In late 2007, the Financial Accounting Standards Board (FASB) changed the definition of mark-to-market accounting rules as they applied to the U.S. financial industry. The board forced financial firms and auditors to use “observable,” market prices to value securities rather than models or cash flow. Within a year, the U.S. was in the middle of the worst pure financial panic in a hundred years. Coincidence? We think not.
On its surface, market-to-market or “fair value” accounting makes some superficial sense. Markets usually provide transparent and verifiable prices, so companies can’t just contrive numbers to make their earnings look good.
The problem with mark-to-market is its failure to recognize that market prices for securities often deviate–sometimes substantially, but always ultimately temporarily–from the underlying fundamental value of the assets. Since markets are forward looking, mark-to-market forces financial firms to take hits to capital over something that “might” happen in the future, but has not happened yet. It’s like forcing homeowners to come up with more capital when the weather man forecasts a hurricane because their homes might be destroyed.
This, in turn, can create a vicious downward cycle as capital constraints hurt banks, undermine the economy and drive prices lower, and then destroy more capital. In 2008, when markets for mortgage-backed securities became extremely illiquid, the financial crisis intensified. This drove away private capital and enticed government to flood the system with liquidity. This government activity helped cause panic and a recession. But all of these government programs were just a way to work around the accounting rules.
As former FDIC chairman William Isaac has repeatedly said, if mark-to-market rules had been in place in the early 1980s, the Latin America debt crisis would have destroyed every money center bank–large banks that borrow and lend to governments and large companies–in the U.S. Thank goodness that did not happen. Instead, the system was given time to heal. That’s what should have happened in 2008. Instead, FASB stubbornly stuck to its guns over MTM accounting.
Finally, in mid-March 2009, with stocks at new lows, Congress started to twist arms on the issue, a rare and unheralded moment of bipartisan action. FASB was forced to loosen up its rules and allow cash flow to be used when markets were illiquid. Just this small change did the trick. Banks were finally able to raise new capital, $100 billion or so, and the stock market surged. In fact, things have improved so much that the Federal Reserve and Treasury are finding less and less interest in the programs they designed to “save” the financial system.
Suspend Mark-to-Market–Now – Brian Wesbury & Robert Stein, Forbes
July 28th, 2009
July 28 (Bloomberg) — The Queen of England recently heard from her nation’s economic experts, who wrote to apologize for their profession’s inability to predict the financial crisis.
It’s different in the U.S. Here, economists don’t apologize to the throne. They sit on it.
The throne in the U.S. is the post of chairman at the Federal Reserve. As currently configured, this office is more powerful than Elizabeth II’s, with almost unlimited discretionary authority to intervene in the world economy.
The Fed was created in 1913. Lawmakers strengthened its powers in the 1930s and then again after World War II by effectively charging it with watching over not only money but economic growth generally.
Until 1971, there existed a mechanism that served as a check on the Fed’s discretion, at least theoretically. It was the gold standard (later, the gold exchange standard). If the Fed created too much money, capital went abroad to less inflationary venues. That in turn forced the economy to contract. Central bankers controlled money creation because they didn’t want to be blamed for a recession.
President Richard Nixon broke that mechanism when he took the country off the gold exchange standard in August 1971. Since then, the economy has been in the hands of the king — the Fed chairman — and his counts and barons, the members of the Federal Open Market Committee.
The record of central bankers suggests that they aren’t deserving of their royal status.
Awful Choices
Central bankers always argued that there was a tradeoff between unemployment and inflation: the country had to pick one of the two poisons. Then the 1970s brought both poisons — joblessness with inflation.
Former Fed Chairman Alan Greenspan, current Chairman Ben Bernanke and many of their economic colleagues all failed to predict the current crisis. Worse, they may have helped cause it by keeping interest rates too low this decade.
Why did the Fed keep rates low? We can guess that the events of Sept. 11, 2001, and the start of the Iraq War in 2003 are part of the answer. The U.S. didn’t want economic trouble at home while it was fighting abroad. What’s clear is that rates were kept low in part for an arbitrary reason: because Greenspan, then Bernanke, felt like keeping them there.
Bernanke’s Promise
In 2002, when Bernanke was still a mere count in the Fed court, he spoke at an event honoring his fellow economist, Milton Friedman. Bernanke recited the errors of the Depression- era monetary authorities, errors Friedman himself had first pointed out: they forced an epic deflation and banking credit crisis on Americans.
Bernanke then promised that he and his Fed colleagues “won’t do it again.”
Fast forward to Sunday in Kansas City, where Bernanke, now chairman, said the current crisis might already be worse than the Great Depression. In other words, the Fed policy of the current decade has worked insufficiently, or hasn’t worked, or has made matters worse. Hardly the festive results both Bernanke and the late Friedman hoped for. Yet the more trouble their arbitrary policy causes, the more ennobled our central bankers seem.
Washington has the power to end this monarchy. It can replace economists with economics — rules-based mechanisms that automatically curtail Fed discretion. This offers the possibility of experimenting with economic models and letting Congress keep or toss them, according to performance.
Follow the Formula
One such experiment could involve the Taylor Rule, named for Stanford University economist John Taylor. It says the Fed should aim to set short-term interest rates following a formula that measures inflation, employment and the pattern of interest rates.
In a damning book released in February, Taylor showed that interest rates diverged from his rule for much of this decade. Had the Fed followed the Taylor Rule, it wouldn’t have loosened rates as much as it did, and that might have slowed the housing boom.
Friedman himself was skeptical about too much discretion and sought a legislated rule on monetary policy. He “wanted the rate of growth for money to be fixed to the rate of growth of the economy,” recalls Don Boudreaux, chairman of the economics department at George Mason University.
Let Markets Rule
Others advocate a new gold standard, which would make the movement of money more automatic, even to the point of “free banking.” Such a system would have no central government bank. The market, not Washington, would determine the survival or death of financial institutions. It’s not a new idea: George Selgin of West Virginia University wrote a book about how British manufacturers in the early 19th century successfully challenged the Crown for control of their country’s money.
Right now, thousands of pages are being typed in hundreds of summer houses in an effort to blame Greenspan or Bernanke, or perhaps their colleagues at the Treasury Department, another imperial institution.
The trouble is not Bernanke or Greenspan or even their respective courts. The trouble is that the throne exists in the first place.
(Amity Shlaes, author of “The Forgotten Man: A New History of the Great Depression” is a Bloomberg News columnist. The opinions expressed are her own.)
Dethrone King Ben Bernanke and His Court – Amity Shlaes, Bloomberg
July 28th, 2009
