Podcast: Play in new window
Buy Alex Pollock’s book: “Finance and Philosophy: Why We’re Always Surprised”
- Risk is the price you never thought you’ll have to pay
- 2% inflation means prices will be up 5 fold in your lifetime
- Federal Reserve’s “Stable Prices” is really Orwellian Newspeak
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
ALEX POLLOCK: WHAT IS THE MOST
DANGEROUS INSTITUTION IN THE WORLD?
November 14, 2018
“The members of the Federal Reserve do not know enough, and the combination of their potentially unlimited power for monetary manipulation, combined with the limitations in knowledge of what will happen when they try this stuff, is what makes them the most dangerous financial institution in the world.”
– Alex Pollock
Kevin:We have a guest today that I am looking forward to. This is a man who, strangely enough, Dave, is in the world of finance, very much in the world of finance as far as crossing paths with the big boys like Greenspan, and testifying before Congress. But his degree was in Philosophy, and I have to poke fun at you just a little bit because I’ve known you since you were a teenager, and I knew your dad, and I remember when he saw what you wanted to do when you picked your major.
David:I think it was what I wanted to study, because I didn’t know what I wanted to do …
Kevin:He looked at me and he said, “David – David wants to be a philosophy major. What – what is he thinking?”
David:I had to write a ten-page paper explaining why – this was for him alone – explaining why philosophy was a legitimate degree and wasn’t the equivalent of underwater basket-weaving or something like that – with all respect to underwater basket-weavers.
Kevin:Well, our guest today – great book – Finance and Philosophy: Why We’re Always Surprised, I have to admit, Dave, by a guy who really could be very haughty if you look at his background. He has been in high places for a long time, but he is one of the most humble bankers – that is his background – but he is just a humble philosopher. He laughs easily, he looks at things in a broad perspective, and I think he takes things in a broad perspective as far as life, as well.
David:Finance and Philosophyis a book I would encourage folks to order and read. There are lots of lessons to learn there. In the present tense, as you anticipate the future and as you try to learn from the past. If you are interested you can order it at Amazon.com – Finance and Philosophy: Why We’re Always Surprised, by Alex Pollock.
Kevin:One of the things I loved is how he characterizes risk. He says we all have risk. He says, “Risk is the price you never thought you would have to pay.” And that’s really true. We can look at prices and see whether they are real or not, but oftentimes when things start falling apart prices can go much further on the upside than you ever would have thought, or crash to a level that you never thought you would see. He has seen that over and over. He was at Continental Illinois. I was in college when Continental Illinois failed, and it was the economics lesson of the day.
* * *
David:Alex, today you join us from your post in Washington as a distinguished Senior Fellow at the R Street Institute. In past roles you have been the President and CEO of the Federal Home Loan Bank. More recently, you were at the Enterprise Institute where you were a Resident Fellow from 2004-2015. You also serve as the Director of the CME Group, a Director for the Great Lakes Higher Education Corp, and Director and past Chairman of the Great Books Foundation, which I am familiar with through Mortimer Adler and many of the things that he has put together. We could go on and on about the things that you are a part of. I think if we look even further back into your history we discover a young man who was fascinated by philosophy and the questions that mingle metaphysics, epistemology and logic, which in my view is not a bad foundation for banking, although in this day and age it is a rare one.
You wrote a book recently, Finance and Philosophy. This is a book you released in recent months. You consider the financial markets, the fads, the foibles, and you put those in the context of history. And with your interest in big questions, philosophical questions, there is a philosophical undertone throughout. I have a few questions for you in light of your banking experience, and with regard to your thoughtful appraisal of where we are today, and where we are going within the financial markets.
I want to start in 1984. In 1984 Continental Illinois went down.
Alex:And I was there, as the book tells.
David:(laughs) And you were there.
Alex:(laughs)
David:It was the last time to go broke, but it wasn’t the first.
Alex:That’s right.
David:Fifty years earlier, 1934, a similar set of decisions was made in the management of their loan book and that took the bank down then, as well. In both instances I am sure there were investors and depositors and managers of the bank that were surprised. Why are we surprised, as your subtitle of the book suggests?
Alex:Let me start by thanking you very much for having me with you. We are surprised because the future is not only unknown, but unknowable, and many times we can have the sense that something is not so good and that things are going to be bad, but usually we are surprised on how bad they can be when they really get bad – how far something can go down when it goes down, as Continental did in 1984, and as you say, before, in 1934. In both cases it was bailed out by capital investment from the government and the management was kicked out and new management was sent in. And it is the sense that the times you experience that are fairly good are good times, or even okay times, are just going to continue, and that defines your idea of normality.
But in the crises, which happen rather frequently, more or less once a decade, those ideas that we convince ourselves of that we are in normality, go by the boards, and we hit the panic and the crisis and prices, which are key to this whole discussion, prices can move around much more than we think. They go up a lot more in the boom, they go down a lot more in the bust, because price has no objective existence – I guess that is my first philosophical point – so it can move a lot more than we think. And especially, when times are bad the prices go down more than we think, and if those prices have against them a lot of debt, or leverage built on the expectation that those prices will sustain themselves or always go up, then we are going to have a first class bust.
I have two sayings from old bankers that I learned in my days at Continental Illinois, which it would have been better had we employed. The first is, “Just remember this young man, your assets shrink, your liabilities don’t shrink.” So when the prices are going down your debt is still there, until you default on it, that is. The second one is, “Risk is the price you never thought you’d have to pay,” which I think is just a great thought, and I can see this old banker telling me that – “Risk is the price you never thought you’d have to pay.”
The question is, why didn’t it occur to you that you might have to pay it? It is because of this illusory sense of what is normalcy that we feel ourselves convinced of, even though it isn’t true.
David:So, in the timeframe of 1984 with Continental Illinois related to the oil patch, and as you say, prices and the extrapolation of good times into the future, another old saying that you mention in the book is that bad loans are made in good times.
Alex:That’s another one, yes (laughs).
David:Love it. But now you have a reversal in price and all of a sudden all that leverage shows itself. We had the same thing happen with the housing market.
Alex:Now it kills you instead of making money for you.
David:Right. That which added to the bottom line now takes away. Well, confidence is an interesting social construct. I want to tie this into the housing debacle here recently because Citibank was front and center for that. Politicians are keen to maintain confidence, even at high cost. Citibank had this near extinction event in the last banking crisis just about ten years ago, and as you recount, the FDIC made sort of a back of the napkin calculation of what it would cost the insurance company to bail out this near-failed entity, and they said, “Well, between 60 and 120 billion dollars.”
So my questions for you are, relating to Citygroup, what would that event have meant for the FDIC, and what impact would that have had on market confidence? And I’m guessing, you’ve been around for the FSLIC debacle and can imagine, future tense, pension fund debacles and things of that nature because of underfunding. But what was that 60-100 billion dollar cost to the FDIC in terms of their viability, or really, the viability of the system at that point?
Alex:That’s a great question. We should preface this by saying, not only was Citibank effectively broke last time around in the 2000s, it was also broke in the early 1990s with the huge commercial real estate bust at the time. And it was also broke in the 1980s. And it also got government money in the 1930s, just like Continental did, but just think of the 1980s, 1990s and 2000s. Ordinarily, you would think that was three strikes, but they are still going, and I think one of the most important reasons they are is because the FDIC could never have afforded the failure of anything as big as Citibank. So if you look through, people talk about too big to fail all the time. If you look through why something like Citibank is too big to fail, it is because if it went down it would very likely take the FDIC down along with it. I will talk in just a second what that would mean.
Now, some people say, “Well, if you look at the numbers it wouldn’t have, but I can guarantee the FDIC did not wish to find out what would happen to it if Citibank went down, and it is my view that the FDIC then would, itself, have been broke, especially if you can imagine the further panic that the failure of a Citibank and the default of a Citibank on its obligations would have brought. So what you have is a government guarantee fund meant to prop up confidence, as you say, and as you rightly say, a social construct, confidence. But that government guarantee fund, itself, can go broke, just like FSLIC or the Savings and Loan Deposit Insurance Fund did in the 1980s, and as the FDIC would have, itself, been broke in the 2000s with the failure of Citibank and the wider panic which would certainly have followed.
What would happen then is the U.S. Treasury would then be bailing out the FDIC, and there is little doubt that that would happen, that the Deposit Insurance Fund, so-called, is actually a vehicle for a U.S. Treasury guarantee of bank deposits, just as happened in the 1980s with the savings and loans. When the savings and loan government insurance fund went broke in the 1980s, that was, as I related in the book, a 150-billion dollar tax-payer bailout so that the guaranteed depositors did not lose money, but if they were taxpayers they lost money on the other side of the transaction. And the bonds that were sold to finance that bailout run to 2030, so here is a sobering thought. For 12 more years, the American taxpayers are still going to be paying for the 1989 bailout, and obviously we had a big bust since then (laughs).
David:You quote Tim Geithner saying that our crisis, after all, was largely a failure of imagination. Every crisis is.
Alex:Yes.
David:How is it that really clever and highly intelligent people routinely do not anticipate problems in the financial system?
Alex:Well, it’s because risk is the price you never thought you’d have to pay. Now, I think the failure of imagination, just to repeat a thought of a minute ago, isn’t so much a failure to imagine that something could go wrong, but the failure to imagine how muchit could go wrong. Now, in 2007 or so, I had this experience myself again. Some of my colleagues and I were thinking about housing. I relate in the book how we had an international conference of the International Union for Housing Finance, which I have been part of for a long time, in September 2006, and the lead plenary session was on, “Are we in a housing bubble?”
One speaker who was a great expert and later Nobel prize winner on this, was very hedged about what might come. And the other speaker who was an expert in the Irish housing finance system gave a very energetic speech about how the Irish housing system was absolutely sound and there was going to be no problem, and the house prices were sustainable in Ireland, just before the complete collapse of the Irish system. So why is it that we don’t imagine how bad the outcomes are?
Many of us at that conference talked to each other and said, “Something really bad is coming.” But it turned out to be even worse than we thought with our pessimism. And it is hard to see how when all of the financial factors shift from optimism to panic, and they are all interacting with each other, how bad it is really going to be. And so we tend to get very surprised that way on the downside.
A final point is, even if somebody did imagine, and of course some people make calls when things are going to be bad, it is hard for professional economists to be too far off the consensus. There is a lot of personal risk if you forecast really extreme scenarios and they don’t come true. So this gives rise to a really pointed, wonderful story, which is, what is the difference between an economist and an engineer? The answer is, if an economist is right once, it makes his career. If an engineer is wrong once, it ends his career.
David:(laughs) So, you have these financial factors. Talk to us about the human factors, because you end up with there being surprising elements, whether it is in politics, international relations. We are pretty close here to the anniversary of World War I, and no one imagined that it could be that bad. I’m not sure anyone imagined, or even understood, why it was happening.
Alex:Absolutely. That is a great example. They absolutely didn’t imagine it. They imagined the opposite. They imagined it would be a short war, which would be settled, and they had no idea how bad it would be. There is something else. There is a really interesting book, as you probably know, written just before the first world war, which argued that in modern developed societies then, there was a global economy which had developed in the era before the first world war. In such societies you couldn’t have big wars because everybody would go broke and it would be an economic disaster.
They had the big war anyway and they all went broke, and it was an incredible economic disaster, which played out all through the 1920s and in my opinion was the best way to understand the subsequent deep depression of the 1930s, was still the amazing destruction of the first world war playing through finance and economics. That is a wonderful example in politics and in military affairs, just as you say, of the same thing.
Now where this doesn’t happen is, of course, in physical science, where you actually have science and predictive mathematical laws. That’s different. But things that are built out of human beings with their frailties, their competing strategies – if you think about financial and economic or military or political reality, it is a different kind of reality than physical reality, and it behaves differently. It behaves subject to radical uncertainty, which means the future is unknown and unknowable because it is radically reflexive, recursive, and incredibly complex.
The ideas that you have today become part of reality tomorrow. The strategies which are all expectational, and among the things that I have to expect in all of these domains – finance, economics, politics, military affairs – I am creating forecasts of other people’s forecasts. And they, in turn, are forecasting my forecasts. And the result of all that is the surprises we get, and sometimes really bad surprises.
David:We have a mutual acquaintance who contrasts the old gold standard to what he calls the Ph.D. standard.
Alex:(laughs)
David:That’s Jim Grant, I’m sure that sounds familiar to you.
Alex:Yes, of course.
David:And it has become fashionable to hire Ph.D. economists to model credit and to assess the kinds of risk that you were just describing. As a banker, what is your opinion of the usefulness or perhaps the danger of relying on these models, and confusing them with something that is scientific?
Alex:You have to use these models, and have them and distrust them, and don’t ever confuse the model for the reality. One of the problems is, in a recursive system, the model, itself, is affecting the future in ways that the model can’t forecast successfully. This applies not only to the models of private actors, but very much to models of government actors. They have the same problem, that they are building their economic and financial models, but those models, themselves, are changing the very reality that they are trying to model, so we get the really notable examples like some of the ones I talk about in the book.
I will just mention one, which is Ben Bernanke, then Chairman of the Federal Reserve. I think the Fed is the largest employer of Ph.D. economists. It has several hundred of them. It certainly has all the computers and the models it wants, and in January of 2008 Bernanke suggested that there would not be a recession when, in fact, the recession had already started.
This is a great example of the problems with models, and how the models enter into the reality and will create a new economic and financial reality for which they are not prepared. You might say they can be self-falsifying. Just like the beliefs we mentioned in the Continental Illinois case that were a problem with believing that oil prices would always go up, and we know that get paradoxical outcomes in finance.
In some cases the more you believe something the more certain it is to be false. The more you believe oil price will always go up the more certain it is that they will come down. And they may come down in really disastrous fashion, as happened in the early 1980s. Same thing with house prices and with low-quality mortgage credit in the 2000s. The more you believed that house prices would always go up, the more certain it was they were coming down. The more you thought your models had successfully modeled the credit behavior of riskier borrowers, the more certain it was that those models would fail.
One of the lines I really like, and I quote in the book, is from Tony Sanders at George Mason University. He said, “The rocket scientists” – meaning the financial modelers – “built a missile which landed on themselves,” and that sums it up nicely, I think.
David:We’re talking about how people react and how other people then try to predict what those other people will do, and there is a bit of circularity. Does that argue for the impossibility of rigging outcomes within the financial markets? We were very taken by the idea that capitalism may take on a new and advanced model, the Chinese model, because they were willing to spend trillions after the global financial crisis, and they didn’t see the kind of chaos that we saw. At least, they have not yet. But there is this idea that maybe the central planning model and rigged outcomes are a possibility.
Alex:When, in fact, they are an impossibility, and this old problem of knowledge and of the recursiveness and self-falsifying properties of economic and financial markets absolutely does lead you to the conclusion that the central planning model will never work, just as great thinkers like Hayek would say.
David:We have regulation. You quote Arnold Kling in the book: “Each era of regulation seems to contribute to the next era of euphoria. And the most recent big – and we’re not talking about a small piece of documentation – but the regulations relating to Dodd-Frank may, in fact, be that next iteration of regulation contributing to the next era of euphoria. I think it is ironic that Dodd is even involved in the construction of that legislation. You quote him on page 52 saying – and these are his words – “What is important are the facts, and the facts are the Fannie and Freddie are in a sound situation.” That was about two months before they both went broke.
Alex:(laughs) Yes, it’s a great quote. And we should mention, while we’re at it, that Congressman Frank was also a big promoter of Fannie and Freddie. So, it’s doubly ironic that we have the Dodd-Frank accents, as they both were important contributors to the disaster through supporting the over-expansion of credit through Fannie Mae and Freddie Mac.
David:Where do you see the next area of euphoric boom and bust?
Alex:The reason it is hard to answer that question well is because each time that you draw your lessons from the last crisis, and that essay I quote in there by Arnold Kling is really a terrific piece of work, the lessons you draw are very plausible. It isn’t that these were drawn by stupid people, they were intelligent people trying to say, “How do we get smarter based on this experience?” And they studied the crisis of the 1980s which went into the 1990s, remembering that between 1982 and 1992 over 2,000 financial institutions failed in the United States. More commercial banks failed than savings and loans. We always talk about it as the savings and loan crisis, but over 1,000 commercial banks failed, as well.
Now, they studied all this and drew from them plausible conclusions. When these plausible conclusions were applied, however, as Arnold so cleverly, and in my judgment, rightly argues, the result was that they made the next crisis worse. So there are these surprising outcomes out of plausible arguable ideas drawn by intelligent people, from the experience, that come back to cause disasters the next time. It’s hard to put your finger on just what those will be next time, but we can say some things. We know that the more confident you are that everything is always going up, the more certain it will become that it will be going down. And we know that the more leverage that is built – and markets and governments both love leverage for their own operations – we know when that leverage gets built in and ever expanded against some price, some asset price that you tend to have great confidence in, that is when you are building up the chance, and in fact, in time, the certainty that it is all going to come down.
There is this thought that any one time you play Russian Roulette, let’s say if it has six chambers in the pistol you only have a 16% chance of killing yourself. But if you play it once a year for a long time, you are certainly going to shoot yourself in the brain. And financial systems in any one year – and I talk about the math of this in the book – in any one year there is a low probability that it is going to come apart, but the probability repeated year after year means that in time it always does. So if we were doing this right we would look for where the leverage gets run up in confidence that the prices correspondingly will go higher or be sustained, and that is where it is going to come apart.
And then it is always a little bit speculative just where that turns out to be, but we know once the unwinding starts, then something really important happens, which is, liquidity disappears. In the book I talk about what is the nature of liquidity? Liquidity is also a social construct, to use your term, and very rightly. Liquidity, I argue, is the belief that other counter-parties are solvent and the prices are meaningful, and once people in general cease believing that counter-parties are solvent, or they at least think it is a good chance that they are insolvent, and they cease to believe that quoted prices mean anything, then there is no liquidity, it has disappeared, and we are on our way into the panic.
David:We have seen record interventions, not that interventions are new. We have seen devaluations and all sorts of interventions through time. But taxpayers have footed the bill for many of the past financial crises, and I’m wondering if there is a threshold at which that becomes politically intolerable. Do you see change in that area where from crisis to crisis, as you mentioned, the 1970s, the 1980s, the 1990s, the 2000s, the 2010s, and we could go back in time further to account for all the banking, financial and monetary crises. At some point doesn’t the public just get sick of it?
Alex:Well, they get sick of it every time, but it still happens again the next time.
David:I guess the other question to go along with that is, do they understand the role that they play when central banks are able to both inflate away liabilities, but also reassign losses? It’s not just a question of Wall Street avoiding taking a hit, but that the Treasury Department and the Fed actually have the ability to assign a loss.
Alex:Absolutely. I think that is a really good point. The moving of the losses through monetary manipulation and through financial repression, as the term is, is subtler and harder to see, but very effective. So we know that after the bust the losses have already happened, there’s nothing you can do about it, the losses are there. The whole discussion is about who gets to pay.
Well, this time around we know one of the most important parties who got to pay was savers. Savers had the better part of a decade of negative real interest rates on their savings. Now it is all the way up to about zero real interest rate which is still a taking from them. And the money was taken, or we can say expropriated from the savers in order to support the profits of other highly leveraged people. And who were those highly leveraged people? They were banks who make a lot of money when short rates are zero nominal and negative real, hedge funds, other kinds of leveraged speculators.
But the biggest beneficiary is, of course, the biggest borrower, and we know who that is – the government, itself. One of the ways the governments and their central banks, always remembering that however much people may talk about the so-called independence of central banks, central banks are part of the government, and the government and the central banks together can operate to expropriate savers and holders of money, people trying to be responsible and save for their families or their own later years, take their money and give it to the government as well as to other highly leverage people.
And that is a political act. That is one of the points I try to make in the book. When the Fed has run its nearly decade-long experiment with negative real interest rates on savings and financial repression, that is an act of taking a lot of money from some people and giving it to other people. That is inherently a political act, and we have to recognize that that is likely to happen as the government tries to cope with dealing out the losses that have already happened because of the crisis.
David:This came up in our conversation with Carmen Reinhart, who we had on the Commentary, about the corralling of investors and savers, and we did talk about financial repression. It made me think of policymakers relying on a greater good ethic as support for their decision making. We had an amazing conversation with Carmen where on the one hand she saw the practical nature of the policies and the necessity of them. On the other hand she was bothered by the way that they were being implemented and their real impact in real life. So where does that brand of ethics, the greater good ethic, fit in? When is it really just an excuse for abusing individual rights and freedoms?
Alex:I think often it is very easy to use the term greater good. A greater good is liable to be that which benefits my constituents, whoever my constituents are (laughs).
David:That’s right. I like that idea of it being a political act, it is a choice, there are constituents that are served by it. You have personally witnessed crises in your tenure as a banker in the 1970s, the 1980s, the 1990s, the 2000s and the 2010s. I am curious what your instincts tell you as time wears on and you see confidence building. Equities are just a few percentage points away from all-time highs. If you are using the Buffet indicator or perhaps borrowing from Robert Shiller’s price earnings multiple, the PE-10. There is a variety of ways of measuring excess. One of those would be just how much money is borrowed to be put into the stock market. These are signs of confidence, but what does that tell you?
Alex:It tells me, as people have called it, we have an “everything” bubble as a result of the financial manipulation, not only of the Fed, but of all the major central banks – the Fed, the Bank of Japan, the European Central bank. They are all doing the same thing, so that we have very high prices in stocks, in bonds, certainly, not as high as they were in bonds, in real estate, both residential and commercial real estate, and in collectibles.
We had a situation where not only short, but long rates, were suppressed. Long rates are now rising, and, as Alan Greenspan said in a session I chaired at AEI a few months ago, “when long rates go up, most everything else goes down,” and I think that’s about where we are now. Does it just go down a little, the famous soft landing much beloved by the central bankers? Or do you get a hard landing? That is what is hard to say. So we know that when the Federal Reserve has given unending speeches about how everything will be gradual, that translates into, “Well, we’re hoping for a soft landing, for moderate falls in asset prices, moderate credit behavior.”
But it often doesn’t work that way. In the 2000s, while house prices were still rising, people used to debate whether this was sustainable, and then everybody knew it wasn’t sustainable. But the question was, how would it end? A very popular theory at the time was, it will end with house prices going sideways, in nominal terms, and therefore falling in real terms. And as they fall in real terms then you will get adjustments. That would have been a soft landing. But instead we had a crash.
David:It sounds a little like hopeful thinking.
Alex:It was. It was hopeful. There is a great story about a rating agency presenting its models for rating mortgage-backed securities to a group of investors, and these models, which were all created by intelligent people based on a lot of data, all had a parameter in them called HPA, which stood for House Price Appreciation. A more scientific name might have been HPC, or House Price Change, because you needed to think about house price depreciation. But they called it HPA, and at this meeting, at least according to the story, somebody in the audience finally said, “Well, what happens if house prices go down instead of up?” And the presenter said, “Then our model will blow up.”
David:(laughs) As it did.
Alex:Well, as it did (laughs).
David:I love the passage in your book where you are talking about the training program that you were put in charge of. Can you tell us a little bit about the training program you ran for bank trainees? You describe the pinstriped suits, the white shirts and the tie, and when you were describing that conservatism it made me smile.
Alex:Well, thank you. I should tell you, I actually didn’t run that program, I was just brought in by the runners of the program to talk to the training group. And of course, the program was very technical. It had a lot to do with accounting and with the forecasting of cash flows, and looking at all kinds of different leverage ratios and present values and things. It had zero financial history in it, which was the same as the training program that I went through a long time before – zero financial history. One of the reasons it is hard to learn from financial history is we don’t study it, and that one didn’t either.
But I will just finish the story that you started. I told them my standard line every time they brought me in to do this. “You will notice around here we all wear dark pinstriped suits and white shirts and ties and the building we are in is very stately with huge pillars and a lot of marble. Have you ever wondered why this is? The answer is because what we are actually doing is so risky we have to lookconservative. People these days are looking less conservative in their dress, but what they are doing is still equally risky.
David:Maybe just comment on that. We assume that when we put money at the bank and are seeing a very low rate of return on that deposit, that must be because it is a staid institution, a stable institution, that really doesn’t take any risk. Tell us about implicit risk and the use of leverage in banks.
Alex:Banks are the most highly leveraged of institutions. That includes investment banks, of course, although not as highly leveraged as Fannie Mae and Freddie Mac were, being government financial institutions. And most of the time it works out okay, but since assets shrink, and liabilities don’t shrink, in the bad times the highly leveraged institutions get in trouble, like banks.
Walter Bagehot who wrote the greatest book on banking ever written, published in 1873, said, “The source of the profitability of banks is the smallness of the capital.” I love this phrase, “the smallness of the capital.” That’s the highness of the leverage, the bigness of the leverage. But the conclusion that Bagehot drew from that is that banks had to have extremely conservative assets. You should only touch unquestionable securities,” he wrote, “because of the smallness of the capital. But when your confidence grows and you are taking a risk and you never think you are going to have to pay the price, the assets of banks, or of other financial intermediaries, grow increasingly risky. But the leverage doesn’t go down, and so the combination of high leverage and risky assets, in time, will mean a bust every time. And also, this next time, in some form or other, which you and I were just a minute ago trying to imagine which form it will be next time around, there certainly are plenty of cases in the world right now where if you look around the world where we have instances of extreme financial problems – one only needs to think of Venezuela, Argentina, Italy, which may be a big bust, Greece or other emerging market countries – but is there an even bigger bust in here somewhere. Well, it will be, as I said before, where the leverage is and the capital is small and the assets grow riskier.
If you look at the history of banking, as one of the chapters of the book does, and you mentioned Carmen Reinhart – this draws from a table of Rogoff and Reinhart’s terrific book, This Time is Different. But I took their table which was International Financial Crises, and I switched it around so that it wasn’t categorized by country but by year, and then we did the whole 20thcentury, 100 years of banking history, and went year by year, at which countries there was a banking crisis starting. The answer was that 54 of the 100 years of the 20thcentury a banking crisis started in some country or countries – 54 of the 100 years. Of course, they weren’t over, necessarily, in a year, so the lesson I draw from that is, inherent in this business of banking is smallness of capital and risky assets.
And we should also mention, being intertwined with government, as banking always is, because governments are always pressuring banks to make the loans that are politically appealing to whoever is in power, that includes loans to the government itself, to the government and its favorite constituencies. As we said before, we will call that loans in the general good, that is, make loans to my friends. So more than half the years, financial crises started in some country or countries over 100 years, and the worst decades of all were the 1980s and 1990s. It wasn’t that we got smarter, financial crises started in ten out of the ten years of both the 1980s, and ten out of the ten years of the 1990s.
I should tell a story here, if I can. We talked about the difference between economists and engineers. What is the difference between banking and politics? That is the question. And the answer is, in banking you borrow money from the public and lend it to your friends, and in politics you take money from the public and give it to your friends. And when politicians put pressure on banks, it is to get the banks to lend money to the politicians’ friends or their constituents.
David:(laughs) You have described the most insidious of bubbles as being those which are credit-driven, and you also title one of your chapters, “The Most Dangerous Financial Institution in the World.” I wonder if you could tie those two together for us and give us some comment. Tell us who is the most dangerous financial institution in the world.
Alex:The most dangerous financial institution is the Federal Reserve, and the reason for that is because the most dangerous kind of institution is a central bank in a fiat currency system because there are no constraints except whatever it decides, itself, or whatever some politician may decide. There is no constraint on what it can do. It can inflate, it can expand credit, it can rob the savers, it can suppress real wages through inflation, and it can create bubbles through its monetary action.
Now, that’s true of all central banks in fiat currency systems, and we know that in pretty good numbers of fiat currency systems the money printing runs away with itself and you turn that into a hyper-inflation. But the reason the Federal Reserve is, of all central banks, the most dangerous is because it is by far the most important, and the biggest. It presides over the dollar, which is the global currency.
So the Federal Reserve is not just the central bank of the United States, it is the central banker to the dollar-using world, which is the whole world. And its mistakes can be utterly disastrous, like the mistakes of creating the great inflation of the 1970s which turned into the collapses of the 1980s, like its mistakes of inflating housing prices in the early 2000s, in which the Federal Reserve consciously wanted to do what they called creating a wealth effect, which meant making house prices go up. So they wanted a housing boom, instead they got a housing bubble.
I try to make it clear these are honest mistakes. I don’t think these are at all malicious. It is very smart people, many of whom have Ph.D.’s, operating their Ph.D. theories and trying to do what seems right, but no one knows enough to, as the saying goes, manage the economy through monetary manipulations, and the members of the Federal Reserve do not know enough, either, and the combination of their potentially unlimited power for monetary manipulation combined with the necessary and unavoidable limitations in knowledge of what will happen when they try this stuff is what makes them the most dangerous financial institution in the world.
David:So if we give them the benefit of the doubt in terms of trying to accomplish something for the greater good, in trying to put their best thinking forward, I wonder if we might level some critique at the level of their ability to define words, or perhaps even go so far as to say, abuse language. Price stability is a phrase which dates back to the Federal Reserve Act, and yet now we have targeted inflation of 2%. Let’s discuss the meaning of price stability past and present and the implications for savers and retirees.
Alex:This is a really key point and thank you for bringing it up. What the Federal Reserve Act actually says is “stable prices.” Well, what do you think stable prices means? It means something that over time stays stable, that is to say, about the same. The Federal Reserve, on its own volition, along with other central banks who have also done this, have decided that they are going to target, as they say, 2% inflation a year. Well, 2% might not sound like very much. If you were a historical figure in the Fed, let’s say, in the 1950s, 2% would have sounded high to you, but now they say that’s not so bad.
But what does 2% a year mean if you do it every year? And their announced intention is to create 2% per year inflation forever. Suppose you live 82 or 83 years, which is very common these days, luckily for us. What does 2% inflation per year do? It means prices will quintuple in your lifetime. That means when you are 80 years old and you are trying to pay for things they are going to cost five times as much as they did when you were young.
And the Federal Reserve, with a straight face, calls that price stability. So they have redefined the term, price stability, to mean perpetual inflation, which if you remember the great George Orwell phrase of Newspeak, I think, it is one of the finer examples of Newspeak that we have experienced in recent times.
David:As you say, you have continuous inflation. That has a remarkable cumulative effect over time. And if it quintuples during your lifetime, does this not become an issue for savers and retirees? And ultimately, doesn’t that become an issue for Congress?
Alex:Yes. Put that together with a central bank which also depresses the rate of return on savings so that it is negative in inflation-adjusted terms. All the while the prices that you have to pay for things are inexorably marching upward. That is a pretty unpleasant combination.
David:Not that we need to pile on here, but then you can consider the large unfunded liabilities of the next 20 years, and I guess that leads me to ask the question, what form of disappointment should we prepare ourselves for?
Alex:Well, that is among the greatest of investment questions, facing that, and knowing the cyclicality which will come with it, one of the items of good news is, however, as the book discusses, as we look at the long-term trend through all the ups and downs, as long as we have a society which is a free market, mostly, which is what I call the enterprising economy, an economy built on enterprise which has active entrepreneurs, which has a rule of law, but we know that there will be sustained, continuing growth over time.
Now, we will cycle around that trend a lot and the central bank can do a lot of damage if it is unlucky or unwise, but the fundamental trend of continuing growth, which is making all our lives better, if an enterprising economy with the rule of law is there, and that gives us hope that we are going to find our way through this in investing, as well.
David:There may be an opportunity, too, to exert some pressure on Congress from the man-in-the-street to the men and women representing us to ultimately bring about some accountability with the Fed. You have a few suggestions in the book that relate to that and perhaps bringing some accountability to Fed monetary policy where greater oversight directly and insight from Congress onto the Fed’s activities can perhaps change some of that course.
Alex:It is what we should do, and I think it would be a good idea. It is hard to do. As you know, I have worked on that. I have testified to the Congress trying to influence the ideas that over the long run determine what happens, that is to say, the ideas. But it is hard to do. We know that under the constitutional design it is the Congress that has, as the Constitution says, the power to coin money and regulate the value thereof. When they wrote the Constitution they weren’t thinking of fiat currency – actually, they were thinking about it, but they were trying to avoid it.
They were going to have the power to coin money, but to regulate the value of money and to determine how that incredibly important – here is another social construct, money, and how the monetary system works – is a deeply political issue, and what kind of society do you want to have with respect to money? And therefore, the elected representatives of the people, in my view, ought to be diligently overseeing the Fed and holding it accountable and telling it what kind of money the society wants. Now, that is easier said than done. There is a whole school on the other side, especially the Federal Reserve itself, that thinks that central banks should be independent, as they say, a little bit of fiefdoms, a world unto themselves.
As I discuss in the book, if you really want the model for this, it is the philosopher Plato, with the philosopher kings of his ideal republic, those people who were so wise and knowledgeable that they could tell everyone else what to do. But in the real world, we know there are no philosopher kings, and we shouldn’t have any part of the government trying to operate as an independent force, or in the case of the Fed, trying to be economic and financial philosopher kings.
David:I know a number of people who aspire to that role (laughs).
Alex:(laughs)
David:They would like to be – they consider themselves qualified.
Alex:(laughs) I have this little saying, “Inside every economist is a philosopher king trying to get out.”
David:(laughs) Well, Thomas Kuhn, you know the writer of The Structure of Scientific Revolutions?
Alex:Yes, sure.
David:He makes it clear that paradigm shifts don’t occur – they do not occur – when you simply have problems and anomalies. You can have the prevailing paradigm which maintains its position for a long time, but when a replacement system is available to solve those problems and anomalies, then, and only then, can a revolution in thinking take place. So I think about the Bretton Woods system with the monetary experiment, were it to fail – and I would argue it has failed but many people don’t appreciate it – as it is appreciated, what is the substitute to replace it, and what is the political path to implementing it?
Alex:Thursday I am going to be commenting on a book by a friend of mine, Brendan Brown calledThe Case Against the 2% Inflation, in which he tries to answer that question in an interesting way. And the answer is what he calls sound money, which is a return to an idea of sound money, by which he means something radically market-oriented. That is to say, nomanipulation of monetary affairs or interest rates, either short term or long term, by the central bank. It could happen, you know, but I think, as you suggest with the scientific revolution analogy, it takes the problems building up. It takes, undoubtedly, some form of financial crisis and then these ideas have to be ready to be implemented. But it strikes me the whole discussion of what that institutional evolution is and what it will be is highly uncertain. We can see what it has been in the past. You mention Bretton Woods. Well, Bretton Woods came out of the crisis of the 1930s under the incredible crisis of the war when they tried to design a system, and did design a system. They tried to design one that would last and bring monetary stability. Well, it came in to force in 1945 and by 1971 it was gone because it didn’t work as they thought and hoped. And in these monetary designs, they are all institutional human creations. You put your best thought into it and maybe if you get 20 years out of it that’s pretty good for a human creation.
David:Well, there are so many more things to consider, whether we do better by design or by default, or if we should find – many things we could still discuss, and Alex, I appreciate your joining us in the conversation today. I want to suggest, highly recommend, that listeners pick up Finance and Philosophy: Why We’re Always Surprised. You’ll find a thousand nuggets in there, not the least of which are the quotes at the back, the compendium of aphorisms. I felt like I was marching through G.K. Chesterton as I went from quote to quote to quote, and I appreciate you cataloging those for us.
Thanks for your contribution today on the Commentary, and the books that you have published, as well.
Alex:Thank you very much for having me. I really enjoyed the conversation.
David:Thank you, Alex.
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Kevin:Dave, how often do you hear a banker say that the most dangerous institution in the world is the Federal Reserve?
Dave:(laughs) That’s the kind of banker I enjoy. But one of the things I really enjoyed, finishing Finance and Philosophy, was getting through the bibliography. If you are ever curious where many of the guests for the Weekly Commentary come from, it is bibliography hopping. So there will be a number of future guests on the Commentary that come from that, another ten books on the way from Amazon out of that bibliography. For those of you who, again, are curious about learning from Alex Pollack, you want to order Finance and Philosophyand enjoy the read as much as we have.
