The Volcker Legacy: Too Big to Fail

Most people associate Paul Volcker with his role as the chairman of the Federal Reserve when inflation was defeated in the early 1980s.  For that, he deserves all the kudos he receives.

Few people associate Paul Volcker with his role as the chairman of the Federal Reserve and through his leadership of bank supervision and regulation creating the concept of Too Big to Fail banks.

However, it is the creation of Too Big to Fail banks that our current financial crisis has shown is his most important, lasting legacy.

In a very interesting American Banker article, Francine McKenna discusses how Continental Illinois was the first Too Big to Fail bank.  The collapse of Continental Illinois was the result of opacity that hid from the market what a combination of irresponsible lending, self-interest, hot money and lack of restraint by the Fed was allowing to be done to a bank that faced no market discipline.

In a related article, Ms. McKenna lays out the lack of regulatory restraint on banks and the adoption of the Too Big to Fail policy.

“The Congressional testimony of the OCC’s Conover in September 1984 also mentioned that the OCC had considered earlier whether it should have taken action much sooner to stop Continental from growing so quickly and, in hindsight, so recklessly.  

Conover testified that he believed such action would have been inappropriate but that the OCC could have placed “more emphasis on . . . evaluation and criticism of Continental’s overall management processes.” 

Federal Reserve Board Governor Charles Partee is quoted in William Grieder’s 1987 book “Secrets of The Temple” saying: “To impose prudential restraints is meddlesome and it restricts profits. If the banking system is expanding rapidly, if they can show they’re making good money by the new business, for us to try to be too tough with them, to hold them back, is just not going to be acceptable.” 

If that’s not enough foreshadowing of the policy prescription the Federal Reserve would deliver during the 2008 financial crisis, here’s Conover again during his testimony explaining to Congress why everyone but shareholders was made whole in the Continental Bank bailout: 

“…had Continental failed and been treated in a way in which depositors and creditors were not made whole, we could very well have seen a national, if not an international, financial crisis, the dimensions of which were difficult to imagine. None of us wanted to find out…” 

The day after Conover’s testimony, the Wall Street Journal published an article by Tim Carrington, “U.S. Won’t Let 11 Biggest Banks in Nation Fail—Testimony by Comptroller at House Hearing Is First Policy Acknowledgement”.

By the mid-1980s, Too Big to Fail had become the policy of the Federal Reserve and other bank regulators.


Regular readers know that I have written extensively about the Loans to Less Developed Countries crisis as it was the next step on the evolution of the concept of Too Big to Fail banks.  This crisis was very important for two reasons:

1. It cemented into the regulatory culture the notion that if the regulators and the Too Big to Fail banks "hid" the true extent of the losses at these banks, the market would go on as if the losses did not exist.
2. It drove monetary policy as the Fed, after informing the banks, chose to cut interest rates in an effort to generate earnings that could be used to recapitalize these institutions.

A little background is necessary to understand these conclusions.

Walter Wriston, a former chairman and CEO of Citicorp, said that "people go bankrupt, but countries don't".  Based on this observation, the large US banks plunged into lending to Less Developed Countries.

Of course, Mr. Wriston was wrong.  Countries do go bankrupt and this point had become obvious by the mid-1980s.  

Unfortunately, by the time this point was obvious, the exposure of the large US banks to the Less Developed Countries was multiples of their book capital levels.  A fact that was well known to market participants as banks disclosed the level of their exposures to the Less Developed Countries.

In fact, the general magnitude of the losses on these loans was also known to the market as predecessors to Bloomberg reported the prices at which the Loans to Less Developed Countries traded. When a Less Developed Country's loans trade at fifty cents on the dollar, it was a pretty safe bet that the value of the loans held by the banks reflected this pricing.

So the question that the Fed as the lead regulator for the Too Big to Fail banks faced was do we require the banks to write down their loans to Less Developed Countries upfront to reflect current market valuations or do we engage in regulatory forbearance and let the banks engage in extend and pretend and bring the losses slowly through their income statement as they generate earnings?

The Fed chose regulatory forbearance and the idea of "hiding" the actual magnitude of the losses from the market.

Please note, the market had a very good idea of the size of the losses, it just did not know the exact amount of the losses.

When John Reed at Citicorp eventually recognized the losses on the Less Developed Country loans, the market responded by bidding up Citicorp's price.  The write-off confirmed the market's conclusion about the size of the losses.

The Fed mistakenly believed that the fact the market had not collapsed when it became obvious the banks were insolvent and the subsequent positive reaction by the market was an endorsement of its policy choice.

The market didn't collapse because there was sufficient transparency into each of the Too Big to Fail banks to determine a) the general magnitude of loss and b) whether the bank's net interest income was greater than its ongoing operating expense after adjusting for the income actually generated by the loans to Less Developed Countries.

The Fed's policy response set another precedent.

Can the Fed pop the next bubble before it is too late?

In a very interesting Fiscal Times column, Mark Thoma tries to answer the question of can the Fed burst the next bubble before it's too late.

Before reflexively saying "no", it is worth pointing out that this question highlights a more fundamental problem with our financial system.

The fundamental problem is that it is currently dependent on the Fed to burst the next bubble before it's too late.

No stable system has a single point of failure.  By definition, a single point of failure will fail.  The only question is when (always at the worst possible time).

Why is the financial system dependent on the Fed?

Because currently only the Fed has access to all the useful, relevant information in an appropriate, timely manner about the global financial institutions, aka the TBTF banks.

Every other market participant is dependent on the Fed to both accurately assess this information and to communicate the results of its assessment.

One of the lessons of the financial crisis is that the Fed and other bank regulators will not accurately communicate the results of their assessment of the risk and solvency of the banks.  The reason for this is institutional.  Specifically, the bank regulators are all concerned with the safety and soundness of the financial system.

As a result, bank regulators will never tell the true condition of a bank experiencing distress as it might trigger issues with the safety and soundness of the financial system.

The problem with our current system is that investors, including other banks, over-invest in the banks based on the assurances by the Fed that the banks are low risk (these assurance come in the form of positive stress test results or comments about how financial innovation has lowered the banks' risk).

This over-investment creates issues like financial contagion; the notion that one bank's failure will trigger other bank failures.

How can the financial system be weaned off of its dependency on the Fed and its ability to burst the next bubble before it is too late?

By requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, investors can independently assess the risk and solvency of each bank and adjust the amount of their investment in each bank to what they can afford to lose.

Ultra transparency directly addresses and eliminates the over-investment problem.  Investors know that with ultra transparency comes the responsibility for all losses on their investments in the banks.  This gives them an incentive to use the data and limit the size of their exposure to each bank.

Then, even if the Fed does not burst the next bubble before it is too late, the financial system is still stable as each market participant is in a position to absorb the bubble related losses.

Sheila Bair is not a substitute for market supervision

In his NY Times Economix column, Professor Simon Johnson argues that it is important to appoint Sheila Bair to the vacant post of Fed Vice Chairwoman for Supervision because without filling this vacancy the Fed faces a potential crisis of legitimacy for its handling of the Too Big to Fail banks.

While there is much to recommend his column, Professor Johnson misses two critical facts.

First, a major reason for the financial crisis was the failure of regulatory supervision.  There is little that has happened since the beginning of our current financial crisis to indicated that the reasons that regulatory supervision is not a viable substitute for market discipline, including regulatory capture, have been fixed.


Second, the Fed has a long running policy of financial failure containment and its corollary the Geithner Doctrine (from Yves Smith, nothing should be done that hurts the profits or reputation of a big or politically connected bank).

As regular readers know, banks are not subject to market discipline because they are, in the words of the Bank of England's Andrew Haldane, "black boxes".  When market participants do not have the information they need to independently assess the risk of the banks, they cannot exert discipline on the banks by adjusting both the amount and price of their exposure based on each bank's risk.

Leading up to the crisis and even now market participants rely on the regulators' representation about the riskiness of the banks.  This reliance is the result of the simple fact that the regulators have access to all the useful, relevant information on each bank in an appropriate, timely manner and investors don't.

Unfortunately, this reliance is misplaced as the regulators have to both correctly assess this information and accurately communicate the results of this assessment to the market.  By definition, regulators cannot accurately communicate the results because of concerns over the safety and soundness of the financial system (the regulators won't say anything bad about the banks).

This problem is compounded by the moral hazard creating Dodd-Frank Act mandated stress tests.  Each year, the Fed performs a stress tests on the banks and pronounces them solvent under extreme economic conditions.  This announcement effectively makes the taxpayer obligated for bailing out the investors for any solvency related losses.

Why?  Where is there the investor who is going to argue with the Fed given that the Fed has better access to information than the investor?

That the government making investment recommendations creates moral hazard has been well known since the 1930s.  FDR warned about it and specifically said that the government should stay out of the business of making investment recommendations as this create a moral hazard to bailout investors who relied on the government's recommendation.  The Fed's stress tests are nothing less than the government making an investment recommendation.

More troubling is that former Treasury Secretary Tim Geithner pledged the full faith and credit of the US to provide the banks with all the capital they need as a guarantee to investors that they would not suffer any losses from investing based on the stress test findings.

The policy of financial failure containment was in place back when I worked for the Fed and can be seen in the handling of Continental Illinois and the Savings & Loan crisis.

This policy has already destroyed the Fed's legitimacy when it comes to dealing with the Too Big to Fail banks.  Everyone knows the Fed will not do anything to control them and prevent them from taking outsized risks.

Rather, the Fed will come along and try to "mop up" after one of these banks blows up again.

If the Fed were truly interested in having the Too Big to Fail banks subjected to appropriate levels of supervision, the new Vice Chairwoman for Supervision would be leading the charge to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With ultra transparency, the banks would be subjected to both market supervision and market discipline.  Supervision that would be far superior in terms of both manpower and resources than anything that our regulators can offer.

The Dodd-Frank Act created the position of the Vice Chairwoman for Supervision at the Fed precisely because Wall Street knows that the Fed will never support ultra transparency.  Supporting ultra transparency means giving up its information monopoly.

It also means that the market could exert discipline on the Fed in its performance of is supervisory duties.  The last thing the Fed and its economists would ever be willing to do would be to put themselves in a position where they could be held accountable for their actions or lack thereof.

Fed chose not to understand fundamental driver behind financial crisis

Why has the Fed chosen not to understand that opacity and with it the freezing of major areas of the capital markets is the fundamental driver behind our current financial crisis?

In an earlier post (see here), your humble blogger looked at the transcripts from the Fed's 2007 meetings and conference calls and noted that Fed officials knew about the problem with opacity in large areas of the financial system.  Yet, they effectively ignored it by assuming it away.

For example, in response to the freezing of the subprime mortgage securities market at the beginning of the financial crisis, the Fed chose to provide liquidity to the capital markets until such time as the market figured out how to value and price these opaque securities.

Of course, without transparency, the market will never be able to figure out how to value and price the opaque subprime mortgage-backed securities.

The Washington Post's Neil Irwin (see here) suggested that the reason the problem of opacity was and still is ignored is that very bright people can have access to data that the rest of the market participants would love to have, but still not understand how to interpret this data to make it useful information for purposes of setting policy and addressing the financial crisis.

I have written numerous posts that would support Mr. Irwin's observation.  These posts cover group think (many of the leading central bankers were at MIT at the same time), failure to understand that transparency is the necessary condition for the proper operation of the invisible hand, and regulatory capture by the banking industry directly and indirectly through politicians.

However, I don't think these posts provide a satisfactory answer to why the Fed continues to choose not to understand the role of opacity in the current financial crisis.

Princeton's Paul Krugman (see here) provides more insight into the Fed's actions as he saw the 2007 transcripts providing personal vindication for the economic policies that he has been suggesting.

He too completely skips the importance of opacity.  He seems to think that because he said that the fiscal stimulus program was too small to restore the economy to health that this indicates his analysis of the problem is correct.

In reality, as shown by Japan over the last 2+ decades, the burden on the real economy from servicing all the excess debt in the financial system can offset a tremendous amount of fiscal stimulus.

Professor Krugman prediction was directionally correct, but this was not because of his insight into the driver of the economic crisis, but rather because the impact of this driver was in the same direction he predicted.

The reason I said that Professor Krugman provides more insight into why the Fed chose not to understand that opacity was the fundamental driver of the current financial crisis is that his self-serving analysis reminded me of my conversations with various Fed officials ranging from governors to economists.

Regular readers know a) I worked at the Fed in the early 1980s and b) that I was very vocal about the impending financial crisis and how to moderate its impact.

Naturally, I reached out to the Fed and these officials.

Each of my conversations fit perfectly into the Professor Krugman view of the world.  Each of these officials effectively told me that opacity could be ignored because their economic model of how the economy worked explained what the right policy response was.

I recall one governor hearing my description of opacity (I used my example comparing structured finance securities to a Brown Paper Bag) and the response was the Fed could predict the US economy using data that was available on a quarterly basis and therefore a Brown Paper Bag was not opaque.

This mind set continues to this day.  It is clear that the Fed officials will cling to the belief in the infallibility of their economic models.  After all, they have modified their models to include a banking sector (something that prior to the crisis the models assumed was irrelevant).

What we have learned in the 2007 transcripts and since is that the Fed's economic models could not predict the US economy as they didn't predict the financial crisis and they have not predicted the success or failure of the various fiscal and monetary policies implemented since the beginning of the financial crisis.

Despite this track record of failure, the Fed continues to chose not to understand the role of opacity as the fundamental driver behind our current financial crisis.

As shown by Professor Krugman, his comments reflect the simple reality that economists prefer working with their models and the assumptions behind these models and ignoring inconvenient real world facts.

Real world facts tend to make the models messy.  Although, in this case, the real world fact of opacity actually makes the model much simpler.  After all, their economic models are built on the assumption that the invisible hand is operating properly.

The existence of opacity gives them an excuse to say why their models haven't worked and that the models cannot be expected to work until transparency is brought to all the opaque corners of the financial system.

Update
From a quest post on Zero Hedge by Gary Evans of Global Macro Monitor:

In his lecture at the Latsis Symposium 2012 “Economics on the Move” in Zurich,  Nobel Laureate Joe Stiglitz nails the fundamental problem and crisis of modern macroeconomics, which failed to predict the financial crisis. 

If you say…what is good science is prediction… and you can’t predict the most important event in 75 years, what good are you?  

In particular, it might be very nice you can talk about the likelihood of an one tenth increase in GDP growth rate…and you miss a major economic downturn….or worse, they said the things can’t happen… 

Here are the money quotes: 

We all know the shock in this crisis…was a credit bubble and we have had those credit bubbles since the beginning of capitalism…So it was remarkable the intellectual bubble led people to believe there were no such thing as credit bubbles when there was 200 years of history of that…..How could people be so stupid? …The theory was with well functioning financial markets, spreading risk, diversifying risk, risk is contained.  They came to believe the models and that’s always dangerous.

Actually, it is not that they came to believe the models so much as they did not know that the models are based on the idea of transparency.

The models assume that all market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

The models and the economic system failed because large parts of the financial system are opaque.  This includes both structured finance securities and bank balance sheets.

Neil Irwin: 2007 Fed transcripts show how little they understood

In a Washington Post column, Neil Irwin confirms what your humble blogger has been saying since the beginning of the financial crisis, despite how much they "knew", the transcripts from the 2007 Fed meetings and conference calls reveal "how little they understood".

There is a difference between access to data and the ability to transform this data into meaningful information and an appropriate policy response.

I have tried to make the point that the Fed's actions showed it didn't and still doesn't understand what has gone wrong in the financial system in different ways on this blog including

• I have talked about group think and the idea that data was discounted because it didn't fit with the economic models that Fed officials think describe the economy and how it works.
• For example, I cited economist Anna Schwartz, Milton Friedman's co-author, who criticized the Fed for not understanding that the problem was bank solvency and not liquidity.  

• I have talked about Economics 101 and how the necessary condition for the invisible hand to operate properly is that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.  While the Fed officials knew about opacity, their statements showed they didn't understand the implications for
• Predicting the path of the financial crisis.  It moved through all the opaque corners of the financial system from structured finance securities to bank balance sheets.
• Understanding what policy responses would work to end the financial crisis.  

• I have talked about the Blob, Jeff Connaughton's phrase for the combination of politicians, financial regulators, lobbyists and Wall Street, and how the Blob influences policy choices for the benefit of the banks.  
• One aspect of the Blob is the notion of regulatory capture as evidenced by the Fed turning to the banks for advice on how to respond to the financial crisis caused by the banks.

Regardless of why the Fed didn't understand what was and is still happening, the lesson to be learned is that the Fed should not have had then and most definitely should not have going forward a monopoly on all the useful, relevant information in an appropriate, timely manner.

For example, the Fed had information on the exposure details for the large US banks that was not available to other market participants, including the banks.  As a result, when the Fed failed to properly assess what was happening, the Fed couldn't properly convey to the other market participants the risks.

Compounding the failure to properly assess what was happening was the determined effort by the Fed officials in the 2007 transcripts to issue press releases that would not 'scare' the financial markets.

By taking away the Fed's information monopoly and making all the useful, relevant data about banks and structured finance securities available to all market participants in an appropriate, timely manner, market participants can then independently assess the risks and make fully informed investment decisions.

Investment decisions where they know they are responsible for all gains and losses (there are no bailouts for their failure to accurately assess the risk of a bank or security under the FDR Framework principal of caveat emptor (buyer beware) on which our financial system is based).

In making sense of the newly released transcripts from the Federal Reserve’s 2007 policy meetings, let’s get one thing out of the way first. Prediction is hard, as Yogi Berra said, especially when it’s about the future.

Making an accurate prediction is virtually impossible if, like the Fed officials, you don't understand what is happening.

However, if like your humble blogger you do understand what is happening, then making accurate predictions becomes much easier.

That is doubly true when you add in the way things work in financial panics, in which outcomes are highly nonlinear—that’s to say, when one bank or segment of the money markets starts to experience problems, it can rapidly become a domino effect that, as we learned, can spread in unpredictable ways that bring down the entire financial system.

Actually, it spread in a very linear fashion through the opaque corners of the financial system starting with structured finance securities and ending with the 'black box' banks.

But here’s the thing. I really thought we would see more foresight in these transcripts than there is to be found. 

I was covering the Fed at the time for the Post, and subsequently reported and wrote a book that covers the events of 2007 ... 

I had the sense that even as leaders of the central bank projected public calm, and confidence that there would be no recession (let alone the near-depression that in fact materialized), that behind closed doors they saw what direction things were heading. It isn’t so. 

Sure, there were hints of clear-headedness....

It should also be added that there’s not much reason to think the crisis could have been prevented if the Fed had been quicker on the draw. If you honestly believe that we would have skirted recession if the Fed had cut rates by 0.5 percentage points at the December 2007 meeting, not 0.25 percentage points, you have a distorted sense of the power of a central bank to shape the course of the economy.

Actually, the way to have moderated the impact of the financial crisis was to bring transparency to all the opaque corners of the financial system.  Bloomberg quoted me as saying so in December 2007.

Here we are more than five years later and transparency has not been brought to all the opaque corners of the financial system.  As a result, the real economy has and is still experiencing the full impact of the financial crisis.

But I expected to see much more evidence in these transcripts that the Fed officials had a good grasp of how the fissures that were emerging in the summer of 2007 could spiral out of control.

That’s not to say they should have been predicting the gory details of what was to come. It would have been hard to see exactly what path the crisis would take... 

I did expect, though, that Fed officials would show more evidence of understanding the possibility that the entire financial system had become a house of cards built on mortgage securities that were anything but secure, with all sorts of financial institutions over-levered and overly dependent on assets that were near-impossible to value. 

And I expected them to understand that once a problem that deep begins correcting itself, it can spiral into all sorts of dangerous directions. Which this one did.

Please re-read the highlighted text as Mr. Irwin nicely summarizes what you humble blogger has said the problem with the financial system was and still is.

In other words, I hoped that when Fed officials publicly dismissed the chances of a recession as late as the fall of 2007, they were acting like parents who try to keep news of a layoff from their children; that they might be fully aware of how dangerous things were becoming, but didn’t want to scare anyone. 

I was wrong about that. 

Theirs was, at its core, a failure of creativity. It was an inability to see how these moving pieces of an infinitely complex financial system and economy could interact to create a very bad situation.... 

Their failure is much worse.  They failed to understand how our financial system actually works.  They failed to understand that our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor.

The Fed officials were aware of opacity in the financial system, they had no idea what the implications of this opacity were.

One lesson here is that our public officials, even the hard-working, highly intelligent ones, are far from demi-gods. They have the same blind spots and tendency toward analytical failures of anyone else. 

Secrecy allows public officials, whether in the world of monetary policy or others like national security, to create a Wizard of Oz like illusion of holding great power, of maneuvering levers with information in hand that mere mortals can only dream of. 

When reporters interview a high official, there is often a subtext the high official aims to convey: If you knew what I know, you would understand the supreme wisdom of my actions. 

Seeing what the Fed officials were saying privately, to each other, in 2007 is a reminder that this isn’t always so, and just because a person has more information, it doesn’t mean he or she has the right answer.

Thank you Mr. Irwin for making the case for stripping the financial regulators of their information monopoly and restoring transparency to all the opaque corners of the financial system.

What did I know and When did I know it?

In a self-congratulatory blog posting, Paul Krugman asserts that he would probably have been the most alarmist person in the room for the 2007 FOMC meetings about the potential for a really big financial crisis.  But then this isn't saying much as he says the FOMC was complacent.

He then goes on to explain what he saw that made him alarmist and why he has "had a pretty good stretch" since then.

For the record, my stretch over the same period has been vastly superior to Professor Krugman's.

People have been poring over the just-released 2007 Fed transcripts, and the main surprise seems to be how complacent the institution was. 

Some members of the open market committee, including Janet Yellen and, let’s give credit where due, Tim Geithner, seem to have had a sense of dread; but the overall consensus was that nothing really bad would happen. 

The obvious question if you’re a pundit, then, is “How did I do?” And the answer is, not too badly. Yes, I hedged — it was a statement of possibilities, not a straight prediction. But I clearly would have been in the camp of Fed alarmists, and probably the most alarmist of them all. 

It is a matter of public record that I wasn't hedging about the problems in the credit markets.  I was featured in a Bloomberg article on December 4, 2007 on how to actually moderate the impact of and deal with the problems in the financial system.

It seems to me that the really big determinant of whether you were intellectually ready for this crisis was how much attention you paid to events in the late 1990s — the crisis in emerging Asia, LTCM here, and the Japanese liquidity trap. I paid a lot of attention back then (as did Nouriel Roubini), taking the lead in resurrecting the theory of the liquidity trap (pdf) and writing a book, The Return of Depression Economics. 

And the result is that I’ve had a pretty good stretch; the only big thing I got wrong, I think, was in underestimating the stickiness of wages, and hence inflation, and therefore overestimating the risks of actual deflation. 

Professor Krugman and I differ on what it took to be intellectually ready for this crisis.  I think it took an understanding of Economics 101.

Specifically, it took an understanding that the necessary condition for the invisible hand and therefore capital markets to operate properly is that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make an informed decision.

It took an understanding that since the Great Depression our financial system has been based on the FDR Framework which combines the philosophy of disclosure with the principal of caveat emptor (buyer beware).

As I was reading the Fed meeting transcripts, what was clear was that nobody in the room understood this necessary condition or the role it plays in our FDR Framework based financial system even though they were well aware that both structured finance securities and bank balance sheets were opaque.

Confirmation of this assertion comes from the Fed's adopting the policy of injecting liquidity into the financial system with the idea that the market would figure out how to value or price the opaque structured finance securities and bank balance sheets.

Hello, the market couldn't figure out how to value or price either structured finance securities or bank balance sheets because they are opaque.

Recognizing that the markets were going to be on life support until transparency was brought to all the opaque corners of the financial system, I have had a much better performance than Professor Krugman since the beginning of the financial crisis.

For example, I knew that the burden of supporting the excess debt in the financial system would swallow both fiscal and monetary stimulus efforts and leave the US economy in a Japan-style economic slump (our economy "grows" only while there is fiscal stimulus and will immediately go back into recession when austerity policies are adopted).

That said... it’s not clear how much difference it would have made if the Fed had grasped the scale of the danger back in 2007.

It makes all the difference in the world because it drives their policy responses.

The big errors came later, after the depth of the crisis was apparent to all, and they came mainly in fiscal and housing policy, not monetary policy.

Actually, there were and still are too many monetary policy errors to mention.

This started with disobeying the father of modern central banking Walter Bagehot's directive that at times of crisis  a central bank lend freely at penalty rates against good collateral.  In 2007, the Fed choose to lend freely at rates they knew the banks would find attractive against bad collateral (I think the term that was used was "dreck").

The Fed knew that opacity was the problem in 2007, why hasn't it championed transparency?

From the Fed transcript of the FOMC meeting on August 7, 2007.  Speaker Bill Dudley, then manager of system open market account:

So how does one explain the contagion to corporate credit from the subprime market given the disparity in fundamentals between these two sectors? 

Although the answer is complex, one factor stands out: There has been a loss of confidence among investors in their ability to assess the value of and risks associated with structured products, which has led to a sharp drop in demand for such products. 

The loss of confidence stems from many sources, including the opacity of such products; the infrequency of trades, which makes it more difficult to judge appropriate valuation; the difficulty in forecasting losses and the correlation of losses in the underlying collateral; the sensitivity of returns to the loss rate and the degree of correlation; and the problem that the credit rating focuses mainly on one risk—that of loss from default.  

Please note that it is the opacity of structured finance markets that makes them impossible for market participants to assess their value and risk.

When investors cannot assess the value and risk of an investment due to a lack of transparency, they stop buying or selling said securities.  They stop because they have no way of independently determining the value of the securities and comparing this independent valuation to the prices shown by Wall Street to make a buy, hold or sell decision.

More than five years after this FOMC meeting, the question is:  what has changed about structured finance securities to make them transparent?

The answer is nothing.

These securities will not be transparent until such time as they provide observable event based reporting and all activities like payments and delinquencies on the underlying collateral are reported before the beginning of the next business day.

Without observable event based reporting, buyers or sellers of these securities are simply blindly betting on the contents of brown paper bags.

The CLO and CDO markets have facilitated the transformation of low-rated paper—for which there is a limited investor appetite—into a high proportion of high-grade-rated debt. 

For example, in a typical CLO structure, the underlying loan quality averages a rating of about B. Yet through the magic of structured finance and the corporate rating agencies, the resulting CLO tranches are rated predominately investment grade. 

Exhibit 8 shows the structure for a representative CLO: More than two-thirds is AAA-rated debt, and 87 percent is investment grade. 

The loss of confidence among investors in the ability to assess the value and risks associated with this structured product has led to a sharp drop in CDO and CLO issuance. 

As shown in exhibit 9, CLO and CDO issuance plummeted in July. 

This is very important because the CLO and CDO markets represent the bulk of the demand for non-investment-grade debt. With this demand falling away at a time when the forward supply of high-yield corporate loans and debt exceeds $300 billion by some measures, a huge mismatch between demand and supply has developed. 

The underlying problem is that the depth of the market for non-investment-grade rated loans and debt—excluding CDO and CLO demand—is far shallower than the market for investment-grade products. 

The only way to restore depth to the market is to provide transparency.  Until this is done, the buyers will remain on strike.

Please note that based on the minutes of the FOMC this simple fact was known prior to the beginning of the financial crisis on August 9, 2007.

Yes, in all of the Fed's responses to the financial crisis, the Fed has never addressed making structured finance securities and bank balance sheets transparent.

Update
From the August 10, 2007 Fed conference call, Ben Bernanke speaking:

President Fisher, our goal is to provide liquidity not to support asset prices per se in any way. 

My understanding of the market’s problem is that price discovery has been inhibited by the illiquidity of the subprime-related assets that are not trading, and nobody knows what they’re worth, and so there’s a general freeze-up. 

The market is not operating in a normal way. The idea of providing liquidity is essentially to give the market some ability to do the appropriate repricing it needs to do and to begin to operate more normally. 

So it’s a question of market functioning, not a question of bailing anybody out. That’s really where we are right now. 

Please re-read the highlighted text as within a span of 3 days following the FOMC meeting that said that opacity was making it impossible for market participants to value structured finance securities, Mr. Bernanke has completely forgotten the problem needs to be addressed.

Note that he asserts that the goal is to provide liquidity until the market's problem with price discovery is fixed.

And lo and behold, the Fed has been adding liquidity through programs like quantitative easing ever since.  Of course there is no end in sight for these liquidity programs because no one is working to make these securities transparent!!! 

Update II
Governor Mishkin on August 16, 2007 conference call discussing letting banks pledge structured finance securities at the discount window as a mechanism for unfreezing the frozen subprime mortgage market caused by the buyers' strike,

The issue is that there’s an information problem in the markets, but the banks’ knowing that there’s a backstop and that we’re doing something in terms of the discount window could actually unfreeze the system so that we could have players come into these mortgage markets to replace the players that are now not in the mortgage markets. 

An information problem that can only be solved by bringing transparency to both structured finance securities and bank balance sheets.

Why have economic forecasts overstated recovery since the beginning of financial crisis

In an interesting Guardian column, Robert Skidelsky looks at why economic forecasts since the beginning of the financial crisis have overstated the recovery and concludes that the assumptions underlying the forecasting models are wrong.

This is a point that your humble blogger has been making.

It has been known since the 1870s that there is a lower bound to effective monetary policy.  Walter Bagehot, the father of modern central banking, set this lower bound at 2%.  He observed that below this rate, behavior would change.

Mark Twain explained exactly what this change in behavior would be when he observed that he was more concerned about the return of his money than the return on his money.  In short, keeping interest rates below 2% interferes with investor attitudes towards risk taking.

I have documented that rates below 2% also interfere with current consumption.  Savers offset the lack of return on their investments by deferring current consumption.  I call this the Retirement Plan Death Spiral.

Confirmation of this self-reinforcing downward spiral is easily seen with companies with defined benefit pension plans.  To offset the lack of earnings on the pension assets, these companies must contribute more money to the pension plans.  The result of this is less money for the companies to reinvest or grow their own business.  This in turn triggers lower return on pension assets ...

"Why did no one see the crisis coming?" Queen Elizabeth II asked economists during a visit to the London School of Economics at the end of 2008. Four years later, the repeated failure of economic forecasters to predict the depth and duration of the slump would have elicited a similar question from the Queen: why the overestimate of recovery?

For the record, I saw the crisis coming and my estimates of recovery have mirrored what has actually taken place.

Consider the facts. ...

Some forecasters are more pessimistic than others (the OBR has a particularly sunny disposition), but no one, it seems, has been pessimistic enough.

Unfortunately, I have been pessimistic enough.  I said at the outset of the financial crisis until we bring transparency to the opaque corners of the financial system and deal with the losses on the excess debt, the global economy would be in a downward spiral.  A downward spiral that vast quantities of fiscal and monetary stimulus is attempting to offset.

Economic forecasting is necessarily imprecise: too many things happen for forecasters to be able to foresee all of them. So judgment calls and best guesses are an inevitable part of "scientific" economic forecasts. 

But imprecision is one thing; the systematic overestimate of the economic recovery in Europe is quite another. 

Indeed, the figures have been repeatedly revised, even over quite short periods of time, casting strong doubt on the validity of the economic models being used. 

These models, and the institutions using them, rely on a built-in theory of the economy, which enables them to "assume" certain relationships. It is among these assumptions that the source of the errors must lie. 

Two key mistakes stand out. 

The models used by all of the forecasting organisations dramatically underestimated the fiscal multiplier: the impact of changes in government spending on output. 

Second, they overestimated the extent to which quantitative easing (QE) by the monetary authorities – that is, printing money – could counterbalance fiscal tightening. ...

Forecasting organisations are finally admitting they underestimated the fiscal multiplier. 

The OBR, reviewing its recent mistakes, accepted that "the average [fiscal] multiplier over the two years would have needed to be 1.3 – more than double our estimate – to fully explain the weak level of GDP in 2011-12". 

The IMF has conceded that "multipliers have actually been in the 0.9 and 1.7 range since the Great Recession". The effect of underestimating the fiscal multiplier has been systematic misjudgment of the damage that "fiscal consolidation" does to the economy.

Which is a polite way of saying that austerity is the equivalent of throwing gasoline on a fire.  It takes a bad situation and makes it worse.

Please recall that the argument for austerity is to reduce the government debt built up since the beginning of the financial crisis.  And why was there an increase in government debt?  To bail out the banks and protect their book capital levels and banker bonuses.

Effectively, the government socialized the losses in the financial system.  This puts the burden of the excess debt on the real economy as oppose to the financial system that is designed to absorb it.  Servicing this excess debt diverts capital from reinvestment and growth in the real economy.  This is what triggers the downward spiral.

This leads us to the second mistake. Forecasters assumed that monetary expansion would provide an effective antidote to fiscal contraction. The Bank of England hoped that by printing £375bn of new money, ($600bn ), it would stimulate total spending to the tune of £50bn, or 3% of GDP. 

But the evidence emerging from successive rounds of QE in the UK and the US suggests that while it did lower bond yields, the extra money was largely retained within the banking system, and never reached the real economy. This implies that the problem has mainly been a lack of demand for credit – reluctance on the part of businesses and households to borrow on almost any terms in a flat market.

Actually, the decline in demand doesn't just represent a lack of demand for credit.  It represents a decline in demand from savers.

These two mistakes compounded each other: if the negative impact of austerity on economic growth is greater than was originally assumed, and the positive impact of quantitative easing is weaker, then the policy mix favored by practically all European governments has been hugely wrong. 

There is much greater scope for fiscal stimulus to boost growth, and much smaller scope for monetary stimulus.

Actually, there is still significant scope for monetary stimulus.

The question is what monetary policies need to be followed to stimulate the economy?

Your humble blogger has been saying for years, listen to Walter Bagehot, reverse current zero interest rate and quantitative easing policies and raise interest rates back to 2%.  Demand should increase as savers can generate a return on their savings and can boost their current consumption.

At the same time, stimulative fiscal policies should continue to be pursued.  This complements monetary policy and reinforces growth in demand.

But what about the losses on the excess debt?  Have the financial system absorb these losses.

This is all quite technical, but it matters a great deal for the welfare of populations. 

All of these models assume outcomes on the basis of existing policies. Their consistent over-optimism about these policies' impact on economic growth validates pursuing them, and enables governments to claim that their remedies are "working," when they clearly are not. 

This is a cruel deception. 

Before they can do any good, the forecasters must go back to the drawing board, and ask themselves whether the theories of the economy underpinning their models are the right ones.

Geithner Doctrine undermines Draghi's claim that ECB oversight of banks will restore confidence

In a Reuters article, the head of the ECB, Mario Draghi, asserts that having the ECB at the head of a single eurozone bank supervisory mechanism will help to restore confidence.

In the US, the Fed is responsible for supervision of large, global banks.  Since at least the start of the current financial crisis, the Fed has operated under the Geithner Doctrine.  Yves Smith at NakedCapitalism stated the doctrine as follows:

Nothing must be done that will hurt the profits or reputation of any bank that is pretty big and/or well connected.

The manipulation of Libor provides an example of how the Geithner Doctrine is applied.

When told in May 2008 that banks were manipulating Libor interest rates for profit, in addition to trying to make their financial health look better than it was, Mr. Geithner sends to the UK a proposal to reform Libor that would not have ended the banks' ability to manipulate Libor.

For those who believe that the Geithner Doctrine is only being followed in the US, the ECB has already shown that it subscribes to the Geithner Doctrine.

For example, the ECB has been actively pushing for the creation of the European Data Warehouse so that banks can sell the equivalent of subprime mortgage-backed securities (think bank profits).  I say banks can sell the equivalent because transparency has two equally important elements, "what" is disclosed and "when" it is disclosed, and opaque subprime mortgage-backed securities meet the definition of transparency used by the data warehouse and endorsed by the ECB.

New European Central Bank powers to oversee euro zone banks will help restore confidence in the sector and revive interbank lending, its president, Mario Draghi, said on Monday. 

European ministers clinched a deal last week to give the ECB powers to supervise the currency bloc's banks from March 2014, taking the first step in a new phase of integration to help underpin the euro. 

"The single supervisory mechanism will contribute to restoring confidence in the banking sector across the euro area. It will help revive interbank lending and cross-border credit flows, with tangible effects for the real economy," Mario Draghi told the European Parliament's Economic and Monetary Affairs Committee. 

Bank-to-bank lending has yet to recover from the onset of the global financial crisis in 2007, and many banks rely on the ECB for their liquidity needs while others hoard their cash rather than lend it on....

Regular readers know that the interbank lending market is frozen because of a lack of transparency.  Banks with deposits to lend cannot assess the risk of the banks looking to borrow.

The solution for unfreezing and keeping the interbank lending market unfrozen is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, banks with deposits to lend can independently assess the risk of the banks looking to borrow.

Draghi said: "The national supervisors' role gets bigger as the banks get smaller, but all national supervisors will be subject to the single rulebook as regulated from the centre. The ECB will retain power to call in any bank under its domain." 

Once ECB supervision is in place, the euro zone's rescue fund - the European Stability Mechanism - will be allowed in principle to recapitalise banks directly. 

For now, euro zone governments have had to shore up their banks, adding further to public debt and creating a vicious circle between weak banks and states. 

"Combined with possible direct recapitalisation of banks by the European Stability Mechanism and an envisaged single resolution mechanism, the single supervisory mechanism will go a long way towards breaking the vicious feedback loops between sovereigns and banks," Draghi said.

Regular readers also know that there is no legitimate reason (protecting banker bonuses not being a legitimate reason) that euro zone governments needed to shore up their banks and add further to public debt.

Modern banks are designed to be able to continue operating even when they have low or negative book capital levels.  They can do this because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers become the banks' silent equity partners when the banks have low or negative book capital levels.  Since taxpayers are already the silent equity partners, there is no need to use the government's ability to borrow in the capital markets to recapitalize the banks.

UBS warns about groupthink at Fed and other central banks

As reported on BusinessInsider, less than a week after your humble blogger discussed how groupthink has come to dominate the major central banks, UBS economists are now warning about groupthink.

The UBS economists observed that groupthink could lead to major policy errors.

Hint:  it already has in the form of zero interest rate and quantitative easing policies.

The Federal Reserve surprised observers last Wednesday by revolutionizing its strategy for communicating with the public on its monetary policy outlook through the introduction of the "Evans Rule." 

By adopting the Evans Rule, the Fed has now laid out thresholds that must be met before the central bank will consider raising interest rates, which have been held near zero since the financial crisis several years ago.... 

The change has been hailed by critics of the Fed – those who charge that the central bank has not done enough to stimulate the economy – as a crucial step toward tapping its full stimulative potential by more forcefully shaping market expectations.  

UBS economists Drew Matus and Sam Coffin do not share such a positive view of Wednesday's meeting as everyone else, however. 

In fact, Matus and Coffin suggest that contrary to popular belief, the Fed's latest decision actually makes things more dangerous for markets and the economy. 

In a note, the UBS economists warn clients, "Given that policy is now tied to the perceptions of a small group of individuals who all adhere to the same orthodoxy, this implies that monetary policy will continue to operate as a poor substitute for responsible fiscal policy and that the possibility of policy errors from such 'groupthink' remains a key risk for the foreseeable future."... 

Matus and Coffin conclude that a dangerous dynamic may be brewing inside the Fed:
In short, consistency is lacking and the FOMC is increasingly tone deaf. 

This may be because, within the Federal Reserve System, the hawks are primarily “freshwater” economists who are concerned about the ever expanding balance sheet.  

In contrast, most of the rest of the FOMC are either non-economists (the majority of the Board of Governors) or “saltwater” economists. These economists dominate not just the Fed, but a number of central banks around the world. 

As such, critiques are limited and critics outside the Fed often dismissed out of hand. 

 A characteristic of groupthink.

Given that policy is now tied to the perceptions of a small group of individuals who all adhere to the same orthodoxy, this implies that monetary policy will continue to operate as a poor substitute for responsible fiscal policy and that the possibility of policy errors from such “groupthink” remains a key risk for the foreseeable future. 

Meanwhile, with Richmond Fed President Jeffrey Lacker, the lone dissenter in several of the Fed's most recent policy decisions in 2012, set to become a non-voting member on the Committee in 2013, that groupthink may grow even stronger.

Groupthink among central bankers has been growing stronger since the beginning of the financial crisis.  Please note that they are all pursuing the same policies that Japan has shown failed over a 2+ decade period following its bank solvency led financial crisis.

Governor of Reserve Bank of Australia lays out limitations of what central banks can do

In a must read speech (hat tip Zero Hedge) on the challenges of central banking, Glenn Stevens, the governor of the Reserve Bank of Australia, laid out the limitations of what central banks can and cannot do.

• Central banks can and did buy some time to address the problem of excess debt in the financial system that triggered our current financial crisis.

• Central banks cannot fix the problem caused by this excess debt.

Mr. Stevens then noted that the policies adopted to buy time carry with them their own negative side-effects.

Regular readers know that your humble blogger has been saying that adopting the Japanese Model for handling a bank solvency led financial crisis and its related monetary and fiscal policies was and is a mistake.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  This puts the burden of the excess debt on the real economy and results in, at best, a Japan-style economic slump or, at worst, a depression like Greece is experiencing.

I say the ongoing pursuit of the Japanese Model is a mistake because our modern banking system is designed to support a different model for handling a bank solvency led financial crisis:  the Swedish Model.

Under the Swedish Model, the banks are required to recognize upfront all the losses that they would realize if the excess debt went through the long process of default and foreclosure.  Subsequently, banks retain 100% of their pre-banker bonus earnings to rebuild their book capital levels.

Banks absorbing the losses on the excess debt protects the real economy as it does not take capital out of the real economy that is being used for reinvestment and growth and divert it for debt service.

Why don't policy makers need to foam the runway so that banks can absorb the losses gradually over time?

Modern banks are designed to continue operating and supporting the real economy even when they have low or negative book capital levels.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, when banks have low or negative book capital levels, taxpayers effectively become the banks' silent equity partners.

Since the problem of excess debt in the financial system has not gone away since the beginning of the current financial crisis, the choice to continue pursuing the Japanese Model must be made every day by policy makers.

Since the problem of excess debt in the financial system has not gone away, the Swedish Model could still be adopted and the current financial crisis brought to an end.

That policy measures of any kind have their limitations is a theme with broader applications, especially for central banks. 

The central banks of major countries were certainly quite innovative in their responses to the unfolding crisis. Numerous programs to provide funding to private institutions, against vastly wider classes of collateral, were a key feature of the central bank response to the situation. 

In essence, when the private financial sector was suddenly under pressure to shrink its balance sheet, the central banks found themselves obliged to facilitate or slow the balance-sheet adjustment by changing the size of their own balance sheets. This is the appropriate response, as dictated by long traditions of central banking stretching back to Bagehot.

Your humble blogger has argued that the implementation of the central banks' policy response was and still is inappropriate.

Walter Bagehot, the father of modern central banking, said that in their lender of last resort role, central banks are suppose to lend freely against good collateral at high interest rates.

So yes, central bank balance sheets should have expanded.

However, central banks didn't always lend against good collateral and they didn't lend at high interest rates.

Conceptually, at least initially, these balance-sheet operations could be seen as distinct from the overall monetary policy stance of the central bank. But as the crisis has gone on such distinctions have inevitably become much less clear as ‘conventional’ monetary policy reached its limits.

Bottom line, central bank balance sheets increased from both their role as lender of last resort and also from the use of unconventional monetary policies like quantitative easing.

It was fortuitous for some, perhaps, that the zero-lower bound on nominal interest rates – modern parlance for what we learned about as the ‘liquidity trap’ – had gone from being a text book curiosum to a real world problem in Japan in the 1990s. 

Japan subsequently pioneered the use of ‘quantitative easing’ in the modern era. This provided some experiential base for other central banks when the recession that unfolded from late 2008 was so deep that there was insufficient scope to cut interest rates in response....

Japan demonstrated that quantitative easing doesn't solve the underlying problem of excess debt that occurs with a bank solvency led financial crisis.

Japan also demonstrated that there are limits to how much time central banks can buy to address the problem of excess debt.

For the major countries a further dimension to what is happening is the blurring of the distinction between monetary and fiscal policy. 

Granted, central banks are not directly purchasing government debt at issue. But the size of secondary market purchases, and the share of the debt stock held by some central banks, are sufficiently large that it can only be concluded that central bank purchases are materially alleviating the market constraint on government borrowing....

Having adopted policies to distort the price of government debt in the hope of stimulating demand, central banks have become the market for government debt.

The problem will be the exit from these policies, and the restoration of the distinction between fiscal and monetary policy with the appropriate disciplines. 

The problem isn't a technical one: the central banks will be able to design appropriate technical modalities for reversing quantitative easing when needed.

Who is going to buy all this government debt?

The real issue is more likely to be that ending a lengthy period of guaranteed cheap funding for governments may prove politically difficult. There is history to suggest so. It is no surprise that some worry that we are heading some way back towards the world of the 1920s to 1960s where central banks were ‘captured’ by the Government of the day. 

Most fundamentally, the question is whether people are fully understanding of the limits to central banks' abilities. 

It is, to repeat, not to be critical of actions to date to wonder whether private market participants, and perhaps more importantly governments, recognise what central banks cannot do. 

Central banks can provide liquidity to shore up financial stability and they can buy time for borrowers to adjust. 

But they cannot, in the end, put government finances on a sustainable course and they cannot create the real resources that need to be found from somewhere to strengthen bank capital. They cannot costlessly correct earlier misallocation of real capital investment. They cannot shield people from the implications of having mis-assessed their own life-time budget constraints and as a result having consumed too much. They cannot combat the effects of population aging or drive the innovation that raises productivity and creates new markets. Nor can they, or should they, put themselves in the position of deciding what real resource transfers should take place between countries in a currency union. 

Please re-read the highlighted text as Mr. Stevens summarizes why the Swedish Model needs to be adopted.

As shown most recently by Iceland and previously by the US in the Great Depression, under the Swedish Model,

• Bank book capital levels are rebuilt through retained earnings and equity sales after all the losses on the excess debt have been realized.  While this is occurring, taxpayers act as the banks' silent equity partners.

• People are protected to the extent that their debts are written down to what they can afford.  This process does not create equity for the borrowers.  Rather, it attempts to keep families in their homes (after all, who is going to buy and live in all these homes if they go through foreclosure).

• The real economy continues to produce the innovations that raise productivity and create new markets.  It can do this because the capital it needs for reinvestment, R&D and growth is not diverted to cover the debt service on the excess debt in the financial system.

• Retirement saving plans can continue without the negative impact of central banks pursuing monetary policies like zero interest rates and quantitative easing.

Groupthink and central bankers' search for new ideas

The Wall Street Journal ran an article that lays out why the leaders of the major economy central banks suffer from a combination of groupthink and defense of the PhD dissertation syndrome.

Every two months, more than a dozen bankers meet here on Sunday evenings to talk and dine on the 18th floor of a cylindrical building looking out on the Rhine. 

The dinner discussions on money and economics are more than academic. At the table are the chiefs of the world's biggest central banks, representing countries that annually produce more than $51 trillion of gross domestic product, three-quarters of the world's economic output. 

Of late, these secret talks have focused on global economic troubles and the aggressive measures by central banks to manage their national economies. 

Since 2007, central banks have flooded the world financial system with more than $11 trillion. Faced with weak recoveries and Europe's churning economic problems, the effort has accelerated. The biggest central banks plan to pump billions more into government bonds, mortgages and business loans. 

Their monetary strategy isn't found in standard textbooks. The central bankers are, in effect, conducting a high-stakes experiment, drawing in part on academic work by some of the men who studied and taught at the Massachusetts Institute of Technology in the 1970s and 1980s. 

While many national governments, including the U.S., have failed to agree on fiscal policy—how best to balance tax revenues with spending during slow growth—the central bankers have forged their own path, independent of voters and politicians, bound by frequent conversations and relationships stretching back to university days.

Please re-read the highlighted text as it describes exactly the situation in which groupthink is most likely to occur.

The Wikipedia discussion of groupthink not only confirms this, but talks about signs that it has occurred.

Irving Janis led the initial research on the groupthink theory. In his first writing on groupthink in 1971, he defined the term as follows: 

I use the term groupthink as a quick and easy way to refer to the mode of thinking that persons engage in when concurrence-seeking becomes so dominant in a cohesive ingroup that it tends to override realistic appraisal of alternative courses of action. 

The WSJ article clearly shows that we have a 'cohesive ingroup' that was 'concurrence-seeking' as they are following the same monetary policies of zero interest rates and quantitative easing.

Groupthink is a term of the same order as the words in the newspeak vocabulary George Orwell used in his dismaying world of 1984. In that context, groupthink takes on an invidious connotation. Exactly such a connotation is intended, since the term refers to a deterioration in mental efficiency, reality testing and moral judgments as a result of group pressures....

Please re-read the highlighted text as it describes why these central bankers chose and continue pursuing monetary policies like zero interest rates and quantitative easing despite significant evidence that it doesn't work.

Each of these central bankers knew before the financial crisis began that

• Walter Bagehot, the father of modern central banking, said in the 1870s that interest rates should not go below 2%; and
• Japan has tried monetary policies that kept interest rates below 2% for almost 2 decades without success.  

For confirmation that the group knew these facts, prior to becoming chairmen of the Fed and the beginning of the financial crisis, Ben Bernanke even told the Japanese that their monetary policies weren't working.  The response of the Japanese was that it was easy to give this advice when you are not the one facing the financial crisis.

Despite knowing that keeping interest rates below 2% doesn't work and that the solution to a bank solvency led financial crisis is to adopt the Swedish Model, this group of central bankers chose to pursue monetary policies like zero interest rates and quantitative easing.

The policy choice of these central bankers fits Professor Janis' description as it reflects 'a deterioration in mental efficiency, reality testing and moral judgments' overriding a 'realistic appraisal of alternative courses of action'.

The main principle of groupthink, which I offer in the spirit of Parkinson's Law, is this: 

 The more amiability and esprit de corps there is among the members of a policy-making ingroup, the greater the danger that independent critical thinking will be replaced by groupthink, which is likely to result in irrational and dehumanizing actions directed against outgroups.

Professor Janis neatly summarizes what has and is still occurring in central banking.

For those who doubt this, Mr. Bernanke recently gave a speech in which he expressed his frustration with consumers for not doing what he wanted them to do.  Subsequently, the Fed announced quantitative easing till eternity.

This announcement was the equivalent in the world of groupthink to saying I am going to keep beating you until you stop crying.

The fact that the consumers did not do what he wanted them to do should have been a clear signal that he wasn't doing the right thing to get the outcome he wanted.

However, it appears the because he is so mired in groupthink Mr. Bernanke could not entertain this alternative.

Update

This comes from a previous post I did on Anna Schwartz, Milton Friedman's co-author.  Please note that it appears that her critique was dismissed as one would expect as a result of groupthink.

From Anna Schwartz's Wall Street Journal obituary,

Across six decades, she contributed strong work and commentary on economics, notably the financial system. In all her efforts to understand and explain financial behavior, Anna Schwartz focused on the system's primary need: stability. 

Which brings us to the present economic instability, on which Schwarz had opinions that deserve to be heard again. Statements she made to this newspaper in a Weekend Interview three and a half years ago, in her early 90s, ring with clarity and relevance to current difficulties: "The Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible." 

Please re-read the highlighted text as Mrs. Schwartz has nicely summarized what your humble blogger has been saying since the beginning of the bank solvency led financial crisis.

There is only one way to return 'stability' to the financial system and end uncertainty about the balance sheets of financial firms:  require ultra transparency and make the banks disclose on an on-going basis their current asset, liability and off balance sheet exposure details.

With this data, market participants can independently assess each bank and be confident in making buy, hold and sell decisions based on this assessment.

From her WSJ Weekend Interview,

She speaks with passion and just a hint of resignation about the current financial situation. And looking at how the authorities have handled it so far, she doesn't like what she sees... 

Federal Reserve Chairman Ben Bernanke has called the 888-page "Monetary History" "the leading and most persuasive explanation of the worst economic disaster in American history."

Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again. 

To understand why, one first has to understand the nature of the current "credit market disturbance," as Ms. Schwartz delicately calls it. We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs. 

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible." 

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. 

An observation that also appeared in the Financial Crisis Inquiry Commission report.

This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

Please re-read the highlighted text as it confirms what your humble blogger has been saying since the beginning that it is a bank solvency crisis.

In the 1930s, as Ms. Schwartz and Mr. Friedman argued in "A Monetary History," the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they'd lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing: 

"If the borrowers hadn't withdrawn cash, they [the banks] would have been in good shape. But the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress," deepening the crisis and causing still more failures. 

But "that's not what's going on in the market now," Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value." 

"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement."...

While Ms. Schwartz understands the need for valuing structured finance securities, she does not understand that they present the identical problem that banks present:  they are opaque.

The only way to answer which bank is solvent and which is not is to require ultra transparency.

The only way to value structured finance securities is to require observable event based reporting on the underlying assets.  Under this reporting, investors have access to current performance information as every activity like a payment or delinquency is reported before the beginning of the next business day after it occurs.

But in doing so, [Mr Paulson] shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down." 

Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years." 

Instead, we've been hearing for most of the past year about "systemic risk" -- the notion that allowing one firm to fail will cause a cascade that will take down otherwise healthy companies in its wake. 

Ms. Schwartz doesn't buy it. "It's very easy when you're a market participant," she notes with a smile, "to claim that you shouldn't shut down a firm that's in really bad straits because everybody else who has lent to it will be injured. Well, if they lent to a firm that they knew was pretty rocky, that's their responsibility. And if they have to be denied repayment of their loans, well, they wished it on themselves.The [government] doesn't have to save them, just as it didn't save the stockholders and the employees of Bear Stearns. Why should they be worried about the creditors? Creditors are no more worthy of being rescued than ordinary people, who are really innocent of what's been going on."

The reason the ultra transparency is needed is so that lenders can once again be responsible for their decisions.

So long as governments have a monopoly on the information disclosed under ultra transparency, there is a moral hazard.  The moral hazard is the need to bailout investors after the government says that a bank is solvent.

It takes real guts to let a large, powerful institution go down....

As your humble blogger has said many times, a modern banking system is designed so that banks can absorb all the losses on the excesses in the financial system without having to be closed down.  Between deposit insurance and access to central bank lending, banks have ample liquidity.

As a result, banks can continue to support the real economy and retain 100% of future pre-banker bonus earnings to rebuild their book capital levels.

In 2002, Mr. Bernanke, then a Federal Reserve Board governor, said in a speech in honor of Mr. Friedman's 90th birthday, "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

"This was [his] claim to be worthy of running the Fed," she says. He was "familiar with history. He knew what had been done." But perhaps this is actually Mr. Bernanke's biggest problem. Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."

Which is not surprising because they are fighting a bank solvency crisis and not a bank liquidity crisis.

The solution to a bank solvency crisis is adopting the Swedish model with ultra transparency.