STAFF NEWS & ANALYSIS
Alan Blinder: Six Errors on the Path to the Financial Crisis
By - January 27, 2009

What's a nice economy like America's doing in a place like this? As the United States descends into what is likely to be its worst postwar recession, Americans are distressed, bewildered and asking serious questions: Didn't we learn how to avoid such catastrophes decades ago? Has American-style capitalism failed us so badly that it needs a radical overhaul? The answers, I believe, are yes and no. The capitalist system did not condemn Americans to this fate. Instead, it was largely a series of avoidable – yes, avoidable – human errors. Recognizing and understanding these errors will help fix the system so that it doesn't malfunction so badly again. And it can be done without ending capitalism as we know it. My list of errors has six whoppers, in chronological order. I omit mistakes that became clear only in hindsight, limiting myself to those where prominent voices advocated a different course at the time. Had these six choices been different, I believe the inevitable bursting of the housing bubble would have caused far less harm. – International Herald Tribune

Dominant Social Theme: Recognize the blame and assign it.

Free-Market Analysis: One of the illuminating experiences of living through a fiat-money crash is to see how the system perpetuates itself, even though the system itself may be at least partially at fault. This article, excerpted above, is a beautiful example, our estimation, of propaganda of the highest order. It is written by a former vice-chairman of the American Federal Reserve, a man of seeming impeccable credentials. Here is how the article bio itself describes him: Alan Blinder is a professor of economics and public affairs at Princeton University and former vice chairman of the U.S. Federal Reserve. He has advised many Democratic politicians.

Yes, Binder is certainly partisan, but the article itself is written in an analytical way. Sorrowfully, not shrilly, he lists six errors that made the financial downturn much worse. The beauty of this approach is that he is correct – no one could really argue too much with his conclusions, as far as they go. But that is just the point. You have to travel further. Here are the six well-reasoned points.

WILD DERIVATIVES. In 1998, when Brooksley Born, then chairwoman of the Commodity Futures Trading Commission, sought to extend its regulatory reach into the derivatives world, top U.S. officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea.

SKY-HIGH LEVERAGE. The second error came in 2004, when the SEC let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1.

A SUBPRIME SURGE. The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.

FIDDLING ON FORECLOSURES. The government's continuing failure to do anything large and serious to limit foreclosures is tragic. The broad contours of the foreclosure tsunami were clear more than a year ago.

LETTING LEHMAN GO. The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail.

TARP'S DETOUR. The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. As I wrote here last month, decisions of Henry Paulson Jr., the former Treasury secretary, about using the TARP's first $350 billion were an inconsistent mess. Instead of pursuing the TARP's intended purposes, he used most of the funds to inject capital into banks – which he did poorly.

Each one of the above issues no doubt contributed to the current Western economic mess – though one could list a number of others as well. What is not excerpted is the series of criticisms that he launches at "free-markets." The critique, coupled with the list, above, is actually kinda creepy. You'd have to read the whole article to get it a real taste, though.

In fact, the money system that is currently in place around the world is, for perhaps the first time in history, unbacked by any asset – gold or silver. In the past, there have been regions and countries experimenting with fiat money, but only in the late 20th and early 21st century did the system take hold throughout the West and beyond.

Even though it is a new financial methodology, the basic system of central banking has caused problems before. The 1920s runup to the great depression was caused, according to hard-money scholars, by over-printing of money by the American Federal Reserve. The over-printing wasn't apparently legal but it happened anyway. This time around, the over-printing was fully revealed. But the result was the same: a massive bubble, created over decades, that has now burst.

Free-market economists believe it does not have to be this way. Honest money – a market-based gold and silver standard – would certainly have its ups and downs, but it would not inflate globally all at the same time. Lacking the rigid coordination of central banking, the system would rise and subside regionally, as it did pre-Civil War in the United States. A bust in one place would lead to a migration to another place where the economy was still doing well, or was on the way up.

There will always be booms and busts in any economic cycle. But central banking and fiat money make booms and busts infinitely worse and more explosive by expanding them and harmonizing them.

After Thoughts

It is impossible to regulate away a boom and a bust. When the boom comes along, the regulations will be done away with – something Binder neglects to mention. In the good times, people will believe to begin again, as always, that the economy is new and the business cycle is banished. The fuddy-parameters of yesterday's society will be undone. The madness will strike again.

The only action that can be taken with any certainty is to un-harmonize economies. Delink them, at least from a banking standpoint. Encourage free-banking, free markets and honest money. It is a fool's game to continue down the road of increased central banking and globalism. It will make the next crash even more powerful and desperate. Maybe Binder and other central bankers will one day rethink their arguments and give us the other side of the story. We'll keep at it in the meantime.

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