Tuesday, December 13, 2011

Lessons of the 1930s include more than central bank and fiscal policies [update]

Why is it that the only lessons learned from the 1930s were about central bank and fiscal policies?

Look at all the articles/columns since the start of the solvency crisis on August 9, 2007 discussing how we avoided a second Great Depression by learning from what was successful and what was wrong in central bank and fiscal policies during FDR's administration.

The Economist magazine provides a nice example of this type of article.

Why is it that the 1933 transformation of the capital markets from the basis of caveat emptor (buyer beware) to the philosophy of disclosure is seldom mentioned?

Are capital markets, especially the credit market, unimportant?

Are economists, especially those who focused on the Great Depression, so focused on central bank and fiscal policies that they take the idea that market participants have access to all the useful, relevant information in an appropriate, timely manner as a given?  Do they have any idea that every area of the capital markets that ceased functioning in 2008/2009 is characterized by opacity?

Regular readers know that your humble blogger predicted the financial crisis.  Subsequently, I predicted that until opacity in the financial system was addressed, we would continue in a downward spiral with no logical stopping point.

To date, opacity has not been addressed and despite massive governmental outlays, a tax cut for the rich and zero interest rate policies, a true recovery is nowhere in sight.  What is in sight is both the Eurozone and China economies contracting.  The former from the adoption of austerity policies and the latter from the bursting of its property bubble.

Could this downward spiral be stopped?  Of course it can be stopped by removing opacity from the global financial system.

When opacity is removed, market participants can once again value financial assets.  Everyone finds out who is holding onto the losses from the financial excesses that occurred prior to the solvency crisis.

Removing opacity is a very good thing as it ends regulatory policies that distort the economy like extend and pretend -- this particular policy makes it easier for a bad credit to access bank funds than a good credit.

The great irony about ending opacity is that this was the advice given by Professor Bernanke and many other economists to Japan when it had its financial crisis.  They just offered this advice without calling it ending opacity.  The advice was to recognize the losses in the financial system.  Japan has never recognized the losses and it has experience 2+ decades of economic underperformance.

This blog has documented how ultra disclosure is good for the banking system.

Together with deposit guarantees and central bank liquidity support, it allows banks that have negative book value to continue operating in a low risk manner.  Banks do not have to sell off their good assets.  Rather, banks can function as the safety valve between the financial excesses and the real economy by absorbing the losses on the financial excesses.

Rather remarkably, the NY Fed has documented that removing opacity fixes the financial system.

Contemporary observers consider the [US] Bank Holiday and [FDR's] Fireside Chat a one-two punch that broke the back of the Great Depression....
Roosevelt’s oratory certainly played an important role, but only the financially naive would have believed that the government could examine thousands of banks in one week to identify those that should survive. 
According to Wigmore (1987, p. 752), “The federal review procedure for reopening banks also had too many weaknesses to create much confidence, given the number of banks reopened, the speed with which they opened, and the lack of current information on them. There were no standards for judging which banks should reopen.”...
This article demonstrates that the Bank Holiday that began on March 6, 1933, marked the end of an old regime, and the Fireside Chat a week later inaugurated a new one. 
The Emergency Banking Act of 1933, passed by Congress on March 9—combined with the Federal Reserve’s commitment to supply unlimited amounts of currency to reopened banks—
created de facto 100 percent deposit insurance. 
Moreover, the evidence shows that people recognized this guarantee and, as a result, believed the President on March 12, 1933, when he said that the reopened banks would be safer than the proverbial “money under the mattress.” 
Confirmation of the turnaround in expectations came in two parts: the Dow Jones Industrial
Average rose by a statistically significant 15.34 percent on March 15, 1933 (taking into account the two-week trading halt during the Bank Holiday), and by the end of the month, the
public had returned to the banks two-thirds of the currency hoarded since the onset of the panic.
Breaking the back of the Great Depression sure sounds like making banks absorb the losses on financial excesses unambiguously works.  Isn't it time we learn this lesson from the 1930s and implement it?

The Telegraph ran an article that reinforces the theme of this post.

With the exception of Mitt Romney, those Republicans vying to take on President Barack Obama next year have made clear they're no friend of this Fed. It's too interventionist, is debasing the dollar, punishing the country's savers and institutionally secretive .... But there's one area most of them and Bernanke would agree on: the string of better economic data over the last month is nothing to get euphoric about.... 
Bernanke's also had to admit that the Fed doesn't fully understand why the recovery has struggled to put down roots. At a press conference in the spring, he pointed to the disruption from Japan's earthquake and higher oil prices, before telling his audience that the bank hadn't got a complete handle on why growth was disappointing....
Despite my lack of an economics Phd, my prediction of a downward spiral for the economy seems to be pretty accurate.

The reason is I recognize the cost of opacity in the financial system.  Until market participants can value financial assets again, the recovery simply will not take hold.  Japan has shown this for 2+ decades. 
To its critics, the Fed, like the Bank of England, has looked like an institution playing a desperate game of catch up since failing to anticipate the credit crunch and, initially at least, underestimating its scale. 
It's why the majority of banks expect the Fed to embark on another round of quantitative easing sometime in the first quarter of next year. That's despite warnings - including one this week from the Bank for International Settlements - that more QE will have a limited effect. Bernanke & Co. are unlikely to be deterred by either internal dissent on the FOMC or greater political opposition, which will surely come if more QE does. 
Bernanke can, rightly, point to a fiscal policy that's both so far failed to provide much in the way of short-term stimulus for the economy and a plan to reverse the long-term trajectory for America's national debt. 
Above all else, though, Bernanke can point to the risks to the US that are still bubbling away in Europe.... 
But the crisis of the euro is the latest - and by far the most dangerous - shock to hit the US economy this year. With the US recovery far from secure, the Fed will keep the stimulus it has in place and possibly extend it. Unlike some of those competing to be the Republican nominee, 2011 will have taught Bernanke that a still fragile economy is not insulated as the effects of the financial crisis play elsewhere in the world.
Opacity knows no bounds in the global financial system.

For example, it was opaque, toxic US sub-prime mortgage backed securities that significantly weakened Eurozone banks.

It will take a global commitment to ultra transparency to fully restore the health of the global financial system.

No comments: