The View From 1776

Wall Street Journal columnist David Wessel, in the October 18 edition, gives us a nice overview of recent activity by central banks to counteract the meltdown of the subprime mortgage market and its ramifications throughout the world’s financial system.

Note Mr. Wessel’s description of central banks’ role:

The Fed, and its counterparts abroad, have made their objectives clear: (1) Do what’s necessary to keep financial markets functioning and prevent a financial crisis from provoking an unwelcome recession; (2) Encourage the return of more prudent, realistic attitudes among investors, lenders and borrowers.

In an op-ed page article in the same Journal edition, Harvey Rosenblum, executive vice president and director of research at the Federal Reserve Bank of Dallas, tells us:

By law, the Fed has a dual mandate to promote maximum employment and price stability.

Those two descriptions reflect the essence of socialism: the belief that free markets lead to subjugation of “the workers” and that only the collectivized government’s intellectuals have the knowledge to control the economy in the interests of social justice, i.e, equal distribution of income and wealth.

In contrast, under the gold standard that prevailed until the advent of Franklin Roosevelt’s New Deal socialism in 1933, both Mr. Wessel’s and Mr. Rosenblum’s descriptions of the Fed’s mandate would have been met by allowing the international movement of gold to stabilize currency values.

In that regard, read Ben Bernanke and the “Barbarous Relic".

The central idea, as I wrote, was:

... central banks, from their inception, have tended to succumb to pressures to create fiat money faster than the increase in underlying assets produced by their economies. 

The result is a false sense of economic well-being such as today’s economy in which our massive trade deficit has effectively been financed by the explosion of so-called home equity (based on the inflated market price) loans on private homes.  Our great-grand-parents would be astonished at the extent to which so many of us live far beyond our true means, floating on credit card debt.

That is a fair description, written in March 2006, of the process leading to today’s subprime mortgage meltdown.

It doesn’t offer much hope that, however well intentioned central bankers may be, their judgment alone will enable them to guess the appropriate combinations of interest rates and money creation to achieve the goals described by Messrs. Wessel and Rosenblum.  If they are less than well intentioned, central bankers can deliberately manipulate the money supply to support a political administration, debasing the currency in the process.

Central Banks Map a Middle Course
October 18, 2007; Page A2
By David Wessel

Watching the global financial system writhe these days is like watching Iraq from afar. There’s no doubt about the pain, but it’s difficult to discern exactly what’s happening, or even if conditions are improving or worsening.

About the only certainty is that many more people now claim that the mess was “inevitable” than were actually preparing for it.

The story so far: The merry-go-round of rising housing prices stopped early in 2006. Builders were thrown off first, then subprime borrowers. Because these homeowners could no longer tap rising home values to refinance mortgages they couldn’t afford, defaults and foreclosures spread more rapidly than investors in mortgage-backed securities had anticipated.

Until late spring, there was a case that the worst of the housing collapse was past and damage to the rest of the economy had been contained. By summer, that case was shattered.

Housing prices kept falling, a surprise to many. “The ongoing housing correction is not ending as quickly as it might have appeared late last year,” Treasury Secretary Henry Paulson said in an unusually blunt speech this week. “And it now looks like it will continue to adversely impact our economy, our capital markets and many homeowners for some time yet.”

Then in August, the problem in the U.S. housing sector became a global financial problem, and that’s when things got complicated.

A lot of subprime mortgages had been turned into securities that were sold to outfits that relied on short-term borrowing. With the value of those securities in doubt, these outfits could no longer borrow and turned to the banks that had created the securities or which had promised to lend to them in a pinch.

Since no bank was sure who was or would be stuck with this toxic waste, banks grew wary about lending to one another, a classic case of distrust that called for central banks to provide credit, which they did.

In the weeks since, mortgage markets have remained troubled, but other financial markets seem to be improving, to the Federal Reserve’s great relief. The $32 billion sale of Texas utility TXU to private-equity firms went through. And this week, in one of the biggest junk-bond deals since the summer, First Data, an electronic-payment-processing firm, raised $2.2 billion in debt, albeit at a pricey yield of 10.875%.

Citigroup and some other big banks clearly remain uneasy about the overhang of mortgage-backed securities that could be dumped on the market if the various funds that own them can’t easily borrow, hence the efforts by the U.S. Treasury and some big bankers to organize a megainvestment pool to buy them.

But why did the woes of the relatively small subprime slice of the overall financial system have such a big effect on the markets?

It was “more a trigger than a fundamental cause of the financial turmoil,” Fed Chairman Ben Bernanke, the nation’s economics-professor-in-chief, explained this week.

Investors, lenders and home buyers had become giddy. Interest rates had been low for a long time. Despite higher oil prices and the housing bust, the U.S. economy kept growing, Europe and Japan were back and emerging markets seemed invincible. Investors and lenders were taking ever-greater risks with ever-lower standards, and not just in housing.

The Cassandras who said this couldn’t last—and there were some—were ignored until August, when suddenly the unquenchable appetite for risky investments abated. “Conditions causing the turmoil in financial markets were long in the making and...these causes should not be conflated with the particular troubles in the mortgage market,” Fed governor Kevin Warsh said recently.

The Fed, and its counterparts abroad, have made their objectives clear: (1) Do what’s necessary to keep financial markets functioning and prevent a financial crisis from provoking an unwelcome recession; (2) Encourage the return of more prudent, realistic attitudes among investors, lenders and borrowers.

Notice that the Fed and other central banks are not trying to restore conditions to the ebullience of earlier this year. “Greater caution on the part of investors seems appropriate,” Mr. Bernanke said this week, acknowledging that that implies “financial restraint on economic growth as credit becomes more expensive and difficult to obtain.”

That pregnant sentence says a lot. The Fed is trying to do enough—cutting rates, lending to banks—to avoid repeating mistakes its predecessors made in the 1930s that exacerbated the Great Depression. But it doesn’t want to do so much—cutting rates further, appearing to be organizing a bailout—that investors start feeling giddy again.

Even by central-banking standards, that’s a very delicate balance to strike. Wish them luck.