The Next Financial Crisis

Its already coming. And, if the trends remain the same, it will be even worse than this one has been.

There is an excellent article in The New Republic with this title, written by Peter Boone and Simon Johnson.

The past crisis was certainly mitigated by the actions of the Federal Reserve and the Treasury, but what they did sowed the seeds of the next crisis. And what they continue to do will make it worse.

This has happened many times before:

" We have seen this spectacle--the Fed saving us from one crisis only to instigate another--many times before. And, over the past few decades, the problem has become significantly more dire. The fault, to be sure, doesn’t lie entirely with the Fed. Bernanke is a prisoner of a financial system with serious built-in flaws. The decisions he made during the recent crisis weren’t necessarily the wrong decisions; indeed, they were, in many respects, the decisions he had to make. But these decisions, however necessary in the moment, are almost guaranteed to hurt our economy in the long run--which, in turn, means that more necessary but harmful measures will be needed in the future. It is a debilitating, vicious cycle. And at the center of this cycle is the Fed."

Back in the "old days" before the Federal Reserve was created, if you ran a bank and lost your depositors' money, the bankers' personal assets and income could be taken to help cover the losses.

"In the United States, there was great experimentation with banking during the 1800s, but those involved in the enterprise typically made a substantial commitment of their own capital. For example, there was a well-established tradition of “double liability,” in which stockholders were responsible for twice the original value of their shares in a bank. This encouraged stockholders to carefully monitor bank executives and employees. And, in turn, it placed a lot of pressure on those who managed banks. If they fared poorly, they typically faced personal and professional ruin. The idea that a bank executive would retain wealth and social status in the event of a self-induced calamity would have struck everyone--including bank executives themselves--as ludicrous."

In 1913 the Federal Reserve was created, and it went to work using liquidity loans and low interest rates to cushion banks in difficulty by reducing their costs.

"But, by insulating banks from the terrible consequences of their own blunders, these measures would also encourage them to keep taking unwise risks, and thereby lay the groundwork for future crises."

The Fed has made many errors with this. In the summer of 1927 it lowered interest rates, fueling the boom that crashed in the fall of 1929. It had belatedly raised rates in 1928, but that did not stop the frenzy. After the crash, it then kept interest too high into 1933, causing many banks to fail.

During the Great Depression, banking came under increasing regulation, and the rules were tightened so that risk taking was more difficult.

But:

"....eventually, banks would learn how to play the new game. They would spend serious money lobbying to keep regulations lax, hiring lawyers and accountants to find methods to minimize or avoid regulations, and incentivizing employees to hide risk from regulators. While the banking sector became more risky, creditors to banks (such as depositors and lenders) knew they could count on the Fed to engineer bailouts via lower interest rates and access to credit if times got tough--so banks had no trouble raising funding from creditors, and our financial system grew rapidly."

As time went on, the Fed continued to protect the banks. In the 1980s, Volcker lowered interest rates during the Latin American debt crisis [and simply ignored it when some banks were technically insolvent]. That caused a real estate boom that resulted in the S&L debacle of 1987. So interest rates were lowered again creating problems in real estate again, and then in the Asian markets. They crashed, then the Long Term Capital Management hedge fund created a "systemic risk" and rates were lowered again, fueling the Hi-tech bubble, also treated with low interest rates. which created the current burst bubble. You get the idea.

Saving the big banks from themselves is getting far more expensive than it used to be:

"Based on what we have seen over the past two decades, the cost of the next collapse will invariably be steep. Since the early 1980s, the Fed has gone back to its origins as the bailout machine for the financial sector. The only difference is that this sector has become much larger since 1907 or 1913. Back then, it accounted for around one percent of GDP. Now it is closer to 8 percent. The cost of bailouts--the current one and those to come--has skyrocketed as a result."

So, what do the big banks get from all of this? Its very simple:

"Consider the lessons learned in the past twelve months by our major banks. If they again get into serious financial trouble, the Fed can be counted on to lend them essentially unlimited amounts at effectively zero interest rates. What would you do with free money? You’d pay off all your old debts, then you’d find something to invest in that would yield a decent return. But then you’d reckon--why not take more risk? After all, if things go badly, you’ll get more free money."

They propose some solutions that might work, but may not be tough enough.

First, banks should have more capital to cover loan losses than is now permitted. Now, it is about 8%, which is ridiculously low.

Second, they propose that banks and their officers, directors and shareholders be at least partly responsible financially when their banks go broke [I would make them fully responsible].

Third, they say we should stop the merry-go-round from the banks to the government and back to the banks. My thought is that right now, because of this, we have the actual perpetrators of the crisis involved in bailing out their former companies. This is simply atrocious.

Last, they say the Fed should take more of a leadership role in regulation the system. My thought is that we should at least consider doing away with the Fed, or curtailing its powers to prevent this continual boom and bust cycle.

At least we should audit the Fed on a frequent basis. There is far too much secrecy there.

They conclude that if the Fed doesn't take the lead in better regulation, it will continue to be the "handmaiden to repeated bailouts." And that the peril to our system becomes even worse with each one.

This is a great article. I somewhat disagree with them in that they treat the Federal Reserve as something different from the banks. The Federal Reserve is owned by its member banks, and with the exception of the Chairman, now Mr. Bernanke, the banks elect the members. We therefore have the foxes guarding the hen house.

I highly recommend you go read the whole article here.

In addition, the two authors blog at The Baseline Scenario.