Financial Nihilism: How the Federal Reserve Caused the Great Credit Crunch of 2008

8/3/2019 Financial Nihilism: How the Federal Reserve Caused the Great Credit Crunch of 2008

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Financial Nihilism: How the

Federal Reserve Caused the

Great Credit Crunch of 2008

A Research Paper

ABSTRACT: Whether you are a liberal or conservative, Keynesian or monetarist, socialist orlibertarian, most everyone agrees that there is something afoul in the American economy. Disagreementarises on what exactly caused this problem, and also what the solution to the situation is. In my paper, Iwill make the case that it is the Federal Reserve who is primarily responsible for causing the CreditCrunch of '08, and the subsequent recession. I will accomplish this by dividing the paper into foursections. The first section will deal with the Federal Reserve, detailing its functions and also theinstitutions history. Second, I will examine the various factors that contributed to the 2008 crash, givingextra attention to the actions of the Federal Reserve. Third, I will detail the government's response tothe crisis, and also produce my own criticism of it. Finally, I will end the paper by putting forth my

own set of solutions to the crisis, and compare them to other proposed solutions.


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PART 1: The Federal Reserve Its History and Functions

What is the Federal Reserve? Strictly speaking, it is the central bank of the United States,

charged with the tasks of determining monetary policy and enforcing specific regulations on American

banks. The Fed has a monopoly control over the money supply, thus being able to either expand or

contract it as it sees fit. Its three primary roles are to ensure full employment, price stability and also to

function as a lender of last resort. It is an independent regulatory agency which means that it is free

from political interference by both Congress and the President. The purported reasoning behind this

political independence is to give the Fed the tools it needs to make tough but necessary decisions

without fearing political repercussions. This sounds reasonable enough, but such a view of the Fed

ignores the more sinister and insidious history of this powerful institution.

Before I address the real intentions and purposes of the Federal Reserve, it first helps to

understand a little bit about the history of the institution (specifically how it was founded) so as to shine

some light onto the intentions and motivations of those who proposed its creation. In November of

1910, seven of the most powerful men in the entire world held a secret meeting on Jekyll Island. These

men were Senator Nelson Aldrich, the Republican whip and chairman of the National Monetary

Commission; Abraham Piatt Andrew, Assistant Secretary of the Treasury; Frank A Vanderlip, president

of National City Bank of New York; Henry P Davison, a senior partner of the J. P. Morgan Company;

Charles D Norton, president of J.P. Morgan's First National Bank of New York; Benjamin Strong, head

of J.P. Morgan's Bankers Trust Company; and Paul Warburg, a major share holder in Kuhn, Loeb &

Company and also a representative of the influential Rothschild banking dynasty. These 7 men had a

total net worth equal to 1/6 of the entire wealth of the world. (Griffin, pg. 5-6) Furthermore, the

meeting was very secretive, and it was not until over a decade after the formation of the Federal

Reserve that any of the founding members publicly acknowledged what happened on Jekyll Island. As

Griffin details, These strangers had been instructed to arrive separately, to avoid reporters and, should

they meet inside the station, to pretend they did not know each other. After boarding the train, they had


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been told to use first names only so as not to reveal each other's identity. If the meeting was

supposedly innocuous and harmless, why would these powerful gentlemen take such great precautions

to prevent the public from gaining knowledge about their plans? Such excessive secrecy should at least

set off a few alarms in the mind of a critical thinker.

These seven men met on Jekyll Island under the ruse of taking a vacation, and it was over the

course of that fateful week that the foundations and framework for what would eventually become the

Federal Reserve System were drafted. Although it was to be sold to the public as a necessary measure

for monetary stability and economic prosperity, the true intentions are far more sinister. I have already

established that the plans for the Fed were drafted by some of the wealthiest individuals in the entire

world, all of whom were connected to the banking and financial sectors in one fashion or another. Thus,

the thought of these bankers drafting up legislation to create what would eventually become the central

bank of the United States should bring one word to mind: cartel. And that is precisely what they

intended:

The purpose of this meeting on Jekyll Island was not to hunt ducks. Simply stated, itwas to come to an agreement on the structure and operation of a banking cartel. Thegoal of the cartel, as is true with all of them, was to maximize profits by minimizingcompetition between members, to make it difficult for new competitors to enter thefield, and to utilize the police power of government to enforce the cartel agreement. Inmore specific terms, the purpose and, indeed, the actual outcome of this meeting was tocreate the blueprint for the Federal Reserve System. (Griffin, pg. 8)

One may be tempted to dismiss these alarming claims as the delusions of a paranoid conspiracy

theorist, and thus should not be taken seriously. It is reasonable to be skeptical, and it is also true that

some conspiratorially-minded individuals do subscribe to this theory. But to dismiss these claims solely

because a few of its supporters rest on the fringe of the belief spectrum would be to engage in the

logical fallacy of poisoning the well, especially in the light of contrary evidence. As a matter of fact,

such a meeting was openly admitted 20 years later by none other than conspirator Paul Warburg

himself, in a book he wrote titled The Federal Reserve System, Its Origins and Growth. (Griffin, pg. 9)

The banking cartel known as the Federal Reserve System would enforce its goals through two


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main mechanisms. As a private business, a bank seeks to make profits and it accomplishes that task

primarily through the collection of interest on debt. In order to profit off of interest, credit must be

cheap and plentiful. In a free market economy with a commodity-backed currency (specifically gold),

the tangible asset backing the currency serves as a natural barrier to prevent banks from creating

excessive amounts of credit. This is good for the economy, as too much credit can have disastrous

effects, but it is not the most profitable for banks which rely on debt to make money. Therefore, one of

the Fed's main goals was to see that, ... the money supply ... be disconnected from gold and made

more plentiful or, as they described it, more elastic. (Griffin, pg. 13) By transitioning to a purely fiat

currency, the one barrier that a market uses to protect itself from excessive credit is destroyed, and thus

banks are free to lend and therefore profit at the expense of the economies long-term health.

The other primary goal of the Fed is to allow member banks to engage in this profit-seeking

loan creation for as long as possible to avoid collapse. In order to allow the usurious banks to stay in

business, they had to eliminate the threat of a currency drain. A currency drain, as defined by Griffin, is

a run on a bank that arises as a result of not having enough money to clear checks held by another bank.

This was only a risk, however, when the reserve ratios between banks differed. If all banks could be

forced to issue loans in the same ratio to their reserves as other banks did, then the amount of checks

to be cleared between them would balance in the long run. No currency drains would ever occur.

(Griffin, pg. 15) Clearly this is in the interests of the individual cartel members. Furthermore:

The entire banking industry might collapse under such a system, but not individualbanks at least not those who were a part of the cartel. All would walk the samedistance from the edge, no matter how close it was. Under such uniformity, noindividual bank could be blamed for failure to meet its obligations. The blame could beshifted, instead, to the 'economy' or 'government policy' or 'interest rates' or 'tradedeficits' or even to the 'capitalist system' itself. (Ibid)

Thus, by giving the Fed the authority to determine reserve requirement across the board, it had acquired

the tools that the member banks needed to excessively profit, insulate themselves from market forces,

and then blame an external scapegoat for the inevitable collapse. What could be better for the banks?!

PART 2: The Factors Behind the Crisis


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The Great Credit Crunch of 2008 was a catastrophic sequence of events which brought the

American economy to the brink of collapse. Starting with Countrywide Financial in early 2007, which

was one of the largest mortgage firms involved in the subprime market, the contagion of malinvestment

and bad debt swept the nation. Over the next 1.5 years, banks and financial intermediaries declared

bankruptcy and filed for Chapter 11, falling over like a row of dominoes. This insolvency started out

with smaller, subsidiary firms, but eventually worked its way into some of the largest banks in the

American economy. Major players such as J.P. Morgan, Bank of America and Citibank were all pushed

to the brink. The cascading failures eventually culminated themselves in the failure of Bear Stearns,

Bank of Americas purchase of Merrill Lynch, the Feds bailout of AIG, and the governments

nationalization of Fannie Mae and Freddie Mac. All of the aforementioned firms were amongst the

largest players in the financial and banking sectors, and these drastic events occurred relatively

simultaneous to one another, all within the period from September 7 to September 16, 2008. (St. Louis

Fed)

Although these four incredibly drastic events occurred within a very short period of time, they

were the culmination of a process which had been festering for years. In order to grasp a true

understanding of their cause, and also to better understand the financial crisis as a whole, one has to

look back a decade in order to understand these events in the context of recent history. Only by

following the money can one possibly hope to narrow down the various factors that lead to this crisis,

and also determine the primary catalyst. After examining the evidence, I have come to the conclusion

that there are three main culprits: deregulation, the creation of complex and leveraged financial

instruments, and the Federal Reserves manipulation of interest rates.

Recent history shows us that finance can play a large role in the success and failure of an

economy. In the past 3 decades, three of the biggest crashes (the 1994 residential mortgage crash, the

1987 stock market crash and the 1998 Long-Term Capital Management crisis) arose from

fundamentally new investment technologies, enabled by breakthroughs in desktop computing and by an


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influx of mathematics PhDs to Wall Street. (Morris, pgs. 38-9) And in the case of our own crisis, the

story is much the same. All the new technologies and strategies harbored dangerous flaws that tended

to reveal themselves only at points of great stress. Bigger, better, even more far-reaching versions of

[the financial devices from the 1980s and 90s] have now, in 2008, placed the entire global economy at

risk. (Ibid) One such asset that played a large role in the 2008 collapse was the collateralized mortgage

obligation (CMO), which is a subset of the larger class of collateralized debt obligations (CDOs).

A portfolio of mortgages would be dedicated to support the issuance of a family ofbonds. The bonds would be tiered in horizontal slices, or tranches, and portfolio cashflows were preferentially directed to the top tranches. Since the top tranches had firstclaim on cash flows, they qualified for the highest investment-grade ratings. The bottomtranches absorbed all initial defaults but paid high yields. The mix of very high-quality,high-rated instruments plus a smaller quantity of high-yield, high-risk paper matched upwell with the preferences of long-term investors. Wall Street inevitably pushed thetranching technology to an extreme, triggering a serious mortgage market crash in 1994.(Morris, pg. 73)

These CMOs became extremely popular financial assets, but were nonetheless risky. In order to hedge

this risk, financial mathematicians developed a security called a credit default swap (CDS), which is a

cheap way of hedging a portfolio's losses. They work as illustrated by the following example, For a

fee, US Bank will guarantee against any losses on a loan held by Asia Bank and will receive the interest

and fees on those loans, so its local customers will see no charge, but Asia Bank, in Street jargon, will

have purchased insurance for its risk portfolio, freeing up regulatory capital for business expansion.

(Morris, pg. 75)

Since these CMOs and CDOs were so profitable during the boom, the major ratings agencies

became complacent, and started stamping these volatile assets with high ratings. This gave investors

and savers the illusion that what was in reality a very risky and volatile asset class was a safe and sound

investment, which further contributed to the financial hysteria. During the boom, there were no

problems: prices just kept rising, investors made lots of profits, and everyone was happy. But what

nobody realized was that they were looking at the illusion of a boom economy, and not genuine and

sustainable economic growth. This influx of investors made the problem much more serious by


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exposing many more people to the eventual collapse.

Blinded by gratuitous profits, Wall Street investors decided to jack up their portfolios on

leverage, which further magnified the amount of profits they made. Although it can be (and was, for a

time) very profitable, leverage is also extremely risky: in addition to exacerbating profits, it also

magnifies losses. When something goes wrong, it can go very wrong as traders say, [leveraged

portfolios] 'eat like chickens and shit like elephants'. (Morris, pg. 50) CDOs and CMOs are already

shaky financial assets with enough implicit risk. Leveraging them only increases that risk. When the

economy was booming and prices kept on rising, this was not a problem. But because the rise in prices

was unsustainable, the eventual credit crash would necessarily cause prices to retrace downwards by a

large amount in order to account for the excessive rise in value. This means people can't pay their

mortgages, and in turn the value of the CMO's plummets. When you also factor in the leverage and the

CDS's, whose value is also affected by a decline in housing prices, it is no surprise that so many banks

were brought to the brink of collapse!

Although the United States government had many regulations in place designed to prevent this

sort of crisis from happening, they were selectively enforced and therefore not effective. One such

regulation which could have gone a long way in preventing this crisis was the Sarbanes-Oxley Act of

2002, which mandated a number of reforms to enhance corporate responsibility, enhance financial

disclosures and combat corporate and accounting fraud, and created the 'Public Company Accounting

Oversight Board,' also known as the PCAOB, to oversee the activities of the auditing profession.

(SEC.gov) Specifically, Section 501 of Sarbanes-Oxley modified existing securities regulations so that,

The [SEC] shall have adopted rules reasonably designed to require ... each registered broker or

dealer to disclose in each research report, as applicable, conflicts of interest that are known or should

have been known by the securities analyst or the broker or dealer, to exist at the time of the appearance

or the date of distribution of the report. (Sarbanes-Oxley, Sec. 501A-b) In other words, the Sarbanes-

Oxley act reformed the law to make it illegal for securities brokers to not disclose and make transparent


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to clients any potential conflicts of interest, such as the particular firms which they have received

compensation from. Because of the Enron scandal in the early 2000's, Sarbanes-Oxley was passed to

prevent this sort of fraud from happening again. But in the hysteria of the bubble economy, regulations

such as this were not enforced very effectively because the economy was doing so well, and nobody

wanted to ruin the party. After all, who needs regulations when everyone is getting a piece of the pie?

As a result of the booming environment, unscrupulous securities brokers engaged in widespread fraud

and dishonesty with their clients.

In his bookThe Two Trillion Dollar Meltdown, Charles Morris refers to this particular problem

of deceitful brokers as the 'Agency Problem', which he explains as, the problem of ensuring that an

employee, a contractor, or a company performing a service doesn't act against [the clients] interests.

(Morris, pg. 55) With the creation of CMO's, investment banks packaged up mortgages and sold them

within a matter of weeks. Individual brokers made their commission off of the fees associated with

these CMO's, so they were naturally incentivized to steer customers in the direction of investing in the

CMO's that generate the highest amount of fees. These CMO's were engineered by financial

mathematicians in such a fashion that, in a time of panic, a large sell-off of these CMO's would cause

an even more drastic decrease in prices. Thus, the agency problem gave rise to the issue of mortgage

brokers being incentivized to sell their clients a bunch of securities that, during a sharp selloff, rapidly

accelerate towards the value of $0. If Sarbanes-Oxley were more rigorously enforced, then the agency

problem would not have been an issue, and the sale of toxic assets like CMOs would have occurred far

less, because brokers would be forced to act in the best interests of their clients, rather than their

wallets. This would have saved peoples savings and increased the solvency of banks, which would

have the effect of greatly easing the financial crisis.

Another important regulation which was repealed in part was the Glass-Steagall Act. Glass-

Steagall had two major effects: the first was to establish the FDIC which insures all commercial bank

deposits, and the second was to legally separate investment banks from commercial banks. In other


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words, under Glass-Steagall the banks that average folks like you and I deposit our paychecks at were

not allowed to engage in speculation with our deposits. It was enacted as a response to the Great

Depression, which was caused in part by excessive speculation amplified by leverage forcing banks to

go insolvent. In 1999, the portion of Glass-Steagall which separated commercial and investment banks

was repealed by the Gramm-Leach-Bliley Act. This once again made it legal for commercial banks to

engage in risky speculation. This repeal also had the effect of encouraging the concentration of a

disproportionate share of the banking industry into the hands of the 5 largest banks. It quadrupled their

market share from roughly 10% to about 40%. (Competition Policy powerpoint, slide 35)

Although speculation of exotic financial devices and deregulation did contribute to the 2008

financial crisis, it would be foolish to consider them to be the sole cause of the crisis. Rather, the role

they played was one of amplification: these two factors made the crisis worst, but the credit crash was

going to happen regardless of whether there was excessive speculation and ineffective regulations.

There was a more fundamental change in the economy which created the environment in which

deregulation and excessive speculation could wreck havoc. In other words, the problems of

deregulation and speculation would have been minimally harmful had it not been for the manipulation

of interest rates on the part of the Federal Reserve. Furthermore, the moral hazard created by an

implicit Fed bailout greatly diminished individual risk to banks, which contributed to the problem.

Thus, I find it reasonable to pin the bulk of the blame upon the Fed as an institution.

Economic analysts generally agree that the Feds manipulation of interest rates was indeed

problematic. As Richard Posner so aptly put it:

The culprit is cheap credit rather than irrational behavior by business or consumers.Cheap credit stimulates economic activity, causing asset prices to rise, including theprices of residential real estate, which is a huge part of the nation's asset base. To takeadvantage of these rising prices, would-be buyers borrow more, so lenders lend moreand prices are driven still higher, and lenders borrow more so they can lend more.Leverage tends to rise and the rapid expansion of the banking industry causes strains. Atsome point the asset-price increase becomes unsustainable, but no one will know inadvance what that point is, and there is a rational reluctance to forego lucrative profitopportunities by bailing out before one senses that the plateau (follows by the inevitablecrash) is about to be reached. (Posner, pg. 105)


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The lower interest rates made it lucrative for banks to give loans to people with questionable

credit. These loans took the form of mortgages, as the Fed was specifically stimulating the housing

industry. Thus, a large number of mortgages were written, and these mortgages served as the basis for

the value of the various mortgage-backed securities that were the subject of destructive speculation.

Therefore, it makes sense to blame the Fed for creating the environment that promoted the speculation.

To the Feds credit, they did try to solve this problem before it became too serious. As David

Wessel points out, Greenspan did incrementally raise the interest rates in order to cool off the economy

before the bubble became too big. However, [The Fed] did so at what it described as a 'measured pace'

very slowly. Taking its foot off the monetary gas pedal ever so cautiously, the Fed raised the fed

funds rate by only one-quarter of a percentage point every six weeks or so. The rate didn't cross 3%

until March 2005. Greenspan took it to 4.5% on his last day on the job. (Wessel, pg. 55) So by the

time he got around to raising the rates, it was already too late: the damage done by manipulating

interest rates had already wreaked havoc on the economy. The action was too late and too slow to

make a difference. The bubble had been inflated too much, and the only possible course of action was

for it to deflate. No amount of interest-rate manipulation or central-bank meddling could have changed

this economic reality. Perhaps if the rates had risen more rapidly, the bubble could have collapsed when

it was not already so large.

PART 3: The Government's Response to the Crisis

The US government responded with an unprecedented heavy-handed set of actions. The two

main players here are the Federal Reserve, who responded via monetary policy, and the US Congress,

who passed the controversial TARP bill and also responded with fiscal stimulus. These government

forces worked together to produce what can be considered a moderate Keynesian response.

Specifically, the monetary response of the US government can be considered extremely Keynesian,

while the fiscal response was far milder in comparison.

In order to understand the thought process behind the monetary policy response to the Credit


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Crunch, it helps to look at Fed chairman Ben Bernanke's academic background. During his academic

career at MIT, Bernanke dedicated himself to studying the Great Depression. In 1983, he published an

article in theAmerican Economic Review on the causes of the Great Depression. In specific, Bernanke

highlighted the importance of banks and their role in the economy. Along with fellow MIT economist

Mark Gertler, he claimed to have found the missing link: the functioning of banks and financial

markets. Bernanke and Gertler emphasized the expertise, information, and relationships on which

banks relied to decide to whom to lend. When this 'credit channel' got clogged because banks were

closing (the Depression) or because they were trying to rebuild their capital cushions (the Great Panic)

the economy suffered. (Wessel, pg. 73) Knowing this, it is now easier to understand why Bernanke

chose the particular policy actions that he did.

What did Bernanke's Fed do, exactly? The Fed's actions can be briefly summarized as flooding

the economy with a tsunami of dollars as Charles Morris puts it. As a student of the Great

Depression, Bernanke saw the damage that runaway deflation could cause to the economy. Determined

to avoid repeating past mistakes, he swore to do anything in his power to prevent another deflationary

depression. His eagerness to engage in monetary activism has earned him the nickname Helicopter

Ben, because his critics believe he would shower consumers in money from a helicopter if that was

what was necessary. Although the Helicopter Ben moniker is a comical hyperbole, it is based on the

reality that Bernanke's response to our own depression has been an extremely loose monetary policy.

One of the drastic steps Bernanke took was to lower the Federal funds rate over the course of 2008

from the 4-4.5% range to 0-0.25% the lowest rate legally allowed (Federal Reserve Bank of New

York). This particular policy has been referred to in financial literature as ZIRP Zero Interest Rate

Policy. The rationale behind this decision is that the credit crunch created a liquidity trap, and that one

of the most effective ways to encourage the lending necessary to jump-start the economy was to lower

interest rates. The most effective way to promote this is by lowering the federal funds rate and that is

precisely what Bernanke did, in hopes that banks would resume lending.


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Another thing Bernanke vowed to prevent was a collapse of the banking system. The

bankruptcy of Bear Stearns, Countrywide Financial and Lehmann Brothers was eerily reminiscent of

the wave of bank collapses that happened during the Great Depression. Thus, Bernanke used whatever

tools available to prevent a similar systematic collapse. Through the Quantitative Easing (QE)

programs, Bernanke used the open-market operation of the Fed to help liquidate toxic assets held by

the banks, so that they could remain solvent and hopefully lend money out. The CDOs, CMOs and

CDSs discussed earlier had drastically plummeted in value, and this dealt a harsh blow to the balance

sheets of banks, decreasing their net worth by billions of dollars. That translates into billions of dollars

of losses in assets that the banks held on reserves, which could cause banks to go under should

depositors decide to withdraw their money out of panic an outcome Bernanke would not let happen

under his watch. Bernanke used his QE1 and QE-lite programs to purchase nearly $1.5 trillion worth of

toxic assets from the banks. Additionally, he pledged $800 billion towards the Quantitative Easing 2

program to purchase U.S. Treasury bonds from banks, in the hopes of stimulating lending. (Censky)

Compared to the Fed and its monetary policy reaction, the Congress' fiscal stimulus efforts are

much milder. The most immediate response to the crisis was the TARP (Trouble Assets Relief Program)

bill passed on October 3, 2008. In common political discourse, TARP is also referred to as the 'bailout'

bill. The bill spent $700 billion to purchase stocks, mortgages and other various securities from banks,

financial institutions and other companies which were threatened by the economic crisis. This had the

effect of bailing them out. In exchange for the purchase of toxic assets, the bailed out companies had to

agree to restructure themselves and put forth a plan to ensure that they would once again become

profitable. This controversial bill was enacted as an immediate form of fiscal stimulus, designed to save

large firms that were deemed too big to fail from declaring bankruptcy. The reasoning behind this

decision was that if these firms were allowed to fail, unemployment would drastically skyrocket

causing social unrest. The severity of the crisis was so bad that Treasury Secretary Hank Paulson was

on the record at a House Banking Committee meeting stating that, [sic] if this bill does not pass, there


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will be chaos and martial law in the streets. (U.S. House)

Later on, in February of 2009, President Obama signed into law the American Recovery and

Reinvestment Act (ARRA), which was another bout of fiscal stimulus. This time, the focus was on

alleviating unemployment and creating jobs. The bill effectively injected $645 billion into the US

economy - $288 billion came in the form of tax incentives and tax breaks, and the other $357 was

directly injected into the economy through infrastructure investment, jobs programs, education

spending, etc. At the time of the bill, unemployment was at 8.1% and steadily rising. This posed a dire

threat to the economy, and the ARRA was seen by Congress as one way to neutralize the problem. The

good majority of the direct spending has been used up, and another bout of fiscal stimulus referred to as

the American Jobs Act is currently being debated on in both the House and the Senate. The overall

effect of the ARRA has yet to be seen, but as of now, unemployment has hovered around 9%. One

could thus argue the ARRA was effective in the fact that it has stalled the increase in unemployment.

Part 4 My Criticisms of the Government Response & My Propose Solutions

I believe that the government has done the complete opposite of what it should do. At every step

of the turn it has made the wrong policy decision, and thus explains the reason why todays economic

climate is so dismal. Although the government has temporarily succeeded in the short term at delaying

the inevitable, it has done absolutely nothing to change the fundamental dynamics of our economy.

Trillions of dollars of junk bonds, toxic assets and volatile derivatives are still floating around in the

financial markets, tying up the capital resources of banks and other firms. The Fed is also still playing

games with the interest rate in hopes of steering the economy in the right direction. However, these are

precisely the root of the problem: until malinvestments and bad debt can be liquidated, and the interest

rate approaches the market equilibrium, the economy will continue to stagnate, and possibly even

collapse.

The first, and most grave, error the government has made was to engage in ZIRP. In a vain

effort to stimulate the economy, the government has set our economy down the path to a currency


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collapse that will drag the entire economy down with it. The reason being is that the near-zero interest

rates are artificially low and suppressed by the Federal Reserve. In an ideal market, the interest rate

would be much higher to promote savings which would give banks capital resources backed by actual

savings, not just printed money. However, the ZIRP produces the opposite effect: it discourages savings

and promotes consumer credit and consumption. This is not what the economy needs at this time; the

entire reason we are in this mess is precisely because there was too much cheap, easy credit that lacked

genuine savings necessary to make it sustainable.

What exactly, then, are the negative consequences of continuing to pursue ZIRP? As Mises so

eloquently put it, If there were no artificial restriction of the credit system at all, and if the individual

credit-issuing banks could agree to parallel procedure, then the complete cessation of the use of money

would only be a question of time. It is, therefore, entirely justifiable to base our discussion on the above

assumption. (Theory of Money and Credit,pg. 397) In other words, Mises is saying that the inevitable

result of pursuing ZIRP is a hyperinflation; a complete abandonment of fiat currency by the people.

This is due to the nature of fractional-reserve banking. Every time a bank makes a loan, they are

essentially printing money through the multiplier effect. However, in a free market, the interest rate

puts a natural cap on precisely how much money a bank can sustainably lend out by creating an

equilibrium between savers and debtors. However, when the interest rate is artificially pushed below

the market interest rate, loans become cheaper to make that they should be. This in turn incentivizes

both the banks to make loans, and consumers to take out loans. Credit flows through the economy, and

is effectively an expansion of the money supply the classic definition of inflation. Although it is true

that banks are not lending right now, it is only a matter of time until they resume their practices and

continue to lend, lest they cease to make profits and go out of business. And once that happens,

hyperinflation is inevitable.

Another nasty side effect of ZIRP is that it is extremely hard to leave ZIRP territory once it has

been entered. Because ZIRP promotes the creation of so much cheap credit, when the cost of credit


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rises, all the existing credit also raises in price. To leave the ZIRP range would make the burden of debt

on the general population unbearably painful, and would lead to just as bad an economic consequence

as hyperinflation. So, in a nutshell, by pursuing ZIRP the Federal Reserve has sentenced the American

people to either a hyperinflation or widespread bankruptcy & excessive deflation. Either way, the

situation is grim.

Another major policy mistake the government has made was to enact the TARP bill into law.

This economy is a mixed economy that leans more towards the side of capitalism, and in order for

capitalism to work there must be both winners and losers. Some firms, even big ones, will go out of

business. By bailing out the so-called too big to fail corporations, the government has created an

environment of moral hazard which completely neuters the ability of the capitalist economy to

sustainably recover itself. Judge Posner defines moral hazard as, the tendency to engage in risky

behavior if one is insured against the consequences of the risks materializing. (Posner, pg. 236) Posner

argues that the inevitable consequence of these bailouts is to create, an incentive for corporate

giantism and financial irresponsibility (which go hand in hand because the difficulty of controlling

subordinates grows with the size of an organization). (Posner, pg. 237) In effect, by passing TARP,

Congress has perpetuated and expanded the very same sort of corporate capitalism and irrational

exuberance that got this country into the current mess it is in. These firms should have been allowed to

fail, and had their assets liquidated on the market. The negative short-term effects would certainly have

been greater, but that is a necessary sacrifice which must be made for the sake of long-term

sustainability and survival.

The successive policies of quantitative easing are also a detriment to the economy. Although

Bernanke understandably wants to avoid a deflationary depression of the 1930s repeating itself, I feel

that he has veered too far towards the opposite but equally serious problem: excessive inflation. The

combined sum of all the QEs have monetized over $1 trillion dollars. That is a dangerously high

number, when one considers that the hyperinflation of the Weimar Republican happened as a result of


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monetizing only billions of dollars worth of debt. Right now, there is not too much inflation due to the

lagging nature of inflation, however the effects can be seen all around, albeit in a mild form. For

example, one need only look at the price of a gallon of gasoline, or groceries in the store, to understand

that there is indeed some inflation going on. The official CPI states inflation is at a reasonable 4%.

However as Kevin Phillips discusses inBad Money, the CPI is no longer an accurate metric of price

inflation due to the manipulation of its statistical indicators. Specifically, by introducing statistical

weightings and hedonics into the calculation, the CPI no longer measures general price inflation, but

rather the rate of price inflation to maintain a constantly declining standard of living. John Williams of

the website Shadow Government Stats has taken the liberty to measure the CPI using the old

methodology, before the introduction of statistical weighting and hedonics. His calculations show that

year-to-year price inflation is actually closer to 11%, compared to the official CPIs estimate of 4%.

One cannot help but think that quantitative easing has something to do with this; after all, as Milton

Friedman once famously said, Inflation is always and forever a monetary phenomenon.

Now that I have addressed what I believe are the errors in the governments response to the

credit crunch, exactly what sort of changes and reforms would I enact to get this economy going? Well,

the first and, by far, the most important change I would make would be to completely abolish the

Federal Reserve. Admittedly this is a radical proposition, but desperate times call for desperate

measures. If an institution is going to remain, it should have to prove itself to be effective at its stated

goals. For the Fed, those goals would be full employment and price stability. However, the facts dont

quite add up to support the claim that the Fed is effective at fulfilling its two mandates. Since [the

Feds] inception, it has presided over the crashes of 1921 and 1929; the Great Depression of 29 to 39;

recessions in 53, 57, 69, 75, and 81; a stock market Black Monday in 87; and a 1000% inflation

which has destroyed 90% of the dollars purchasing power. (Griffin, pg. 20) It is clear that the Fed has

done an extremely poor job at maintaining price stability, given the loss of 90% of the purchasing

power of the US Dollar. The Fed has also presided over the two worst economic depressions in the


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history of the United States, where unemployment has skyrocketed to over 20%. Clearly it is not

succeeding at its other mandate full employment. Furthermore, as discussed earlier, the Fed does not

have the best interests of the public at heart it is of the banks, by the banks and for the banks. This

isnt to say the Fed doesnt have a vested interest in fulfilling its mandate, because it certainly does.

However, as Griffin writes:

There is no doubt that those who run it are motivated to maintain full employment, lowinflation, and a generally sound economy. They are not interested in killing the goosethat lays such beautiful golden eggs. But, when there is a conflict between the publicinterest and the private needs of the cartel a conflict that arises almost daily thepublic will be sacrificed. That is the nature of the beast. It is foolish to expect a cartel toact in any other way. (Griffin, pg. 21)Furthermore, the Fed as a lender of last resort causes all sorts of problems. As discussed earlier,

the Fed creates an environment of moral hazard. The implicit guarantee of an emergency line of credit

subsidizes risky behavior that has the power to destroy an entire economy. One need only look at the

irrational exuberance of financial firms and the Credit Crunch to see what a destructive impact moral

hazard can have on an economy. Speculation is certainly a contributing factor to the overall problem,

but such reckless and rampant speculation is a product of an environment of moral hazard. Therefore,

in order to rid the markets of such irrational exuberance, one must strike the cause of the moral hazard.

And that cause is the Federal Reserve.

The last policy recommendation I would make to Congress would be to actually enforce

regulations that are on the books, and also to reinstate Glass-Steagall. Although free markets are

generally effective at creating economic prosperity and promoting sustainable growth, they have their

limits. An effective, fair and consistent regulatory apparatus must be in place in order to hold firms

accountable. Markets only work when the public has a maximal amount of information at their disposal

to make rational choices, and sometimes firms do not find transparency to be in their best interests.

Fraud and deceit can be profitable, and although they will undermine a business in the long run,

sometimes that can give them enough time to cause great damage to an economy. Therefore,

regulations need to actually be enforced in order to guarantee the complete honesty and transparency of


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business. As discussed earlier, a lack of regulatory enforcement was one of the major contributing

factors to the Credit Crunch of 08. To prevent another such crisis, regulations do need to be enforced.


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Conclusion

History has a tendency to repeat itself, and we just so happen to be living in such an era. Our

own depression is astonishingly similar to the Great Depression of the 1930s. We have lived through

one of the largest speculative bubbles in all human history, and are now paying the price for those good

times. However, unlike the Great Depression which had no historical antecedent on par with its

severity, we can learn from the mistakes of our past and look to the Great Depression to see what

exactly we can change, to prevent this from happening again. Ive come to the conclusion that, above

all, we need to abolish the Federal Reserve. Since its inception, the two worst economic downturns in

the history of the United States have occurred. Furthermore, the causes of these two depressions are

largely the same: speculation, deregulation, and the manipulation of interest rates by a central bank.

During the Great Depression, we didnt have historical hindsight because the Federal Reserve was a

relatively new institution, and had not presided over such a drastic crash. But looking back on our own

economic environment, we have the benefit of history on our side, and it makes one thing absolutely

certain in my book: that the Federal Reserve is the root cause of these problems. This banking cartel is

primarily responsible for sacrificing our economy so that its member banks could rake in gross

amounts of profit. We must abolish this institution and end the Fed, because if we do not, history will

be destined to repeat itself once more, and the next generation will have to suffer the misery which has

plagued my own generation. I certainly wouldnt want to inflict this economy on anyone!

Although the United States makes mistakes from time to time, it is a resilient nation of strong-

willed people who tend to do the right thing, and correct their mistakes. The Federal Reserve is not the

first central bank this country has been forced to endure. Weve had 2 banks before it, and each of those

were abolished in due time. I think its about time we scrap the third one.

Documents

Financial Nihilism: How the Federal Reserve Caused the Great Credit Crunch of 2008