Promoting Failure
By John Mauldin
The true measure of a career is to be able to be
content, even proud, that you succeeded through your own endeavors without
leaving a trail of casualties in your wake.
– Alan Greenspan
If economists could manage to get themselves thought
of as humble, competent people on a level with dentists, that would be
splendid.
– John Maynard Keynes
And He spoke a parable to them: "Can the blind
lead the blind? Will they not both fall into the ditch?"
– Luke 6:39-40
Six years ago I
hosted my first Thanksgiving in a Dallas high-rise, and my then-90-year-old
mother came to celebrate, along with about 25 other family members and friends.
We were ensconced in the 21st floor penthouse, carousing
merrily, when the fire alarms went off and fire trucks began to descend on the building.
There was indeed a fire, and we had to carry my poor mother down 21 flights of
stairs through smoke and chaos as the firemen rushed to put out the fire. So
much for the advanced fire-sprinkler system, which failed to work correctly.
I wrote one of my
better letters that week, called "The Financial Fire Trucks Are
Gathering." You can read all about it here, if you like. I
led off by forming an analogy to my Thanksgiving Day experience:
I rather think the stock market is acting like we did
at dinner. When the alarms go off, we note that we have heard them several
times over the past few months, and there has never been a real fire. Sure, we
had a credit crisis in August, but the Fed came to the rescue. Yes, the
subprime market is nonexistent. And the housing market is in free-fall. But the
economy is weathering the various crises quite well. Wasn't GDP at an almost
inexplicably high 4.9% last quarter, when we were in the middle of the credit
crisis? And Abu Dhabi injects $7.5 billion in capital into Citigroup, setting
the market's mind at ease. All is well. So party on like it's 1999.
However, I think when we look out the window from the
lofty market heights, we see a few fire trucks starting to gather, and those
sirens are telling us that more are on the way. There is smoke coming from the
building. Attention must be paid.
I was wrong when I
took the (decidedly contrarian) position that we were in for a mild recession.
It turned out to be much worse than even I thought it would be, though I had
the direction right. Sadly, it usually turns out that I have been overly
optimistic.
This year we again
brought my now-96-year-old mother to my new, not-quite-finished high-rise
apartment to share Thanksgiving with 60 people; only this time we had to
contract with a private ambulance, as she is, sadly, bedridden, although
mentally still with us. And I couldn't help pondering, do we now have an
economy and a market that must be totally taken care of by an ever-watchful
central bank, which can no longer move on its own?
I am becoming
increasingly exercised that the new direction of the US Federal Reserve, which
is shaping up as "extended forward rate guidance" of a
zero-interest-rate policy (ZIRP) through 2017, is going to have significant
unintended consequences. My London partner, Niels Jensen, reminded me in his
November client letter that,
In his masterpiece The General Theory of
Employment, Interest and Money, John Maynard Keynes referred to what
he called the "euthanasia of the rentier". Keynes argued that
interest rates should be lowered to the point where it secures full employment
(through an increase in investments). At the same time he recognized that such
a policy would probably destroy the livelihoods of those who lived off of their
investment income, hence the expression. Published in 1936, little did he know
that his book referred to the implications of a policy which, three quarters of
a century later, would be on everybody's lips. Welcome to QE.
It is this
neo-Keynesian fetish that low interest rates can somehow spur consumer spending
and increase employment and should thus be promoted even at the expense of
savers and retirees that is at the heart of today's central banking policies.
The counterproductive fact that savers and retirees have less to spend and
therefore less propensity to consume seems to be lost in the equation. It is
financial repression of the most serious variety, done in the name of the
greater good; and it is hurting those who played by the rules, working and
saving all their lives, only to see the goal posts moved as the game nears its
end.
Central banks
around the world have engineered multiple bubbles over the last few decades,
only to protest innocence and ask for further regulatory authority and more
freedom to perform untested operations on our economic body without benefit of
anesthesia. Their justifications are theoretical in nature, derived from
limited-variable models that are supposed to somehow predict the behavior of a
massively variable economy. The fact that their models have been stunningly
wrong for decades seems to not diminish the vigor with which central bankers
attempt to micromanage the economy.
The destruction of
future returns of pension funds is evident and will require massive
restructuring by both beneficiaries and taxpayers. People who have made
retirement plans based on past return assumptions will not be happy. Does
anyone truly understand the implications of making the world's reserve currency
a carry-trade currency for an extended period of time? I can see how
this is good for bankers and the financial industry, and any intelligent
investor will try to take advantage of it; but dear gods, the distortions in
the economic landscape are mind-boggling. We can only hope there will be a net
benefit, but we have no true way of knowing, and the track records of those in
the driver's seats are decidedly discouraging.
For this week's
Thanksgiving weekend letter I offer a section from my new book (co-authored
with Jonathan Tepper), called Code Red. You can see a video
interview with Jonathan Tepper and me and buy the book here, or of course
you can go to Amazon and read the
reviews. And the book is in all the bookstores. Needless to say, it will make
an excellent gift for clients, family, and friends.
At the end of the
letter I will provide a link to a free webinar I am doing next week with
Jonathan Tepper and Lacy Hunt, hosted by Altegris Investments, on the
implications of ZIRP and other unconventional policies; but now let's jump
into Code Red. In this section, we deal with the topic of
central banking and its failures and ponder the implications of continuing to
give the same people ever more authority and responsibility. This is from Chapter 5, called:
In the old days,
central banks raised or lowered interest rates if they wanted to tighten or
loosen monetary policy. In a Code Red world everything is more difficult.
Policies like ZIRP, QE, LSAPs, and currency wars are immensely more
complicated. Knowing how much money to print and when to undo Code Red policies
will require wisdom and foresight. Putting such policies into practice is easy,
almost like squeezing toothpaste. But unwinding them will be like putting the
toothpaste back in the tube.
We'll admit that
we're having too much fun criticizing central bankers, the Colonel Jessups of
the Code Red world. But please don't just take our word for it when we tell you
that they're clueless. Let's look at what others have written.
In 2009 Congress
created the Financial Crisis Inquiry Commission to uncover the causes and consequences
of the financial catastrophe that almost brought down the world financial
system. They roundly condemned the Federal Reserve:
We conclude this crisis was avoidable. The crisis was
the result of human action and inaction…. The prime example is the Federal
Reserve's pivotal failure to stem the flow of toxic mortgages, which it could
have done by setting prudent mortgage lending standards. The Federal Reserve
was the one entity empowered to do so and it did not…. We conclude widespread
failures in financial regulation and supervision proved devastating to the
stability of the nation's financial markets.
Not surprisingly,
public confidence in the Fed has plummeted.
The Federal
Reserve performed disastrously before the Great Financial Crisis, but almost
all central banks were asleep at the wheel. The record of central banks around
the world leading up to the Great Financial Crisis was an unmitigated disaster.
All countries that had housing bubbles and large bank failures failed to spot
them beforehand. In the case of England, where almost all major banks went bust
(some rather spectacularly!) and required either nationalization or fire sales
to foreign banks, the Bank of England never saw the crisis coming. Let's look
at what The Economist has to say about central bank failures:
In 1996 the Bank of England pioneered
financial-stability reports (FSRs); over the next decade around 50 central
banks and the IMF followed suit. But according to research cited by Howard
Davies and David Green in "Banking on the Future: The Fall and Rise of
Central Banking," published last year, in 2006 virtually all the reports,
including Britain's, assessed financial systems as healthy. In the basic
function of identifying emerging threats, "many central banks have been
performing poorly," they wrote.
According to
published reports, the Bank of England only learned about the bankruptcy of one
huge bank after another a few days before the actual public announcement. So
much for staying on top of the situation. The regulators were captured by the
very institutions they were supposed to regulate, with neither the banks of the
regulators understanding the serious nature of the problems they were creating
with their actions.
Housing bubbles
swelled and burst everywhere: Spain, Ireland, Latvia, Cyprus, and the United
Kingdom. Countries that had to recapitalize or nationalize their banks were
broadsided by a disaster they did not anticipate, prepare for, or take action
to prevent. In the case of Spain, even after the crisis unfolded, the Bank of
Spain acted like a pimp for its own banks. It insisted nothing was wrong and
proceeded to help its banks sell loads of crap to unsuspecting Spaniards in
order to recapitalize the banks. (We apologize for our language, but there is
no other word besides crap that properly characterizes selling
worthless securities to poor pensioners – well, there are, but they are even
less suitable for public consumption).
In fairness,
central bankers did save the world after the Lehman Brothers bankruptcy. The
money printing that the Federal Reserve oversaw after the failure of Lehman
Brothers was entirely appropriate to avoid another Great Depression. But giving
them credit for that is like praising an arsonist for putting out the fire he
started.
Figure 5.3 Ben
Bernanke: The hero who saved the world
The
failure of central banks makes it all the more remarkable that they were given
even more responsibility in the wake of crisis. Since 2007 central banks have
expanded their remits, either at their own initiative or at governments'
behest. They have exceeded the limits of conventional monetary policy by buying
massive amounts of long-dated government bonds, mortgage-backed securities, and
other assets. They have also taken on more responsibility for the supervision
of banks and the stability of financial systems.
The Banking
Act of 1933, more popularly known as the Glass-Steagall Act, forced a
separation of commercial and investment banks by preventing commercial banks
from underwriting securities. Investment banks were prohibited from taking deposits.
Until it was repealed in 1999, the Glass-Steagall Act worked brilliantly,
helping to prevent a major financial crisis. It was replaced by the
Graham-Leach-Bliley Act, which ended regulations that prevented the merger of
banks, stock brokerage companies, and insurance companies. The American
public's interests were thrown to the wolves of Wall Street, and the Fed and
the Clinton administration gave the middle finger to financial stability.
After the
Great Financial Crisis, Congress could have simply reinstated Glass-Steagall.
The act was only 37 pages long, but it had worked incredibly well. Instead,
after an orgy of bank lobbying and Congressional kowtowing to the bankers who
had brought the world to the brink of a global depression, Congress passed the
Dodd-Frank Act. It is over 2,300 pages long; no one is sure what is in it or
what it means; and it has added a dizzyingly complex tangle of regulations and
bureaucracy to what should have been a simple, straightforward reform of the
financial sector. (The act is so long and complicated that it was nicknamed the
"Lawyers' and Consultants' Full Employment Act of 2010.") You will
hardly be reassured to learn that the Federal Reserve's powers were expanded
through Dodd-Frank.
Please note
that it was the same banks and investment firms that lobbied to repeal
Glass-Steagall in 1999 that so aggressively and successfully lobbied for the
Dodd-Frank Act. While there are some features contained in the plan that are
good, the basic problems still remain. Industry insiders were able to assure
that business as usual could continue. And to judge from their profits, it has
done so remarkably well.
Figure 5.4
Major financial legislation: number of pages
The Fed
didn't need more powers. In the years leading up to the Great Financial Crisis,
the Fed already had almost all the tools it needed to prevent the subprime
debacle. It simply failed to use them. You could call that lapse nonfeasance,
dereliction of duty, going AWOL, or anything other than doing their duty. If
you don't believe you are capable of recognizing a bubble in advance, then all
the additional regulations in the world won't make any difference in preventing
a bubble. Dodd-Frank merely gave them more regulations not to enforce. It is
the mindset that needs changing, not simply the regulations.
According to
the Financial Crisis Inquiry Commission, the Federal Reserve failed to use the
tools at its disposal to regulate mortgages or bank holding companies or to
prevent the abusive lending practices that contributed to the crisis. The
central bank didn't "recognize the cataclysmic danger posed by the housing
bubble to the financial system and refused to take timely action to constrain
its growth," the report said. It also "failed to meet its statutory
obligation to establish and maintain prudent mortgage lending standards and to
protect against predatory lending."
The most
sordid part of the Great Financial Crisis was not the extreme failure by
central banks to regulate. The most egregious violation of the public interest
came in the form of the massive subsidies and aid the central banks gave to the
banking system when the crisis was underway. The great journalist and essayist
Walter Bagehot argued in the mid-19th century that during a
financial crisis central banks should lend freely but at interest rates high
enough to deter borrowers not genuinely in need, and only against good
collateral. During the crisis, the Fed and other central banks lent trillions
of dollars at zero cost against the shoddiest of collateral. And the Fed went
out of its way to provide gifts to Wall Street banks via the back door. For
example, when AIG went bust, Timothy Geithner decided that the US taxpayer
should pay out credit default swaps to AIG's counterparties at full price.
Goldman Sachs was given a parting gift to $10 billion. Ge ithner did not even
negotiate a haircut. The money went to dozens of banks, many which were not
even American. It is no wonder Geithner became well-known as "Wall Street's
lapdog."
Our good
friend Dylan Grice wrote a fascinating piece on what happens when you have too
many rules and too little common sense. In a Dutch town called Drachten, local
government decided to take out all traffic lights and signs. They hoped people
would pay more attention to the road rather than fixate on rules and
regulations. They were right. In Drachten there used to be a road death every
three years, but there have been none since traffic light removal started in
1999. There have been a few small collisions, but these are almost to be
encouraged. A traffic planner explained, "We want small accidents in order
to prevent serious ones in which people get hurt." Let's see what Dylan
has to say about the lessons for capital markets:
You might be
thinking that traffic lights don't have anything to do with the markets we all
work in. But I think they do. Instead of traffic lights and road signs think
rating agencies; think Basel risk weights for Core 1 and Core 2 bank capital;
think Solvency 2; or think of the ultimate market regulators of our currencies
– the central banks – and the Greenspan/Bernanke "put" which was once
imagined to exist. Haven't these regulators provided the same illusion of
safety to financial market participants as traffic safety tools do for drivers?
And hasn't this illusion of safety been even more lethal?
Wouldn't it
be nice if central bankers thought more like Drachten town planners? But
central bankers and parliaments prefer extensive rules to a common-sense
approach.
Unlike the
planners of Drachten, the Federal Reserve and central banks around the world
issue extensive sets of regulation, fail to enforce them, encourage everyone to
speed, and then when crashes happen they protect as many banks as possible from
the consequences of their own actions.
The Federal
Reserve is in desperate need of reform. This doesn't mean that politicians
should be deciding interest rates or that banking supervision should be taken
away from central banks. But central bankers should be answerable to the public
for how they do their jobs. Accountability has been completely missing
throughout the entire crisis. Almost all central banks failed to do even the
basics of their job. The regulations they created, especially in Europe, made
it possible for banks to take massive risk and make huge profits that
ultimately had to be bailed out by taxpayers.
They believe
the banks and other institutions they were regulating when they showed the
models which they created which demonstrated conclusively there was no risk. Everyone,
bankers and regulators, believed we were in a new era, for the old rules of
common sense didn't apply. Central bankers didn't need more rules or
regulations. They failed miserably at even carrying out the simple job they
had. The regulatory functions of central banks should be treated like those of
any other regulatory agency. It is critical that we hold central bankers
accountable for their management of the banking system.
One of the
most disastrous battles of World War I was the British Gallipoli campaign in
Turkey in 1915. It was utterly devastating, leaving more than 50,000 British
wounded and almost 100,000 dead. Winston Churchill, first lord of the
Admiralty, was one of the architects of the campaign. In the wake of the
outcome, he resigned his post to become a soldier in the war. Churchill was a
humble man who felt he was at fault. He was honorable. But if Churchill had
been a central banker, he would never have had to accept responsibility or
resign. He would have kept his job and been given even more far-reaching powers
and a big pay raise to boot.
For the past
few years, central bankers have been living large. The same people who brought
us the Great Financial Crisis are now bringing us a world of Code Red policies
and financial repression. The arsonists are running the fire brigade.
Where is the
central banker who has apologized for contributing to the crisis or for being
asleep at the wheel? Given how disastrous their performance has been, it is
extraordinary that the same cast of characters is still running the show.
Central bankers are lucky that they still have jobs. As far as we are aware, no
central banker was fired for incompetence or mismanagement. Many have retired
and are now enjoying generous pensions and highly paid consulting careers
advising investment funds as to what their former colleagues might do next.
Central
bankers have had plenty of time to discuss the financial crisis since 2008, but
they have provided only scholarly disquisitions as to what went wrong in the
banking crisis, without accepting any responsibility at all. At no time have
any central bankers admitted that they might have ignored the warning signs of
excessive debt, kept interest rates too low for too long, ignored bubbles in housing
markets, failed to regulate banks correctly, or proved themselves even mildly
incompetent.
Not only
were central bankers not fired, many were promoted instead and given pay
raises. Timothy Geithner, who headed the Federal Reserve Bank of New York, not
only failed to regulate a host of banks that needed massive government bailouts
but was an active apologist for Wall Street banks. For his efforts he was
promoted to Secretary of the Treasury under President Obama. In Europe, Spanish
central bankers stand out as perhaps the most incompetent ever, having overseen
dozens of banks that created the biggest housing bubble in European history and
having failed to recognize problems not only before but after they happened.
Bankers like Jose Viñals, Jose Caruana, and others were given plum jobs at the
IMF and the ECB after being asleep at the wheel in Spain.
Granting
extra powers to central banks without a change in the philosophy behind their
management is like encouraging an irresponsible teenager. Imagine your teenage
son borrowed the family car and crashed it, and instead of punishing him you
bought him a new Ferrari to test drive. Conventional monetary policies are like
a sturdy old family station wagon, but Code Red policies are like a modified
Ferrari 288 GTO capable of hitting 275 miles per hour. Given how spectacularly
central banks failed during the Great Financial Crisis, it blows the mind that
they've been handed the keys to a faster set of wheels.
One last
thought. You might get from reading this that we are against rules and
regulations. Far from it. We just like very simple, workable rules. Reinstate
Glass-Steagall. Limit the ability of banks to create leverage, and require even
more capital as they get larger. Banks that are systemically too big to fail
are too big, period. Take away the incentive to grow beyond what is prudent for
the deposit insurance scheme of a nation to maintain. Allowing bankers to take
the profits and then hand taxpayers the losses in a crisis is not good policy,
even if it is bolstered by 1,000 pages of regulations written by lawyers and
bank lobbyists who then proceed to "massage" them in order to do what
they want to anyway.
But, alas,
such hopes may remain dreams deferred until there is yet another crisis and
taxpayers are asked to absorb even greater losses (but we can always hope!).
So, in the meantime, as prudent investors and managers, we must be aware of the
realities we face. The saying in Africa is that it is not the lion you can see
that is the danger, instead it is the one hidden in the grass that leaps out at
you as you try to escape the one you see. Later we will talk about a few
strategies that can help you handle the risks that crouch hidden in the grass.
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