ratings. The rating agencies had a vested interest to rate well or they went out of business.

The SEC turned this model upside down, sponsored Moody’s, Fitch, and the S&P;, and the big three started getting paid not on how well they rated debt but on how much debt they rated. Is it any wonder everything got rated AAA?

The cure is not more regulation of rating agencies, the cure is to return to a model where rating agencies get paid by the quality of their work, not the quantity of it. In addition, the SEC sponsorship of Moody’s, Fitch, and the S&P; has to go. For more on this issue, please see Time To Break Up The Credit Rating Cartel.

Glass-Steagall Scapegoat

Like many others, Kaufman rails against the removal of Glass-Steagall. On this point, there is merit to the idea that conflicts of interest arise when the granting of credit — lending — and the use of credit — investing — by the same entity, can lead to abuses.

However, it’s also important to note that the Glass-Steagall Act of 1933 established the Federal Deposit Insurance Corporation (FDIC), and all of the moral hazards along with it.

Because of FDIC, money flowed to the worst banks offering the highest rates on CDs and savings accounts. This in turn provided funding for the worst projects such as building numerous condo towers in Florida, Las Vegas, and San Diego, along with off balance sheet financing of SIVs, and various mall projects that should never have been funded.

In simple terms, FDIC traded small more frequent bank failures that could quickly and easily be absorbed by the system into the massive mess of bank failures we see today. Moreover, the correct response would have been to let failed banks go bankrupt. Instead, regulators are compounding the problem by keeping zombie banks alive. This is the same failed regulatory response Japan took and it is unquestionably delaying the recovery while adding to the national debt.

Fractional Reserve Lending The Main Problem

Finally, it is extremely important to point out that it is fractional reserve lending, not the repeal of Glass-Steagall that is the root cause the massive credit expansion that has now blown up.

Fractional reserve lending is nothing more than a fraudulent Ponzi scheme that allows money (credit really) to be borrowed into existence when it is mathematically impossible for that credit to be paid back.

All Ponzi schemes eventually blow up as this credit bubble just did.

Excessive Regulation

Every economic problem we face can be traced back to excessive regulation, not the lack of regulation.

  • The Fed
  • Fractional Reserve Lending
  • Fannie Mae and Freddie Mac
  • The Rating Agencies
  • Congressional Sponsorship of Unfunded Pet Projects

Kaufman concludes with ….

We should, therefore, fundamentally re-examine the role of the Fed and the supervision of our financial institutions. Are the current arrangements within the Fed structure adequate – from its regional representation to its compensation for chairman and governors to its terms of office for governors? How can the Fed’s decision-making process be improved? If we were to create a new central bank from the ground up, how would it differ? At a minimum, the Fed’s sensitivity to financial excesses must be improved.

Missing The Boat

The Fed is a failed institution. Fannie Mae is a failed institution. Freddie Mac is a failed institution. Fractional reserve lending is a fraud.

The correct policy decision is to abolish all of them, not to add layer after layer after layer of regulators watching over other regulators, who in turn watch over still other regulators, where some “god-like” super-regulator at the top supposedly has infinite wisdom and knows exactly how to regulate.

Thus, the correct question is not “If we were to create a new central bank from the ground up, how would it differ?

The correct question is “How do we get rid of the Fed and phase out fractional reserve lending?”

The ultimate irony is that Kaufman blames Libertarianism when the very existence of the Fed is 180 degrees removed from Libertarianism. There is not a true Libertarian in existence who thinks the Fed is a good idea.

The problem with regulation is easy to describe: Regulation typically fails, often spectacularly. And every time it fails, people come out of the woodwork begging for more of it.

When does the madness stop?

Mike “Mish” Shedlock
Click Here To Scroll Thru My Recent Post List