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Hear that noise? That’s the sound of the gods laughing. They’re laughing at Northern Rock, Bear Stearns, and all the angels, archangels, seraphim and cherubim of the whole financial industry. The geniuses thought they had put an ankle bracelet on uncertainty. They believed that with their new tools they could model risk, quantify it, and control it. Now, they’re going broke… and the gods are tumbling off their chairs. But the biggest laughs are still ahead.
Alan Greenspan, the world’s most-famous civil servant since Pontius Pilate, wrote in the FT this week. In the interest of saving readers’ time, we reduce his half-page circumlocution on today’s financial crisis to four simple words: it wasn’t his fault. An unexpected and unpredictable force had taken over in the financial markets, he explained – a kind of ‘dark matter’ that caused everyone to act a little funny.
According to Mr. Greenspan, the source of the proximate problem is the homebuilding industry. For some reason, (he decided not to mention what), it overbuilt. The crisis will end “when home prices stabilize and with them the value of equity in homes supporting troubled mortgage securities”. Mr. Greenspan further explained that “trust” in the system was “badly shaken… when BNP Paribas revealed large unanticipated losses on US subprime securities. Risk management systems – and the models at their core – were supposed to guard against outsized losses. How did we go so wrong?”
He followed this rhetorical question with what was essentially an elaborate feint, designed to send the hounds barking up the wrong tree. Risk management systems, he says, “do not fully capture... the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve”. The former Fed chief has a point. The public is subject to mood swings. It’s just a shame he dodged credit for his own contribution to the euphoria of 2002-2007.
Looking back at the long history of the market’s manic-depressive episodes, it is hard to find a case in which an extreme mood swing was not exaggerated by something in the water. Neither the Mississippi Bubble nor the South Sea Bubble would have happened had not John Law invented the first central bank – the Banque Generale – in 1716. Americans wouldn’t have been so bumptious in 1929 had it not been for Fed chairman Benjamin Strong’s little ‘coup de whiskey’ intended to help out his friend Montagu Norman at the Bank of England.
The Japanese wouldn’t have goosed their stock market up to 39,000 (currently near 12,000) had it not been for the exceptionally low rates following the Plaza Accords in September 1985; rates were cut four times the following year – sending Japanese property and equities soaring. And Americans never would have gone on a residential property binge had the prime rate not been kept exceptionally low for an exceptionally long period under the very same person writing in the FT this week – Alan Greenspan.
Centrally-planned prices send the wrong signals and cause people to miscalculate. No price causes as many miscalculations as the price of credit – controlled at the short end by central bankers. Anyone can make a mistake. But to make the kind of mess we’re seeing in capital markets now, you need a theory. Central bankers had one. The foundation for modern central banking theory was laid down in the very year Alan Greenspan was born – 1926. That was when one of the first “neoclassical” economists, Professor Irving Fisher, published A Statistical Relationship between Unemployment and Price Changes, arguing that a little inflation was a good thing, since it seemed to stimulate employment.
Then, “in the 1970s”, writes Nobel Prize winner Edmund Phelps in the Wall Street Journal, “a new school of neo-neoclassical economists proposed that the market economy, though noisy, was basically predictable. All the risks in the economy, it was claimed, are driven by purely random shocks – like coin throws – subject to known probabilities”. By 2001, the Fed opened a new museum in Chicago. Visitors were invited to view the economy as if it were a science project. They were confronted with a problem and asked what would be the appropriate response – lower rates or raise them? Then they were given the correct answer.
Today, America’s central bank applies a “rule-based monetary policy”, supposedly founded on the ‘scientific’ discoveries of Irving Fisher and his heirs. What’s the rule? Balance out inflation against unemployment. When inflation threatens, raise rates. When the economy is menaced by unemployment, cut them. And always, like a dishonest butcher, make sure your thumb lingers on the inflation side.
Professor Fisher lived long enough to see the gods laughing at him. Just days before the stock market crash of 1929, he wrote that “stock prices have reached what look like a permanently high plateau”. Then, when the crash came, he said that the “market was only shaking out the lunatic fringe”, and claimed that prices would soon go much higher. A few months later, Fisher had lost his fortune and his reputation, but still told investors that recovery was just around the corner.
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Bill Bonner
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