A Stitch in Haste

Now is a good time to summarize my general thoughts on the Federal Reserve System.

--A national currency (i.e., money supply) is both a legitimate public good and an enumerated power of the federal government.

--A gold standard is both impossible and undesirable. Fractional reserve banking is not an abomination.

--There is one and only one legitimate monetary policy: Changes in the money supply should reflect changes in real output, adjusted for changes in money velocity. (Note: That's just a fancy way of saying: "No government-imposed general inflation or deflation.")

--To the extent that the Federal Reserve performs or facilitates the function of maintaining our national currency and implementing the aforementioned monetary policy (i.e., by administering the fractional reserve framework underlying the money supply), it is not an affront to libertarianism.

--To the extent that the Fed deviates from that core function, it is an affront to libertarianism. Specifically:

--It is not the purpose of the Fed to prop up the stock market.

--It is not the purpose of the Fed to prop up the subprime lending market specifically or the credit markets generally.

--It is not the purpose of the Fed to manipulate the dollar relative to other currencies.

--It is not the purpose of the Fed, or any part of government, to bail out anyone after their own financial recklessness, or to prevent or punish "predatory" lending (or "predatory" anything, for that matter).

--The Federal Reserve has the following controls over the financial system:

1. The discount rate should be adjusted to reflect, not to control, the rest of the yield curve.

2. The reserve requirement can and should be adjusted only to reflect evolving financial systems (e.g., e-commerce).

3. Open market operations are only a proper function of government to the extent that they are used to implement a proper long-term monetary policy. Using short-term open-market operations (i.e., manipulating the federal funds rate) is not a legitimate function of the Fed under any circumstances (i.e., the fed funds rate should float freely).

Discuss.

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Related, if light-hearted, thoughts at LoSC, Hodak Value.

More demands that the Fed, among others, "just do something" —

The past few weeks have exposed a giant crack in modern financial architecture, created by the youthful wizards and endorsed as a diversifying positive by central bankers present and past. While the newborn derivatives may hedge individual, institutional and sector risk, they cannot hedge liquidity risk. In fact, the inherent leverage that accompanies derivative creation may foster systemic risk when information is unavailable or delayed. Only the central banks can solve this, with their own liquidity infusions and perhaps a series of rate cuts.

"Liquidity risk" is a fancy name for a phenomenon that most people understand perfectly well. It simply means that in some circumstances you need to wait before paper worth becomes tangible worth. Examples include:

• "I can sell my house for $300,000 — just not tomorrow."



• "The value of a 401(k) account is essentially zero before you reach age 59 1/2."



• "How can you have any pudding if you don't eat yer meat?"

"Liquidity" is a good (or, if you prefer, "providing liquidity" is a service). It has a market (several actually), with supply and demand curves and market-clearing rates. If the demand for liquidity goes up, or the supply goes down, then the price charged for liquidity goes up. It's just sophomore economics. "Youthful wizards" have nothing to do with it.

Which begs the question: why should fluctuations — even major ones — in "just another market" imply mandatory intervention by central bankers, or by any other part of government? People make money and lose money in markets all the time — the liquidity market is no exception. If the "youthful wizards" — and the not-so-youthful senior Wall Street executives who hire them — miscalculated, then so what? Too bad so sad.

But that cuts both ways. If a speculator thinks he can use the liquidity market (i.e., make easy money) by purchasing 20 undeveloped lots in Las Vegas but turns out to be wrong, then so what? Too bad so sad. (Again, and this is important: The spike in foreclosures is not Mr. & Mrs. Bluecollar being kicked out of their single-family home; it's Mrs. & Mr. Infomercial failing to flip their 20 "no money down" speculative properties. That's one investor, twenty foreclosures, zero homelessness.)

If there are anecdotal cases of institutions engaging in false advertising, deceptive accounting, manipulating the legally incompetent, then fine — pursue them with the full force of the law. But the mere fact that many otherwise competent people, including financial professionals, happened to make very bad decisions is no claim check on the Fed, Congress, or taxpayers' wallets.

More:

The ultimate solution must not emanate from the Fed but from the White House. Fiscal, not monetary, policy should be the preferred remedy. In the early 1990s the government absorbed the bad debts of the failing savings and loan industry. Why is it possible to rescue corrupt S&L buccaneers yet 2 million homeowners must be thrown to the wolves today? If we can bail out Chrysler, why can't we support American homeowners?

The savings & loan industry was a mutant creation of the post-Glass-Steagall, pre-Gramm-Leach-Bliley financial omni-regulatory state. Those "corrupt S&L buccaneers" were spawned by government, much like the "corrupt lobbyist buccaneers" of today. The S&L crisis, meanwhile, was the direct result of incompetent central planners changing the rules for financial institutions post facto and making the S&L industry, which they themselves created, non-viable and doomed to collapse. It was completely avoidable before government changed the rules and completely unavoidable after government changed the rules. Chrysler, meanwhile, is the perfect case study of why government should never bail out failing corporations — did it end up doing any good?

And, one more time: "American homeowners" aren't the ones suffering; speculators and their financiers are. In another context these are the same people dismissed by central planner wannabes as "greedy capitalist bastards." Now suddenly they're helpless victims in need of a dole check underwritten by the financier of last resort: the innocent taxpayer who had absolutely nothing to do with this mess. Go figure.

Similar thoughts at EconLog.

I'm not the first to notice this, but it bears repeating:

--Back when banks and other "greedy capitalist bastards" refused to loan money to poor people in poor neighborhoods, they were damned by politicians and bureaucrats for "redlining."

--Now that banks and other "greedy capitalist bastards" are indeed loaning money to poor people in poor neighborhoods, they are being damned by politicians and bureaucrats for "predatory lending."

Is it possible that maybe, just maybe, the problem is with the politicians and bureaucrats and not with the banks and other "greedy capitalist bastards"?

Either way, expect taxpayers to be the truly innocent victims.

Faced with a possible tidal wave of home foreclosures beginning this fall, Democrats and Republicans are battling over a philosophical question with huge practical implications: should the government ride to the rescue?
...
Senator Charles E. Schumer of New York, chairman of the Joint Economic Committee, has proposed that the government distribute $300 million to nonprofit groups that could advise families on how to refinance or renegotiate their mortgages. The Senate recently included $100 million for such programs in a spending bill for HUD.

Another idea, being considered by Senator Richard J. Durbin, Democrat of Illinois, would give bankruptcy judges the ability to revise mortgage contracts, much as they already do when sorting out payments to other kinds of creditors.

Schumer is a socialist whiner who screeches his radical liberal indignation over this travesty or that every weekend via press release. This is nothing new.

But could you imagine the chilling effect on mortgage lending if banks were suddenly told that, in the event of default, their mortgages (i.e., their liens on the properties) were in fact nothing of the kind, but just another smile-and-handshake IOU backed only by whatever recovery a judge might feel was appropriate? Does Durbin not understand the underlying, and all-important, distinction between secured versus unsecured debt, and the potentially devastating implications of blurring or eradicating that distinction?

Or is he, like Schumer, simply doing what politicians do best: telling simpletons what they want to hear, reality notwithstanding?

A comment I left at another blog regarding a proposal to ban prepayment penalties on mortgages:

It takes a special kind of arrogant, "central planner wannabe" mentality to insist that restricting the ability of competent consenting adults to enter into strictly private contracts with one another actually makes them better off.

It's cute when such malcontents lament having "too many toothpastes," but when they set their sights on the financial markets, it's time to get very, very nervous.

As I've blogged previously:

If there are anecdotal cases of institutions engaging in false advertising, deceptive accounting, manipulating the legally incompetent, then fine — pursue them with the full force of the law. But the mere fact that many otherwise competent people, including financial professionals, happened to make very bad decisions is no claim check on the Fed, Congress, or taxpayers' wallets.

Neither is it a license for regulators to "save from themselves" those who are in no way caught up in the current subprime turbulence.

There's not much to say, and I said it here:

There is a difference between "bailing out" and "underwriting the orderly liquidation of." The Fed, via JPM, is doing the latter, not the former.

A perfectly reasonable libertarian case can be made that neither undertaking is a legitimate function of government (just as it is not a legitimate function of government to use the tax code or monetary tools to foster home ownership in the first place). But there is nevertheless a substantive difference between the two forms of intervention.

For who require analogies: Rescuing the FSLIC (a government program, incidentally) was "bailing out"; the Resolution Trust Corporation was "underwriting the orderly liquidation of." Saying "this is just like the S&L crisis" achieves nothing (other than to prove one's ignorance about the subject).

Robert J. Samuelson proffers one typically collectivist answer:

Except for oil executives, no group of business leaders is now more resented than the titans of finance — bankers, traders, hedge fund managers. They are blamed for the housing crisis, global financial turmoil and a possible recession. But this broad indictment, though true, is only half the story. The job of modern finance is to allocate Americans' nearly $2 trillion in annual savings to its most productive uses; the paradox of finance is that its virtues and vices come tightly packaged together.

This is, of course, utter nonsense.

The "job" of modern finance is the same as any other industry's "job" — to provide a good or service that customers want. Whether that good or service (i.e., the supply) or customers' desire for it (i.e., the demand) are more or less (or not at all) "productive" is completely beside the point.

The "job" of a food company (or especially a restaurant) is not necessarily "to allocate food to its most productive uses." The "job" of a food company (or very especially a restaurant) is to satisfy customers. "Productivity" (defined however you like) is secondary at best.

So too with "modern finance" — and every other sector in a capitalist (i.e., free) economy: Who wants what, who is willing to provide it, and can they be brought together in voluntary exchange? All else is economic detritus.

If competent consenting adults wanted to take on risky levels of mortgage debt, and if banks and other institutions wanted to loan them the funds to do so, and if other companies wanted to buy up those risky mortgages and package them into complicated (and risky) securities, and if institutional investors wanted to buy those complicated (and risky) securities — then "modern finance" did exactly what it was supposed to do. The fact that so many of these voluntary transactions turned out to be unwise, unprofitable and even calamitous — i.e., if they turned out not to be the "most productive uses" — is not the point. People sought, as is their right in a free society, to take big gambles. The fact that they lost does not constitute a "market failure." Indeed, the exact opposite is true.

There are footnotes, to be sure. Where there was fraud (e.g., predatory borrowers who lied on their mortgage applications in order to exploit lenders), then free markets can indeed be impeded. Such anti-capitalist endeavors were, one could say, an "unproductive allocation of resources." Point conceded.

But that kind of risk is also nothing unique to "modern finance." Unscrupulous sellers — and buyers — try to exploit each other all the time. And in response, we have developed a combination of tort, contract and criminal law to constrain them — glued together by the (capitalist) concept of "due diligence" (i.e., the self-imposed vigilance expected of competent consenting adults in a free society). This system provides all the protection one ought to need.

For the government or its central planner / nanny state apologists to attempt more (bailouts, recisions of contracts, tax breaks, etc.) confuses the orthogonal notions of "market failure" and "market participant failure." The subprime fiasco is strictly a case of the latter; to treat it as the former will only result in the wrong cures being applied to the wrong illness.