David Wessel’s book, In Fed We Trust: Ben Bernanke’s War on the Great Panic, is the definitive chronicle of the 2007-2009 financial crisis, but it is much more.  The book gives us an inside view of how policy making took place in response to the striking events. Wessel provides insights into the key players and decision makers, and conveys a very real sense of what they were thinking as those events unfolded.  In doing so, however, his account triggers serious questions about the Treasury/Federal Reserve decision-making process.  Here, we emphasize three serious flaws in the policy-making process that Wessel describes: the consistent lack of a plan and short-time horizon of the decisions, the insularity of the decision makers, and the apparent disregard for FOMC information-security rules governing meetings and associated documents.  We conclude by noting some oversights in Wessel’s account of the Great Depression and the Panic of 1907.

Lack of a Plan

The insider’s view of the policy making is the unabashed strength of this book, and Wessel provides an extensive chronology of how the crisis unfolded.  It is not a pretty picture.  His most telling observation is that the principals seem to have lurched from event to event without a plan, even after it should have been apparent that one was needed.

The discussions among key participants – namely Chairman Bernanke, Secretary Paulson, then-president Geithner, and Governors Kohn and Warsh – seem rushed, from Wessel’s descriptions of them.  The policy discussions tended to focus on short-term problems, pushing off potential longer-run consequences of the policy responses as a matter of expediency.  The sense is that the participants expected each decision to be sufficient to return markets to normalcy; but of course, they were not.  The ad hoc, short-term nature of policy process, as described in the book, carried with it the risk that not all decisions would be good and would carry with them unintended consequences.  For example, the problems of exiting from many of the policies are now significant and have yet to be addressed.

Wessel alleges that the policy makers continually underestimated the crisis and that there was no long-range planning undertaken from the time that the crisis initially erupted.  This should come as no surprise to anyone reading closely the financial press throughout the crisis, and yet it remains disappointing.  It is important to note that not all the decisions had the time constraints that surrounded the issue of the Lehman failure in the fall of 2008.  That event was preceded by almost a year of financial turmoil, serial reports of losses, failures or mortgage related institutions, and market disruptions that should have signaled to policy makers that something serious was at hand and that they weren’t simply facing a short-term liquidity problem.

By now, it is apparent that the crisis was misdiagnosed as a liquidity problem when in fact it was a solvency crisis.  Funds didn’t suddenly dry up and markets did not stop functioning because there were no funds available.  Rather, because of the trail of losses and preceding events, financial markets finally became wary of the solvency of key counterparties, as the Bear Stearns episode clearly demonstrated.  This was long before the problems in Lehman Brothers emerged.  Market participants’ concerns, as subsequent events proved, were well-founded.  It took policy makers too long to recognize the capital deficiencies relative to the risk exposures of major primary dealers, which then left them with insufficient time to design resolution plans.  Most of the largest financial institutions – both domestic and international – proved to have inadequate capital.  Some failed, and many were bailed out by their respective governments.

Wessel’s description of the decision-making process reminds one of a perpetual Chinese fire drill rather than a considered, analytic approach to the problems as they unfolded over time.  The latter implies a systematic plan, and the former implies a sequence of ad hoc responses to unrelated shocks. Even if an initial plan proved inadequate, the experience would have permitted corrections as events evolved.  And lacking a plan, it is harder to see if and when a decision was wrong.

Delegated and Concentrated Decision Making

The second issue that emerges from Wessel’s account is the insular and concentrated nature of the decision-making process, which excluded many members of the Board of Governors and FOMC.  Three governors and the president of the NY Fed apparently took on the decision-making responsibility for the central bank in the midst of the crisis. From the narrative, it seems as if this core group effectively froze out the remaining two members of the Board and FOMC members from both decision making and access to key real-time information.

Why did it happen?  Under what authority did this happen?  One plausible answer is that the core group felt that the existing structure was too cumbersome to effectively coordinate policy among so many principals, and so they simply exploited a loophole in the law governing open and closed meetings of government agencies.  Let us explain.  Normally, there are seven members of the Board of Governors, so that a gathering of four would constitute a majority and could officially make decisions.  According to the 1976 Government in the Sunshine Act, which sets out the rules meetings of  federal governmental agencies, official Federal Reserve Board meetings in which policies are considered must be announced in advance and,  at a minimum, an agenda must be provided,.  For this reason, only three governors can get together in the same room without it constituting a “meeting”  and invoking the provisions of the Sunshine Act.   But during the entire crisis there have only been five governors on the Board, with two vacancies.  (David Kotok has written extensively on this issue in previous commentaries.)  Thus, the gathering of the three governors in the meetings that Wessel describes meant that while not technically meeting the legal requirement for a meeting, the three de facto constituted a majority of the sitting governors and could actually make decisions.  Coordinating policy with the entire FOMC would have been more cumbersome and likely would have also required that a written transcript be prepared.  It could be that the core principals felt that a smaller group would make decisions more quickly, and the sense of such a desire for quick decisions comes across in the narrative.  Nevertheless, one can’t help but feel that it might have been beneficial to have been able to tap the broader experience and expertise of the Federal Reserve Bank presidents, especially since so many of the key principals making the crucial decisions were relatively new to their jobs.

The Sanctity of FOMC Meetings

From the perspective of former senior officials of the Federal Reserve System, the details that Wessel reports about specific material in confidential FOMC documents and discussions that took place during FOMC meetings are especially discomforting.  FOMC security is governed by the FOMC’s Program for Security of FOMC Materials, which is a classified program that defines the security levels and handling of FOMC-classified documents.  The Program also sets out rules for how many people can have access to such documents.  At one time, only 10 people at each reserve bank (with the exception of New York and the Board) could have access to the Bluebooks, which contain the policy options presented by the staff to the FOMC.  The Bluebooks receive the highest level of  security classification.  The procedures also require detailed record keeping and govern storage and delivery of both hard-copy and electronic documents.

Most importantly, it is also clear in the Program to every attendee that what goes on in that board room at the Board of Governors stays in that room until the transcripts are made public five years later.  In the past there have been a few leaks.  When that happened, staff who attended the meetings, as well as bank presidents, and presumably Governors, were interviewed under oath by the FBI in one case and by a representative of the Board’s Inspector General in another case in an attempt to smoke out the source of the leaks.  The penalties for divulging classified information are extremely severe and might even include criminal charges.

Against that background, the kinds of candid conversations that Wessel had and divulged in his book are indeed surprising.  There are at least a dozen revelations of what went on at various FOMC meetings, who said what, and even what was substantively covered, that rise to a level of severity far above that which triggered investigations by the FBI and Inspector General during the Greenspan era.  One might deduce by simply examining historical Bluebook documents released on the Board’s website that the staff typically offers three policy options for FOMC consideration at each meeting.  So in describing that process Wessel is merely drawing on public information. However, Wessel indicates that in one meeting during the crisis there were actually four options presented, and he describes what some of those options were.  Either there have been significant revisions in the Program for Security of FOMC Materials in the past couple of years or there is now blatant disregard, for whatever reason, of the rules and sanctity of the meetings.  One could view this as another example of how the rules are now being bent at the Fed.  In the near term, these revelations may further damage the credibility of both the FOMC and the Federal Reserve.  It certainly weakens the Federal Reserve’s arguments against additional Congressional auditing of Federal Reserve activities.  After all, if FOMC participants can freely talk to the press in violation of their own security rules, surely Congress has a right to know what is going on as well.

Prior Financial Crises: 1907; The Great Depression vs. Depression 2.0

Wessel devotes Chapter 2 to describing what he believes are parallels between financial crises of the past and present.  In the interest of historical accuracy, even if it appears that we are nitpicking,  it appropriate to point out a couple of factual oversights.  In the second chapter of the book Wessel mischaracterizes key events during the Panic of 1907.  Specifically, he notes that the suspension of Knickerbocker Trust on October 22, 1907, after several days of depositor withdrawals, was the catalyst for the onset of that crisis. Wessel refers to the Knickerbocker Trust as the “Bear Stearns” of its day, claiming that Knickerbocker had lent heavily to the copper speculators, who failed in an attempt to corner that market and brought that firm down, just as Bear Stearns’ mortgage activities brought it down.  But in fact, such allegations about Knickerbocker have never been substantiated, and Wessels may have drawn upon a flawed analogy.  Bear Sterns’ problems were of its own making and not due to the actions of its borrowers.  In discussing Knickerbocker’s failure, Wessels also suggests that Benjamin Strong, then a Morgan employee who was asked by Morgan to inspect the books of the trust company, said that Knickerbocker Trust was insolvent.  Rather, Strong said that he was unable to determine whether it was solvent or not, a subtle but important difference.  That uncertainty parallels the uncertainty that market participants apparently felt about counterparties during the current crisis.  Finally, in contrast to Bear Stearns, which was rescued, Knickerbocker Trust suspended operations but eventually reopened as a going concern in March of 1908.  Ironically, the corrected analogy is likely a closer parallel than the one Wessel draws.  It is precisely the lack of clarity about financial-market solvency in 1907 that parallels the opacity that existed in 2007-2008.

Regardless of perspective, we do not really know how close the financial market came to collapse in 2008.  Whether letting Lehman Brothers fail was good policy or not, it is clear that timely resolution is critical when systemic issues are of concern.  If policy makers, present and future, draw their insights from past attempts to alleviate crises, they should distinguish the successes from the failures during those episodes.  Allowing Knickerbocker Trust to fail was likely a mistake, and one that arose from the lack of timely information about its solvency to the existing lender of last resort at the time (Morgan).

In another section, Wessel suggests that the Federal Reserve System’s creation was largely based on an earlier plan written by investment banker Paul Warburg.  The statement overlooks the overarching point that the Federal Reserve Act was not the work of one person, but was in fact the outcome of several years of careful research, discussion, and debate.  In particular, the National Monetary Commission and its proposal for banking reform, named the National Reserve Association, did incorporate many of Warburg’s ideas.  But Wicker (2005) emphasizes that the Federal Reserve Act bore a striking resemblance to the National Reserve Association legislation.  More importantly, the process was completed nearly five years after the Aldrich-Vreeland Act created the commission to study the reform of the monetary system.  The larger point about the time taken to appropriately reform the financial and monetary system is especially relevant today, as the Congress seems to be in a great rush to reform our financial regulatory system in response to the current crisis.

Wessel’s treatment of the Great Depression era is essentially in accord with the standard views regarding that period.  There are two minor points of difference, however.  First, some of the Reserve Bank presidents (governors, as they were then called), most particularly Eugene Robert Black of Atlanta, were consistently supporting the extension of liquidity, rather than policies to enforce the gold standard.  It was this policy that Friedman and Schwartz document and that resulted in a one third contraction in the U.S. money supply, thereby exacerbating the depression.

Bottom Lines

Wessel’s book confirms that the process of saving the financial system was, to no one’s surprise, ad hoc.  Further, the decisions were imperfectly informed by the principals’ perceptions of what was actually occurring.  Clearly, Chairman Bernanke understood the big risk of a financial meltdown and made bold moves to ensure that we didn’t experience another Great Depression.  President Geithner, now Treasury Secretary Geithner, is described as an interventionist whose main concern was the short run and who was willing to deal with the unintended consequences as they arose. Finally, Secretary Paulson seems to have been solely a markets person, long on the bravado associated with a deal maker and short on the analytics required to formulate good policy.

Whether all the actions taken were necessary we will never know, because we can’t observe what might have been had other policies been followed.  But it is clear that the process of dealing with the crisis might have benefited from additional inputs and analysis by people who held responsible positions within the Federal Reserve, but who, for whatever reasons, were not actively involved in the policy-framing process.  Perhaps in the debate that surrounds regulatory reform of the financial markets, the basic management issues of decision-making process design and planning should become a priority.  If not, then we may in the words of Yogi Berra experience déjà vu all over again.

The Federal Reserve Act of December 23, 1913, was part and parcel of the wave of Progressive legislation on local, state, and federal levels of government that began about 1900. Progressivism was a bipartisan movement that, in the course of the first two decades of the 20th century, transformed the American economy and society from one of roughly laissez-faire to one of centralized statism.

Until the 1960s, historians had established the myth that Progressivism was a virtual uprising of workers and farmers who, guided by a new generation of altruistic experts and intellectuals, surmounted fierce big business opposition in order to curb, regulate, and control what had been a system of accelerating monopoly in the late 19th century. A generation of research and scholarship, however, has now exploded that myth for all parts of the American polity, and it has become all too clear that the truth is the reverse of this well-worn fable.

In contrast, what actually happened was that business became increasingly competitive during the late 19th century, and that various big-business interests, led by the powerful financial house of J. P. Morgan and Company, tried desperately to establish successful cartels on the free market. The first wave of such cartels was in the first large-scale business — railroads. In every case, the attempt to increase profits — by cutting sales with a quota system — and thereby to raise prices or rates, collapsed quickly from internal competition within the cartel and from external competition by new competitors eager to undercut the cartel.

During the 1890s, in the new field of large-scale industrial corporations, big-business interests tried to establish high prices and reduced production via mergers, and again, in every case, the merger collapsed from the winds of new competition. In both sets of cartel attempts, J. P. Morgan and Company had taken the lead, and in both sets of cases, the market, hampered though it was by high protective, tariff walls, managed to nullify these attempts at voluntary cartelization.

It then became clear to these big-business interests that the only way to establish a cartelized economy, an economy that would ensure their continued economic dominance and high profits, would be to use the powers of government to establish and maintain cartels by coercion, in other words, to transform the economy from roughly laissez-faire to centralized, coordinated statism. But how could the American people, steeped in a long tradition of fierce opposition to government-imposed monopoly, go along with this program? How could the public’s consent to the New Order be engineered?

Fortunately for the cartelists, a solution to this vexing problem lay at hand. Monopoly could be put over in the name of opposition to monopoly! In that way, using the rhetoric beloved by Americans, the form of the political economy could be maintained, while the content could be totally reversed.

Monopoly had always been defined, in the popular parlance and among economists, as “grants of exclusive privilege” by the government. It was now simply redefined as “big business” or business competitive practices, such as price-cutting, so that regulatory commissions, from the Interstate Commerce Commission (ICC) to the Federal Trade Commission (FTC) to state insurance commissions, were lobbied for and staffed with big-business men from the regulated industry, all done in the name of curbing “big-business monopoly” on the free market.

In that way, the regulatory commissions could subsidize, restrict, and cartelize in the name of “opposing monopoly,” as well as promoting the general welfare and national security. Once again, it was railroad monopoly that paved the way.

For this intellectual shell game, the cartelists needed the support of the nation’s intellectuals, the class of professional opinion molders in society. The Morgans needed a smokescreen of ideology, setting forth the rationale and the apologetics for the New Order. Again, fortunately for them, the intellectuals were ready and eager for the new alliance.

The enormous growth of intellectuals, academics, social scientists, technocrats, engineers, social workers, physicians, and occupational “guilds” of all types in the late 19th century led most of these groups to organize for a far greater share of the pie than they could possibly achieve on the free market. These intellectuals needed the State to license, restrict, and cartelize their occupations, so as to raise the incomes for the fortunate people already in these fields.

In return for their serving as apologists for the new statism, the State was prepared to offer not only cartelized occupations, but also ever-increasing and cushier jobs in the bureaucracy to plan and propagandize for the newly statized society. And the intellectuals were ready for it, having learned in graduate schools in Germany the glories of statism and organicist socialism, of a harmonious “middle way” between dog-eat-dog laissez-faire on the one hand and proletarian Marxism on the other. Big government, staffed by intellectuals and technocrats, steered by big business, and aided by unions organizing a subservient labor force, would impose a cooperative commonwealth for the alleged benefit of all.

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Goldman Sachs is putting an end to the deflation vs inflation debate, once and for all!

In a 30-page research note out on Wednesday, the bank comes down firmly on the side of (moderate) deflation in the near-term.

Here, GS analyst Andrew Tilton says, is why:

• Inflation is already low, with the core CPI down to 1.4% on a year-overyear basis and the overall CPI in deflation territory.

• Excess capacity in the economy is huge, probably at least 6% of GDP and possibly at its highest level since the Great Depression.

• Spare capacity is likely to persist for years [see below table]. While the financial crisis and recession probably have reduced the economy’s production capacity somewhat, we do not see strong evidence for persistently lower growth of capacity going forward. Even if we assume substantially above-trend real GDP growth of, say, 5% per year, it will take more than three years to get back to equilibrium in the labor market and two in the manufacturing sector. Our own assumptions of a somewhat slower recovery suggest it could well take more than five years to reach equilibrium in the labor market and nearly as long in housing.

• Monetary policy is arguably too tight despite a near-zero funds rate and unconventional easing. Our own calculations using estimated Taylor rule parameters, as well as those in recent research from the San Francisco Fed, point to an `appropriate’ funds rate of -5% or below.
  

• The default path of current policy is for removal of stimulus. Fed asset purchase programs are scheduled to end within the next several months and its balance sheet will begin to shrink after that point, while the growth impact of fiscal stimulus is already peaking.

Nevertheless, Goldman’s Tilton gets why investors are worried about inflation, and the bank itself is not oblivious to the possibility, given the massive unconventional fiscal and monetary policies undertaken by the Federal Reserve. In fact, Tilton says, there are a few inflationary warnings signs investors should be looking out for.

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Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said he’s been buying longer maturity Treasuries in recent weeks as protection against deflation.

“There has been significant flattening on the long end of the curve,” Gross said in an interview from Newport Beach, California, with Bloomberg Radio. “This reflects the re- emergence of deflationary fears. The U.S. is at the center of de-levering as opposed to accelerating growth.”

Gross had said during the midst of the credit crunch that Treasuries offered little value as investors seeking a refuge from turmoil in global financial markets drove yields to record lows in December. He boosted the $177.5 billion Total Return Fund’s investment in government-related bonds to 44 percent of assets, the most since August 2004, from 25 percent in July, according data released earlier this month on Pimco’s Web site. The fund cut mortgage debt to 38 percent from 47 percent.

…Officials at Pimco have forecast a “new normal” in the global economy that will include heightened government regulation, lower consumption and slower growth. The economy will likely expand at a 2 percent to 3 percent rate going forward, Gross said.

The world’s largest economy shrank at a 1.2 percent annual rate from April to June, more than the originally reported 1 percent contraction, according to a Bloomberg News survey before the Commerce Department’s Sept. 30 report. The jobless rate climbed to 9.8 percent this month, from 9.7 percent in August, according to a separate Bloomberg survey before the Labor Department reports figures on Oct. 2.

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Federal Reserve Chairman Ben S. Bernanke’s efforts to stoke a U.S. economic recovery may be undermined by the central bank’s other goal of restoring the banking system to health.

The Federal Open Market Committee, at the conclusion tomorrow of a two-day meeting, will probably maintain its assessment that “tight” bank credit is impeding growth, said economists including former Fed Governor Lyle Gramley. Lending contracted for five straight weeks through Sept. 9, a drop that in part reflects Fed orders to banks to raise more capital and toughen lending standards, analysts say.

A failure to restore the flow of bank credit carries the risk that the economic recovery will be slower than the Fed anticipates, or even that the U.S. lapses into another recession, economists say. That would make it more likely the Fed will keep its main interest rate close to zero for a longer period.

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“Even though from a technical perspective the recession is very likely over at this point, it’s still going to feel like a very weak economy for some time,” Bernanke said in response to a question after a speech in Washington. Fed officials in June predicted that GDP will expand 2.1 percent to 3.3 percent next year after shrinking 1.5 percent to 1 percent this year, according to the central tendency of their forecasts.

Banks have plenty of reasons to hold back on lending, analysts say.

Americans fell behind on their mortgage payments at a record pace in the second quarter, with delinquencies rising to 9.24 percent, according to an August report by the Mortgage Bankers Association.

“Consumers aren’t necessarily that creditworthy a proposition right now,” said John Ryding, chief economist and founder of RDQ Economics LLC in New York.

Falling values of commercial real estate are also a problem for banks, with an “uncertain degree of losses” to come, said Ryding, a former Fed researcher. Loans made for commercial property will probably sour and lenders will need to raise more capital to cover credit losses, Mike Mayo, a banking analyst at CLSA Ltd., said today at a conference in Hong Kong.

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Are there any mirrors in the headquarters of the Federal Reserve? If so, I think it’s time for Ben Bernanke and his colleagues to look into one.

The Fed, according to a Wall Street Journal report Friday, is said to be considering a plan that would allow regulators to closely monitor and even change the pay practices at financial firms in order to make sure that these companies aren’t encouraging excessive risk-taking.

Considering that the mess that we find ourselves in is partly due to big banks and insurance firms failing to recognize the many subprime warning signs in order to satisfy Wall Street’s myopic focus on quarterly profits, reining in bonuses and other compensation tied to stock performance may not sound like a bad idea.

But riddle me this Bat-readers: Isn’t it more than a tad hypocritical for the Fed to be trying to tell banks that too much risk is a bad thing?

After all, the Fed has kept its key overnight bank lending rate near 0% since December and has shown no indication that it will raise this rate anytime soon.

And the Fed has pumped trillions of dollars into the financial system through a variety of programs in order to try and get banks to loan more again. The business of lending is inherently risky. So what kind of message is the Fed trying to send here?

…It’s hypocritical plain and simple. Isn’t all this cheap money designed to push banks to take on more risks? The Fed wants to slap banks on the wrist for paying its employees too much because that might encourage them to get reckless. But at the same time, the Fed is tempting banks to lapse into bad habits with what may be an overly accommodative monetary policy.

This is the equivalent of your doctor telling you that he wants to approve every meal you eat for the next few months so you don’t gain a lot of weight — while handing you coupons for McDonald’s and Krispy Kreme on your way out of the office.

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Ron Paul: End the Fed

What would a world without the Fed look like?

You’d go back to the day that if you wanted to borrow money to build a house, somebody would’ve had to save some money. You wouldn’t have zero savings and all the credit in the world. That’s just a total distortion of capitalism. Capital comes from savings. The part you don’t use for everyday living which you have left over, you reinvest and you save or you loan it out. We were living with something absolutely bizarre that had nothing to do with capitalism. We had no savings whatsoever yet there was all the credit in the world.

So without the Fed, there wouldn’t be as much credit.

Yeah, it would be different. If you were selling me a car and the car was worth $10,000 and I didn’t want to pay cash, you could take credit from me. You’ve got to have something to measure it by. What is a dollar? We don’t even know what a dollar is. There’s no definition for a dollar. There’s never been a time in law that said a Federal Reserve note is a dollar. That’s the basic flaw. There’s no definition for money. We’ve built a worldwide economy on a measuring rod that varies every single day. That’s why it was fragile, and that’s why it collapsed. There was no soundness to it. So that’s why you have to have a stable unit of account.

If you live in a primitive society, you’d trade goods. And if you wanted to advance, then you would trade a universal good, which would be a coin. But we’ve become sophisticated and smart and say, ‘Oh, you don’t have to go through that. We’ll just print the money. And we’ll trust the government not to print too much, and distribute it fairly.’ That’s often just a total farce. People are realizing that it is.

Do you think the Fed will be abolished during your career?

I always thought the day would come… This economy is going to get worse and this dollar is going to get a lot worse. It’ll take care of itself. My real goal is educating people to the nature of money so that when this system fails, that they’ll know what to do and not just say ‘Well, we need a better manager.’

Read the full interview here

Further reading: Two must-read books by Ron Paul: End the Fed and The Revolution: A Manifesto

Central bankers have no clue. In the first place, the financial crisis was not a black swan. It was perfectly predictable. They ignored the phenomenal buildup in leverage since 1980. They acted like airline pilots who’d never heard of hurricanes.

After finishing The Black Swan, I realized there was a cancer. The cancer was a huge buildup of risk-taking based on the lack of understanding of reality. The second problem is the hidden risk with new financial products. And the third is the interdependence among financial institutions.

…Today we still have the same amount of debt, but it belongs to governments. Normally debt would get destroyed and turn to air. Debt is a mistake between lender and borrower, and both should suffer. But the government is socializing all these losses by transforming them into liabilities for your children and grandchildren and great-grandchildren. What is the effect? The doctor has shown up and relieved the patient’s symptoms – and transformed the tumour into a metastatic tumour. We still have the same disease. We still have too much debt, too many big banks, too much state sponsorship of risk-taking. And now we have six million more Americans who are unemployed – a lot more than that if you count hidden unemployment.

…Ben Bernanke saved nothing! He shouldn’t be allowed in Washington. He’s like a doctor who misses the metastatic tumour and says the patient is doing very well. The first thing I would tell Chinese officials is, how can you buy U.S. bonds as long as Larry Summers is there? He’s a textbook case of overconfidence. Look what happened to Harvard’s finances. They took a lot of risk they didn’t understand, and it was a disaster. That’s the Larry Summers mentality.

Read the full interview here

San Francisco Fed President Janet Yellen delivered a superb speech last night that really resonated with us — a true reality check for a stock market which has galloped ahead by 54% from the lows, purely on a record eight point expansion of the P/E multiple. The move in equity valuation suggests that stock market investors are anticipating 4% real GDP growth in the coming year. Janet Yellen has proven to be one of the more astute economic forecasters at the Federal Reserve and so we thought it prudent to re-print part of her sermon.

First, the good news

“I’m happy to report that the downturn has probably now run its course. This summer likely marked the end of the recession and the economy should expand in the second half of this year.”

A slow motion recovery lies ahead

“But I regret to say that I expect the recovery to be tepid. What’s more, the gradual expansion gathering steam will remain vulnerable to shocks. The financial system has improved but is not yet back to normal. It still holds hazards that could derail a fragile recovery. Even if the economy grows as I expect, things won’t feel very good for some time to come. In particular, the unemployment rate will remain elevated for a few more years, meaning hardship for millions of workers. Moreover, the slack in the economy, demonstrated by high unemployment and low utilization of industrial capacity, threatens to push inflation lower at a time when it is already below the level that, in the view of most members of the Federal Open Market Committee (FOMC) best promotes the Fed’s dual mandate for full employment and price stability.”

Sorry, but the credit crisis is not over

“Unfortunately, more credit losses are in store even as the economy improves and overall financial conditions ease. Certainly, households remain stressed. In the face of high and rising unemployment, delinquencies and foreclosures are showing no sign of turning around. The delinquency rate on adjustable-rate mortgages is now up to about 18 percent, and, on fixed-rate loans, it’s about 6 percent. Delinquencies on both types of loans have increased sharply over the past year and are still rising. This trend is consistent across other major loan categories, and is affecting high- and low-quality borrowers alike. Even recent-vintage loans are experiencing rising delinquency rates …

…As I said, financial conditions are better, but not back to normal. And the likelihood of continuing losses by financial institutions will add new fuel to the credit crunch. In particular, small and medium-size banks could experience damaging losses on commercial real estate loans. Thus far, the largest losses have been on loans for construction and land development. Going forward, however, rising loan losses on other commercial real estate lending is likely because property values are falling, office vacancy rates are rising, and credit remains tight or nonexistent for those many property owners that will need to refinance mortgages over the next few years. Financial contagion from this sector is one of the most important threats to recovery.”

Severe consumer headwinds

“The chances are slim for a robust rebound in consumer spending, which represents around 70 percent of economic activity. Of course, consumers are getting a boost from the fiscal stimulus package. But this program is temporary. Over the long term, consumers face daunting issues of their own. In fact, it’s easy to draw a comparison between the financial state of households and that of financial institutions. For years prior to the recession, households went on a spending spree. This occurred during a period that economists call the “Great Moderation,” about two decades when recessions were infrequent and mild, and inflation was low and stable. Credit became ever easier to get and consumers took advantage of this to borrow and buy. Stock and home prices rose year after year, giving households additional wherewithal to keep spending. In this culture of consumption, the personal saving rate fell from around 10 percent in the mid-1980s to 1½ percent or lower in recent years. At the same time, households took on larger proportions of debt. From 1960 to the mid-1980s, debt represented a manageable 65 percent of disposable income. Since then, it has risen steadily, with a notable acceleration in the last economic expansion. By 2008, it had doubled to about 130 percent of income.

It may well be that we are witnessing the start of a new era for consumers following the traumatic financial blows they have endured. The destruction of their nest eggs caused by falling house and stock prices is prompting them to rebuild savings. The personal saving rate is finally on the rise, averaging almost 4½ percent so far this year. While certainly sensible from the standpoint of individual households, this retreat from debt-fueled consumption could reduce the growth rate of consumer spending for years. An increase in saving should ultimately support the economy’s capacity to produce and grow by channeling resources from consumption to investment. And higher investment is the key to greater productivity and faster growth in living standards. But the transition could be painful if subpar growth in consumer spending holds back the pace of economic recovery.”

Soft labour market underbelly

“Weakness in the labor market is another factor that may keep the recovery in low gear for a while … my business contacts indicate that they will be very reluctant to hire again until they see clear evidence of a sustained recovery, and that suggests we could see another so-called jobless recovery in which employment growth lags the improvement in overall output. What’s more, wage growth has slowed sharply … when the array of problems facing consumers is considered, it is hard to see how we can avoid sluggish spending growth.”

Inventories the major impetus to growth

“Putting the whole puzzle together, the main impetus to growth in the second half of this year will be inventory investment. The boost it provides will be a big help for a while, but we will need to look to other sectors to sustain growth. The fact that the largest sector of the economy — consumer spending — is likely to be lackluster implies a less-than-robust expansion. Even the gradual recovery we expect will be vulnerable to shocks, especially from the financial sector.”

Deflation the principal risk, not inflation

“The slow recovery I expect means that it could still take several years to return to full employment. The same is true for capacity utilization in manufacturing. It will take a long time before these human and capital resources are put to full use.

My personal belief is that the more significant threat to price stability over the next several years stems from the disinflationary forces unleashed by the enormous slack in the economy. The 1980s provides a useful historical comparison. During that period, fears about burgeoning federal deficits and an unsustainable fiscal situation were widespread, as they are today. Moreover, the Fed was under significant political pressure, and some worried whether it would be able to safeguard its independence. But those circumstances didn’t ignite a renewed bout of inflation …

…Of course, that period differed from ours in one critical respect. Then, inflation was coming down from unacceptably high levels. Monetary policy was designed to be tight enough to bring inflation down to price stability, a goal we accomplished and have maintained for two-and-a-half decades. Today, we are starting with very low inflation. Core PCE price inflation has averaged just under 1½ percent over the past twelve months, which is already below the 2 percent rate that I and most of my FOMC colleagues consider an appropriate long-term price stability objective. With slack likely to persist for years, it seems likely that core inflation will move even lower, departing yet farther from our price stability objective …

…I can assure you that we will be ready, willing, and able to tighten policy when it’s necessary to maintain price stability. But, until that time comes, we need to defend our price stability goal on the low side and promote full employment. Thank you very much.”

Janet Yellen and Alan Blinder: The Fabulous Decade: Macroeconomic Lessons from the 1990s

Hat tip to Washington’s Blog for bringing this story to my attention. Morningstar Advisor posted a great piece back in June when they held a conversation with Ed Kane, Martin Mayer, and Walker Todd–three people who have great depth and experience in understanding the plumbing, history, and effects of the regulatory infrastructure of our financial markets. Below are some highlights:

[Finance professor Ed] Kane: One has to remember that these are profit-making institutions. Issuers will would pay more money for a good rating than a bad one, and issuers are very clear what kind of ratings they want. This is a straight-forward way to pay bribes without ever violating the law, it appears, and the credit rating organizations do not take formal responsibility for their incompetence or negligence.

[Prolific financial journalist, Brookings Institution scholar, and the author of more than 30 books on financial market issues Martin] Mayer: One of the untold scandals of this country is that our museums are stuffed with fake old masters because the people who authenticated paintings for the Mellons and Morgans of this world were paid a percentage of the price for the authentication. If they said it was no good, they got a few hundred bucks. If they said it was great, they got $100,000. Same story in the credit-rating organizations.

[Former Federal Reserve attorney and economist Walker] Todd: Right. They also drop the ball. I’ve been around failing banks and financial crises since 1974, and the rating agencies have dropped the ball almost every time. They were always at best late to the party.

Mayer: John Heimann [former comptroller of the currency] used to say that the function of the ratings agency is to go on the battlefield after the battle is over and shoot the wounded.

Read the whole Morningstar discussion after the jump…

How the Fed Contributes to Crises
by Bill Bergman | 06-03-09

If your clients had a bad year last year, it might seem easy to conclude that you shouldn’t take it personally, because your clients were far from alone. After all, market prices for individual investments are driven by macro-economic factors as well as factors specific to the investments at hand. And the financial crisis significantly undermined economic and investment confidence in many corners of the markets.

On the other hand, there could be a good reason to take the meltdown personally. Our crisis has had important regulatory underpinnings. Those institutions we’ve created to help “stabilize” banking markets and to “protect investors” may not have done what they advertise heading into the crisis, as well as when dealing with it.

On April 27, we held a conversation with Ed Kane, Martin Mayer, and Walker Todd–three people who have great depth and experience in understanding the plumbing, history, and effects of the regulatory infrastructure of our financial markets. Kane is professor of finance at Boston College, past president of the American Finance Association, and co-founder of the Shadow Financial Regulatory Committee. Martin Mayer is a prolific financial journalist, a scholar at the Brookings Institution, and the author of more than 30 books on financial market issues. Todd worked in the Federal Reserve System as an attorney and economist and is now affiliated with the American Institute for Economic Research. The conversation has been edited for clarity and length.

Bill Bergman: Where does this financial crisis rank historically?

Ed Kane: I call it the Great Recession. It hasn’t become a depression by any means, but it is the worst recession we’ve had since Keynesian economics led to a more active government acceptance of the responsibility to ameliorate business cycles.

Martin Mayer: We were always going to have a bad patch. A lot of very dumb things had been done, particularly at the federal banks, but also, a lot of people’s worst instincts were pandered to, and they were inviting what is now fashionable to call the Minsky moment, when actually it looks as though it’s a Goldilocks moment–the economy was suddenly eaten by bears.

Walker Todd: I would note that Martin’s book, The Fed (Plume, 2002), should be required reading for everybody to gain a view of the run-up to this crisis. You can easily see how we got here. This financial situation is the worst since the end of World War II. We looked at the charts at AIER last Friday, and virtually all the economic-performance charts were at unheard-of or post-war lows. This really is the big one.

Kane: Officials panicked in September 2008, and the public lost confidence in their ability to manage. It is striking how in these different agencies, a small inner circle of people have closed themselves off to ideas from even the rest of their staff. I understand that in a lot of agencies everybody goes home on time, but this inner circle has been working itself to death. Along with panic, I think there is exhaustion and some loss of judgment, because they’ve been under pressure for so long.

Mayer: What happened right after Lehman was that the commercial paper market closed down, and quite a lot of the extension of credit in the U.S. economy ran through the commercial paper market. I got a peculiar insight on the situation. I was giving a talk to the fixed-income division of Fidelity. It was the week after the Lehman collapse. There was a $600 billion money market fund that Fidelity ran, and the Fidelity folks said that all of their institutional clientele were calling up and saying, “Get us out of commercial paper. Get us out of anything that’s private. We want nothing but government guaranteed paper. Cleanse that money market fund of yours!”

The whole crisis accelerated over the course of that week, while the Treasury and the Fed, which had not anticipated any of this, didn’t understand well enough how their own system worked. They thought that all that mattered was the banks. Meanwhile, all the informal sources of credit in the economy, which are bigger than bank loans in the commercial economy, faded away to nothing. These guys sat there and wrung their hands and wondered what was going on.

Todd: The panic then spread into the general public after September and October because of the meltdown of 401(k) plan values. There, too, it’s not entirely clear who’s to blame. One wants to point the finger at the sell-side distributors of securities, but the typical 401(k) plan does not offer a vehicle with a proper hedge for the consumer in moments like these. I, like other investors, was confronted with the question of: Do I go all to cash, risking the devaluation by the Fed of the value of that cash in the future? Where were the commodities? Where were the gold funds offered in 401(k)s that would both offer investors some protection and upside against future Fed inflation?

Bergman: Martin, you had an interesting story in The Bankers (Plume, 1998) about the origins of AIG’s financial products unit. To what extent was AIG and its involvement in the credit default swap market at the center of the storm?

Mayer: Certainly, it was the center of the panic. That the Federal Reserve system would support, on very dubious legal authority, an insurance company with $180 billion of advances so that this insurance company could get away with the fact that they wrote policies and never put aside any reserve to be able to pay them–it’s a disgrace.

Incidentally, this problem is by no means gone, because one of the reasons you can’t price assets is that nobody knows whether they’re really insured. Nobody wants to release a loan that may in fact be insured, but no one knows whether it’s insured or not.

Kane: Another point is that these so-called “hard-to-price assets” have much more value to “zombie banks” than to anyone else, which is why there is no liquidity in that market. The deeply insolvent institutions want what everyone else calls “toxic assets” because it gives them a chance to climb back if the economy recovers well into solvency.

Bergman: Ed, you coined the term “zombie banks” in the S&L crisis. What inspired you?

Kane: It was just an attempt to make clear to people the dangers of keeping an institution that was deeply insolvent alive, or at least walking. The notion of the zombie is that it would be put in its grave by its creditors if it weren’t for the black magic of government credit support guarantees and loans. These institutions have very distorted incentives, just as the zombies do in the horror movies. They’re looking for things that even might have negative present value but have a possibility of producing good results. It’s a long shot bet to plug a hole in their balance sheet.

The trouble with the zombies is that they ruin the market for everyone else. They’re not looking for solid investments but something that has a chance of a big payoff. They’re willing to pay more for deposits or funding generally than other institutions, so they spread “zombieness.” They make other institutions have trouble earning a living.

Todd: It is the dead feeding on the living.

Bergman: Martin, you used the words “dubious legal authority” for the Federal Reserve’s lending. Walker’s done a lot of work in that area and Section 13(3) of the Federal Reserve Act. Walker, could you describe the origin of Section 13(3) and its relevance to this crisis?

Todd: Most of the actions the Fed has taken since the spring of 2008 have been said to be under the authority of Section 13(3) of the Federal Reserve Act. That’s an emergency powers section that was plugged in first around 1932. It gave the Federal Reserve Board of Governors the power in “unusual and exigent circumstances” to make loans directly to individuals, partnerships, and corporations–not just to banks or other financial institutions. It required a positive vote of five members of the board to invoke this authority. It was rarely used during the 1930s because the Reconstruction Finance Corporation was created and made the great bulk of all the loans that this statute was originally contemplated to do. That Section 13(3) authority, in fact, was not used after 1936.

Until 1991. In the dark of night during the Senate markup of the FDIC Improvements Act, lobbyists for the investment banks saw to it that Sen. Christopher Dodd introduced an amendment that would waive the statute’s technical collateral requirements, because the statute required collateral of the type eligible for discount at the Federal Reserve–which was short-term trade-related obligations and certain government securities. By and large, investment banks did not hold that kind of collateral, but they had lots of stocks and bonds and other things that were not eligible for discount.

So the collateral requirement was changed to any collateral satisfactory to the Federal Reserve Bank, and that meant that investment banks could borrow at the Fed for a change. Now, I opposed that change, and I identified it in an article that was published by the Cleveland Federal Reserve Bank in its Economic Review in the third quarter of 1993. The publication of the article created an internal firestorm. The Board of Governors really came down on me hard for having published it. Years later, we find out why. They wanted to use that power if they had a big enough emergency–as they thought they did once Bear Stearns went down–to make a bailout loan to an investment bank.

This stands the entire Federal Reserve Act on its head. The exceptional rule–the emergency power–has now become the regular way of doing things and the quantitatively dominant method of extending credit for the Fed. It’s very bad from a number of perspectives, not the least of which is institutional structure, because it means that the narrow and insular views of the Board of Governors together with the New York Federal Reserve Bank, the entity that’s making these loans, are the only views listened to in deciding when and how an emergency loan is being made. Basically, the credit gets booked and then the other Reserve Banks are required to eat a pro-rata share of these loans through loss-sharing agreements and the like.

It’s a process that needs to be stopped. They need to channel all of this out into something like a newly created RFC. The only other alternative would be to just explicitly require the Treasury to take these loans off the books of the Fed, to recapitalize them and refund them with Treasury debt issues.

Kane: What do you think is going to be the long-term effect on the Federal Reserve as an institution? It has exercised discretion it was never given. The independence of monetary policy was always the central principle underlying its responsibilities and discretion. By putting bankers and brokers first in the line out of all other members of society, do you think that the Federal Reserve can retain its independence going forward?

Todd: Martin, do you want to respond to that?

Mayer: I have been very disturbed about the way this thing has worked in terms of body language. [Fed chairman from 1951 to 1970] Bill Martin was very reluctant to go to the White House for lunch with Lyndon Johnson because he thought that he was not part of the executive branch, which indeed the Fed is not, remember? The Constitution gives Congress the power to coin money and regulate the value thereof. [House Banking Committee chairman from 1965 to 1975] Wright Patman used to say, “We farmed it out to the open market committee of the Federal Reserve.” The basic source of the Fed’s real authority is in the Congress, not the executive branch.

It was always Bill Martin’s feeling–and it was certainly the feeling of [Fed chairman from 1979 to 1987] Paul Volcker–that they were not part of the executive branch. They didn’t take dictation from the president of the United States, and indeed, Lyndon Johnson blew his stack about Martin once raising interest rates, but Johnson couldn’t do a thing about it.

I think all of this has been lost. The Fed has sacrificed under Ben Bernanke, as it had under [Fed chairman from 1970 to 1978] Arthur Burns, quite a lot of its independence. There should be a law that prevents academics from becoming chairmen of the Fed.

Kane: Do you think that there’s something just inherently weak in the experience of these people–that they haven’t had enough tussles to be able to stand up to authority?

Mayer: I think so. The experience of being an academic is not good for the sort of self-assertion that Bill Martin was good at.

Todd: The main problem with these guys is that they never examined a bank and they never made a loan before they got these jobs. Tom Hoenig of the Kansas City Fed wrote a very interesting speech, essentially dissenting from current Fed policy and advocating explicitly that the new lending activities be channeled off into a newly constituted RFC. He does have a Ph.D. in economics and he is a Keynesian, but he came up through the bank examination channel and served as the discount window officer at the Kansas City Fed. As he used to put it, unlike all his other colleagues at the Federal Open Market Committee meetings, he had in fact examined a bank or made a loan, and nobody else sitting at the table had ever done that.

Kane: I think it’s wrong to suggest that it is a matter of individuals. I do think there’s a terrible problem in how we recruit top officials in government, but I suspect that whoever would have been Fed chairman at this time, whether he was an academic or not, would have been subject to intense pressure to do what the Treasury wanted, what Wall Street wanted, to keep from having these losses go to counterparties who are politically very powerful. A person would have to be extraordinarily tough to survive this pressure.

Mayer: Volcker.

Kane: Volcker was a unique person, and we were lucky to have him at the time.

Todd: He would have been the best choice for chairman, but I have seen him cave on occasions when he shouldn’t have.

Kane: You’ve worked in government, so you know how intense these pressures are, and it’s always hard to do the right thing. Someone who does the right thing 90% of the time is a hero in Washington.

Todd: In Washington, 70% is good.

Mayer: The thing that shocked me the last few days is the fact that the Fed is now insisting that on the Term Asset-Backed Securities Loan Facility, it all has to be rated by the same stupid rating agencies that got us into trouble to begin with. What’s wrong with these people?

Kane: It’s plain avoidance is what it is. It has been very convenient to let these credit rating organizations call themselves “agencies,” even though they aren’t. I’ve been objecting to that term for decades.

Bergman: It’s also the way the government incorporates credit ratings into their own regulations, thereby downloading the regulatory responsibility on the rating agency. Was that part of the problem?

Kane: Absolutely. One has to remember that these are profit-making institutions. Issuers will would pay more money for a good rating than a bad one, and issuers are very clear what kind of ratings they want. This is a straight-forward way to pay bribes without ever violating the law, it appears, and the credit rating organizations do not take formal responsibility for their incompetence or negligence.

Mayer: One of the untold scandals of this country is that our museums are stuffed with fake old masters because the people who authenticated paintings for the Mellons and Morgans of this world were paid a percentage of the price for the authentication. If they said it was no good, they got a few hundred bucks. If they said it was great, they got $100,000. Same story in the credit-rating organizations.

Todd: Right. They also drop the ball. I’ve been around failing banks and financial crises since 1974, and the rating agencies have dropped the ball almost every time. They were always at best late to the party.

Mayer: John Heimann [former comptroller of the currency] used to say that the function of the ratings agency is to go on the battlefield after the battle is over and shoot the wounded.

Bergman: Maybe we’ll learn something from that and pass some legislation.

Kane: Oh, I don’t think so. All kinds of regulations are reasserting the role of the credit agencies. You know what is really disturbing? If you take something like a money market fund, it isn’t a matter of rating the portfolio’s individual securities. Rather, the focus should be on how the portfolio as a whole rates. The current focus says it’s okay to take a lot of things that are investment grade, as if that could keep people from taking a lot of credit risk. Many firms, as we know, were concentrated in their real estate risk exposure, most of which was rated as being investment-grade.

Todd: In historical time, this credit-rating mess was created only the day before yesterday. Before the 1990s, I don’t think you’d find any explicit incorporation of ratings into federal bank supervisory regulations. So it’s something that could be undone. For those who say that we’re stuck in the world we’ve created, I think it’s easy enough to do: Just rewrite the regulations to take the rating agencies out of it.

Bergman: One other thing historically we’ve learned to be concerned about is rapid growth in banks. One of the fastest-growing banks out there is the Federal Reserve Bank in New York. Should we be leery about this?

Kane: We’ve been leery of this throughout our entire discussion! The assertion of the right to make all kinds of risky loans in the context of a staff that lacks experience in lending goes back to what Walker was saying. We know that the trick is to get the money back, and there doesn’t seem to have been enough effort to be sure they can get the money back. It’s just this belief that somehow if you kept putting money into these zombies, the tide will turn and everything will get well.

Mayer: The notion that the nation’s currency is backed by a bunch of junk bonds and CDOs and such things on the books of the Federal Reserve District Banks is pretty scary.

Todd: I looked at the currency tables last week, and currently it’s about 40% backed by mortgage-backed securities and the like. There’s still somewhere around a 50% to a 60% backing by full faith and credit Treasuries. Of course, you could argue that that’s nothing other than a feedback loop. How does the full faith and credit Treasury get paid off? The answer is by taxes or by borrowing. There’s no gold claim.

Mayer: The two weeks after Lehman, there was a huge rush into actual euro notes– under mattresses. The disappearance of euros was one of the things that was confusing to the European Central Bank.

Bergman: In our monetary aggregates, in the past six months the currency component of M1–the currency circulating outside of banks–has risen at the fastest rate for any six-month interval since World War II.

Mayer: They never heard of gold.

Todd: You wouldn’t want to see that continue if you were serious about containing inflation, but it’s the non-currency components that are troublesome now. For example, the banks’ free reserves at the Fed are just shy of $950 billion. This is off of a base measure of around $8 billion to $10 billion before August 2007. It’s a monster number. The Fed has created an awful lot of potential spending power. The money will show up as inflation when the banks withdraw it through the Fed and make loans, which would trigger the spending. I think the only way of avoiding it would be to pull a nationalization-style trick, not that I’m advocating it, but the Fed does think this way. They could say to the banks, “Remember that $950 billion that you had for your reserves? We’re now converting it into mandatory 10-year Treasuries, and that’s that.”

Bergman: What do you make of the government’s stress tests on banks?

Todd: Let me chime in with a little bit of background. In Washington, the party line of both parties is that we don’t want to know anything about what was done in the U.S. in the 1930s, in part because of the political perception that that would be admitting that we’re reliving the 1930s. Neither party wants to bear that onus. So whenever I talk about the Reconstruction Finance Corporation or temporary nationalization or bank holiday or some device that gets you to more or less the same point of a quick, simultaneous fair market value evaluation of the banking system, nobody wants to hear about it, because my reference point is what was done in the U.S. in the 1930s. But if a reference point is foreign, they’ll listen to it. So they talk about the Swedish model of 1993 or the Japanese bank model of 1999. But both of those models were in turn relying on what was done here in the U.S. during the bank holiday of 1933, which was led by the RFC.

Kane: I would like to underscore Walker’s point. The term zombie bank came up in some hearings, and Bernanke said that the term had been invented in Japan in the late 1990s.

Mayer: It’s yours, that term!

Kane: No question about it. He said this, I believe, because he wanted to give the notion that we didn’t have anything in our history that you could compare it to. It shows the extent to which people will go to make it seem like this is a unique time in American history and that we have to have creative responses without any guidance from the past.

Bergman: Will we see any more backbone on the part of our regulators in the next year?

Kane: I think we will only because they’re going to see that what they’re doing isn’t working and can’t work. It’s one of these instances where people eventually do the right thing, but only because there’s no choice to do anything else.

Todd: People ask me, “When will you get the RFC?” My answer is when they’ve tried everything else.

Mayer: Well, I think that the bolstering of the commercial paper market has in fact done some of the things that they had hoped it was going to do. It’s in the banks, where their proper responsibility and powers are, that they’re screwing up.

Todd: I agree with you, Martin, that the Fed has succeeded a little bit better than I thought it would in propping up the commercial paper market, which looked to be on its last legs last fall. But I think that has a short half life, and I can’t imagine that that rosy new world can last long in light of the continuing rise of unemployment, and the prospective shut down of half the automobile industry in the heartland. In agriculture, there are equally scary things happening.

I think all the chickens will begin flocking home to roost in about the middle of the third quarter. Whenever the further downturn comes, if I’m right, what will these players do then for an encore? What happens if and when the next downturn comes?

Mayer: I think one of the questions that has bewildered me is why there isn’t more work done on the question of what’s in the black box at the Fed when they put money out? How does that thing work? Where does the money go out? It seems to me that what Greenspan did was to put out money, and because it didn’t go into consumer price inflation, they could ignore the fact that it went into dotcoms and then it went into housing. But the Fed money goes somewhere, and it gets used by people eventually. In some periods of time, it goes to real estate. In some periods, it goes to real production. In some periods, it goes to inflating paper of one kind or another. What distinguishes one period from another?

But I am not as pessimistic as Walker. The flooding of money is, after all, worldwide at this point in the game. I note with fascination that we hear that the IMF is talking about issuing bonds that will be bought by the Chinese, Indians, Brazilians, and, God save us, the Russians. Who has the big dollar reserves and how can you get them to pump them? You get them to pump by giving them paper.

Half the population of the world is still looking forward to next year. The other half is looking forward with dread, but half of them will keep going. You combine that with this flood of money, and we may muddle through it.

Todd: Is the danger, though, that after you muddle through it, you reach the other side of the downturn and you look across and see the monetary tsunami coming back at you of all the liquidity you have created?

Mayer: And then what do you do about it? I agree with that. I think the people who are in office three or four years from now are going to face some really nasty decisions. But in terms of how much deeper does this go, I’ve become a little less pessimistic in the last month myself.

Kane: But when you say you’re less pessimistic, it is presumably because you expect inflation to cause a lot of nominal repricing that will make losses go away. It’s just a question of one poison for another. I don’t see how in the world the Fed can believe politics will allow it to extract even half of the huge amount of free reserves that are just waiting to become money supply.

Bill Bergman is a senior equity analyst with Morningstar. He also contributes to the Markets & Economy blog for MorningstarAdvisor.com.