The Fed: Still In A "Hole"!

There are articles all over the place discussing the possibilities for what Fed Chairman Ben Bernanke is going to say at his late August speech at the Federal Reserve Conference in Jackson Hole, Wyoming.  Last year, of course, Bernanke announced QE2.  And, for the next ten months we lived QE2. 

The question is…what is Bernanke going to spring on us this year?

Listen to this…”what is Bernanke going to spring on us this year?”

Ben Bernanke is considered to be one of the most creative economists in the world.  He has basically improvised his way through the last three years or so in a way few others could.

But, this is the central bank we are talking about.  Historically, central banks have been the promoter of stability.  Central Banks have been predictable.  Central banks have attempted to reduce uncertainty.

And, maybe this is a clue to the situation we face in the world today.  Maybe things are not what they once were.  Maybe central banking must change…must create a new “business” model”.

Central banking after World War II was different than it was before the 1930s.  Benjamin Strong, President of the Federal Reserve Bank of New York, Montagu Norman of the Bank of England, Emile Moreau of the Banque de France and Hjalmar Schacht of the Reichsbank were what central banking was all about during the 1920s and early 1930s.

But, the world was on the gold standard back then, international capital flows were restricted, and the world was moving from economies based on agriculture to economies based on industrial manufacturing.  “Country” banking, Fed Districts, and the Fed’s discount window dominated central banking in the country.  

The world after World War I was different from the world after World War II and the central bank had to develop a new model. 

Post-World War II, the responsibilities of the central bank changed and grew.  The objectives of central banks also changed.  Whereas the primary responsibility of central banks before this time had been to be the “lender of last resort” to the banking industry, it now took on new responsibilities.  First, under the influence of Keynesian thinking, central banks became responsible for achieving high levels of employment.  Then, after the work of Milton Friedman and the Monetarists, the Fed added price stability as another goal of monetary policy.  Thus, the Fed entered the manufacturing era with three goals, being a lender of last resort, achieving low unemployment, and keeping inflation under control.

Then things changed during this time period.  The global economy became a reality and capital became mobile throughout the world, the gold standard collapsed, and fixed exchange rates gave way to floating exchange rates.  The manufacturing economy gave way to the information age.  Large domestically orientated banks became global behemoths and financial innovation (allowed by the advances in information technology) came to dominate the financial scene. 

Toward the end of the twentieth century, the environment shifted.  Money easily flowed where it wanted to.  We had the high tech bubble of the 1990s and the explosion of securitization.  We saw countries brought to their knees by the international capital markets.  France was certainly the most noticed instance of this but the United States also felt the “end of the stick” and this led Treasury Secretary Robert Rubin to convince President Bill Clinton to get the budget under control.  The fiscal policy of the Clinton administration “bailed out” Alan Greenspan for the time as Fed Chair constantly waited for the substantial increase in productivity to come from the advances in information technology. 

,

The 2000-2001 recession came followed by Greenspan’s fear of a further deep recession which resulted in a lengthy period in which the target Federal Funds rate was kept at 1.00 percent for an “extended period of time.”  The housing bubble resulted accompanied by a bubble in the stock market.  It seems that in the new financial environment, funds could flow effortlessly around the world and create bubbles where ever the opportunity arose.

Chairman Bernanke came along and Bernanke, an “inflation hawk”, raised interest rates and kept a lid on the banking system until the “crash” came.  The Fed kept the “punch bowl” away from the economy for too long. 

This story is leading up to this point.  Bernanke’s effort at “inflation targeting”, which over stayed its welcome, was the last effort to conduct monetary policy under the “old”, post-World War II monetary regime.  Everything since that time has been improvisation and innovation.

This puts us right where we are today.  There is no current model of central bank operations that can explain what the Fed…and the European Central Bank…and the Bank of England…and so forth…are doing…or will do. 

We are in a new age…the information age.  It became apparent over the past ten years that money…credit…finance…was just a subset of information.  Money, credit, and finance, are really nothing more than 0s and 1s that can be “sliced and diced” anyway one can want.  And, a buyer can be found for these “sliced and diced” pieces of information. 

The large banks and other large financial institutions understand this.  So do many of the manufacturing giants of the past 60 years or so.  General Electric was at one time earning three-quarters of its profits from…its finance wing.  And, what about GMAC and General Motors?  And, the list goes on. 

We have gotten to the point where a huge proportion of the economy is represented by the finance industry…both in terms of income and in terms of employment. 

The manufacturing age is fading.  Yes, we still need manufacturing, but we also still need agriculture.  The world moves on.  Where is employment going to be in the coming years and what kind of training are these workers going to require.  The problem in the United States seems to be a misfit between where the jobs are and how the workforce is trained. But, we are talking about banking and about the Federal Reserve and about monetary policy. 

To me it is evident that things have changed in the financial industry.  Over sixty percent of the commercial banking industry in terms of assets are in the hands of twenty five banks, and most of the activities of these banks are nowhere near what the activities of commercial banks were fifty years ago.  And, most of this difference can be related to the advances in information technology.

And, my prediction for the next five years…you will hardly know what banking is in five years.

Where does that leave Mr. Bernanke and the Fed?  My guess here is that the Fed is going to have to go through changes in its “business model” just as most other institutions are doing.  The conduct of monetary policy in the future will be different than it is now, just as the conduct of monetary policy in the last half of the twentieth century was different from that in the first half. 

I don’t know how monetary policy is going to be conducted in the next decade or so, but my guess is that it will be different.  The Fed is in a “hole” and must find its way out of the “hole” and not dig the “hole” its in any deeper.     

Mr. Bernanke's Testimony

How important was Ben Bernanke’s testimony given to the Financial Crisis Inquiry Commission?

Well, the New York Times reported it on page B3 of the Business section and the Wall Street Journal reported it on page A6 of its first section. Ho hum!

This more or less puts the testimony in the class of Alan Greenspan’s efforts to recover his reputation once he stepped down from the position Bernanke now holds.

The important thing, to me, about the testimony is what it says about one of the leaders of economic and monetary policy in Washington, D. C. these days. I have just commented on this leadership recently.

“Economic leadership of the United States currently rests in the hands of individuals that were an instrumental part in the excessive credit inflation of the 2000s. Ben Bernanke was a member of the Board of Governors of the Federal Reserve System and a vocal supporter of Alan Greenspan’s move to keep the Federal Funds target rate around one percent in 2003 and beyond, having joined the Board in 2002. Timothy Geithner became President of the Federal Reserve Bank of New York in 2003. This position has a permanent vote on the Open Market Committee, so that Geithner was in on all votes during this time as was Bernanke. After a short stint as the Chairman of the President’s Council of Economic Advisors in 2005-2006, Bernanke became Chairman of the Board of Governors of the Federal Reserve System in February 2006. Geithner moved from the New York Fed to become Treasury Secretary in January 2009.

These two leaders, arguably the most important leaders in economics and finance in the United States government, have held top positions and been voting members of policy boards during one of the most un-disciplined times in United States history. And, their lack of discipline continues, as is evident by the speech given by Bernanke last Friday at Jackson Hole, Wyoming. The only policy that these two people follow is one of throwing everything they can at a problem and seeing what works.

The problem is that their interest rate efforts in the 2003 to 2005 period led to a housing bubble and stock market bubble which resulted in the collapse of the sub-prime market in 2006 and 2007. Their response to this break-down resulted in the financial disaster of the 2008 to 2009 period when the government threw just about everything it could at the disaster in order to try and avoid worse. We are now in 2010 and the evidence of the lack of discipline is still around us. Consumers are plagued with debt fostering record numbers of foreclosures and personal bankruptcies. Businesses are overwhelmed with debt, not only with high-yield bond debt but also with commercial real estate loans and foreclosures and bankruptcies are also high in this area. State and local governments are piled high with debt and we find that states and cities are cutting back on the most basic of services including the release of fire fighters and police. And, the federal government faces budget deficits that some estimate will result in $15 trillion or more in additional debt over the next ten years.”

And, Mr. Bernanke is so disingenuous as to say about letting Lehman Brothers fail: I wasn’t “straightforward” in my statements about the condition of the company. In his view “Lehman didn’t have enough collateral to support a loan from the central bank.” That is, there were no choices!

Then Mr. Bernanke says, “This is my own fault, in a sense...”

What is this “in a sense” business! Either you did or you didn’t!

Going on, “I regret not being more straightforward there because clearly it has supported the mistaken impression that in fact we could have done something. We could not have done anything.”

Thank you Mr. Greensp…whoops…Mr. Bernanke.

I have yet to hear anything, from Mr. Bernanke, Mr. Paulson, or anybody, that has changed my mind concerning that time back in September of 2008. My post on the events of that specific period is titled “The Bailout Plan: Did Bernanke Panic?” (See http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.”

This is the leadership we are now getting in Washington, D. C. Need I say more?

A Time for Crybabies

The headlines of the day: “European Leaders Call for Crackdown on Derivatives” (http://www.nytimes.com/2010/03/10/business/global/10swaps.html?hpw) and “Call for Action on Speculation Rules” (http://www.ft.com/cms/s/0/7a22b968-2bad-11df-a5c7-00144feabdc0.html).

Alternative headlines to these are “Financial Markets Call for Crackdown on Undisciplined and Irresponsible Government Budget Behavior” or “Call for Action on Fiscal Policy Biases.”

This is the time for cry-babies and the leaders of many nations in the world are not letting us down.

Their basic theme is “All our problems can be laid at the feet of the financial community, its innovations, and its speculative behavior. We need better and tougher regulation and we need stricter laws and rules about what can be done. Doing this will make everything better!”

This, however, is getting “cause and effect” turned around!

My question is, “Who created the inflationary environment of the last fifty or sixty years that resulted in the financial innovation and speculation that resulted? Who promoted almost perpetual government budget deficits, in recessions as well as booms, and who underwrote this deficit spending with supportive monetary policies that encouraged the expansions but fought the contractions? Who is responsible for the 85% decline in the purchasing power of the United
States dollar since January 1961?”

The stage was set in the United States in 1946 when Congress passed the “Full Employment Act of 1946.” In 1961, an administration took over the presidency that was devoted to the Keynesian full employment policy. In 1971, President Nixon in an effort to stimulate the economy to get himself re-elected claimed that “We are all Keynesians now!” In this effort to get re-elected, Nixon appointed Arthur Burns as the Chairman of the Board of Governors of the Federal Reserve System. Monetary policy supported the effort to achieve the economic goals Nixon believed he needed to have in order to get re-elected. Then in 1978, Congress enacted the “Full Employment and Balanced Growth Act”, often referred to as the “Humphrey-Hawkins Full Employment Act.”

The true test of government monetary and fiscal policy, as written into the law of the land was full employment and high levels of economic growth. And, explicitly or implicitly, countries throughout the free world followed this pattern in the post World War II world.

And, what resulted from this policy bias?

Well, by the last half of 1968 we had high-grade corporate bond rates in the 6.5% range. These yields had not really gotten much above 4% until late 1959 into 1960, and did not cross 5% until the middle of the latter decade. It was during the late 1960s that researchers started discussing the presence of “inflationary expectations” in interest rates, a concern that vanished toward the end of the 1920s.

In the 1960s we also saw the first real post-World War II financial innovation take place. The primary source of business credit at that time was the commercial banks. As the presence of inflation spread and in order to expand their capacity to lend and to compete against banks worldwide, United States commercial banks developed the negotiable Certificate of Deposit, the Euro dollar, and the use of Commercial Paper to raise funds through bank holding companies. Large banks ceased to have funding limits on their ability to raise money to lend. This was an omen for the future.

In August 1971, President Nixon froze wages and prices and took the United States off of the gold standard. Inflation had obviously reached a point where it had become a concern of the nation.

The bid to get Nixon re-elected re-ignited inflationary pressures and his predecessor Gerald Ford attempted to Whip Inflation Now! (The WIN campaign) By the middle of 1979 inflation had become so bad in the United States that President Jimmy Carter had to appoint someone of the prestige of Paul Volcker to take over at the Fed and “get serious” about the high levels of inflation existing in the country.

In the 1980s financial innovation was rampant. One only needs to go to the Michael Lewis book, “Liar’s Poker” to get an idea of how much financial innovation had taken over Wall Street by the middle of the decade. Increasing tensions between the Reagan administration and Volcker resulted in Volcker resigning in August 1987. Someone much more conciliatory, Alan Greenspan, got appointed Fed Chairman.

All one needs to be said about Greenspan is that the term the “Greenspan put” was created during his tenure. Greenspan supported economic expansion, but protected financial markets on the downside. In the 1990s the United States experienced credit bubbles, the best known being the dot-com boom…and bust. The 2000s saw bubbles in both the housing market and the stock market. And, during the credit inflation of the 1990s and the 2000s financial innovation exploded!

And, I haven’t touched on the governmental deficits created since the 1980s that the Federal
Reserve was helping to underwrite. But, enough said about the United States.

Leaders throughout the free world behaved in this manner through much of the last fifty years. There were, of course, earlier periods in which the cry-babies came out. This occurred numerous times, but the blame then was placed on those “shadowy people” known as “the international bankers.” Government deficits and loose monetary policy resulted in a sell-off of the currency of the country. This sell-off continued until the government made some efforts to bring on fiscal discipline and give some independence to its central bank. But, again, the governments assumed little of the blame; it was always the fault of “the bankers”.

Governmental leaders just don’t get it. Inflation becomes the music that everyone has to dance to. As long as inflation continues the dance goes on. As Charles “Chuck” Prince III, the former CEO of Citigroup famously said, “As long as the music continues to play, you must keep dancing.” And people and governments kept borrowing, bankers and other financial geniuses continued to craft new financial innovations, and bonuses continued to rise. And the music went on and on…

One of the difficulties of economics is that in most situations it takes time for things to work themselves out. That is, there can sometimes be a long lapse of time between the cause of something and the effect that the action brings about.

A classic example given is the long run impact of rent controls. Rent controls are great for renters in the short run. But, if low rents result in landlords reducing the amount of maintenance applied to the rent-controlled properties, the properties deteriorate in quality. Blame is then assessed against the greedy landlords and not against the rent controls.

We see a similar situation in the case of the financial speculation the governmental leaders are crying out against. Blame is assessed against the “bankers” and not against those that created the inflationary environment that produced the financial innovation and subsequent financial transactions. Unfortunately, a lot of people, those that can’t really defend themselves, get hurt in the process.

Whereas the renters got hurt in the previous example; workers, the people that were being helped by the governmental policies, are the ones that end up suffering when the music ends and people stop dancing. See “Irish Take Bitter Medicine to Survive Age of Red Ink”: http://online.wsj.com/article/SB20001424052748704486504575097672075207734.html#mod=todays_us_page_one.

Fannie, Freddie, and Feddie?

Will the Federal Reserve System join the ranks of other government public supported agencies like Fannie Mae and Freddie Mac?

One could argue that they are on the verge of such ignominy.

Never before has the Federal Reserve been under such attack and from all sides. The attacks have gotten so severe that the subject even made the front page of the New York Times today. (See “Under Attack, Fed Chief Studies Politics,” http://www.nytimes.com/2009/11/11/business/11fed.html?hp.) The legislative attack on the Fed continues with the new proposals on financial regulation coming from the Senate Banking Committee. (See “Senate Democrats Seek Sweeping Curbs on Fed,” http://online.wsj.com/article/SB125786789140341325.html?mod=WSJ_hps_LEFTWhatsNews.)

Certainly the leadership of the Federal Reserve seems to be deserving this scorn. Henry Kaufman states bluntly that “there is the Fed’s legacy of its inability to limit past financial excesses. By failing to be an effective guardian of our financial system, it has lost credibility.” (See, “The Real Threat to Fed Independence,” http://online.wsj.com/article/SB10001424052748703574604574501632123501814.html.)

Of course, Alan Greenspan gets his share of the blame for “keeping interest rates too low for too long in the early years of this decade”; for his failure to understand the changes in the financial markets coming from financial innovation; and for his role in the repeal of the Glass-Steagall Act.

But, Ben Benanke must also bear his share in the decline of Fed credibility. He was Greenspan’s co-conspirator, serving on the Board of Governors of the Federal Reserve System during the 2002 to 2005 period in which the Federal Funds Rate was kept below 2.00% from the time he joined the Board until November 2004. For much of the time this Fed Funds rate was around 1.00%. Bernanke was a strong defender of keeping the rates so low, both in terms of economic analysis and speeches.

After Bernanke assumed the position of Chairman he was slow responding to the possibility that the bubble was bursting in the subprime market. Then, Bernanke reacted very strongly to the financial collapse, possibly over-reacted, in the week of September 15, 2008. (See my post of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

Congress certainly saw Bernanke in action that week. According to a Wall Street Journal article, which I quoted in the post, “(Hank) Paulson called the leadership in Congress and asked them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and ‘scared the daylights out of everyone.’ Bernanke got his wish in that Congress ultimately passed the TARP bill, although they did not pass the bill by the next Monday as Bernanke had originally pressed for.

I’m not completely convinced that Congress, deep down, has all that much confidence in a Ben Bernanke-led Federal Reserve System going forward even though President Obama seems to.

Then, the Federal Reserve, under Bernanke’s guidance, flooded the banking system with reserves, leading up the current time where excess reserves in the banking system total more than $1.0 trillion. His concern over this time period has been the liquidity of financial markets. (See my recent post, “Dear Fed: the Problem is Solvency, not Liquidity,” http://seekingalpha.com/article/171826-dear-fed-the-problem-is-solvency-not-liquidity.)

As Kaufman points out in his Wall Street Journal article, the Federal Reserve now has another major conundrum: “How will the Fed reduce its bloated balance sheet?” This is a real problem because the Federal Reserve has subsidized the financing of massive amounts of federal debt and has also provided massive support to the markets for mortgage-backed securities and federal agency issues. As of November 4, 2009, the Fed owned outright $777 billion in U. S. Treasury issues, $774 billion in mortgage-backed securities, and $147 billion in Federal agency debt securities, roughly $1.7 trillion.

In supporting these markets, the Federal Reserve has kept the interest rates on these securities below the level they would have attained without the support of the central bank. The first question is, what will happen to these rates once the Fed stops supporting these securities. Will their rates ratchet upwards?

And, then, what will happen once the Federal Reserve finally decides it needs to let interest rates move up as the economy gains strength? If the Federal Reserve pursues its exit policy of removing reserves from the banking system it will have to take a loss on these securities. No matter though, it will just reduce the amount of funds (its profits) it returns to the Treasury Department at the end of the year.

In a sense, this will make the Fed like Fannie and Freddie in that it can absorb losses deemed necessary by the government for good social reasons. However, the Fed will not have to go to the Treasury with its hand out, as Fannie and Freddie has to, in order to cover its losses because the Fed makes so much profits by being able to create money whenever it wants to.

But, there is another problem: how much upward pressure will the liquidation of the mortgage-backed securities put on interest rates. How much will Congress resist this upward movement in interest rates? What will the housing lobby do to counter-act this move in rates because such a move will certainly not be good for a recovering housing market.

There is another concern: billions and billions of dollars of government debt have been purchased at subsidized interest rates. Helping this along was the extremely low short-term rates resulting from the Fed’s “close to zero” interest rate policy. If I can borrow for six months at, say, 50 basis points or so, and lend these funds out at around 3.00% on 7-year Treasuries, with a “guarantee” from the Fed that the 50 basis points will remain for “an extended period” of time, I have a pretty nice deal.

And, making money in this way doesn’t even include the returns that are available on the “cover” trade.

But, what will happen to those that “underwrote” the placing of the federal debt when the Fed begins to let rates start to rise? How extensive and deep will be the capital losses? Not everyone can make it through the “exit door” at the same time. Will Congress hear about this?

There are additional regulatory issues relating to institutions that are “too big to fail”. These, too, get us into the political realm. Congress is going to want to get their hands into this “solution” as well.

Has the current leadership at the Fed (Republican appointed) brought us to the brink of the government making the Fed into another Fannie Mae or Freddie Mac? Printing money is sure an attractive way to try and achieve social goals. It is interesting that the political party (the Republicans) that was supposedly the strongest supporter of free-market capitalism has brought us to the edge of greater government control of industry (like autos and housing) and financial institutions (like large banks and the Fed).

Mr. Geithner and Mr. Bernanke Support the Dollar?

“Top U. S. officials threw their weight behind the dollar Thursday, with the Treasury chief stressing the importance of a strong dollar and the Federal Reserve chief addressing concern about the greenback’s future as a reserve currency.” (Wall Street Journal: http://online.wsj.com/article/SB125440283756156107.html.)

What was the name of the Treasury Secretary…O’Neill? Or, was it Snow? Or, was it Paulson?
Oh, well.

And the Federal Reserve chief…that was Greenspan, wasn’t it?

And the value of the dollar dropped more than 40% against other major currencies!

Oh, that was the Bush (43) Administration.

When it comes to international confidence in a country’s currency, the officials of that country’s government must not just “Talk the Talk”, they must “Walk the Walk”!

Don’t watch the lips…keep your eyes on the hips!

Talk, talk, talk, talk…

Federal deficits growing out into the future in the neighborhood of $10 trillion or more!

Monetary policy where the banking system averaged excess reserves of $855 billion for the two weeks ending September 23, 2009! And, in a banking system where required reserves averaged only $60 billion for the same time period.

After nine years of promises from different Treasury Secretaries and from two Chairmen of the Board of Governors of the Federal Reserve System why is there no credibility in these statements?

The value of the U. S. Dollar is down against the Euro by about 11% since January 20, 2009 and the value of the U. S. Dollar against major currencies is down about 10% since January 20, 2009.

The report card given this administration by international financial markets is not good.

My guess is that the value of the U. S. Dollar will continue to fall over the next year or two and will continue to fall until participants in international financial markets see some action on the part of the United States Government and not just empty talk from its Treasury Secretary and the Chairman of its central bank.

The Regulation of Banks and Financial Markets: One Year Later

The papers and the news broadcasts over the last week have been filled with stories about the failure of Lehman Brothers and the need to re-regulate the financial system. The second-guessing has been enormous on the failure of the federal government to come to the aid of the troubled investment banking firm, especially when put into the context of the bailout of AIG and the help given to other investment banks and commercial banks.

Furthermore, the report card on the government’s effort to re-regulate the financial system seems to be hovering between D and F! The consensus review of what has happened over the past year is: nothing!

In terms of letting Lehman Brothers go, let me just say that the second-guessing is a fun game and provides a diversion for journalists and makes good reading but is not very productive. This is the problem with decision making under very stressful conditions with very little information on what the potential outcomes of actions might be.

For one thing, very few people in the summer of 2008 even considered that the financial might be on the verge of collapse. That is what makes situations risky, the lack of knowledge of what might happen in the future. Yes, we can talk about Black Swans and so forth, but the probability of a severe financial crises occurring is a very unlikely event and business is not conducted on a “what-if-the-worst-happens” scenario. Second, no one has “experience” in dealing with a very serious financial crisis. It is entirely different studying previous examples of financial crisis, but to have to deal with one face-to-face is an entirely different matter. Third, the biases and prejudices and world views of the individuals in charge of making these decisions play a role in how people respond to a crises and no one, before-the-fact, can make an adequate prediction of how leaders will perform in a “once-in-a-lifetime” situation.

The financial system is still functioning and the economy seems to be working its way out of a deep recession. Could things have been done better? Yes. Could things have turned out worse? Of course. But, we seem to have muddled through the real crisis period. Hopefully, we will not have a second shock wave that sends us back into another panic mode.

In terms of re-regulating the financial system, I have several opinions I would like to share. First, to try and re-regulate a financial system immediately after a financial crisis occurs is, in my mind, not the thing to do. For one thing, you don’t really know what happened or what caused the crisis and to rush to judgment is often to rush into folly. Furthermore, villains are usually identified that may or may not really be the “bad guys” that need punishment or controlling. Powerful politicians or government officials impose their own biases and prejudices into the discussion and they are not always the best forces to design a new regulatory system. Also, new regulatory systems that are quickly put into place following a debacle are often designed to “fight the last war” and are not really appropriate for the environment the world is moving into.

The problem with not moving to re-regulate relatively quickly is that the movement to re-regulate loses its urgency.

My second concern has to do with the causes of the financial crisis. Since the financial collapse has to do with financial institutions and financial instruments, people look first at the individuals running these organizations or dealing in these instruments for the culprits of the crisis. The problem I have with this is that the leaders and practitioners of finance are responding to the economic and financial environment that they work within. The macro-incentives that exist within an economy are oftentimes created by others with very little insight into the incentives that they are actually setting up. The “others” I am talking about are, of course, our governmental leaders. Who created the macro-environment that produced the incentives for individuals to act in the way they did? What about Mr. Greenspan and Mr. Bernanke and the credit inflation that they spawned in the early part of this decade? What about the Bush 43 administration that created the huge fiscal deficits that resulted in a more than 40% decline in the value of the dollar?

The federal government represents more than 25% of GDP in the United States and with this impact on economic activity as well as through the rules and regulations it creates, the government has a very pervasive influence on the incentives that individuals and businesses have to respond to and operate within. The leaders in the federal government go free of blame while the people that have to live within the environment these leaders created must bear the burden of shame and guilt for the financial crisis that resulted.

My concern here is that maybe the re-regulation of the financial system is not the entire problem. My concern here is that people do not really understand who created the environment in which a financial meltdown could occur. Maybe better government policy making is in order, but maybe that is too much to ask for.

Finally, I would like to argue that financial types, human beings, are going to continue to innovate in the future and there is ultimately very little that governments or regulators can do to prevent financial innovation from taking place. (Human beings, by their very nature are problem-solvers and innovators.) Financial innovation has existed throughout history. Finance, really, is nothing more than information. That is one reason why financial innovation was able to explode beginning in the 1990s with the advancements in computer technology. The computer just allowed people to “slice and dice” massive amounts of information flows more efficiently and more quickly. (Even one of the staunchest proponents of behavioral finance, Robert Shiller, proposes using computer assisted financial innovation to take contribute to the evolution of new financial markets and instruments: see his books “Macro Markets” and “The New Financial Order.”) The whole idea of “information markets” builds upon models of financial innovation and how these models can be extended to other markets using massive new data base systems and the advanced computing power that is available in the ever-evolving world of information technology.

There must be oversight of the financial system and this oversight must be accompanied by increases in the openness and transparency of financial transactions and financial reporting. The innovation, in my mind, cannot be controlled. Therefore, we (business leaders, investors, and regulators) must also have more and more information available to us on a more timely basis in order to try and understand what is happening and to react to it. This, to me, is the world of the future.

It is this world of the future that must be considered in any effort to re-regulate the financial system. Fighting the last war is not going to produce the regulatory system we need. Ignoring the incentives that government creates is not going to produce the regulatory system we need. Regulations to produce specific “results” will not work. To my mind, it is not all bad that the rush to re-regulate or to develop a new regulatory system has stalled or been put on the bad burner.