It's (Almost) An Official Recession

Jeffrey Frankel directs the program in International Finance and Macroeconomics at the National Bureau of Economic Research, where he is also a member of the Business Cycle Dating Committee. The committee is the deliberative body that officially declares recessions. He writes:

The weight of evidence is now overwhelming: We are currently in recession.

His full analysis is here. Notice how he looks at data, unemployment, GDP etc., to see what is going up and what is going down, but says nothing about a business cycle and what might cause an economic downturn. Notice, further, how he is totally befuddled by the strength in the economy earlier this year:

The rate of change of real GDP, surprisingly, was above zero in the first quarter of 2008, and was even moderately strong in the second quarter: 2.8%. (The revised “final” estimate of GDP in the fourth quarter of 2007 did turn out to be below zero, but just barely.) It is quite a mystery why output pointed up during the first half of the year, while everything else pointed down.

And although a version of money supply, "real" money supply is one of the leading economic indicators, there is no mention, by Frankel, as to dating a recession when Bernanke first slammed the breaks on money growth earlier this year. That would explain why GDP just turned down in Q3, before that it was just a sector specific regulatory downturn.

A member of the group that dates the beginning and end of recessions doesn't have a business cycle theory, for him it is just data falling from the sky. Amazing. Even more amazing is that most other members of the Business Cycle Dating Committee are probably just as uninformed.

Blame The Current Crisis On Greg Mankiw?

It's obvious that most of the players caught up in the current Wall Street meltdown don't have a clue about business cycle theory and an understanding about how it would impact their business.

But it doesn't stop with business leaders. We have frequently commented on the fact that Alan Greenspan did not appear to have any type of theory of the business cycle. A peculiar situation for a one time Federal Reserve chairman. (Read his autobiography, not a word about business cycle theory) The same goes for Warren Buffett. He doesn't ever seem to mention business cycle theory. Who's to blame for this vacuum in understanding of the business cycle? How about the authors of introductory economic textbooks, such as Greg Mankiw, the current leader among authors of best selling economic texts .

Davd Warsh comments:

How peculiar is it that the leading introductory economics texts scarcely mention the cycles of manias, panics and crashes that have been a familiar feature of global capitalism since its emergence in the seventeenth century?

No propensity to bubble or bail is among the ten big ideas that govern economics in N. Gregory Mankiw’s text, for example. Ben Bernanke, in the book he wrote with Robert Frank before he became chairman of the Fed, discusses the 1990s banking crisis in Japan, the dot.com episode in the US and the Argentine collapse in 2001, along with the Great Depression, on which he is an expert; he even mentions in passing the “reckless lending” that led to the US savings and loan crisis in the 1980s: but the tendency to repeated financial crises is not remarked, and neither “bubble” nor “credit crunch” appear in the glossary...

Even Karl Case and Ray Fair don’t make much of a case for the perennial nature of crises (at least in my edition), though Case, of Wellesley College, and his colleague Robert Shiller, of Yale University, have played a prescient and central role in the analysis of the real estate crash.

When it comes to the business cycle, you really have to study it on your own. A good place to start is Roger Garrison's The Austrian Theory of the Business Cycle, which also does a good job of explaining why mainstream economists don't understand the business cycle.

In Defense Of 'Rumor' Mongering, Short Sellers

By Robert Wenzel

Investment banking stocks are crashing and regulators are all in a huff. They are aggressively harassing short-sellers.

SEC Chairman Chris Cox previously announced a ban on naked short selling, even though regulations already existed that banned that specific type of short sale. On Thursday, Cox proposed requiring hedge funds to post daily the short positions they have in stocks.

New York State Attorney General Andrew Cuomo, tried to one-up Cox, and has started a "wide-ranging investigation" of his own into short selling and has called for the SEC to put a " freeze on short selling of financial stocks on a temporary basis."

Republican presidential candidate John McCain, who apparently isn't satisfied with calling for war against Iran, Russia and China, wants to see battle also joined against short sellers. In fact on Thursday, he called for the firing of the wonderfully incompetent and ineffective SEC chairman Christopher Cox.

So what gives? Are short-sellers the evil monsters of Wall Street?

No there are not and, as Walter Block might say, they are, in fact, heroes.

To understand what is going on, one must realize that the structure of the now collapsing financial industry was built upon the money pumping ways of Alan Greenspan and the early Ben Bernanke. It was easy for the macho, testosterone fueled big swinging dick investment bankers of Wall Street to borrow the money that Greenspan and Bernake printed at the below normal market rates.

Since the Fed operates on the short term end of the interest rate spectrum, that's where investment bankers borrowed their billions. Borrow at the low short-term rates and lend long on mortgages and the like at higher rates, and earn the spread. That was the Fed enabled game. The more billions you borrowed, the more you earned. And the Fed certainly accommodated the Wall Street players. Even early this year, three month annualized M2 money growth was moving along at double digit rates. Indeed, in March, three month annualized money growth was 12.5% Then something peculiar happened a few months ago. Either Ben Bernanke became a closet Austrian economist (The only ones who really understand business cycle theory, and who would call for a complete end to money supply manipulation) or he really didn't understand mainstream economic monetary theory well enough to realize he was dramatically slowing the money supply. (Note: I'm not betting he is a closet Austrian. My bet is he is incompetent and bumbled his way into slowing money growth.) As of last Thursday, three month annualized M2 money growth was only 1.5%.

Now Wall Street investment bankers need fresh new money all the time, to keep the long term assets they bought with short term money, financed. With less new money being created, it was a case of musical monetary chairs. There were more investment bankers needing "financing chairs", then actual financing out there. Lehman was the first to find itself short of funds.With hedge funds being run by very aggressive, very savvy traders, it did not take them long to realize that there was a shortage of money to finance the current financial structure. Always seeking profit from whatever the financial situation, the hedgies poured over financial statements to see who was the most vulnerable investment bank. Who leveraged the most? and Who would never be able to find the money to support the previous financial structure? were the questions they asked. The name Bear Stearns popped up. And thus the hedgies shorted whatever Bear Stearns stock they could find. Once loaded up, they, of course, told the world what a financial wreck Bear Stearns was--and thus became labeled rumor mongers, In fact, they were speaking truth to Wall Street, not rumors.

Once Bear Stearns was wiped out, they moved on to identify and load up short positions in others who played in the Federal Reserve induced high leverage game. Next came Freddie Mac and Fannie Mae, then Lehman Brothers and then AIG. So what was the role of the short-selling hedge funds?

They scoured the balance sheets to discover who was overly leveraged--so we wouldn't have to. They leaked to the financial press who was in trouble--so we could get the news with our morning paper and they speeded up the financial crisis so that it occurred in just weeks instead of months or years. As a result of their aggressive due diligence, they pointed out a mis-match and shortage of funds that would otherwise have taken months, if not years to become clear and unwound. The economic mess would have dragged on and on. They are, indeed, heroes. And as if in an Ayn Rand novel, they will be harassed and investigated by the evil keepers of the ugly, manipulative, inflation created, status quo.

Christopher Cox, Andrew Cuomo and John McCain will pander to the unthinking masses, satisfy their status quo sponsors on Wall Street, and harass, interrogate, regulate and attempt to destroy the true heroes of this financial drama.

But the drama doesn't end here. There may be a kind of Benedict Arnold in cahoots with the hedge funds.

Very little on Wall Street is exactly as it seems. It is so even with our hedge fund heroes, since I suspect that Treasury Secretary Paulson may have played some type of role in the early short-selling escapades. While our hedge fund/short selling operators may have been involved in a noble cause, the role of Treasury Secretary Paulson may have been to use these short-sellers as his tool to wipe-out competitors, so that the Fed money printing game will be the exclusive domain of Paulson's old firm Goldman Sachs. It is noteworthy than Paulson's lapdog, Ben Bernanke, may have accelerated the money printing presses again at this time, just when it appears that Goldman Sachs may be the only major independent investment bank left standing--and just before the hedgies started to take a good hard look to see why Goldman shouldn't end up in the same trash bin as its competitors.

It is very important to keep in mind what Robert Novak reported about, one, Hank Paulson: "Hank is for Hank." And it is also important to keep in mind, as the inevitable hearings and mud slinging begins, that hedge fund short sellers are as much heroes warning of  dangerous balance sheets as was Paul Revere in his midnight ride and warnings.

Robert Wenzel is an economic consultant and Editor & Publisher of EconomicPolicyJournal.com. He can be reached at rw@economicpolicyjournal.com.

Greenspan, Again

Former Fed chairman Alan Greenspan has a commentary on the current financial crisis, over at FT.

He doesn't say anything different from what he sad in his interview last week with Maria Bartiromo, that the end of the financial crisis will not occur until the housing oversupply clears.

We found this comment by Greenspan interesting since it proves our point that Greenspan doesn't get the business cycle:

The cause of our economic despair, however, is human nature’s propensity to sway from fear to euphoria and back, a condition that no economic paradigm has provedcapable of suppressing without severe hardship.

This is Keynes' old 'animal spirits' explanation for the business cycle. In fact, there is nothing inherent in the economy, or the nature of man, that suggests that the business cycle is an inevitable consequence of market activity. The business cycle is caused by Federal Reserve manipulation of the money supply. When the Fed increases the money supply, it distorts the direction of economic activity towards the capital good sector, when the Fed stops printing money the economy re-adjusts to the pre-money manipulation economy. Greenspan has a blind spot that prevents him from even recognizing this theory.

Paulson Speech: From Bad To Worse

Add another name to the list. Along with luminaries such as Alan Greenspan, Treasury Secretary Henry Paulson in remarks on Reinforcing Market Stability and Confidence, delivered at the New York Public Library, made clear at the start that he doesn't understand business cycle theory:

As we all know, the U.S. economy and our financial markets are undergoing a period of stress. We will work through this period, as we always do. Our workers, industries and companies are the most productive, resilient and innovative in the world. Periods of economic difficulty are not new. They are,unfortunately, inevitable.

Inevitable? No. They are the inevitable result of the Federal Reserve micro-managing the money supply. But, end the micro-managing and freeze the money supply at current levels and the distortions that cause the business cycle will disappear.(For a thorough explanation of business cycle theory see, Rothbard: Economic Depressions: Their Cause and Cure):

From there Paulson went from bad to worse.

He called for a "Modernized Financial Regulatory Structure ", which Carlyle Groups' Randal Quarles seems to think means, "let private equity buy up banks stocks, while they are flat on their butts." By coincident, we're sure, Paulson also called for (our emphasis):

Working through the current turmoil will take additional time, as markets and financial institutions continue to reassess risk and re-price securities across a number of asset classes and sectors. I have and will continue to encourage financial institutions to strengthen their balance sheets by raising capital, de-leveraging and reviewing dividend policies so that they continue to play their vital role in supporting economic growth.

Of course, Quarles, who used to work at the Treasury under Paulson, has made clear that only private equity has the ability to supply such capital. And, we are sure that Quarles is happy to hear that that this capital funding should be done at "re-priced" levels.

Paulson also dropped this interesting comment toward the end of his speech (our emphasis):

We also need additional powers to manage the resolution, or wind-down, of large non-depository financial institutions, such as larger hedge funds, so as to limit the impact of a failure on the broader financial system.

Hedge funds? Who said there was any problem with any hedge funds? Is Paulson just being forward looking, or does he know something the rest of us don't? Time will tell.

Paulson really needs to understand, though, that the United States financial system needs to stop being fed from the breast of Big Mother. The U.S. financial system is beyond infancy, hell, it is beyond puberty, it is nearly at old age. An old man sucking at his mother's teat is not an attractive picture.

If someone is trading with a hedge fund, then they should be aware of the risks involved and suffer the consequences should the fund go belly up. To set up to "manage the resolution of hedge funds" is simply setting up for larger collapses. Talk about moral hazard!

Scary character, this Paulson.