Next Financial Crisis
by Gary North: The
Safe Banking Fantasy
financial media are running stories on the next financial crisis.
This is unheard of two years into a so-called economic recovery.
So weak is this recovery that the old pre-2008 confidence has not
The first sign
that "this time, it's different," was Treasury Secretary Geithner's
statement, which received widespread coverage, that there will be
On May 18,
The Daily Beast ran a story on Geithner's unexpected appearance
at the initial screening of an HBO movie, Too
Big to Fail, which dramatizes the crisis of late 2008, during
which time Geithner was president of the Federal Reserve Bank of
New York. In an interview, Geithner said this. "It will come again.
There will be another storm. But it's not going to come for a while."
That was surely
forthright for a sitting Treasury Secretary. He was not specific,
but to say that another crisis will come was unique. He added this:
"It's not going to be possible for people to capture risk with perfect
foresight and knowledge."
That was amazingly
forthright. It points to the reality of the naive faith of regulators
that they can devise formulas that will keep the system from being
hit by some unexpected mini-crisis that will trigger a wider systemic
breakdown. He acknowledged that risk analysis, based on statistics,
cannot deal with uncertainty: events outside the law of large numbers
that serves as the basis of statistics. Ludwig von Mises discussed
this in 1949, and Frank H. Knight wrote a book on this in 1921:
Uncertainty, and Profit. Nassim Taleb has called this a
black swan event. Whatever we call it, such an event torpedoes the
best-laid plans of government regulators as well as statisticians
advising leveraged banks.
falling apart," Geithner said. "We had no playbook and no tools.
. . . Life's about choices. We had no good choices. . . . We allowed
this huge financial system to emerge without any meaningful constraints.
. . . The size of the shock was larger than what precipitated the
That is the
official government line, which Treasury Secretary Hank Paulson
used to persuade Congress to fork over $700 billion in TARP loans.
It justified the Federal Reserve's swaps at face value of liquid
Treasury debt in its portfolio for unmarketable toxic assets held
by large banks. It justified the 2009 stimulus package of another
of the article correctly noted: "In the end, the taxpayers saved
the Wall Street investment banks, with Geithner & Co. injecting
enough capital to cushion them from bad bets." That is exactly what
On June 6,
spoke at a meeting of the American Bankers Association in Atlanta.
Here, his analysis was completely different from what he had revealed
in his appearance at the HBO screening. It turns out that the system
was saved by investors, not by the government and the Federal Reserve.
Of the 15 largest
financial institutions in the United States before the crisis, only
nine remain as independent entities.
that survived did so because they were able to raise capital from
private investors, significantly diluting existing shareholders.
We used stress tests to give the private market the ability
through unprecedented disclosure requirements and clear targets
for how much capital these institutions needed to distinguish
between those institutions that needed to strengthen their capital
base and those that did not.
He did not
mention that the reason why investors came to the rescue was that
the winners had been bailed out by the taxpayers and the Federal
has saved us, he insisted, and it will continue to save us.
We now have
the authority to subject all major financial institutions operating
in the United States to comprehensive, consolidated limitations
on risk taking. That represents a dramatic change from before
the crisis, when more than half of the financial activity in the
nation that was involved in "banking" from the investment banks
to large finance companies, AIG, and Fannie Mae and Freddie Mac,
operated outside those limits.
And the markets
where firms came together like the over-the-counter derivatives
markets will now be subject to oversight, once regulators
finalize and implement new rules authorized by Dodd-Frank. We
now have much stronger tools to limit the risk that one firm's
failure could cascade through markets to weaken the rest of the
and this is the most important test of crisis response, the U.S.
financial system is now in a position to finance a growing economy
and is no longer a source of risk to the recovery.
He ended with
this inspiring promise. "So we will do what we need to do to make
the United States financial system stronger. We will do so carefully.
And as we do it, we will bring the world with us."
This was cheerleading
for government regulation. This is what we have come to expect.
The problem is this: it is a full-scale retreat from his admission
at the HBO screening.
took him to task in the New York Times on June 9, in an article
Banking Emperor Has No Clothes." Johnson was the chief economist
of the International Monetary Fund, and is a member F.D.I.C.'s newly
established Systemic Resolution Advisory Committee. He said that
Geithner is naive about the supposedly high degree of safety for
the banking system. He complains that Geithner is way too optimistic.
First, he reminds
us that the government bailed out the banks. He reminds us of Geithner's
admission of this in his HBO interview. Second, he reminds us that
the international banking system is interconnected.
big banks in almost all other major countries have run into serious
trouble, including those in Britain and Switzerland where
policy makers are now open about the potential scope of further
disasters. French and German banks made large amounts of reckless
loans to peripheral Europe and have strongly resisted higher capital
requirements, helping to create the current potential for contagion
throughout the euro zone (and explaining why the Europeans are so
keen to keep control of the International Monetary Fund).
in Atlanta that U.S. banks are less concentrated than other nation's'
banks. But how will that save our banks from a crisis that is triggered
outside the U.S.? "Mr. Geithner's most serious mistake is to believe
that we can handle the failure of a global megabank within the Dodd-Frank
Geithner's thinking on bank size is completely flawed. The lesson
should be: big banks have gotten themselves into trouble almost
everywhere; banks in the United States are very big and have an
incentive to become even bigger; one or more of these banks will
reach the brink of failure soon.
gets to the famous bottom line. The bottom line is this:
is no cross-border resolution mechanism or other framework that
will handle the failure of a bank like Citigroup, JPMorgan Chase
or Goldman Sachs in an orderly manner. The only techniques available
are those used by Mr. Geithner and his colleagues in September 2008
a mad scramble to find buyers for assets, backed by Federal
Reserve and other government guarantees for creditors.
That this should
appear in the New York Times is indicative of the extent
to which the old confidence in the banking system is fading.
On June 8,
the Wall Street Journal ran a
column by Martin Feldstein, who served as Reagan's chairman
of the Council of Economic Advisers. He is a Harvard faculty member.
a Keynesian. He has a reputation as a conservative. He is on the
board of contributors to the Journal. He is regarded as a
conservative because he favors tax cuts. But he also favors Federal
spending in times of crisis. Somehow, he also comes out for a lower
He said that
Obama's $830 billion stimulus package did not go far enough. "As
for the 'stimulus' package, both its size and structure were inadequate
to offset the enormous decline in aggregate demand." The money should
have gone to the Defense Department.
shows that the most cost-effective form of temporary fiscal stimulus
is direct government spending. The most obvious way to achieve that
in 2009 was to repair and replace the military equipment used in
Iraq and Afghanistan that would otherwise have to be done in the
future. But the Obama stimulus had nothing for the Defense Department.
Instead, President Obama allowed the Democratic leadership in Congress
to design a hodgepodge package of transfers to state and local governments,
increased transfers to individuals, temporary tax cuts for lower-income
taxpayers, etc. So we got a bigger deficit without economic growth.
This is pure
Keynesianism. It is a call for massive spending in a recession.
So, should there be another fiscal crisis, Feldstein's recommendation
is a bigger stimulus. The problem for his is this: with the economy
slowing, it will be even more vulnerable to an unexpected black
Second, we are getting an economic slowdown, he says, because
Obama will not make the Bush tax cuts permanent. This creates
uncertainty in the minds of investors.
So, he sounds like a supply-side economist. But he isn't. He is
a traditional Keynesian.
is the deficit.
third problem stems from the administration's lack of an explicit
plan to deal with future budget deficits and with the exploding
national debt. This creates uncertainty about future tax increases
and interest rates that impedes spending by households and investment
is the official strong dollar policy that has led to the decline
of the dollar. But he never mentions Federal Reserve policy: QE2.
What are our
prospects? He is not optimistic.
economy will continue to suffer until there is a coherent and favorable
economic policy. That means bringing long-term deficits under control
without raising marginal tax rates by cutting government
outlays and by limiting the tax expenditures that substitute for
direct government spending. It means lower tax rates on businesses
and individuals to spur entrepreneurship and investment. And it
means reforming Social Security and Medicare to protect the living
standards of future retirees while limiting the cost to future taxpayers.
All of these
things are doable. But the Obama administration has not done them
and shows no inclination to do them in the future.
So, here is
a Harvard economist saying that we needed a larger stimulus in 2009,
but we need reduced spending now. We also need to reform Social
Security and Medicare, while protecting the future retirees and
limiting costs. All this is doable.
All this is
utter nonsense. The politics of Medicare and Social Security have
not changed in 40 years because there is no politically acceptable
way to limit their costs. Voters will vote against anyone who suggests
such a reform. The voters were promised the Keynesian moon, and
they will not tolerate the popping of that pipe dream. In short,
none of what Feldstein suggests is doable, short of a monumental
crisis that enables Congress to start goring specific electoral
oxen. And when that crisis comes, Feldstein will no doubt recommend
a large deficit, with the money going to the Defense Department.
This is Establishment
Wall Street opinion.
TELLS IT STRAIGHT
there was an article in Forbes, a conventional outlet, written
by Agora's Addison Wiggin. He begins with this.
is definitely going to be another financial crisis around the corner,"
says hedge fund legend Mark Mobius, "because we haven't solved any
of the things that caused the previous crisis."
Mobius is a
legendary hedge fund manager. If he thinks there is going to be
another crisis, we would be wise to listen.
the Greek debt crisis is a good candidate for a trigger event.
Greek crisis is first and foremost about the German and French banks
that were foolish enough to lend money to Greece in the first place.
What sort of derivative contracts tied to Greek debt are they sitting
on? What worldwide mayhem would ensue if Greece didn't pay back
100 centimes on the euro?
rhetorical question, since the balance sheets of European banks
are even more opaque than American ones. Whatever the actual answer,
it's scary enough that the European Central Bank has refused to
entertain any talk about the holders of Greek sovereign debt taking
a haircut, even in the form of Greece stretching out its payments.
The ECB is
determined to protect the Too Big to Fail banks. It always says
that it will not lend more money to the Greek government, but it
always does. It calls for more bailouts by the German and French
governments. The game must go on!
will accomplish nothing. Going deeper into hock is never a good
way to get out of debt. And at some point, this exercise in kicking
the can has to stop. When it does, you get your next financial crisis.
We are being
warned in advance by the financial media: expect another major crisis.
The bailouts were not enough. The expansion of the monetary base
was not enough. The new Dodd-Frank regulatory structure is not enough.
international banking system is an interdependent, interconnected
system. The system is not transparent. Even if it were, the level
of debt unsecured IOUs is enormous. Wiggin comments.
on the amount of derivatives out there worldwide vary. An oft-heard
estimate is $600 trillion. That squares with Mobius' guess of 10
times the world's annual GDP. "Are the derivatives regulated?" asks
Mobius. "No. Are you still getting growth in derivatives? Yes."
words, something along the lines of securitized mortgages is lurking
out there, ready to trigger another crisis as in 2007-08.
There is no
formula to deal with this. There is no organized government response
that is waiting in the wings. There will be another crisis. And
when it comes, the response will be the same: to preserve the solvency
of the biggest banks, at taxpayer expense and at central bank expense.
When it comes to bailouts and central bank inflation, it's all "doable."
It will therefore be done.
North [send him mail]
is the author of Mises
on Money. Visit http://www.garynorth.com.
He is also the author of a free 20-volume series, An
Economic Commentary on the Bible.
2011 Gary North
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