The Federal Reserve School of Monetary Witchcraft and Wizardry

Here are some key excerpts from the account by The Institutional Risk Analyst of his trip to "The International Financial Crisis" conference in Chicago. You may read it in its entirety here.

It matches up with our feel from reading on the web, that most economists are going to be painfully slow to change their thinking, particularly in the US, even after this latest financial crisis of historic proportions. It is hard to change when one cannot even admit one's mistakes, and the green shoots of a false Spring bring out new hopes that old ways might still work once again.

The status quo often has a powerful grip on the levers of thought leadership, and a social science like economics is especially vulnerable to peer pigheadedness, even when it is shown to be flat out wrong. The lack of innovation seems even slower now than in the 1970's when the appearance of a virulent stagflation shook up the assumptions of the economic establishment.

One thing which is almost certain is that change will not come from within, but from without. The great opportunity for reform that Obama was presented is passing quickly, probably from the point at which he surrounded himself with highly atrophied economic thinkers, from the atavistic Larry Summers to the clever but highly tailored Ben Bernanke, who is like Alan Greenspan with a real PhD. The Treasury Secretary is not a thinker, but a pair of hands, at best, what T. S. Eliot called 'a willing tool, glad to be of use.'

A new school of economics will rise out of this crisis, and we are more sure now than before that it will not originate in the States, which is seeing an appalling failure in economic thought leadership, in part caused by a dominant Fed, acting in part to stifle innovation as MITI did in Japan.

But the stock market is up, after a brief period of housecleaning last week by the funds and the banks, opening the door to the end of quarter window dressing. So let's ignore our problems once again and keep the printing presses and that wealth transfer mechanism turning. For now.

The US may indeed suffer a lost decade after all.

Institutional Risk Analytics
The Global Carry Trade and the Crimes of Patriots
September 29, 2009

Our trip to Chicago last week to participate in "The International Financial Crisis" conference sponsored by the Federal Reserve Bank of Chicago and the World Bank was instructive in several ways. First and foremost, it confirmed that the US economics profession is still trying to defend the old ways and means in terms of analytical methods for bank safety and soundness.

While there were many calls for "reform" of regulation, we heard nary a suggestion that the mish-mash of quantitative methods that currently comprise the framework for assessing the safety and soundness of banks needs to be set aside and a new approach defined. Indeed, the foreign participants in the two-days of presentations seem to be far more advanced in their thinking about bank safety and soundness than their counterparts from the US.

Andrew Sheng of the China Banking Regulatory Commission, reproached us for thinking that throwing debt at a global problem of insolvency will be successful. We have created the world's largest ever carry trade, Sheng noted, and suggested that the approach of exchanging a bank solvency problem for a sovereign debt problem could effectively replicate the lost decade of Japan on an international scale. He also wondered how any nation will be able to raise interest rates when vast sums of cash (i.e. fiat paper dollars) are ready to immediately pounce on any carry trade opportunities that arise.

Charles Goodhart of the London School of Economics.... reminded the audience that whereas Americans still debate the merits of regulation vs. innovation, in the EU the political class has already decided the robust regulation of banks is a necessary condition for stability. He also dismissed the idea that you can separate the "utility" bank from "the casino," again suggesting that the EU view of regulation of banks is comprehensive and should be emulated by the US....

While the members of our panel suggested various ways to restore balance and even virtue to the regulatory process, we suggested that Washington does not need another oversight agency or more platonic guardians. Rather, we need to address the problem where it truly resides, first with the debt issuance of our profligate government and second with the accommodative monetary policy of our central bank. As one participant noted, there is no longer any distinction between fiscal and monetary policy in the US.

Though there were many insightful and interesting comments made at the two-day conference in the FRB Chicago, the one thing that we heard virtually no one say is that the current financial crisis stems from irresponsible monetary and fiscal policies. Many participants talked about the role of "global capital flows" in fueling the crisis, but none made the basic statement that having printed this money to pay for imports and fund domestic deficit spending, the US was bound to see the dollars eventually come home in the form of a credit bubble.

Since the October 1987 financial crisis, the Federal Reserve System has not denied the Street either liquidity or collateral. The objective goal of policy, it seems, has been to keep the ability of Congress to issue debt intact all the while keeping the casino part of the banking system operating at full steam regardless of the impact on inflation and, more important, investor behavior. Seen in this light, the proliferation of hedge funds and OTC securities is the natural response of investors to inflationary fiscal and monetary policies in Washington, a city where income and the proceeds of borrowing are seen as being equivalent.

Today the amount of debt and fiat money issued by the US government is threatening not only the solvency of private financial institutions and companies, but the stability of the entire global economy. Yet virtually no observers make the connection between the reality of secular inflation in the US and the bad outcomes in the financial markets, and in the global economy, where trade flows continue to shrink. Indeed, if members of Congress ever wanted a reason not to give the Fed more power as a regulator of financial institutions, they should start with an investigation of the Fed's conduct of monetary policy, not bank regulation. Just imagine how the US economy would look several decades from now were the Congress to give the Fed hegemony over bank supervision via the rubric of "systemic risk" even as the central bank continues its reckless policies with respect to monetary policy and its accommodation of US debt issuance.

Systemic risk, it seems, is not the result of bad regulatory policies, but the natural outcome of a system where income from productive economic activities is being increasingly supplemented with debt and inflation. Our political leaders say that such policies are meant to help the American people, but we've heard such empty justifications before. Call the policies of borrow and spend and print the "crimes of patriots," a powerful metaphor used by author Jonathan Kwitny to describe the bad acts of the CIA in the banking world decades ago. Since then, the money game and the role of government in our financial markets has only grown larger.

If the American people want to get the US financial system under control, then the first areas of investigation, we submit, must be fiscal and monetary policies. And if Americans do not soon get control over the habit of borrow and spend practiced by the Congress and facilitated by the Fed, then end result must be a populist backlash against Washington and incumbents in politics and the corporate world. As Congressman Ron Paul (R-TX) writes in his latest book, End the Fed: "Nothing good can come from the Federal Reserve… It's immoral, unconstitutional, impractical, promotes bad economics, and undermines liberty."