Mises Daily Articles
The Federal Reserve as a Confidence Game: What They Were Saying in 2007
In February of 2004, I published an article entitled "Greenspam." The general lesson was not to listen to Greenspan's deceptive testimony. Delete it from your mind like spam email messages. Watch what he has done and what he is doing, in order to protect your wealth and capital. Discount anything you read about his testimony, except Congressmen Paul's questions and commentary.
This talk will be a follow up to that article. I will describe central banking as a confidence game. The Federal Reserve plays a confidence game with us. A confidence game (also known as a bunko, con, flimflam, hustle, scam, scheme, or swindle) is defined as an attempt to defraud a person or group by gaining their confidence. The victim is known as the mark, the trickster is called a confidence man, con man, or con artist, and any accomplices are known as shills. Confidence men exploit human characteristics such as greed, vanity, honesty, compassion, credulity, and naïveté. The common factor is that the mark relies on the good faith of the con artist.
Here I will concentrate on the Fed's basic confidence game of trying to gain and maintain our confidence in its system and getting us to not take proper precautions against the negative effects of its policies.
Inflation is surely a scam and part of the confidence game — printing up money and lowering the value of all dollar-denominated assets while simultaneously benefitting political friends and accomplices is surely a fraud that could be classified as a confidence game. This is even more true because when the people finally lose confidence in the Fed system and realize what the Fed has been doing, the game will be up, the dollar will go down, and the Fed will come to an end!
There are some more basic aspects of the fraudulent nature of the Fed that I will not address here. Is the Fed a "conspiracy"? This is an aspect that is probably addressed most fully by the G. Edward Griffin book, The Creature from Jekyll Island. Or is the Federal Reserve just a cover for a banking cartel? This question has been fully addressed in the works of Murray Rothbard.
We will set aside some other fraudulent issues with the Fed. Issues like, why hasn't the nation's gold supply been audited in decades? Why hasn't the Fed itself been properly audited? And has the Fed been manipulating the gold market or surreptitiously leasing out the nation's gold supply? I suppose all of these issues are related to the basic general con game, but they are not necessary to make our general point here today.
The basic focus here will be on the Fed's mission to instill confidence in us about the economy while simultaneously instilling confidence in us about the abilities of the Fed itself. The first mission is easy to see because Fed officials are almost always publically bullish and hardly ever publically bearish about the economy. The economy always looks good, if not great. If there are some problems, don't worry, the Fed will come to the rescue with truckloads of money, lower interest rates, and easy credit. If things were to get worse, which they won't, the Fed would be able to respond with monetary weapons of mass stimulation.
"There are several reasons to believe that this concern about burst bubbles may be overstated."
All this is consistent with the viewpoint of mainstream economists who see the business cycle as caused by psychological problems and random shocks. In their view, it is your fault for becoming overly speculative and risky and then lapsing into risk aversion and depression. It is your fault!
I will also limit my analysis in terms of time. When the subject of this talk was first constructed — so many months ago — the only reason it was limited to 2007 was because that was the period just prior to the onset of the current crisis. The crisis finally revealed itself in 2007. With all the data at their disposal, surely the Fed would have been alerting the people to prepare for what was to come. In fact, we could probably pick any time frame and find the consistently bullish sentiment expressed by the establishment community. I had no particular statements or testimony in mind when the title of the talk was chosen, only the conviction that the "confidence game" was a consistent and dependable part of how the Fed operates.
I also limit my analysis to the leading officials of the Federal Reserve. It is, after all, their game. However, we could also extend the investigation and dependably find similar statements and testimony from other government officials from the Treasury Department and White House, as well as the advocates and promoters of malinvestments from Wall Street and the real-estate complex. What I will do here is to cut and paste their words and present the relevant highlights from their speeches. Predictably, their testimony and speeches are highly nuanced and hedged.
"Central Banking and Bank Supervision in the United States." – Speech given at the Allied Social Science Association Annual Meeting, Chicago, January 5, 2007.
Let us begin at the beginning of 2007 with the chairman of the Fed, Ben Bernanke. The former economics professor from Princeton gave an address to the annual meeting of the American Economic Association. Bernanke is the first chairman of the Fed from academia since Arthur Burns. It was Burns who helped take us off the gold standard. God only knows where Bernanke is leading us!
In addressing his fellow mainstream academic economists, Bernanke was unusually bold in describing the Fed's access and ability to use information and data concerning financial markets. This knowledge and expertise includes the market for derivatives and securitized assets. He describes the Fed as a type of superhero for financial markets. In discussing the Fed's role as chief regulator of financial markets he makes powerful claims concerning the Fed's ability to identify risks, anticipate financial crises, and effectively respond to any financial challenge.
Many large banking organizations are sophisticated participants in financial markets, including the markets for derivatives and securitized assets. In monitoring and analyzing the activities of these banks, the Fed obtains valuable information about trends and current developments in these markets. Together with the knowledge obtained through its monetary-policy and payments activities, information gained through its supervisory activities gives the Fed an exceptionally broad and deep understanding of developments in financial markets and financial institutions.…
In its capacity as a bank supervisor, the Fed can obtain detailed information from these institutions about their operations and risk-management practices and can take action as needed to address risks and deficiencies. The Fed is also either the direct or umbrella supervisor of several large commercial banks that are critical to the payments system through their clearing and settlement activities.
In other words, the Fed knows everything about financial markets. But it gets worse:
In my view, however, the greatest external benefits of the Fed's supervisory activities are those related to the institution's role in preventing and managing financial crises.1
In other words, the Fed can prevent most crises and manage the ones that do occur.
Finally, the wide scope of the Fed's activities in financial markets — including not only bank supervision and its roles in the payments system but also the interaction with primary dealers and the monitoring of capital markets associated with the making of monetary policy — has given the Fed a uniquely broad expertise in evaluating and responding to emerging financial strains.
In other words, the Fed is an experienced, forward-looking preventer of financial crises. This is a strong claim given Bernanke's own abysmal record of forecasting near-term events.
Chairman Bernanke is infamous on the internet because of the YouTube video that chronicles his rosy view of the developing crisis from 2005 to 2007. He denied there was a housing bubble in 2005, he denied that housing prices could decrease substantively in 2005 and that it would affect the real economy and employment in 2006, and he tried to calm fears about the subprime-mortgage market. He stated that he expected reasonable growth and strength in the economy in 2007, and that the problem in the subprime market (which had then become apparent) would not impact the overall mortgage market or the market in general. In mid-2007 he declared the global economy strong and predicted a quick return to normal growth in the United States. Remember, Austrians were writing about the housing bubble, its cause, and the probable outcomes as early as 2003.
Possibly the worst of Bernanke's statements occurred in 2006, near the zenith of the housing bubble and at a time when all the exotic mortgage manipulations were in their "prime." This was the era of the subprime mortgage, the interest-only mortgage, the no-documentation loan, and the heyday of mortgage-backed securities. The new Fed chairman admitted the possibility of "slower growth in house prices," but confidently declared that if this did happen he would just lower interest rates.
Bernanke also stated in 2006 that he believed that the mortgage market was more stable than in the past. He noted in particular that "our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real estate appraisal practices have improved."
This, my friends, is what the Fed is all about. Take a $100-billion budget, thousands of economists and statisticians, add in every piece of economic data, including detailed information concerning every major financial firm, and what do you come up with? They produced consistently wrong answers, or answers that were designed to maintain the "confidence" of the average citizen.
"Enterprise Risk Management and Mortgage Lending." – Speech given at the Forecaster's Club of New York on January 17, 2007.
Less than two weeks after Bernanke's address to the American Economic Association, fellow academic Fred Mishkin, a governor of the Federal Reserve Board, took the stage at the Forecaster's Club of New York. A leading mainstream economist and expert on money and banking, Mishkin addressed the group on the topic of "Enterprise Risk Management and Mortgage Lending."
Over the past ten years, we have seen extraordinary run-ups in house prices … but … it is extremely hard to say whether they are above their fundamental value.… Nevertheless, when asset prices increase explosively, concern always arises that a bubble may be developing and that its bursting might lead to a sharp fall in prices that could severely damage the economy.…
The issue here is the same one that applies to how central banks should respond to potential bubbles in asset prices in general: Because subsequent collapses of these asset prices might be highly damaging to the economy … should the monetary authority try to prick, or at least slow the growth of, developing bubbles?
I view the answer as no.
In others words, if the Fed is not worried, you shouldn't be either.
There is no question that asset price bubbles have potential negative effects on the economy. The departure of asset prices from fundamentals can lead to inappropriate investments that decrease the efficiency of the economy.
In other words, there are some theoretical problems with bubbles. But Mishkin has a theory that says there can be no such things as bubbles.
If the central bank has no informational advantage, and if it knows that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble that could be identified with certainty by the central bank would be unlikely ever to develop much further.
He then tells his listeners that in the unlikely event of a bubble, it really would not be a problem:
Asset price crashes can sometimes lead to severe episodes of financial instability.… Yet there are several reasons to believe that this concern about burst bubbles may be overstated.
To begin with, the bursting of asset price bubbles often does not lead to financial instability.…
There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small.… Hence, declines in home prices are far less likely to cause losses to financial institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures are high. Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices.
Boy, I bet he would like to take back his words today. Everything he just said turned out to be untrue; and he should have known that all of the assumptions he used to quell fear and instill confidence were simply not true.
My discussion so far indicates that central banks should not put a special emphasis on prices of houses or other assets in the conduct of monetary policy. This does not mean that central banks should stand by idly when such prices climb steeply.…
Large run-ups in prices of assets such as houses present serious challenges to central bankers. I have argued that central banks should not give a special role to house prices in the conduct of monetary policy but should respond to them only to the extent that they have foreseeable effects on inflation and employment. Nevertheless, central banks can take measures to prepare for possible sharp reversals in the prices of homes or other assets to ensure that they will not do serious harm to the economy.
In other words, the Fed likes bubbles. Mishkin says the Fed is prepared to protect us from the bursting of the bubble, but obviously he was wrong on that point too. Of course the issue of the Fed causing bubbles is never broached, and if it is, Fed officials will chime in to squash any such notion.
"Financial Stability: Preventing and Managing Crises." – Speech given at the Exchequer Club Luncheon, Washington, DC. February 21, 2007.
Fed Vice Chairman Donald L. Kohn downplayed the possibility of a crisis but said,
In such a world, it would be imprudent to rule out sharp movements in asset prices and deterioration in market liquidity that would test the resiliency of market infrastructure and financial institutions.
While these factors have stimulated interest in both crisis deterrence and crisis management, the development of financial markets has also increased the resiliency of the financial system. Indeed, U.S. financial markets have proved to be notably robust during some significant recent shocks.
In other words, just thinking about crises makes them less likely.
The Federal Reserve, in its roles as a central bank, a bank supervisor, and a participant in the payments system, has been working in various ways and with other supervisors to deter financial crises. As the central bank, we strive to foster economic stability. As a bank supervisor, we are working with others to improve risk management and market discipline. And in the payments and settlement area, we have been active in managing our risk and encouraging others to manage theirs.
In other words, the Fed will deter any crisis.
The first line of defense against financial crises is to try to prevent them. A number of our current efforts to encourage sound risk-taking practices and to enhance market discipline are a continuation of the response to the banking and thrift institution crises of the 1980s and early 1990s.
"Encourage sound risk-taking practices" — did I hear that right?
Identifying risk and encouraging management responses are also at the heart of our efforts to encourage enterprise wide risk-management practices at financial firms. Essential to those practices is the stress testing of portfolios for extreme, or "tail," events. Stress testing per se is not new, but it has become much more important. The evolution of financial markets and instruments and the increased importance of market liquidity for managing risks have made risk managers in both the public and private sectors acutely aware of the need to ensure that financial firms' risk-measurement and management systems are taking sufficient account of stresses that might not have been threatening ten or twenty years ago.
In other words, the Fed's number one job is to prevent "extreme" events — or was that, to cause such events?
A second core reform that emerged from past crises was the need to limit the moral hazard of the safety net extended to insured depository institutions — a safety net that is required to help maintain financial stability. Moral hazard refers to the heightened incentive to take risk that can be created by an insurance system. Private insurance companies attempt to control moral hazard by, for example, charging risk-based premiums and imposing deductibles. In the public sector, things are often more complicated.
I guess they are! In other words the Fed must refrain from bailing out markets or it will encourage risk and speculation.
The systemic-risk exception has never been invoked, and efforts are currently underway to lower the chances that it ever will be.
Well, I think that record has now been broken — into several trillion pieces.
"Recent Innovations in Credit Markets." – Speech given at the Credit Markets Symposium at the Charlotte Branch of the Federal Reserve Bank in North Carolina, March 22, 2007.
Fed Governor Randall S. Kroszner was the Fed's number-one guy in terms of regulation of financial markets. He was the point man in preventing things like systemic risk, but he considered all this financial "innovation" and "engineering" to be a good thing:
Credit markets have been evolving very rapidly in recent years. New instruments for transferring credit risk have been introduced and loan markets have become more liquid.… Taken together, these changes have transformed the process through which credit demands are met and credit risks are allocated and managed.… I believe these developments generally have enhanced the efficiency and the stability of the credit markets and the broader financial system by making credit markets more transparent and liquid, by creating new instruments for unbundling and managing credit risks, and by dispersing credit risks more broadly.…
The new instruments, markets, and participants I just described have brought some important benefits to credit markets. I will touch on three of these benefits: enhanced liquidity and transparency, the availability of new tools for managing credit risk, and a greater dispersion of credit risk.
What he then goes on to discuss are "recent developments" such as credit default swaps (CDS) of which the "fastest growing and most liquid" are credit-derivative indexes involving such things as packages of subprime residential mortgages. He says that "Among the more complex credit derivatives, the credit index tranches stand out as an important development."
He goes on to state that, historically, secondary markets were illiquid and nontransparent (banks held their own loans!). Now liquidity has improved and transparency has improved. This promotes better risk management as risk is measured and priced better because market participants have better tools to manage risk. The result has been a "wider dispersion of risk."
On its face, a wider dispersion of credit risk would seem to enhance the stability of the financial system by reducing the likelihood that credit defaults will weaken any one financial institution or class of financial institutions.
Yes, there are some concerns, but most of these concerns are "based on questionable assumptions." Yes, there is risk, but it's the risk that has been out there all along; now we can trade this risk among ourselves. There is "nothing fundamentally new to investors … credit derivative indexes simply replicate the sort of credit exposures that have always existed." Plus, remember that this risk is greatly diminished because lenders require borrowers to put up collateral.
What Kroszner has failed to realize is that by allowing institutions to disperse their risk, the regulators have encouraged and allowed for a huge increase in the aggregate amount of risk. When banks kept their own loans on their own books, they were careful to make prudent loans, but with nearly free money available from the Fed, they wanted to make more loans, and the only way to do that is to make riskier loans. They didn't want to hold the risky loans so they "dispersed" them.
Kroszner told his audience that the market already experienced a surprise in May of 2005, but that since that time much energy has been expended by market participants to improve risk management.
We don't have to worry, Kroszner tells us, because Gerald Corrigan is in charge of making sure nothing goes wrong. Corrigan — a former president of the New York Fed and a managing director in the Office of the Chairman of Goldman Sachs — has been in charge of a private-sector group that controls "counterparty risk management policy" for the financial industry.
Cooperative initiatives, such as [this one led by Corrigan] can contribute greatly to ensuring that those challenges are met successfully by identifying effective risk-management practices and by stimulating collective action when it is necessary.… The recent success of such initiatives strengthens my confidence that future innovations in the market will serve to enhance market efficiency and stability, notwithstanding the challenges that inevitably accompany change.
Checking ahead, we find Kroszner still bullish later that same year
"Risk Management and the Economic Outlook." – Speech given at the Conference on Competitive Markets and Effective Regulation, Institute of International Finance, New York. November 16, 2007.
Looking further ahead, the current stance of monetary policy should help the economy get through the rough patch [yes, he called it a rough patch] during the next year, with growth then likely to return to its longer-run sustainable rate. As conditions in mortgage markets gradually normalize, home sales should pick up, and homebuilders are likely to make progress in reducing their inventory overhang. With the drag from the housing sector waning, the growth of employment and income should pick up and support somewhat larger increases in consumer spending. And as long as demand from domestic consumers and our export partners expand, increases in business investment would be expected to broadly keep pace with the rise in consumption.
Over the next year, the Dow would lose 6,000 points; we have now doubled the amount of unemployment, adding more than 7 million unemployed. Consumer confidence hit a 27-year low this week, and sales of new homes hit the lowest level in a half a century — the lowest level on record! Kroszner, an economist groomed by the Institute for Humane Studies, has since returned to the University of Chicago and the directorship of the George Stigler Center.
We can see that the Fed is a confidence game. Their public pronouncements, while heavily nuanced and hedged, uniformly present the American people with a rosy scenario of the economy, the future, and the ability of the Fed to manage the market. Ben Bernanke told Congress this week that we are in the early stages of an economic recovery. Of course, he has been saying that since the spring of 2009 (if not earlier).
These are the people who said that there was no housing bubble, that there was no danger of financial crisis, and then that a financial crisis would not impact the real economy. These are the same people who said they needed a multitrillion dollar bailout of the financial industry, or we would get severe trouble in the economy. They got their bailout, and we got the severe trouble anyways. It is time to bring this game, this confidence game, to an end.
- 1. All emphases added.