Surprise, the Only Constant

Published in the Federalist Society.

A review of Alex Pollock & Howard Adler, Surprised Again! The COVID Crisis and the New Market Bubble (2022)

I approach phenomena that I don’t understand with good cheer and don’t give in to them. I’m above them. Man should be aware that he is above lions, tigers, stars, above everything in nature, even above what is incomprehensible and seems miraculous, otherwise he’s not a man but a mouse afraid of everything.

The House with the Mezzanine: An Artist’s Story, Anton Chekhov

In the late 1980s, the United States experienced what was called the “Savings and Loan Crisis.” Savings and loan associations (S&Ls), firms much like banks, had committed the financial sin of borrowing short and lending long: they borrowed by taking deposits repayable in the near term to finance their making of longer-term thirty-year residential and other real estate loans at fixed interest rates. As interest rates eventually rose, the S&Ls and investment firms found themselves having to pay higher and higher amounts of interest to cover the low fixed amounts of interest they were receiving from their borrowers. That is a financial practice in which one can engage, albeit not indefinitely. Regulators and investors nonetheless were surprised when many S&Ls failed, costing the federal government billions of dollars.

Even after that, in the late 1990s and early 2000s, the government and financial markets incented banks and investment firms to lend to higher-risk low-income borrowers to purchase homes. Policymakers thought sincerely that relaxed lending standards would enable lower-income persons to more quickly and easily realize the American dream of home ownership, which would in turn enable them to build up equity in their newly purchased homes as home values rose. That equity could be used to start a small business or send children to college. Unfortunately, home prices did not continue to rise relentlessly and eventually dropped, leaving lenders with inadequate collateral. As these borrowers eventually were unable to repay their loans, the lenders found themselves holding loans of dubious and uncertain value, and investors were surprised. This all came to a head in 2008 with what is now called the “Great Financial Crisis.” Regulators charged with protecting our financial system were surprised again.

Read the rest here.

Quantum attack would trigger Great Depression, think tank warns

Published in SC Media:

“If you were having a dispute with the United States in other ways and you wanted to make it more complicated, why not take down the financial system as a distraction?,” said Alex Pollock, a former deputy director of the Treasury Department’s Office of Financial Research in response to the report.

“If you were having a dispute with the United States in other ways and you wanted to make it more complicated, why not take down the financial system as a distraction?”

Event video: Hudson Institute: Prosperity at Risk: The Quantum Computer Threat to the US Financial System

Hosted by the Hudson Institute.

May 22, 2023.12:00 p.m. - 1:00 p.m.

Listen to Event Audio

Cybersecurity experts and technology policy officials, including those in the White House, are realizing that quantum computers will pose a significant threat to existing public encryption systems and that they need to act now to make America’s key infrastructure quantum ready and secure.

Join Hudson Senior Fellow and Director of the Quantum Alliance Initiative (QAI) Arthur Herman and QAI Associate Director Alex Butler as they discuss their most recent report. This publication details the potential consequences of a future quantum computer attack on the Federal Reserve, specifically the Fedwire Funds Service, which facilitates large-scale interbank transactions. 

Mises Institute Senior Fellow and former Deputy Director of the Treasury Department’s Office of Financial Research Alex Pollock, and John Prisco, CEO and founder of Quantum Safe Inc., will discuss the implications of the report for the future of our financial system.

Speakers:

• Arthur Herman, Senior Fellow

• Alexander Butler, Associate Director, Quantum Alliance Initiative

• Alex J. Pollock, Senior Fellow, Mises Institute

• John Prisco, CEO and Founder, Quantum Safe, Inc.

Ukraine and the cost of war

Published in the Washington Examiner.

In an example unrelated to war, consider former President Richard Nixon’s 1971 decision to abandon the gold standard and impose wage and price controls and tariffs to calm inflationary forces. This was primarily a response to France’s effort to convert dollars to gold.

Seven Possible Causes of the Next Financial Crisis

Published in Law & Liberty.

The great financial historian, Charles Kindleberger, pointed out in the 1970s that over several centuries, history showed there was a financial crisis about once every ten years. His observation still holds. In every decade since his classic Manias, Panics and Crashes of 1978, such crises have indeed continued to erupt in their turn, in the 1980s, 1990s, 2000s, 2010s, and again in 2020. What could cause the next crisis in this long, recurring series? I suggest seven possibilities:

1. What Nobody Sees Coming

A notable headline from 2017 was “Yellen: I Don’t See a Financial Crisis Coming in Our Lifetimes.” The then-head of the Federal Reserve was right that she didn’t see it coming; nonetheless, well within her and our lifetimes, a new financial crisis arrived in 2020, from unexpected causes.

It has been well said that “The riskiest stuff is what you don’t see coming.” Especially risky is what you don’t think is possible, but happens anyway.

About the Global Financial Crisis of 2007-09, a former Vice Chairman of the Federal Reserve candidly observed: “Not only didn’t we see it coming,” but in the midst of it, “had trouble understanding what was happening.” Similarly, “Central banks and regulators failed to see the bust coming, just as they failed to anticipate its potential magnitude,” as another top central banking expert wrote.

The next financial crisis could be the same—we may take another blindside hit for a big financial sack.

In his memoir of the 2007-09 crisis, former Secretary of the Treasury Henry Paulson wrote, “We had no choice but to fly by the seat of our pants, making it up as we went along.” If the next financial crisis is again triggered by what we don’t see coming, the government reactions will once again be flying by the seat of their pants, making it up as they go along.

2. A Purely Malicious Macro-Hack of the Financial System

We keep learning about how vulnerable to hacking, especially by state-sponsored hackers, even the most “secure” systems are. Here I am not considering a hack to make money or collect blackmail, or a hack for spying, but a purely malicious hack with the sole goal of creating destruction and panic, to cripple the United States by bringing down our amazingly complex and totally computer-dependent financial information systems.

Imagine macro-hackers attacking with the same destructive motivation as the 9/11 terrorists. Suppose when they strike, trading and payments systems can’t clear, there are no market prices, no one can find out the balances in their accounts or the value of their risk positions, and no one knows who is broke or solvent. That is my second next crisis scenario.

3. All the Central Banks Get It Wrong Together

We know that the major central banks operate as a tight international club. Their decisions are subject to vast uncertainty, and as a result, they display significant cognitive and behavioral herding.

I read somewhere the colorful line, “Central banks have become slaves of the bubbles they blow.” Whether or not we think that, there is no question that the principal central banks have all together managed to create a gigantic global asset price inflation.

Suppose they have also managed to set off a disastrous, runaway general price inflation. Then ultimately interest rates must rise, and asset prices fall. This will be in a setting of stretched asset prices and high debt. As asset prices fall, speculative leverage will be punished. “Every great crisis reveals the excessive speculations of many houses which no one before suspected,” as Walter Bagehot said. The Everything Bubble of our time would then implode and the crisis would be upon us. Huge government bailouts would ensue.

We have discovered that to combat a pandemic, governments can close down economies and cause massive unemployment and economic disruption. Would they do that again—or something else?

4. A Housing Collapse Again

A particularly notable asset price inflation is, once again, that in the price of houses, which are the biggest investment most households have and are the mortgage collateral for the biggest loan market in the world. House prices are now rising in the U.S. at the unsustainable rate of more than 18% a year, but this is also global problem. Many countries, about 20 by one reckoning, face extreme house price inflation. Said one financial commentator, “This is now a global property bubble of epic proportions, never before seen by man or beast, and it has entrapped more central banks than just the Fed.”

House prices depend on high leverage and are, as is well known, very interest rate sensitive. What would an actual market-determined mortgage rate look like, instead of the Federal Reserve-manipulated 3% mortgage rate the U.S. has now? A reasonable estimate would begin with a 3% general inflation, and therefore a 4.5% 10-year Treasury note. The long-term mortgage rate would be 1.5% over that, or 6%. That would more or less double the monthly payment for the same-sized mortgage, house prices would fall steeply, and our world record house price bubble implode. Faced with that possibility, so far the Federal Reserve’s choice has been to keep pumping up the bubble.

Overpriced, leveraged real estate is a frequent culprit in financial crises. Maybe once again.

5. An Electricity System Failure

Imagine a failure, similar to our financial system macro-hack scenario, resulting from an attack maliciously carried out to bring down the national electricity system, or from a huge solar flare, bigger than the one that took down the electric system of Quebec in 1989.

Physically speaking, the financial system, including of course all forms of electronic payments, is an electronic system, utterly dependent upon the supply of electricity. Should that fail, it would certainly be good to have some paper currency in your wallet, or actual gold coins. Bank accounts and cryptocurrencies will not be working so well.

6. The Next Pandemic

It feels like we have survived the Covid pandemic and the crisis is passing. Even with the ongoing problem of the Delta variant, we are certainly more relaxed than at the peak of the intense fear and the lockdowns of 2020. Instead of financial markets being in free fall as they were, they are booming.

But what about the next pandemic? We have discovered that to combat a pandemic, governments can close down economies and cause massive unemployment and economic disruption. Would they do that again—or something else?

How soon could a new pandemic happen? We don’t know.

Might that new pandemic be much more deadly than Covid? Consider Professor Adam Tooze: “One thing 2020 forces us to come to terms with is that this wasn’t a black swan [an unknown possibility]. This kind of pandemic was widely and insistently and repeatedly predicted.” What wasn’t predicted was the political response and the financial panic. “In fact,” Tooze continues, “what people had predicted was worse than the coronavirus.”

If the prediction of an even worse and more deadly new pandemic becomes right, perhaps sooner than we might think, that might trigger our next financial crisis.

7. A Major War

By far the most important financial events of all are big wars.

A sobering talk I heard a few years ago described China as “Germany in 1913.”

This of course brings our mind to 1914. The incredible destruction then unleashed included a financial panic, and the war created huge, intractable financial problems which lasted up to the numerous sovereign defaults of the 1930s.

What if a big war happened again in the 21st century? If you think that is not possible, recall the once-famous book, Norman Angel’s The Great Illusion, which argued that a 20th-century war among European powers would be so economically costly that it would not happen. In the event, it was unimaginably costly, but nonetheless happened.

One distinguished scholar, Graham Allison of Harvard, has written: “A disastrous war between the United States and China in the decades ahead is not just possible, but much more likely than most of us are willing to allow.” A particular point of tension is the Chinese claim to sovereignty over Taiwan.  Might a Chinese decision to end Taiwan’s freedom by force be the equivalent of the German invasion of Belgium in 1914?

Would anyone be crazy enough to start a war between China and the United States? We all certainly hope not, but we should remember that such a war did already occur: most of the Korean War consisted of battles between the Chinese and American armies. In his history of the Korean War, David Halberstam wrote, “The Chinese viewed Korea as a great success,” and that Mao “had shrewdly understood the domestic benefits of having his county at war with the Americans.”

If it happened again it would be a terrific crisis, needless to say, with perhaps a global financial panic thrown in.

Overall, we can say there is plenty of risk and uncertainty to provide the possibility of the next financial crisis.

Based on remarks at an American Enterprise Institute teleconference, “What might cause the next financial crisis?” on June 29, 2021.

Fifty Years Without Gold

Published in Law & Liberty.

Fifty years ago, on Sunday evening, August 15, 1971, after crisis meetings with close advisers at Camp David, President Richard Nixon announced an historic decision in his “Address to the Nation Outlining a New Economic Policy.” It was by then clear that the United States might not have enough gold to meet its international commitment to redeem dollars. It was experiencing “the start of a run on the dollar.” Paul Volcker, then with the Treasury Department, reported to the President on gold losses. “Dollar dumping accelerated. France sent a battleship to take home French gold from the New York Fed’s vaults.” The French not unreasonably believed that the special status of the dollar gave it an “exorbitant privilege,” making it “monumentally over-privileged.” Already in the 1960s, French President Charles de Gaulle had ordered the Bank of France to increase the amount of payments in gold from the United States.

Said Nixon to the nation, “The speculators have been waging an all-out war on the American dollar,” and that to “protect the dollar from the attacks of the international money speculators” would take “bold action.” “Accordingly,” he announced, “I have directed [Treasury] Secretary Connolly to suspend temporarily the convertibility of the dollar into gold.” The suspension of course turned out to be permanent. Today everybody considers it normal and almost nobody even imagines the slightest possibility of reversing it.

Nixon had thereby put the economic and financial world into a new era. By his decision to “close the gold window” and have the American government renege on its Bretton Woods commitment to redeem dollars for gold for foreign governments, he fundamentally changed the international monetary system. In this new system, still the system of today, the whole world always runs on pure fiat currencies, none of which is redeemable in gold or anything else, except more paper currency or more accounting entries. Instead of having fixed exchange rates, or “parities,” with respect to each other, the exchange rates among currencies can constantly change according to the international market and the interventions and manipulations of central banks. The central banks are free to print as much of their own money as they and the government of which they are a part like.

This was a very big change and highly controversial at the time. The Bretton Woods agreement was a jewel of the post-World War II economic order, negotiated in 1944 and overwhelmingly voted in by the Congress and signed into law by President Truman in 1945. Its central idea was that all currencies were linked by fixed exchange rates to the dollar and the dollar was permanently linked to gold. Now that was over. Sic transit gloria.

Economist Benn Steil nicely summed up the global transition:  “The Bretton Woods monetary system was finished. Though the bond between money and gold had been fraying for nearly sixty years, it had throughout most of the world and two and a half millennia of history been one that had only been severed as a temporary expedient in times of crisis. This time was different. The dollar was, in essence, the last ship moored to gold, with all the rest of the world’s currencies on board, and the United States was cutting the anchor and sailing off for good.” It was sailing, we might say, from a Newtonian into an Einsteinian monetary world, from a fixed frame of reference into many frames of reference moving with respect to each other. Nobody knew how it would turn out.

Fifty years later, we are completely used to this post-Bretton Woods monetary world. We take a pure fiat money system entirely for granted as the normal state of things. In this sense, in this country and around the world, we are all Nixonians now.

How very different our prevailing monetary system is from the ideas of Bretton Woods. The principal U.S. designer of the Bretton Woods system, Harry Dexter White insisted, strange to our ears, that “the United States dollar and gold are synonymous.” Moreover, he opined that “there is no likelihood that . . . the United States will, at any time, be faced with the difficulty of buying and selling gold at a fixed price.”

This was a truly bad forecast. It may have been arguable in 1944, but by the 1960s, let alone 1971, it was obviously false. (White’s misjudgment here was exceeded by his bad judgment in being, in addition to an officer of the U.S. Treasury, a spy for the Soviet Union.)

A better forecast was made by Nixon’s Treasury Secretary, John Connally. Meeting with the President two weeks before the August 15, 1971 announcement, he said, “We may never go back to it [convertibility]. I suspect we never will.”  He’s been right so far for fifty years.

In the early years of the Nixonian system, Friedrich Hayek wrote: “A very intelligent and wholly independent national or international monetary authority might do better than an international gold standard. . . . But I see not the slightest hope that any government, or any institution subject to political pressure, will ever be able to act in such a manner.”

Running low on gold and facing the inability to meet its Bretton Woods obligations, the American government had to do something. Instead of cutting off gold redemption, it could have devalued the dollar in terms of gold. A decade before, British Prime Minister Harold Macmillan had suggested to President John Kennedy that the already-apparent problems could be addressed if the dollar were devalued to $70 per ounce of gold, from the official $35. Whether you have enough gold or not depends on the price. But announcing a formal devaluation was politically very unattractive and no one could really know what the right number was going forward. Today, after fifty years of inflation, it takes about $1,800 to buy an ounce of gold, which is a 98% devaluation of the dollar relative to the old $35 an ounce.

How shall we judge the momentous Nixon decision? Was it good to break the fetters of the “barbarous relic” of gold and voyage into uncharted seas of central bank discretion? Most economists say definitely yes. At the time, the public response to Nixon’s speech was very positive. The stock market went up strongly.

But wasn’t it dangerous to remove the discipline Bretton Woods provided against wanton money creation and inflationary credit expansion? The end of Bretton Woods was followed by the international Great Inflation of the 1970s, and later by our times in which central banks, including the Federal Reserve, with a clear conscience, commit themselves to perpetual inflation instead of stable prices, and promise to depreciate the value of the currency they issue. They speak of “price stability,” but mean by that a stable rate of everlasting inflation. As we observe the renewed unstable and very high rate of inflation of 2021, we may reasonably ask whether discretionary central banks can ever know what they are really doing. Personally, I doubt it.

In the early years of the Nixonian system, Friedrich Hayek wrote: “A very intelligent and wholly independent national or international monetary authority might do better than an international gold standard….But I see not the slightest hope that any government, or any institution subject to political pressure, will ever be able to act in such a manner.” Central banks, including the Federal Reserve, are indeed subject to political pressure and depend on political support. Politicians, Hayek added, are governed by the “modified Keynesian maxim that in the long run we are all out of office.” If Hayek is watching today from economic Valhalla as the Federal Reserve buys hundreds of billions of dollars of mortgages, and thus stokes the housing market’s runaway price inflation, he will be murmuring, “As I said.”

The distinguished economist and scholar of financial crises, Robert Aliber, pointedly observed that the Nixonian system of pure fiat money and floating exchange rates has been marked by a recurring series of financial crises around the world. Such crises erupted in the 1970s, 1980s, 1990s, 2000s, and 2010s. The fiat currency system was born to solve the 1971 crisis, but it certainly cannot be given a gold medal for financial stability since then. Aliber wrote to me recently: “I used to think that the failure to ‘save Lehman’ was the biggest mistake that the U.S. Treasury ever made, now I realize 1971 was the bigger mistake.”

Professor Guido Hülsmann, speaking in 2021, described the results of the end of Bretton Woods in these colorful terms: “All central banks were suddenly free to print and lend as many dollars and pounds and francs and marks as they wished. . . . Nixon’s decision led to an explosion of debt public and private; to an unprecedented boom of real estate and financial markets;…to a mind-boggling redistribution of incomes and wealth in favor of governments and the financial sector;…and to a pathetic dependence of the so-called financial industry on every whim of the central banks.”

As always in economics, you cannot run the history twice. What would have happened had there been a different decision in 1971, and whether it would have been better or worse than it has been under the Nixonian system, is a matter for pure speculation. Another speculation, good for our humility, is to wonder what we ourselves would usefully have said or done, had we been at Camp David among the counselors of the President, or even been the President, in that crucial August of fifty years ago.

The Bretton Woods system had developed by then a severe, and as it turned out, fatal problem. Our Nixonian system is seriously imperfect. But given the deep, fundamental uncertainty of the economic and financial future at all times; the inescapable limitations of human minds, even the best of them; and the inevitable politics that shape government behavior, including central bank behavior, we are not likely ever to achieve an ideal international monetary system. We are well-advised not to entertain either foolish hopes or foolish faith in central banks.

In any case, there is no denying that August 15, 1971 was a fateful date.

Event: What might cause the next financial crisis?

Hosted by the American Enterprise Institute.

Panelists:
Rebel A. Cole, Lynn Eminent Scholar Chaired Professor of Finance, Florida Atlantic University
Gerald P. Dwyer, BB&T Scholar, Clemson University
Edward Kane, Professor, Boston College
Alex J. Pollock, Distinguished Senior Fellow, R Street Institute
Ehud I. Ronn, Professor, University of Texas at Austin
Richard Christopher Whalen, Chairman, Whalen Global Advisors LLC

Moderator:
Paul H. Kupiec, Resident Scholar, AEI

More than 60 countries and multinational organizations produce financial stability reports. All are political documents that rarely identify actual financial crises in advance, especially if risks arise from government-regulated institutions or are linked to government policies that promote financial excesses such as lax lending standards, over-stimulative monetary policy, or unsustainable exchange rates.

Financial activities believed to be fail-safe frequently are not. Successfully identifying the activities that result in disastrous losses before they materialize requires imagination, intuition, and luck. Statistical models rarely predict economic turning points.

Join AEI as six financial-sector experts use data, statistics, and their keen intuition and in-depth knowledge of our financial system to propose risks that could trigger the next financial crisis.

Book notes: Finance and philosophy, by Alex J Pollock

From Central Banking:

Pollock started his working life as a banker. In 1970, he was a management trainee in the international banking department of the Continental Illinois Bank of Chicago. He stuck with it, but in 1984 – by which time he was a senior vice-president – Continental Illinois Bank failed.

He writes it was “intellectually stimulating – indeed, a highly educational experience”.

Read the rest here.

Global financial market risks: Entering unchartered territory

Hosted by the American Enterprise Institute.

text

The end of ‘too big to fail’ remains difficult to picture

Published in the Financial Times.

If you buy shares of stock for $100 and they fall to $30, we say, “Oh well, that’s the stock market.” If you buy a bond for $100 and it ends up paying 20 cents on the dollar, we say, “Oh well, that’s the bond market.”

But if your deposits in big banks are going to pay 97 cents instead of par, that is a financial crisis, and the government must intervene to protect you.

That is why Simon Samuels is so right that “we are a long way from ending ‘too big to fail’” (“The ECB should resist the lure of bigger banks,” Jan. 31). As long as we insist that no one can lose money on bank deposits, too big to fail can never end and never will.

The Bill Walton Show: Finance, Philosophy and more with Alex Pollock

Published by the Bill Walton Show.

People look to the government to prevent future financial crises and trust that politicians and economic experts can create policies to protect us and our 401(k) plans. We shouldn’t trust them. These experts are smart, mostly well-intentioned people but they can’t prevent the next crisis. No one can. Why is that? Why is a future crisis inevitable? I discuss these and many other questions with “Finance and Philosophy” author Alex Pollock.

Finance and Philosophy: Why We’re Always Surprised

Published by Paul Dry Books. Order here.

“Pollock tells us all we need to know about money and banking, risk and uncertainty, debt and temptation, and science and economics. He delights as he instructs.”―James Grant, founder and editor, Grant’s Interest Rate Observer

Finance and Philosophy provides a concise and witty account of how bankers and financial regulators think, of the alleged causes of the cycles of booms and busts, of the implicit and often un-thought-out assumptions shaping retirement finance, fiat money, corporate governance. Pollock deftly shows how poorly bankers have measured the risk their banks have been exposed to. With candor and clarity, he uncovers the persistent and unavoidable uncertainty inherent in the business of banking. We learn that a banker’s confidence in his ability to measure banking risk accurately is the lure which has repeatedly led to bank failures. Pollock has a modest and compelling suggestion: Acknowledge the unavoidability of ignorance with respect to financial risk, and, in the light of this ignorance of the future, act moderately.

“Why can’t human beings take the lessons of boom and bust, bubbles and crashes that are clearly described in history books―and learn from experience? That’s where Mr. Pollock’s wry humor and philosophic bent help understand the hubris that makes every generation believe that not only can it predict the markets, but control them . . . [Finance and Philosophy] should be required reading in economics classes, or before opening an investment account―and by every member of Congress.”―The Washington Times

“At the height of the 2008 financial panic, Queen Elizabeth plaintively asked why nobody saw it coming. In the winning pages of Finance and Philosophy, Her Majesty can find the answer. With a lightness of touch that belies the complexity of his subject, Alex Pollock shows why the financial future is now, why it has been and always must be a closed book. A successful banker and gifted writer, Pollock tells us all we need to know about money and banking, risk and uncertainty, debt and temptation, and science and economics. He delights as he instructs.”―James Grant, founder and editor, Grant’s Interest Rate Observer

“Pollock’s observations and historical examples are compelling, and his wide-ranging discussion of banking and financial crises is not only accessible, but a pleasure to read.”―Real Clear Markets

“An intellectually penetrating and thought-provoking book.”―Central Banking

“Alex Pollock shows how financial jargon obscures simple realities, how very smart people are prone to spectacular financial mistakes, and how government efforts to make finance smarter and more stable have made it much worse on both scores. Drawing on Pollock’s highly successful career in banking and scholarship, Finance and Philosophy is a fount of sharp insight and high wisdom.”―Chris DeMuth, President, American Enterprise Institute, 1986–2008

“As in all of Alex Pollock’s writings, Finance and Philosophy combines the author’s subtle but caustic wit with brilliant insights grounded in his long experience analyzing America’s financial fads and foibles. No one does a better job of pointing out the philosophical and historical fallacies underlying the portentous pronouncements by our leading economic and fiscal ‘experts’ on everything from the future of interest rates and the national debt to the tech bubble of the 1990s and the 2007–09 financial meltdown. This book needs to be read by every present and future Secretary of the Treasury and chairman of the Federal Reserve.”―Arthur Herman, author of 1917: Lenin, Wilson, and the Birth of the New World Disorder

Knowledge, Risk, and the Surprised Banker: A Conversation with Alex Pollock

Published in Law and Liberty’s LibertyLawTalk podcast.

Longtime Law and Liberty contributor Alex Pollock joins this edition of LibertyLawTalk to discuss his new book Finance and Philosophy.

Two books that will enrich your understanding of banking and bank crises

Published in Real Clear Markets.

Over the summer, I had the pleasure of reading the prerelease versions of two books about banking and financial crises: Finance and Philosophy: Why We’re Always Surprised, by Alex J. Pollock, (Paul Dry Books, October 16, 2018), and Borrowed Time: Two Centuries of Booms, Busts, and Bailouts at Citi, by James Freeman and Vern McKinley (Harper Business, 2018). Pollock’s book is being released in October, and Freeman and McKinley’s book is already available. If the history of banking and financial crises interests you, I think you will find both books to be rich in content and enjoyable to read. I know I did.

In Finance and Philosophy Alex Pollock, a former president and CEO of the Federal Home Loan Bank of Chicago, applies his formidable intellect and a lifetime of banking experience to explain in a simple and entertaining way why we continue to have banking crises and why post-crisis regulatory reforms are doomed to fail.

Banking systems will be prone to crises so long as investors confuse risk and uncertainty writes Pollock. Risk can be modeled, assessed and managed, but not so uncertainty.

[…]

Pollock recounts numerous historical examples where the accuracy of heuristic models evaporated once investors and regulators adopted models to guide their actions. For example, in the recent financial crisis, institutions relied on models to parse the risk in subprime mortgage-backed securities. To describe the impact of uncertainty, Pollock quotes Tony Saunders “[t]he rocket scientists built a missile which landed on themselves.”

In Pollock’s view, over confidence in heuristic models is especially problematic when models are sanctioned by bank regulators or the Federal Reserve. For example, time and again, investors have been crushed when uncertainty reveals that investments like government bonds—presumed to be “riskless” in regulatory models— aren’t. Or markets presumed to be deep and dependably liquid—like commercial paper—cease to function.

The confusion between risk and uncertainty is not limited to private bankers and investors—in Pollock’s view, it is endemic among the modern central bankers entrusted with managing the economy. Unable to anticipate economic uncertainty, their economic models often misinterpret the economic tea leaves and lead central bankers (Pollock’s would-be “philosopher kings”) to adopt policies that magnify financial instability as they did in the great inflation of the 1970s and the great moderation (a.k.a. the housing bubble) more recently.

Pollock’s observations and historical examples are compelling, and his wide-ranging discussion of banking and financial crises is not only accessible, but a pleasure to read.

Have financial follies changed since Walter Bagehot’s day?

Published by the R Street Institute.

Among everything you might read in the realm of finance, there is nothing more enjoyable than reading Jim Grant, with his sparkling mixture of ideas, research and wit—except perhaps reading the great Walter Bagehot himself, with his wonderful Victorian rhetoric. Now we have Jim Grant writing on Walter Bagehot—a terrific combination. I have had the pleasure of reading several chapters from this new book in process.

Of course, Jim finds striking quotations from Bagehot, sometimes from surprising sources. For example, in a letter to his fiancée, Eliza Wilson, written during the financial panic of 1857, Jim has found what Bagehot observed about the “nature of financial faith.”

All banking rests on credit and credit is rather a superstition. At any rate it is adopted not from distinct evidence but from habit, usage and local custom.

That is why it is true that, as Bagehot later wrote in Lombard Street, “(e)very banker knows that if he has to prove he is worthy of credit … in fact his credit is gone.”

When the 1857 panic was over, Bagehot wrote Eliza from London:

The last few times I have been here everybody was on their knees asking for money, now you have to go on your knees to ask people to take it.

“Few better observations of the cycles of bankerly feast and famine have ever been written,” says Jim, continuing: “Historians of economic thought may make of it what they will that the passages formed part of Bagehot’s love letters” to Eliza!

I’m not sure what to make of that, either.

Credit expansion replaced panic, and proceeding to the 1860s, Jim relates, “Financiers reconsidered the field of opportunity. They found it to be bigger and more alluring than before,” just as their successors did in the 1970s, 1980s, 1990s, 2000s and 2010s. Continuing Jim’s text:

The British government borrowed at 3% with the assurance of absolute safety. The Turkish government, with no such assurance, willingly paid 12% to 15%; the Egyptian government, 8% to 9%; the government of the Confederate States of America [this is in the 1860s, remember] 7% along with an option on the price of cotton.

This international credit expansion, like others, led ultimately to defaults and losses. Need we add that today we are once again experiencing stresses in emerging market debts?

The mention of the bonds of the Confederate States of America should remind us of Pollock’s Law of War Finance, which is: Do not lend to the side that is going to lose. By 1865, it was clear that the holders of Confederate bonds were out of luck. The next year, 1866, brought the infamous collapse of the previously prestigious and unquestioned financial firm of Overend, Gurney & Co. in London. As Overend was going down, we learn from Jim’s text:

Their only recourse was to the Bank of England. Would the Old Lady Bank extend a helping hand? The Bank dispatched a three-man team to inspect the supplicant’s books. The verdict was negative—[Overend] was insolvent—and the Bank declined to assist. The heretofore unimaginable occurred. Overend, Gurney closed its doors. The ensuing panic exhausted the descriptive powers of the financial press.

The formerly famous insolvent bank as supplicant to the central bank; this may sound too familiar.

“In the aftermath of the failure of Overend, Gurney,” Jim writes, “investors in foreign bonds arrived in force … In the dull, post-panic British economy, savers strained to earn more than the 3 ¼% available on British government bonds. Risky borrowers, arm-in-arm with their opportunistic bankers, stepped forward to fill the void.” But “Bagehot anticipated the consequences of the coming overseas bond bubble.”

In the 1870s, Jim continues:

Egypt, then a semi-autonomous province of the Turkish, or Ottoman, Empire, was one such seeker of funds. In the case of Egypt, not even the Egyptian government had the [financial] figures.

We may instructively note, much more recently, that neither did, nor does, the government of Puerto Rico, the largest municipal insolvency in history, have its financial figures straight. Nor did the biggest municipal insolvency of its time, the government of New York City, a generation ago and a century after Bagehot was writing on Egypt. But in none of these cases did it stop the investors from sending in their money on faith.

So Bagehot acutely described the financial adventures, mistakes, and foibles of his day, which were a lot like those of our day. Jim draws a further key conclusion about his subject’s character:

Bagehot stood up for the ideal of personal responsibility in financial dealings.

May we all.

We are certainly looking forward to reading the whole of Jim’s new book on Bagehot’s life, ideas, controversies and times.