The Bang! Moment Shock

By John Mauldin

Jul 13, 2013


Future shock is the shattering stress and disorientation that we induce in individuals by subjecting them to too much change in too short a time.

– Alvin Toffler

What is it about humans that we fail to see a crisis in advance, yet when we look back, its likelihood or inevitability so often seems blindingly obvious? Rather than a flaw, our under-reliance on foresight as opposed to hindsight is perhaps a necessary evolutionary design feature that has allowed us to make rapid progress as a species (especially over the last few thousand years), but in a complex modern society it can really create quite the crisis for individuals. This week we resume our musings about Cyprus, to see what that tiny island can teach us about our own personal need to engage in ongoing critical analysis of our lives and investment portfolios. Cyprus is not Greece or France or Spain or Japan or the US or … (pick a country). I get that. No two situations are the same, but there may be a rhyme or two here that is instructive.


This Country Is Different


In 1974, Turkey invaded Cyprus. Eventually the island was divided into two zones, and Greeks in the Turkish zone, like Turks in the Greek zone, were forced to leave with only the clothes on their backs and little else. That was a defining moment for Cyprus, and the aftershock is still evident when you get past the normal polite conversation. Plus, the wall dividing the two countries is always there when you are in the capital city of Nicosia, although lately there are a few places where you can cross into the other zone. The first night I was in Nicosia, we ate dinner outside at a Greek taverna (what else?) that stands almost in the shadow of the wall.

One hundred years after the Civil War, the South of my childhood was still mixed up with the aftereffects of that war. The war in Cyprus was less than 40 years ago. Another evening we went to a local club where the members were Greeks who had been expelled from a particular neighborhood in the Turkish-occupied area. Many looked young enough that they could not have been alive during the war, but the memory of the "old neighborhood" was still strong among them.

These people lost homes and businesses, jobs everything. They had to start over. (I am sure it was that way for the Turks who had to relocate as well.) But for the next 40 years there was very steady economic growth, 4% or so a year over time. The people took advantage of what they had. There was no university, so children went abroad to study and work and then came back, generally with skills.

The legal and accounting professions grew particularly strong. Like two other former British island colonies, Singapore and Hong Kong, Cyprus became a financial center. Fifty double tax treaties later, the island had become a place to domicile companies, handle taxes and accounting, etc.

And then they branched out into banking. After the creation of the euro, the deposit base of Cypriot banks went through the roof, until it was up to six times the size of local GDP (depending on whom you believeofficial sources make it closer to five times). By some measures, Cyprus had the second wealthiest population in Europe and certainly one of the best educated. Twenty-five percent of the world's ships were operated under the flag of Cyprus. Because the country had been a member of the nonaligned movement in the '80s (remember that?), it had good ties (and double tax treaties) with Eastern Europe and the USSR.

Some of the kids went to university in Russia and developed contacts there. After the collapse of the Soviet Union, it was natural for Russians to use Cyprus as a conduit to the West.

Cyprus has, by some accounts, the best beaches in the Mediterranean, and so more and more people came and built vacation homes. They brought their money with them and deposited it in the local banks and took out loans to build their homes. Real estate prices climbed and climbed. Below are Cypriot bank deposits and loans from 2009 through April of this year (data from the central bank).

 

Unemployment was quite low, less than 4% in 2008, although the global credit crisis led to a gradual rise (though nothing like that seen in the rest of Europe). Much of the new unemployment was in the construction industry, which fell into a slump along with the rest of Europe during the crisis.



Banking soon became the biggest industry. There were more banking branches per capita in Cyprus than anywhere else in the world, more than double the European average.

And there were over 40% more employees per branch than in the average eurozone country. Money was easy to get, so debt exploded by over 50% in both businesses and households in just six years, from 2005–2011.

The country had always run a current account deficit, but by 2008 that deficit had topped 15%, keeping pace with Greece's and Portugal's. However, earnings and productivity had more than kept up. Cypriots worked hard and offered good value for their services. They saw themselves as different from the other Southern European countries. But, as in much of the rest of Europe, public-sector employment doubled from 1990, with the second-highest government wage bill (behind Denmark's) and a monstrous 50% growth in social benefits in the last 10 years.

Still, starting in 2003, public debt-to-GDP actually fell. Why ring the alarm bell when things are getting better?


Cyprus: Public sector debt as % GDP 1995-2012


There were in fact no alarms bells ringing as 2012 opened. But there should have been. Cyrpiot banks were flush with cash. They bought foreign banks in Greece and Russia. They made ever more loans and then looked around and decided that Greek sovereign debt was something they needed more of.

And then came the Greek sovereign debt crisis, and the capital base of the Cypriot banks was essentially wiped out. But the ECB and the EU had bailed out Irish and Spanish banks; and so depositors in Cyprus, many of them Russian, decided, along with the local citizens, to leave their money in the banks.

The country had been under the parliamentary control of the Communist Party since 2008. Seriously. Supported by the Orthodox Church. (Note that public debt began its serious rise after the communists came to power). No one reined in the banks, and they grew ever fatter and more exposed until the crisis hit. Then Cyprus could no longer fund its debt and needed EU help. Further, the Central Bank of Cyprus (not to be confused with the commercial Bank of Cyprus) had to make emergency liquidity loans to Cypriot banks that had to meet demands for withdrawals and could no longer raise capital. There was not a bank run, but there was a fast-paced walk.

The ECB balked, as the quality of the collateral offered did not come close to the standards of the Emergency Lending Assistance (ELA) program. The government of Cyprus needed money to fund its basic needs as well as to "roll over" its debt as it came due. The EU basically declined to negotiate, as there was a Cypriot election scheduled for late February, and the EU preferred to wait to see the results before acting. There was talk of a "bail-in" (where depositors would shoulder some of the loss), but as usual that proposal came from the Germans, and the rest of Europe would surely not agree.

The new president assumed office and saw immediately that the country was in trouble. He tapped Michael Sarris, a "technocrat," to be his finance minister. Sarris was the man who had helped bring Cyprus into the euro and who oversaw the reduction in Cypriot debt. While he was not a member of the winning political party, he had been at the World Bank and had relationships with many of the finance heads of Europe.

Sarris went to Brussels, only to find no friends of Cyprus there. The Germans privately told him they would approve no bailout of Russian depositors (rumored to account for over half of the base of some of the banks) prior to the German elections this fall. Cyprus was seen as a money haven and a place for rather loose tax accounting. I have to admit that many of the Cypriots I talked to knew that money laundering was going on. It was a very open secret. Cyprus had very strict rules, but it seems there were ways to engineer exceptions.

In the end, Cyprus makes no difference – that was the perception in Europe, and while they were just talking a few billion euros here and there, a fraction of what Ireland or Spain needed, there was just no sympathy for Cyprus. Many of the European finance ministers wanted to establish the questionable principle that bank deposits were no longer sacrosanct, and Cyprus was just not seen as a systemic risk. The best deal Sarris could get was a 6.75% "tax" on deposits of less than €100,000 and 9.9% above that, with the aim of raising €5.8 billion. That was on a weekend, and by Monday, when Sarris returned, the indignation in Cyprus had grown to the point that not one politician voted to accept the deal.

A bank holiday was declared and Laiki Bank was put into receivership and closed as a "bad bank," but within a week the EU decided to insure all deposits up to €100,000, the number that "everyone" had understood to be the safe deposit amount. The banks eventually reopened, but Cyprus placed capital controls on deposits and limited withdrawals. A euro in a Cypriot bank was no longer the same as a euro in an Irish bank.

The Economist wrote shortly thereafter:

"The Cypriot deal has no coherence in the larger context. The euro crisis has been in abeyance for a few months, thanks largely to the readiness of the European Central Bank to intervene to help struggling countries. The ECB's price for helping countries is to insist they go into a bail-out programme. The political price of going into a programme has just gone up, so the ECB's safety net looks a little thinner. The bail-out appears to move Europe further away from the institutional reforms that are needed to resolve the crisis once and for all. Rather than using the European Stability Mechanism to recapitalise banks, and thereby weaken the link between banks and their governments, the euro zone continues to equate bank bail-outs with sovereign bail- outs. As for debt mutualisation, after imposing losses on local depositors, the price of support from the rest of Europe is arguably costlier now than it ever has been."

Since then, the crisis has deepened. Deposits of over €100,000 in Laiki Bank, which was the second largest bank in Cyprus, have been completely wiped out. The bad debts of Laiki Bank were forced into the Bank of Cyprus, saddling their depositor base with approximately 60% losses.

If you had a business with over €100,000 deposited in Cyprus, you are likely out of business. Many businesses that were going concerns on March 14, 2013, when the crisis fully erupted, were out of business a few days later. All the employees lost their jobs and their benefits. Unemployment will soon reach 20%. For now, all of the branch banks are open, but at least half will soon be shut.

On an ironic note, the EU resisted any talk of Russian banks coming in to take over the failed Cypriot banks. Now it looks as if Russian citizens may own over 50% of whatever is left of the Bank of Cyprus.


The Bang! Moment Shock


Cypriots are deeply shocked by these events. From "insiders" who sat on boards to politicians and ordinary citizens, no one can believe that the EU treated them the way they did. I was asked time and again, "How could this happen?" and not just by ordinary citizens.

I talked with one lady who had just retired from the Bank of Cyprus. She had 100% of her pension and life savings at the bank and now faces losses of up to 60%. She had no idea the crisis was coming. Interestingly, she and others I spoke to insisted that the Bank of Cyprus was a good bank. But when asked if she would redeposit her money in a Cypriot bank when (if) she ever gets it out, she shook her head no. The trust in the system is gone.

I talked with Symeon Matsis, a man in his early 70s who was at one time in charge of planning at the Ministry of Finance. He carried a copy of This Time Is Different by Rogoff and Reinhart. It was dog-eared and full of notes. "I am reading it so I can try to understand what happened to us. The more I read the more I understand that they were describing Cyprus. And we did think that 'This country is different.' Which is why the crisis has been such a shock to our local culture."

The Cypriots believed not just that their country was different but also that the stability they had seen for 40 years was normal and easy to achieve. Why would it end? They were just doing their jobs, and everything seemed OKuntil it wasn't.

Humans are hardwired to be optimists. Keeping our chins up is the only way we can keep working today and have hope for the future. If we lose that optimism, what Keynes called our "animal spirits," then why should we take risks? And the growth of free markets and capitalism over the last 500 years is nothing if not the growth in our ability to tame risk, through institutions such as insurance companies and corporations and mechanisms such as securitization and pensions. (I highly recommend the masterful book, Against the Gods: The Remarkable Story of Risk, by the late and sorely missed Peter Bernstein. This is on my list of must-read books for everyone who asks.)

But with all the controls we have created, we still have not reduced risk to nothing. And the biggest risk is that created by our own politicians and institutions – by those we trust to somehow protect us from risk.

We write laws to protect us from politicians and government, limiting the power of the state to encroach on our lives. The citizens of Cyprus thought they had rules protecting them, too, but at the end of the day, there were no rules.

The central bankers and finance ministers of Europe are making the rules up as they go along. The monstrously long EU treaties and other eurozone agreements are wide open to bureaucratic interpretation.

If you live in the EU, you now must understand that the central risk to your financial well-being is the very governments you have asked to protect you from that risk. Many of those governments have made promises they cannot keep. I wrote a few weeks ago about the problems in France. I heard from some French readers who disagreed with me. The gist of their arguments boiled down to "we are different."

I agree that France is different in the sense that France will find some uniquely French way to deal with its crisis of too much debt and leverage, a government that is too large, and a system that is sclerotic. But whatever that is, it won't save France. French citizens and their politicians feel that their pensions, investments, and lifestyles are safe. Yes, things may have to change, they say, but not in any fundamental sort of way. They feel pretty much like the citizens of Cyprus did until March.

The word catastrophe is the same in English and French. And at some time in the future, lacking serious reform, a catastrophe is what France is facing. The same is true of dozens of countries in the "developed" world.

We love to tell ourselves that this time is different. But outcomes among countries with debt and deficits out of control, constrained by a limited ability to grow their way out of their problems, are unmistakably similar. Each country has its own reasons for thinking it is different, and right up until the end it goes on telling itself that it is. And then people are shocked when one day they wake up to a very different reality.

Michael Sarris did not come back empty-handed. He came back with billions of euros from the EU and the ECB. It just wasn't enough to keep things the way they were. The same plotline is repeated in Greece, Spain, and the rest of peripheral Europe.

Europe is making up the rules to deal with its crisis. Do you remember my writing about the very creative way the Irish dealt with their debt? Where was that in the rules? When the next phase of the crisis hits, the Europeans will make up more new rules. And that near certainty poses a serious risk for Europe.

Of course, we in the US are different. We have the rule of law. That's what we all learn in school and what we keep telling ourselves, anyhow. Well, except that we find the President now wants not to have to deal with a law he helped pass, and so some third assistant at Treasury was appointed to mention as everyone went home for the holiday weekend that parts of the Affordable Care Act will be postponed without consulting with Congress, which is supposed to be involved in the whole law thing.

It's not just this president; it's everywhere. We have wandered far down the path from the rule of law to rule by lawyers. We have a Congress that refuses to deal with our deficit crisis in any manner.

We have a central bank that is afraid to let the stock market learn to cope without easy money and financial repression, thereby making the bankers and finance world rich but hurting the average citizen. Indeed, low rates are killing those who worked and saved all their lives and now need to receive at least modest returns on their savings just to live.

My suggestion is that you pay attention to what is going on around you. If things are out of balance, do what you can to not get caught in the problem. It is almost never, ever different this time. You do not want to experience your own personal Bang! momento.

It is time to hit the send button. It is still light outside this evening, so I did something right this time, schedule-wise. Have a great week.

Your thinking economics is stranger than science fiction (and maybe even scarier!) analyst,

John Mauldin

Copyright 2013 John Mauldin. All Rights Reserved.


Bernanke's Comment

Doug Noland

July 12, 2013 


Somehow the Fed has succeeded in making unstable global markets even more so.


I read with keen interest chairman Bernanke’s paperThe First 100 Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future,” presented Wednesday to the National Bureau of Economic Research:

“In the words of one of the authors of the Federal Reserve Act, Robert Latham Owen, the Federal Reserve was established to ‘provide a means by which periodic panics which shake the American Republic and do it enormous injury shall be stopped.’ In short, the original goal of the Great Experiment that was the founding of the Fed was the preservation of financial stability. At the time, the standard view of panics was that they were triggered when the needs of business and agriculture for liquid funds outstripped the available supply--as when seasonal plantings or shipments of crops had to be financed, for example--and that panics were further exacerbated by the incentives of banks and private individuals to hoard liquidity during such times. The new institution was intended to relieve such strains by providing an ‘elasticcurrency--that is, by providing liquidity as needed to individual member banks through the discount window; commercial banks, in turn, would then be able to accommodate their customers.

Dr. Bernanke is renowned as a preeminent expert on the causes of the Great Depression. We share the view that understanding this historic downturn is indeed “the Holy Grail of economics.”

Bernanke’s views of monetary policymistakesmade early in the 1930s profoundly shaped the Fed’s monetary policy doctrine following the post-tech Bubble downturn and then even more so during this extended post-mortgage finance Bubble period.

I take strong exception with what has over decades become a distorted revisionist view of the 1920s and 1930s periods. For starters, I’ll take issue with the general context of how Bernanke explains the objectives of the new Federal Reserve back at its inception in 1913. The U.S. economy and banking system had suffered through decades of destabilizing boom and bust cycles. While having a central bank to help manage systemic liquidity issues during crisis periods was advantageous, the critical role for the Federal Reserve was to more effectively regulate Credit – to try to avoid crises. There was a clear appreciation at the time that Credit and speculative excesses were the bane of financial stability.

It is worth noting that Bernanke and others’ historical accounts of the 1920s basically disregard a crucial fact: The Federal Reserve patently failed in its responsibilities to safeguard financial stability during that period. It basically accommodated a runaway boom. By intervening to limit downturns and backstop system liquidity, the Fed nurtured historic financial and economic Bubbles. It failed in regulating Credit and it failed in dealing with historic financial excess. Its policies were instrumental in what evolved into epic economic maladjustment and imbalances on a globalized basis.

Dr. Bernanke and others gloss over these failures, preferring instead their ideological focus on activist central bank post-Bubblemopping up stimulus and market interventions. When Milton Friedman in the early-1960s canonized the 1920s as the “Golden Age of Capitalism,” this seemingly brought to an end the critical evaluation of one of the most relevant periods in financial, economic and policy history. The focus shifted to post-Bubble policy activism.

The Friedmanite view holds that the Fed committed a dereliction of duties by not dramatically loosening policy and printing money early in the 1930’s downturn. From Bernanke: ‘The Great Depression was the Federal Reserve's most difficult test.

Tragically, the Fed failed to meet its mandate to maintain financial stability.” I would argue that mistakes are indeed commonplace in the fog and confusion associated with bursting Bubbles (look no further than contemporary Europe). Post-Bubble landscapes are fraught with financial, economic, political and social upheaval and discontinuities – and this is a critical reason why central banks should place money, Credit and Bubble analysis prominently in policy doctrines.

I strongly believe that the Fed’s fateful dereliction of responsibilities was committed during the 1920s accommodation of destabilizing Credit and speculative excesses, especially late in the decade. While they may very well remain latent throughout a protracted Bubble period, the reality is that the foundation of financial stability is compromised during the boom. Moreover, the greatest risks to systemic stability manifest during the boom’s late-cycle period, often as authorities move to aggressive interventions in an attempt to stave off the collapse of increasingly vulnerable Credit and speculative Bubbles. This is a most relevant topic, as I believe the Bernanke Fed is now repeating errors similar to those committed by the Benjamin Strong Federal Reserve during the late-twenties period.

Benjamin Strong, first head of the Federal Reserve Bank of New York (1914-1928), is a controversial figure. He was the dominant leader at the Fed during the twenties – the Greenspan or Bernanke of that era. And based on one’s historical/ideological perspective, he was either the central bank genius whose death in 1928 left a fateful leadership void at the Fed - or a dominating activist central banker much too eager to intervene in the marketplace and accommodate a historic Bubble.

From “Benjamin Strong, the Federal Reserve, and the Limits to Interwar American Nationalism…,” Priscilla Roberts, Federal Reserve Bank of Richmond Economic Quarterly, Spring 2000):
 
The most notorious episode of monetary ease, however, occurred in July and August 1927, when Strong, though alarmed by the American market’s speculative and inflationary tendencies, nonetheless forced through the Federal Reserve System a decrease in the discount rate from 4 to 3 percent. This move relieved the excessive pressures to which the initial level of American interest rates was subjecting the dangerously shaky [British] pound. In July 1927 the central bankers of Great Britain, the United State, France, and Germany had met on Long Island in the United States to discuss means of strengthening Britain’s gold reserves and the general European currency situation. Strong’s reduction of discount ratesappears to have been the direct result of this conference. Indeed, according to Charles Rist, one of the French central bankers who attended, Strong said that the American authorities would reduce discount rates as “un petit coup de whisky for the stock exchange.’ Strong pushed this reduction through the Federal Reserve System despite strong opposition

Throughout the Roaring Twenties, U.S.-based Credit became an increasingly dominant source of finance internationally. Some have criticized Strong for being too close to Wall Street. He was definitely a avid proponent for the U.S. taking an active internationalist approach with policymaking.

Strong came to recognize the powerful new tools available for the Fed to lower market yields, bolster system liquidity and backstop the financial markets (at home and abroad). The Fed in general believed the proliferation of productivity-enhancing technologies and low (and falling) inflation provided an opportune backdrop for implementing accommodative monetary policy.

There was definitely a New Era/New Paradigm mentality that took root at the Federal Reserve, in Wall Street and throughout segments of the real economy. Enlightened policymaking ensured a “permanent plateau” in U.S. prosperity – or so leading economic thinkers believed heading into 1929.

The Great Credit Inflation/Bubble that set the stage for the Great Depression generally commenced with the outbreak of World War I. There are myriad disconcerting parallels between that period and today's ongoing Credit Bubble – including extraordinary technological innovation, U.S. dominance of global finance, major destabilizing financial innovations, expanding use of leverage in financial speculation, and expanding domestic and international financial and economic imbalances. In both periods, I would argue, central banking policy doctrine was ill-prepared for the major evolutions in the functioning of economies and financial systems. In the twenties, central bankers were confused by how new technologies and a global Credit boom had altered inflation dynamics, while failing to appreciate the latent financial and economic fragilities associated with a long period of rampant Credit growth and leveraged speculation. They unwittingly accommodated Bubble excess – and then systemically tried to sustain the boom when Bubble fragilities became acute risks to global financial and economic systems.

I’m sticking to my view that chairman Bernanke moved forward last summer with open-ended QE primarily because of worsening global fragilities. Tyingmoney printing” to the unemployment rate was politically expedient – yet deeply flawed policy for an economy suffering from major structural issues. U.S. stocks are up better than 20% from last August’s lows, in the face of slowing U.S. growth and a rapidly deteriorating global economic backdrop. Dr. Bernanke, similar to Strong, could not resist the (“coup de whisky”) stimulus expedient a surge in securities prices might provide to vulnerable financial and economic systems. 

Both were willing to accommodate dangerous divergences between deteriorating economic fundamentals and highly speculative financial Bubbles.
Chairman Bernanke committed another major policy blunder this week. The media focused on his “highly accommodative monetary policy for the foreseeable future is what's neededcomment. While important, I would argue the following statement was more impactful: “If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that.” It was this statement, I believe, that had such a dramatic impact on global markets – the dollar, currencies, the emerging markets, bonds and record U.S. stock prices.

The Fed needs to begin extracting itself from the aggressive market backstop and intervention business. Such a role, as should be abundantly clear by now, only feeds speculative excess and serial Bubbles. The Fed’s $85bn monthly QE has been fueling speculation and exacerbating global financial instabilities – with marginal (at best) benefits.

To be sure, injecting enormous amounts of liquidity into a highly speculative marketplace and generally unstable backdrop carries huge risks. The Fed needed to begin winding down this program – a process Bernanke signaled several weeks back. Our central bank should not have been surprised by market reactions.

The Bernanke Fed needed to demonstrate some courage and resolve. Instead, it almost immediately signaled its limited tolerance for even moderate market tumult. “If financial conditions were to tighten” are code words for the Fed being there as necessary with open-ended QE to backstop U.S. and global markets. Bernanke’s Comment came with the dollar at multiyear highs, emboldening the view that he’s there to push the dollar lower as necessary to stem global de-risking and de-leveraging.

Bernanke’s Comment emboldened the view he’ll backpedal from any move to reduce stimulus at the first sign of market unrest. Bernanke’s Comment emboldened the view that he and global central bankers will punish sellers of risk assets and reward those that disregard risk and accumulate securities.

Bernanke’s comment emboldened those leveraging and taking outsized risks with the view that the Fed and global central bankers will ensure robust securities markets. Bernanke’s Comment further distorted perceptions of risk throughout global markets. Bernanke’s Comment bolstered the “QE forevercamp and provided a green light to further speculation, especially in the U.S. stock market.

“If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that” – is one for the history books. At this point, the Fed has been accommodating Credit and market Bubbles for so long that the only way to ensure ongoing loose financial conditions is to perpetuate Bubble excess. I would argue – and I believe recent market behavior supports this view – that various Bubbles have inflated to the point of acute vulnerability. This implies fragility to waning liquidity and episodes of risk aversion, hence – and as the speculator community assumes - unrelenting Fed QE activism.

From Bernanke’s paper: “The financial crisis and the ensuing Great Recession reminded us of a lesson that we learned both in the 19th century and during the Depression but had forgotten to some extent, which is that severe financial instability can do grave damage to the broader economy. The implication is that a central bank must take into account risks to financial stability if it is to help achieve good macroeconomic performance. Today, the Federal Reserve sees its responsibilities for the maintenance of financial stability as coequal with its responsibilities for the management of monetary policy, and we have made substantial institutional changes in recognition of this change in goals. In a sense, we have come full circle, back to the original goal of the Federal Reserve of preventing financial panics.

How should a central bank enhance financial stability? One means is by assuming the lender-of-last-resort function that Bagehot understood and described 140 years ago, under which the central bank uses its power to provide liquidity to ease market conditions during periods of panic or incipient panic. The Fed's many liquidity programs played a central role in containing the crisis of 2008 to 2009. However, putting out the fire is not enough; it is also important to foster a financial system that is sufficiently resilient to withstand large financial shocks.

Well, allow me to suggest a few things the Fed shouldn’t do if it endeavors to enhance financial stability. It shouldn’t peg short-term interest rates; it shouldn’t seek to manipulate long-term market yields (bond prices); it shouldn’t seek to promote the stock market or risk assets more generally – as all such interventions work to distort market behavior, misprice securities and risk, and incentivize destabilizing speculation. Its policy doctrine should not incentivize the issuance of potentially destabilizing marketable debt, at the expense of more stable traditional bank finance. The Fed should not pre-commit to a future policy course – or provide policymakingtransparency” that works to promote risk-taking and speculation. The Fed should only resort to backstopping market liquidity in the event of dire systemic vulnerability.

Significant Fed balance sheet expansions should be temporary and then reversed as soon as possible. The Fed should refrain from non-crisis asset purchases/liquidity injections – and should limit its open-market activity to Treasury bills. The Fed should not accommodate a doubling of mortgage debt in six years. It shouldn’t then accommodate a doubling of federal debt in four. Fed policymaking should not unduly impact system Credit and resource allocationalbeit to housing or, more recently, the federal government.

The Fed should avoid the slippery slope of intervening in the markets in the name of promoting economic growth. Its policies shouldn’t distort market risk perceptions or the pricing of finance. This will only fuel asset inflation, Credit Bubbles and the misallocation of real and financial resources.

The Fed should not accommodate persistently large current account deficits. These only promote liquidity excesses and global financial and economic imbalances. The Fed must never set off on an experimental path, but should instead strive toward a stable and conservative rules-based policy regime.

Generally, in what direction should the Fed be going? When it comes to financial stability, the Fed must be disciplined and preemptive. In this World of Unanchored Global Finance, the Fed finds itself full-circle back to where it began 100 years ago: It’s imperative that some type of policy regime or mechanism is constructed to help regulate U.S. and global Credit. The Fed must develop a framework for recognizing Bubble dynamics and nipping them in the bud before they become too powerful to address. And, importantly, the Fed will need to scrap this inflationist doctrine and dangerous notion that our central bank can print its away out of problems. It can’t. As we’ve been witnessing, the Fed can onlyprint more and inflate bigger Bubbles. Clearly, there’s too much left unlearned from the Fed’s checkered 100-year history.