Don't Blame the Pencil

By Leo Melamed

International Finance Forum
Diaoyutai State Guesthouse
Beijing, China - November 15, 2009

Ask most people about what caused the global financial meltdown of 2008 and you are likely to get the following answers: "The cause was the laissez faire philosophy by government, principally in the U.S.," in other words, because of lack of government regulation; alternatively, you might be told "it was caused by corporate greed, particularly on Wall Street;" and in some instances, by the more sophisticated observers, you might hear that "it was caused by financial derivatives." Let's call it the RG&D causation.

I would like to assert that those answers are terribly simplistic. If one were to take them at face value, they will lead to erroneous conclusions and flawed corrective measures, which can do irreparable damage to the economic fabric of the world. The President of France, Nicolas Sarkozy, is guilty of blithely accepting the false premise and reaching a conclusion of his choice: "Le laisser-fair, c'est fini," ("Free market capitalism is dead") he said the other day. I trust that wiser heads will prevail.

Let me be clear: This is not an attempt to absolve the private sector from blame. Without question, the private sector is guilty of aiding and abetting the financial fiasco. As Peter J. Wallison of the American Enterprise Institute (AEI), stated, "Yes, greedy investment bankers, incompetent rating agencies, irresponsible housing speculators, shortsighted homeowners, and predatory mortgage brokers, all played a part---but they were following the economic incentives that government policy laid out for them."¹ That is the essential point!

It is imperative to understand that barely a month before the collapse of Lehman Brothers in September of 2008, no one at the U.S. Treasury or Federal Reserve, or anywhere else in the official world, sounded the alarm. In fact, few in government had much of an idea of what was coming even after the demise of Bear Stearns in March of 2008. Indeed, in August of 2008, thirty days before the unprecedented collapse of the global economy, the U.S. Fed kept the federal funds rate at 2 percent, stating: "it had significant worries about inflation." In other words, with but few exceptions, not many in government made any serious claims that there was lack of regulation, or that there was greed on Wall Street, or that financial derivatives were being used indiscriminately. Did those causal conditions suddenly materialize during the next 30 days? Nonsense! RG&D as the cause was simply a convenient scapegoat for government officials to divert the full truth from being understood.

Most authoritative economic experts presently accept the fact that the root cause for the boom and bust we experienced was easy money. And easy money was the creation of government, not lack of regulation, not greed, not financial derivatives. Michael Bordo, professor of economics at Rutgers University stated it precisely: "It was not a failure of capitalism, it was a failure of the central bank." While RG&D were factors in the consequential result, they could not have possibly been so without the conditions that only governmental powers can create.

During the past decade governments and central bankers allowed the financial world to become awash with liquidity. Easy money policies led to financial excesses, unreasonable risk assumptions, and a pyramid of debt. This was true for Europe, Asia, and certainly for the U.S. For one thing, the American Federal Reserve held its target interest rate, especially, from June 2003 to June 2004 at one percent, well below historical levels and guidelines. Consequently, interest rates, especially the U.S., fell to the lowest level in a generation. These easy money conditions were instituted by central bankers not merely to prevent a recession after the bursting of the tech bubble in March of 2000; they were based on the ongoing governmental policy, particularly in the U.S., to expand home ownership. Indeed, most economists agree that the bubble was created by a government-sponsored obsession with home ownership. As professor Bob Shiller of Yale, stated, "The housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the US and around the world."

Home ownership for everyone, while a laudatory principle to be sure, is not one that is grounded in economic reality. Not everyone can support home ownership. This principle was fostered and supported by government. According to the Wall Street Journal, the most egregious culprits of the financial collapse were two Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac. Their ability to borrow without limit was supported by the market's assumption that their debt was guaranteed by the government. These two GSEs were on an affordable-housing mission, becoming the largest buyers between 2004 and 2007 of subprime and, so called, Alt-A loans (mortgages that are characterized by borrowers with less than full documentation and lower credit scores) with a total exposure exceeding $1 trillion and amounting to about 40% of their mortgage purchases during that period. The GSE's purchases of subprime and Alt-A loans affected the rest of the market by increasing the competition for these loans and their demand by the private sector. To be fair, some Federal Reserve officials did warn about these practices, but they were ignored by both parties on Capitol Hill. It resulted in a flood of marginally qualified or unqualified recipients of mortgages and a housing boom grounded in the ridiculous belief that housing values would continue to rise forever.

At the same time, to make matters worse, the Securities Exchange Commission (SEC) in 2004 agreed to allow investment banks to increase their ratio of debt to assets from its historical level of about 12 to 1 to 50 to 1 and beyond. All together it was a recipe for disaster. As Ludwig von Mises predicted in his classic 1927 book, Liberalism, government intervention in markets would inevitably lead to unintended consequences. It did exactly that. It accelerated the use of a new market in derivatives such as structured investment vehicles (SIVs) and Collateralized Debt Obligations (CDOs). The high risks these instruments represented were carried "off balance-sheets." This process was greatly assisted by rating agencies, such as S&P, Moody's, and Fitch who did not understand the risks involved. It vastly expanded mortgage financing to borrowers who could not possibly afford the homes they were purchasing. As Princeton's, Professor Burton Malkiel explained: "The hunger for more mortgages as backing for new securities led to the acceleration of undocumented, no-down payment, negative amortization mortgage loans to individuals with virtually no prospect of servicing them---and poisoned the global financial system."

The foregoing scenario must lead to the inescapable conclusion stated by economist John Makin: "A bubble created by rigged financial markets and government-sponsored obsession with home ownership is not the result of market failure."² Nor is it the result of RG&D.

Allow me to digress by complimenting the leaders of the People's Republic of China. During the financial crisis the world has just endured and is still facing, the Chinese economy, for the first time in history, has played a substantial role in determining the path of the global economy. According to the American Enterprise Institute, China's massive fiscal stimulus action played a huge role in helping stabilize the global economy. The rapid response by the Chinese central bank, following the collapse of Lehman Brothers, reversing its policy of withdrawing liquidity from what appeared as an overheated economy that was driving up commodity and energy prices, was a prescient and courageous act. In November of 2008, it announced a massive public works program that would over a period of 2 years be the equivalent of 14% of GDP. The Chinese response produced immediate results. No one can doubt the power of Chinese policy measures to boost the economy and assist the markets of China, Asia, and the G7 economies.

But in some quarters the consequences of the financial crisis created the impression that financial derivatives were evil. Let me be clear, for the vast majority of financial managers, these risk management tools work exceptionally well. It is estimated that over 90% of the world's 500 largest companies---domestic and international banks, public and private pension funds, investment companies, mutual funds, hedge funds, energy providers, asset and liability managers, swap dealers, and insurance companies---use OTC derivatives to help manage their business exposure. Nor could it be different in today's complex and interdependent financial world. Financial derivatives are indispensable tools in the management of balance-sheet risk. They liquefy capital markets. They reduce the cost of capital, which in turn spurs investment and raises standards of living. Indeed, if financial derivatives applications were suddenly not available in business today, they would have to be invented. Without them, it would be like going back to the Stone Age.

Allow me also to underscore what should be an obvious truism. Financial derivatives are not like mushrooms that sprout without warning after a rain. Financial derivatives do not grow spontaneously. Their creation and application is the product of individuals. If they are used indiscriminately without regard to the risks they represent, it is not the fault of the instrument. Do not blame the pencil for what it has written.

It is also imperative to understand the distinction between Over the Counter (OTC) derivatives and those traded on regulated futures exchanges. The differences between them are dramatic. While nothing is perfect and no one can foresee all eventualities, the structure and procedures at regulated futures exchanges represent a time-tested mechanism with default-free success. All transactions on regulated futures exchanges have the guaranty of a central counterparty clearing system (CCP). They operate within a no-debt mechanism based on daily mark-to-the-market value adjustments. They require margin deposits and maintain price and position limits. Their hallmark is disclosure and transparency. And unlike their OTC counterparts, which until now have lacked sufficient regulatory controls, futures markets have always been subject to the regulatory authority of the Commodity Futures Trading Commission (CFTC).

Consider: In stark contrast to the turmoil of recent events, the CME clearinghouse has operated for more than 100 years without failure. Consider: during the current unprecedented financial crisis, as marquee names of finance such as Bear Stearns, Lehman Brothers, AIG, Merrill Lynch, and Bank of America failed or trembled, the CME and other futures markets performed their operational functions without a disruption. No failures, no defaults, no federal bailouts. Indeed, future markets were the poster-child for what went right during the crisis.

If we embrace the RG&D causation, if we accept the simplistic conclusions, as did President Sarkozy---that the crisis was somehow the fault of free market capitalism---it will do most serious injury to civilization.

Surely the United States has been the world leader on behalf of free market capitalism. From its beginning, it fostered an economic/political model that fused individual freedom with economic freedom. In his book Free to Choose, Milton Friedman asserts that the story of the United States is a story of two interdependent miracles: an economic miracle and a political miracle. Each miracle resulted from a separate set of revolutionary ideas---both sets of ideas, by a curious coincidence, were formulated in the same year, 1776. One set of ideas was embodied in Adam Smith's The Wealth of Nations, which established that an economic system could succeed only in an environment which allowed the freedom of individuals to pursue their own objectives. The second set of ideas, drafted by Thomas Jefferson, was embodied in The Declaration of Independence. It proclaimed the entitlement of some self-evident truths among which are life, liberty and the pursuit of happiness.

The results were astounding. During the two centuries following their introduction, when these two ideals were applied to a people with an immigrant ancestry, of a multi-cultural heritage, and a multi-racial composition, they produced an unimaginable result. They became a lightning rod for ideas. They created a crucible for innovation. They combined to become the decisive driver of progress in science, technology, and economic development. They enabled Americans to think freely, to experiment, and to innovate. And they encouraged competition which acted as the ultimate incentive to succeed.

I will readily agree the American model is far from perfect. It has many faults, has made mistakes, can improve and learn from others. But let there be no doubt, in my opinion the American economic model has proven to be far better than most others. And this has been to the benefit of the rest of the world and, to one degree or another, has been copied by much of the world. In the 20th Century alone, the American free market capital system utilizing its know-how and financial strength, led the world to the highest plateau it has ever achieved in science, technology and individual freedom. This knowledge, power and ideal enabled civilization with American leadership to bring down the Berlin Wall; to unify Germany; to end Apartheid; to end the Cold War; to liberate Eastern Europe; to encourage globalization, promote free trade, and oppose protectionism. In short, it taught the world the value and tenets of democracy and individual freedom. At the same time, the American model opened its shores to educate aspiring students from foreign lands, helped them achieve professional careers, and bring their knowledge back to their own shores. And in finance, the American free market model helped nations large and small develop their capital markets and devise sophisticated market instruments and innovations that provided them the ability to measurably attain wealth and raise the standard of living of their people.

For me, those are the tenets of free market capitalism. And Mr. Sarkozy, those are not fini.

¹ Peter J. Wallison, American Enterprise Institute, 2009.

² John Makin, American Enterprise Institute, 2009.

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