The roots of the current crisis are not unlike those of earlier bubbles. They originated in the seductive power of price escalation—of a “whole lot of excess”—and the “egocentricity of the present,” which led some to believe we had entered a “new era.” We either didn’t notice this elaborate conceit or failed to deal with it.
On the Fed’s goals. The objective of all this activity is to provide a bridge for the financial system while it transitions from a period of indiscriminate excess and gets back to normalcy. I do not believe the Fed should be, or is, “bailing out” any particular institution. Nor do I personally believe that any institution in and of itself is “too big to fail.”
But I do believe that we must have a financial system that is in working order. We must have a system where the chain of delegated monitors operates smoothly and efficiently. We must have a system where the financial pipes and sprinkler heads that nourish capitalism sustain the fertile lawn that is the American economy. It is the Fed’s duty as lender of last resort to lead the way to restoring the efficacy of the financial system.
The Fed has made some tough judgment calls lately, and, having been party to making those calls, I can assure you they certainly were not made lightly. In principle, we know that the market should decide the winners and losers, who survives and who fails. I am a big fan of Winston Churchill. “It is always more easy to discover and proclaim general principles than to apply them,” Churchill said. I now know full well what he meant.
On the historical perspective. In assessing the situation, don’t let anyone convince you that we’ve entered a “new era.” The details may be different, but we’ve been here before. Allow me to temper the ego of the present by recalling the not-too-distant past and the events that happened right here in Texas.
In the 1980s, the euphoria of oil prices around $100 a barrel in today’s dollars led to a frenzy of lending activity in Texas. At least I think that’s what any reasonable observer would call the annual growth rate of business loans of over 40 percent at Texas banks and annual growth in commercial real estate lending of almost 50 percent that we saw in the early part of that decade.
Ned Gramlich, a much-revered and very wise former Fed governor who, sadly, succumbed to leukemia in September, reminded us that America’s economic progress has been punctuated with booms and busts. The 19th century had its canal, railroad and mineral booms. The 20th century had its rushes of financial innovation and new technology.
Each boom was followed by a collapse when prices could no longer keep up. “When the dust clears,” Gramlich wrote, “there is financial carnage, many investors learning to be more careful next time, but there are often the fruits of the boom still around to benefit productivity…. The canals and railroads are still there and functional, the minerals are discovered and in use, the financing innovations stay and we still have the Internet and all its capabilities.” The fruits of the subprime market boom, he reminded us, are the millions of low-income and minority borrowers who now own their own homes and are successfully making their payments and building equity for the future.
Keep this in mind as the housing market corrects and the new financial instruments spawned by the housing boom and turbocharged financial technology continue seeking more rational price levels—levels that will be determined not by ersatz valuation models and unsustainable return assumptions, but by the market’s discipline in equilibrating supply and demand. A great many families who would never have had access to the ultimate fruit of the American harvest—homeownership—were able to achieve that dream because of the housing boom.
Our job is not to bail out imprudent decisionmakers or errant bankers, nor is it to directly support the stock market or to somehow make whole those money managers, financial engineers and real estate speculators who got it wrong. And it most definitely is not to err on the side of Wall Street at the expense of Main Street.
In fact, to benefit Main Street, we have a duty to maintain a financial system that enables American capitalism to do its magic.
There is nothing “unprecedented” about the situation we find ourselves in. To illustrate the point, I want to read a passage from Washington Irving’s 1819 essay on the Mississippi Bubble. For those of you who think the recent housing bubble and the ensuing financial imbroglio are “unprecedented,” listen to these words penned almost 200 years ago:
Every now and then the world is visited by one of these delusive seasons, when the ‘credit system’…expands to full luxuriance: everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open…. Banks…become so many mints to coin words into cash; and as the supply of words is inexhaustible, it may readily be supposed what a vast amount of promissory capital is soon in circulation…. Nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital….
Now is the time for speculative and dreaming or designing men. They relate their dreams and projects to the ignorant and credulous, [and] dazzle them with golden visions…. The example of one stimulates another; speculation rises on speculation; bubble rises on bubble…. No ‘operation’ is thought worthy of attention, that does not double or treble the investment…. Could this delusion always last, the life of a merchant would indeed be a golden dream; but it is as short as it is brilliant.
And to think, Washington Irving had never met a subprime mortgage, or a CDO, a CLO, an SIV or a credit default swap! It is indeed true that those who ignore history are condemned to repeat it. That is the bad news. Financiers, “dazzle[ing] the credulous,” including regulators, repeated history in spades, despite their claim to unprecedentedly clever and new risk-management tools and mathematical sophistication. It was as short as it was momentarily “brilliant.”
But that is done, and now we must do what we can to remedy the situation. One thing, however, is clear. The answer, to be curt, is not to compound the bad by repeating the oft-prescribed remedy of inflating our way out of our predicament with a wing-and-a-prayer promise that it can always be reined in later, as some public commentators have suggested. It is for this reason that I have maintained a strong reluctance to further general monetary accommodation and the FOMC as a group has stressed vigilence on inflation. At the same time, I have been an advocate of using our various discount window facilities, within reason, to bridge the financial system’s structural problems as the credit markets correct themselves and run the long course of contrition.
Washington Irving, “A Time of Unexampled Prosperity,” The Crayon Papers: The Great Mississippi Bubble (1819–1820).