Dec. 7: AEI: Surprised Again!―The COVID Crisis and the New Market Bubble

Hosted by the American Enterprise Institute. Also video on C-SPAN here.

Alex Pollock and Howard Adler were senior US Treasury officials during the financial markets’ bust-to-boom cycle of the COVID-19 crisis. Their new book, Surprised Again!—The COVID Crisis and the New Market Bubble (Paul Dry Books, 2022), analyzes how the government’s crisis response affected the US financial system. Their clear exposition of the financial stability risks lurking in the Federal Reserve, housing, pension funds, municipal finance, student loans, and cryptocurrencies may surprise many readers with the extent of the financial system problems hiding in plain sight.

Join AEI as Christopher DeMuth and Paul Kupiec engage Mr. Pollock and Mr. Adler in a discussion of the many important issues the authors raise in Surprised Again!

LIVE Q&A: Submit questions to Beatrice.Lee@aei.org or on Twitter with #AskAEIEcon.

Agenda

5:00 p.m.
Introduction:
Paul H. Kupiec, Senior Fellow, AEI

5:10 p.m.
Book Preview:
Alex J. Pollock, Senior Fellow, Mises Institute
Howard B. Adler, Former Deputy Assistant Secretary of the Treasury, Financial Stability Oversight Council

5:35 p.m.
Discussion:
Christopher DeMuth, Distinguished Fellow, Hudson Institute
Paul H. Kupiec, Senior Fellow, AEI

6:00 p.m.
Q&A

7:00 p.m.
Adjournment

Dec. 15: Johns Hopkins: "Surprised Again!" Book Conversation with Howard Adler & Alex Pollock

Hosted by Johns Hopkins University:

Sponsored by Alumni in Government, Education, Law & Policy, Alumni in Real Estate, Administration & Finance, Alumni in Arts, Media, Athletics and Entertainment and the Office of Alumni Relations Lifelong Learning

Are you interested in finance or even the economy? Join former Treasury officials, Howard Adler and Alex J. Pollock as they present their book "Surprised Again!:The COVID Crisis and the New Market Bubble". Howard and Alex will present Chapter 6, “Cryptocurrencies: An Assault on central Banks or Their New Triumph?”  and Chapter 12, “Central Banking to the Max” and discuss the impact of the COVID pandemic and the economic bubbles in the economy.  Dive in for the opportunities to ask questions and get answers! 

Learn more and purchase this well reviewed book here at https://www.pauldrybooks.com/products/surprised-again-the-covid-crisis-and-the-new-market-bubble and also available through most book sellers including Amazon, Barnes & Noble, Target, Walmart, etc.

Surprised Again! Book Overview

About every ten years, we are surprised by a financial crisis. In 2020, we were Surprised Again! by the financial panic of the spring triggered by the Covid-19 pandemic. Not one of the 30 official systemic risk studies developed in 2019 had even hinted at this financial crisis as a possibility, or at the frightening economic contraction which resulted from the political responses to control the virus. In response came the unprecedented government fiscal and monetary expansions and bailouts. Later 2020 brought a second big surprise: the appearance of an amazing boom in asset prices, including stocks, houses, and cryptocurrencies.

Alex Pollock and Howard Adler lived through this historic instability while serving as senior officials of the U.S. Department of the Treasury. Their book lays out the many elements of the panic and its aftermath, from the massive elastic currency operations which rode to the rescue by financing the bust with unprecedented government debt, to the consequent asset price boom, which included a renewed bubble in house prices financed by government guarantees. It considers key leveraged sectors such as commercial real estate, student loans, pension funds, banks, and the government itself. It reflects on how to understand these events both in retrospect and prospect.

Surprised Again! The COVID Crisis and the New Market Bubble

Published in Library Journal:

by Alex J. Pollock & Howard B. Adler

Paul Dry. Nov. 2022. 222p. ISBN 9781589881655. pap. $21.95. ECONOMICS

COPY ISBN

As former senior officials of the U.S. Department of Treasury under the Trump administration, Pollock (Finance and Philosophy: Why We’re Always Surprised) and Adler are qualified to synthesize complex financial behaviors into digestible chapters; the graphs they include are excellent. This book analyzes prime money market funds, cryptocurrencies, mortgages, municipal debt, pension debt, and student loans, in regard to their pre and current pandemic behavior. Each chapter serves as a primer and an update of each category. The authors argue that all finance is political finance, and they believe that predicting financial market behavior is ineffective, since many times those forecasts are wrong or surprising. Salient points are emphasized with a “Dear Reader” salutation that is both annoying and effective, as the examples in those paragraphs are essential for understanding. The chapters on prime market funds and cryptocurrencies are especially enlightening due to their exploration of regulations, both real and theoretical, that influence their behavior. Although the book is designed to be read in sequence, readers looking to delve into these topics beyond daily media coverage will be able to start at the chapter they’re most interested in.

VERDICT A helpful and insightful analysis of current economics.

Reviewed by Tina Panik , Nov 01, 2022

Economic Truths, Perennially Forgotten

A review of Surprised Again! The Covid Crisis and the New Market Bubble, written by William M. Briggs and published in Law & Liberty.

In 2021, Treasury Secretary Janet Yellen assured Americans that recent inflation was “transitory.” Back in 2017, Yellen, then Chairman of the Federal Reserve Board, hinted there would not be another financial crisis “in our lifetimes.”

Maybe she got that idea from Morgan Stanley boss James Gorman, who in 2013 put the chance of a crisis “in our lifetime” as “close to zero” as he could imagine. Well, imagination, as the song says, is crazy. “Your whole perspective gets hazy.”

These two experts, as Alex J. Pollock and Howard B. Adler tell us in Surprised Again! The Covid Crisis and the New Market Bubble, are far from alone. Economic experts, they confirm, have a collective accuracy that would embarrass a busload of blind golfers. Not one expert, they remind us, saw the Great Depression coming. And none foresaw the Calamitous Coronadoom Panic of 2020. Which lasted until now.

What is fascinating is that being wrong in no way dents the awesome armor of assurance donned by our experts. Whatever they do when given power, they do it boldly and without doubt. Whether this lack of humility is caused by amnesia or hubris can be debated. But no one can doubt  the astonishing effects of the economic “solutions” foisted upon us by a string of experts during the panic, each trying to correct the ill effects of the other “solutions.”

Read the rest here.

Surprised Again!: The COVID Crisis and the New Market Bubble Paperback

Published by Paul Dry Books.

by Alex J. Pollock and Howard B. Adler

Order here.

About every ten years, we are surprised by a financial crisis. In 2020, we were Surprised Again! by the financial panic of the spring triggered by the COVID-19 pandemic. Not one of the more than two dozen official systemic risk studies diligently developed in 2019 had even hinted at this financial crisis as a possibility, or at the frightening economic contraction which resulted from the political responses to control the virus. In response came the unprecedented government fiscal and monetary expansions and bailouts. Later 2020 brought a second big surprise: the appearance of an amazing boom in asset prices, including stocks, houses and cryptocurrencies.

Alex Pollock and Howard Adler lived through this historic instability while managing analytical support offices for the U.S. Financial Stability Oversight Committee. Their book lays out the many elements of the panic, the massive elastic currency operations which rode to the rescue, financing the bust with unprecedented government debt, the second surprise of the boom in asset prices, including a renewed apparent bubble in house prices financed by government guarantees, as well as considering key leveraged sectors such as commercial real estate, student loans, pension funds, banks, and the government itself. It reflects philosophically on how to understand these events in retrospect and prospect.

Why You Can Bet on Another Bubble Popping

Published by Gold Newsletter.

Why do bubbles still prevail in an era of ubiquitous information? Alex J. Pollock, a senior fellow with the Mises Institute, makes the case that fundamental uncertainty in finance and economics is unavoidable.

Recommended Links

• Visit Alex’s website.

• Purchase his books:

  • Finance and Philosophy: Why We’re Always Surprised.

  • Boom and Bust: Financial Cycles and Human Prosperity.

• “What Intellectuals Resent about Laissez Faire,” by Fergus Hodgson.

• “Why Financial Genius Will Fail Again,” by Fergus Hodgson.

• Purchase the book: Manias, Panics, and Crashes: A History of Financial Crises.

Wisco Weekly Podcast: MMT...RIP (Market Booms & Busts, Austrian Economics) with Alex Pollock

Episode #201 features Alex J. Pollock.

Listen on: Spotify, Apple, Google, Amazon.

Alex J. Pollock is a student of financial systems. His work includes cycles of booms and busts, financial crises with their political responses, housing finance, government-sponsored enterprises, risk and uncertainty, central banking, banking and financial regulation, corporate governance, retirement finance, student loans, and the politics of finance.

Pre-order Alex Pollock's upcoming book Surprised Again!: The COVID Crisis and the New Market Bubble.

The Economics Review Podcast: Ep. 36 - Alex J. Pollock

The Economics Review Podcast

Alex J. Pollock is a Senior Fellow with the Mises Institute, previously the Distinguished Senior Fellow at the R. Street Institute, and the former Principal Deputy Director of the U.S. Department of Treasury's Office of Financial Research. He is also the former President and CEO of the Federal Home Loan Bank of Chicago. Holding advanced degrees from the University of Chicago, and Princeton University, he is the author of the legendary book, Finance and Philosophy: Why We’re Always Surprised.

Click here to listen.

We can’t help feeling that we today are smarter

Published in the Financial Times.

Martin Wolf is certainly correct that “further financial crises are inevitable” (March 20). Let me add one more reason why this is so — another procyclical factor rooted in human nature. This is the intellectual egotism of the present time: the conviction we can’t help feeling that we are smarter than people in the past were, smarter than those old bankers, regulators, economists and politicians of past cycles, and that therefore we will make fewer mistakes. We aren’t and we won’t. The intellectual egotists of the future will condescendingly look back on us in their turn.

Better late than never

Published by the R Street Institute.

September brought endless discussions of the 10th anniversary of the bankruptcy of Lehman Brothers and the failures of Fannie Mae and Freddie Mac. Tomorrow, Oct. 3, brings the 10th anniversary of congressional authorization of the Troubled Asset Relief Program (TARP) bailouts created by the Emergency Economic Stability Act.

After all this time, we still await reform of American housing finance – the giant sector that produced the bubble, its deflation, the panic and the bust.

During the panic in fall 2008, in the fog of crisis, “We had no choice but to fly by the seat of our pants, making it up as we went along,” Treasury Secretary Henry Paulson has written of the time. That is no longer the problem.

In retrospect, it is clear that the panic was the climax of a decadelong buildup of leverage and risk, much of which had been promoted by the U.S. government. This long escalation of risk was thought at the time to be the “Great Moderation,” although it was in fact the “Great Leveraging.”

The U.S. government promoted and still promotes housing debt. The “National Home Ownership Strategy” of the Clinton administration—which praised “innovative,” which is to say poor-credit-quality, mortgage loans—is notorious, but both political parties were responsible. The government today continues to promote excess housing debt and leverage though Fannie and Freddie. It has never corrected its debt-promotion strategies.

A profound question is why the regulators of the 2000s failed to foresee the crisis. It was not because they were not trying—they were diligently regulating away. It was not because they were not intelligent. Instead, the problem was and always is the mismatch between prevailing ideas and the emergent, surprising reality when the risks turn out to be much greater and more costly than previously imagined.

There is a related problem: regulators are employees of the government and feel reluctant to address risky activities the government is intent to promote.

At this point, a decade later, reform of the big housing finance picture is still elusive. But there is one positive, concrete step which could be taken now without any further congressional action. The Financial Stability Oversight Council (FSOC), created in 2010, was given the power to designate large financial firms, in addition to the big banks, as Systemically Important Financial Institutions (SIFIs) for increased oversight of their systemic risk. In general, I believe this was a bad idea, but it exists, and it might be used to good effect in one critical case to help control the overexpansion of government-promoted housing finance debt.

FSOC has failed to designate as SIFIs the most blatantly obvious SIFIs of all:  Fannie and Freddie. FSOC has not admitted, let alone acted on, a fact clear to everybody in the world: that Fannie and Freddie are systemically important and systemically risky. This failure to act may reflect a political judgment, but it is intellectually vacuous.

Fannie and Freddie should be forthwith designated as the SIFIs they so unquestionably are. Better eight years late than never.

Ten Years After the 2008 Crisis: The Downside of the 30-year Fixed-Rate Mortgage

Published by the R Street Institute.

Here’s a lesson on the 10th anniversary of the 2008 financial crisis that almost nobody seems to have noticed:  the serious downside of the standard U.S. 30-year fixed rate mortgage, as displayed during the collapse of the housing bubble.

To hear politicians, promoters of government mortgage guarantees, proponents of Fannie Mae and Freddie Mac, and typical American housing-finance commentators at all times loudly singing the praises of the 30-year fixed-rate mortgage, you would think it has no downside at all. But of course, like everything else, it does.

Glenn Hubbard, former chairman of the Council of Economic Advisers, wrote recently of the crisis: “Millions of homeowners who were current on their mortgage payments were unable to refinance to lower rates because they were underwater” — in other words, the price of their house had fallen below what they owed on the mortgage. But that is only half of the explanation; the other half is that these homeowners could not get a lower interest rate because they had a fixed-rate mortgage. Therefore, they were stuck with what had become a burdensome interest rate relative to the market.

In contrast, the interest rate on floating-rate mortgages automatically goes down, even if the falling price of the house has put the loan underwater. This automatically reduces the mortgage payments due, reduces the financial pressure on the borrowers, and improves their cash position. Mortgage borrowers in many countries benefited from this reality during the financial crisis, but not the unlucky Americans who had a 30-year fixed-rate mortgage combined with a sinking house price.

Floating-rate mortgages naturally do become more expensive if interest rates rise, but are less expensive when interest rates fall — as they did dramatically during the crisis. Conversely, our 30-year fixed-rate mortgages are fine if house prices inflate upward forever, but in a housing deflation with falling interest rates, they are terrible for the borrowers. As the housing bubble shriveled, they turned out not to be a “free lunch” of a continuous option to refinance, but a very expensive lunch for, as professor Hubbard says, “millions of homeowners.” The more highly leveraged the mortgages were, the more expensive it was.

There is no doubt that the prevalence of the 30-year fixed-rate mortgage made the American housing finance crisis worse. Few people understand this.

Remarks at AEI’s ‘Conference on the 10th anniversary of the financial crisis’

Published by the R Street Institute.

Thanks, Peter. It’s a pleasure to be in a panel with such distinguished colleagues.

I’d like to begin by pointing out that, in addition to being the instructive 10th anniversary we have been discussing, today is also a notable 11th anniversary: On Sept. 14, 2007, Northern Rock bank, a major British mortgage lender, could no longer fund itself in wholesale markets, and an emergency lender-of-last-resort facility from the Bank of England was announced. That day, long lines of depositors began to form outside branches of Northern Rock, its website collapsed and its phone lines were jammed.

The first bank run in England since the days of Queen Victoria was underway. So was the first bailout of the 2007-2009 financial crisis. The crisis reached its peak panic just one year later, as Lehman Brothers went down.

Let’s review a few of the events as the ultimate panic approached.

In June 2008, Larry Lindsay wrote an article for AEI entitled, “It’s Only Going to Get Worse.” He was so right.

In July, Congress passed the law authorizing the Treasury to put money into Fannie and Freddie. Secretary Paulson said he wouldn’t need to. “Nervous calls” from officials of foreign countries to the U.S. Treasury were urging that their large investments in the securities of the tottering Fannie Mae and Freddie Mac be protected by the U.S. government.

On Sept. 7, Fannie and Freddie were put into conservatorship along with their Treasury bailout. Fannie’s common stock had closed at $7 a share Friday, Sept. 5. On Monday, Sept. 8, it was 73 cents.

A week later, Friday, Sept. 12, Lehman’s common stock closed at $3.65 a share. By Monday, Sept. 15, it was 21 cents.

On Sept. 16, losses on Lehman commercial paper forced the Reserve Primary money market fund to “break the buck”; also the Federal Reserve loaned AIG $85 billion.

On Sept. 20, the Bush administration submitted TARP legislation to Congress.

The times were frightening, to be sure and obscured by the “fog of crisis.” As Secretary Paulson later wrote, “We had no choice but to fly by the seat of our pants, making it up as we went along.”

Imagine you are a Treasury secretary, finance minister or head of a central bank. You are in the fog of crisis, but you can see that you and your colleagues are standing on the edge of a cliff, staring down into the abyss of potential debt deflation. Will you choose to risk the eternal obloquy of being the one who did nothing?  Of course not. You will intervene and keep intervening with whatever bailouts seem necessary. Your only objective will be to survive the crisis. That’s what you would do, if you were in office, and so would everybody else, just as is always done.

Only, of course, in 2008, they didn’t bail out Lehman. Would you have done so, under the circumstances of the time?

But more fundamentally, the panic was the climax of more than a decade of a long buildup of leverage and risk, and much of this, as has been rightly said, was promoted by the U.S. government. How had the long increase in risk seemed at the time?

Well, the central bankers believed they had created the “Great Moderation,” which turned out to be the “Great Leveraging.” Tim Geithner, then-president of the Federal Reserve Bank of New York, thought in 2006 that “[f]inancial institutions are able to measure and manage risk more effectively,” a belief common at the time.

But: “The reality is that we didn’t understand the economy as well as we thought we did,” as Fed Vice Chairman Don Kohn candidly reflected. “Central bankers, along with other policymakers, professional economists and the private sector failed to foresee or prevent a financial crisis.”

That is reasonably close to a mea culpa, although he sweeps in a lot of other people in his confession. Does the Fed understand the economy any better today than it did in the 2000s?  Is it ever, as Peter Fisher has asked, “candid about the uncertainty” it always faces?

The government promoted housing debt. Most notoriously, the “National Home Ownership Strategy” of the Clinton administration pushed for “innovative” – that is, poor credit quality – mortgage loans. It goes without saying that the government promoted excess housing debt and leverage though Fannie and Freddie, as it continues to do today. These debt-promotion strategies never have been rejected by the U.S. government.

The crisis ended in the spring of 2009, after the Fed had the very good sense to replace mark-to-market tests with “stress tests.” That was an ingenious way out of a problem. Whether by cause or coincidence, the stock market started back up on its long bull run. The S&P Bank Index, which had been at 281 on Sept. 12, 2008, bottomed at 77 on March 5, 2009, after a loss of more than 70 percent. It has since then gotten up over 500.

In the boom, it seems like the boom will last forever. In the bust, it seems like the bust will last forever. Of course, neither is the case, but it feels that way.

By midyear 2009, it was clear we had survived the crisis. Now, it was time for the inevitable political reaction to it, as happens in every financial cycle. Now was the hour for the politicians, including those who had pushed the policies that made things worse, to show how they could fix the problems.

Imagine you are a politician. What would you do in the wake of a huge crisis and bust?

First of all, you certainly have to Do Something!  You can’t just stand there, any more than the central bankers and regulators could during the panic.

Some of us, including Peter Wallison, Ed Pinto, Chairman Jeb Hensarling and me, thought it was a great opportunity to restructure U.S. housing finance into a primarily private, market system, with private capital bearing the risk of its actions.

In 2010, I proposed, in a piece called “After the Bubble,” a list of reform actions which included these:

-Create a private secondary market for prime, middle-class mortgages;

-Design a transition to having no government-sponsored enterprises;

-Stop using the banking system to double-leverage the GSEs, should they survive;

-Facilitate credit-risk retention by mortgage originators;

-Develop countercyclical loan-to-value discipline;

-Create bigger loss reserves in good times;

-Use a one-page key mortgage information form focused on whether the borrower can afford the loan;

-Address the banking system’s overconcentration in real estate risk; and

-Rediscover savings as an explicit goal of housing finance.

It still seems like a good list to me, but needless to say, this wasn’t the direction taken.

A different path was chosen, one always available to the legislature: to expand regulations and the regulatory bureaucracy, with orders that they are not to allow such problems again. This was in spite of the fact that “[n]o regulator had the foresight to predict the financial crisis,” as Andrew Haldane of the Bank of England said, adding, “although some have since exhibited supernatural powers of hindsight.”

But the most interesting question is why did regulators fail to foresee the crisis?  It was not because they were not trying—they were diligently regulating away. It was not because they were not intelligent. Instead, the problem was and always is one of knowledge of the future, not of effort. The problem is the inherent uncertainty, the ineluctable lack of knowledge of the future—the mismatch between prevailing ideas and the emergent, surprising reality.

There is another problem: regulators are employees of the government and cannot be expected to stop activities the government is intent on promoting, or act against the interests of their employers. As Bill Poole so convincingly wrote in his paper for this conference:

“An obvious first observation is that the affordable housing policy and mortgage goals given to the GSEs were policies of the Congress, President Clinton and President Bush.” He asks rhetorically, “Should the Fed somehow have undercut the stated policies of the president and the Congress?” The same question applies to all the other regulators.

In spite of these problems, the politicians did what they usually do in the wake of the bust: expand the regulatory bureaucracies and give them more power, renewing Woodrow Wilson’s faith in “expert” bureaucracy. The resulting many thousands of pages of new rules protect the politicians who had to Do Something from the charge of not doing anything or of not doing enough. There is no doubt that the thousands of man-years that went into negotiating and writing the new rules were spent by intelligent, informed, well-intentioned people intent on making the financial system into a mechanism with less chance of failure, although we all know the chance of failure never becomes zero. This is a fine goal, but suffers because financial markets are not a mechanism. (Of course, the bureaucratic excesses of Dodd-Frank were enabled by the temporarily overwhelming congressional majorities of the Democratic Party, which only lasted until they were lost in 2010.)

In the wake of the crisis, the power of the Federal Reserve was also greatly expanded, its role in feeding the bubble and its complete failure to anticipate the collapse notwithstanding. This is the latest of numerous examples in history of Shull’s Paradox, which is that the Fed always gets more powerful, no matter what blunders it makes.

Another action always available to politicians is to set up a committee and give them a big, great-sounding assignment. In this case, the committee was FSOC (the Financial Stability Oversight Council) and its assignment was to figure out, address and avoid systemic risk. There is no evidence that FSOC has the ability to do this, but creating it was a perfectly sensible action from the politicians’ point of view. No one can accuse them of ignoring systemic risk!

FSOC was given the power to designate large financial firms, in addition to the big banks, as Systemically Important Financial Institutions, or SIFIs. FSOC has designated a few firms, then de-designated most of them, but it has utterly failed to designate as SIFIs the most blatantly obvious SIFIs of all:  Fannie and Freddie. FSOC has not admitted, let alone acted on, a fact clear to everybody in the world: that Fannie and Freddie are systemically important. This may be politically prudent on its part, but is intellectually vacuous. I believe Fannie and Freddie should be designated as the SIFIs they so obviously are immediately. Better late than never.

The Fannie and Freddie problem displays the more general fatal flaw in FSOC. It cannot control or even point out the systemic risk created by the government itself. Its members cannot criticize their employer.

The last point I will mention here is a key one: the post-crisis political reaction insisted that there had to be more equity capital in the financial system. This was a good idea, agreed upon by almost everybody. But note that the banks’ capital was able to get so small in the first place, only because the government was correctly believed to be guaranteeing the depositors. Fannie and Freddie’s capital was able to get even smaller because of the correct belief that the government was guaranteeing their creditors.

In the wake of the bust, the Federal Reserve set out to create a “wealth effect” by pushing back up the prices of houses and the prices of financial assets, in order in theory to stimulate economic growth. As we all know too well, it pursued this by massive purchases of long-term Treasury bonds (while reducing its portfolio of short-term Treasury bills to zero) and of very long-term mortgage-backed securities, increasing the Fed’s own balance sheet, as is well-known, up to $4.5 trillion. The Fed also kept real short-term interest rates negative for the better part of seven years.

Whatever the arguments for doing these things as short-term measures, the Fed has kept them as long-term, unquestionably distortionary programs, even now reducing its balance sheet only slightly and getting real short-term interest rates up to approximately zero. The result has been a massive asset price inflation in real estate, financial assets and other assets.

The Fed got its renewed house price boom, all right. Nominal house prices are now well over their bubble peak.

The Fed also instituted the payment of interest on excess reserves held with it by banks. This allowed it to suppress the credit expansion that would have occurred in classic banking theory, and to itself allocate credit instead. To what did it allocate credit?  To housing and to the government deficit.

Where and how will the Fed-induced remarkable asset price inflation end?  I don’t know. The Fed doesn’t know. The financial regulators don’t know. That is hidden in the uncertainty of the economic future. It may be the Fed’s hoped-for soft landing, but then, it might not be.

Finally, here is a reminder of some essential things not done by the politicians or the regulators or the central bank in the wake of the crisis, among others:

• They did not create a primarily private secondary market for prime mortgages.

• They did not design a transition to having no GSEs.

• They did not develop countercyclical LTV discipline.

• They did not address the overconcentration of the banking system in real estate risk.

• They did not rediscover savings as an explicit goal of housing finance.

They did get equity ratios increased, which was good.

They did preside over an efflorescence of bureaucracy and a giant asset price inflation.

What next?  This is a period of uncertainty, just like every other period.

Letters to Barron’s: Rediscovering Minsky

Published in Barron’s.

Hyman Minsky is featured in Randall W. Forsyth’s “Musk’s Buyout Plan May Signal Market Woes Ahead,”(Up & Down Wall Street, Aug. 11). About Hy, who was a good friend of mine and from whom I learned a lot, Forsyth says that his “insights were rediscovered after the financial crisis,” meaning the crisis of 2007-09. That is true, but Hy was previously rediscovered in the financial crises of the 1990s, and before that was discovered during the financial crises of the 1980s. The popularity of his ideas is a coincident indicator of financial stress.

Hy’s most important insight, in my opinion, is that the buildup of financial fragility is endogenous, arising from the intrinsic development of the financial system, not from some “shock” that comes from outside. I believe this key contribution to understanding credit cycles can be improved by adding that “the financial system” includes within itself all of the financial regulators, central banks, and governments. All are within the system; no one is outside it, looking down. They all are part of the endogenous process that generates the crises, which periodically cause Hy Minsky to be rediscovered again.
Alex J. Pollock
R Street Institute
Washington

Letter to Editor Barron’s: Listen up, Uncle Sam

Published in Barron’s.

Governments “should take particular care to prevent real estate bubbles,” writes Michael Heise (“Global Debt Is Heading Toward Dangerous Levels, Again,” Other Voices, May 19).

He’s right, of course. But the U.S. government does the opposite. As it has for decades, it promotes real estate debt and inflates real estate prices through government credit, subsidies, guarantees, and regulation—not to mention the massive monetization of mortgages by the Federal Reserve. When will they ever learn? The best bet is never.

How does our ‘Great Recession’ compare to ones from the past?

Published in Real Clear Markets.

A prominent economist opened his book, The Great Recession, with this observation: “In the years ______, the world economy passed through its most dangerous adventure since the 1930s.”  This should sound familiar. “Its world-wide character and the associated bankruptcies and financial disturbances,” he added, “made this episode the long-awaited postwar economic crisis.”  But what years was Otto Eckstein in fact describing, so how do you fill in the blank in the first quotation?  The correct answer is the great recession of 1973-75. (How did you do on the quiz, esteemed Reader?)

“The capitalist process progressively raises the standard of life for the masses,” wrote the ever-provocative Joseph Schumpeter, but “It does so though a series of vicissitudes.”  Further, “Economic progress, in capitalist society, means turmoil.”  If Schumpeter is right that progressively raising the standard of living for ordinary people requires vicissitudes and turmoil, then cycles of booms and busts do not just happen, but are necessary in theory to economic progress.  They certainly do seem unavoidable so far.  Empirically, recessions are reasonably frequent.  In the last 100 years, there were 18 recessions in the United States, thus on average about once every 5 1/2 years. In the last 50 years, there have been seven recessions or on average once about every seven years.

Many recessions are shallower, but there are occasional great recessions.  How does “our” great recession—that of 2007-09– look relative to some of its predecessors?  Specifically, we compare it to the great recessions of 1981-82, 1973-75, and 1937-38.

The 2007-09 great recession led to a U.S. unemployment rate peak of 10.6%.  This was surely bad, but not as bad as the 11.4% which followed the 1981-82 bust.  The unemployment rate in 1973-75 got to 9.1%.  The great recession of 1937-38 was far worse, with unemployment peaking at about 20%.  (These unemployment rates are not seasonally adjusted.)

For 2007-09, 477 financial institutions failed in the five years from the onset of the great recession.  For 1981-82, the comparable number is 625 financial institution failures.  In the five years after 1973, there were 46 failures, but it is possible that the whole banking system was insolvent on a mark-to-market basis.  There were 262 failures in the five years after 1937.

In terms of peak-to-trough drop in real GDP, 2007-09 is the second worst of our examples.  In order of increasing severity the aggregate real GDP changes were:  1981-82, -2.8%; 1973-75, -3.1%; 2007-09, -4.2%; and estimated for 1937-38, -18%.

These great recessions had very different inflation experiences.  In 1973-75, in addition to the high unemployment, the U.S. suffered from painful double-digit inflation rates, with an annualized average of 10.9% on top of the other problems.  In 1981-82, the inflation rate was 5.2% along with recession, compared to 1.8% in 2007-09.  In 1937-38, they had deflation, or an inflation rate of -1.9%.

Then there is the cratering of the stock market in each case.  As measured by the peak to trough percentage drop in the Dow Jones Industrial Average, “our” great recession was the worst, with a 52% drop.  In 1937-38, the drop was 48%.   The DJIA fell 39% in 1973-75, and 20% 1981-82.  All painful, to be sure, especially if you were on margin.

Short-term interest rates fell dramatically in all four great recessions, but from very different levels.  Three-month Treasury bill yields started the 1981-82 great recession at the remarkable level of 15% and fell to 8.1%, the biggest change in number of percentage points.  The biggest drop measured as a percentage of the initial level was our 2007-09, in which three-month bill yields dropped from 3% to 0.18% or by 94%.  In 1973-75, these yields went from 7.8% to 5.5%, which sounds still very high to us now.  The lowest trough in rates was in 1937-38, when three-month bills went down to 0.05% from 0.41%.

In sum, the great recession of 2007-09 has predecessor great recessions.  These were worse in some ways, less bad in other ways, and present different combinations of painful problems.  All were severe downers.  But great recessions and ordinary recessions notwithstanding, on the trend the enterprising economy keeps taking income per capita ever higher, “progressively raising the standard of life for the masses” over time. If there is some way to do that without the cycles, it has yet to be discovered.

House prices: What the Fed hath wrought

Published in The Hill.

After the peak of the housing bubble in 2006, U.S. house prices fell for six years, until 2012. Are these memories getting a little hazy?

The Federal Reserve, through forcing years of negative real short-term interest rates, suppressing long-term rates, and financing Fannie Mae and Freddie Mac to the tune of $1.8 trillion on its own vastly expanded balance sheet, set out to make house prices go back up.  It succeeded.  Indeed it has overachieved.  Average house prices are now significantly higher than they were at the top of the bubble.  This is shown in the following 20-year history of the familiar S&P Case-Shiller national house price index.

Read the full article here.

Banks need more skin in the housing finance game

Published by American Banker.

We all know it was a really bad idea in the last cycle to concentrate so much of the credit risk of the huge American mortgage loan market on the banks of the Potomac River — in Fannie Mae and Freddie Mac.

But the concentration is still there, a decade later.

The Fannie and Freddie-centric U.S. housing finance system removes credit risk from the original lenders, taking away their credit skin in the game. It puts the risk instead on the government and the taxpayers.

Many realized in the wake of the crisis that this was a big mistake (although a mistake made by a lot of smart people) in the basic design of the inherently risk-creating activity of lending money. Many realized after the fact that the American housing finance system needed more credit skin in the game.

Skin-in-the-game requirements were legislated for private mortgage securitizations by the Dodd-Frank Act, but do not apply to lenders putting risk into Fannie and Freddie. Regulatory pressure subsequently caused Fannie and Freddie to transfer some of their acquired credit risk to investors — but this is yet another step farther away from those who originated the risk in the first place.

That isn’t where the skin in the game is best placed. The best place, which provides the maximum alignment of incentives, and the maximum use of direct knowledge of the borrowing customer, is for the creator of the mortgage loan to retain significant credit risk. No one else is as well placed.

The single most important reform of American housing finance would be to encourage more retention of credit skin in the game by those making the original credit decision.

In this country, we unfortunately cannot achieve the excellent structure of the Danish mortgage bond system, where 100% of the credit risk is retained by the lenders, and 100 percent of the interest rate risk is passed on to the bond market. The Danish mortgage bank which makes the loan stays on the hook for the default risk and receives corresponding fee income. The loans are pooled into mortgage bonds, which convey all the interest rate and prepayment risk to bond investors. This system has been working well for over 200 years.

There are clearly many American mortgage banks which do not have the capital to keep credit skin in the game in the Danish fashion. But there are thousands of American banks, savings banks and credit unions which do have the capital and can use to it back up their credit judgments. The mix of the housing finance system could definitely be shifted in this direction.

If you are a bank, your fundamental skill and your reason for being in business is credit judgment and the managing of credit risk. Residential mortgage loans are essential to your customers and are the biggest loan market in the country (and the world). Why do you want to divest the credit risk of the loans you have made to your own customers, and pay a big fee to do so, instead of managing the credit yourself for a profit? There is no good answer to this question, unless you think your own mortgage loans are of poor credit quality. For any bankers who may be reading this: Do you think that?

But, it will be objected: The regulators force me to sell my fixed-rate mortgage loans because of the interest rate risk, which results from funding 30-year fixed-rate loans with short-term deposits. True, but as in Denmark, the interest rate risk can be divested while credit risk is maintained. For example, the original 1970 congressional charter of Freddie provided lenders the option of selling Freddie high loan-to-value ratio loans by maintaining a 10% participation in the loan or by effectively guaranteeing them, not only by getting somebody else to insure them.

Treasury Secretary Steven Mnuchin recently told Congress that private capital must be put in front of any government guarantee of mortgages. That’s absolutely right — but whose capital? The best solution would be to include the capital of the lenders themselves.

In sharp contrast to American mortgage-backed securities in this respect are their international competitors, covered bonds. These are bonds banks can issue, collateralized by a “cover pool” of mortgage loans which remain assets of the bank. Thus covered bonds allow a long-term bond market financing, but all the credit risk stays on the bank’s balance sheet, with its capital fully at risk.

American regulators and bankers need to shake off their assumption, conditioned by years of Fannie and Freddie’s government-promoted dominance, that the “natural” state of things is for mortgage lenders to divest the credit risk of their own customers. The true natural state for banks is the opposite: to be in the business of credit risk. What could be more obvious than that?

The housing finance system should promote, not discourage, mortgage lenders staying in the credit business. Regulators, legislators, accountants and financial actors should undertake to reform regulatory, accounting and legal obstacles to the right alignment of incentives and risks. The Federal Housing Finance Agency should be pushing Fannie and Freddie to structure their deals to encourage originator retention of credit risk.

The result will be to correct, at least in part, a fundamental misalignment that the Fannie and Freddie model foisted on American housing finance.

The Cincinnatian Doctrine revisited

Published by the R Street Institute.

The attached policy study originally appeared in the Winter 2016 edition of Housing Finance International.

Ten years ago, in September 2006, just before the great housing bubble’s disastrous collapse, the World Congress of the International Union for Housing Finance, meeting in Vancouver, Canada, devoted its opening plenary session to the topic of “Housing Bubbles and Bubble Markets.” That was certainly timely!

Naturally, knowing what would come next is easier for us in retrospect than it was for those of us then present in prospect. One keynote speaker, Robert Shiller, famous for studies of irrational financial expectations and later a winner of a Nobel Prize in economics, hedged his position about any predictions of what would come next in housing finance. Six months later, the U.S. housing collapse was underway. The second keynote speaker argued, with many graphs and charts, that the Irish housing boom was solid. Of course, it soon turned into a colossal bust. As the saying goes, “Predicting is hard, especially the future.”

Some IUHF members, in the ensuing discussion, expressed the correct view that something very bad was going to result from the excess leverage and risky financial behavior of the time. None of us, however, foresaw how very severe the crisis in both the United States and Europe would turn out to be, and the huge extent of the interventions by numerous governments it would involve.

Later in the program, also very timely as it turned out, was a session on the “Role of Government” in housing finance. On that panel, I proposed what I called “The Cincinnatian Doctrine.” Looking back a decade later, it seems to me that that this idea proved sound and is highly relevant to our situation now. I am therefore reviewing the argument with observations on the accompanying “Cincinnatian Dilemma” as 2016 draws to a close.

The two dominant theories of the proper role for government in the financial system, including housing finance, are respectively derived from two of the greatest political economists, Adam Smith and John Maynard Keynes.

Smith’s classic work, “The Wealth of Nations,” published in the famous year 1776, set the enduring intellectual framework for understanding the amazing productive power of competitive private markets, which have since then utterly transformed human life. In this view, government intervention into markets is particularly prone to creating monopolies and special privileges for politically favored groups, which constrains competition, generates monopoly profits or economic rents, reduces productivity and growth, and transfers money from consumers to the recipients of government favors. It thus results in less wealth being created for the society and ordinary people are made worse off.

Keynes, writing amid the world economic collapse of the 1930s, came to the opposite view: that government intervention was both necessary and beneficial to address problems that private markets could not solve on their own. When the behavior underlying financial markets becomes dominated by fear and panic, when uncertainty is extreme, then only the compact power of the state, with its sovereign authority to compel and tax, and its sovereign credit to borrow against, is available to stabilize the situation and move things back to going forward.

Which of these two is right? Considering this ongoing debate between fundamental ideas and prescriptions for political economy, the eminent financial historian, Charles Kindleberger, asked, “So should we follow Smith or Keynes?” He concluded that the only possible rational answer is: “Both, depending on the circumstances.” In other words, the answer is different at different times.

Kindleberger was the author (among many other works) of “Manias, Panics and Crashes,” a wide-ranging history of the financial busts which follow enthusiastic booms. First published in 1978, the book was prescient about the financial crises that would follow in subsequent decades, and has become a modern financial classic. A sixth edition of this book, updated by Robert Z. Aliber in 2011, brought the history up through the 21st century’s international housing bubbles, the shrivels of these bubbles that inevitably followed and the crisis bailouts performed by the involved governments. Throughout all the history Kindleberger and Aliber recount, the same fundamental patterns continue to recur.

Surveying several centuries of financial history, Kindleberger concluded that financial crises and their accompanying scandals occur, on average, about once every 10 years. In the same vein, former Federal Reserve Chairman Paul Volcker wittily remarked, “About every 10 years, we have the biggest crisis in 50 years.” This matches my own experience in banking, which began with the “credit crunch” of 1969 and has featured many memorable busts since, not less than one a decade. Unfortunately, financial group memory is short, and it seems to take financial actors less than a decade to lose track of the lessons previously so painfully (it was thought) learned.

Note that with the peak of the last crisis being in 2008, on the historical average, another crisis might be due in 2018 or so. About how severe it might be we have no more insight than those of us present at the 2006 World Congress did.

The historical pattern gives rise to my proposal for balancing Smith and Keynes, building on Kindleberger’s great insight of “Both, depending on the circumstances.” I quantify how much we should have of each. Since crises occur about 10 percent of the time, the right mix is:

• Adam Smith, 90 percent, for normal times

• J.M. Keynes, 10 percent, for times of crisis.

In normal times, we want the economic effi­ciency, innovation, risk-taking, productivity and the resulting economic well-being of ordinary people that only competitive private markets can create. But when the financial system hits its periodic crisis and panic, we want the interven­tion and coordination of the government. The intervention should, however, be temporary. This is an essential point. If prolonged, it will tend to monopoly, more bureaucracy, less innovation, less risk-taking and less growth and less eco­nomic well-being. In the extreme, it will become socialist stagnation.

To get the 90 percent Smith, 10 percent Keynes mix, the state interventions and bailouts must be with­drawn after the crisis is over.

This is the Cincinnatian Doctrine, named after the Roman hero Cincinnatus, who flourished in the fifth century B.C. Cincinnatus became the dictator of Rome, being “called from the plough to save the state.” In the old Roman Republic, the dictatorship was a temporary office, from which the holder had to resign after the crisis was over. Cincinnatus did—and went back to his farm.

Cincinnatus was a model for the American founding fathers, and for George Washington in particular. Washington became the “modern Cincinnatus” for saving his country twice, once as general and once as president, and returning to his farm each time.

But those who attain political, economic and bureaucratic power do not often have the virtue of Cincinnatus or Washington. When the crisis is over, they want to hang around and keep wielding the power which has come to them in the crisis. The Cincinnatian Dilemma is how to get the government interventions withdrawn once the crisis is past. In other words, how to bring the Keynesian 10 percent crisis period to end, and the normal Smith 90 percent to resume its natural creation of growth and wealth.

The financial panic ended in the United States in 2009 and in Europe in 2012. But the interventions have not been withdrawn. The central banks of the United States and Europe are still running hugely distorting negative real interest rate experiments years after the respective crises ended. Fannie Mae and Freddie Mac, effectively nationalized in the midst of the crisis in 2008, have not been reformed and are still operating as arms of the U.S. Treasury. The Dodd-Frank extreme regula­tory overreaction, obviously a child of the heat of its political moment, has not yet been reformed.

The Cincinnatian Doctrine cannot work to its optimum unless we can figure out how to solve the Cincinnatian Dilemma.

Was the Bank of England right to lie for its country in 1914?

Published by the R Street Institute.

Jean-Claude Juncker, now the president of the European Commission and then head of the European finance ministers, sardonically observed about government officials trying to cope with financial crises:  “When it becomes serious, you have to lie.” The underlying rationale is presumably that the officials think stating the truth might make the crisis worse.

No one would be surprised by politicians lying, but Juncker’s dictum is the opposite of the classic theory of the Roman statesman Cicero, who taught that “What is morally wrong can never be expedient.” Probably few practicing politicians in their hearts agree with Cicero about this. But how about central bankers, for whom public credibility is of the essence?  Should they lie if things are too bad to admit?

An instructive moment of things getting seriously bad enough to lie came for the Bank of England at the beginning of the crisis of the First World War in 1914. At the time, the bank was far and away the top central bank in the world, and London was the unquestioned center of global finance. One might reasonably have assumed the Bank of England to be highly credible.

A fascinating article, “Your country needs funds: The extraordinary story of Britain’s early efforts to finance the First World War” in Bank Underground, a blog for Bank of England staffers, has revealed the less-than-admirable behavior of their predecessors at the bank a century before. Or alternately, do you, thoughtful reader, conclude that it was admirable to serve the patriotic cause by dishonesty?

Fraud is a crime, and the Bank of England engaged in fraud to deceive the British public about the failed attempts of the first big government-war-bond issue. This issue raised less than a third of its target, but the real result was kept hidden. Addressing “this failure and it subsequent cover-up,” authors Michael Anson, et al., reveal that “the shortfall was secretly plugged by the Bank, with funds registered individually under the names of the Chief Cashier and his deputy to hide their true origin.” In other words, the Bank of England bought and monetized the new government debt and lied about it to the public to support the war effort.

The lie passed into the Financial Times under the headline, “OVER-SUBSCRIBED WAR LOAN”—an odd description, to say the least, of an issue that in fact was undersubscribed by two-thirds. Imagine what the Securities and Exchange Commission would do to some corporate financial officer who did the same thing.

But it was thought by the responsible officers of the British government and the Bank of England that speaking the truth would have been a disaster. Say the authors, “Revealing the truth would doubtless have led to the collapse of all outstanding War Loan prices, endangering any future capital raising. Apart from the need to plug the funding shortfall, any failure would have been a propaganda coup for Germany.” Which do you choose: truth or a preventing a German propaganda coup?

We learn from the article that the famous economist, John Maynard Keynes, wrote a secret memo to His Majesty’s Treasury, in which he described the Bank of England’s actions as “compelled by circumstances” and that they had been “concealed from the public by a masterful manipulation.” A politic and memorable euphemism.

Is it right to lie to your fellow citizens for your country? Was it right for the world’s greatest central bank to commit fraud for its country?  The Bank of England thought so in 1914. What do central banks think now?

And what do you think, honored reader?  Suppose you were a senior British official not in on the deception in 1914, but you found out about it with your country enmeshed in the expanding world war. Would you choose the theory of Juncker or Cicero?

What is the actual collateral for a mortgage loan?

Published in Real Clear Markets.

“Economics and finance are like going to the dog races,” my friend Desmond Lachman of the American Enterprise Institute is fond of saying. “Stand in the same place and the dogs will come around again.” So they will.

U.S. financial markets produced sequential bubbles – first in tech stocks in the 1990s and then in houses in the 2000s.

“What is the collateral for a home mortgage loan?” I like to ask audiences of mortgage lenders.  Of course, they say, “the house,” so I am pleased to tell them that is the wrong answer.  The correct answer is the price of the house.  My next question is, “How much can a price change?”  Ponder that.  The correct answer is that prices, having no independent, objective existence, can change a lot more than you think. They can go up a lot more than you think probable, and they can go down a lot more than you think possible. And they can do first one and then the other.

This is notably displayed by the asset price behavior in both the tech stock and housing bubbles.  As the dogs raced around again, they made a remarkably symmetrical round trip in prices.

Graph 1 shows the symmetrical round trip of the notorious “irrational exuberance” in dot-com equities, followed by unexuberance. It displays the NASDAQ stock index expressed in constant dollars.

Now consider houses.  Graph 2 shows the Case-Shiller U.S. national house price index expressed in constant dollars.  Quite a similar pattern of going up a lot and then going down as much.

The mortgage lending excesses essential to the housing bubble reflected, in part, a mania of politicians to drive up the U.S. homeownership rate. The pols discovered, so they thought, how to do this: make more bad loans—only they called them, “creative loans.” The homeownership rate did rise significantly—and then went back down to exactly where it was before. Another instructive symmetrical round trip, as shown in Graph 3.

The first symmetrical up and down played out in the course of three years, the second in 12 years, the third in two decades. Much longer patterns are possible. Graph 4 shows the amazing six-decade symmetry in U.S. long-term interest rates.

Is there magic or determinism in this symmetry? Well, perhaps the persistence of underlying fundamental trends and the regression to them shows through, as does the reminder of how very much prices can change. In the fourth graph, we also see the dangerous power of fiat currency-issuing central banks to drive prices to extremes.

Unfortunately, graphs of the past do not tell us what is coming next, no matter how many of them economists and analysts may draw. But they do usefully remind us of the frequent vanity of human hopes and political schemes.