An Open Letter to the Most Responsible Lads

An Open Letter to the Most Responsible Lads

January 10, 2009

Ben Bernanke, Chairman of the Board of the Federal Reserve:

Per The Economist, the root causes of the current crises are house prices and mortgage defaults. If it is true that you once said you would “rain money from helicopters” to prevent recession, then the deluge is falling primarily on Wall Street banks and related firms in the money markets. This is akin to rewarding the team of doctors who prescribed a medical regimen for an otherwise healthy patient who consequently died. Neither the crises nor the recession will end until their causes are addressed with a strategy for (1) halting mortgage defaults that continue to generate toxic debt and (2) internalizing the now global negative externality of some $300 billion to $600 billion to $1.2 trillion in toxic debt instruments still in the system. (Estimates vary, as you know.) The problem is not liquidity. As the Financial Times reported at least twice this year, there is more than enough liquidity in global markets. The problem is toxic debt still in the financial system and the continuing creation of such debt as a result of foreclosures, which are predicted to grow through 2009 if nothing is done to stop them. Thus, no single financial institution is willing to take the next hit of write-downs worth billions, so they are sitting on their moneys as they wait for others to take the hit. No amount of liquidity will change that, the London Inter-Bank Overnight Rate (LIBOR) and your discount window be damned. Also per The Economist, the “whiff of panic” in drastically lowering discount window interest rates adds to uncertainty.

Also, please note that I use your textbooks, co-authored with Frank Rich, in my International Baccalaureate Organization economics classes. Your definitions of market failure and externalities describe the crises perfectly.

Hank Paulson, Secretary of the Treasury:

Please stop floundering about; you are further panicking the markets. The decision to allow Lehman Brothers to fall was one of the four “worst mistakes” of the year, according to the Financial Times. That decision was not yours alone, of course. But changing your mind – twice – on major objectives of the Troubled Asset Relief Program (TARP) program evidently was: You announced the changes, and wrote a defense of them in an op-ed piece for the New York Times. Such floundering merely causes further uncertainty, thus panic, thus further freezing up of the credit and related financial markets. So please decide on a strategic solution and stick to it. Two excellent strategies were recommended by economists out of Columbia University (C.J. Mayer) and the University of Chicago (James Heckmann, a Nobel Laureate), among others. Please read and consider them. Address the root cause(s) of the crises. Sure, sure: The decision reported last December 4th, that the Fed would help homeowners, is very welcome. So just do it. That’s where the continuing generation of toxic debt originates. Jesu meine Freude!

Also: Note that a lack of transparency and accountability regarding where TARP funds are going is causing a tsunami of disgust and outrage among American taxpayers. Read the usual chat sites. Disregard that at your own risk.

Speaking of ‘risk’: You were an investment banker. Why is it neither you nor Goldman Sachs did your own risk assessment of the collateralized debt obligations (CDO’s) at the heart of the crises? Humm . . .

Barney Frank, Chairman of the House Financial Services Committee:

Reliable sources report that some -- perhaps many? -- banks will not use TARP funds to extend credit. This was the primary objective of your bailout. Instead, some or many of them plan to use TARP cash to purchase other banks to augment their capital bases, thus their balance sheets.

Therefore, please do not – repeat, not -- release one more dime of TARP funds until and unless Ben and Hank put together a credible strategy, and then sign a contract to adhere to that strategy. Their tactical, floundering approach simply adds to uncertainty, thus to the crises. In fact, I recommend you rally your colleagues in both House and Senate to sign into law the conditionalities the TARP program should have included in the first place: transparency and accountability; a cap on executive compensation; elimination of bonuses; and – most urgently – a requirement that TARP funds be used to make loans rather than to acquire smaller banks or other agencies, etc.

Take them all – pols and appointees -- out behind the woodpile for a good old fashion whooping if they don’t. Play hardball; they deserve it.

Lads: I wish you well. Hope you get things right soon.

Cheers and best regards,
Ned

* Oh, yes! Before I forget: Alan Greenspan, former Chairman of the Federal Reserve:

I am sorry to say it, but the two crises were “Made in America” -- by you. Yes, you.

You were warned about the mortgage market and the housing bubble by two of your own Board members. You are responsible for the “easy money” policy that stoked both the Internet bubble and the housing bubble. Further, you refused to use the Fed’s regulatory powers to order audits of dubious assets and highly suspect lending by banks because, you maintained, the Fed does not have such regulatory powers.

I beg to disagree. Just this weekend, I perused at great length the Commercial Bank Examination Manual and related pages on the Fed’s own website. (In case you did not read that document, it is here: http://www.federalreserve.gov/ [1].)

"The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other, more-exotic forms of adjustable-rate mortgages, are developments that bear close scrutiny." Those are your words, as reported in major media such as The Economist and the New York Times in 2005. Yet “froth” can and does create “bubbles.” Your “froth” and easy money policy resulted in the housing bubble that now has brought the international financial system to its knees. Thanks to you, Iceland is bankrupt.

Yes, yes, I read how you and others like you are experiencing “shocked disbelief.” That was during your testimony before Congress on 23 October of last year. Yet you said the same thing in 2002 and through to this day – after the Savings and Loans meltdown; after Enron, then WorldComm, then all the others – when you insisted that there was no need for further regulation; that businessmen’s reputations would prevent them from offering inferior products. Your documents and speeches are all available on the Fed website or other media. Yet even Shakespeare knew better: How quickly nature falls into revolt//When gold becomes her object! (Henry IV, Part 2, 4.5.65-67)

Please note that, over the past few weeks since your last Congressional testimony, I’ve also read your publications of 1963, 1969 and many others, including your autobiography. Hence I must conclude that your failure to appreciate or research risk in the mortgage market was based on a blind faith in markets – all evidence to the contrary be damned and ignored. Yet, as we all know, Neo-Classical economic theory is partially based on the concept of market failure: (In other words, markets may often not achieve constrained-Pareto optimality – roughly, social welfare – or exist at all.) For example, the Marginal Social Cost of commuting via car is offset by the Marginal Social Benefits of productive work, stable household incomes, contributing to GDP and so on. At that equilibrium point the negative externality – supposedly -- ceases to exist. Yet even though the externality is internalized, the pollution caused is not reduced to zero. Hence pollution by tens of millions of commuters increases despite all best efforts of markets. Similarly, the dual crises: The buying and selling of CDO’s benefited many people for a few years and seemed to contribute to both Gross Domestic Product and social welfare (Pareto optimality), yet later imposed dreadful external costs on counter-parties, as well as on third parties – read, all Americans, and millions of others – who were not engaged in the economic activities that caused the crises. (Ben’s definition of externality.)

All your dissembling and all your protestations to the contrary, you are to blame. Your blind faith in your ideology blinded you to reality. I do not know how to describe you: a callow virgin of 82 years who believes – all empiric evidence to the contrary – in the inherent goodness of business men and business women, much to your credit; a mere ideologue, much to your debit side; or an idiot savant who speaks rather well. Sorry: You rather remind me of Jerzy Kosinski’s protagonist, Chance, in Being There. I am sure you’ve read it.

Now please be so kind as to fade into silence. Your reputation is not merely tarnished; it is -- with Robert Rubin’s -- entirely shattered among those of us who ‘followed the money’ and did the research. Research was your specialty in your youth, with your clarinet. (Did you ever play through Benny Goodman’s concerto? Or Alex North’s? But I digress.) You really should have done more research. Shame on you.

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Ned Boudreau, a native of Syracuse, NY, teaches economics in the IBDP (International Baccalaureate Diploma Programme) at Shanghai Pinghe School in Shanghai, China. He holds an M.Sc. degree in economics.