What Were They Saying in July 2007?

0:00Ladies and gentlemen, it's a pleasure to be with you here today. In February of 2004, I wrote an article for lewrockwell.com called Green Spam. And in that article, I argued that you shouldn't listen to the testimony and the public announcements of Alan Green Spann, the then chairman of the Federal Reserve. I said, delete it from your memory like you would delete spam email messages. Watch what he's done, watch what he's doing, but don't listen to what he's saying and his testimony before Congress, unless it's Ron Paul doing the talking.

0:49Now this talk is going to be a follow-up on that previous article, and what I'm going to do here is to describe central banking and the Federal Reserve as a confidence game. The Federal Reserve plays a confidence game with us, and a confidence game, also known One as a hustle, a scam, a scheme, or a swindle is defined as an attempt to defraud a person or group by gaining their confidence. The common factor is that the mark relies on the good faith of the con artist. And the con artist here is the Federal Reserve and you are its mark.

1:38So here I'm going to concentrate on the Fed's basic confidence game of trying to gain our confidence about the economy, to gain our confidence about their ability to run the economy and to run monetary policy. Of course there's a lot of other fraudulent things about the Federal Reserve. Surely inflation itself is a scam or a confidence gain, printing up money, and valuing our dollars and so on, helping out their politically connected friends. The Fed has also been described as a conspiracy. That's not the point here. It's also been described as a cartel for the banking industry. We're not going to worry about that.

2:24We're even going to set aside other fraudulent issues that are out there that may be on your minds. Things like, why hasn't anybody audited the nation's gold supply in decades? Why hasn't the Fed itself been properly audited? Has the Fed been manipulating the gold market or secretly leasing out the gold into the market economy? All of these are potential con games or scams, but we're going to have a basic focus here on the Fed's mission to instill confidence in the economy and simultaneously instilling The Federal Reserve officials are always publicly bullish and hardly ever publicly bearish about the economy. According to them, the economy always looks good, if not great. It's going to get better. And if there is some problems, don't worry, the Fed will fix it. They can come to the rescue with truckloads of Money, lower interest rate, easy credit, and if things get worse, the Fed can resort with responding with monetary weapons of mass stimulation.

3:43And even though I'm describing this as a con game and they may take offense of it, it's really not. Mainstream economists view this exactly as I'm presenting it to you. They view the macroeconomy as a psychological problem, that people get overly speculative, they get overly risky, they get rambunctious when it comes to the economy during the boom, and then problems set in and they become despondent and become depressed. In other words, and there's a new book out called Animal Spirits, the psychological problems of the Macroeconomy by two famous mainstream economists where confidence is the key issue.

4:29So basically what they're saying is that the business cycle, the boom, the runaway boom and the terrible bust, the crust, the crisis that we're in right now, it's your fault. That's what they're saying when in reality, of course, it's the Federal Reserve's fault. But in their own mind, the Fed has no choice but to instill confidence in you. Now what I'm going to take a look at here today is evidence from testimony from Federal Reserve officials in the year 2007. Really any period would do, but early 2007 is a period just before the economic crisis started to set in in the second half of 2007.

5:16So the Fed, with its unlimited budget, thousands of economists and statisticians, access to every piece of economic data that exists, including inside information about every or at least all major financial firms. You would have thought that they might have thought that there were some problems existing in the economy and they might want to let us in on it so that we could be in a position to protect ourselves. So that's the reason I picked that particular period to analyze, and I didn't really have any particular testimony in mind when I structured this talk. I just had the confidence, no pun intended, that when I did go to look at the testimony of Fed officials, I'd find exactly what I did find, and there's plenty of it to suggest that they were playing a confidence game on us.

6:13And of course, I'm only going to be looking at the major Federal Reserve officials. It is, after all, their game. We could also probably find similar statements by officials at the Treasury Department and the White House, as well as Wall Street and the real estate complex. Well, let's begin by looking at Ben Bernanke. The former economics professor from Princeton addressed the American Economic Association meeting in January of 2007, and this is a big deal for an academic to come back as the all-powerful chairman of the Federal Reserve. He's the first academic to take that post since Arthur Burns, and it was Burns who helped take us off the gold standard, so we can only imagine what Bernanke is going to lead us to.

7:06In addressing his academic audience, Bernanke was unusually bold. He said the Fed's access and ability to use information and data concerning financial markets was complete. This knowledge and expertise included the advanced knowledge of markets for derivatives and securitized assets. The Fed is described by Bernanke as a type of superhero for financial markets. In discussing the Fed's role as chief regulator of financial markets, he makes very powerful claims in the Fed's ability to identify risk, anticipate financial crisis, and to effectively respond to any financial crisis.

7:52Quote, many large banking organizations are sophisticated participants in financial markets, including the markets for derivatives and securitized assets, and monitoring and analyzing In understanding the activities of these banks, the Fed obtains valuable information about trends and current developments in these markets. Together with the knowledge obtained through its monetary policy and payments activities, information gained through its supervisory activities gives the Fed an exceptionally broad and deep understanding of the developments in financial markets and financial institutions. In its capacity as a bank supervisor, the Fed can obtain detailed information from these institutions about their operations and risk management practices and can take action as needed to address risks and deficiencies.

8:45The Fed is also either the direct or umbrella supervisor of several large commercial banks that are critical to the payment system through their clearing and settlement activities. In other words, the Fed knows everything there is to know about financial markets, and this is again right before the crisis. Quote, in my view, that is Bernanke, however, the greatest external benefit of the Fed's supervisory activities are those related to the institution's role in preventing and managing financial crises. Finally, the wide scope of the Fed's activity in financial markets, including not only bank supervision and its roles in the payment system, but also the interaction with primary dealers and the monitors of capital markets associated with the making of monetary policy, has given In other words, the Fed is a very experienced, forward-looking preventer of financial crises.

10:01This is an incredibly strong claim given Bernanke's own abysmal record of forecasting near-term events. Of course, he's famous on the internet for the YouTube video which chronicles his pathetic record of making forecasts and predictions. He denied, for example, in 2005 that there was such a thing as a housing bubble. He denied the housing prices could decrease substantially or that it would affect the Real Economy or that it would affect employment in 2006. He tried to calm fears about the subprime mortgage market and stated that he expected reasonable growth and strength in the economy in 2007 and that the problem of the subprime market, which had then become apparent, would not affect the overall mortgage market or the market in general, which is is exactly kind of what happened.

11:11In mid-2007, he declared the global economy stronger and predicted a quick return to normal growth in the U.S. I think one of the worst public pronouncements by Bernanke was right before he became chairman. He was the vice-chairman. And this quote occurred right at the pinnacle of the housing bubble. Right at the time when the mortgage market was being overwhelmed with these new products, subprime mortgages, interest-only mortgages, no documentation loans, the heyday of mortgage-backed security and teaser rates, so on and so forth, all of this was happening. It was big news.

11:58It was the new developments. If you were paying attention at all to anything to do with the real estate market, you would have realized that things had changed dramatically. But in 2006, Bernanke stated that he believed that the mortgage market was more stable than in the past. And he noted in particular, quote, our examiners at the Fed tell us that lending standards are generally sound and are not are not comparable to the standards of the past. Well, that's the one part, it's true. And in particular, real estate appraisal prices and practices, excuse me, have improved.

12:44Well, that, my friends, is what the Fed is all about. You take an unlimited budget, thousands of economists and statisticians, at every piece of economic data including detailed financial information about the interior of these financial firms and what do you come up with? Consistently wrong answers or my perspective is that these are answers that are simply designed to maintain the confidence of the average citizen. Now next up is Governor Fred Michigan of the Federal Reserve who gave a talk less than two weeks later in New York City. Michigan, in addition to being a prominent Federal Reserve economist, is the leading textbook author in the subject of money and banking. And he He did admit, he said, over the last 10 years, we'd seen extraordinary run-ups in housing prices but he says it's extremely hard to say whether or not they're over their fundamental value.

13:52The issue here is the one that applies to how central banks should respond to potential bubbles in asset prices in general because subsequent collapses in asset prices might be highly damaging to the economy should the monetary I view the answer as no, said Mischkin. In other words, if the Fed isn't worried, neither should you. He had a theory about how there can be no such thing as bubbles. He said, quote, If a central bank knows that a bubble has developed, the market will already know that as well, and so the bubble will burst prematurely, thus any bubble that could be identified with certainty by the central bank would be unlikely to ever develop in the first place.

14:49See? No problem. He says, but there's even stronger reasons to believe that a bursting of a bubble in housing prices is unlikely to produce any financial instability. Okay, so these guys are right on target. Housing prices are far less volatile than stock prices. And this actually reminds me of a speech that Alan Greenspan gave, because he's going right through the same reasons why you can't have a housing bubble, because housing prices are are less volatile than stock prices. Outright declines after a run-up are not the norm. And declines that do occur are typically relatively small.

15:35Hence declines in home prices are far less likely to cause losses to financial institutions. Default rates on residential mortgages typically are low. And recovery rates on foreclosure are high. this means basically what this leading textbook author is saying is you can't lose money in real estate of course if he had been paying attention to what had been going on in the subject matter of his textbook over the previous five years he would have realized that all of those assumptions about money, banking, mortgages and real estate were no longer valid Vice Chairman Donald Cohn, he also had an extended testimony the following month, and I don't have time to get into all of it, but he did say that the Fed's number one job was to prevent extreme events, to find out what caused them, to prevent them, and to manage and how to manage those crises.

16:50Quote, a core reform that emerged from past crises was the need to limit the moral hazard of the safety net extended to insured depository institutions or banks. A safety net that is required to help maintain financial stability. Moral hazard refers to the heightened incentive to take risks created by an insurance system. Private insurance companies attempt to control moral hazard, for example, by charging risk-based premiums and imposing deductibles. In the public sector, things are more complicated. That's right, things are more complicated.

17:36Basically, what he's saying is that if we have things like FDIC insurance or if the Fed is to bail out banks, that would create a moral hazard so that financial institutions would be less reliable, more risk-taking in the future. So it's very important for the Fed not to provide a safety net. It's important for the Fed not to bail out imprudent institutions. And of course, that's more or less precisely what they had been doing and have been doing through the entire crisis. In fact, he makes the statement, the systemic risk exception, and this is before the crisis, the systemic risk exception has never been invoked and efforts are currently underway to lower the chances that it ever will be.

18:36In other words, we're not really worried about systematic failure of the financial institutions. And we're going to try to never bail them out in that fashion. And then, of course, exactly less than one year later, that's precisely what they did. I guess that record has now been clearly broken into seven or several trillion dollar pieces. The final Fed figure that I want to look at here today is Governor Randall S. Krosner, who spoke at the Credit Market Symposium of the Federal Reserve Bank of Richmond in March March 22, 2007, on the topic of recent innovations in credit markets.

19:28And Krosner is, or was, the Fed's number one guy in terms of regulating financial markets. He was kind of their micro guy. He was the point man in preventing things like systemic risk. He was, and so that was his main job, but he considered all the financial innovation and Engineering to be a good thing. So while Austrian economists generally saw all this financial engineering and innovation as a consequence of easy credit policies, okay, if the Fed is gonna make credit easily available, then the market has gotta come up with some way to get that credit into the hands of sometimes unsuspecting, unreliable credit risks.

20:19Quote, credit markets have been evolving very rapidly in recent years. New instruments for transferring risk have been introduced and loan markets have become more liquid. Taken together, these changes have transformed the process through which credit demands are met and credit risks are allocated and managed. I believe these developments generally have enhanced the efficiency and the stability of the credit markets and the broader financial system by making credit markets more transparent and more liquid by creating new instruments for unbundling and managing credit risks and by, and this is important, dispersing credit risks more broadly.

21:08The new instruments, markets and participants I have just described, have brought some important benefits to the credit markets. I will touch on three of these benefits. Enhanced liquidity and transparency, the availability of new tools for managing credit risk, and a greater dispersion of credit risks. So what is he talking about here? Well, he's talking about all these new products, credit default swaps, collateralized debt obligations, Collateralized Loan Obligations, Asset Back Securities, Credit Derivatives, Credit Derivative Indexes, and so on. Krosner says that among the more complex credit derivatives, the credit index tranches stand out as an important development.

21:56So that's when they brought all the mortgages, created them into a big package, and then sliced the package into tranches So you could have highly risky, almost sure-to-go bus tranches and then some tranches that were of subprime mortgages, for example, that could then be labeled as AAA rated. And all of these new instruments allow the dispersion of risk. Quote, on the face of it, a wider dispersion of credit risk would seem to enhance the stability of the financial system by reducing the likelihood that credit defaults will weaken any one financial institution or any class of financial institutions.

22:43He says, quote, there is nothing fundamentally new to investors. Credit derivatives indexes simply replicate the sort of credit exposures that have always existed. So this is a very smart guy, but he doesn't seem to understand that all of these new instruments were not just taking a set aggregate amount of risk, chopping it up and dispersing it to the winds, so that instead of me burying all of the risk in the economy, I disperse it to all of you. That's not exact, that's the first step. The second step is that that allows me to take on even more risk. Okay, so we're increasing the aggregate level of risk in the economy.

23:30And the third step is, of course, if I'm making loans to people and then selling them off to other people, All of a sudden, the standards that I use to make those loans, all of a sudden take on a different look. Because when it's my money of my bank, I'm going to be darn sure that I lend it to customers, borrowers, who are going to be able to pay back those loans. But if I'm making a loan to somebody that I plant on reselling to somebody else, and I'm just going to make a fee from that loan, then I no longer have the same incentive to impose the same credit restrictions that I used to.

24:18As a matter of fact, if I can reduce those standards, I'm going to make more loans, I'm going to make more fees, and I'm going to flood the economy with a lot more risk. So there is something fundamentally different. It's not just making things more liquid and more transparent. You're reducing the standards of using credit, and you're increasing the amount of credit, excuse me, you're increasing the amount of aggregate risk that exists in a credit, in the economy. And that's exactly what we're going through here today. Kroesner also tells us that we don't have to worry about, quote, counterparty risk management policies because Gerald Corrigan, who was the former president of the New York Fed, is now in the chief executive office of Goldman Sachs and he's gotten together all of his friends from the 14 largest financial firms in New York and they're going to privately regulate, quote, counterparty risk management policy, so we don't have to worry about it, the Fed doesn't have to worry about it because we got one of our former guys who's working

25:31for Goldman Sachs who gets together with all of the big guys and they talk about it. Cooperative initiatives such as this one led by Corrigan can contribute greatly to ensuring that challenges are met successfully by identifying effective risk management practices and by stimulating collective action when necessary. The recent success of such initiatives strengthens my confidence that future innovations in the market will serve to enhance market efficiency and stability, notwithstanding the challenges that inevitably accompany change. Checking ahead in 2007, we find Krosner still bullish at the end of the year.

26:21Now things have started to deteriorate in the U.S. economy by November 17, 2007. Subprime problem, mortgage originators melting down. Things are going wrong, they're going wrong fast, things are going downhill. Voting Krosner, November 17, 2007. Looking further ahead, the current stance of monetary policy should help the economy get through this rough patch during the next year, with growth then likely to return to its longer run sustainable rate. As conditions in the mortgage markets generally normalize, home sales should pick up. The home builders are likely to make progress in reducing their inventory overhang.

27:08And with this drag from the housing sector waning, the growth of employment and income should pick up and support somewhat larger increases in consumer spending. And as long as demand for domestic consumers and our export partners expand, increases in business investment would be expected to broadly keep pace with the rise in consumption. I can't imagine anybody getting it wrong, wronger than Governor Krosner. Over the next year, the Dow would lose 6,000 points, and we have now doubled the amount of unemployment, adding more than 7 million people to the unemployment rolls.

27:57Consumer confidence hit a 27-year low this week, and sales of new homes, which he had expected to pick up in early 2008, hit the lowest level ever. A data going back a half a century, we just hit the lowest level of new home sales ever. Now Kroesner, who is a Institute for Humane Studies groomed economist, has since returned to the University of Chicago to a Chaired Professorship and as the Director of the George Stigler Center. In conclusion, we can see that the Fed really is playing a confidence game.

28:44Their public pronouncements are heavily nuanced and hedged, but they uniformly present the American people with a rosy scenario of the economy, the future, and most importantly, Ben Bernanke told Congress this week that we are in the early stages of an economic recovery. Of course, he has been saying this since the spring of 2009, if not earlier. These people are the people who said that there was no housing bubble, that there was no danger of a financial crisis, that a financial crisis would then not impact the real economy. And these are the same people who then said that they needed a multi-trillion dollar bailout of the financial industry or that we risked severe trouble in the economy.

29:40They got their bailout, we got the trouble anyways. It's time to bring this game to an end.