Return To Recent News & Publications Index
Blame the Pencil
Diaoyutai State Guesthouse
Beijing, China - November 15, 2009
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.
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.
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!
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.
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.
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."
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.
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
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
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
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.
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.
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).
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.
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.
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.
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.
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
me, those are the tenets of free market capitalism. And Mr. Sarkozy,
those are not fini.
J. Wallison, American Enterprise Institute, 2009.
Makin, American Enterprise Institute, 2009.