Market Will Recover Despite Government
Review of It’s Not As Bad As You Think, Why Capitalism Trumps Fear and the Economy Will Thrive, by Brian S. Wesbury (John Wiley & Sons, Inc. 2010), ISBN: 978-0-470-23833-2, $24.95
Brian Wesbury’s new book is for investors, policy analysts, market forecasters, ordinary citizens, and government regulators and politicians, if they will only listen to the message. Wesbury lays out the causes of the current financial crisis, explains how the government turned a contraction in the housing market into a crisis, and outlines how the government’s actions are not helping the recovery.
That is the bad news. The good news is that the market is adjusting and a recovery is taking place. In short, the market is stronger than the combined forces of all the governments in the world.
What Caused the Crisis?
Many commentators agree the actions by Congress to promote homeownership for all, including those who would not qualify under traditional rules, caused the crisis. Indeed, many of the new homeowners are now called “Ninjas” because they had no income, no job, no assets.
The Federal Reserve also contributed to the disaster by holding interest rates at very low levels. The mortgage brokers signed up these folks and in many cases hid the fact that many did not qualify even under the new, relaxed rules. The subprime mortgages were then securitized into packages and traded. These became the holdings of the large investment banks and two government-sponsored mortgage enterprises, Freddie Mac and Fannie Mae. Insurance was taken out in the form of credit default swaps, most of which were written by American International Group, now nearly 80 percent owned by the federal government to keep the company from collapsing.
Thus a bubble was created that was bound to burst. Wesbury lays out the chronology perfectly. He also shows the road to recovery: the balance sheets have to be cleaned up at the banks and other lending institutions. To this point, the diagnosis and prescription for the cure track the contribution of John Taylor (see his book Getting Off Track, Hoover Institution Press, 2009).
Toward a Solution
It is at this point that Wesbury makes a unique contribution. The market will improve on its own and will be helped if the mark-to-market accounting rule is relaxed, he writes. This accounting rule rates the value of an asset based on the prices from spot markets and derivative trading. But during a crisis these prices are far lower than the long-term projections used to justify the original investment decisions.
A word is in order at this point to clarify the nature and use of mark-to-market accounting. Think of an airline with large risk exposure from volatile fuel prices. The airline must plan its future route structure, commit to new aircraft, hire crews and agents, and set prices in competition with other airlines. Most of these decisions are affected by fuel prices. It is prudent for the airline to hedge. It does this by taking an opposite position with distillate futures and/or options.
The prevailing institution in these markets is mark-to-market accounting. With exchange-traded contracts, prices are updated and contract values settled twice a day. This reduces the chances of default because no trader gets so deep into the pockets of another that reneging is a temptation. But the problem with the airline is that the adjustments from the derivative settlements are not aligned in time with the cash flow of the investment and staffing decisions. Synchronizing the two flows is typically done by using very volatile mark-to-market adjustments.
Market makers and traders do this because both sides of their transactions are completed each day. This is also acceptable in normal times for an airline or other firms with long-term physical positions to hedge. But it is not so during a financial crisis when prices are temporarily stuck at a low level.
Bank Balance Sheets
This might explain why government regulators, such as former Treasury Secretary Hank Paulson (who came from Goldman Sachs), tend to favor mark-to-market or fair-value accounting, as he and others call it, and why they had such trouble dealing with the problems caused by the housing bubble. (See Henry M. Paulson Jr., On The Brink, Business Plus, 2009, pp. 448-9.) While Paulson tried to clean up the banks’ balance sheets with the $700 billion troubled assets relief program, he was clueless on how to achieve that objective.
Thus the troubled assets relief program morphed into the government’s taking an equity position in the large investment banks. To his credit, Paulson resisted bailing out the Ninjas, which was being promoted by Federal Deposit Insurance Corporation Chairwoman Sheila Bair. Paulson worried such programs would reinflate the subprime bubble and later require an even larger bailout.
Lesson from the 1930s
Wesbury points out that there was less ignorance of the mark-to-market accounting problem during the Great Depression of the 1930s. He cites Milton Friedman’s and Anna Schwartz’s description of how the mark-to-market technique was eventually abandoned in 1938 because it “was the most important source of impairment of capital lending to bank suspensions.” (See Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960, Princeton University Press, 1963, p. 355.)
The political background is found in Allan H. Meltzer, A History of the Federal Reserve, Vol. 1: 1913-1951 (The University of Chicago Press, 2003, pp. 487-8). Meltzer notes that at the time Treasury Secretary Henry Morgenthau was vying with Federal Reserve Chairman Marriner Eccles over which agency would control bank examination. Some bureaucratic turf wars never end.
After several false starts, the Financial Accounting Standards Board announced on April 2, 2009 that for cases of illiquid assets, an institution could use “cash flow” to value assets. Bank assets became more valuable and were recognized in the financial stock prices. They bottomed out in mid-March 2009 and have been on a tear ever since.
However, values of nonfinancial stocks have not increased and are still stalled because the credit markets are still frozen for the most part. This is at least partly due to the FASB’s attempt to reimpose the mark-to-market rule on all assets of financial institutions, including loans.
In Wesbury’s opinion the market will handle that obstacle, although the recovery will be delayed. Other programs such as the recently approved national health care reform bill, the forthcoming financial regulation bill, and the cap-and-trade energy scheme are also delaying recovery. But the market is stronger than the attempts at intervention by government. Brian Wesbury is right. Pass it on.
Jim Johnston (JamesLJohston@cs.com) is economic advisor to The Heartland Institute.