The ‘Great Recession’

Steven Horwitz, professor of Economics at St. Lawrence University and blogger at The Austrian Economists, gave a presentation in March of 2009 on the causes of the current recession – specifically, how many of those causes have their origins in the New Deal.

Before talking about how we did get here, let me say a quick word about what didn’t cause this mess.  Those who wish to blame greed for the crisis need to explain how and why it is that greed seems to causes crises only at specific times, despite the fact that it is omnipresent as a feature of human nature and market economies.  As the economist Larry White has noted, if we saw a bunch of planes crash all on the same day, we wouldn’t blame gravity.  It’s always there.  Something else must be at work.  I would argue that the key is the set of institutions through which greed or self-interest is channeled.  That is, good institutions can cause self-interest to generate desirable unintended consequences, and bad ones can cause undesirable ones.  So perhaps we should be looking at institutions and policy. Those who wish to blame deregulation or the supposed “laissez-faire” philosophy of the Bush Administration are going to have to identify the deregulation in question, which will be a challenge given that the last deregulatory legislation in the financial industry was in 1999 under Clinton.  These folks will also have to explain how the enormous growth in the Federal Register and domestic spending over Bush’s two terms reconciles with his supposed belief in laissez-faire.  Answer: it doesn’t.

The two key causes of this crisis are expansionary monetary policy on the part of the Fed and a series of regulatory and institutional interventions that channeled that excess credit into the housing market, creating a bubble that eventually had to burst.  In other words, the boom (and the inevitable bust) are the product of misguided government policy, not unbridled capitalism.

The Fed drove up the money supply and drove down interest rates very consistently since 9/11.  When central banks do so, they make long-term investments relatively cheaper than short-term ones, thus the excess funds flow toward such goods.  Historically, these were producer goods in capital industries, but in this particular case, a set of other government interventions and policies pushed those funds toward housing.

Too much of the discussion about the stimulus and recovery has been focused on the “macroeconomics” of GDP and overall rates of unemployment, and not nearly enough on the required microeconomic adjustments that are necessary.  Part of the curative process of the recession is not just an overall retrenchment from inflation, but a sectoral reallocation of resources away from the artificially large longer-term asset sectors toward where real consumer demands lie.  Unfortunately, no one person or group knows what those are, which is why we need to rely on the competitive discovery process of the market to figure it out, rather than government allocators who both lack the necessary knowledge and have, as we’ve seen, every reason to use such resources to serve their political self-interest.

The Obama Administration’s 2009 budget is also connected to the current mess.  According to the president, the reason we got into this mess is that we apparently spent too much on housing, the financial sector, and debt in general and not enough on the core issues of the environment, health care, and education.  For the life of me, I cannot see how such a theory can explain anything of what’s happened the last six months, but it does serve to create a rationale for a budget that contains a whole bunch of new initiatives that don’t obviously seem to be related to the Great Recession.  At a time when the US government has taken on a whole bunch of new debt with the bailouts and the stimulus, one would think that the next year’s budget should show more restraint and focus on issues central to economic recovery.  As many commentators have noted, it’s hard to both argue that too much debt got us into this mess and that more will get us out.

There are indeed parallels between this recession and the Great Depression, but they are not what much of the public commentary would lead you to believe.  What we are living through today is a recession whose causes are significantly the unintended result of institutional changes made during the Great Depression and whose proposed solutions reflect the same failed understanding of the causes that motivated Great Depression “solutions” that largely ended up doing more harm than good.  History is indeed repeating itself, and not in a good way.

The preceding paragraphs are my personal favorites from the presentation, but I strongly encourage a full reading as it very explicitly lays out the “how” and “why” of our current economic predicament.

Moral Cannibalism

Another update from the Wall Street Journal on the fate of Bank of America CEO Ken Lewis:

The political class has finally got its man, which is to say that Bank of America CEO Ken Lewis has announced he will retire at the end of the year. Don’t you feel better already? Someone had to be sacrificed as expiation for the financial panic and bailout, and the politicians are determined to convince voters that the bankers did it all. So heave-ho, Mr. Lewis had to go.

His alleged offense—investigated by the SEC, a House oversight committee and New York Attorney General Andrew Cuomo—is that his bank failed to adequately disclose to shareholders potential losses and employee bonuses at Merrill Lynch prior to their December vote to approve the BofA takeover of Merrill.

Thus the same government that told Mr. Lewis to keep his mouth shut and close the Merrill transaction now says he should have been more candid with shareholders. The same government that also threatened his job if Mr. Lewis didn’t accept Merrill’s mounting losses along with new federal money—while refusing to provide an agreement in writing because it didn’t want to inform taxpayers—now questions the disclosures he made to investors. Too bad the same investigative resources will never be used to find out how financial “systemic risk” was supposed to be reduced by forcing Mr. Lewis to merge the country’s largest deposit-taking bank with a failing Wall Street trading firm.

On the weekend that Lehman Brothers failed in September 2008, could Mr. Lewis have bought a teetering Merrill Lynch for less than he agreed to pay? Probably. Could he have killed the deal or negotiated a better price before the January closing if Treasury Secretary Hank Paulson hadn’t pressured him not to make an issue of Merrill’s rising trading losses? Perhaps.

But his real, and ultimately fatal, mistake was to believe the feds when they urged him to buy Merrill—and, before that, Countrywide Financial—in the name of saving the financial system. He forgot the oldest lesson about the second oldest profession: Never trust a politician.

Does the majority of the population believe that wealth is a natural occurring phenomenon? Do they believe that innovation and prosperity are spontaneously generated? Though businessmen and corporations are often branded as blackguards by populist politicians, they are largely responsible for the high standard in the U.S. For years, production has been penalized by regulation, taxes, and a plethora of government actions designed to distribute wealth. With each new measure, however, our society further discourages achievement and rewards mediocrity.

Judge Slams SEC for Regulatory Cynicism

A few days back I posted on the plight of Bank of America and its legal battle against the SEC. It seems that the two parties attempted to reach a deal wherein BofA would pay $33 million, but plead neither guilt nor innocence. But the presiding federal judge, Jed Rakoff, decided to make a stand for truth, justice, economic freedom. The Wall Street Journal reports:

Judge Rakoff was having none of it. In a 12-page opinion, he tore into the SEC for ignoring its own guidelines and penalizing shareholders rather than the individuals who supposedly acted improperly. The settlement “does not comport with the most elementary notions of justice and morality, in that it proposes that the shareholders who were the victims of the Bank’s alleged misconduct now pay the penalty for that misconduct.” As for the SEC’s argument that this shareholder punishment will result in better management, the judge called it “absurd.”

The judge also had little sympathy for the SEC’s argument that it would be too difficult to pursue executives, since they had been guided by lawyers. “If that is the case, why are the penalties not then sought from the lawyers? And why, in any event, does that justify imposing penalties on the victims of the lie, shareholders?” he asked.

He also had harsh words for BofA, which has recently filed court papers claiming its proxy statement was neither false nor misleading. “If the Bank is innocent of lying to its shareholders, why is it prepared to pay $33 million of its shareholders’ money as a penalty for lying to them?”

The judge had other complaints, but broadly the deal “suggests a rather cynical relationship between the parties: the SEC gets to claim that it is exposing wrongdoing on the part of the Bank of America in a high-profile merger; the Bank’s management gets to claim that they have been coerced into an onerous settlement by overzealous regulators. And all of this is done at the expense, not only of the shareholders, but also of the truth.” The parties will go to trial in February.

We look forward to it, especially in light of the recent news that Fed and Treasury knew all about these bonuses and stayed mum. Judge Rakoff has done a public service by exposing the political point-scoring that drives far too many regulatory actions.

We can only hope that February’s trial will involve some exploration into the exact roles that Paulson and Bernanke played in this abominable affair.

Creative Destruction

A story that should have a higher media profile is the SEC’s civil lawsuit against Bank of America. I would suggest a thorough reading of the Wall Street Journal’s latest op-ed on the subject; but for the purposes of this post, a quick recap is sufficient.

Last year, Bank of America entered into a deal to buy the failing Merrill Lynch. However, toxic assets were discovered on Merrill Lynch’s books. Then Chairman, CEO, and President Kenneth Lewis (he has since lost the position of Chairman), planned on disclosing this new information to investors before the board voted to approve the Merrill Lynch deal. Lewis, however, never disclosed the toxic assets. He claims his clear violation of SEC regulations (and basic ethics) is due to pressure applied by former Treasury Secretary Paulson.

The SEC’s lawsuit against Bank of America seems to indicate that Lewis’ accusations are true. Primarily because the SEC’s lawsuit is against Bank of America and not Kenneth Lewis. The standard practice in cases of this kind would be for the SEC to file charges against the individual officers who have committed a wrongdoing. The logic being that the shareholders have already suffered once from the fraud perpetrated by the corporate officers, fining the corporation as a whole would be inflicting further damage on the shareholders, who have already been victimized.

Granted, all the facts are certainly not presently clear in this case (as there has yet to be a thorough investigation into the matter). However, this entire issue would have been avoided had we not had a government willing and eager to involve itself in the affairs of private businesses. Organizations and individuals fail, it is part of the process of creative destruction that is an inherent and necessary part of capitalism. When this process is impeded, and a successful firm such as Bank of America is forced to compensate for an unsuccessful firm such as Merrill Lynch, everybody loses.