David Beckworth (ed.), Boom and Bust Banking: The Causes and Cures of the Great Recession (Oakland, CA: The Independent Institute, 2012)
Lehman Brothers filed for bankruptcy five years ago last September and people still wonder what happened. There have been documentaries and books aplenty, pointing the finger at Wall Street greed and lack of regulation.
For a real understanding of what happened, the essays in The Independent Institute’s Boom and Bust Banking: The Causes and Cures of the Great Recession are essential. The volume features multiple authors but puts the blame for the crisis with one institution–the Federal Reserve.
While many free market economists and writers have fingered the central bank as the villain for the crash, Boom and Bust provides a more nuanced analysis with some surprising insights.
The Fed-held-rates-too-low-for-too-long explanation is told often but Lawrence H. White argues the central bank’s rate policy actually influenced what type of mortgages were originated during the boom. The Fed’s aggressive forcing of the Fed Funds rate down from 2001 to 2004 made adjustable rate mortgages (ARM) attractive relative to the more traditional 30-year mortgages.
In February of 2004 the Maestro himself told a Credit Union National Association audience, “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.” Lenders had already complied with the market share for ARMs going from 11 percent in 2001 to 40 percent in 2004.
The Fed’s low rates and its promise to keep them low led investors to fearlessly play what is known as the carry-trade: borrow at low short-term rates and invest long-term. Diego Espinosa explains Wall Street answered the call with the securitization of mortgages ultimately including the subprime variety dressed up with a triple A rating.
One explanation never found in the Austrian economics literature on the crash is that the Fed actually tightened in 2008. This would comport with Austrian theory as an explanation for the crash. However, the standard narrative is the Fed frantically lowered Fed Funds rates. Scott Sumner tells us real interest rates as measured by the yields on Treasury Inflation-Protected Securities (TIPS) actually soared from less than one percent in July 2008 to four percent in December of 2008. Cheap credit was choked off by higher real rates.
Sumner cites an interesting quote from Milton Friedman about tight and loose money. “I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”
Friedman is the primary focus of Jeffrey Rogers Hummel’s chapter comparing the free market champion with the current Fed Chair Ben Bernanke and the central bank’s increasing role as central planner. While many Austrians focus on the supply of money, Hummel discusses the demand. As was the case in the Great Depression, the velocity of money plunged in the Great Recession (and still is). Velocity is something the Fed can’t print.
Hummel writes that Alan Greenspan faced three crises during his tenure–the October 1987 stock market crash, the Y2K threat, and the 9/11 attacks. Greenspan flooded the financial system with money each time. Bernanke, while known as “helicopter Ben, actually tightened in 2008, by selling Treasury securities.
Greenspan increased the monetary base at an average rate of 7.54 percent during his 19 years at the Fed. Bernanke increased the base just 2.24 percent at the end of August 2008. “Bernanke was not injecting liquidity, just redirecting it,” Hummel explains.
With this redirection the Fed under Bernanke became a central planner, managing the money supply to allocate credit in the direction it deems critical. The Fed, writes Hummel, “has become similar to Fannie and Freddie, with the important distinction that the Fed has greater discretion in subsidizing a wider variety of assets.”
Bernanke is no helicopter pilot dropping bales of cash haphazardly, but is “Bailout Ben” carefully directing the nation’s savings to the financial system.
George Selgin describes this central planning Fed as inherently destabilizing in the book’s final chapter. This is anathema to financial writers and government cheerleaders who sleep better at night knowing the PhDs at the Eccles Building are on the job.
While the central bank monopoly allows banks to create credit beyond sustainability, banks in a free banking system are linked like “prisoners in a chain gang,” writes Selgin, “escape is impossible for any single prisoner acting alone, and hardly less so for the group as a whole,” because coordinating their steps is so difficult. The greater the gang, the more difficult the escape. The presence of a central bank undoes this check on credit creation and allows the chain gang to act as one.
Walter Bagehot is often viewed as a supporter of central banking, his quote about these banks lending freely in a crisis from his book Lombard Street being evidence. However, in his chapter Selgin sets the record straight. Bagehot was no fan of central banking, believing, “central banks were financially destabilizing and hence undesirable institutions,” writes Selgin, “and that it would have been far better had England never created one.”
Sadly, history has been written with central banks being required as lenders of last resort, citing the words of Bagehot. His exact words were instead, “I have tediously insisted that the natural system of banking is that of many banks keeping their own cash reserve, with a penalty of failure before them if they neglect it.”
Past is prolog because history is constantly misinterpreted. Five years after the crisis America’s financial system is bigger and just as precarious. The six largest banks are 37 percent larger and comprise 67 percent of bank holding company assets. All of this engineered by a central bank that itself has grown from less than $800 billion in assets pre-crisis to more than $3.6 trillion today. But more important than its size the Fed has grown in power and visibility, evidenced by the drama over who will fill the shoes of Time’s 2009 Person of the Year.
The essays in Boom and Bust carefully place the blame for the ‘08 crash where it belongs. It was not greed or animal spirits but the creature that government created 100 years ago: the same perpetrator that will cause the next crisis.
This review first appeared in the Journal of Prices & Markets