On Sunday, Bob had on Niall Ferguson, author of ³The Assent of Money: A Financial History of the Word.² Mr. Ferguson is Laurence A. Tisch Professor of History at Harvard University and William Ziegler Professor of Business Administration at Harvard Business School. He is also a Senior Research Fellow at Jesus College, Oxford University, and a Senior Fellow at the Hoover Institution, Stanford University. In other words, he is a pretty smart dude. At first, I wasn¹t going to summarize the interview, but after I listened to it, I thought this was one of the best interviews I have heard in a long time. Ferguson is a great communicator, so I changed my mind Sunday evening and put pen to paper (or finger to keyboard as it were).
Brinker: Bob opened the interview pointing out that Keynesian economics seems to be in vogue right now with stimulus package after stimulus package being suggested by the government, including the mother of all stimulus packages coming up. What do you think Keynes would think of it all?
EC: In economics, Keynesianism is based on the ideas of twentieth-century British economist John Maynard Keynes. According to Keynesian economics the state should stimulate economic growth and improve stability in the private sector.
Ferguson: Ferguson said that Keynes would be a little uneasy that his teachings from the 1930s are being applied here. Ferguson said it¹s not only Keynes¹s ideas, but also Milton Friedman¹s work, that Ben Bernanke at the Fed is being influenced by. In many ways, the Fed¹s response to this crises is more akin to Milton Friedman¹s approach because Bernanke has thrown cash at the problem. He has acted as a true monetarist, doing everything in his power to prevent a massive series of banking failures. It was Milton Friedman¹s argument that banking failures were a main cause of the depression and the Fed should have done more in the 1930s.
Ferguson acknowledged that our legislators are adopting a Keynesian model by running a big fiscal deficit and try to get the economy going by having public sector demand substitute for private sector demand as banks tighten their lending and individuals tighten their belts. Ferguson said that much of what Keynes said about the Depression applies to a relatively closed economy with high tariff barriers. It is not clear that Keynesian solutions can work in a global economy of free capital flows. That is the big question as we head to 2009.
EC: Milton Friedman was originally a Keynesian supporter but later promoted an alternative macroeconomic policy called monetarism. He theorized that there existed a natural rate of unemployment and he argued the central government could not micromanage the economy and instead that a steady expansion of the money supply was a better policy.
Ferguson: Bob praised Keynes for correctly noting that the terms of settlement of World War I laid the foundation for World War II. Ferguson said that Keynes was right to see that the debts that were being imposed on Germany through the Treaty of Versailles, in addition to the debts incurred by the victors, were creating a problem that would weigh down on world economies.
EC: Under the Treaty of Versailles, Germany and its allies were held responsible for all loss and damage suffered by the Allies during the war and provided the basis for reparations. In January 1921, the total sum due was decided by an Inter-Allied Reparations Commission and was set at 269 billion gold marks (roughly equivalent to $400 Billion US Dollars as of 2005). This was a sum that many economists deemed to be excessive because it would have taken Germany until 1984 to pay. Later that year, the amount was reduced to 132 billion marks. Germany had paid about one eight of the sum required, before the a vote to cancel reparations at the Lausanne Conference occurred. Of course, it all became irrelevant upon Hitler's rise to power. And the rest, as they say, his history.
Ferguson: There is a parallel to be drawn to today with the post-World War I era relative to the impact of excessive debt, except that the debts today are not exclusively run-up by governments, but also by households that took out excessively large mortgages, and debts by institutions that became highly leveraged. It is a familiar problem. Excessive debt problems are very difficult to get solutions for. Keynes warned the big debts of the first World War would be inflated away -- that it would be currency crises that would ultimately resolve the issue. That is a danger that some people fear today, although Ferguson said that policy makers are more worried about deflation, not inflation.
What is clear is that stimulus packages -- especially if they translate into a $1 trillion deficit in the year ahead -- aren¹t actually solving the debt problem. It is just converting the debt problem from private debt to government debt. If policy continues in this direction, we are looking at perhaps a doubling of our national debt within the term of the Obama presidency. That is a terrifying thought because it begs the question: who is going to finance all of this debt? Will foreign investors absorb more than $1 trillion in new bond issues in the next fiscal year? And if not, will the Federal Reserve simply print money to finance the debt? This brings us back to something Keynes wrote about; namely, monetary reform where he speculated about the choice policy makers have between inflation and deflation. Keynes, on balance, tended to prefer inflation rather than deflation because he felt that it was worse (in an unfair world) to increase unemployment versus decreasing the value of savings through inflation. We might face a similar choice today, but it will be very hard for any policy maker today to prevent unemployment from inexorably rising in the United States and indeed around the world.
EC: Here is a good article discussing the main difference between inflation and deflation, with reference to the view espoused by Keynes:
Brinker/Ferguson: What is your take on the automakers asking for taxpayer money? Ferguson said we must not let ourselves be distracted from the core problem of this financial crises. There are going to be companies that will line up asking for handouts because very few sectors will not be hit hard by this recession. If we start giving handouts to the Big Three in Detroit, it will be hard to say no to everyone else. The core of the financial crises, however, is not the auto industry, it¹s the financial system -- the banking system and all of the financial institutions that create credit. Since August 2007, there has been a crises in the financial system and it has not really been solved despite all the money thrown at it and all of the schemes hatched by the Treasury and the Fed. Ferguson said we should probably give the automakers some short term money because the last thing we need right now is some extremely painful bankruptcy, particularly since it would be hard to finance, but longer term the problem has to be seen as a financial one which we haven¹t solved -- especially in the big banks. Even the bailout put together for Citigroup has not addressed the magnitude of the debt on one side of the balance sheet and the toxic assets on the other side of the balance sheet. It is the financial system seizure that is causing problems for all of main street, not just the auto industry. It is not practical for us to bailout every industry, but if we can focus on and fix the financial industry, the other problems will diminish.
EC: Two points. Ferguson is not only brilliant, but sounds to me like a practical guy to a degree. But when he says a bailout of the auto industry is necessary, but not every other company that comes with its hands out, the question is where do you draw the line? The auto industry is front and center this week, but if Ferguson is right, there will be plenty of other companies and industries coming with their hands out. And the main argument seems to be that the auto industry is tied to so many facets of our economy, that it is necessary. Well, I am sure there are plenty of other companies that could make the same argument. Not that I am necessarily against it, but logically speaking where or perhaps more precisely, when do you draw the line?
EC#2: I am not exactly sure what Ferguson meant by it would be difficult to finance an automaker bankruptcy. I think he may be referring to the ability (or inability) of the automakers to secure debtor-in-possession (DIP) financing which are loans made by lenders as part of a Chapter 11 bankruptcy that allows them to go to the front of the line of a company¹s creditors if the company is not able to stay in business. In return, the bankrupt company uses the cash to hopefully turn around the company and make it profitable again. Given the state of the capital markets, the possibility of DIP financing becomes more questionable.
Brinker/Ferguson: The efforts by the Federal Reserve, the changes by the FDIC, the actions by the government -- this is all unprecedented correct? Ferguson said in the absence of a world war, the answer is yes. The kind of measures we are seeing right now have only been taken by governments during the worst wars in history; namely, during 1914-1918 and 1939-1945. We are seeing emergency measures that are usually only taken during world wars, so in that aspect it is unprecedented.
Ferguson pointed out that if you add in all of the different investments, loans and guarantees, you get a number around $8 trillion which is close to the entire existing national debt. Yet despite all this money, we haven¹t really seen a turnaround. Why? Because to some extent the losses incurred by financial institutions over the past 15 months still have not been fully acknowledged. We have had somewhere in the region of $500 billion in write-downs, but the estimate of losses is closer to $2.8 trillion. Without the true realization of the problem, that is why we haven¹t seen confidence return and why interest rates for mortgages and loans haven¹t come down the way the fed funds rates have come down close to zero. There is still enormous anxiety in the financial system as to where these losses are because they haven¹t been fully acknowledged and people want to know exactly where those losses are.
Brinker/Ferguson: Whose to blame for this mess? Ferguson said it has been fashionable to blame Alan Greenspan for this mess and some of the blame should go to him, not the least because under his leadership the Fed became focused on the narrow role of the expectations of inflation as measured by the CPI, excluding housing and food. That is as narrow as you can get. Asset markets like stocks and real estate were ignored until things went wrong and only then the Fed would act. But you can¹t blame the Fed for everything. The SEC was negligent in the way it supervised the investment banks. The people running the investment banks deserve some blame for not knowing their balance sheets and allowing leverage to get out of control. We also need to recognize that legislatures in Congress on both sides of the house were negligent in their oversight of Fannie Mae and Freddie Mac, not only for economic reasons but for some political reasons, not all of which is fully understood. And finally, the economics profession bears some blame. It is striking how few of the great minds anticipated this crises. They had elaborate models that were supposed to understand and anticipate this crises. It is comparable to the crises that caused the Great Depression and it is far from clear whether the steps we have taken will ensure that we avoid a second Great Depression.
Caller: Why did you write this book? Ferguson said that too many people invested in the stock market are widely uninformed about the long run and instead rely on their personal experience, which only goes a couple of decades. The last 20-25 years is the ³age of leverage² and the ³age of debt.² Going forward, it is going to be much more difficult to borrow money and that is going to change the nature of our banking system.
Caller: This caller brought up Bob¹s earlier comment in the broadcast about the fact that going back 60 years, there have only been 68 trading days during which the S&P 500 has gained or lost 4% in a single day. Twenty-eight of those have occurred in the last three months. The caller said he did a rough calculation and the 4% up or down used to happen (prior to December 2008) about once every 548 days. Now it occurs about once every 3-4 days. That is a shocking increase. What is the cause of this and how can it be corrected to provide some stability? Ferguson said he used to get papers that had titles such as, ³the death of volatility² and the ³abolition of risk² which made him worry a lot a few years back and become almost certain that volatility would return. Ferguson pointed out that the survey Bob cited only covers the last six decades. Ferguson said that doesn¹t go back far enough. Any meaningful sample has to go back 100 years. There are huge spikes in volatility that are left out of the 60 year sample. It leaves out 1914, and the period following the depression which is a scary parallel. If you look at the returns between 1929-1933, there were significant gains in individual days, followed by even more serious declines. Ferguson said this is a financial crises comparable to 1930s. The difference is the regulators (Fed and Treasury) are reacting differently now. The question is will it work. We are trying out our solutions, which are essentially an experiment. We are trying to repress a massive financial crises by injecting mass amounts of liquidity to prevent a repeat of the 1930s. Despite that, the markets remain quite volatile.
EC: Check out this message board discussing the crazy volatility in the markets:
Brinker/Ferguson: Bob said in 1929, the Fed did the wrong thing by tightening monetary policy. We also did not have FDIC in the 1929 crash so we had a run on the banks. The third item, the anti-trade mentality we don¹t have now. Ferguson said he agrees with all of those, but the potential does exist for a breakdown in the trading system, not through tariffs, but through a scramble in central banks with some trying to weaken their currency to increase exports - a prime example being China who is terrified of what is happening to their exports. If every country tried that, it could be a big problem, especially when we need global cooperation. We still have a potential for that type of global breakdown. If everyone injects liquidity, and does it in an uncoordinated way, we could end up in a mess. In the 1930s, countries became detached from each other. Today, we are more interrelated so every act has a consequence globally.
Caller: Explain stagflation and is that a concern? Ferguson said stagflation was the nightmare of the 1970s where we had double digit inflation but falling growth and rising unemployment. Some people who have raised the specter of stagflation are worried that the Fed¹s action (and other central banks) could result in a return of inflation at a future date. Right now, that seems to be less of a worry. The banks in the private sector are trying to avoid credit, despite the Fed injecting liquidity. The monetary stimulus is not as terrifying if you look at more than the fed. Also, fear of inflation exceeds fear of deflation with the 10-year yield and other yields going incredibly low. There is no inflation fear. They are worried about deflation because of the high amount of leverage in households and the financial system. Bottom line, Bernanke is right that deflation is the main worry.
Caller: Could the stimulus package and all of the government efforts lead to a currency crises in the United States? Ferguson said the United States is in the unusual position of being at the center of the crises, yet still being regarded as a safe haven. That is why we have seen the dollar rally and foreign investors still piling into 10-year Treasuries. That gives us an advantage. Other currencies are weakening and will continue to weaken and we therefore have a cushion. As long as the dollar is regarded as the safest currency, even with the Fed printing money we don¹t have to worry too much. The demand for gold remains strong and many people view it as a hedge against inflation. But there is not enough gold to reset the gold standard. Ferguson said when he looks out 2-4 years down the road, he does not rule out inflation expectations increasing. But right now we have huge deflationary forces in the world that we didn¹t have in the 1930s. With households groaning under the weight of debt, there isn¹t much probability of soaring consumer expenditures which drives inflation. People are tightening their belts and the savings rate is already going up. The inflation in the Weimar Republic (Germany) in the 1920s is not something that is a threat.
EC: Germany went through its worst inflation in 1923. In 1922, the highest denomination was 50,000 Mark. By 1923, the highest denomination was 100,000,000,000,000 Mark. In December 1923 the exchange rate was 4,200,000,000,000 Marks to 1 US dollar. I can almost here someone saying, you know last year, I only paid a trillion marks for a haircut and now I am paying 4 trillion!
Brinker Comment: When you look back through the financial history, how can you put into context what has happened in the United States versus the study of financial history. Ferguson that this is the result of a strategy that goes back to the 1930s of steadily increasing the number of households that own their own homes through the mortgage of that debt. The majority of people rented before then. However, we had a sustained effort by the government through the creation of Fannie Mae/Freddie Mac and tax breaks for home ownership. This is not an undesirable trend and was part of the American dream. But the last decade we took it beyond a reasonable expectation when we allowed people to buy homes that should have rented. Without the encouragement by both parties, it would not have spiraled beyond control. We wanted people to lend to some households because it is socially desirable and it was practically mandated by Congress. In that scenario, it is not surprising to see shoddy financial practices.
EC: Fantastic guest! Niall Ferguson has written the book, ³The Ascent of Money: A Financial History of the World.² PBS has made a two-hour documentary based on this book which will premier on Tuesday, January 13th at 9 p.m. Eastern time. The film is written and presented by Niall Ferguson........"
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