Holte's corner

Cato Spins the Concept of "Asset Bubble"

This article shows that "righties" are finally starting to become aware of a problem that has been talked about for nearly 80 years:
http://www.cato.org/pub_display.php?pub_id=9389

"In the past, the federal government has introduced moral hazard in the banking system through deposit insurance. Banks under-priced risk because of the federal guarantee that backed deposits. After banking crises in the 1980s and 1990s, deposit insurance was put on a sound basis and that source of moral hazard was mitigated. In its place, monetary policy has become a source of moral hazard. In acting to counter the economic effects of declining asset prices, the Federal Reserve has come to be viewed as underwriting risky investments. Policy pronouncements by senior Fed officials have reinforced that perception. These actions and pronouncements are mutually reinforcing and destructive to the operation of financial markets. The current financial crisis began in the subprime housing market and then spread throughout credit markets. The new Fed policy fueled the housing boom. Refusing to accept responsibility for the housing bubble, the Fed's recent actions will likely fuel a new asset bubble. The cumulative effects of recent monetary policy undermine the case for free markets."

One principle I believe in is that while people are entitled to their opinions, when debating with other people it is important to look first at the facts. Reporters used to report "facts". Facts are things like "So and so was arrested at the corner of Lamont and Driskoll after a fight broke out. There was a cut on John Does face afterward, and a bruise on So and So's face." Editorial content is when we start evaluating the information. A good reporter tries to limit editorial content. Modern Pseudo-Journalists all think of themselves as Editorialists. Because of that when we read reports, disguised as "objective" one has to deconstruct or analyze the facts and then look carefully at the editorial content. There is no getting away from POV, but sometimes the spin prevents the author of a reality from seeing the implications of his own reporting.

I'm glad that the Cato institute is finally addressing the "moral hazard" of bubbles and the developing mega-bubble that is about to collapse the dollar and ruin the majority of the middle class and lower upper class people who have made the mistake of trusting pundits such as the people working for the Cato Institute. The trouble is the analysis is so demagogued and spun as to have little useful analytical content.

The first problem with the above is that what they are talking about is a "financial bubble." Thinking of it as an "Asset Bubble" is supply side thinking. However, the issue is not the assets themselves it is the false valuation of those assets, which is "finance." We have a short term "supply surplus" of investment seeking assets, with no long term guarantee of a concurrent demand.

Second, the author starts out with a series of mis-statements:

"In the past, the federal government has introduced moral hazard in the banking system through deposit insurance."

This is a "mistatement" (to put it nicely) because moral hazard is why deposit insurance was introduced into the banking system in the first place. Moral hazard is the taking of innocent deposits from common folks by banks that mis-invested their money and predates the creation of the FDIC and involvement of the Federal Government. I would say the author is telling an outright lie but I think he's talking "temporally" and either doesn't know his history or doesn't care about actual the actual history of banking bubbles.

He should read Kevin Phillips. Starting with this link: http://www.huffingtonpost.com/kevin-phillips/the-destructive-rise-of-b_b_94351.html

Moral Hazard has been a regular and abiding feature of financial systems in general and United States Finances in particular during all times when banks have been a feature of the American landscape. Banking bubbles and collapses were a regular effect of moral hazard in investment bubbles and deflationary collapses long before the Federal Government tried to stop this phenomena with deposit insurance.

Banking has regularly been a way that savvy con-men (sometimes known as bankers) could convert money from more or less innocent investors to their own pockets and then get out of town leaving their colleagues to deal with angry depositors who had just lost their entire life savings to banks that had promised them 'stability' and 'trust.' The FDIC didn't introduce moral hazard, it tried to mitigate it.

The issue is not that the Federal Government tries to protect deposits, in the process somehow assuming responsibility for a pre-existing moral hazard, but that they don't force the source of the risk (investors) to bond or insure their risk, but instead pile the costs on consumers (small depositors), with the usual result that we have public costs and privatized benefits from regulatory failure.

The Feds current efforts are mostly reacting to increasingly risky efforts of investors and others to "game the system" -- but within the context of the game. The result is that the Feds approaches and proposed solutions are being driven by these same investors, their lobbyists, their assumptions, and in support of bankers rather than the banking system's victims. Part of the reason for this is that the Federal Reserve has never been a purely democratic institution responsible to the general welfare, but represents two sets of persons. On the top it is responsible to the Federal Government, but in essence it is itself a Banking institution. It serves two masters:

http://www.federalreserve.gov/pf/pdf/pf_1.pdf

The current situation got more risky largely because of de-regulation based on false or arrogant assumptions and because of "system capture" by money men sharing those functions and with perverse incentives. This same sort of "capture" by persons with conflicts of interest and thus perverse incentives has become a feature of almost all the Federal Government Agencies and bureaus right now resulting in massive "legal" corruption. The author does get this right:

"Financial folly has been a feature, however, of both highly regulated and largely unregulated financial systems."

This much is true. And so is this "The question is whether the central bank actively underwrites such folly."

The Federal reserve has the role of watching, preventing, and mitigating the effects of "such folly" as what is folly to a fat researcher is life or death to folks whose retirement, savings, or livelihood, depend on whether or not banks can be expected to store and pay interest or simply convert and steal their deposits. Asset bubbles are almost always tied to speculation and institutional gambling with "other people's money." He can call it "folly" all he wants but it amounts to white collar crime.

"We need not wait for all questions to be answered to put an end to the inflating, deflating, and reflating of asset bubbles."

What questions? Again he should be reading folks like Kevin Phillips instead of his fellows at Cato. There is nothing new about any of this "folly."

"Martin Wolf has reached the correct conclusion when he called for central banks to “pay more attention to asset prices in the future. It may be impossible to identify bubbles with confidence in advance. But central bankers will be expected to exercise their judgment, both before and after the fact.”

Martin Wolf is a false prophet. The Fed has been paying attention to "asset prices" -- what it hasn't been doing is watching carefully to ensure that those responsible for handling "other peoples money" are truly held responsible for the consequences of their decisions and watched carefully to make sure they aren't converting OPM to their own funds.

If this were truly an "Old testament Biblical Country" Mr Wolf and Company would be stoned. It is not that hard to identify a bubble before its collapse. In every case you have whole classes of people who will tell regulators and other critics that they don't know what they are talking about when they warn of what is happening and push for deregulation, which for them always means advocating trusting the "trustees" of other people money at the very moment when they are most able to cause mischief. Which is precisely what Wolf was doing before our author so confidently quoted him offering the same "solutions" to the mess we are about to enter that created the mess in the first place!

The result is that the costs are pushed onto depositors until depositors are better off stuffing their money into mattresses and the public is then expected to pick up the tab -- while meanwhile the people who gamed the system to make false profits and bad investments walk off with their "cut" unpunished except for one or two scape-goats. Such a system, which punishes the victims for the crimes of white collar felons is going to be unstable. Without forcing investment markets to bond, back up with assets, and insure their investments and link pay to investment houses to long term performance, this cycle is only going to continue to repeat.

Further reading:
http://www.cato.org/pubs/journal/cj21n1/cj21n1-12.pdf
http://www.cato.org/pubs/journal/cj24n3/cj24n3-13.pdf
http://economistsview.typepad.com/economistsview/2007/01/the_davos_dilem.html

I can understand how his ideology influences his thinking. After all the cure for "financial market misbehavior" is indeed in better markets, not totalitarian control of markets or deregulation of them. There is no invisible hand in financial markets because they almost always represent unstable markets (where instabilities propagate) where Gambling pays off for an ever shrinking few until there is no more free market. Eliminate the opportunities to gamble with OPM and you eliminate much of the instability. Markets become boring and less heroic. I don't know about you but that really sounds good to me.

Instead our author offers a "solution" which is very certain to kill our financial markets completely. He says:

"That change will move the Fed from the myth of monetary policy on autopilot and return the Fed to its old maxim of removing the punch bowl just when the fun begins."

What the author is saying is that the Fed should go back to its old policy of inducing recessions in order to "correct" markets that are getting too enthusiastic; by tightening money and putting the screws to money markets in order to "stop" inflation. This doesn't really stop people from engaging in speculation or gaming markets, it just punishes the general economy. It's not really a solution at all. However, once again he's half right because the next point is true:

"It will end a monetary policy that equates prosperity with a boom-and-bust economy and wreak financial mayhem on the public. It is
a policy that, if continued, will erode the case for free markets generally."

No there are simple things the Fed can do: One the Federal Government can pass laws restricting the use of OPM to speculate in financial markets; require higher capitalization of the futures markets:
1. Once again limit banks from engaging in risky behavior,
2. Hold CEOs and Money Managers more than legally accountable for risk directly and beyond Sarbanes-Oaxley through risk bonding and insurance requirements on their activities and forcing pay to be tied to the integrity of such bonds over the long-term.
3. Give Stock-holders back some of the power they've lost to oversee their own companies.
4. Force Banks, Utilities and similar companies back into being capitalized around "Mission" rather than in Pirate Mode.
5. Force companies to divest from investments that create conflicts of interest in their core missions.
6. Lower the Pirate flags from Multinationals.
7. Require borrowed money investments to be backed with real assets at a higher rate of capitalization.

All these things are solutions that Wolf, Cato and this author haven't got a clue about. Why? Because of their ideological lens.

http://www.cato.org/pub_display.php?pub_id=9389

Full article:
http://www.cato.org/pubs/bp/bp103.pdf

Posted by cholte at May 21, 2008 01:47 AM