Are the Fed, the Congress and the Primary Dealers an Alliance of Convenience?

What is the economic impact of the DJ Industrial Index crossing 10,000? Absolutely nothing! There is very little difference between 10 K and 10,010 or 9,990, but we like to point to guideposts we can remember. We have a fascination with whole numbers as if they are barriers or have significant economic meaning; in reality they are just mileage markers on a well traveled road. The media hyped this week's crossing of 10,000 as if it meant something; financial news personalities asked their guests what they were advising their clients. The NYSE prematurely passed out hats celebrating the crossing as if it were an important milestone. In reality the DJ Industrial Index is a price-weighted index which sums the prices of one share of 30 stocks and then divides that sum by a factor that adjusts when new companies are added to the Index or when one of the component company stocks splits. The divisor is currently 0.13231916. What does the DJ 10,000 mean? It means that if you bought the 30 stocks in the spring of 1999 when the Index first crossed 10,000 and made all of the adjustments in your portfolio to replicate the index since that time (ignoring taxes) you would have earned only the dividends over the past 10+ years. The index spent most of 1999 through 2000 above 10,000, most of the years 2003 and 2004 below 10,000, and most of the next years prior to 2008 above 10,000. The 10,000 marker is a reminder of the opportunity cost of missing out on buying the Index stocks at 6.6 K this past March. The DJ 10,000 does not tell you anything about the future.

John W. Davidson, CFA
Managing Director
Strategic Asset Alliance

This comment is a draft based on remarks by IRA co-founder Christopher Whalen from the October 9, 2009 conference held at AEI that will be published as part of the "No Way Out: Government Response to the Financial Crisis" series organized by Vince Reinhart, Resident Scholar of American Enterprise Institute. The author wishes to thank Dr. Reinhart and AEI for the invitation to contribute to this discussion and Greg Ip of The Economist and Angel Ubide of Tudor Corporation for their comments.

For the better part of a year, many smart, talented people in the worlds of finance and economics have been struggling to describe the causes of the financial crisis and solutions. I witnessed such a debate recently at the international banking conference sponsored by the Federal Reserve Bank of Chicago. It is fair to say that the representatives from Europe, Asia and the Americas continue to have differing views of the crisis and how to address it; more regulation or less, more capital or less, and whether markets should be re-regulated.

Far from being dismayed by such disparity of views, I am encouraged by this difference of opinion and I hope that the debate intensifies in coming months. To recall the words of Alfred Sloan, it is only by sharpening our differences can we understand complex problems and understand those distinctions which matter and those which do not. But as we build a narrative to understand the crisis, we seem to be converging on one view of the causes of the financial "bubble" and thereby ignoring other perspectives and views that might be instructive.

In his books such as The Black Swan, the author Nassim Taleb warns us that the news media and particularly condensed versions of reality such as television force all of us into a view of the world that is often over simplified. As social creatures, we all tend to use narrative to describe and understand complexity. We speak and write and discuss. Gradually we distill our impressions and these views merge together into the collective understanding, the "official" story.

But just as bubbles are probably not a good technical metaphor to describe financial crises, we need to beware the tendency to simplify and categorize complex events when it comes to public policy for our financial institutions and markets. Americans have a wonderful tendency to look at public policy from a vertical perspective, in silos, that suggest we can somehow isolate monetary policy and bank supervision and fiscal policy into neat, separate little boxes that are never affected or disturbed by one another.

In particular, this comes to mind when we hear US economists talk about foreign capital inflows as an externality. Those fiat paper dollars belong to us. We printed them and of course they are returning home in search of at least a nominal return. That's why we have problems such a mortgage market bubbles and a surfeit of capital inflows, then a sudden outflow of these same pools of credit. In a fiat money system, after all, there is no "money" in a classical sense, merely credit. These large flows of fiat paper dollars, I submit, explain the increasingly manic behavior of markets, investors and large banks over the past decade as true investment opportunities are increasingly outnumbered by speculation.

I agree with Vince and the other speakers about the nature of the problem created by America's addiction to debt and inflationary monetary policy, and how difficult it makes it for us to address more basic structural problems in our economy. This is especially true so long as the rest of the world is willing to allow the US to retain a global monopoly on dollars as the primary means of exchange and as a short-term store of value. But I believe to achieve a true understanding of the crisis, we must step back and take a political perspective.

The evolution of the US from a democratic republic into a more statist, more corporate formulation that looks more and more like the states of Europe and Asia every day, is what makes concepts such as too big to fail ("TBTF") and "systemic risk" viable. The migration of the US from a society based on individual liberty, work and responsibility, to a society where a largely corporate and socialist perspective holds sway, in my view, is changing the way we look at our financial and monetary system. Because of the huge and some would say illegal subsidies provided to Wall Street firms during the early part of the crisis, particularly in cases such as the rescue of American International Group, the American electorate is engaged in an intense, sometimes angry debate about financial policy and government.

This debate is also very intense among the bank regulatory community, where you have FDIC Chairman Sheila Bair, the FDIC and state regulators, and smaller banks supporting a traditional if somewhat legalistic American view of banks regarding issues like insolvency and resolution, on the one hand. Then we have the internationalist tendency represented by the large banks, the Federal Reserve Board, Treasury and White House, who like the leaders of the EU advocate a socialist and proudly statist perspective where banks are "too big to fail" and under the table subsidies to well-connected institutions are encouraged. Whereas in the 1800s the New York banks advocated hard money and sound banks, and the inflationists where among the agrarian populist ranks, today it is Washington, Paris and Berlin, among the largest dealer banks and their political allies, that are found advocates of inflation and public sector debt.

Our friends at the Fed and Treasury seem to know nothing about American values when it comes to insolvency or bank safety and soundness. Our founders embedded bankruptcy in the Constitution not out of generosity, but because they knew that prompt resolution and liquidation of claims benefitted all of society. The internationalist set, like their counterparts in Europe and Japan, talk of the ill-effects of resolving zombie banks via traditional bankruptcy, but fail to notice the benefits with equal concern. If we do not have losers and well as winners in our society, then we shall have neither. For every loser in the case of the failures of Lehman Brothers and Washington Mutual, there were winners at JPMorganChase and Barclays PLC, which bought the assets of the failed companies for pennies on the dollar and absorbed thousands of valuable employees.

The internationalist tendency prefers instead to align themselves with the view of foreign nations whose governments are predominantly socialist in economic orientation and authoritarian politically. These politicians and their economists prefer to pick "losers as winners," to paraphrase my friend Bob Feinberg. Look at the situation in Germany, where the political leadership refuses to even acknowledge the depth of the crisis in the state or private banking sector. Germany is a case study illustrating the corruption and incompetence that prevails when you allow the political class to take unilateral control over all financial institutions and markets.

It is both fascinating and troubling for me to watch members of the Fed staff who I love and respect as friends and former colleagues being seduced by the siren song of political expediency when it comes to issues such as "systemic risk," a political concept that has no place in a serious discussion of finance. Certain banks, say Fed and Treasury officials, are "too big to fail." But just as true finance is about the arithmetic certainty of market prices and cash flow rather than speculative models, Fed officials seem to confuse safety and soundness in a financial sense with pleasing the political class that inhabits both of the major political parties in Washington.

I hear my colleagues at the Fed recite the mantra about how Lehman Brothers should not have been "allowed" to fail and large banks are too connected globally to be subject to traditional resolutions, as in the case of the failures of both Lehman and Washington Mutual. When I point out to these same Fed officials that Lehman had been for sale, unsuccessfully, for a year, I hear only silence. When I note that Harvey Miller working as bankruptcy trustee and SIPIC and the good people of the Southern District of New York did a very fine job handling the Lehman insolvency, there is likewise only silence from the TBTF advocates. Instead of being used as an excuse for inaction and delay, the insolvency of Lehman Brothers and WaMu should be held up as examples of the American legal system functioning well.

When you challenge officials at the Fed and Treasury about TBTF and systemic risk, they point to the fact that using bankruptcy to resolve complex institutions is too damaging to "confidence." Vince mentions in his fine presentation that avoiding damage to confidence is a top-level priority for policy makers. We must avoid damaging sacred confidence. But if you have such a rule, then you cannot have a true market system. Markets must be allowed to go from exuberance to terror in order to have a free market system and also a free and democratic society. Investors, bank managers and politicians can only be held accountable if failure is allowed to occur. If we allow government to legislate confidence via the imposition of "systemic risk" regulators and rules such as TBTF, then I suggest that we will not be a free society for much longer.

If you want to see where the US is headed by embracing concepts such as "systemic risk" and TBTF into public policy, then just look at the EU, where whole nations have lost their private banking sector, where there is no private capital formation to create new banks and the state-sector has largely monopolized many areas of personal and commercial finance. In 2008, there were more de novo banks created in the great state of Texas than in all of the EU. By not allowing failure and insolvency for even the largest banks and companies in the US, we deprive our citizens of opportunity.

That the largest portion of the damage done to EU banks in the latest speculative cycle is found among state-sector banks should come as no surprise. Claims by EU politicians as to the effectiveness of regulation in terms of mitigating financial risk seem to be belied by the facts when it comes to regenerating a healthy banking system. EU politicians and bureaucrats may have regulated away bad acts and freedom of choice for private investors, but that only means that the misbehavior has migrated to the public sector and is for the benefit of entrenched political elites. We see the same pattern now in the US.

Let's turn now to Fed policy, an area where Vince spent a great deal of time in his research, in terms of whether the Fed can be both an effective safety and soundness regulator and a monetary authority, especially given the corporatist political evolution already mentioned. If you really analyze the way in which political power flows in the US today, there are three significant groupings:

First we have a central bank that manages a global fiat dollar system based on a currency unit that is not convertible into specie or commodities. The Fed enables the issuance of dollar debt by the Treasury and imposes no effective policy restraint, no check to balance US fiscal policy. In fact, since the October 1987 crisis, the Fed has never said "no" to the Congress or the markets in terms of liquidity or collateral. It has only been a matter of price. When was the last time we had a Fed Chairman willing to say no to the politicians in the White House or the Congress? Paul Volcker? I suggest that it has been far too long.

Second we have a corrupt, entrenched Congress that equates tax revenues with the proceeds of debt. All fiat paper dollars are one and the same to our esteemed Congress, which believes that the borrowing capacity of the US is infinite. There is no effective limit on spending to keep the electorate mollified and the entrenched political class in power. The Fed enables the spending habit of the Congress and whatever administration occupies the White House.

Some of the supporters of former Fed Chairman Alan Greenspan like to argue that no Fed chairman could have stopped the party in housing early; that no Fed chairman could go up to Capitol Hill and say tough things to members of the Congress about housing policy or public spending. I think that tough talking Fed governors is precisely what we need. If the heads of independent agencies are not ready to lose their jobs every day and be willing to take tough policy stands on equally tough issues, then we need new leaders. I would hold up Chairman Bair at the FDIC as an example of a public servant who understands that part of her job is to offer advice to the Congress and the White House, and not to be a creature of politics or special interests as so many of our supposed leaders seem to be today.

Thirdly we have the dealer community, especially the members of the primary dealers of US government securities, who have a special relationship with the Fed and the Treasury, most recently by placing former Wall Street chieftains and their minions as Secretary of the Treasury. Many of these banks created the trillions of dollars in toxic waste that has crippled our financial system and were subsequently bailed out by the extraordinary actions taken by NYFRB President Tim Geithner and the Fed's Board of Governors starting last year.

These large dealers such as JPMorgan, Goldman Sachs, Wells Fargo, Morgan Stanley and Citigroup, enable the US Treasury to sell debt and thereby keep the US fiat dollar system stable for another day. These large, TBTF banks are also the mechanism through which the Fed executes monetary policy or at least used to until the Fed itself grew operationally into a de facto primary dealer in its own right, merging fiscal and monetary policy explicitly.

In order to boost the profitability of these TBTF dealer banks, the Fed and the Congress encouraged the creation of opaque, unregulated over-the-counter ("OTC") markets for derivatives and complex assets. The growth of OTC markets were a retrograde development in historical terms and again illustrate the tendency of the Fed and Treasury, the Congress and the large banks to take an anti-American view of issues like market structure, transparency and solvency, encouraging instruments of fraud like OTC derivatives and private placements, while the FDIC, state regulators and smaller banks tend to oppose such innovations. By allowing the creation of derivatives for which there was no basis, the Fed enabled some of the worst acts by the dealer community.

OTC markets for derivatives and structure assets have been the primary source of "systemic risk" over the past 24 months and have contributed the lion's share of losses sustained by banks and the taxpayers of the industrial nations. Indeed, without the active support from the Congress and the Fed for "innovations" such as OTC and opaque, unregistered complex structured securities, the current crisis might never have occurred. It important to be very specific as to the alien nature of things like "dark pools" and closed, bilateral market structures such as OTC, structures that go against the most basic American principles of transparency and fairness.

When Vince and I were in Chicago for the Fed's international banking conference, I reminded our colleagues that the analog to the political checks and balances revered in the history books is a public, open outcry market. Whether virtual or physical, an open market structure is essentially for having true confidence in markets. When markets start to slip back into retrograde formulations like OTC, we are also eroding the very basis of American markets, namely openness and fairness. If our OTC markets are deliberately opaque and unfair, deceptive by design as I told the Senate Banking Committee earlier this year, then can we reasonably hope that our financial institutions and markets will be stable?

I submit that our spendthrift government, the Federal Reserve System and the TBTF banks together now comprise the paramount political tendency in America today. This tripartite "Alliance of Convenience," let's not call it a conspiracy, fits beautifully into the corporatist mold that seems to be America in the 21st Century - but only viewed by the elites in cities like New York and Washington. Many Americans of all political descriptions oppose this corrupt and unaccountable political formulation. I hope and expect that these differences will become even more pronounced as the election approaches next November.

The difference that separates the United States from the rest of the world is the difference which has always divided us, namely our at least theoretical devotion to individual liberty and free markets. Until we break the Alliance of Convenience between the Congress, the Fed and the large, TBTF banks and force our public officials to embrace core American values regarding transparency, insolvency and accountability, we will not in my view find a way out of the crisis. In may ways, the differences that separate the popular view and the views of our political elite have been turned on their heads compared with a century ago, but this does not mean that the debate and resulting political competition for ideas will be any less intense.