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Root Cause Of This Financial Crisis

  • The Fed
  • Fractional Reserve Lending
  • Government sponsorship of the rating agencies (See Time To Break Up The Credit Rating Cartel)
  • Government sponsorship and promotion of housing via GSEs, tax breaks, etc.

There is not a free market failure in the group, nor will there ever be.

Although Geithner fails to understand the cause, he does paint an accurate picture of the chain of events leading up to the crisis.

  • Real short-term interest rates were reduced around the world.
  • Global savings appeared to rise faster than did perceived real investment opportunities.
  • Emerging market economies built up very large levels of official reserves to hold the value of their currencies stable against the dollar.
  • The exchange rate policies in those economies made overall global financial conditions more accommodative.
  • Expected and realized volatility in both debt and equity markets dropped. Term premiums declined and remained low.
  • Credit spreads across a wide range of asset classes fell to levels that assumed unusually low levels of future losses.
  • Many households, including those previously lacking access to credit or with access only to expensive credit, found they could borrow on a significant scale to finance the purchase of a home and other expenses.
  • Prices rose across a range of real and financial assets, most notably the prices of homes.
  • This constellation of broad economic and financial conditions was accompanied by rapid innovation in financial instruments that made credit risk easier to trade and, in principle at least, to hedge.
  • Issuance of asset-backed securities (ABS), collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs), as well as credit default swaps (CDS), expanded on a dramatic scale.
  • The proliferation of credit risk transfer instruments was driven in part by an assumption of frictionless, uninterrupted liquidity.
  • A sizable fraction of long-term assets -- assets with exposure to different forms of credit risk -- ended up in vehicles financed with very short-term liabilities and was placed with investors and funds that were also exposed to liquidity risk.


Self Reinforcing Action

Continuing the discussion from Geithner:

The self-reinforcing dynamic within financial markets has intensified the downside risks to growth for an economy that is already confronting a very substantial adjustment in housing and the possibility of a significant rise in household savings.

"The intensity of the crisis is in part a function of the size of the preceding financial boom, but also of the speed of the deterioration in confidence about the prospects for growth and in some of the basic features of our financial markets. The damage to confidence—confidence in ratings, in valuation tools, in the capacity of investors to evaluate risk—will prolong the process of adjustment in markets. This process carries with it risks to the broader economy.

For more on self reinforcing action, please see the excellent discussion on Daisy Chain Reactions by Professor Bennet Sedacca in Changing the Benchmark."


Fed Has No Confidence In Monetary Policy

"We cannot know with confidence today what level of the short-term real funds rate will be consistent with our objectives of sustainable growth and low inflation, but if turbulent financial conditions and the associated downside risks to growth persist, monetary policy may have to remain accommodative for some time."

There you have it. That is an explicit comment from a Fed Governor that they have no idea with any confidence they know what they are doing.


I Have 100% Confidence

On the other hand, I have 100% confidence they have no idea what they are doing. They can no more accurately fix the interest rate than they can fix the price of orange juice. Heck, in actual practice, the latter would be far easier.


Fed Attempts To Wash Hands

Sadly Geithner sticks to the myth that this was not preventable.

"Was this preventable? I don’t believe that asset price and credit booms are preventable. They cannot be effectively diffused preemptively. There is no reliable early warning system for financial shocks."

Of course it was preventable. Two simple measures would have prevented 80% of this mess: Elimination of the Fed, and elimination of fractional reserve lending.


Three Part Solution

Geithner's speech goes on and on and on. Still, it is probably one of the most important speeches ever by a Fed governor in admitting what the problems are. I recommend reading it in entirety. And while the Fed (at least Geithner) admits it has no idea what to do, I offer this 3 part solution.

  • Abolish the Fed.
  • Eliminate fractional reserve lending.
  • Implement a sound monetary policy based on hard assets such as gold as opposed to price fixing by government sponsored clowns.