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New At Reason: Treating Wall Street Like the Mafia

anthony.randazzo@reason.org (Anthony Randazzo) — Fri, 20 Nov 2009 14:23:00 EST

I have a new commentary posted at Reason Online looking at how Sen. Dodd's new Agency for Financial Stability would be the financial equivalent for the FBI seeking to take down La Cosa Nostra:

Perhaps Senate Banking Committee Chairman Chris Dodd (D-Conn.) thinks of himself as a modern day John Sherman. In 1890, Ohio Sen. Sherman set out on a mission to establish “just competition” laws and level the economic playing field. His quest culminated in the dismantling of monopolies—such as American Tobacco and Standard Oil—and the passage of new laws prohibiting malicious competitive practices. In a similar way, Dodd now seeks the power to tear apart any company he considers a risk to the national economy. But unlike Sherman, Dodd isn’t out to create the best possible conditions for competition to thrive. He’s out for blood.

Dodd’s plan for overhauling Wall Street regulations, released last week, includes a proposed new organization: the Agency for Financial Stability (AFS). This new regulator would be tasked with identifying and addressing “systemic risks posed by large, complex companies as well as products and activities that can spread risk across firms.” This represents one piece of the most extensive proposal to reform financial services regulation—topping even the ridiculousness of the Obama plan and Barney Frank plan. Which is saying a lot.

The financial crisis has made off with nearly $30 trillion in global wealth. Dodd believes Wall Street banks and other financial institutions are the chief culprits in this dubious economic caper. And to exact revenge, he will push for some of the toughest, most expansive regulatory powers to date.

To do this, Dodd plans to go Elliot Ness on Wall Street, using economists and accountants as if they were FBI agents. Only instead of targeting Al Capone and Big Angelo Lonardo, these number-crunchers would be given nearly limitless power to hunt down systemic risks inside America’s financial institutions.

Read the whole piece here.

Treating Wall Street Like the Mafia

anthony.randazzo@reason.org (Anthony Randazzo) — Fri, 20 Nov 2009 13:53:00 EST

Perhaps Senate Banking Committee Chairman Chris Dodd (D-Conn.) thinks of himself as a modern day John Sherman. In 1890, Ohio Sen. Sherman set out on a mission to establish “just competition” laws and level the economic playing field. His quest culminated in the dismantling of monopolies—such as American Tobacco and Standard Oil—and the passage of new laws prohibiting malicious competitive practices. In a similar way, Dodd now seeks the power to tear apart any company he considers a risk to the national economy. But unlike Sherman, Dodd isn’t out to create the best possible conditions for competition to thrive. He’s out for blood.

Dodd’s plan for overhauling Wall Street regulations, released last week, includes a proposed new organization: the Agency for Financial Stability (AFS). This new regulator would be tasked with identifying and addressing “systemic risks posed by large, complex companies as well as products and activities that can spread risk across firms.” This represents one piece of the most extensive proposal to reform financial services regulation—topping even the ridiculousness of the Obama plan and Barney Frank plan. Which is saying a lot.

The financial crisis has made off with nearly $30 trillion in global wealth. Dodd believes Wall Street banks and other financial institutions are the chief culprits in this dubious economic caper. And to exact revenge, he will push for some of the toughest, most expansive regulatory powers to date.

To do this, Dodd plans to go Elliot Ness on Wall Street, using economists and accountants as if they were FBI agents. Only instead of targeting Al Capone and Big Angelo Lonardo, these number-crunchers would be given nearly limitless power to hunt down systemic risks inside America’s financial institutions.

Here’s one of the biggest problems with this (and with the Obama and Frank plans, too): the government offers only a dangerously vague definition of what constitutes a financial institution. So not only would Goldman Sachs and JP Morgan Chase qualify, but firms like Wal-Mart, Ford, and Texas Instruments—not exactly the companies you think of when discussing Wall Street regulation—might be subject to higher compliance standards as well. It all depends on the subjective whims of the Agency for Financial Stability.

As outlined in the Dodd plan, AFS would be an independent agency, one whose chairman was appointed by the president and confirmed by the Senate. It would also have a 9-member board comprised of federal financial regulators and an independent expert.

The structure is similar to President Obama’s proposed Financial Services Oversight Council. Both of these proposed overseers would monitor the market for systemic risks, and would possess the authority to collect information from financial institutions as needed. The major difference is that where the Obama council would only have the power to designate firms as “Tier 1” companies, a category that would require stricter regulation, Dodd’s agency would actually have the power to break-up those companies considered too big to fail.

In other words, an Agency for Financial Stability would enjoy unprecedented power over the private sector. Presently, if the government wants to take a large firm apart, it must first take its case to court, proving that the company is either a monopoly or that it is maliciously attacking its competitors.

Yet not only would Dodd’s AFS write rules for capital requirements, leverage limiting, and risk management compliance, it would also have the authority to treat Wells Fargo or UBS like the Bonanno crime family.

Which means that the risk of undue political influence is palpable. Let say’s enough people come to believe that Goldman Sachs is secretly controlling the Treasury Department, as Rolling Stone’s Matt Taibbi so viciously claimed. All those people need to do is pressure the government into taking the company apart on the grounds that it’s size has become too critical to the economic health of the nation. There are certainly enough anti-Goldman Sachs staffers on Capitol Hill to make that happen. And it doesn’t take a follower of Ayn Rand to imagine a scenario where flimsy justifications like “to expand competition” and “create a fair playing field” start rolling off the tongues of aggressive AFS agents.

Nor is the Agency for Financial Stability the only part of the Dodd plan worth worrying about. His regulatory overhaul proposal also includes a Consumer Financial Protection Agency, similar to the one currently being considered in the House. Even more aggressive than Rep. Frank’s version, this consumer agency would also ultimately protect the market to death.

The Wall Street Journal pointed out last week that the Dodd overhaul plan would open up anyone who associates with someone accused of fraud to civil suits, even if prosecutors have no proof or are just on a fishing expedition. The Dodd proposal also repeats the errors of the Obama plan on issues like derivative reform, hedge funds, and executive compensation.

There are a few good ideas in the proposal. Consolidating federal banking rules into a single regulator could do a lot to simplify and refocus banking rules. Though that reform shouldn’t be kept separate from consumer protection concerns, and it would be inappropriate for the regulator to force the various charters under its supervision into one-size-fits-all regulations.

The Dodd plan also requires large firms to provide “funeral plans” outlining how they could be quickly and effectively shutdown in the case of an emergency. In theory, this is just a part of responsible risk management. But the Dodd plan treads into dangerous waters by giving AFS the authority to approve or reject such plans.

In the end, the Dodd plan is on the highest order of hubris. Politicians in Washington honestly believe they can fix the economy and prevent future calamity. Sure, they weren’t quite right when they “fixed” the system after Enron, or when they “reformed” the rules under Clinton, or when they “fixed” everything after the Savings and Loan Crisis. But this time will be different! At least Elliot Ness knew enough to change tactics after several initial failures to capture Al Capone.

The current financial crisis was largely brought about by well-intentioned regulations that just got it wrong. We thought that 8 percent was enough capital for banks to hold onto in case they ran into trouble. We thought that subprime mortgage-backed securities were decreasing risk. We were wrong on both counts. We can’t anticipate every risk. Under the Dodd plan—like the Obama and Frank plans before it— we’ll be proven wrong once again.

Anthony Randazzo is a policy analyst for Reason Foundation. This column first appeared at Reason.com.

Don't Let Banks Keep Disguising Risk

anthony.randazzo@reason.org (Anthony Randazzo) — Fri, 20 Nov 2009 10:24:00 EST

Systemic risk oversight is on tap up on the Hill. (Though you wouldn’t know it with all the health care talk.) The House is laying the groundwork for a new division of Treasury called the "Financial Services Oversight Council" to monitor systemic risk. The Senate Banking Committee is going to be discussing the creation of a new, independent "Agency for Financial Stability" with much wider authority. Ironically, both ideas—as currently proposed—for creating a systemic risk regulator, which are based on the Obama plan from this summer, are dangerous to the health of the financial sector.

One of the dangers some believe we face is highlighted in yesterday’s WSJ in an op-ed from three former chairmen of the SEC. Roderick Hills, Harvey Pitt, and David Ruder write:

the Obama administration is on the verge of transferring accounting standards responsibility from the SEC to a systemic risk regulator. Such a radical move would have extremely negative consequences for our capital markets. […]

Today, the American Bankers Association, on behalf of many commercial banks, is seeking to prevent disclosure of the fair value of the financial instruments they own. It is attempting to persuade Congress that the safety and soundness of the banking system will be protected if a systemic risk regulator can prescribe accounting disclosures for financial companies.

The government shouldn't follow their advice. This change might well interfere with efforts by financial firms to raise capital. Investors will assume that the accounting standards they employ are designed to mask risks.

Read their whole column here.

I’ve written more about the Obama proposal for systemic risk in these two papers:

Fixing the Regulation of Wall Street: A review of the Obama administration's proposal for reforming financial services regulation and recommendations to end the era of too big to fail
The Future of Too Big to Fail and Bailouts: A comparison of the two plans to overhaul financial services regulation in the 21st Century

Also see some blogged thoughts on this here and here.

Worse Than Taxes

info@reason.org (John Stossel) — Thu, 19 Nov 2009 13:49:00 EST

Bill O'Reilly is mad at me because I'm not mad enough about taxes.

Last week on The O'Reilly Factor, we talked about California's and New York's enormous budget deficits and planned tax increases. Those states would have big surpluses had they just grown their governments in pace with inflation. But of course they didn't. Now the politicians act like their current deficits are something imposed on them by the recession.

But that's nonsense. They created the problem with their reckless spending.

Let's look at the particulars. Had the government of New York state grown at the rate of population and inflation over the past 10 years, it would have a $14 billion surplus today. Instead, spending grew at twice the rate of inflation. So New York has a $3 billion deficit.

To dent California's deficit, bureaucrats will withhold an extra 10 percent from every taxpayer—at least from those who don't flee the state. New York planned to raise the price of new license plates, but then backed off. The visible tax was unpopular. But the hidden taxes grow.

Hidden taxes are more pernicious because they disguise what we pay for government. We blame merchants, not our legislators, for the high price of gasoline, liquor, cigarettes, and phone calls, but the money goes to the political thieves.

New York imposes a gas tax of 61 cents a gallon—almost a quarter of the cost of the gas. New York City taxes cigarettes at $4.25 a pack. Washington state collects $26 per gallon of hard liquor. Illinois politicians take a sneaky cut when you buy junk food: They add 6.25 percent to the cost of soda and candy.

My phone bill lists seven different taxes—unintelligible stuff like a "Public Safety Commission Surcharge" and an "MCTD tax." The payroll tax is one of the biggest hidden taxes. You assume that you know what you pay because it's listed on your paycheck, but that's actually only half of it. Employers must pay an equal amount—money that otherwise would have been part your salary.

O'Reilly was most indignant about the visible taxes. "You, Stossel, are going to be paying 45 percent of your money to the government!" he said. I replied that I already pay more than that, since I live in New York City.

But I apparently was not indignant enough, because later in his show he told comedian Dennis Miller, "Stossel doesn't get it."

O'Reilly is right about my not being furious. It's not that taxes don't anger me. They do. But I'm more angry about the arrogance of the ruling class. It reminds me of Walter Williams' riff: "Politicians are worse than thieves. At least when thieves take your money, they don't expect you to thank them for it."

Taxes, even counting hidden taxes, are not the real measure of what the thieves take. The true burden of government, the late Milton Friedman said, is the spending level. Taxation is just one way government gets money. The other ways—borrowing and inflation—are equally burdens on the people. (State governments can't inflate, but they sure can borrow.)

O'Reilly told me that America is ready for a tax revolt. I hope he's right. But I don't think it will happen until more people see the ruling elite for what it is: a gang of arrogant bullies that has the audacity to believe that they know how to direct our lives better than we do.

That's why, bad as the taxes are, I'm more upset about ObamaCare, Medicare, the "stimulus," the auto bailout, the bank bailouts, the Fannie/Freddie bailouts, the trillions in guarantees, and on and on.

The politicians' spending schemes represent presumptuous interference in our lives. They are an assault on our autonomy.

John Stossel will soon host Stossel on the Fox Business Network. He's the author of Give Me a Break and of Myth, Lies, and Downright Stupidity. This column first appeared at Reason.com.

Congress Plans "Too Big To Fail" Witch Hunts

anthony.randazzo@reason.org (Anthony Randazzo) — Thu, 19 Nov 2009 11:18:00 EST

Now Congress really is out for blood. Yesterday, the House Financial Services Committee moved a step closer to giving regulators the power to break apart companies if they are considered too big to fail. The Committee is currently discussing the creation of a Financial Services Oversight Council that would be the systemic risk watch dog in the overhaul of Wall St. rules.

Here is the crazy part: under the proposed legislation, the FSOC would be allowed to take apart big firms, even if they were well-capitalized and not displaying any signs of weakness.

With such unbridled authority, the potential for political games is palpable. Just think about all the rage that directed towards Goldman Sachs these days. Are they in danger of collapsing right now? Almost assuredly not. Woud their collapse negatively impact the financial system? I'm sure a host of Hill staffers could make an impassioned case for that. So it would just be a matter of time before an entrenched political war began between the systemic risk regulator and Goldman over the question of whether the firm should be taken apart "for the good of the whole."

It doesn’t take a Randian stretch to imagine excuses like “to expand competition” or “to create a fair playing field” rolling off the tongues of council spokesmen on the attack. Before long, the witch hunts, partially to exact vengeance for the financial crisis, partially out of of political ideology, will start. And the meantime, the threat of having the government gunning for the overly successful will be sure to be a disincentive to growth.

The provision passed yesterday is similar to one recently unveiled in the Dodd plan for financial services reform in the Senate. That plan would create an independent Agency for Financial Stability to manage systemic risk and go after big companies.

GAO: Stimulus Program Has Significant Reporting Problems

sam.staley@reason.org (Samuel Staley) — Wed, 18 Nov 2009 16:30:00 EST

The U.S. Government Accountability Office (GAO), the federal government's watchdog agency, has taken a look at the numbers and found 10 percent of the jobs claimed as "saved" or "created" by the so-called stimulus program didn't have any spending attached to them. In other words, the reported numbers are so unreliable they really shouldn't be used.

According to an ABC News report:

More than 50,000 jobs, or one out of every 10 jobs the White House says were "saved or created" by their economic stimulus plan, came from projects that reported spending no money yet, according to a government report obtained by ABC News.

The report by the Government Accountability Office (GAO) analyzes the Administration's October 2009 report on jobs saved or created by the $787 billion stimulus program and finds a "range of significant reporting and processing problems that need to be addressed."

Even with the errors, GAO gives the Obama Administration high marks for its efforts at transparency and in making so much information public in such a short period of time.

While the Obama Adminsitration should get credit for its attempt at transparency, we can't lose sight of what this really means. These numbers should not be used as any indication of how well the stimulus program is working. They simply aren't reliable enough. It will take months, perhaps years, to just sort out the accuracy of the reported numbers.

Again from ABC News:

On Thursday the GAO's Gene Dodaro will testify before the House Oversight & Government Reform Committee.

"Neither the recipients nor analysts can identify with certainty the impact of the Recovery Act because of the inability to compare the observed outcome with the unobserved, counterfactual scenario in which the stimulus does not take place," Dodaro says in draft testimony prepared for the hearing that was obtained Wednesday by ABC News.

In his prepared testimony Dodaro notes problems such as "different interpretations" of the administration's guidance for what constitutes a job saved or created by stimulus funds. These problems, he says, were "one of the most significant problems" they found. Therefore the GAO states that the Office of Management & Budget should "clarify the definition" and "consider being more explicit that 'jobs saved or retained' are to be reported as hours worked and paid for with Recovery Act funds."

In response to the watchdog's findings, OMB has "generally agreed to implement" the recommendations, Dodaro says, noting that OMB has also "undertaken a lessons learned process for the first round of recipient reporting." No OMB officials will testify at Thursday's hearing, despite calls from the House panel's ranking member Darrell Issa, R-Calif., that they do so.

Beyond that, there is the more fundamental and substantive question of sorting out whether a job actually was "saved" or "created" (an issue I have discussed earlier on this blog). In truth, this is viritually impossible to evaluate without examining each report individually and subjecting each to a consistent, regorous methodology with well defined criteria about how to classify the jobs. Each report would be scored against these criteria by an independent auditor or analyst.

To my knowledge, no one is taking up that task. Then again, perhaps this can be part of the next stimulus program so the federal government can "create" jobs by hiring auditors for the first stimulus program.

Reason's Stimulus and Bailouts Coverage

Globalization With a Human Face

shikha.dalmia@reason.org (Shikha Dalmia) — Wed, 18 Nov 2009 13:41:00 EST

Free trade is never more necessary—or vulnerable—than in times of economic distress. The current global downturn is no exception. Protectionist barriers have shot up all over the world, including the United States. Earlier this year, Congress killed a pilot program allowing Mexican trucks to transport goods across America and included “Buy America” provisions in the stimulus bill banning foreign steel and iron from infrastructure projects funded by the legislation. More disturbingly, President Barack Obama, after chiding Congress for flirting with protectionism, initiated his own ill-advised affair by imposing a 35 percent tariff on cheap Chinese tires.

If the world manages to avoid an all-out trade war of the kind that helped trigger the Great Depression after the U.S. imposed the Smoot-Hawley tariffs in 1930, it will be in no small part due to the efforts of one man: Jagdish N. Bhagwati, an ebullient and irreverent 76-year-old professor of economics at Columbia University. Bhagwati has done more than perhaps any other person alive to advance the cause of unfettered global trade.

A native of India, Bhagwati immigrated to the United States in the late ’60s after a brief stint on the Indian Planning Commission, where he learned first-hand the insanity of an economic approach that tried to modernize a country by cutting it off from world trade. Since then, he has devoted his efforts, both in academia and in the popular press, to showing that there is no better way of improving the lot of both advanced countries and the developing world than through free trade. His path-breaking contributions to trade theory have put him on the short list for a Nobel Prize in economics.

Though a dogged trade advocate, Bhagwati is anything but dogmatic. He is a free spirit who draws intellectual inspiration from many disparate ideological camps. A self-avowed liberal, he is also something of a Gandhian social progressive, though Gandhi himself supported economic autarky. Bhagwati works with numerous Third World NGOs on a host of human rights issues. Yet he has no problem taking on these groups—or his famous student, Nobel laureate Paul Krugman—when they question the benefits of trade. In fact, he devoted his 2004 magnum opus, In Defense of Globalization, to a point-by-point rebuttal of these critics. Although he doesn’t vote Republican because he dislikes the party’s nationalistic jingoism, he readily declares that Democrats pose a far bigger threat to international exchange than Republicans.

This summer Shikha Dalmia, a senior analyst at the Reason Foundation, interviewed Bhagwati in his New York office.

reason: You have been on the short list for a Nobel Prize in economics for your contribution to trade theory. Could you explain what your main contribution is?

Jagdish Bhagwati: My breakthrough in trade theory was very simple, as all breakthroughs are. Back in the 1950s, when the case for free trade was widely regarded as less compelling analytically than today, protectionists had one very powerful argument on their side. They noted that a country necessarily benefits from free trade only when markets are perfect—that is to say, only when market prices reflect true social costs can we expect these prices to guide allocation correctly. Take pollution. Say your production process makes you spew things into the air and water but you do not have to pay for this pollution. Then the social cost of harming others is not being taken into account by you and hence your production costs are less than the “correct” social costs.

So you could take two points of view. The time-honored view was that when there is such “market failure,” or what might be better called a “missing market,” the case for free trade was compromised and any form of protectionism was justified. I argued that if you had a market failure, fix that, and you are back to perfect markets and the legitimacy of free trade. So, for example, you can have a polluter-pay principle on the environment. If you do that, then there’s no damaging spillover which has not been taken into account.

The proper policy response then is not to abandon free trade but rather to fix the market failure and then to embrace free trade. This was a revolutionary thought. For 200 years, serious economists had abandoned free trade in the presence of market failures of one kind or another.

reason: In Defense of Globalization was addressed to non-academic critics of free trade and globalization who claim that globalization does not have a human face. What was your argument?

Bhagwati: When I was in Seattle in 1999, when everything went haywire as far as trying to get a new round of trade negotiations, I realized that the young people who were agitating, and some of the older folks also, were not interested in whether trade was good for national income and prosperity. They were claiming that globalization has an adverse impact on a whole lot of social issues—gender equity issues, environmental issues, the effects of globalization on the polity and democratic rights. In short, to use the fetching phrase, they were concerned that economic globalization lacked a human face.

My book addressed precisely such issues. I found that, contrary to the fears of the critics, most social agendas were advanced rather than handicapped by globalization. Globalization, I concluded, had a human face.

Take women’s issues, for example: If you look at what happens to the gender gap on pay inequality, it turns out that you can make a perfectly solid argument that in fact it’s narrowed rather than widened as a result of international trade. The reason is very simple: If a man is paid twice as much as a woman, when they are both equally competent, that is inefficient. So when you are engaged in international competition, you’re really not going to be able to indulge your prejudice in this way. This will lead to more demand for women and less for men, bringing pressure to bear on their relative wages in the direction of greater pay equality.

Two brilliant young women, Sandra Black and Elizabeth Brainerd, did their dissertation at Harvard on this hypothesis. They found that in two decades in internationally traded industries in the United States, the gender wage gap narrowed faster than in non-traded industries. Trade had thus been good for an important social objective, not a drag on it.

reason: You still hear the argument—President Obama made it during his campaign—that we want fair trade, not free trade.

Bhagwati: In the United States the phrase “fair trade” holds a lot of sway, because fairness is an important issue here. In the United States it’s the equality of opportunity, not of outcome, that matters. We have a fairness-oriented culture. The Europeans, who are actually more stratified—they’re more into equality of outcome. The social mobility of people is much less, so they want the state to intervene and redistribute. They’re more into justice and we’re more into fairness.

So if you want to be a protectionist in the U.S., you’ve got to say that these Japanese or these Indians are trading unfairly. People will much more readily give you protection if they think the other guy is a wicked unfair trader.

President Obama hasn’t really understood the case for free trade because I don’t think he’s been too interested in trade. His background is as an activist working with the poor people, so he hasn’t thought about these issues. So he ends up listening to other people, and a lot of people who are protectionist are around him, particularly the unions, who are afraid of international competition. But they dress up the fair trade argument in altruism, that they’re doing it to raise the labor standards and wages of workers in India and Brazil and so on and so forth, when in fact, they’re doing it to protect their own workers from competition. The president doesn’t seem to realize that this is something which other people, whom you pretend you’re trying to help, actually see as a naked, cynical ploy.

Instead of pandering to union fear, Obama has got to engage them. You have got to help these doubting Thomases confront their fears. He’s got to say that trade with the poor countries is actually helping, not hurting, you. The unions’ main fear is that unskilled jobs are disappearing. They see these jobs being taken up elsewhere where the labor is cheap. But they can’t hold onto these jobs anyway. What they get in return from trade are cheap products that they need as consumers. So free trade moderates the downward pressure on their real wages.

Big portions of the wages of poor workers go toward low quality textiles, for instance. That is well-established. But if you look at the structure of protectionism, if you go and buy something from Anne Klein that’s going to be expensive, but it carries no tariff at all because these high-end designers compete on variety. Tariffs matter where the competition is on prices. So the low-quality items which poor people buy end up carrying higher tariffs than high-end items that rich people buy.

reason: So free trade’s harm to union workers as producers is minimal, but the harm to them as consumers would be very great if we didn’t have free trade?

Bhagwati: Yes. So what President Obama has to do is basically change the ethos in this country so that it understands that the United States has profited enormously from free trade. Free trade has rescued India and China from poverty, yes. But the U.S. working class has also profited from international trade.

He’s got to make an eloquent case like that. He’s got to see that this is something that needs as much attention and as much of his eloquence as the speech he made on race after he got into trouble over his pastor.

But then to move the case of free trade forward, the Obama administration has to show global leadership, because the U.S. is the biggest trading country. He has got to make sure that the stimulus package and everything that he does is completely consistent with openness. I think he’s got to understand this is not something he can keep postponing and postponing.

When President Clinton came in the first year, he was into Japan bashing and he hadn’t made up his mind on whether he wanted trade or not, because he had advisors on both sides. So his first year was extremely tentative. Then he made up his mind and was fiercely pro-trade after that. President Bush, the junior, he too gave into steel tariffs when he first came in, but after the first year, when he found his feet, he was very pro-trade.

President Obama doesn’t have that luxury because the weaknesses are showing in the way the stimulus is being designed and played out. So someone has to tell him very clearly that he doesn’t have the luxury of most presidents, which is to use a first year to find your feet on trade. He’s got to be out there and he’s got to provide the leadership. He’s got to bring in the people who waiver and dither, the AFL-CIO, the Democrats who are indebted to the AFL-CIO, and say: “Look, you’re wrong. Here, let’s have a debate.” There are lots of Democratic economists who’d be able to engage these guys in a proper debate.

reason: In recent years, the opposition to free trade hasn’t just come from left-wing unions, but also people on the right who fear that outsourcing will cause the U.S. to lose its economic edge as it imports high-value-added products and exports low-value-added ones. How do you respond to that?

Bhagwati: It’s an irrelevant argument. To say that the United States should be exporting high-value items rather than low-value items is itself a fallacy. But America’s great comparative advantage lies in innovation. For someone like me who has come from India it is very obvious that this country is full of innovators. When I was a student I read about Britain’s Industrial Revolution. And it was powered by all kinds of people, inventing the spinning jenny and so on. They were like little Americans, you know, thinking of new ways of doing things and making a buck. Almost every other American I know is thinking about something, some way to do something. We are a highly inventive people, and technology therefore is our driving force. It’s not savings and investments which are driving our productivity. It’s technology and innovation and immigrants like me—not me in particular—lots of people who come here and by the second generation go through the mill and become Colin Powell or Orlando Patterson at Harvard.

Nobody can compete with us in the long run, in my view, because these are not advantages which people in traditional societies can reproduce. So we’re always going to be doing high value. We’ll lose the high value we generate to others quickly because now technology diffuses very fast. But then we’ll have new ideas, new technologies.

reason: Which side poses the bigger threat to free trade, conservatives on sovereignty, neo-mercantilist grounds, or liberals on equity and environmental grounds?

Bhagwati: In the U.S., I think the Democrats are the biggest threat to free trade. I don’t see the right-wing threat to globalization in terms of sovereignty as being a major one, frankly.

Conservatives are principled people, so they have Edmund Burke type of reservations about continuous change and so on. But they are not people who are going to undermine the rule of law when it comes to trade. Even their arguments against immigration are rule-of-law arguments. Anti-globalization noises saying we’ve lost our sovereignty and so on and so forth, it’s not going to get very far in the U.S. system.

The threat from the left, on the other hand, is much more serious because they oppose free trade on equity grounds. I love America. I have settled in it. But there is a tendency, particularly on the part of the Democrats, to become totally self-righteous on everything and this is the way it has to be and if you disagree, then you’re a Republican. I mean, that’s the way they argue it. It’s unbelievable. They don’t want to argue the merits of the case.

reason: Why do you think Republicans are better on free trade than Democrats?

Bhagwati: Both the last Bush and Ronald Reagan believed in America. They thought that their own people could win. That made them more prone to accept international competition and trade.

They carried that attitude over into politics, of course. For instance, President Reagan won the Cold War by pushing Gorbachev to the limit. But he was lucky. President Bush went into Iraq with the same attitude, and that was unfortunate.

But since they both believed that Americans would win, they were good on international trade, although maybe for the wrong reasons. Democrats don’t believe that America can remain number one, and hence they cannot bring themselves to be completely in favor of open markets.

reason: You are a big believer in multilateral trade agreements over bilateral trade agreements. What’s wrong with bilateral trade agreements?

Bhagwati: Free trade agreements and protectionism are two sides of the same coin. When I have free trade just with you, I’m freeing trade with you but I handicap those who are not members of our free trade area. They have to keep paying the duties to get into our markets. So that becomes a de facto way of increasing protection against outsiders. Multilateral free trade would be a closer thing to pure free trade.

But there are two additional worries about bilateral trade agreements: One, we don’t just have two or three free trade agreements. Today there are close to 500, and every week there’s another new one being constructed. As a result, you’re getting all kinds of special tariffs, rules of origin, and other things multiplying in the system, something which I’ve called the spaghetti bowl. Exporters rightly get upset by the large numbers of tariffs they face depending on where you’re coming from.

Two, how do you enforce these agreements in a globalized world? It’s very chaotic. Parts are coming from everywhere. For a country to have to then decide which product is my partner country’s product rather than an outside country’s product becomes completely arbitrary. A car produced in Canada with Japanese steel and German chemicals, where 80 or 90 percent of the parts may come from elsewhere—is that a Canadian car or is it really something else? Does it qualify for the zero tariff under the North American Free Trade Agreement or not?

reason: Was NAFTA a mistake?

Bhagwati: I think in retrospect, yes. It’s not a slam dunk argument because it did bring in Mexico. Otherwise, they were talking about CAFTA which included just Canada and the U.S. But when you brought in Mexico, it made it a much bigger thing.

President Clinton was carrying on the multilateral negotiations in tandem with NAFTA. But NAFTA created worries on the part of the unions here, because this is a poor country and they were worried that Mexican competition would really hurt their wages. So even though the multilateral talks would’ve gone through without any difficulty, President Clinton ended up having to fight very hard for NAFTA, which survived by a very narrow majority. In order to win NAFTA, he had to give in on things like labor standards and so on. That’s when all these social things became part of trade deals. From there, it never looked back.

So in retrospect, I would say, because of the concessions they had to make, Clinton started us down a road which really has been counterproductive.

There is another thing to worry about. When you look at a trade agreement like NAFTA, it’s about that thick (holds his hands about two feet apart). When I debate people like Lori Wallach of Public Citizen, she arrives with a lot of books, and among them is this NAFTA treaty she carries for effect. I hope she gets a hernia from doing this often enough, because it looks pretty heavy to me. I wouldn’t be carrying it around. Anyway, she shows this book and asks, “Is this free trade?” And mad as she is, she’s right to raise that issue. You should be able to say maybe in 10 pages that in these sectors we are going to liberalize and so on. But nine-tenths of what’s in these agreements are things which have nothing to do with trade. Labor standards, environmental standards, intellectual property rights. If I were Jane Fonda, in order to sell more workout tapes, I could put into the agreement a clause that the president of Mexico has to do his exercise to my tapes. And it would go in, because ours is a lobbying culture and nobody really would know that it’s there. Because who opens these things except the lobbyists?

So many developing countries are now waking up to the fact that they’re being sold a bill of goods in the form of trade agreements.

reason: Do you think a global externality problem like global warming poses a fundamental threat to free trade?

Bhagwati: I think it depends on the way you do it. First, you’ve got to decide whether there is a problem of an externality. I have doubts about these scientists who claim to have a consensus on global warming because, you know, Freeman Dyson, a great scientific figure, says these guys are really low-level scientists and I’m told by many that they, in fact, are. And if they reach a consensus, I don’t care. I mean, that’s the consensus of incompetents.

But so long as only the scientists were talking about global warming, nobody paid the slightest attention. Remember, not a single senator voted for the Kyoto resolution back in the ’90s. Even Al Gore and Clinton had to walk away from Kyoto. But then the polar bears were threatened, the glaciers began to melt, and then that great French film about the penguins which touched all our hearts came out. So these were three whammies. Even if you live in Peoria you will understand, wrongly maybe, that global warming is a problem. I tell all my students: If they think of something like that for free trade, please let me know.

What countries like India and China are saying is that if the CO2 was accumulating and it’s going to create a disaster, then that took a lot of time to establish. So they want the West to bear primary responsibility for the damage it has caused in the past. If America applies some kind of a carbon tax and it says that if India and China don’t impose a similar tax, it’s going to use what is called border tax adjustment, then that is protectionism. And there’s no reason why Indians and Chinese have to accept this. Just as America was not willing to accept it when it didn’t sign onto Kyoto and Europe started threatening a countervailing duty on American exports. But everybody reacted to that talk and said this is a cockeyed thing to do. Peter Mandelson, who was the EU Commissioner, said it was very unwise because the United States will retaliate.

It’s ironic that we are now using exactly that kind of threat on India and China. But America’s fuel tax is so much lower than that of most other countries, except the Middle East. So India and China are going to hit us because we had a low gas tax for a long time. And all hell would break loose. India and China are big guys. They can get legal [World Trade Organization] retaliation against the U.S. Or India could take away contracts from Boeing and give them to Air France. It can have nuclear reactors go to France rather than to G.E. Caterpillar would be shut out.

So I suggest a different way. If in our own U.S. system you’re going to get your companies to clean up under the Superfund Act, that’s a tort principle which we accept. Then we ought to be willing to pay in some form to other poor countries for the past damages. The West has completely ignored this suggestion so far. It has provided maybe a few million dollars in assistance to Third World countries for this purpose. But if the West seriously starts contributing to this fund, Third World countries could get anywhere from $150 million to $1 billion to mitigate global warming.

reason: This is a political non-starter, you know.

Bhagwati: Yes. But the president actually has made some remarks about border tax adjustments not being such a good idea. He’s got to do more than that. He’s got to say this is a crazy thing to do. He’s still very cool—he needs to lose his temper once in a while. Because it’s too important. The U.S. is one of the biggest trading nations in the world. We want the rule of law. We don’t want retaliation, which would be massive. India and China are not Zaire or Zimbabwe. They’re not little countries you can push around. We don’t want to unleash that kind of trade war, because it would be very hard to control, I’m afraid.

Shikha Dalmia is a senior analyst at Reason Foundation. This interview first appeared at Reason.com.

Obama Said What About the Economy?

anthony.randazzo@reason.org (Anthony Randazzo) — Wed, 18 Nov 2009 09:15:00 EST

In a Fox News interview with President Obama to air later today, the president will make an interesting remark:

"It is important though to recognize if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession."

Really?

In all fairness, this isn't completely new language from the president. Obama has mentioned the problem of deficits since his campaign. His first budget was called "A New Era of Fiscal Responsibility" on the platform that spending was out of control. The problem is that his actions have never matched his words.

I agree with the president that out of control spending, piling on to the debt, could cause a double dip recession. I've said so on this blog, as early as May this year. But what is not clear is how the president can support increased national budget spending programs while also taking this Roubiniesk position.

Consider that:

Health care will not be deficit neutral. Despite what the CBO score winds up being (which on the House bill it is well over $1 trillion), history shows that these kinds of bills always wind up spending more than was originally projected.
Financial services reform as has been proposed by Sen. Dodd and Rep. Frank will damage the financial industry, firms will make less money, and tax receipts (aka revenue) will decline, further hampering the federal deficit.
Cap and trade would wreak serious havoc with our debt level.

And this doesn't even go into issues like revenue damage done by the SCHIP cigarette tax, Treasury's talk of extending TARP, the pending "need" to bailout FHA, or what health care proposed tax increases will actually do to revenue. New York and Maryland are prime examples for how millionaire taxes ultimately hurt your tax base, not increase it.

Oh, and a $250 check to seniors because inflation didn't raise the level of social security checks? Buying their vote on health care and throwing a few billion more on the debt pile?

Why would the president support all of this if he fears debt will trigger a double-dip recession? A great first step towards recovery would be to end the recently extended first-time housing buyers credit. This is artificially supporting the price of housing, stealing demand from the future, and distorting the real price of houses. It is preventing the housing industry from finding its real bottom to build back up from and is extending the length of the recovery process.

Right now Congress is wrestling with one of our major budget issues: out of control Medicare costs. We have the opportunity to reform the system and make our economic future more stable. The president should tell congress he will veto any health bill that does not fix this problem. (Of course, my definition of fix will never be the president's, so I won't hold my breath.)

Another thing to do would be to slash some big cost item in the budget. Nips here and there aren't going to reduce this debt issue. A serious surgery is needed. And a major move, like putting an end date on the social security program, would show the president really means business.

10 New Ohio Congressional Districts "Created" By Stimulus

sam.staley@reason.org (Samuel Staley) — Wed, 18 Nov 2009 09:07:00 EST

The evidence of the strikingly poor data provided to the federal government on jobs "created" or "saved" from the stimulus continues to mount. Ohio Watchdog reports that according to recovery.org, the federal web site tracking stimulus dollars, ten new Congressional Districts spent $5.3 million and created 11 jobs. These district don't exist. According to the Ohio Watchdog press release:

Over $5 billion of stimulus money has seen its way into the State of Ohio thanks to the federal stimulus. The main goal of the money is to create or retain jobs and stimulate the economy in Ohio. According to www.recovery.gov more than 17,00 jobs have been created or retained, 11 of which are in Congressional Districts that do not exist: 21st, 99th, 69th, 87th, 85th, 49th, 20th, 54th, 56th, and 00. These 11 jobs have cost more than $5.3 million; more than 80% of the jobs created or retained so far are located in the Central Ohio area.

Of course, most of these are data entry errors, and not outright fraud. But, they speak to the quality of the data and argue for a healthy skepticism about using any of these numbers to evaluate the effectiveness of these programs. It will take years before the effects of the stimulus can be sorted out.

The next time someone cites these numbers to show the effectiveness of the program, remind them of the old computer programming saying: "Garbage in, garbage out."

These errors are also not isolated, as the post by my colleague Anthony Randazzo yesterday pointed out.

More Job Creation Discovered in Non-Existent Congressional Districts

anthony.randazzo@reason.org (Anthony Randazzo) — Tue, 17 Nov 2009 15:40:00 EST

Got to love transparency. Building on Sam Staley's post from earlier today—pointing out how MPI discovered the government was reporting job creation numbers in 12 districts that don't exist—there is now a slew of reports pointing out bogus job creation numbers. An ABC News report highlighted several of them:

Arizona 15th district, $761,420 spent for 30 jobs... but Arizona only has 8 districts
Arizona 86th district, $34 million spent on the Navajo Housing authority... but that project is in the 1st district
Connecticut 42nd district, $0 spent for 25 jobs... beyond the confusing spending aspect, but the state only has 5 districts
Iowa, $10.6 million for 39 jobs in nonexistent districts
Oklahoma, $19 million for 15 jobs in nonexistent districts
Virgin Islands 99th district, $8.4 million for 40.3 jobs... uh, they don't even have one congressional district
Northern Mariana Islands 69th district, $1.5 million for .3 jobs... too bad they don't have any districts, cause I'd love to be the leg of some dude who is getting paid $1.5 million
Puerto Rico 99th district, $47.7 million for 291 jobs... they voted down entry into the union multiple times, so they don't have any congressional votes.

The administration claims this is human error. And it probably is. So we can safely say that the bogus job creation numbers are human error too. That, nevertheless, still means they are bogus.

Bernanke's Philosopher

info@reason.org (Penn Bullock) — Tue, 17 Nov 2009 15:17:00 EST

When Ben Bernanke took charge of the Federal Reserve in 2006, the media made a few passing references that suggested he secretly subscribed to libertarianism. “I worked with him for years before I even knew he was a libertarian-leaning Republican,” the former Fed vice chairman Alan Blinder told CNN. The Wall Street Journal reported that Bernanke, “though a libertarian Republican …displays few partisan leanings.”

Last summer President Barack Obama re-nominated Bernanke to another four-year term atop the central bank, a reward for allegedly saving the world from a second Great Depression. Bernanke will arrive at his Senate confirmation hearings this January with an unbeatable recommendation. “As an expert on the causes of the Great Depression,” Obama raved in August, “I’m sure Ben never imagined that he would be part of a team responsible for preventing another. But because of his background, his temperament, his courage and his creativity, that’s exactly what he has helped to achieve.”

“Mission Accomplished,” the banner might have read.

Missing from Obama’s speech was any mention of Bernanke’s economic philosophy. These days, the media have taken to calling him a Keynesian—a believer in fiscal stimulus and the mixed economy. “We are all Keynesians again,” the liberal Washington Monthly headlined a January 2009 feature on the Fed chief.

In reality, Bernanke is following a monetarist depression-prevention model laid out by Nobel laureate and libertarian patron saint Milton Friedman. The Fed chairman has invoked the late economist in support of lowering interest rates to zero and bailing out banks. Trillions of dollars have been staked on the insights of “monetarism,” the economic theory of central banking and inflation-management associated with Friedman and Anna Schwartz. Though Schwartz now distances herself from Bernanke, opposing his reappointment on the grounds that he’s gone too far, the irony remains that a series of Fed policies many libertarians find repugnant are being championed by a man claiming to take his chief inspiration from the most influential libertarian economist of the 20th century.

A Monetary History of Ben Bernanke

The story begins in 1963, when Friedman and co-author Anna Schwartz published A Monetary History of the United States, an opening salvo in what Friedman called a “counterrevolution” against Keynesian theory. Their chapter on the Great Depression was spun off into a stand-alone book, The Great Contraction: 1929–1933, an epic revisionist history that changed America’s understanding of the causes of the Depression. Friedman and Schwartz contended that the Federal Reserve—not capitalism or Wall Street—was to blame for the dismal ’30s.

“The fact of the matter is that it was the [Fed’s] decision to tighten credit policy in 1928 that produced the Great Contraction,” the 93-year-old Schwartz says by phone from her office at the National Bureau of Economic Research in New York City. The Fed hiked interest rates in 1928 to curb what it saw as rampant speculation on Wall Street—a conflagration of leverage, margin buying, and outright Ponzi scheming fueled in the first instance by cheap credit from the Federal Reserve. (Goldman Sachs’ various pyramid schemes from that era, after they collapsed in 1929, generated losses of $475 billion in today’s dollars.)

Friedman and Schwartz rejected the widely held theory that speculation had been a major problem, or that there had even been a credit bubble in the 1920s. Bad loans and reckless banking practices were a “minor factor,” at most, in the Great Depression, they said. In this narrative, a Federal Reserve paranoid about speculation had needlessly constricted the money supply, imploding an otherwise sound economy.

After the Great Crash of 1929, the Federal Reserve drastically cut interest rates from a brief high of 6 percent to 1.5 percent by mid-1931. But during the first few years of the crisis, the Fed occasionally felt forced to abruptly raise rates again in complicated maneuvers to stem outflows of gold into Europe. Friedman and Schwartz blamed these sporadic interest rate hikes for smothering incipient recoveries, opening a vortex of deflation, and transforming a recession into the Great Depression.

“What the Fed had to do was increase the money supply,” Schwartz tells me. “By taking that action, it would have revived the economy. That’s the lesson of the Great Depression.” In The Great Contraction, she and Friedman argued that the Fed squandered its ample latitude to combat deflation. “The monetary authorities,” they wrote, “could have prevented the decline in the stock of money—indeed, could have produced almost any desired increase in the money stock.”

When it comes to his academic specialty, Bernanke is a disciple of Friedman and Schwartz. In 2002, at Friedman’s 90th birthday party at the University of Chicago, Bernanke was effusive. “Among economic scholars,” he began, “Friedman has no peers.” He developed the “leading and most persuasive” explanation of the Depression, whose impact on economics and the popular mind “cannot be overstated.”

At the end of his encomium, Bernanke made a soon-to-be-famous apology on behalf of the Federal Reserve, where he was then president of the powerful New York branch: “I would like to say to Milton and Anna…regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” (The speech was published as the afterword to the latest edition of The Great Contraction.)

Schwartz was present at the birthday party. “I’m sure he was sincere when he said that,” she says. And Bernanke stayed true to his word. In 2006 he replaced Alan Greenspan as chairman of the Federal Reserve. Greenspan, a self-described “libertarian Republican” who had once been part of Ayn Rand’s inner circle, had engineered an era of low-inflation growth that won Friedman’s endorsement. “There is no other period of comparable length in which the Federal Reserve System has performed so well,” Friedman declared in The Wall Street Journal on January 31, 2006.

Monetarism and Freedom

When the economy collapsed two years into Bernanke’s watch because of a massive credit bubble, he slashed interest rates to zero and ordered the money-printing presses to full steam. He also embarked on a course of “quantitative easing,” where a central bank convolutedly buys its own government’s bonds with printed money so as to sink interest rates even further.

This approach was not new. Friedman had prescribed quantitative easing, combined with “easy money” and inflation, as a cure for Japan’s 1990s economic slump, which he described as an “eerie, if less dramatic, replay of the Great Contraction.” As he did with the Depression-era Fed, Friedman emphasized that “there is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so.” In 1998, a year after Friedman penned his advice in The Wall Street Journal, Japan introduced monetary stimulus: a cocktail of zero interest rates and quantitative easing. But deflation continued. Today Japan’s exports are down an unthinkable 36 percent from just last year, and prices are plummeting at an all-time record pace.

Stateside, in the shadow of the Fed’s multi-trillion-dollar balance sheet, it has been all too easy to categorize Bernanke simply as a Keynesian supporter of public works projects, socialistic safety nets, and profligate, government-led consumption. While it’s true that the Obama ad-ministration is pursuing Keynesian fiscal stimulus, the Federal Reserve under Bernanke has consciously acted on the Friedman/Schwartz insight that loosening central bank credit is a fundamental tool in forestalling deflation and depression. Understanding that monetarism can mean both the management of low inflation in good times, and the creation of inflation in bad times, has proven too difficult for most of the media.

The New York Times, for instance, has identified Bernanke as “a student if not necessarily a devotee of the British economist John Maynard Keynes.” Actually, Bernanke spent most of his academic career elaborating on Friedman’s Keynes-refuting interpretation of the Great Depression. Athough his research sometimes strayed into nonmonetary subjects, it was always, as he said at Friedman’s birthday party, “an embellishment of the Friedman-Schwartz story…and in no way contradict[ed] the basic logic of their analysis.” In 2003, at a conference honoring Friedman’s Free to Choose, Bernanke said, “Friedman’s monetary framework has been so influential that, in its broad outlines at least, it has nearly become identical with modern monetary theory and practice.” So great was Friedman’s influence that Bernanke compared it with Shakespeare’s contributions to English literature.

Even Bernanke’s nickname “Helicopter Ben” derives directly from Milton Friedman. It came about during a 2002 speech entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” in which he quoted Friedman on the importance of conjoining fiscal and monetary policies. The ideal fiscal stimulus, Bernanke said, was a shower of tax cuts “equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.” Friedman had originally used the phrase to counter Keynes’ idea of the “liquidity trap,” in which setting interest rates at zero leads to bank hoarding and leaves the Federal Reserve no room to maneuver. Friedman suggested that countries could escape the liquidity trap by handing out money to consumers, and he explained his argument in a tale about a helicopter unloading cash on a town. Likewise, Bernanke’s Federal Reserve has created special “vehicles” to disburse consumer credit from on high.

In February, Bloomberg News added to the philosophical confusion by reporting that “Federal Reserve Chairman Ben S. Bernanke is siding with John Maynard Keynes against Milton Friedman by flooding the financial system with money.” Of course, Bernanke has said precisely the opposite. He’s flooding the financial system with money during a deflationary crisis, he says, because that’s what Friedman would have him do.

On February 10, Bernanke further underscored his allegiance to Friedman in an overlooked Capitol Hill question-and-answer session with Rep. Ron Paul (R-Texas). Their exchange is worth quoting at length.

“Chairman,” Paul began, “you have written a lot about the Depression. There was a famous quote you made once to Milton Friedman, apologizing for the Federal Reserve bringing on the Depression. But you assured him it wouldn’t happen again.…But the key to this discussion has to be: Was it too much credit in the ’20s that created the conditions that demanded a recession/depression, or was it lack of credit in the Depression that caused the prolongation?…Here we’re working frantically to keep prices up. What’s wrong with allowing the market to dictate this…and prices to go down quickly so we can all go back to work again?”

In response, Bernanke repeated the lesson of The Great Contraction: “Milton Friedman’s view was that the cause of the Great Depression was the failure of the Federal Reserve to avoid excessively tight monetary policy in the early ’30s. That was Friedman and Schwartz’s famous book. With that lesson in mind, the Federal Reserve has reacted very aggressively to cut interest rates in this current crisis. Moreover, we’ve tried to avoid the collapse of the banking system.”

For her part, Schwartz is critical of Bernanke’s application of her and Friedman’s theories. “You don’t have to lower the interest rates to the extent that he has in order to increase the money supply,” she says. “The essential action should be increasing the money supply. That’s the lesson of the Great Depression.” She adds, “There’s nothing contradictory in The Great Contraction with reference to what the Fed should be doing currently.”

Schwartz is alarmed by the enthusiasm with which Bernanke has put “monetary expansion” into practice. She berates the Fed for going too far and predicts that it will have to raise interest rates “in the near future” to arrest inflation. Asked if she sees hyperinflation on the horizon, she exclaims, “Oh, yes!”

In a New York Times op-ed last July, Schwartz criticized Bernanke as a “man without a plan,” warning that his “easy monetary policy is a sin.” She concluded, “He does not deserve reappointment.”

Schwartz also seems to have undergone a late-life conversion to at least some part of Keynesian theory. Asked for her current solution to the crisis, she repeats the ultimate Keynesian maxim: The government should pick up slackening demand in the private sector.

“People are saving, not spending. In order to revive this economy,” she says, hesitating before continuing, “the government will have to resume spending. By spending, the government will require that the current inventory will be depleted and have to be replenished. And that will bring on additional production and jobs.”

Bernanke’s Money Mischief

Ron Paul, like Schwartz and Friedman, is a libertarian, but he embraces the “Austrian” school of economic theory that rejects the very concept of the Federal Reserve. He is critical of what he sees as the Fed’s ongoing monetarism. “In essence,” Paul says in a phone interview, “Bernanke is following Friedman’s advice. He’s a Friedmanite when it comes to massively inflating. Bernanke was able to justify [his policies] by using Friedman.”

Does Friedman’s enthusiasm for inflating the monetary supply in crises flout libertarianism? “Absolutely,” Paul answers. “The monetarists said that you could overcome a natural market correction of a collapsing system by inflation—print money faster! Which contradicts Friedman’s whole thesis. He wanted a steady, managed increase in the supply of money of about 3 percent.” Here Paul is alluding to Money Mischief, Friedman’s 1991 book in which he called on the Fed to grow the money supply at 3 percent annually, presumably forever. “Yet at the same time, Friedman said the Depression could have been prevented by massively inflating.” Paul has kind words for Friedman, whom he praises as a staunch defender of economic liberty, but his final summation is damning: “Friedman’s very, very libertarian—except on monetary issues.”

With Bernanke at the helm, the Federal Reserve has unleashed monetary expansion, the very definition of inflation—and Friedman’s blueprint for averting economic depression. According to Bernanke, Obama, and scores of economists, it’s working. “Prospects for a return to growth in the near term appear good,” Bernanke predicted in August.

But with lenders foreclosing on 358,000 homes that month, the commercial real estate market only beginning to collapse, a 20 percent annual fall in railroad freight, and unemployment projected to crack double digits any minute now, the much-vaunted recovery is no given. And if it isn’t working, we might still relapse into recession, or worse.

The total cost of the Fed’s monetarist-inspired program is mysterious. Paul, whose bill to audit the Fed is now co-sponsored by more than half of the House of Representatives, declares: “We don’t know for sure how much the Fed has spent—I’ve heard it could be $6 trillion. But we have no knowledge of what the Fed’s doing. All these dealings are very secret.” A Reuters estimate in late September pegged the Fed’s balance sheet around $2.1 trillion, with $111 billion doled out to banks every day through the Fed’s overnight discount window. Bloomberg News has sued the Federal Reserve for full disclosure, and we may soon find out the exact number. Manhattan Chief U.S. District Judge Loretta Preska has ordered the Federal Reserve to open its books, though the bank has filed an appeal.

Friedman and Schwartz, those champions of low inflation, have helped inspire the greatest monetary expansion in Federal Reserve history, a program of limitless market interventions and tireless money printing whose end game is likely to be a return to the bad old days of inflation that they fought for so long. For two libertarian champions of free markets and limited government, this unintended legacy has the ring of a world-historic irony.

Penn Bullock (penneth@gmail.com) is a freelance writer for Village Voice Media. He lives in Florida. This column first appeared at Reason.com.

Where's That Inflation?

vdereugy@gmu.edu (Veronique de Rugy) — Tue, 17 Nov 2009 14:54:00 EST

From September 2008 to September 2009, the Federal Reserve pumped an unprecedented $2 trillion into the financial system by buying Treasury bonds and assets from banks. According to most mainstream economists, such action should create a general increase in prices.

Inflation is the result of more dollars chasing the same number of (or fewer) goods. As the Nobel laureate Milton Friedman put it, in one of his main contributions to “monetarist” economics, inflation is always and everywhere a monetary phenomenon—that is, it’s caused by an expansion in the supply of money or credit. So why haven’t we seen inflation in 2009? Are we looking in the wrong places, or is it time to update monetarist theory?

The monetary base, which consists of currency in circulation plus bank reserves on deposit with the Federal Reserve, has exploded, as Figure 1 shows. Figure 2, by contrast, shows inflation as gauged by the consumer price index (CPI)—the cost of goods purchased by the average U.S. household—and by a measure called the median CPI. Standard CPI is the traditional measure for inflation, but a few extreme outliers (such as the price of fuel) can throw off the average; thus the median is a more robust statistic to estimate the central tendency in the data.

So while the standard CPI shows deflation over the past year, that stems from a few anomalous sectors, such as energy, where prices have dipped significantly since 2008. The median CPI, on the other hand, shows an inflation rate that does not look very unusual.

The standard explanation for the lack of inflation is that banks are sitting on all that new cash. As soon as the economy shows signs of recovery, goes the theory, banks will make more loans, and the broader monetary aggregates will shoot up rapidly. But that expectation ignores an important factor: Beginning in October 2008, for the first time in history, the Federal Reserve started paying interest on reserves held by banks. So even when the economy starts heating up, banks will have an incentive to hold money rather than lend it.

What’s more, should inflation rear its head anytime soon, the Fed could suck the newly created money out of the banking system by selling assets, such as some of the higher-quality mortgage-backed securities it bought from banks at the depth of the financial crisis. That would decrease the amount of money in the system and choke back inflation.

On top of that, the Georgetown University economist Donald Marron has argued, if investors really thought we were on the verge of inflation, we would see the 10-year Treasury or 30-year mortgage rates go through the roof. But that hasn’t happened.

Marron’s view reflects what might be called the monetarist consensus. It is embraced by economists across the political spectrum, including Obama’s economic adviser Larry Summers and the current and former Fed chairmen. It is a position that relies on the wisdom of politically independent (and hopefully monetarist) central bankers to manage both the economy and the threat of inflation.

Besides placing undue faith in the Fed’s ability to time perfectly any necessary anti-inflationary measures, the consensus suggests that the nation’s central bank now has the heretofore undiscovered ability to increase the money supply without creating inflation. If true, this would be an important new development, since inflation has long been rightly vilified for destroying entrepreneurship and long-term economic growth. But if false, this conceit could prove dangerous indeed. And it’s probably false.

On his blog Free Advice in September, the Pacific Research Institute economist Robert Murphy argued that inflation is already here but economists are missing the signs. “From [December 2008] until August 2009, the unadjusted CPI level has increased 2.7%, which translates to an annualized increase of just over 4%,” Murphy wrote. He acknowledged that “ten-year yields [on Treasury bonds] are…low” but added that the price of gold has increased enormously. “Why do we assume that TIPS [Treasury Inflation-Protected Securities] traders are genius forecasters, but gold traders are morons?” he asked.

In an email message, Murphy adds: “I believe we are currently witnessing a bubble in Treasury debt. I consider the current yields on 10-year U.S. government bonds to be absurdly low, just like the price of housing was absurdly high in early 2006. After this bubble bursts, investors will slap themselves on the forehead and say, ‘What were we thinking? Why did we rush into Treasurys even as the government told us it was planning to double the federal debt burden in a decade?’ ”

The St. Lawrence University economist Steven Horwitz agrees both that inflation is already happening and that it is widely misunderstood. Monetarists, he says, were “too focused on aggregates like ‘the’ price level, which led economists to ignore the way inflation could distort individual prices at the microeconomic level, causing resource misallocation in the process.” Virtually all economists now agree, for example, that the Fed’s low interest rates inflated housing prices earlier in the decade. Yet as the prices of houses went up, few economists worried about inflation because the CPI looked relatively stable, due in part to a decrease in energy prices. When housing started to crash in 2007, many economists thought the Fed should inject still more funds into the system to stave off further declines. They failed to see that the Fed had distorted relative prices in the first place.

As the George Mason University economist Peter Boettke explains, “A problem with the current monetarists is that while they learned from Friedman the idea that we should fight inflation, in practice they learned from his writings on the Great Depression that central banks should fear deflation.” As a result, economists who are theoretically inflation-hating Friedmanites now want to meet every downturn by fighting deflation.

Because of this tendency, bursting government-created bubbles leads to the creation of new ones. The real lesson may be that inflation is not only a monetary phenomenon but also a political one. Which makes it that much more difficult to predict, much less control.

Contributing Editor Veronique de Rugy (vderugy@gmu.edu) is a senior research fellow at the Mercatus Center at George Mason University. This column first appeared at Reason.com.

Stimulus Creates Jobs in Non-Existent Congressional Districts

sam.staley@reason.org (Samuel Staley) — Tue, 17 Nov 2009 11:55:00 EST

The Montana Policy Institute decided to check out where the federal stimulus package was "creating" jobs in the state. Much to its surprise, the number of Congressional districts in Montana has expanded, from one to thirteen!

According to MPI's press release written by Michael Noyes and distributed on the web:

BOZEMAN - The government-funded website that tracks stimulus spending is reporting jobs created and dollars received in congressional districts that don't exist.
     According to recovery.gov, thirteen different congressional districts in the state reported receiving stimulus funds as of September 30. Montana has only one federal congressional district.
     The majority of state spending and jobs listed on the site are in the congressional district marked "00." A spokesman from Congressman Denny Rehberg's (R) office said that is an accounting tool used to mark at-large districts.
     However, jobs created or stimulus dollars spent were also reported in twelve other Montana districts, including the second, fifth, twelfth, and sixteenth.
     Ed Pound, director of communications for the Recovery Accountability and Transparency Board which oversees the site, said his organization is accurately reporting the information that recipients provide. He said in some cases it appears recipients are entering the wrong congressional districts in their reports.
     "People make errors, and we've found people are making errors in these reports," Pound said.
     Visitors to the website are also able to track the dollars by project, he said.
     Pound said he has received three phone calls about jobs listed in congressional districts that do not exist, including a call a couple of weeks earlier from Wyoming.
     On Monday, media reports from a number of states including New Mexico, New Hampshire, and Kansas also claimed to have discovered stimulus dollars and jobs reported for districts that do not exist.

Seems to me Montana needs a readjustment to the number of representives it can send to the U.S. House of Representatives.

The Trouble with Job Retraining

adrian.moore@reason.org (Adrian Moore) — Mon, 16 Nov 2009 18:41:00 EST

Job retraining without job creation is, um, pointless. The federal government is banking heavily on job retraining to help those who lost jobs in this recession, as are many states. But job retraining is taking a beating these days. As my colleague Brian Doherty summarized for Reason magazine:

The federal government is planning to spend more than $1 billion this year on job retraining programs for Americans suffering layoffs during the recession. But a late 2008 government-funded study found that job retraining might not really work.

The study, commissioned by the Department of Labor and performed by the social science research firm Impaq International, looked at the effects of a 1998 federal job retraining initiative in 12 states, following 160,000 total participants who started with the program from 2003 to 2005. In the short term, earnings prospects for many groups of workers actually got worse after they participated in job retraining, “implying that those who participate in the program experience lower earnings during the first five quarters after program participation as a result of their program participation.”

Part of that effect may be due to concentrating on retraining rather than trying to find new jobs, but the assessment of the program’s long-term benefits was no brighter. It took two years for the earnings of those who received job retraining to catch up to those of their nonparticipating counterparts. “Perhaps more important,” the study said, “the growth in earnings, relative to nonparticipants, slows at that point.…Overall, it appears possible that ultimate gains from participation are small or nonexistent.”

Why might the programs be ineffective? Job retraining is irrelevant without job creation, especially job creation in the particular fields for which people are being trained. Predicting where the next employment boom will take place is difficult enough for entrepreneurs. It certainly isn’t a specialty of government bureaucrats.

Read a NY Times article on the study here. Read the whole study here.

A better strategy is policies that make it easier to start new businesses or expand existing ones. That creates jobs and the incentive for people to get the skills needed to land one of the new jobs.

More Coverage of the Cioffi/Tannin Verdict

anthony.randazzo@reason.org (Anthony Randazzo) — Mon, 16 Nov 2009 15:48:00 EST

Last week former Bear Sterns hedge fund managers were found not-guilty of fraud. Here is a good summary of the issue and the competing views on the verdict:

My take on the issue is here.

The Dodd Plan Isn't Any Improvement On the Obama or Frank Proposals

anthony.randazzo@reason.org (Anthony Randazzo) — Mon, 16 Nov 2009 13:09:00 EST

This summer I was on a driving tour around the Turkish capital city, Ankara. About half way through the day, an economist friend of mine pointed out a rather imposing structure: “That’s the Bureau of Economic Planning.” Internally reflecting on some of Turkey’s recent economic troubles, I quipped back, “And how’s that working out for you?”

Last week, chairman of the Senate Banking Committee, Chris Dodd (D-CT), revealed his plan to overhaul Wall Street regulations. And while the plan isn’t quite on par with Soviet-style economic planning, it would not be hyperbole to equate the regulatory structure he proposes with some of the more dire policy proposals pursued by politicians in the collapsing world of Atlas Shrugged.

Of particular interest is Dodd’s proposed Agency for Financial Stability. This is the widest reaching proposal for dealing with systemic risk. The AFS would be able to break apart big firms, keep firms from growing too large, and restrict any activity it deemed harmful to the system. The Obama/Geithner plan suggested an Oversight Council made up of the regulators, chaired in Treasury but using the Fed to do its dirty work. The GOP has asked for a toothless board that would just make suggestions. Bernanke has testified that the Fed is capable of handling the role of systemic risk overseer on its own.

The AFS is probably the worst of the proposals to deal with systemic risk. And the rest of his plan is similarly problematic. I’m going through it now and will have a breakdown out by the end of the week. It doesn't quite amount to a Turkish economic central planning center, but it's not exactly free market either.

For more, see my breakdown of the GOP and Obama/Geithner proposals for dealing financial services regulation here. And see my full review and critique of the Obama plan here.

Stimulus Job Counting Nightmare Continues

sam.staley@reason.org (Samuel Staley) — Fri, 13 Nov 2009 11:55:00 EST

The Boston Globe has investigated the number of jobs supposedly "saved" or "created" in Massachusetts by $4 billion in stimulus money, and--surprise!--they found huge errors, omissions, and flat out wrong numbers. In some cases, such as rental subsidies, money that would have normally gone to agencies and landlords anyway was counted as stimulus money. In another case, stimulus money was used to give cost-of-living adjustments to public employees. In numerous cases, jobs "created" were literally fabrications based on no real methodology or approach to figuring out the difference let alone whether the money was simply supporting existing jobs.

A few tidbits from the Globe article (13 November 2009):

But in interviews with recipients, the Globe found that several openly acknowledged creating far fewer jobs than they have been credited for.

One of the largest reported jobs figures comes from Bridgewater State College, which is listed as using $77,181 in stimulus money for 160 full-time work-study jobs for students. But Bridgewater State spokesman Bryan Baldwin said the college made a mistake and the actual number of new jobs was “almost nothing.’’ Bridgewater has submitted a correction, but it is not yet reflected in the report.

In other cases, federal money that recipients already receive annually - subsidies for affordable housing, for example - was reclassified this year as stimulus spending, and the existing jobs already supported by those programs were credited to stimulus spending. Some of these recipients said they did not even know the money they were getting was classified as stimulus funds until September, when federal officials told them they had to file reports.

“There were no jobs created. It was just shuffling around of the funds,’’ said Susan Kelly, director of property management for Boston Land Co., which reported retaining 26 jobs with $2.7 million in rental subsidies for its affordable housing developments in Waltham. “It’s hard to figure out if you did the paperwork right. We never asked for this.’’

and from page 2:

"Some of the errors are striking: The community action agency based in Greenfield reported 90 full-time jobs associated with the $245,000 it got for its preschool Head Start program. That averages out to just $2,700 per full-time job. The agency said it used the money to give roughly 150 staffers cost-of-living raises. The figure reported on the federal report was a mistake, a result of a staffer’s misunderstanding of the filing instructions, said executive director Jane Sanders.

"Several other Head Start agencies also reported using stimulus funds for pay raises and claimed jobs for it.

"At Bridgewater State, Baldwin said the college mistakenly counted part-time student jobs as full time.

"Some agencies that received stimulus money reported jobs for work that had not started. The Greater Lawrence Family Health Center reported 30 construction jobs “have been created,’’ even though it hadn’t begun construction on a $1.5 million renovation and expansion. Grant administrator Beth Melnikas said the health center does expect to hire 30 workers.

"There was often variance among recipients of the same source of funding. Some did not report any positions retained; others did. Some used different methods and got different results.

Recipients of stimulus money found the paperwork and filing instructions confusing and cumbersome. Many agencies had simply never considered whether a job was new, saved, or created before, so they had trouble following federal guidelines. In short, implementing programs through a bureaucracy is difficult, tedious, and often wasteful.

Some experts believe we will never know how many jobs were created or saved by the stimulus package.

This isn't quite true. We can tease out these numbers using statistical analysis. We will have to compare economic performance before and after the stimulus funds were spent, controlling for other major factors that influence macroeconomic performance. But, that will take years to sort out and President Obama will likely be long-gone from office even if he serves two terms.

Will Obama Cut the Deficit He Helped Create?

anthony.randazzo@reason.org (Anthony Randazzo) — Fri, 13 Nov 2009 09:32:00 EST

Politico reports this morning that President Obama has decided to keep his promise to be fiscally responsible... next year:

President Barack Obama plans to announce in next year's State of the Union address that he wants to focus extensively on cutting the federal deficit in 2010 – and will downplay other new domestic spending beyond jobs programs, according to top aides involved in the planning.

Since the president has already expanded the deficit by over a trillion, he certainly has set himself up to succeed. And the word is that the president might set aside cap and trade to avoid the negative impact it would have on our economy. But to tackle the deficit, the president will have to make a fundamental shift in thinking about spending. He's already spent more in the nine months of his presidency than Clinton did in eight years, though he has a long way to go to surpass the bar set by super-spender Bush.

But it seems unlikely that the same president that supports a $1 trillion-plus health care package and Wall Street reform rules that would hurt small businesses (and big businesses) will also find ways to cut the deficit in meaningful, long-term ways. Yet, however unlikely it may seem, there are ideas out there on the table to cut back spending, the president does have the capacity to grab hold of them and make them his own. Time will tell if he does.

What's Really Behind the GDP Numbers?

anthony.randazzo@reason.org (Anthony Randazzo) — Thu, 12 Nov 2009 17:43:00 EST

This is sure to brighten your Thursday evening: according to the Bureau of Economic Analysis (BEA) numbers, motor vehicle output accounted for 47.78% of GDP growth in the third quarter. The Cash for Clunkers program had a huge impact on sales in the third quarter, leading to a huge spike in sales, but one that was not sustained after the end of the program. The BEA numbers mean that the real GDP growth rate from last quarter would likely have only been around 1.7% instead of the 3.5% including the government intervention. (It's difficult to know exactly what motor vehicle output would have been without the Cash for Clunkers program.)

The U.S. House of Presumptuous Meddlers

info@reason.org (John Stossel) — Thu, 12 Nov 2009 15:08:00 EST

As an American, I am embarrassed that the U.S. House of Representatives has 220 members who actually believe the government can successfully centrally plan the medical and insurance industries.

I'm embarrassed that my representatives think that government can subsidize the consumption of medical care without increasing the budget deficit or interfering with free choice.

It's a triumph of mindless wishful thinking over logic and experience.

The 1,990-page bill is breathtaking in its bone-headed audacity. The notion that a small group of politicians can know enough to design something so complex and so personal is astounding. That they were advised by "experts" means nothing since no one is expert enough to do that. There are too many tradeoffs faced by unique individuals with infinitely varying needs.

Government cannot do simple things efficiently. The bureaucrats struggle to count votes correctly. They give subsidized loans to "homeowners" who turn out to be 4-year-olds. Yet congressmen want government to manage our medicine and insurance.

Competition is a "discovery procedure," Nobel-prize-winning economist F. A. Hayek taught. Through the competitive market process, we producers and consumers constantly learn things that force us to adjust our behavior if we are to succeed. Central planners fail for two reasons:

First, knowledge about supply, demand, individual preferences and resource availability is scattered—much of it never articulated—throughout society. It is not concentrated in a database where a group of planners can access it.

Second, this "data" is dynamic: It changes without notice.

No matter how honorable the central planners' intentions, they will fail because they cannot know the needs and wishes of 300 million different people. And if they somehow did know their needs, they wouldn't know them tomorrow.

Proponents of so-called reform—it's not really reform unless it makes things better—have shamefully avoided criticism of their proposals. Often they just dismiss their opponents as greedy corporate apologists or paranoid right-wing loonies. That's easier than answering questions like these:

1) How can the government subsidize the purchase of medical services without driving up prices? Econ 101 teaches—without controversy—that when demand goes up, if other things remain equal, price goes up. The politicians want to have their cake and eat it, too.

2) How can the government promise lower medical costs without restricting choices? Medicare already does that. Once the planners' mandatory insurance pushes prices to new heights, they must put even tougher limits on what we may buy—or their budget will be even deeper in the red than it already is. As economist Thomas Sowell points out, government cannot really reduce costs. All it can do is disguise and shift costs (through taxation) and refuse to pay for some services (rationing).

3) How does government "create choice" by imposing uniformity on insurers? Uniformity limits choice. Under House Speaker Nancy Pelosi's bill and the Senate versions, government would dictate to all insurers what their "minimum" coverage policy must include. Truly basic high-deductible, low-cost catastrophic policies tailored to individual needs would be forbidden.

4) How does it "create choice" by making insurance companies compete against a privileged government-sponsored program? The so-called government option, let's call it Fannie Med, would have implicit government backing and therefore little market discipline. The resulting environment of conformity and government power is not what I mean by choice and competition. Rep. Barney Frank is at least honest enough to say that the public option will bring us a government monopoly.

Advocates of government control want you to believe that the serious shortcomings of our medical and insurance system are failures of the free market. But that's impossible because our market is not free. Each state operates a cozy medical and insurance cartel that restricts competition through licensing and keeps prices higher than they would be in a genuine free market. But the planners won't talk about that. After all, if government is the problem in the first place, how can they justify a government takeover?

Many people are priced out of the medical and insurance markets for one reason: the politicians' refusal to give up power. Allowing them to seize another 16 percent of the economy won't solve our problems.

Freedom will.

John Stossel will soon host Stossel on the Fox Business Network. He's the author of Give Me a Break and of Myth, Lies, and Downright Stupidity. This column first appeared at Reason.com.

UPS vs. FedExâ��Ultimate Whiteboard Remix

Thu, 12 Nov 2009 11:35:00 EST

You may have heard that UPS is in quite the fight with FedEx. Though both are package-delivery companies, they're governed by totally different federal labor rules. As a result, UPS's workforce is much more heavily unionized than FedEx's—and more than twice as expensive.

So now UPS is trying to get FedEx reclassified under federal law as a way of screwing a competitor. That's horrendous, but it also makes a sick kind of business sense. And it also reveals the real villain: A government that is big enough to absolutely, positively guarantee it can screw any business. Overnight.

"UPS Vs. FEDEX" was produced by Meredith Bragg and Nick Gillespie (who also hosts). Approximately two minutes long.

This video is based on "Using Unions as Weapons," by Veronique de Rugy, which appeared in the October 2009 print edition of Reason.

Go here for downloadable versions. This video is also available at Reason.tv's YouTube channel. Subscribe now.

Under Federal Watch, Fannie Mae Has Now Lost $111 Billion

anthony.randazzo@reason.org (Anthony Randazzo) — Wed, 11 Nov 2009 18:44:00 EST

The good news is that Fannie Mae lost $10 billion less than before. The bad news is that the GSE still lost nearly $20 billion and is asking for another $15 billion in "help us" money:

Last week, Fannie Mae posted a quarterly loss of $19.8 billion—which believe it or not was an improvement on the $29.4 billion that it lost a year earlier. Last quarter's results came with yet another request for government aid—$15 billion worth. That brings the total tab for Fannie and Freddie to $111 billion since they were put into conservatorship in September 2008.

Read the whole story here.

Questions For the Federal Reserve

anthony.randazzo@reason.org (Anthony Randazzo) — Wed, 11 Nov 2009 15:29:00 EST

Henrey Kaufman presents a lot of questions that the Fed is dealing with right now:

Today, with interest rates near zero and the stock market booming, increased political pressure will be put on the Fed when it begins to shift away from its current posture of quantitative easing. What will most inspire a shift toward tightening? The inflation rate? Better employment numbers or a housing recovery? That's hard to say.

Even harder to say is how the Fed will deal with the speculative fervor now fomenting in the financial markets, i.e., the increase in the carry trade (borrowing dollars to buy assets) and the run-up of many stock and commodity prices. Will the Fed ignore these developments and wait until the economy gains full traction to raise rates?

The current economic situation suggests continued substantial monetary ease, but developments in the financial markets do not.

Closely related to the this conundrum is another one: How will the Fed reduce its bloated balance sheet—which has reached $2.2 trillion, compared with $919 billion in mid 2008? Fed holdings now include more than $1 trillion of obligations involving largely longer-dated mortgage-related securities.

Bernanke's job is not enviable. But long-term success would be more likely if we clear the decks sooner than later. Where's the light switch for that exit sign?

Read Kaufman's whole piece in WSJ here.

Amendment to Ron Paul's "Audit the Fed" Bill Isn't A Bad Compromise

anthony.randazzo@reason.org (Anthony Randazzo) — Tue, 10 Nov 2009 19:52:00 EST

Rep. Ron Paul's "Audit the Fed" bill has been back in the national conversation the past week with news of an amendment offered by North Carolina Rep. Mel Watt (D). The Ron Paul amendment would have the GAO audit Fed monetary policy decisions, including the recent expansion of the Fed balance sheet in the wake of the financial crisis meltdown. Rep. Watt's amendment essentially would essentially have the GAO audit just the ways the Fed has been lending money over the past 18 months by claiming special circumstance.

In today's Journal, Anil Kashyap and Frederic Mishkin argue that Rep. Paul's bill would be dangerous because it would overexpose the Fed and hurt independence. This argument has been the major one from Paul's critics all along. But they support Rep. Watt's amendment as a positive thing Congress can do to hold the Fed accountable. And I agree that it is a good compromise. Kashyap and Mishkin write:

Congress is considering an amendment to the bill that would prevent the negative consequences of the original Paul legislation. This amendment, put forward by Rep. Mel Watt (D., N.C.) would change the focus of the bill by instructing the GAO to audit the new lending facilities at the Federal Reserve that were authorized under the 13(3) "unusual and exigent circumstances" clause of the Federal Reserve Act. The 13(3) lending authority, which had not been used by the Fed since the Great Depression, was the basis for many of the most controversial decisions made during the crisis, including the rescue of AIG and the establishment of new lending facilities.

This audit would involve oversight of the operational integrity of these facilities' accounting, internal controls, and protection against losses. It would also disclose the borrowers from these facilities one year after the facilities are closed. The audit would produce new, important information that is not otherwise available and would play to the strengths of the GAO. And the amendment would exempt the Fed's normal monetary policy actions from the audit.

Now, I wrote back in July that I more or less supported the Ron Paul bill:

...does the proposed GAO audit of the Fed constitute a threat of its independence. The audit is not an attempt to control interest rates. The audit would not make monetary policy recommendations the Fed would be forced to follow. The audit would simply provide an outside perspective. Congress doesn't need a tool to intimidate the Fed into changing rates since the Fed isn't completely independent. Now, I'm not sure what Congress plans to do after the GAO audits the Fed, but if there is any debate here, it should be over the value of transparency itself.

I still disagree with Kashyap and Mishkin that the GAO audit would destroy independence. As they point out in their editorial, most of the monetary policy information is already public. And it is unlikely that a GAO opinion on monetary policy will shift the market much. The more important part of the bill—which is why I supported the Paul bill—is a review of where all the money the Fed has been lending is going.

The Fed has lent billions as a way of controlling interest rates and providing liquidity to the marketplace. They have not been upfront with where the money went, and it should be public information to keep the Fed accountable. Even if it is just a Congressional committee that sees an "eyes only" report.

Rep. Paul claims that the Watt amendment guts his bill, as my colleague Adam Summers noted last week. But if the issue is keeping the Fed accountable, then the sensible approach would be a bill that requires an audit of the "exigent circumstances" lending facilities. The Watt amendment might not be everything Rep. Paul wants, and it might need to be tweaked to get it just right, but the compromise path here would lead to the fastest approval of some necessary accountability checks on the Fed.

Cioffi and Tannin Found Not Guilty

anthony.randazzo@reason.org (Anthony Randazzo) — Tue, 10 Nov 2009 17:42:00 EST

In a somewhat surprising decision today, former Bear Stearns hedge fund managers Ralph Cioffi and Matt Tannin were found not guilty by a jury of their peers in federal court. Nearly a month to the day after their trial began, the jury ruled that Cioffi and Tannin did not mislead investors nor commit fraud. The AP reports:

A jury in federal court in Brooklyn deliberated about eight hours over two days before finding Ralph Cioffi and Matthew Tannin not guilty of conspiracy and other charges in an alleged scheme that cost 300 investors about $1.6 billion and nearly caused the demise of Bear Stearns itself. The firm avoided bankruptcy in a rescue buyout by JPMorgan Chase & Co.

Both men had been charged with three counts of securities fraud and two counts of wire fraud. Cioffi was also charged with insider trading.

After the verdict, some jurors told reporters that they concluded that the evidence against Cioffi and Tannin was flimsy and contradictory. Other suggested the pair were being blamed for market forces beyond their control.

Having not been in the court room for any of the trial, it certainly would be unfair for me to completely disagree with the decision—especially since it is possible they are not guilty on technical grounds. Nevertheless, I am disappointed by the decision.

To begin with, I certainly don't believe Cioffi and Tannin should be held to account for what is technically not against the law. We should not judge people ex post facto in this country, not matter the distaste. Neither am I in favor of a Wall Street witch hunt, or of the opinion that the court system should be used to mediate cultural justice. But that said, for all practical purposes, Cioffi and Tannin did mislead investors. And that needs to be addressed.

First, Cioffi was not upfront about pulling his own money out of one account that was losing money. He should have told the other investors he did that, and why. If it's not against the law to disclose selling your own stock in a fund while it is losing money rapidly, we should consider something to that effect (provided such a rule didn't create unintended negative consequences).

Second, while Cioffi and Tannin were selling "AAA-rated" securities, the underlying assets of the securities were subprime crap. And it is pretty clear that the fund managers realized this well before communicating anything of the sort to investors. Why else was Tannin so torn up about their investment choices? (This was chronicled in emails from Tannin to Cioffi later published in William Cohan's House of Cards.) And why did Tannin and Cioffi use wives email accounts to discuss problems with the fund? They had knowledge which they did not share. This is a fiduciary responsibility issue.

It's not that they lost money. Sure, they pumped Bear Stearns money into the funds as they were going down, praying for a surge in the marketplace. That is just being bad at your job. But when you mislead investors who are trusting you with their money and you not only refrain from being upfront with them, but pull your own money out in fear of a loss, there is something wrong going on.

It might be that they didn't break a technical law. In which case, the jury should be praised for not letting their emotions get in the way. But Wall Street shouldn't take this jury decision as permission to avoid transparency and disclosure. Wall Street should understand that, in exchange for a (relatively) relaxed and free market, they must obey the letter and spirit of the laws. Corruption, dishonesty, and the use of technicalities are crony capitalism, and do not help to make a prosperous society.