Will Heroic Bailouts Work?

By: Bob Hoye | Fri, Sep 26, 2008
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The late bubble has been the greatest on record and is the accumulated consequence of 95 years of Fed stimulation. This shows up most directly as a 95% decline in the purchasing power of the dollar, and indirectly as a series of business expansions accompanied by increasingly unstable booms in asset prices. The latest boom was in both tangible and financial assets culminated in a classic mania of credit innovation. There have been a number of great bubbles, and the prosperity has been so compelling to participants and governments that no one person or agency deliberately ended the boom. Indeed there have been well-documented examples of heroic efforts to restore the boom and then to prevent the contraction - all in vain.

Every experiment in currency depreciation ends with great market and political volatility, and the transition to eventually severe contraction started in June, 2007 when the yield curve reversed from inverted to steepening. This was soon followed by a turn to credit spread widening, which confirmed that the financial world had accomplished a classic reversal towards adversity.

With a number of examples since the advent of modern markets in the late 1600s the instruction has been that various passionate interests will attempt to resurrect the boom and, ironically in ignoring such efforts, the severity of the contraction is proportionate to the exuberance of the boom.

Keynes remains as a charismatic interventionist economist, and inspired by the dislocations of the early 1930s, thought that he had invented a way to end credit contractions. But, because he was ignorant of market history he didn't know that almost every century has an example of some intellectual having a personal revelation about avoiding or prematurely ending a post-bubble contraction. An early example occurred with the post-1618 bust, when in 1622 Missleden prescribed adding credit to a credit contraction.

The forever-esteemed editor of The Economist, Walter Bagehot, wrote in 1873: "A panic in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready...to advance it most freely for the liabilities of others."

In policymaking circles that was and still is sound advice. No problems, if the right thing is done at the right time. As expanded below, the subsequent period was described as "The Great Depression" and it ran from 1873 to 1895.

Actually, the implementation of such sound advice predates Bagehot, and had been implied by the Bank of England in a report following the catastrophic end of the 1825 mania: "We lent by every possible means and in modes we have never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on Exchequer bills of exchange to an immense amount, in short, by every possible means...seeing the dreadful state in which the public were, we rendered every assistance."

That records a mighty effort by the senior central bank to prevent the subsequent general contraction that endured from the climax of the bubble in 1825 until the mid 1840s.

At the height of the 1929 mania the Fed with its "elastic" currency was celebrated, as the old system of the 1873 to 1895 "Great Depression" was condemned. The following is by John Moody:

"The old breeder of financial panics, the National Banking Law, which had been a menace to American progress for two decades, has now been replaced by a modern, scientific reserve system which embodied an elastic currency and an orderly control of the money market."

In so many words, "nothing could go wrong".

Ultimate confidence in the old system prevailed as the 1873 bubble came under the usual credit changes that signal a top. A leading New York paper, the Herald, editorialized:

"True, some great event may prick the commercial bubble of the hour, and create convulsions; but while the Secretary of the Treasury plays the role of banker for the entire United States it is difficult to conceive of any condition of circumstances which he cannot control. Power has been centralized in him to an extent not enjoyed by the Governor of the Bank of England. He can issue the paper representatives of gold, and count it as much as the yellow metal itself. [He has] a greater influence than is possessed by all the banking institutions of New York."

In so many words, "nothing could go wrong".

Ironically, the editorial contained some totems that are still deemed to have great power. Even today, for some the terms "centralized", "banker for the U. S." and "influence" provide considerable assurance. On the initial panic into late September, the Herald editors extolled abiding confidence in the Treasury System with "A crisis in our financial dealings has been met and passed without loss of confidence... Here are growth, understanding, [and] increased knowledge."

As it had done on previous crises, the Treasury added liquidity and appeared to have avoided disaster. Under similar pressures, today's Fed and Treasury have been injecting liquidity and on the technical rebound into May such orthodoxy was celebrated: "The policy response to financial asset deflation was not only extremely fast, but extremely well coordinated. US policymakers deserve the Nobel Prize."

Back to all the confidences and issuance of liquidity in the early panics of the post-1873 contraction. The usual business cycle prevailed, but the recessions were stronger than the expansions. By 1884 leading economists began calling the prolonged contraction as the "The Great Depression". Although it ended in 1895, it was still being analyzed as such until as late as 1939.

In order to preserve the notion about an infallible Federal Reserve System, it has been expedient to lay the blame on the Fed keeping too tight a policy during the post-1929 contraction. A couple of points suggest otherwise:

A Fed memorandum following the 1929 crash explained: "The drain upon bank reserves was met in the classic way with a policy of free lending".

By free they meant liberal and this was exemplified by George Harrison, who was head of the New York Fed. As with today, the NY branch was huge compared to the whole Reserve System and Harrison, in discounting freely, exceeded his authority by a factor of six times. This was conventional theory and practice and as with a number of examples did not prematurely end a post-bubble contraction.

It seems that part of the tout at the top of the mania includes a celebration of whatever central banking or treasury system that happens to be in place. This also has included celebrating the treasury secretary as the "greatest since Alexander Hamilton". The two best known have been Andrew Mellon and Robert Rubin. Actually, each "earned" the accolade by merely being in office when an era of financial innovation and mania brewed up. Mellon during the 1920s and Rubin during the 1990s. On the mania that climaxed in 1720 John Law, as the first really reckless central banker, was celebrated during the boom and reviled during the bust.

Naturally, with the recrimination and revulsion that goes with any post-bubble contraction the prevailing system will be criticized during the contraction.

With the fullness of this failure the first stage will likely be an ad hominem attack on the personalities running the Fed and Treasury. Bernanke will be worked over for not providing the exact interest rate change that would have prevented the contraction. The rate change of the perfect amount made with perfect timing only exists in the imagination of interventionist economists.

Eventually, the contraction could become severe enough to prompt rigorous scrutiny. This would involve examining the history of central banking - not for policy errors, but for systemic inadequacy - through all of the great financial manias.

In the meantime, some old advice about stock analysts seems applicable. "In a bull market who needs them, and in a bear market who wants them?"

Considering the implacable nature of credit, this applies to interventionist economists. In an expansion who needs them, and in the consequent contraction who can afford them?

Heroic efforts in the past have not reinvigorated the ultimate boom and have not prevented a severe contraction.



Bob Hoye

Author: Bob Hoye

Bob Hoye
Institutional Advisors

Bob Hoye

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