How the Federal Reserve Contributes to Crises

Interview with Ed Kane, Martin Mayer & Walker Todd

Published on Global, by Bill Bergman, September 7, 2009.

… On April 27, we held a conversation with Ed Kane, Martin Mayer, and Walker Todd–three people who have great depth and experience in understanding the plumbing, history, and effects of the regulatory infrastructure of our financial markets. Kane is professor of finance at Boston College, past president of the American Finance Association, and co-founder of the Shadow Financial Regulatory Committee. Martin Mayer is a prolific financial journalist, a scholar at the Brookings Institution, and the author of more than 30 books on financial market issues. Todd worked in the Federal Reserve System as an attorney and economist and is now affiliated with the American Institute for Economic Research. The conversation has been edited for clarity and length:  

Bill Bergman: Where does this financial crisis rank historically?

Ed Kane: I call it the Great Recession. It hasn’t become a depression by any means, but it is the worst recession we’ve had since Keynesian economics led to a more active government acceptance of the responsibility to ameliorate business cycles.

Martin Mayer: We were always going to have a bad patch. A lot of very dumb things had been done, particularly at the federal banks, but also, a lot of people’s worst instincts were pandered to, and they were inviting what is now fashionable to call the Minsky moment, when actually it looks as though it’s a Goldilocks moment–the economy was suddenly eaten by bears.

Walker Todd: I would note that Martin’s book, The Fed (Plume, 2002), should be required reading for everybody to gain a view of the run-up to this crisis. You can easily see how we got here. This financial situation is the worst since the end of World War II. We looked at the charts at AIER last Friday, and virtually all the economic-performance charts were at unheard-of or post-war lows. This really is the big one.

Kane: Officials panicked in September 2008, and the public lost confidence in their ability to manage. It is striking how in these different agencies, a small inner circle of people have closed themselves off to ideas from even the rest of their staff. I understand that in a lot of agencies everybody goes home on time, but this inner circle has been working itself to death. Along with panic, I think there is exhaustion and some loss of judgment, because they’ve been under pressure for so long.

Mayer: What happened right after Lehman was that the commercial paper market closed down, and quite a lot of the extension of credit in the U.S. economy ran through the commercial paper market. I got a peculiar insight on the situation. I was giving a talk to the fixed-income division of Fidelity. It was the week after the Lehman collapse. There was a $600 billion money market fund that Fidelity ran, and the Fidelity folks said that all of their institutional clientele were calling up and saying, “Get us out of commercial paper. Get us out of anything that’s private. We want nothing but government guaranteed paper. Cleanse that money market fund of yours!”

The whole crisis accelerated over the course of that week, while the Treasury and the Fed, which had not anticipated any of this, didn’t understand well enough how their own system worked. They thought that all that mattered was the banks. Meanwhile, all the informal sources of credit in the economy, which are bigger than bank loans in the commercial economy, faded away to nothing. These guys sat there and wrung their hands and wondered what was going on.

Todd: The panic then spread into the general public after September and October because of the meltdown of 401(k) plan values. There, too, it’s not entirely clear who’s to blame. One wants to point the finger at the sell-side distributors of securities, but the typical 401(k) plan does not offer a vehicle with a proper hedge for the consumer in moments like these. I, like other investors, was confronted with the question of: Do I go all to cash, risking the devaluation by the Fed of the value of that cash in the future? Where were the commodities? Where were the gold funds offered in 401(k)s that would both offer investors some protection and upside against future Fed inflation?

Bergman: Martin, you had an interesting story in The Bankers (Plume, 1998) about the origins of AIG’s financial products unit. To what extent was AIG and its involvement in the credit default swap market at the center of the storm?

Mayer: Certainly, it was the center of the panic. That the Federal Reserve system would support, on very dubious legal authority, an insurance company with $180 billion of advances so that this insurance company could get away with the fact that they wrote policies and never put aside any reserve to be able to pay them–it’s a disgrace.

Incidentally, this problem is by no means gone, because one of the reasons you can’t price assets is that nobody knows whether they’re really insured. Nobody wants to release a loan that may in fact be insured, but no one knows whether it’s insured or not … (full long text).

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