Arnold Kling  

An Open Letter to Ben Bernanke

Modern Financial Systemic Risk... Wishful Thinking...

Dear Ben,
The Wall Street Journal reports,

"If it doesn't pass, then heaven help us all," responded Mr. Paulson

He is referring to legislation to authorize the next round of bailout activity by the Treasury, with rules, methods and accountability all to be determined. You should oppose this legislation. It is an attempt to avert a financial meltdown by means of a political and fiscal meltdown.

I fear you may be seeing this crisis through the lens of the Great Depression. Then, the wave of bank failures was an element in the severity of the downturn. However, keep in mind that there is still controversy over the relative weights of various causes of the Depression, and not everyone is convinced that bank failures per se were the main factor.

Today, it is clear that the U.S. financial sector needs to shrink. As another one of your former classmates, Ken Rogoff, has pointed out, the financial sector has accounted for an unusually large share of corporate profits in recent years. It is time for this country to shift talent and capital elsewhere. In order for that to happen, some firms in the industry need to tighten their belts, some weaker firms need to merge with stronger firms, and the weakest firms need to fail. As tempting as it is to intervene in this process to try to make it more orderly, dislocation is inevitable, and intervention may only make it worse.

We have excesses. Too many housing units. Too many "homeowners" who don't have equity in their homes and never did. Too many banks and financial institutions. The excesses need to be worked out by the markets.

Henry Paulson is not the first strong Treasury Secretary to appear in a crisis. John Connally held that job in the Nixon Administration, In response to a run on the dollar, he abandoned the Bretton Woods agreement and introduced wage and price controls. In the short term, this was well received, and it allowed the economy to rebound in time for Nixon's re-election. In the long run, it was a disaster, ultimately unleashing virulent inflation and, as oil prices rose, leading to the painful disorder of rationing and lines at gasoline stations.

Connally's cure was worse than the disease. I strongly suspect that Paulson's cure will prove similarly harmful.

My suggestion to you is that you get out of your financial industry cocoon for a while. Talk to people who are concerned about the direction that policy is taking, including former colleagues of yours in academia. A Central Banker should stand up to fear-mongering. Even when it comes from a Treasury Secretary.

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TRACKBACKS (3 to date)
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The author at I'm not asking, I'm driving. in a related article titled I post these in the hopes that somebody in government will actually step back and realize the insanity that’s going on writes:
    EconLog, An Open Letter to Ben Bernanke, Arnold Kling: Library of Economics and Liberty: We have excesses. Too many housing units. Too many “homeowners” who don’t have equity in their homes and never did. Too many banks and financial ... [Tracked on September 21, 2008 10:34 PM]
The author at PrestoPundit in a related article titled BUSH PLANS TO END HIS KATRINA PRESIDENCY writes:
    with $700 billion bailout for Wall Street.  Think of it as a thousand Katrinas for the American taxpayer, and a great big wet kiss for the most pathological sector in the American economy, a sector which has already sucked hundreds... [Tracked on September 22, 2008 12:46 AM]
The author at The Volokh Conspiracy in a related article titled Dueling Analogies: writes:

    One of the interesting things that is going on with the financial crisis is the issue of "dueling analogies." In fact, I think that may be the key to understanding the wisdom of the policy interventions here--and the dueling ana...

    [Tracked on September 22, 2008 2:58 PM]
COMMENTS (21 to date)
E. Barandiaran writes:

Although I agree with your position, I'm afraid it's too late to stop Paulson's proposal to purchase assets from financial institutions. I think the debate should focus now on the terms and conditions of the purchase of assets. These terms and conditions will determine the effectiveness of the proposal to stop the downturn, but more importantly they will determine the type of financial system we will have in the next five/ten years.

David R. Henderson writes:

Well done, Arnold. Here's what a good reporter should do: when those Congressmen emerge from the meeting and say that Paulson and Bernanke scared them with the consequences of doing nothing, ask them, "OK, what scared you? Be specific. What argument did they make? How did they say this thing would unwind to the point that Barney Frank and some of the rest of you think people won't be able to get car loans?"

steve Hsu writes:

Bernanke is the one who pushed for this, at least according to the Times.

Talking into the speaker phone on a coffee table in his office, Mr. Bernanke told Mr. Paulson that it was time to stop treating the symptoms by bailing out distressed companies and instead start attacking the root problem with a comprehensive strategy.

Congress would have to sign off, and it would fall to Mr. Paulson, as the envoy of the executive branch, to take the lead.

Mr. Paulson understood.

Jesse Rouse writes:

Connally went bankrupt in 1986. Just goes to show how centralized decision making can be harmful especially when one of the few in charge can't manage his own personal finances.

From my blog:

$700 billion dollars. That's how much our government is going to spend on bailing out a bunch of companies run by incompetents and who were in large pert put in this position because of the regulations currently on the books. What the financial sector of the market needs is deregulation, not more regulations. They need to have failure privatized. Meaning, companies need to know that they will be allowed to fail. And the government needs to let them fail. The situation we're in now, the government has only postponed the inevitable. And, worse, like a fault line prone to earthquakes, the longer we put things off, the worse the quake is going to be.

The federal government doesn't have almost a trillion dollars to spend. It does not have $700,000,000,000. So where will it get the money? It will borrow it. That's another $700 billion added to the debt. How will it pay off this debt, which will come due some day?

1) taxes -- which will take more money out of the economy and create a worse economy overall
2) print money -- which will result in massive inflation
3) default -- considering how much of our debt countries like China own, this is the last thing we want to do. Can you imagine defaulting on a trillion dollars to China? We would be at war with China -- and they would be in the right.

Some wonderful choices given to us from the ghosts of socialism past. The interventionist state does not work. Socialism doesn't work. Centralized financial planning works no better than overall economic planning does. I hope -- but doubt -- someone will get the message and get the government out of the economy. I expect instead that we will get even more regulations out of this. When the collapse does finally happen, it will be the Great Depression II -- only in an even more globalized economy. But don't worry -- Obama plans to hurry things along by raising taxes and imposing tariffs. That worked so well during The Great Depression. It didn't make things worse or lead to WWII at all. Please ignore history. Nothing to see here.

E. Barandiaran writes:

Some comments to your post fail to acknowledge that the consequences of Paulson's proposal cannot be assessed until the terms and conditions of the purchase of assets are defined. The relevant economic cost of the proposal may not be as large as you and other people fear if the terms and conditions are properly chosen. Please open a discussion of these terms and conditions before the politicians set them (don't ask me to do it because I'm an Argentinian, living in Spain, and right now traveling in Chile).

The specific consequences may not be able to be ascertained until then, but we have a lot of historical evidence supporting a general understanding of what will happen. I don't need the details to understand that what I said will happen will happen.

Lord writes:

I agree finance needs to shrink. If we need counteracting expansion let it be in other areas at the expense of finance. The prices must be heavily discounted. A 50% discount from peak housing prices seems reasonable.

Niccolo writes:

This message brought to you by,

Arnold Kling's Straight Talk Express.

stylized.fact writes:

I agree impulsively with the notion that reorganization in the financial services sector would be beneficial to the economy overall. However, it does raise the question of how we know when the financial sector is properly sized. This no doubt relates to some degree on scarcity of innovation in other sectors. Maybe quants would be better off working on alternative fuels, but then again, maybe they aren't. Maybe FIRE is properly sized, they just need extra time and resources to innovate a little more. Disposable diapers and the VCR took quite a while.

Ben White writes:

Specify what you think the future consequences will be. Otherwise this is just "it sounds like a bad idea to me".

Will the economy be able to operate without credit? How long should we shut it down for?

bc writes:

It doesn't have to be sink or swim, all or nothing. The Fed could push congress to undo SOX, and formally rescind "mark to market" requirements under GAP. And it could raise interest rates to strengthen the dollar, while amping up spending on public works to create dollar demand and to prime the pump. Borrowing and buying assets should be a last resort, and it should hurt like hell for the sellers.

Max writes:

Bernanke and Paulson have the experience and intellectual firepower for this time in history.

A Central Banker should stand up to fear-mongering. Even when it comes from Arnold Kling.

lowbeyond writes:

Here is a solution

edh writes:

I think the debate should focus now on the terms and conditions of the purchase of assets.

For all the negative talk, I still have no idea how much the loan assets will be discounted before govt purchase. As for the $700b figure, is that how much the govt will spend to purchase the assets, or is that the nominal amount of the debt assets the govt will buy at discount?

If the govt has these holders of debt over a liquidity barrel, why shouldn't the govt be able to sell eventually the debt it buys at discount for as much or more than what it pays for it?

justcurious writes:

I'm just curious why you would be writing an open letter to Ben Bernanke, who will be the recipient of the $700 billion, urging him not to take the government handout that he himself has urged that the government give him?

It makes no sense. Ben Bernanke, last time I checked, was chairman of the Federal Reserve ... a non-governmental agency ... a private bank holding organization. It, and its member banks, will be the recipient of the very handout you are criticizing.

What makes you think they would refuse it?

Look folks, here's the deal. Rich people don't have to participate in our economy. They're rich. That's the deal. They can always take their dollars and go home. And that's just what many of them are doing and that's what the current crisis is about.

What you are seeing is a rush OUT of the credit business as the rich preserve their assets. They've decided they aren't going to lend money because they can't calculate the interest and the risk.

If the rich decide not to provide working capital to America, then America won't work. Think 25% unemployment, breadlines, soup kitchens. Color televisions will suddenly only display images in golden sepia tones.

It's too late to whine about it. The damage was already done the moment that the Fed decided it was OK for banks to lend money to illegal aliens (and others) with zero down and no income verification. The government allowed it because it increased property taxes as home prices were inflated.

That's when the damage was done, and there's no undoing it.

So, those of you still paying taxes into the system should just bend over and get prepared.

Me. I've quit my job. I'm no longer willing to work for half-pay while the other half of my pay goes for Wall Street bailouts for guys with yachts. That will cost the Treasury about $45,000/year, and that's not counting the government checks I will shortly be eligible for.

So long, suckers!

Derek writes:

I think listing the number of housing units as an excess is misguided. The US will need about 90 million additional units before 2050 based on population projections.

Fast Ben writes:

An economy built on debt is a false economy.

Dan Weber writes:

What's the total amount of mortgage property in this country? I thought it was something like 4 trillion dollars, but I can't google up the exact answer at the moment.

0.7 trillion sounds pretty big compared to that, especially with as many property values that have been falling.

B.H. writes:

In defense of poor Nixon.

First, as Milton Friedman predicted, a fixed exchange rate system (with or without price fixing for gold) is doomed, but he said it would take a crisis to kill it. He was right. We should congratulate Nixon for the courage to abandon Bretton Woods, even if took two years to do it. The dollar was badly overvalued, and the one-time readjustment to equilibrium caused a one-time surge in the CPI.

Second, Congressional Democrats authorized Nixon to impose wage-price controls. They did not think Nixon would use them, but they wanted to give him the authority so they could embarrass him and blame him in the elections for not fixing inflation. Our country has made progress in that no one advocates price-wage controls anymore. (If we could only get rid of windfall profits taxes.)

Fixel writes:

Please consider this attached article, for ideas on how to correct and strengthen the economy, by the British economist Fred Harrison. I feel he makes the correct point to use as a basis to change and improve our economy . Are you familiar with these ideas and the ideas of the economist , Henry George ? I feel that especially since the economy is in bad condition, it is even more important that we have a system of taxes that could help prevent a small group from having a monopoly on land , and also will enact a fair and just tax system for all the citizens.

Initially please seriously consider studying the use and ramification of a tax system focused on collecting most government taxes from taxing land according to it's value, awhile at the same time trying to reduce or eliminate as much as possble taxes on income . The next step might be creating many classes to study this system in the universities. Then if you find merit in these ideas and systems, we must try to find ways to actually implimate the system .
I would aslo very much like to hear your comments on these ideas, either by telephone or e-mail. Good luck.


Bust will follow boom - but when?
Aug 05, 2005
Many think that the global real-estate bubble has nearly run its course. Fred Harrison disagrees. He thinks it has another three years to run. Here he tells us why.
From California's Silicon Valley through the hot spots of Europe all the way to the booming property market of Shanghai, house prices have hit record highs – driven upwards by easy money and the speculation it always causes. The effects of the boom have spread through the world economy, thanks to the impact the feel-good factor of rising house prices has on consumer spending, and hence on economic growth. But can the good times last? And what happens if they don't and probably the biggest bubble in history turns to bust? We may not have long to wait to find out. If history is any guide, property prices around the world will start to fall in three years' time and a global economic depression will follow in 2010 as consumer consumption collapses.

This analysis is based on a theory of the property cycle. I have drawn on 300 years of business-cycle history and reached one firm conclusion: housing booms precede recessions. That said, there is a big difference between this bubble and past bubbles. In the past, national economies have operated with a degree of independence. Today, we all sink or swim together: the major economies of the world are synchronised into a single business cycle and so are property prices.
In the US, house prices have doubled in the past five years, and as land becomes unaffordable to first-time buyers, builders are turning to the construction of smaller dwellings and condos. This echoes what has happened in Britain, and the story is repeated in countries such as Australia and the sun spots of southern Europe. Even in China, all along the coast erstwhile Communists are "flipping" properties just like their capitalist cousins in America – buying off-plan and re-selling apartments before the blocks are even constructed as prices soar. Consider the numbers. In the UK alone, the value of the housing stock reached £3.3trn in 2004, triple the value of ten years earlier, according to Halifax. Then look at all the developed countries put together: real-estate prices have risen by more than $30trn over the past five years. That's equivalent to 100% of their combined annual GDPs. This eclipses the 1990s stockmarket bubble (an increase over five years of 80% of GDP), and Wall Street's bubble of the late 1920s (55%). But this bubble may not be done yet.
The 18-year cycle
House prices can't rise indefinitely for the simple reason that at some point they become unaffordable. Wages can't rise as fast as house prices can when a speculative frenzy is underway, so there will come a point when the average man can't buy the average house, and prices have to fall as a result. My research shows that this tends to work in 18-year cycles. There are usually 14 years of rising prices followed by four years of recession across the broader economy. I've looked at data across four continents and at 300 years of British economic history and it seems that this 18-year cycle is present across the globe, irrespective of the distinctive characteristics of each economy – whether the country is resource-rich (USA) or resource-poor (Japan), or whether the population is high density (the UK), or low density (Australia).
Governments always think they can in some way control boom and bust cycles, but so far they have failed. Why? Because their economic models are overly focused on labour and capital rather than on land and property prices, the things that really drive economies. Classical economists such as Adam Smith thought that because the supply of land is one of the few things that is by nature finite, it is land that ultimately determines our economic fate. So while we talk (endlessly) about investing in "bricks and mortar", it is in fact the plot underneath the house that really makes the difference. In fact, the price of land is the best leading indicator we have of the state of health of the economy.
Look at what has happened to prices since 1979. In the Nigel Lawson boom/bust of the late 1980s and early 1990s, the price of new houses rose by 300%, but the price of raw land rose by 1,000%. Then both turned down, ushering in a recession that hit bottom in 1992. Then from 1993 until Gordon Brown moved into the Treasury in 1997, house prices stayed on an even keel. But while house prices subsequently escalated to an annual increase of 25% at their peak, the price of land launched into the stratosphere. Land prices have risen an extraordinary 1,700% since 1979.
So what next? Well, just like the 1980s boom, this will end in disaster for the wider economy, as people struggle to meet mortgage payments and have to slash all their other discretionary spending. Already there is a 51% upturn in the repossession of homes during the first half of this year and Lloyds TSB reported a 21% increase in bad debts over the six months to July compared with 2004 – clearly, people are already struggling. Cuts in consumption ultimately hit manufacturers. Indeed, the Purchasing Manager Index fell to 49.2 in July from 49.6 in June, the fourth straight month of contraction.
It all happens in 2008
So when will the crunch really come? History suggests that things will start to collapse in 2008 (18 years on from 1990 when the last bubble burst). But there are a few good reasons apart from the historical 18-year cycle that should make us think that the bubble will run to 2008. Government spending is still very high in the UK, for example – now that the Treasury has redefined its version of a 'cycle', Gordon Brown can raise borrowing to support his spending commitments. This should continue to offer some stimulus to the economy until 2007/2008, when it is scheduled to tail off.
John Prescott's plans to help first-time buyers and 'key workers' into the market should also help make it look more solid than it is, as should the fact that higher income earners are predicted to inject more than £8bn into property through self-invested personal pension funds from next April. There are similar stimulative measures afoot in Europe (the European Commission is promoting a Europe-wide mortgage market), which should keep prices moving there for a while as well. However, all the pressures on the market will converge on 2008 as the stimuli run out. And it isn't just the residential market that will be in trouble. The commercial property sector also has an ominous feel about it. Speculative skyscrapers are going up as much because of their iconic appearance as for the economics of the tenanted sector, and more and more capital is being tied up in real estate rather than put to work in research and development. All over Europe too, money that should be funding the factories and infrastructure that would raise EU productivity is instead seeking out windfall gains in real estate. This will also end in tears and the net result will be the arrival of recession by 2010, something that may well be aggravated in Britain by a new 'land tax'.
Lower interest rates won't stop the crash
Can anything be done to head off the depression of 2010? In my view, it's too late for the UK. The Bank of England is caught in a double-bind on monetary policy. If house prices are to be held at their current levels, debt levels will have to keep rising. That puts a continuing downward pressure on interest rates, which induces further upward twists in the price of houses. But if the Bank keeps cutting interest rates as unemployment rises and high street sales drop, it will aggravate stresses in the economy (inflation, for example). There is nothing it can do in the short term.
The fundamental reform that would re-balance the economy needs a much more long-term political strategy. It involves a drastic cut in the tax taken from people's wages and savings in order to encourage them to work and invest. Then, as FT columnists such as Samuel Brittan and Martin Wolf have recently argued, we should pursue the Adam Smith approach to public finance: revenue should be drawn from the rents of land (not on the value of land assets as discussed in the box below – this would only make things worse).
This reform – promoted by Winston Churchill a century ago, but thwarted by the landowners in the House of Lords – would turn taxation into a counter-cyclical policy. As land prices rise (as they do, in a growing economy), more revenue would flow into the public coffers to pay for better services. At the same time, tax policy would deter land speculation while rewarding enterprise – the opposite to what it does now.
In the meantime, the best thing investors can do for themselves is to shift their portfolios into assets that can quickly be liquidated. Don't believe anyone who says that the property market is going to recover strongly from here and don't believe anyone who says that even if it doesn't, the effect of housing on the wider economy is marginal. It isn't. It is absolutely key to the health of both the UK and the global economy.
Fred Harrison is executive director of the Land Research Trust in London. He is the author of Boom, Bust: House Prices, Banking and the Depression of 2010 (Shepheard Walwyn, 2005)
Has Gordon Brown lost the plot?
Bank of England economist Kate Barker, in her report on the UK housing market last year, recommended a 'Planning Gain Supplement'. Deputy prime minister John Prescott has also signalled his support for what would effectively be a tax on developing land. Town councils want this 'roof tax' to pay for roads and schools. But Development Land Taxes have been tried and tested on three occasions since 1948. Owners withdrew their land to avoid these taxes, damaging the development industry and raising house prices still further.
The new tax, if it is introduced by Gordon Brown, would become operable in 2009/2010, just as building activity grinds to a halt. The ensuing recession in real-estate prices will be prolonged, as owners hold back their plots andwait for a new government to abolish the tax.

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