Risk, Uncertainty and Profit 100 Years Later

Published in Law & Liberty. Also appears in AIER.

The year 2021 marks the 100th anniversary of Frank Knight’s great book, Risk, Uncertainty and Profit (RU&P), which established uncertainty as a fundamental idea in economics and finance, and as a key to understanding enterprise, entrepreneurship, cycles of booms and busts, and economic growth. Viewed from the present, it also explains why faith in economic management by central banks will be disappointed, and why any idea that economies or financial markets are governed by “mechanisms” is deluded. Its ideas open the way to seeing that economies and financial markets are a different kind of reality than are machines, and thus why the econometric equations that seem so plausible in some times, at other times fail.

Knight lived from 1885 to 1972; RU&P was published in 1921 when he was 35. Although he subsequently had a long and distinguished career at the University of Chicago, where he influenced numerous future economists including Milton Friedman, RU&P is far and away his magnum opus, a book that “ended up changing the course of economic theory” and established Knight “in the pantheon of economic thinkers.” It might also be called “the most cited economics book you have never read.” Indeed, it is long, complex, and often difficult, but contains brilliant insights which do not go out of date. We may enjoy the irony that it arose from a contest by the publishers in 1917 in which its original text won second, not first, prize.

RU&P is most and justifiably famous for its critical distinction between Uncertainty and Risk, with the term “Knightian Uncertainty” immortalizing the author, at least among those of us who have thought about it. Although in common language, then and now, “It’s uncertain” or “It’s risky” might be taken to mean more or less the same thing, in Knight’s clarified concepts, they are not only not the same, but are utterly different, with vast consequences.

Knight set out to address, as he wrote in RU&P, “a confusion of ideas which goes down deep into the foundations of our thinking. The key to the whole tangle will be found to lie in the notion of risk or uncertainty and the ambiguities concealed therein.” So “the answer is to be found in a thorough examination and criticism of the concept of uncertainty, and its bearings upon economic processes.”

“But,” Knight continued, “Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated”—until RU&P in 1921, of course. They are “two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different.”

Specifically, risk means “a quantity susceptible of measurement,” but uncertainty is “unmeasurable,” and “a measurable uncertainty is so far different from an unmeasurable one that it is not in effect an uncertainty at all.” It is only a risk.

Another way of saying this is that for a measurable risk, you can know the odds of outcomes, although you don’t know exactly what will happen in any given case. With uncertainty, you do not even know the odds, and more importantly, you cannot know the odds.

When facing risk, since you can know the odds, you can know in a large number of repeated events what the distribution of the outcomes will be. You can know the mean of the distribution of outcomes, its variation, and the probability of extreme outcomes. With fair pair of dice, you know that rolling snake eyes (one spot on each die) has a reliable probability of 1/36. We know that the extreme outcome of rolling snake eyes three times in a row has a probability of about 0.00002—roughly the same probability of flipping a fair coin and getting tails 16 times in a row. Of course, even that remote probability is not zero.

With risk, by knowing the odds in this fashion, and knowing how much money is being risked, you can rationally write insurance for bearing the risk when it is spread over a large number of participants. It may take specialized skill and a lot of data, but you can always in principle calculate a fair price for insuring the risk over time, and the ones taking the risk can accordingly buy insurance from you at a fair price, solving their risk problem.

Faced with uncertainty, however, you cannot rationally write the insurance, and the uncertainty bearers cannot buy sound insurance from you, because nobody knows or can know the odds. Therefore, they do not and cannot know the fair price for bearing the uncertainty.

In short, an essential result of Knight’s logic is that risk is in principle insurable, but uncertainty is not.

Of course, you might convince yourself that the uncertainty is really risk and then estimate the odds from the past and make calculations, including complicated and sophisticated calculations, manipulating your guesses about the odds. There is often a strong temptation to do this. It helps a lot in selling securities, for example, or in making subprime loans. You can build models using the estimated odds, creating complicated series of linked probabilities for surviving various stress tests and for calculating the required prices.

It is the special function of the entrepreneur to generate unpredictable change and the economic profit or loss, progress or mistakes, that result from it.

Your analysts will certainly solve the mathematical equations in the models properly; however, under uncertainty, the question is not doing the math correctly, but the relationship of the math to the unknown and unknowable future reality. In the uncertainty case, your models will one day fail, because in fact you cannot know the odds, no matter how many models you run. The same is true of a central bank, say the Federal Reserve, running a complex model of the whole economy and employing scores of economists. Under uncertainty, it may, for example, in spite of all its sophisticated efforts, forecast low inflation when what really is about to happen is very high inflation—just as in 2021.

There is no one to ensure against the mistake of thinking Uncertainty is Risk.

Let us come to the P in RU&P: Profit. Every time Knight writes “profit,” as in the following quotations, and also as used in the following discussion, it does not mean accounting profit, as we are accustomed to seeing in a profit and loss statement, but “economic profit.” Economic profit is profit in excess of the economy’s cost of capital. When economic profit is zero, then the firm’s revenues equal its costs, including the cost of capital and the cost of Risk, so the firm has earned exactly its cost of capital.

In a theoretical world of perfect competition, prices, including the price for insuring Risk, would adjust so that revenues always would equal cost. That means in a competitive world in which the future risks are insurable, there should be no profit. We obviously observe large profits in many cases, especially those earned by successful entrepreneurs. Knight concludes that in a competitive economy, Uncertainty, but not Risk, can give rise to Profit.

It is “vital to contrast profit with payment for risk-taking,” he wrote. “The ‘risk’ which gives rise to profit is an uncertainty which cannot be evaluated, connected with a situation such that there is no possibility of grouping on any objective basis,” and “the only ‘risk’ which leads to a profit is a unique uncertainty resulting from an exercise of ultimate responsibility which in its very nature cannot be insured.” Thus, “profit arises out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated…a probability calculation in regard to them is impossible and meaningless.” Loss also arises from the same brute fact, of course. We are again reminded that human activity is a different kind of reality than that of predictable physical systems.

Economic progress, or a rising standard of living for ordinary people, depends on creating and bearing Uncertainty, but this obviously also makes possible many mistakes. These include, we may add, the group mistakes which result in financial cycles. We don’t get the progress without the uncertainty or without mistakes. “The problem of management or control, being a correlate or implication of uncertainty, is in correspondingly large measure the problem of progress.” The paradox of economic progress is that there is no progress without Uncertainty, and no Uncertainty without mistakes.

To have Uncertainty, there must be change, for “in an absolutely unchanging world the future would be accurately foreknown.” But change per se does not create an unknowable future and Uncertainty. Change which follows a known law would be insurable; so “if the law of change is known…no profits can arise.” Profits in a competitive system can arise “only in so far as the changes and their consequences are unpredictable.”

It is the special function of the entrepreneur to generate unpredictable change and the economic profit or loss, progress or mistakes, that result from it. He takes the “ultimate responsibility” of bearing uncertainty in business.

Knight clearly enjoyed summing up “the main facts in the psychology of the case” of the entrepreneurs, when the uncertainties “do not relate to objective external probabilities, but to the value of the judgment and executive powers of the person taking the chance.” The entrepreneurs may have “an irrational confidence in their own good fortune, and that is doubly true when their personal prowess comes into the reckoning, when they are betting on themselves.” They are “the class of men of whom these things are most strikingly true; they are not the critical and hesitant individuals, but rather those with restless energy, buoyant optimism, and large faith in things generally and themselves in particular.” This suggests that a kind of irrational faith is required for progress.

A former student of philosophy, Knight always was a very philosophical economist. On the last page of RU&P comes this true perspective on it all: “The fundamental fact about society as a going concern is that it is made of individuals who are born and die and give place to others; and the fundamental fact about modern civilization is that it is dependent upon the utilization of three great accumulating funds of inheritance from the past, material goods and appliances, knowledge and skill, and morale. . . . Life must in some manner be carried forward to new individuals born devoid of all these things as older individuals pass out.” We need to be reminded of this as we in our turn strive to increase the great funds of inheritance for those who will carry on into the ever-uncertain future.

For it is as true now and going forward as when RU&P was published one hundred years ago that, as Knight wrote, “Uncertainty is one of the fundamental facts of life.”

Given Enough Time

Published in Barron’s.

Randall W. Forsyth distorts Murphy’s celebrated law with a truncated version of it, writing “whatever can go wrong, will” (“Sometimes Things Can Go Right—and a Lot Did for the Stock Market Last Week,” Up & Down Wall Street, Oct. 11).

Although a common misquotation, this is an incomplete version. The full, correct, and much subtler statement of Murphy’s Law is, “Whatever can go wrong, will go wrong, given enough time.” It is with enough time that structural flaws in a system will necessarily emerge, and that financial vulnerabilities will burst from potential dangers to an actual bust. As properly stated, Murphy’s Law will doubtless prevail once again in finance, as in other domains.

Surprised again

Published by the Housing Finance International Journal.

“Why We’re Always Surprised” is the subtitle of my book, Finance and Philosophy. The reason we are so often surprised by financial developments, I argue in the book, is that “The financial future is marked by fundamental uncertainty. This means we not only do not know the financial future, but cannot know it, and that this limitation of knowledge is ineluctable for everybody.” That certainly includes me!

At the end of last year (in December 2018), interest rates had been rising, and it seemed obvious that they would likely rise to a normal level, at last adjusting out of the abnormally low levels to which central banks had pushed them in reaction to the financial crisis. The crisis began in 2007 with the collapse of the subprime lending sector in the United States and of the Northern Rock bank in the United Kingdom, and ran to 2012, which saw the trough of U.S. house prices and settlement of defaulted Greek sovereign debt at 25 cents on the dollar.

Six years had gone by since then, it seemed that it was high time for normalization. This view was shared during 2018 by the chairman of the Federal Reserve Board and its Open Market Committee. It also seemed that the long period of imposing negative real interest rates on savers, thus transferring wealth from savers to leveraged speculators and other borrowers, needed to end.

What would “normal” be? I thought a normal rate for the 10-year U.S. Treasury note would be about 4 percent and correspondingly for a 30-year U.S. fixed-rate mortgage loan about 6 percent, assuming inflation ran at about 2 percent. I still think those would be normal rates. But obviously, it is not where we are going at this point.

For the final 2018 issue of Housing Finance International, I wrote, “The most important thing about U.S. housing finance is that long-term interest rates are rising.” Surprise! Long-term interest rates have fallen dramatically. The United States does not have the negative interest rates, once considered impossible by many economists, which have become so prevalent in Europe, remarkably spreading in some cases to deposits and even mortgage loans. But the United States does have negative rates in inflation-adjusted terms. The 10-year U.S. Treasury note is, as I write, yielding about 1.5 percent. The year-over-year consumer price index is up 1.8 percent, and “core inflation” running at 2.2 percent, so the investor gets a negative real yield once again, savers are again having their assets effectively expropriated, and we can once again wonder how long this can continue.

What do the new, super-low interest rates mean for U.S. housing finance?

The higher U.S. mortgage loan rates, which reached almost 5 percent for the typical U.S. 30-year fixed-rate loan in late 2018, “would have serious downward implications for the elevated level of U.S. house prices, which already stress buyers’ affordability,” I wrote then. Had those levels been maintained, they definitely would have put downward pressure on prices. But as of now, seven years after the 2012 bottom in house prices, the U.S. long-term mortgage borrowing rate has dropped again to about 3.8 percent. This has set off another American mortgage refinancing cycle and is helping house prices to continue upward.

In the U.S. system, getting a new fixed-rate mortgage to refinance the old one is an expensive transaction for the borrower, with fees and costs which must be weighed against the future savings on interest payments. The fees depend on state laws and regulations; they range among the various states from about $1,900 on the low end to almost $6,900 on the high end, according to recent estimates. On the lender side, the post-crisis increases in regulatory burden had raised the lenders’ cost to originate a mortgage loan to as much as $9,000 per loan – the increased volume from “refis” (as we say) may have reduced this average cost to the lender to about $7,500. It is expensive to move all the paper the American housing finance system requires in order for the borrower to obtain a lower interest rate.

Meanwhile, with the new low interest rates and high house prices, “cash out refis” are again becoming more popular. In these transactions, not only do borrowers increase their debt by borrowing more than they owe on the old mortgage loan, but they reset their amortization of the principal further out to a new 30-year schedule. In both ways, they reduce the buildup of equity in their house, making it more likely that they will still have mortgage debt to pay during their retirement.

In general, there are no mortgage prepayment fees in the United States. The old, higher rate loans are simply settled at par. This continues to make prices of mortgage securities in the U.S. system very sensitive to changes in expected prepayment rates. If investors have bought mortgage loans at a premium to par, which they often do, upon prepayment they have lost and must write off any unamortized premiums they paid.

The most notable American investor in mortgage securities is the central bank, the Federal Reserve. As of Aug. 21, 2019, it had on its books $115 billion (with a B) of unamortized premium, net of unamortized discounts. Not all of this may be for its $1.5 trillion mortgage portfolio; still, a refi boom might be expensive for the Fed.

Speaking of the Federal Reserve, then-Chairman Ben Bernanke wrote in 2010 about his bond buying or “quantitative easing” programs: “Lower mortgage rates will make housing more affordable and allow more homeowners to refinance.” The latter effect of promoting refis is always true, but not the former claim of improved affordability. It ceases to be true when low mortgage rates have induced great increases in house prices, as they have. The high prices obviously make houses less affordable, and obviously mean that more debt is required to buy the same house, often with higher leverage – notably higher debt service-to-income ratios.

U.S. house prices are now significantly above where they were at the peak of the housing bubble in 2006. They have risen since 2012 far more rapidly than average incomes. The Fed’s strategy to induce asset price inflation has succeeded in reducing affordability.

According to the Federal Housing Finance Board’s House Price Index, U.S. house prices increased another 5 percent year-over-year for the second quarter of 2019. “House prices rose in all 50 states…and all 100 of the largest metropolitan areas,” it reports. Its house price index has now gone up for 32 consecutive quarters.

The S&P Case-Shiller National House Price Index has just reported a somewhat lower rate of increase, with house prices on average up 3.1 percent for the year ending in June. There is art as well as science in these indexes – the FHFA’s index notably does not include the very high (“jumbo,” in American terms) end of the market. According to Case-Shiller, in some particularly expensive cities, house price appreciation has distinctly moderated, with year-over-year increases of 1.1 percent for New York, 0.7 percent for San Francisco, and negative 1.3 percent for Seattle.

The AEI Housing Center of the American Enterprise Institute has house price indexes that very usefully divide the market into four price tiers. It finds that at the high end of the market, the rate of increase in prices is now falling, while the most rapid increases are in the lowest-priced houses – just where affordability and high leverage are the biggest issues, and where the U.S. government’s subprime lender, the Federal Housing Administration, is most active.

On a longer-term view, Case-Shiller reports that national U.S. house prices are 57 percent over their 2012 trough, and 14 percent over their bubble peak. When U.S. interest rates rise again, whether to normal levels or something else, these prices are vulnerable. How much might they fall? That may be another surprise.

What Does the Fed Know that Nobody Else Knows?

Published in Law & Liberty and in the Federalist Society.

When it comes to the financial and economic future, everybody is myopic. Nobody can see clearly. That includes the Federal Reserve.

As François Villeroy de Galhau, the Governor of the Bank of France, recently said in a brilliant talk, central banks are subject to four uncertainties. These are, in my paraphrased summary:  

1) They don’t really know where we are.

2) They don’t know where we are going.

3) They are affected by what other people are going to do, but don’t know what others will do.

4) They know there are underlying structural changes going on, but don’t know what they are or what effects they will have.  

Yet it appears that central banks usually feel the urge to pretend to know more than they can, in order to inspire “confidence” in themselves, and to try to manage expectations, while they go on making judgments subject to a lot of uncertainty, otherwise known as guesses.

A refreshing exception to this pretense was the speech Federal Reserve Chairman Jerome Powell gave in last August at the annual Jackson Hole symposium, 2018. He reviewed three key “stars” in monetary policy models: u* (“u-star),” r* (“r-star”) and ϖ (“pi-star,”), which are respectively the “natural rate of unemployment,” the “neutral rate of interest,” and the right rate of inflation.  None of these are observable and all are of necessity theoretical, so in a clever metaphor, Powell candidly pointed out that these supposedly navigational stars are actually “shifting stars.” Bravo, Mr. Chairman!

Let’s consider this question: What does the Fed know that nobody else knows? Nothing.

Can the Fed know what the right rate of inflation is? No. Of course, it can guess. It can set a “target” of steady depreciation of the dollar at 2% per year in perpetuity. Can it know what the long-term results of this strategy will be? No.

Moreover, nobody knows or can know what the right interest rate is. That includes the Fed (and the President). Interest rates are prices, and government committees, like the Federal Open Market Committee, cannot know what prices should be. That (among many other reasons) is why we have markets.

The Wall Street Journal recently published an article by James Mackintosh, “Fed Is Shifting the Goal Posts, and Investors Should Care.” With shifting goalposts or shifting stars, the Fed cannot know where they should be, but investors should and do indeed care very much about what the Fed thinks and does.

This is because, as we all know, the Fed’s actions or inaction, and also, financial actors’ beliefs about future Fed actions or inaction, can and do move prices of stocks and bonds substantially. Indeed, the more financial actors believe that Fed actions will move asset prices, the more it will be true that they do.

Mackintosh discusses whether the Fed’s inflation target will become “symmetric”—that is, the target would change into an average of periods both over it and under it, rather than a simple goal. Thus, sometimes “inflation above 2% is as acceptable as inflation below 2%.” Ah, the old temptation of governments to further depreciate the currency never fades for long.

“Goldman Sachs thinks the emphasis on symmetry in the inflation target is already influencing long-dated bonds,” the article reports, and opines that the change could have “big implications for markets,” that is, for asset prices. That seems right.

But the 2 percent inflation, whether as an average or as a simple goal, “isn’t up for debate.” Why not? The Humphrey-Hawkins Act of 1978, the same act that gave the Fed the so-called “dual mandate” which it endlessly cites, also set a long-term goal of zero inflation. What does the Fed think about that provision of the laws of the United States?

A true sound money regime has goods and services prices which average about flat over the long term. But being prices, they do fluctuate around their stable trend. The Fed, like other central banks, is in contrast committed to prices which rise always and forever. Discussing which of these two regimes we should want would focus consideration on where the goalposts should be.

Mackintosh worries that there may be a “loss of faith in the Fed’s ability.” On the contrary, I think a lack of faith in the Fed’s ability is rational, desirable, and wise.

In Finance, the Blind Spots Will Always Be With You

Published in Law & Liberty.

“Where are our blind spots?” is an excellent question to ask about systemic risk, one I recently was asked to speak on at the U.S. Treasury. Naturally, we don’t know where the blind spots are, but they are assuredly there, and there will always be darkness when it comes to the financial future.

Finance and Politics

The first reason is that all finance is intertwined with politics. Banking scholar Charles Calomiris concludes that every banking system is a deal between the politicians and the bankers. This is so true. As far as banking and finance go, the 19th century had a better name for what we call “economics”—they called it “political economy.”

There will always be political bind spots—risk issues too politically sensitive to address, or which conflict with the desire of politicians to direct credit to favored borrowers. This is notably the case with housing finance and sovereign debt.

The fatal flaw of the Financial Stability Oversight Council (FSOC) is that being part of the government, lodged right here in the Treasury Department, it is unable to address the risks and systemic risks created by the government itself—and the government, including its central bank—is a huge creator of systemic financial risk.

For example, consider “Systemically Important Financial Institutions” or SIFIs. It is obvious to anyone who thinks about it for at least a minute that the government mortgage institutions Fannie Mae and Freddie Mac are SIFIs. If they are not SIFIs, then no one in the world is a SIFI. Yet FSOC has not designated them as such. Why not? Of course the answer is contained in one word: politics.

A further political problem with systemic financial risk is that governments, including their central banks, are always tempted to lie, and often do, when problems are mounting. The reason is that they are afraid that if they tell the truth, they may themselves set off the financial panic they fear and wish at all costs to avoid. As Jean-Claude Juncker of the European Union so frankly said about financial crises, “When it becomes serious, you have to lie.”

Uncertainty and the Unknowable

We often consider “known unknowns” and “unknown unknowns.” Far more interesting and important are “unknowable unknowns.” For the financial future is inherently not only unknown but unknowable: in other words, it is marked by fundamental and ineradicable uncertainty. Uncertainty is far more difficult to deal with and much more intellectually interesting than risk. I remind you that, as famously discussed by Frank Knight, risk means you do not know what the outcome will be, but you do know the odds; while uncertainty means that you do not even know the odds, and moreover you cannot know them. Of course, you can make your best guess at odds, so you can run your models, but that doesn’t mean that you know them.

Needless to say, prices and the ability of prices to change are central to all markets and to the amazing productivity of the market economy.

But a price has no sustainable existence. As we know so well with asset prices in particular, the last price, or even all the former prices together, do not tell you what the next price will be.

With housing finance audiences, I like to illustrate the risk problem with the following question: What is the collateral for a mortgage loan? Most people say, “The house, of course.” That is wrong. The right answer is that it is the price of the house. In the case of the borrower’s default, it is only through the price of the house that the lender can collect anything.

The next question is: How much can a price change? Here the answer is: More than you think. It can go up more in a boom, and down a lot more in a bust than you ever imagined.

One key factor always influencing current asset prices is the expectation of what the future prices will be, and that expectation is influenced by what the recent behavior of the prices has been. Here is an important and unavoidable recursiveness or self-reference, and we know that self-reference generates paradoxes. For example, the more people believe that house prices will always rise, the more certain it is that they will fall. The more people believe that they cannot fall very much, the more likely it is that they will fall a lot.

The Nature of Financial Reality

Financial reality is a fascinating kind of reality. It is not mechanical; it is inherently uncertain, not only risky; it is not organic; it is full of interacting feedback relationships, thus recursive or reflexive (to use George Soros’ term); unlike physics, it does not lend itself to precise mathematical predictions.

Therefore we observe everybody’s failure to consistently predict the financial future with success. This failure is not a matter of intelligence or education or diligence. Hundreds of Ph.D. economists armed with all the computers they want do not succeed.

The problem is not the quality of the minds that are trying to know the financial future, but of the strange nature of the thing they are trying to know.

Another troublesome aspect of financial reality is its recurring discontinuous behavior. “Soft landings” are continuous, but “hard landings” are discontinuous. Finance has plenty of hard landings.

From this odd nature of financial reality there follows a hugely important conclusion: Everybody is inside the recursive set of interacting strategies and actions. No one is outside it, let alone above it, looking down with celestial perspective. The regulators, central bankers and risk oversight committees are all inside the interactions along with everybody else, contributing to the uncertainty. Their own actions generate unforeseen combinations of changes in the expectations and strategies of other actors, so they cannot know what the results of their actions will be.

Another way to say this is that there are no financial philosopher-kings and there can never be any, in central banks or anywhere else. No artificial intelligence system can ever be a philosopher-king either.

Odin’s Sight

We can conclude that blind spots are inevitable, because of politics, and because of the unknowability of the outcomes of reflexive, expectational, interacting, feedback-rich combinations of strategies and actions.

I will close with a story of Odin, the king of the Norse gods. Odin was worried about the looming final battle with the giants, the destruction of Valhalla, and the twilight of the gods. Of course he wanted to prevent it, and he heard that the King of the Trolls had the secret of how to do so. Searching out this king by a deep pool in a dark forest, he asked for the secret. “Such a great secret has a very high price,” the troll replied, “one of your eyes.” Odin considered what was at stake, and decided to pluck out one of his eyes, which he handed over.

“The secret is,” said the King of the Trolls, “Watch with both eyes!”

When it comes to seeing the financial future, like Odin, we have to keep doing our best to watch with both eyes, even though we have only one.

Predicting is hard…

Published by the R Street Institute.

From Reuters, on June 27, 2017:

U.S. Federal Reserve Chair Janet Yellen said on Tuesday that she does not believe there will be another financial crisis for at least as long as she lives.

From CNBC, on Dec. 11, 2018:

There could be another financial crisis on the horizon, warned former Federal Reserve Chair Janet Yellen in a speech Monday night.

The financial future is murky, but one of these predictions will be right.

Who is the boss when it comes to Federal Reserve and Congress?

Published in The Hill.

In January 2008, Federal Reserve Chairman Ben Bernanke made this memorable announcement: “The Federal Reserve is not currently forecasting a recession.” This was a poor forecast indeed, since as we now know, a very deep and painful recession had already started by the time of this prediction that there would not be one.

But this is only one of many such errors. If you have the unrealistic belief that the Fed should somehow manage the economy, banking system, stock market, financial stability, interest rates, employment, inflation and risks, you run into a granite wall of a knowledge problem. The Fed does not know and cannot know enough to do all this.

The simple fact is that the economic and financial future of this great nation is not only unknown, but unknowable, for the Fed as it is for everybody else. It is not that our central bank is any worse than anybody else at knowing the future, including what the results of its own actions will be, but the Fed is just not any better than anybody else.

Yet, the Fed keeps insisting and has enshrined as part of its own confession of faith that it ought to be “independent” as an immensely powerful fiefdom answerable only to its own theories. Should the Fed be independent of Congress? Given the inherent human will to power, naturally those leading the central bank would like to be.

This desire to act as independent economic philosopher kings could be justified by a claim to superior knowledge. But the Fed demonstrably does not have such superior knowledge. Still, we cannot avoid observing that there is a strange and quite common faith in the Fed. For example, it is endlessly repeated in the media that an inflation rate of 2 percent a year must be good because that is the Fed target, apparently without wondering whether this target is a good idea or not.

Of course, some people have more skeptically considered the 2 percent question. Olivier Blanchard, formerly the chief economist of the International Monetary Fund, has stated, “There is no sound economic research that shows 2 percent to be the economically optimal inflation rate.” He was arguing for higher inflation. On the other hand, Alan Greenspan, when asked what the right inflation target was, said “zero” and added “if measured correctly,” a wonderfully famous hedge.

A remarkable thing about the current idea of a Fed inflation target is that it is a target in perpetuity at 2 percent a year forever. To commit for 2 percent a year forever means that in an expected lifetime of 82 years, average prices will quintuple. With a straight face, the Fed informs us that this is “price stability.” Should Congress have anything to say about whether it wants inflation of 2 percent a year forever?

The Fed often states that “price stability” is part of its statutory “dual mandate.” The reference is to the Federal Reserve Reform Act of 1977. But this law does not say “price stability.” It says “stable prices.” It does in particular not say a “stable rate of inflation.” It says “stable prices.” Does the term “stable prices” mean perpetual inflation? What did Congress mean by “stable prices” when it put that term into law?

We learn from the minutes of the Federal Open Market Committee that in 1996, when the Fed was discussing whether it should have an inflation target, one member of the committee dared to ask what Congress meant by the statutory language. This question was quickly passed over and not pursued. But it was a good question, was it not?

In fact, we have a good indication of what Congress meant by “stable prices.” The very next year, in the Humphrey Hawkins Act of 1978, Congress provided the “goal of achieving by 1988 a rate of inflation of zero.” Obviously, this was not achieved and somehow, we never hear the Fed discussing this goal as expressed in statute.

Bernanke advised Janet Yellen, his successor as head of the central bank, to remember that “Congress is our boss.” But does the Fed and those who work there really believe that Congress should be the boss? That these mere politicians, elected by the American people, should be in charge of the powerful economic and financial experts of the Fed?

William Proxmire, a former senator from Wisconsin, once put the case for Congress pretty bluntly in a hearing. He stated, “You recognize, I take it, that the Federal Reserve Board is a creature of Congress?” and “Congress can create it, abolish it, and so forth?” While that is certainly true, but short of abolishing it, what steps can be taken for greater accountability and more effective legislative governance of the Fed?

It seems the best model might be to think of Congress as the board of directors and Federal Reserve officers as the management of government operations in money. With this model in mind, the relationship of the Fed and Congress should evolve into a grown up and real discussion of issues, alternatives, strategies and risks. That would be quite a contrast to the media event that Fed testimony now represents.

Such discussions might even include the Fed asking Congress what it means by “stable prices” as a goal. Of course, the Fed could lay out all its arguments for 2 percent inflation and its thoughts on alternatives for legislative consideration. Can you imagine that? Perhaps you cannot, but as the long history of the Fed demonstrates, many things that were previously unimaginable nevertheless came to pass.

Gold: An especially bad prediction

Published by the R Street Institute.

The history of finance and economics is full of utterly wrong predictions. This should, but doesn’t, teach us intellectual humility when it comes to pontificating about the future. Here is a memorable one, worthy of special mention in the all-time worst financial predictions list:

When the U.S. government stops wasting our resources by trying to maintain the price of gold, its price will sink…to $6 an ounce rather than the current $35 an ounce.

–Henry Ruess, chairman of the Joint Economic Committee of the U.S. Congress, 1967*

In the 1960s, pace Chairman Ruess, the U.S. government was not trying to hold up the price of gold, but to hold up the price of its dollar; that is, to hold down the price of gold. In this effort, it admitted complete defeat in 1971 by reneging on its Bretton-Woods commitments.

The price of gold today is $1,291 an ounce. It is equally true to say that the price of the dollar is 1/1,291 of an ounce of gold, as compared to the official price in Ruess’ day of 1/35 of an ounce.

__________________

*Thanks to investor-philosopher David Kotok of Cumberland Advisors for this instructive quotation.

What’s in a name of a Banking Committee?

Published by the R Street Institute.

Adair Turner, whose insights into finance among other contributions got him promoted to Lord Turner, has concluded that lending on housing and other real estate is by far the largest creator of systemic financial risk and banking busts. This conclusion is clearly correct. Among the principal recommendations of his highly interesting 2016 book, Between Debt and the Devil, is that governments must therefore work to constrain banks’ real estate loans and act to limit their recurring tendency to expand into booms and bubbles.

This is precisely the opposite of the historical policy of the American government, which has usually been to enthusiastically promote the inflation of housing credit and denounce the ensuing busts.  Currently, the U.S. government guarantees about 60% of all outstanding mortgage loans and its central bank has created money to the tune of $1.8 trillion to inject into housing finance.

In this context, we reflect on the highly suggestive symbolic shifts in the names of the Congressional committees with jurisdiction over banking.

From 1913, when it was formed, to 1971, the relevant committee of the U.S. Senate was named the Committee on Banking and Currency—a logical and consistent name.  In 1971, the name was changed to the Committee on Banking, Housing, and Urban Affairs—a very different combination of ideas, displaying interest in very different political constituencies. Shortly before, the Congress had restructured Fannie Mae into a government-sponsored housing finance enterprise, and created another one in Freddie Mac, both actions with momentous but unintended future results.

The Committee on Banking, Housing, and Urban Affairs the Senate committee remains.  This displays, as Lord Turner’s view suggests, an overemphasis on housing.  And “Urban Affairs”? The name change is strikingly supportive of Charles Calomiris’ theory that the dominant coalition in U.S. banking politics shifted in the latter 20th century from an alliance of small banks and rural populists, to one of big banks and urban populists.

The relevant committee in the U.S. House of Representatives for 110 years, starting in 1865, had the same historical name: the Committee on Banking and Currency.  In 1975, this was changed to the Committee on Banking, Currency, and Housing.  Promoting housing finance was gaining focus.  Then in 1977, the name became the Committee on Banking, Finance and Urban Affairs.  “Currency” had lost out.  This was during the 1970s, a decade of runaway consumer price inflation, in which an emphasis on controlling the currency might have been useful.  As in the Senate, “Urban Affairs” represented important Democratic Party constituencies and accompanied the government promotion of expanding housing finance.

The House committee’s name changed in the opposite direction in 1995, with a Republican Party majority in the House for the first time in four decades, mostly maintained since then.  It became the Committee on Banking and Financial Services, then in 2001, simply the Committee on Financial Services.  The new name reflected the committee’s greatly expanded jurisdiction, most notably to include the securities industry.  In recent years, this committee has been the Congressional center of trying to reform housing finance along market lines, and in particular, to reform Fannie Mae and Freddie Mac.  These efforts have yet to succeed, unfortunately.

“What’s in a name?”  Nothing, as Shakespeare makes Juliet argue?  Or, over the last several decades, would committees which focused on “banking and currency” have behaved differently from ones diligently expanding their banking interventions to include “housing and urban affairs”?

Economic crises are invariably failures of the imagination

Published in Real Clear Markets.

A fundamental issue in all risk management is oversight vs. seeing.  You can be doing plenty of oversight, analysis, regulation and compliance, with much diligence and having checkers check on checkers, but is the whole process able to envision the deep and surprising risks that are the true fault lines under your feet?  Or are you only analyzing, regulating, writing up and color coding dozens of factors which while important, are not the big risk which is going to take you and perhaps the system of which you are a part, down?  For example, in the midst of your risk management oversight efforts, whether as a company or as the government, could you see in 2005 or 2006, or at the latest by 2007, that U.S. average house prices across the whole country, were likely to drop like a stone?  And see what would happen then?

Most people, including the most intelligent, experienced and informed, could not.

Former Treasury Secretary Timothy Geithner, in his memoir of the 2007-2009 financial crisis, Stress Test (2014), draws this essential conclusion: “Our crisis, after all, was largely a failure of imagination. Every crisis is.” If you can’t imagine it, if you consider that the deep risk event is unimaginable or impossible, your oversight will not see the risk. “For all our concern about ‘froth’,” Geithner continues, “we didn’t foresee how a nationwide decline in home prices could induce panic in the financial system.”

This is a profoundly important insight.  Geithner expands on it: “Our failures of foresight were primarily failures of imagination, like the failure to foresee terrorists flying planes into buildings before September 11.  But severe financial crises had happened for centuries in multiple countries, in many shapes and forms, always with pretty bad outcomes.  For all my talk about tail risk, negative extremes, and stress scenarios, our visions of darkness still weren’t dark enough.”

That was not for lack of effort, but for lack of seeing.  “The actual main failing was over-reliance on formal econometric models,” banking scholar Charles Goodhart suggests in his acute essay, “Central bank evolution: lessons learnt from the sub-prime crisis” (2016).  He points out that as the housing bubble was inflating, there was copious housing finance data which could be and was analyzed:

“There were excellent monthly data on virtually all aspects of mortgage finance in the USA starting from the 1950s.  By the 2000s such data provided over 50 years of all aspects of US mortgage finance.  During this period, there had only been a very few months in which the value of houses, and the mortgages related to them, of a regionally diversified portfolio of housing assets over the US as a whole had faced a loss, and then only a very small one.

“While there had been sharp declines in housing valuations in certain specific regions, i.e. the North East in 1991-2, the oil producing states in the mid-1980s, etc., a regionally diversified portfolio virtually never showed a loss, and then only a minor one, over these 50 years.”  The conclusion seemed clear enough at the time: house prices did not, so would not, fall on a national average basis.  A portfolio of mortgages diversified across regions would be protected.  “Virtually everyone was sucked into the general conventional wisdom that housing prices”—on average—“were almost sure to continue trending generally upwards.”

This clear, though in retrospect completely wrong, conclusion could be professionally quantified: “Put those data into a regression analysis, and then what you will get out is an estimate that any loss of value in a regionally diversified portfolio of greater than about three or four percent would be…highly improbable.”  But as the bubble got maximally inflated, its shriveling became highly probable instead of improbable.  As we know, average U.S, house prices went down by 27% and fell not for a few months, but for six years, in spite of all kinds of government interventions.  The housing market went down for longer than a great many people could stay solvent.

“Of course,” Goodhart reminds us, “econometric regressions are based on the implicit assumption that the future will be like the past.” The less of the past we know, the worse an assumption this is. In this case, fifty years and one country, even a very big country, were not enough.

To expand how much of the past we have studied, both in terms of more time and more places, is perhaps one way to improve our ability to see risks, imagine otherwise unimaginable outcomes, and thus improve our risk oversight.  Perhaps.  There are no guarantees of success.

Who is this ‘we’ that should manage the economy?

Published in Law & Liberty.

Adair Turner, the former Chairman of the British Financial Services Authority, has written a book about the risks and unpredictability of financial markets which has many provocative insights. It also has a frustrating blind spot about how government actions can and do contribute to financial crises.

Turner clearly addresses the failure of governments to understand what was going on as the crises of the 2000’s approached, including his notable mea culpa discussed below. But there is no discussion anywhere of the culpability of government actions which greatly contributed to inflating the bubble of housing debt and pumping up leverage on the road to the U.S. housing finance collapse.

The fateful history of Fannie Mae and Freddie Mac is not discussed, even though Turner rightly emphasizes how dangerous leveraged real estate is as a key source of financial fragility. Fannie and Freddie, with $5 trillion in real estate risk, do not rate an entry in the index.

The problems of student debt make it into a footnote in chapter six, where its rapid growth in the United States is observed, along with the judgment that “much of it will prove unpayable,” but it is not mentioned that this is another government loan program.

The role of government deposit insurance in distorting credit markets, so notable in the U.S. savings and loan collapse of the 1980s, is not considered. That instructive collapse gets one passing sentence.

The Federal Reserve, along with other central banks, created the Great Inflation of the 1970s that led to the disastrous financial crises of the 1980’s. Seeking a house price boom and a “wealth effect” in the 2000’s, the Federal Reserve promoted what turned out to be a house price bubble. Turner provides no proposals about how to control the obvious dangers of central banks, although he does point out their mistake in thinking that they had created a so-called “Great Moderation.” That turned out to have been instead a Great Overleveraging.

There can be no doubt of Turner’s high intelligence, as his double first in history and economics at Cambridge and his stellar career, leading to his becoming Lord Turner, attest. But as an old banking boss of mine memorably observed, “it is easier to be brilliant than right.”

This universal principle applies as well to leading central bankers, regulators, and government officials of all kinds as it does to private actors. The bankers “that made big mistakes,” Turner correctly says, “did not consciously seek to take risks, get paid, and get out: they honestly but wrongly believed that they were serving their shareholders’ interests.”  So also for the authors of mistaken government actions: they didn’t intend to make mistakes, but wrongly believed they were serving the public interest.

When former Congressman Barney Frank, for example, the “Frank” of the bureaucracy-loving Dodd-Frank Act, said before the crisis said that he wanted to “load the dice” with Fannie and Freddie, he never intended for the dice to come up snake eyes, but they did. Throughout the book, Turner displays the tendency to assume the consequences of government action to be knowable and benign, rather than unknowable and often perverse.

Debt and the Devil opens with the remarkable confession of government ignorance shown in the following excerpts.  As he became Chairman of the Financial Services Authority in 2008, Turner relates:

“I had no idea we were on the verge of disaster.”

“Nor did almost everyone in the central banks, regulators, or finance ministries, nor in financial markets or major economics departments.”

“Neither official commentators nor financial markets anticipated how deep and long lasting would be the post-crisis recession.”

“Almost nobody foresaw that interest rates in major advanced countries would stay close to zero for at least 6 [now it’s 8] years.”

“Almost no one predicted that the Eurozone would suffer a severe crisis.”  (That crisis featured defaults on government debt.)

“I held no official policy role before the crisis.  But if I had, I would have made the same errors.”

If governments, their regulators, and their central banks cannot understand what is happening and the real risks are, then it is easy to see why their actions may be unsuccessful and indeed generate perverse results.  So we have to amend some of Turner’s conclusions, to make his partial insights more complete.

“Central banks and regulators alone cannot make the financial system and economies stable,” he says.  True, but we must add:  but they can make financial systems and economies unstable by monetary and credit distortions.

We are “faced with a free market bias toward real estate lending” needs additionally: and an even bigger government bias and government promotion of real estate lending.

Turner quotes Charles Kindleberger approvingly: “The central question is whether central banks can contain the instability of credit and slow speculation.” This needs a matching observation:  The central question is whether central banks can hype the instability of credit and accelerate speculation. They can.

“Banking systems left to themselves are bound to create too much of the wrong sort of debt” needs amendment:  Banking systems pushed by governments to expand risky loans to favored political constituencies are bound to create too much of the wrong sort of debt, which will lead to large losses.  This will be cheered by the government until it is condemned.

“At the core of financial instability in advanced economies lies the interaction between the potentially limitless supply of bank credit and the highly inelastic supply of real estate.” Insightful, but incomplete.  Here is the complete thought: At the core of financial instability lies the interaction between the potentially limitless supply of the punchbowl of central bank credit, bank credit, government guarantees of real estate credit, and the inelastic supply of real estate.

“Private credit creation is inherently unstable.” Here the full thought needs to be: Private and government credit creation is inherently unstable. Indeed, Turner supplies a good example of the latter: Japanese government debt has become so large relative to the Japanese economy that it “will simply not be repaid in the normal sense of the word.”

According to Turner, what is to be done?  He supplies a deus ex machina: “We.” So he asserts that “We need to manage the quantity and influence the allocation of credit,” and “We must influence the allocation of credit among alternate uses,” and “We must therefore deliberately manage and constrain lending against real estate assets.” Who is this “We”?  Lord Turner and his friends?  There is no “We” who know how credit should be allocated.

In an overall view, Turner concludes that “All complex systems are potentially unstable,” and that is true. But it must be understood that the complex system of finance includes inside itself all the governments, central banks, regulators and politicians, as well as all the private financial actors. Everybody is inside the system; nobody is outside the system, let alone above the system, looking down with ethereal perspective and the ability to manage everything. In particular, there is no “We” outside the complex system.  “We,” whoever they may be, are inside the complex system with its inherent uncertainty and instability, along with everybody else.

Economics and politics are always mixed together

Published in the Financial Times.

Sir, Mark Hudson (Letters, Oct. 3) is certainly correct that “economics is not a science.” Nothing could be clearer than that! But he exaggerates in asserting that economics is “a subsidiary branch of politics.” Rather, economics and politics are in actual experience always mixed together. The old term “political economy” captures the reality nicely.

Mr. Hudson is also right that the tenets of political economy are inevitably based on some psychological generalisation — going back to Chapter 2 of The Wealth of Nations and “a certain propensity in human nature . . . to truck, barter, and exchange.” For this propensity, we should be ever grateful.

Data transparency and multiple perspectives

Published in Data Coalition.

One question underlying the very interesting data project and proposed legislation we are considering today is the relationship of data transparency to multiple perspectives on financial reality. In a minute, we will take up the question: Of all the possible views of a statue, which is the true view?

But first, let me say what a pleasure it is to participate in these discussions of financial transparency; the new Financial Transparency Act, a bill introduced in Congress last night; data standardization; and of course, greater efficiency— we are all for making reporting and compliance less costly.

Let me add to this list the separation of data and analysis, or what we may call the multiplication of perspectives on the financial object. The potential separation of data and analysis may allow a richer and more varied analysis and deeper understanding, in addition to greater efficiency, in both government and business.

As the new white paper “Standard Business Reporting,” by the Data Foundation and PricewaterhouseCoopers, says: “By eliminating documents and PDFs from their intake, and replacing document-based reporting with open data…agencies…gained the ability to deploy analytics without any translation.” Further, that standardized data “will allow individuals to focus on analytics and spend time understanding the data.”

In historical contrast to these ideas, it is easy for me to remember when we couldn’t do anything like that. When I was a young international banking officer working in Germany, one day—4,000 miles to the west, back in the Chicago headquarters—the head of the international banking department had lunch with the chairman of the board. Picture the chairman’s elegant private dining room, with china, silver and obsequious service. In the course of the lunch, the chairman asked: “For our large customers, can we see in one place all the credit exposure we have to them in different places around the world?” Said the executive vice president of international banking: “Of course we can!”

The next day, all over the world, junior people like me were busy with yellow pads and calculators, wildly working to add up all the credit exposure grouped into corporate families, so those papers could be sent to somebody else to aggregate further until ultimately they all were added up for the chairman.

That was definitely not data independent of documents. Imagine the high probability, or rather the certainty, of error in all those manually prepared pages.

A classic problem in the philosophical theory of knowledge turns out to be highly relevant to the issues of data transparency. It is the difference between the real object, the “thing in itself,” and any particular representation or perspective on it. In philosophical terms, the object is different from any particular perspective on it, but we can only perceive it or think about it or analyze it from particular perspectives.

Likewise, a reporting document is a composite of the data—the thing—and some theory or perspective on the data which form the questions the report is designed to pursue and answer.

Let’s consider a famous type of report: GAAP financial statements.

Somewhere far underneath all the high-level abstractions, reflecting many accounting theories, are the debits and credits, myriad of them doing a complex dance.

I think of my old, practical-minded instructor in Accounting 101. This essential subject I studied in night school when I was a trainee in the bank. I would ride the Chicago “L” train to my class, my feet freezing from the cold draft blowing under the doors. But this lesson got burned into my mind: “If you don’t know what to debit and what to credit,” he said, “then you don’t understand the transaction from an accounting point of view.” This has always seemed to me exactly right.

Later on, in this spirit, I used to enjoy saying to accountants advising me on some accounting theory: “Just tell me what you are going to debit and what you are going to credit.” This usually surprised them!

I wonder how many of us here could even begin to pass my old accounting instructor’s test when considering, say, the consolidated financial statements of JPMorgan. What would you debit and credit to produce those?  Of course we don’t know.

For JPMorgan, and everybody else, the debits and credits are turned into financial statements by a very large set of elaborate theories and imposed perspectives. These are mandated by thousands of pages of Financial Accounting Standards pronounced by the Financial Accounting Standards Board. Many of these binding interpretations are highly debatable and subject to strongly held, inconsistent views among equally knowledgeable experts.

Any large regulatory report has the same character: it is a compound of data and theory.

An articulate recent letter to the editor of the Wall Street Journal argues that: “The CPA profession has made the accounting rules so convoluted that GAAP financials no longer tell you whether the company actually made money.” This, the letter continues, is “why companies are increasingly reporting non-GAAP. Investors are demanding this information. …Why should public companies not supply shareholders with the same metrics that the management uses?” Why not, indeed?

In other words, why not have multiple interpretative perspectives on the same data, instead of only one?  This is a fine example of the difference between one perspective—GAAP—and other possibly insightful perspectives on the same financial object. Why not have as many perspectives readily available as prove to be useful?

We are meeting today in Washington, D.C., a city full of equestrian statues of winning Civil War generals. (The losing side is naturally not represented.)  Think, for example, of the statues of General Grant or Sheridan or Sherman or Logan—all astride their steeds. Perhaps you can picture these heroic statues in imagination.

I like to ask people to consider this question:  What is the true view of a statue?  Is it the one from the front, the top, the side (which side?), or what?  Every view is a true view, but each is partial. Even the view of such an equestrian statue directly from behind—featuring the horse’s derriere—is one true view among others. It is not the most attractive one, perhaps, but it may make you think of some people you know.

Likewise, what is the true view of a company, a bank, a government agency, a regulated activity or a customer relationship?  Every document is one view.

Pondering this brings back a memory of my professor of 19th century German philosophy. “The object,” he proposed, “is the sum of all possible perspectives on it.”

Similarly, we may say that a financial structure or a policy problem or an entity or an activity is the sum of many perspectives on it. The ideal of open data available for multiple reports, analyses and purposes is a practical application of this metaphysical idea.

The ideal is not new. In 1975, I went to London to work on a project to define all the elements—what were supposed to become the standardized data—for characterizing all the bank’s corporate customer relationships. The computing technology expert leading the project convincingly explained how these data elements could then be combined and reordered into all the reports and analyses we would desire.

Then, as now, it was a great idea—but then it never actually happened. It was before its time in technical demands. But now I suspect the time has really come. Fortunately, since then, we have had four decades of Moore’s Law operating, so that our information capacities are more than astronomically expanded.

So:

• By freeing transparent, open data from being held captive in the dictated perspectives of thousands of reporting documents;

• By saving data from being lost in the muddle of mutually inconsistent documents;

• Can we provide transparent data, consistently defined, which will promote a wide variety of multiple perspectives to enrich our analysis and create new insights;

• Not to mention making the process a lot cheaper?

This would be a great outcome of the project under consideration in our discussions today.

Murphy’s Law and a banking career

Published by the R Street Institute.

Murphy’s law is well-known in the form: “Whatever can go wrong, will go wrong” and similar variations on the theme. But the intellectually interesting substance of Murphy’s law is:  “Whatever can go wrong, will go wrong, given enough time.”

When a financial calamity has a very small probability of occurring—let’s say a 1 percent chance that it will and 99 percent that it won’t in any given year—we tend not, as a practical matter, to worry about it much. In most years, nothing will happen, and when it hasn’t happened for a long time, we may even start to treat the risk as essentially zero. Professors Jack Guttentag and Richard Herring authored a classic paper that gave this tendency the provocative name “disaster myopia.”

Banking and finance are full of events with a very small expected probability, but which are very costly when they do happen – e.g., a financial crisis.

Suppose the chance of a financial crisis is 1 percent annually. Suppose you optimistically start your banking career at the age of 23 and work to age 68, by which time you will be seasoned and cynical. That will be 45 years. Because you have given it enough time, the probability that you will experience at least one crisis during your career grows from that 1 percent in your trainee year to a pretty big number: 36 percent.

We observe in the real world that financial crises occur pretty frequently—every decade or two—and that there are a lot of different countries where a financial crisis can start. We also observe that virtually no one—not central bankers, regulators, bankers, economists, stock brokers or anybody else—is good at predicting the financial future successfully. Do we really believe the risk management and credit screens of banks, regulators and central banks are as efficient enough to screen down to a 1 percent probability?  I don’t.

Suppose instead that the probability of the banking crisis is 2 percent, with 98 percent probability that it won’t happen in a given year. Are banks even that good?  How about 5 percent, with a 95 percent probability of not happening?  That would still feel pretty safe. One more dubious of the risk-management skills of bankers, regulators and the rest might guess the probability, in reality, is more like 10 percent, rather than 1 percent. Even then, in most years, nothing will happen.

How does our banker fare over 45 years with these alternate probabilities?  At 2 percent chance per-year, over 45 years, there is a 60 percent probability he will experience at least one crisis. At 5 percent, the probability becomes 90 percent of at least one crisis, with a 67 percent chance to see two or more. If it’s 10 percent, then over 45 years, the probability of experiencing at least one crisis is 99 percent, and the probability of experiencing at least two is 95 percent. Since we learn from troubles and failures, banking looks like it furnishes the probability of an educational career.

In the last 45 years, there have been financial crises in the 1970s, 1980s, 1990s and 2000s. In the 2010s, we have so far had a big sovereign default in Greece, set the record for a municipal insolvency with the City of Detroit, and then broke that record with the insolvency of Puerto Rico. And the decade is not over. All of these crises by decade have been included in my own career around banking systems, of now close to 48 often-eventful years. The first one—the Penn Central Railroad bankruptcy and the ensuing panic in the commercial paper market—occurred when I was a trainee.

Since 1982, on average, a little less than 1 percent of U.S. financial institutions failed per year, but in the aggregate, there were 3,464 failures. Failures are lumped together in crisis periods, while some periods are calm. There were zero failures in the years 2005-2006, just as the housing bubble was at its peak and the risks were at their maximum, and very few failures in 2003-2004, as the bubble dangerously inflated. Of course, every failure in any period was a crisis from the point of view of the careers of then-active managers and employees.

A further consideration is that the probability of a crisis does not stay the same over long periods—especially if there has not been a crisis for some time. As Guttentag and Herring pointed out, risks may come to be treated as if they were zero, which makes them increase a lot. The behavior induced by the years in which nothing happens makes the chance that something bad will happen go up. In a more complex calculation than ours, the probability of the event would rise over each period it doesn’t occur, thanks to human behavior.

But we don’t need that further complexity to see that, even with quite small and unchanging odds of crises, given enough time across a career, the probability that our banker will have one or more intense learning experiences is very high, just as Mr. Murphy suggests.

Risk doesn’t stand still

Published in Library Of Law And Liberty.

Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe explores the movement and transformation of risks in adapting, self-referencing systems, of which financial systems are a notable example. In this provocative new book, the Wall Street Journal’s chief economics commentator Greg Ip contemplates how actions to reduce and control risk are often discovered to have increased it in some other way, and thus, “how safety can be dangerous.”

This is an eclectic exploration of the theme, ranging over financial markets, forest fires, airline and automobile safety, bacterial adaptation to antibiotics, flood control, monetary policy and financial regulation. In every area, Ip shows the limits of human minds trying to anticipate the long-term consequences of decisions whose effects are entangled in complex systems.

In the early 2000s, the central bankers of the world congratulated themselves on their insight and talent for having achieved, as they thought, the Great Moderation. It turned out they didn’t know what they had really been doing, which was to preside over the Great Leveraging. Consequently, and much to their surprise, they found themselves in the Great Collapse of 2007 to 2009, and then, with no respite, in the European debt crisis of 2010 to 2012.

Ip begins his book two decades before that, in 1989, at a high-level conference on the topic of financial crises. (Personally I have been going to conferences on financial crises for 30 years.) He cites Hyman Minsky, who “for decades had flogged an iconoclastic theory of business cycles that fellow scholars had largely ignored.” Minsky’s theory is often summarized as “Stability creates instability”—that is, periods of safety induce the complacency and the mistakes that lead to the crisis. He was right, of course. Minsky (who was a good friend of mine) added something else essential: the rise of financial instability is endogenous, arising from within the financial system, not from some outside “shock.”

At the same conference, the famous former Federal Reserve Chairman Paul Volcker raised “the disturbing question” of whether governments and central banks “end up reinforcing the behavior patterns that aggravate the risk.” Foolproof shows that the answer is yes, they do.

Besides financial implosions, Ip reflects on a number of natural and engineering disasters, including flooding rivers, hurricane damage, nuclear reactor meltdowns, and forest fires, and concludes that in all of these situations, as well, measures were taken that made people feel safe, “and the feeling of safety allowed danger to re-emerge, often hidden from view.”

The natural and the man-made, the “forests, bacteria and economies” are all “irrepressibly adaptable,” he writes. “Every step we take to suppress the risks . . . will provoke some other, offsetting step.” So “neither the economy nor the natural world turned out to be as amenable to human management” as was believed.

As Velleius Paterculus observed in the history of Rome that he wrote circa 30 AD, “The most common beginning of disaster was a sense of security.”

Why are we like this? Ip demonstrates, for one thing, how quickly memories fade as new and unscarred generations arrive to create their own disasters. Nor is he himself immune to this trait, writing: “The years from 1982 to 2007 were uncommonly tranquil.”

Well, no.

In fact, the years between 1982 and 1992 brought one financial disaster after another. In that time more than 2,800 U.S. financial institutions failed, or on average more than 250 a year. It was a decade that saw a sovereign debt crisis; an oil bubble implosion; a farm credit crisis; the collapse of the savings and loan industry; the insolvency of the government deposit insurer of the savings and loans; and, to top it off, a huge commercial real estate bust. Not exactly “tranquil.” (As I wrote last year, “Don’t Forget the 1980s.”)

“Make the most of memory,” Ip advises. After the Exxon Valdez oil spill disaster, he says, the oil company “used the disaster to institute a culture of safety . . . designed to maintain the culture of safety and risk management even as memories of Valdez fade.”

We often do try to ensure that “this can never happen again.” After the 1980s, many intelligent and well-intentioned government officials went to work to enact regulatory safeguards. They didn’t work. As Arnold Kling pointed out in an insightful paper, “Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008,” some of the biggest reforms from the earlier time became central causes of the next crisis—a notable example of Ip’s conclusions.

We are forced to realize that the U.S. housing finance sector collapsed twice in three decades. We may ask ourselves, are we that incompetent?

Consider a financial system. The “system” is not just all the private financial actors—bankers, brokers, investors, borrowers, savers, traders, speculators, hucksters, rating agencies, entrepreneurs, principals and agents—but equally all the government actors—multiple legislatures and central banks, the treasuries and finance ministries who must constantly borrow, politicians with competing ambitions, all varieties of regulatory agencies and bureaucrats, government credit and subsidy programs, multilateral bodies. All are intertwined and all interacting with each other, all forming expectations of the others’ likely actions, all strategizing.

No one is outside the system; all are inside the system. Its complexity leaves the many and varied participants inescapably uncertain of the outcomes of their interactions.

Within the interacting system, a fundamental strategy, as Ip says, is “to do something risky, then transfer some of the risk to someone else.” This seems perfectly sensible—say, getting subsidized flood insurance for your house built too near the river, or selling your risky loans to somebody else. But “the belief that they are now safer encourages them to take more risk, and so the aggregate level of risk in the system goes up.”

“Or,” he continues, “it might cause the risky activity to migrate elsewhere.” Where will the risk migrate to? According to Stanton’s Law, which seems right to me, “Risk migrates to the hands least competent to manage it.” Risk “finds the vulnerabilities we missed,” Ip writes. This means we are always confronted with uncertainty about what unforeseen vulnerabilities the risk will find.

Finally, the author puts all of this in a wider perspective. “My story, however, is not about human failure,” he writes, “it is about human success.” There can be no economic growth without risk and uncertainty. The cycles and crises will continue, so what we should look for is not utter stability but “the right trade-off between risk and stability.” The cycles and crises are “the price we pay for an economic system that encourages and rewards risk.” This seems to me profoundly correct.

The Fed Is as Poor at Knowing the Future as Everybody Else

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Subcommittee on Monetary Policy and Trade

Of the Committee on Financial Services

U.S. House of Representatives

Hearing on “The Fed Turns 100: Lessons Learned from a Century of Central Banking”

September 11, 2013 

The Fed Is as Poor at Knowing the Future as Everybody Else

Mr. Chairman, Ranking Member Clay, and Members of the Subcommittee, thank you for the opportunity to be here today.  I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI, I was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.  I have published numerous articles on banking and financial systems, including the role of the Federal Reserve and central banks in general. 

A striking lesson of the 100-year history of the Federal Reserve is how it has been able from its beginning to now to inspire entirely unjustified optimism about what it can know and what it can accomplish. 

Upon the occasion of the Federal Reserve Act in 1913, an American Banker writer opined, “The financial disorders which have marked the history of the past generation will pass away forever.”  Needless to say, the Fed has not made financial disorders disappear, and not for lack of trying, while it has often enough contributed to them.  

In 1914, the then-Comptroller of the Currency expressed the view that with the creation of the Fed, “financial and commercial crises, or panics…seem to be mathematically impossible.”  They weren’t.

The unrealistic hopes continued.  As a forthcoming history says, “The bankers at the Federal Reserve kept the money flowing in to the American economy at a pitch that held interest rates low and kept expanding business and consumer credit… [but] there was no rise in prices.  The business cycle…had finally been tamed—or so it seemed.  Economists around the world praised the Federal Reserve.  Some even predicted that a ‘new era’ in economics had begun.”  This passage sounds like it is describing the central bank optimism of the early 2000s with the so-called “Great Moderation,” but in fact it is describing the 1920s.  We know what came next, and the Fed is widely blamed for its deflationary blunders in the crisis of the early 1930s, and again in 1937.

In the 1940s, the Fed was the willing servant of the Treasury Department in order to finance the war and hold down the interest rates on government debt, thus doing in great scale exactly what the fathers of the Federal Reserve Act had tried to prevent: monetizing government debt.  (The Fed had also lent its full efforts to finance the government during the American participation in the First World War.)

After enjoying the American global economic hegemony of the 1950s, the 1960s brought a new high point in optimism about what discretionary manipulation of interest rates and financial markets could achieve.  Otherwise intelligent and certainly well-educated economists actually came to believe in what they called “fine tuning”: that the Fed and government policy “could keep the economy more or less perfectly on course,” as discussed by Fed Chairman Bernanke in his new book, The Federal Reserve and the Financial Crisis.  Some economists even held a conference in 1967 to discuss “Is the Business Cycle Obsolete?”  It wasn’t. 

The fine tuning notion “turned out to be too optimistic, too hubristic, as we collectively learned during the 1970s,” Bernanke writes, “so one of the themes here is that—and this probably applies in any complex endeavor—a little humility never hurts.”  Very true.

Indeed, the performance of the Federal Reserve at economic and financial forecasting in the last decade, including missing the extent of the Housing Bubble, missing the huge impact of its collapse, and failing to foresee the ensuing sharp recession, certainly strengthens the case for humility on the Fed’s part, especially when it attempts to forecast financial market dynamics.  The poor record of economic forecasting is notorious, and the Fed is no exception to the rule.

If only the Chairman, the Governors, the Presidents and the scores of economists of the Federal Reserve could really know the future!  Then they could carry out their discretionary actions without the many mistakes, both deflationary and inflationary, which have marked the history of the Fed.  These mistakes should not surprise us.  As Arthur Burns, Fed Chairman in the 1970s and architect of the utterly disastrous Great Inflation of that decade, said: “In a rapidly changing world, the opportunities for making mistakes are legion.”

In a 1996 speech otherwise famous for raising the issue of “irrational exuberance,” then-Fed Chairman Alan Greenspan sensibly discussed the limits of the Fed’s knowledge.  “There is, regrettably, no simple model of the American economy that can effectively explain the levels of output, employment and inflation,” he said.  (Since it is effectively the world’s central bank embedded in globalized financial markets, the Fed would need not merely a model of the American economy, but one of the world economy.) 

“In principle,” Chairman Greenspan continued,” there may be some unbelievably complex set of equations that does that.  But we [the Fed] have not been able to find them, and do not believe anyone else has either.”  They certainly have not, as subsequent history has amply demonstrated.  Moreover, in my view, not even in principle can any model successfully predict the complex, recursive financial and economic future—so the Fed cannot know with certainty what the results of its own actions will be. 

Nonetheless, the 21st century Federal Reserve and its economists again became optimistic, and perhaps hubristic, about the central bank’s abilities when Chairman Greenspan had been dubbed “The Maestro” by the media and knighted by the Queen of England.  It is now hard to remember the faith he and the Fed then inspired and the confidence financial markets had in the support of what was called the “Greenspan put.”

Queen Elizabeth would later quite reasonably ask why the economists and central banks failed to see the crisis coming.  One lesson we can draw from this failure is that a group of limited human beings, none of whom is blessed with knowledge of the future, with all the estimates, guesses, and fundamental uncertainty involved, by being formed into a committee, cannot rationally be expected to fulfill the mystical notion that they can guarantee financial and economic stability.

In the early 2000s, of particular pride to the Fed was that the central bankers thought they were observing a durable “Great Moderation” of macro-economic behavior, a promising “new era,” and gave their own monetary policies an important share of the credit.  With an eye on a hoped-for “wealth effect” from rising house prices, the Fed pushed interest rates exceptionally low as the housing bubble was rapidly inflating, which many observers, including me, view as a critical mistake.  Chairman Bernanke has since insisted that the Great Moderation was “very real and striking.”  Yet, since it is apparent that the Great Moderation led to the Great Bubble and then to the Great Collapse, how could it have been so real?

Economic historian Bernard Shull has explored the paradox that throughout its 100 years, no matter how many mistakes the Fed makes, or how big such mistakes are, it nonetheless keeps gaining more power and prestige.  In 2005, he made the following insightful prediction:  “We might expect, on the basis of the paradoxical historical record, still further enhancements of Federal Reserve authority.”  Indeed, in the wake of the bubble and collapse, the political and regulatory overreaction came, as it always does each cycle.  The Dodd-Frank Act gave the Fed much expanded regulatory authority over financial firms deemed “systemically important financial institutions” or “SIFIs,” and a prime role in trying to control “systemic risk.”

But the lessons of history make it readily apparent that the greatest SIFI of them all is the Federal Reserve itself.  It is unsurpassed in its ability to create systemic risk for everybody else through its unlimited command of the principal global fiat money, the paper dollar.  As former-Senator Bunning reportedly asked Chairman Bernanke, “How can you regulate systemic risk when you are the systemic risk?”  A good question!  Who will guard these guardians?

A memorable example of systemic risk is how the Fed’s Great Inflation of the 1970s destroyed most of the savings and loan industry by driving interest rates to levels previously thought impossible.  In the 1980s, the Fed under then-Chairman Paul  Volcker, set out to “fight inflation”--—the inflation the Fed had itself created.  In this it was successful, but the high interest rates, deep recession and sky-high dollar exchange rate which resulted, then created often-fatal systemic risk for heartland industries and led to a new popular term, “the rust belt.”  A truly painful outcome of some kind was unavoidable, given the earlier inflationary blunders.

A half-century before that, in 1927, the then-dominant personality in the Federal Reserve, Benjamin Strong, famously decided to give the stock market a “little coup de whiskey.”  In our times, the Fed has decided to give the bond market and the mortgage market a barrel or so of whiskey in the form of so-called “quantitative easing.”  This would undoubtedly have astonished previous generations of Federal Reserve Governors, and have been utterly unimaginable to the authors of the Federal Reserve Act.

How will this massive manipulation of the government debt and mortgage markets turn out?  Will it make the current Fed into a great success or become another historic blunder?  In my opinion, neither the Fed nor anybody else knows—about this all of us can only guess.  It is a huge and fascinating gamble, which has without doubt induced a lot of new systemic interest rate risk into the economy and remarkable concentration of interest rate risk into the balance sheet of the Federal Reserve itself.

In the psychology of risky situations, actions seem less risky if other people are doing the same thing.  That is why, to paraphrase a celebrated line of John Maynard Keynes, a “prudent banker” is one who goes broke when everybody else goes broke.  That other central banks are also practicing versions of “quantitative easing” may induce the same subjective comfort.  A decade ago, bankers felt a similar effect when they all were expanding mortgage debt together.

Robert Solow recently claimed that “Central banking is not rocket science.”  Indeed, it isn’t: discretionary central banking is a lot harder than rocket science.  This is because it is not and cannot be a science at all, because it cannot operate with determinative mathematical laws, because it cannot make reliable predictions, because it must cope with ineluctable uncertainty and an unknowable future.  We should have no illusions, in sharp contrast to the 100 years of illusions we have entertained, about the probability of success of such a difficult attempt, no matter how intellectually brilliant and personally impressive its practitioners may be.

It is often debated whether the Fed can successfully achieve two objectives, the so-called “dual mandate,” rather than one.  It does seem doubtful that it can, but the question oversimplifies the problem, for the Fed has not two mandates, but six.

The precise provision of the Federal Reserve Reform Act of 1977, which gives rise to the discussion of the “dual mandate,” is almost always mischaracterized, for that provision assigns the Fed three mandates, not two.  The Fed shall, it says, “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  This is a “triple mandate,” at least.  The third statutorily assigned goal is almost always forgotten.  It is doubtful indeed that the Fed can simultaneously do all three. 

But in addition to these, the Fed has three more mandates.  These are: to furnish an elastic currency, the historically first mandate and the principal reason for the existence of the Fed in the first place; to act as the manager of the risks and profits of the banking club, now expanded to include other “SIFIs”; and finally, to provide ready financing for the deficits of the government of which it is a part, as needed.

Let us do a quick review of how the Fed is doing at each of its six mandates.

To begin with “stable prices”:  this goal was in fact dropped long ago.  The Fed’s goal is not and has not been for decades stable prices, but instead permanent inflation—with a relatively stable rate of increase in prices.  In other words, the Fed’s express intention is a steady depreciation of the currency it issues, another idea which would have greatly surprised the authors of the Federal Reserve Act.  At its “target” of 2% inflation a year, average prices will quintuple in a normal lifetime.  Economists can debate whether a stable rate of price increases rather than a stable price level is a good idea, but you cannot term perpetual inflation “price stability” with a straight face.

Turning to “maximum employment”:  Nobody believes any more, as many people believed when this goal was added to the governing statute in 1977, that there is a simple trade-off between inflation and sustained employment.  It was still believed when the Humphrey-Hawkins Act of 1978 was passed, although it was already being falsified by the great stagflation of the late 1970s.  Humphrey-Hawkins added a wordy provision requiring the Fed to report to and discuss with Congress its plans and progress on the triple mandate.  Did these sessions succeed?  They obviously did not avoid the financial disasters of the 1980s and 2000s, or the inflation of giant bubbles in tech stocks and housing.

On “moderate long-term interest rates”:  As the Treasury’s servant in the 1940s, the Fed kept the yield on long-term government bonds at 2 ½%.  After this practice was ended by the “Treasury-Fed Accord” of 1951, a 30-year bear bond market ensued, which ultimately took long-term interest rates to 15% in the early 1980s—this was not a “moderate” interest rate, to be sure.  With the Fed’s current massive bond buying, rates on long-term government bonds got to 1½%-2%, which was zero or negative in real terms—also not a “moderate” interest rate.

The fourth mandate stood right at the beginning of the original Federal Reserve Act in 1913.  The authors of the Act told us clearly what they wanted to achieve:

     “An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency….”

An elastic currency is most definitely what we have got, not only in the U.S., but given the global role of the dollar, in the world.  Indeed, we have one much more elastic than originally intended.  This is very handy during financial panics when the Fed is acting as the lender of last resort.  The unanswered question is:  given a pure paper currency (not originally intended, of course) with unlimited elastic powers, what limits should there be other than the demonstrably fallible beliefs and judgments of the members of the Federal Reserve?  

Charles Goodhart’s monograph, The Evolution of Central Banks, makes a strong argument that it helps to understand central banks, including the Fed, by thinking of them as the manager of the banking club, which tries to preserve and protect the banking industry.  This becomes most evident in banking crises.  It was explicitly expressed in an early Fed plaque:  “The foundation of the Federal Reserve System is the co-operation and community of interest of the nation’s banks.”  Such candor is not currently in fashion—the fifth mandate is now called “financial stability.”  As discussed, this mandate has been expanded by Dodd-Frank beyond banks to make the Fed the head of an even bigger financial club. 

Sixth is the most basic central bank function, and Fed mandate, of all: financing the government, a core role of central banks for over three centuries.   As economist Elga Bartsch has correctly written, “The feature that sets sovereign debt apart from other forms of debt is the unlimited recourse to the central bank.”  Thus for governments that wish to finance long-term deficits with debt, like the United States, central banks are exceptionally useful, which is one reason virtually all governments have one-- no matter how disappointing the central bank’s performance at stable prices, maximum employment, moderate long-term interest rates, and financial stability may be.  Needless to say, the power of financing the government is also dangerous. 

Allan Meltzer, an eminent scholar of the Federal Reserve and our colleague on this panel, near the end of his magisterial A History of the Federal Reserve, quotes the classic wisdom of monetary thinker Henry Thornton from 1802-- 211 years ago, who proposed:

     “to limit the total amount of paper issued, and to resort for this purpose, whenever the temptation to borrow is strong, to some effectual principle of restriction: in no case, however, materially to diminish the sum in circulation, but to let it vibrate only within certain limits; to allow a slow and cautious extension of it, as the general trade of the kingdom enlarges itself….  To suffer the solicitations of the merchants, or the wishes of the government, to determine the measure of bank issues, is unquestionably to adopt a very false principle of conduct.”

These are sensible guidelines, as my friend Allan suggests.  But another lesson of 100 years of Federal Reserve history is that we have still not figured out how to implement them.

Thank you again for the opportunity to share these views.

Hearing on Systemic Risk and Regulation

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Committee on Financial Services

United States House of Representatives

Hearing on Systemic Risk and Regulation 

October 2, 2007

Mr. Chairman, Ranking Member Bachus and members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a Resident Fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI, I spent 35 years in banking, including twelve years as President and CEO of the Federal Home Loan Bank of Chicago.  I am a Past President of the International Union for Housing Finance and a director of three companies in financial businesses. 

My career has included many credit cycles which involved issues of systemic risk, from the credit crunch of 1969, the commercial paper panic of 1970, and the real estate investment trust collapse of 1975 (in which the entire commercial banking system was thought by some to be insolvent) to the current example of the credit panic triggered by the ongoing subprime mortgage and housing bust, and a number of others in between.  Moreover, I have studied the long history of such financial events and their recurring patterns. 

Booms and Busts in Context

To begin with, let me try to put the issues of financial booms and busts and the related question of systemic risk in context.

The fundamental principle is that long term growth and the greatest economic well being for ordinary people can only be created by market innovation and experimentation.  Markets for goods and services must be accompanied by markets in financial instruments, which by definition place a current price on future, thus inherently uncertain, events.  This much is obvious but easy to forget when addressing the results of a bust with the benefit of hindsight, when it seems like you would have to stupid to make the mistakes that smart people actually made.

Dealing with putting prices on the inherently uncertain future, all financial markets are constantly experimenting with how much risk there should be, how risks are distributed, what the price of risk-bearing should be, and how risk trades off with financial success or failure.  Should individuals and institutions be free to take financial risks if they want to?  Yes, they should.

In the boom, many people succeed, just as many people succeeded for a long time in the subprime mortgage and housing boom.  This success gets extrapolated, supports optimism and makes lenders and investors, including private pools of capital, confident.  Lender and investor confidence tends to the underestimation of risks, in particular, the risk that the price of the asset in favor, most recently houses, could fall or fall very much; and underestimation of the risk that if prices fall, especially in a leveraged sector, asset and credit markets could become illiquid.

In my opinion, the principles stated by the President’s Working Group for private pools of capital are professional and sensible.  But even if everybody followed them, we would not avoid the inevitable times of financial turbulence.

We know for certain that markets will create long term growth and also cyclical booms and busts, but just what or when the outcome of a particular innovation will be cannot be known in advance.  It can only be discovered by running the market experiment, as so brilliantly discussed in Friedrich Hayek’s “Competition as a Discovery Procedure.”

How hard it is to outguess this discovery procedure is shown by the fact that a mere three months ago, the financial and economic world was constantly treated to statements by very intelligent and well-informed people that there was “abundant liquidity” or even a “flood of liquidity,” which would guarantee a firm market bid for risky assets and narrow spreads.  Then we were suddenly confronted with a lack of bids, nonfunctioning markets and the “evaporation of liquidity.”

Likewise, some very intelligent and well-informed people said, up until August, that the subprime mortgage bust would be “contained” and not cause wider financial or economic problems.  Now we have had a subprime-induced credit panic and an ongoing credit crunch, with falling house prices, but the stock market has gone back up to near its high.  How do we interpret that?  

A fundamental point is that markets are recursive.  Whatever opinions influence buying and selling and hedging, whatever models of financial behavior are relied on, whatever is done to regulate them, are all fed back into the system of interactions and change behavior in unpredictable ways.  Thus models of financial behavior, themselves changing the market, tend to become less effective or obsolete, as did subprime credit models. 

Regulations likewise change financial behavior, are arbitraged, and may end up producing the opposite of their intent.  This is why regardless of what any regulator or legislator may do, markets will always create however much risk they want.  Then when the bust has begun, regulatory actions to reduce or control risk may turn out to be procyclical, reinforcing the downward momentum.

Models  

To successfully avoid booms and busts, regulatory operations or market actors would have to know the future.  They often attempt to do so through creating models.

Of course, there is always a difference between financial models, however mathematically refined, and financial reality.  This is so whether the models are those of Wall Street “rocket scientists” structuring securities, credit rating agencies, hedge funds or other private pools of capital, sophisticated institutions, the Federal Reserve or other regulators, or investment analysts.  Finance cannot in principle be turned into physics. 

John Maynard Keynes memorably observed that a prudent banker is one who goes broke when everybody else goes broke.  One way to do this is to use models with the same assumptions that everybody else has.  Then you can be confident when everybody else is confident and afraid when everybody else is afraid. (We can be skeptical of the models approach of Basel II in this respect.)

Once a Decade, On Average

The classic patterns of booms based on credit overexpansions and their following busts are colorfully discussed by such students of financial cycles as Charles Kindleberger, Walter Bagehot and Hyman Minsky. 

Kindleberger, surveying several centuries of financial history, observed that financial crises and scandals occur, on average, about once every ten years.  This matches my own experience.  Every bust is followed by reforms, but the next bust arrives nonetheless.  Still the trend of market innovation and long term growth continues.

The increased risk accumulated in credit overexpansions ultimately comes home to roost and prices of the favored asset fall.  There is a hangover of defaults, failures, dispossession of unwise or unlucky borrowers, revelations of frauds and swindles (always), and then the search for the guilty.  There is a sharp restriction of credit.  For example, the chief executive of Countrywide recently announced, “We are out of the subprime business.” 

There is a generalized retreat from risky assets, and a new danger arises: fire sales of assets turning into a debt deflation and the ruin of the financial system—systemic risk has arrived.  Our students of financial cycles all support government intervention to stabilize the downward momentum.  This is the correct answer as long as it is temporary.

To come to the current situation, it is evident that the present combination of the excess inventory of houses and condominiums, with the rapid restriction of mortgage credit—in other words, increased supply plus falling demand, equals a trend of falling house prices.  The models used to analyze, rate and price subprime securitizations include as a key factor house price appreciation (“HPA” in the trade jargon).  Now that we have house price depreciation, what will happen if prices fall much more and much more broadly than the models, the investors, the lenders and the regulators thought they could?

Unfortunately, a vicious cycle of falling house prices, more defaults, further credit tightening, less demand, further falls in prices, more defaults, and so on, is possible for a while, though of course not forever.  Financial market result: Fear. 

The fear is increased by great uncertainty about the value of subprime securities if no one wants to buy them anymore.  What are they worth as assets to an investor, notably a leveraged investor?  What are they worth as collateral to a lender—especially a very risk-averse repo dealer or commercial paper buyer?

Greater disclosure and transparency are reasonably suggested, although financial accounting, at least, is never truly “transparent.”

For example, what does “value” even mean when there are few or no buyers?  How can assets be marked to market if there is no active market?  Should everybody’s portfolio be marked to fire sale prices, or instead to some estimate of intrinsic value?  Who is actually broke and who isn’t?  The answers to these classic questions of the bust are never clear, except in retrospect.

Liquidity

As Bagehot wrote, “Every great crisis reveals the excessive speculations of many houses which no one before suspected.”  So has our current bust, and these unpleasant surprises reinforce the uncertainty make about who is broke and who isn’t (perhaps including yourself).  With this uncertainty and personal as well as institutional risk, everyone becomes conservative at once.  When all investors and lenders, institutionally and personally, try quite logically to protect themselves by avoiding risk, the result is to make liquidity disappear and to put the whole at risk. Note that possibility of regulatory or political punishment arising from the search for the guilty will increase the risk aversion.

In other words, it is belated risk aversion which creates systemic risk. To understand why this can happen, we have to see that “liquidity” is not a substance which can “flow,” be a “flood,” “slosh around,” or be “pumped” somewhere, to use a number of misleading expressions.

In fact, liquidity is a figure of speech.  It is verbal shorthand for the following situation:  

     -A is ready and able to buy an asset from B on short notice

     -At a price B considers reasonable

     -Which usually means  C has to be willing to lend money to A

     -And if C is a dealer, both A and C have to believe the asset could readily be sold to D

     -Which means A and C believe there is an E willing to lend money to D.

Good times, a long period of profits, and an expansionary economy induce financial actors and observers to take this situation, “liquidity,” too much for granted, so liquidity comes to be thought of as how much you can borrow.  When the crisis comes, it is found to be about what happens when you can’t borrow, except from some government instrumentality.

At this point we have arrived at why central banks exist.  The power of the government, with its ability to compel, borrow, tax, print money, and credibly guarantee the payment of claims, can intervene to break the everybody-stops-taking-risk-at-once psychology of systemic risk.

The key is to assure that this intervention is temporary, as are credit panics by nature.  As historically recent examples of government interventions in housing busts, since 1970 we have had the Emergency Home Finance Act of 1970, the Emergency Housing Act of 1975, the Emergency Housing Assistance Act of 1983, and the Emergency Housing Assistance Act of 1988.  (I do not count the Hurricane Katrina Emergency Housing Act of 2005, a special case.)  This is in line with Kindleberger’s estimate of about once a decade on average, and an emergency housing act of 2007 would fit the pattern.

The liquidity crunch won’t last forever.  Large losses will be taken,  the market get used to the idea, who is broke and who isn’t sorted out, failures reorganized, risks reassessed, models rewritten, and revised clearing prices discovered.  A, B, C, D and E will get back into business trading and lending to each other again. 

Liquidity will return reasonably quickly for markets in prime instruments.  One long time observer of finance, whose insights I value, has predicted that “the panic about credit markets will be a memory by Thanksgiving.”

I believe this is probably right; however, the severe problems with subprime mortgages and securities made out of them, related defaults and foreclosures, and falling house prices will continue long past then.  They will continue to cause macroeconomic drag and financial difficulties, but the moment of systemic panic will have passed. 

The “Cincinnatian Doctrine”

In conclusion, my view is that it is not possible to design society, no matter what regulatory systems may be implemented, to avoid financial booms and busts and their resulting risk of systemic panics.  We do need temporary interventions of the government periodically, when the financial system is threatened by a downward spiraling debt deflation.  In other words, booms and busts are endemic to market economies with financial markets in which people are free to take risks and engage in borrowing against the uncertain future.  They are a price well worth paying in return for the innovation and growth only such markets can create.

In normal times, that is, about 90% of the time, we predominately want the economic efficiency, innovation, productivity and the resulting well-being for ordinary people produced by competitive markets.  But when the financial system hits its inevitable periodic crises, about 10% of the time, the intervention of the government is often necessary.  This intervention should be temporary.  If prolonged, it will tend to cartels, bureaucracy, less innovation, and less growth.  In the extreme, of course, it becomes socialist stagnation. 

Thus I suggest a 90%-10% policy mix.  I have elsewhere explored this idea as the “Cincinnatian Doctrine.”

In the wake of every bust, various plans are put in place to prevent all future ones, but the next bust arrives in about ten years anyway. Such plans suffer from the assumption that financial group behavior is mechanistic and can be addressed by designing mechanisms.  In fact, it is organic, creative, recursive and emergent. That is the source of its strength in creating wealth, also of its weakness in getting periodically carried away.  I do not believe any regulatory structures can alter these fundamental characteristics.

Thank you again for the opportunity to share these views.

How to Improve the Credit Rating Agency Sector

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Committee on Banking, Housing and Urban Affairs

United States Senate 

Hearing on Assessing the Current Oversight and Operations of Credit Rating Agencies

March 7, 2006

How to Improve the Credit Rating Agency Sector

Good morning, Mr. Chairman, Ranking Member Sarbanes and members of the Committee.  Thank you for the opportunity to testify today.  I am Alex Pollock, a Resident Fellow at the American Enterprise Institute, and these are my personal views on the need to reform the credit rating agency sector.

It is important and timely for Congress to address this issue.  There is no doubt that the existing SEC regulation and practice represents a significant anti-competitive barrier to entry in the credit rating business, although this was not intended when the regulation was introduced 30 years ago.  Nonetheless, the actual result of the SEC’s actions, and in recent years, inaction, has been to create what is in effect a government-sponsored cartel.

A few weeks ago Barron’s magazine had this to say about the two leading rating agencies:

     “Moody’s and Standard and Poor’s are among the world’s great businesses.  The firms amount to a duopoly and they have enjoyed huge growth in revenue and profits in the past decade.”

Barron’s continues:

     “Moody’s has a lush operating profit margin of 55%...S&P’s [is] 42%.”

An equity analyst’s investment recommendation from last year explains the reason for this exceptional and enviable profit performance: 

     “Companies are not unlike medieval castles.  The most successful are that boast some sort of economic moat that makes it difficult, if not impossible, for competitors to attack or emulate.  Thanks to the fact that the credit ratings market is heavily regulated by the federal government, rating agencies enjoy a wide economic moat.”  (emphasis added)

This is an accurate assessment. 

I recommend that Congress remove such government-created protection or “economic moat,” and promote instead a truly competitive rating agency sector, with all the advantages to customers that competition will bring, including better prices, more customer choice, more innovation, greater efficiency, and reduced potential conflicts of interest. 

I believe that the time has come for legislation to achieve this. 

Instead of allowing the SEC to protect the dominant firms (in fact, if not on purpose), in my view Congress should mandate an approach which is pro-competitive and pro-market discipline.  Last year the AEI  published an article of mine (attached for the record) entitled, “End the Government-Sponsored Cartel in Credit Ratings”:  I respectfully hope Congress will do so this year. 

The “NRSRO” Issue

In the best theoretical case, not only the designation by the SEC of favored rating agencies, but also the regulatory term “NRSRO” would be eliminated.  The term has produced unintended effects never imagined when it was introduced in 1975, and in theory it is unquestionably time for it to retire.

In its place, the responsibility to choose among rating agencies and their services should belong to investors, financial firms, issuers, creditors and other users of ratings—in short, to the market.  A competitive market test, not a bureaucratic process, will then determine which rating agencies turn out to be “widely accepted by the predominant users of ratings,” and competition will provide its normal benefits.

This is altogether different from the approach taken in proposals by the SEC staff, which in my opinion, are entirely unsatisfactory.

Very much in the right direction is the bill introduced in the House by Congressman Michael Fitzpatrick, HR 2990. 

This bill directly addresses the fact that a major practical obstacle to reform is that the SEC’s “NRSRO” designation has over three decades become enshrined in a very large and complex web of interlocking regulations and statutes affecting thousands of financial actors.  The combined effect is to spread the anti-competitive force of the SEC’s regulation throughout the financial system, with too few customer alternatives, too little price and service competition, and the extremely high profits for the favored firms, as we have already noted.  But how can we untangle this regulatory web?

As you know, HR 2990 does so in what I think is an elegant fashion by keeping the abbreviation “NRSRO,” but completely changing its meaning.  By changing the first “R” from “Recognized” to “Registered,” it moves from a restrictive designation regime, to a pro-competitive disclosure regime.  This change, in my view, is in the best tradition of American financial market theory and practice: competition based on disclosure, with informed investors making their own choices. 

Voluntary Registration 

Becoming an “NRSRO” is now, and would be under a registration approach, an entry into the regulated use of your ratings by regulated financial entities.  Therefore I believe that registration in a new system should be entirely voluntary.  If any rating agency wants to continue as simply a private provider of ratings to customers who make such use of them as they desire, other than regulatory use, it should continue as it is, with no requirement to register.  But if it wants to be an “NRSRO,” the way is plain and open.

I think this voluntary approach entirely removes the First Amendment arguments which have been made against HR 2990. 

Rating Agency Pricing Models

An extremely important advantage of a voluntary registration, as opposed to an SEC designation, regime is that it would allow multiple rating agency pricing models to compete for customer favor.  The model of the dominant agencies is that securities issuers pay for credit ratings.  Some critics argue that this creates a conflict of interest.

The alternative of having investors purchase the credit ratings arguably creates a superior incentive structure.  This was the original historical model for the first 50 years of the rating agency business.  If investors pay, it obviously removes the potential conflict of interest and any tendency toward a “race to the bottom” in ratings quality.

In my view, there should be no regulatory or legal prescription of one model or the other:  the market should use whichever credit rating providers best serve the various needs, including the regulatory needs, of those who use the ratings. 

Transition to a New Regime

The decentralization of decisions entailed by a competitive, disclosure-based regime is wholly positive.  Investors and creditors, as well as multiple regulatory agencies, should have to think about how credit ratings should be used and what related policies they wish to adopt.  They should be expected to make informed judgments, rather than merely following an SEC staff decision about whether somebody is “recognized.”

The worst outcome, to be avoided in any case, would be regulation of actual credit ratings by the SEC, or (what would come to be equivalent) regulation of the process of forming credit ratings.  This would be a worse regime than we have now.

Of course, a fully competitive rating agency market will not happen all at once.  There are significant natural (as well as the SEC’s artificial) barriers to entry in this sector, including the need to establish reputation, reliability, and integrity; the prestige factor involved in the purchase of opinions and judgments; and the inherent conservatism of institutional risk management policies.  Nevertheless, in time, innovation and better products can surmount such barriers, when not prevented by regulation.

Because the desirable transition to a competitive rating agency sector would be evolutionary, I believe any concern about disrupting the fixed income markets is misplaced. 

It is important to remember that no matter what the rating agency regime may be, we simply cannot hope for 100% success in predicting future credit performance.  There will never be a world in which there are no ratings mistakes, any more than in any other endeavor which makes judgments about future risks and uncertainties.  But this fact only emphasizes the importance of a vibrant marketplace of ratings opinions, analysis, ideas, forecasts, and risk assessments. 

On timing, the “NRSRO” issue has been a regulatory issue and discussion for a decade, in what seems to me a dilatory fashion.  My recommendation is that Congress should now settle the issue of competition vs. cartel in this key financial sector, moving to create the best American model of competition and disclosure, rather than prescription and government sponsorship. 

This will bring in time better customer service, more innovation, more customer alternatives, greater price competition, and reduced duopoly profits, and indeed better credit ratings will emerge.

Thank you again for the chance to be here today.