Global Financial Crisis : Causes & Possible Cures —an Austrian Perspective

1. Global Financial Crisis : Causes & Possible Cures—an Austrian Perspective ……. a presentation by R.Kuppanna , General Manager, Kuwait India International Exchange Co. March 15, 2010

2. Introduction • Since mid-2008, • Severe global economic downturn – mainly US & Europe • Stock markets plunged; companies folded; economic fear, uncertainty, risk aversion increased • Extreme volatility across all markets: stocks, currencies, commodities, real estate

3. Introduction • Declining output, stagnant income, high unemployment, low growth rates • Financial system, worldwide, impaired; large-scale failures of banks/institutions/corporates (e.g. Merrill Lynch, Bear Stearns, Lehman Brothers, Citicorp, AIG, Washington Mutual, Countrywide Financial, Wachovia) • Sovereign failures: Iceland; Greece, Italy, Ireland, Portugal, Spain, UK in trouble

4. Introduction • China in trouble?? • Other crises looming? - currency, credit cards, commercial real-estate? • Crisis: from US Housing Bubble (sub-prime) • Repercussions beyond housing: secondary mortgage markets, rating agencies, capital markets, international markets etc. etc. “When the money goes bad, everything goes bad”

5. Background • Why did this happen? • Entire mortgage market (US) failing all at once? • How come this “cluster of errors”? • What is the root cause, if there is one? • Conventional wisdom: lack of regulation, uncontrolled markets, greed of businessmen. • Is it true? For this, we’ll have to look for explanations not in the prevailing Keynesian orthodoxy but elsewhere.

6. The Broken Window

7. Prime Cause • Government policies primary cause of crisis • Global economies: mixed, socialist, other variants of interventionist • Financial industry more government than private (in the US and other countries too) • Monetary system : fiat money and credit expansion • Potential for limitless inflation and massive deflation “Every step which leads from capitalism toward planning is necessarily a step nearer to absolutism and dictatorship” Dr. Ludwig von Mises (Omnipotent Government)

8. Residential Real Estate • $600+ billion overinvestment in residential real estate • Too many houses, houses too big, houses in wrong place. • Should have invested in technology, manufacturing capacity, agriculture, education, etc.

9. How Did Overinvestment of thisScale Occur • Only government can make a mistake of this magnitude possible • Primary Sources of Problems ― Federal Reserve ― FDIC ― Housing Policy ― Freddie Mac / Fannie Mae ― SEC “Abolish the Fed and then resign”, said Jim Rogers (on CNBC) when asked what two things he’d do if he became Fed Chief

10. Cluster of Errors • Businessmen not infallible; misjudgments result in failure; closed down; no surprises • When a great many businesses, all at once, suffer losses or have to close, that should surprise us • Why? Is it as Karl Marx says an “inherent feature” of market economies? • Here’s a clue “interest rate coordinates production across time”

11. Cluster of Errors • Lionel Robbins, British economist (first to use expression ‘cluster of errors’ in 1934): “Why should the leaders of business in the various industries producing producers’ goods make errors of judgment at the same time and in the same direction?”

12. Cluster of Errors • Things consumers actually buy don’t suffer from busts as much as do things produced in the higher stages of production, farther removed from finished consumer goods (i.e. capital goods).. • F.A.Hayek, economics Nobel laureate(1974), of an Austrian persuasion - - theory of the business cycle – great explanatory power “Is it not probable that disturbances affecting many lines of industry at once will be found to have monetary causes” Lionel Robbins ( The Great Depression ) , 1934

13. Business Cycle Theory • Building on the work of economist Ludwig von Mises, Hayek finds the root of the boom-bust cycle in the central bank…the very institution that postures as the protector of the economy. • Theory • Analogy of ‘home builder’ and ‘circus in town’ “The key economic activity that causes growth is not consumer spending but production.” - Yaron Brook

14. Contra: Prevailing Viewpoint “The remedy for the boom is not a higher rate of interest but a lower rate of interest ! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and keeping us permanently in a quasi-boom.” John Maynard Keynes

15. Government Policy As CausationFederal Reserve • Government owns monetary system – Unlimited federal debt / print money / inflation – Reduced capital requirements – Perception of “no” risk • Low savings rate – Significant mismanagement of monetary policy – Inverted yield curve The Fed is like “ an arsonist watching a fire he set, expressing amazement at how such an event could have happened”…Economist Gerald O’Driscoll (former senior Fed offical)

16. A Brief Aside • Credit Expansion underlay: > the recent housing bubble > the stock market bubble of the late 1990s > the earlier, long series of other booms/busts > the Great Depression of 1929 > the earlier stock market boom of the 1920s > bubbles of the 19th & 18th centuries, all the way back to the Mississippi Bubble of 1719 “Those who cannot learn from history are doomed to repeat it” - - George Santayana

17. Government Policy As CausationFDIC Insurance • Lack of market discipline • Moral Hazard • Examples: Indy Mac, WaMu, Countrywide

18. Government Policy As CausationHousing Policy • Increase home ownership above natural market rate • Tax policy • Affordable Housing / Subprime: NY Times 9/30/99 • Freddie Mac / Fannie Mae: Government sponsored enterprises – Would not exist in free market – Leverage 1000 to 1 – $5 Trillion – Government did have to “bailout” – implied guarantee – Politics • Freddie / Fannie primary current cause of housing/financial problems • Belief that housing prices never fall: based on government policies “The road to hell is paved with good intentions.” – F.A.Hayek

19. Fundamental Role of FinancialIntermediaries (Banks) • Liquidity Issue • Enable individuals to invest for longer periods than • savers want to have their money invested: Pool Risk – • credit and liquidity • Borrow short / lend long: significant role in creating • economic growth • When they cannot sell assets financial institutions cannot • meet liquidity requirements • Bear Stearns: solvent but not liquid • – Not happened in many years

20. Fundamental Role of FinancialIntermediaries • Leverage • Banks are leveraged 10 to 1 • Investment banks leveraged 30 to 1 • Federal Reserve has “encouraged” increased leverage to • fund government debt • SEC established capital rules for investment banks using • mathematical models • Pre-Fed banks leveraged 1 to 1 • Even conservative banks had to leverage to be competitive

21. Another Failure of Government Policy How Did Residential Real Estate Markets So Significantly Impact Capital Markets • Subprime mortgage crisis • Failure of rating agencies: S&P / Moody's / Fitch: Government sanctioned (SEC) • Market could not evaluate risk: no liquidity • Auction Rate Municipal Bond Market • Ambac, MBIC – Insurance / mortgage and municipal • S&P, Moody’s, Fitch rating of AMBAC, MBIC – not reliable • Lack of liquidity / bonds not marketable at almost any price

22. How Government Policy Created“Originate and Sell” Model • Federal Reserve / FSLIC systematically destroyed thrift industry • “Originate and sell model” replaces “originate and hold” • Freddie/Fannie drive many financial intermediaries out of mortgage markets due to government guarantees on debt: leverage 1000 to 1 – lower cost of capital – Encourages banks to hold riskier mortgages • Freddie/Fannie make “mortgage broker” origination model viable – Brokers feed Countrywide/Washington Mutual who feed Freddie/Fannie to meet “affordable housing” goals to keep support in congress

23. Originate and Sell • Perverse incentives for originations: sloppiness/fraud • S&P, Moody’s, Fitch (government sanctioned) make huge rating mistakes • Investment bankers create financial “innovations” under belief that Federal Reserve will keep risk in financial markets low • Investment bankers make irresponsible decisions based on pragmatic thinking: i.e., short term: irrational/lacks integrity/evasion/arrogance

24. Another Factor:Misuse of Credit Instruments • CDO / SIV / CDO2 (Double Leverage) – Failure of rating agencies (S&P, Moody’s & Fitch): Government sanctioned – Investment banks hold risky “strips” • Credit Default Swaps (CDS) – AIG • Rating agencies • Failed mathematical models • Investment banks “eat” each other: Bear Stearns? • State government pension plans / public university endowments invest in hedge funds who speculate in CDS and short stocks • Why Save AIG? – Insurance subsidiaries safe – To save Goldman? (crony capitalism or system risk?)

25. Misregulation: Not Deregulation • Regulatory cost at all time high at peak of bubble (2005-2007) – Sarbanes Oxley – Patriot Act • Irrational belief in “models” – Wachovia as “Best Practices” – BASEL/European banks • Huge misdirection of management energy • Bank Regulators pose major risk to residential construction and development industry – Talk one game / play another: unequal incentives for regulators

26. Failure of Government PolicySEC • Sanctioning Rating Agencies • BASEL rules for investment banks – Significantly increased leverage • Misregulation – Sarbanes Oxley – Meaningless, confusing, detailed disclosure • Short sale rules: not enforced • Ownership of accounting system -- Reliance on rules instead of principles – Fair Value – Loan loss reserves • Artificially created fluctuations in accounting results

27. Another Failure of Government Policy:Fair Value Accounting • New accounting rule: mark-to-market • Does not work when there is no market: ― Inconsistent with law of supply and demand: must be willing buyer and willingseller ― Violates “going concern” concept • Major Cause of systematic liquidity problem: Public companies not purchasing economically valuable assets because of accounting risk • Fails to consider gains. Example: bank retail deposits

28. Fair Value Accounting • Asset values should be based on projected cash flows, not “fire sale” value • If Fair Value Accounting applied in 1990 U.S. financial system / economy would have failed • If applied to all business in U.S. as applied to financial intermediaries: 90% of U.S. businesses would be insolvent given lack of liquidity in markets • SEC (government agency) makes accounting rules: i.e., laws: primary supporters of Fair Value: State Government and union pension plans

29. Fair Value Accounting Did Fair Value Accounting play a role in the crisis? Research : Two streams > FVA provides information relevant to investors ..messenger carrying bad news > Undermines core of financial reporting (difficult to verify, unreliable assumptions provides management with too much discretion; hence not a neutral or unbiased messenger)

30. Fair Value Accounting FVA creates a circular dynamic in financial reporting: markets provide inputs for measurement, affecting reported earnings, and then used by investors to assess firm’s market value. Earnings volatility in line with market volatility, fuelling investor apprehensions. FVA – allows managers to postpone day of recognition; create distortions in investors/regulators.

31. Market Corrections Are Not All Bad • World is a better place to live with Countrywide and WaMu out of business: misallocations of capital. • Credit standards were far too loose at peak of bubble: standards need to be tightened – Excessive leverage • Saving rate needs to be increased • Overinvestment in housing needs to be corrected: less capital to housing: more to productive investment • We needed a correction: natural market process: creative destruction • We did not need a panic: never would have had excesses and misallocations of this magnitude without government policy – We would have experienced minor corrections all along

32. “Panics” Are All Bad • Action of Federal Reserve, Treasury, President and Congress have created “panic” – $700 billion: scary amount – Inconsistency (Citi vs. Wachovia / Goldman vs. Lehman) – Unpredictability • “Panics” negatively affect even the best run financial companies and the overall economy • Even best run financial institutions had to compete against risky institutions • Remember: Financial institutions borrow short and lend long: – “Panic” creates liquidity risk for all – Lending standards being too tight is destructive – Self fulfilling spiral down • Deflation is extraordinarily destructive

33. Plight Current plight is result of credit expansion & malinvestment it engenders Other consequences of credit expansion: > encourages high debt & dangerous leverage > lower cash holdings relative to scale of economic activity ( of firms)

34. Road to Recovery Answer stems from knowledge of credit expansion and its consequences Contra the prevailing Keynesian view of spending way through crisis A major misconception: It ignores that fundamental problem is not insufficient spending but insufficient capital (losses caused by malinvestment)

35. Road to Recovery Ignores the fact that credit expansion has brought about excessive debt / insufficient cash Too little capital, too much debt, and not enough cash are problems faced Essential , for recovery, to fix widespread problems in the balance sheets of firms

36. Road to Recovery -- 100% Reserve Establish a 100% reserve system against checking deposits (end credit expansion and prevent deflation of money supply). Ideally, though, the reserve would be in gold That’s the ultimate, long-term solution Establish freedom of wage rates and prices to fall…this to eliminate mass unemployment

37. Road to Recovery Would greatly enhance banks’ capital which would be more than enough to cover loan/investment losses and thus eliminate government ownership & management of banks Though, it can’t control the increase in paper-currency and paper-currency reserves This would require a 100%-gold-reserve system

38. Road to Recovery Freedom of wage rates and prices to fall must be established (repeal of pro-union and minimum-wage laws) Educate public about the errors of the Marxian exploitation theory…actual knowledge of what determines wages and standard of living to be explained

39. What Are Possible CuresLong Term • Most fundamental issue is the attack on capitalism / free markets – We do not have a free market in U.S.: mixed economy – Financial system is primarily government owned: Federal Reserve – By far the primary causes of current financial crisis is government policy, not market failure: Federal Reserve, FDIC, Housing Policy, Freddie / Fannie, SEC, HUD • Less regulation, not more “Those who expect to reap the benefits of freedom, must like men, undergo the fatigues of supporting it.” Thomas Paine ( The Crisis Number IV )

40. What Are Possible CuresLong Term • Privatize / Liquidate Freddie/Fannie – After crisis: 2011 – Political risk / affordable housing • Return to originate / hold for residential mortgages: Do not attempt to salvage originate / sell model: Canada – Reintermediate to banking system – Do not “save” irrational competitors: mutual money funds • Federal Reserve stripped of powers: one basic goal to grow monetary supply at fixed rate (Milton Friedman – 3%) – Do not manage in short run • Consider market based monetary standard (gold) – Federal Government owns monetary system: unlimited federal debt

41. What Are Possible CuresLong Term • Raise capital requirements for bank (especially “start ups”) – Reduce FDIC insurance back to $100,000 • Make it explicitly clear that Federal Reserve can not/will not “save” non-banks – If you buy GE’s commercial paper that is your risk • Stop subsidies to housing (tax policy) • Encourage productive investment – low/neutral tax rates: tax consumption, not savings – increase productivity • Free trade

42. What Are Possible CuresLong Term • Carefully and systematically privatize Medicare, Social Security, and education • Significantly cut cost of defense: By defending U.S. – not “saving” world • Encourage immigration of the productive and hardworking; especially well educated • Restore discipline to system – Save more – Spend less

43. Deepest Causes are Philosophical -Different Than You May Think • Altruism – Affordable Housing – Redistribute from productive to non-productive – No one has a right to their own life • Pragmatism – Short term: What works: Subprime worked for several years – Irrationality – Lack of integrity • “Free Lunch” Mentality – Social Security – Medicare • Lack of Personal Responsibility – Death of Democracies: Tyranny of Majority

44. Deepest Cure is Philosophical • Life, Liberty, and the Pursuit of Happiness – Right to your life and your happiness – Personal responsibility – No “free” lunches • Demands and rewards rationality / self-discipline • Pursuit of each individual’s long term rational self-interest in the context of the “Trader Principle” – creating win/win relationships

45. The Trader Principle There is no conflict of interests among men who do not desire the undeserved, who do not make sacrifices nor accept them, who deal with one another as traders, giving value for value. The principle of trade is the only rational ethical principle for all human relationships, personal and social, private and public, spiritual and material. It is the principle of justice. -- Ayn Rand

46. Summing Up

47. Global Crisis - - Causes US Government’s Encouragement of Risky Mortgages to “sub-prime” borrowers (Community Reinvestment Act, Federal Housing Administration’s lowering of down-payment standards, Dept. of Housing & Urban Development’s pressure on lending institutions) Freddie Mac & Fannie Mae grew to own or guarantee about 50% of the $ 12 trillion mortgage market. ======================================= All that is necessary for the triumph of evil is that good men do nothing - - Edmund Burke

48. Global Crisis - - Causes Moral Hazard caused by Freddie/Fannie Cheap Money Policy of the Fed that fueled these risky mortgages (fed rates down from 6.25% to 1.75% in 2001; reduced further to a low of 1% in mid-2003)

49. Global Crisis - - Consequences Riskier mortgages, irresponsible buying/lending of loans, rising volumes, skyrocketing housing prices, price crash, rising defaults, bankruptcies of major institutions, cascading effects on other markets, global meltdown, decline in income/savings, rising unemployment, risk aversion, massive wealth destruction… Demand for more intervention, stimulus/bailouts and more of the same disastrous policies Seeds for another, greater CRISIS

50. Your Choice From a state monopoly on money, to state guarantees of bank liabilities, to state sponsorship of mortgages, to state ownership of banks ---the progression in the past century has been to move away from free markets toward socialist banking. The welfare state and its main financier, the Federal Reserve, are ultimately “justified” on the grounds that the government has a moral duty to provide the needy with goods and services – from education to health care/insurance to mortgages. Think!! The choice between the alternatives is yours. So are the consequences.