MONEY FOR NOTHING

Is Bailing Out Reckless Investors Wise? Don’t Bank on It.

By William R. Bonner and Lila Rajiva

Sunday, October 28, 2007; Page B04

Last summer, the bill started to come due on our debt-fueled economy. We should have let it — and let reckless speculators, subprime lenders and banks finally get what they had coming. But instead, the financial authorities let them off the hook. Rather than simply letting markets be markets, they bailed out both the fools and the knaves. We’ll all live to regret it.

At the moment of truth, the Federal Reserve cut the overnight cost of money in the United States (known as the Fed funds rate) by 0.5 percent. Meanwhile, the governor of the Bank of England also succumbed to temptation, infusing ¿10 billion into the British banking system. Next, the Fed let Citigroup and Bank of America increase the quantity of funds that federally insured banks could lend to their affiliates, many of which held risky mortgage debts. When investors, spooked by the subprime lending crisis, stampeded out, the affiliates ran short of cash. Then, just this month, Treasury Secretary Henry M. Paulson Jr. announced the creation of yet another fund, guaranteed by three major banks — a piece of folly that was no more than a bailout of the cash-strapped affiliates.

But bad investments do not become good ones just because a central bank lends more money to the investors who made the rash choices. Problems caused by too much credit do not disappear when you hand out even more credit. And the syndrome that such moves create only makes our economic woes worse.

Mervyn King, the head of the Bank of England, told Parliament that he had been initially reluctant to intervene in Britain’s credit market because he feared the ” moral hazard” that might ensue. Moral hazard is the idea that eliminating all potential risks from an action encourages people to take excessive risks. King worried that when speculators think that they’ll be bailed out, they tend to take bigger chances. After all, why not go for broke when you’ve got the central bank behind you?

The same thought should have troubled Fed chief Ben S. Bernanke, but somehow America’s central bankers didn’t seem to share even the nascent qualms of the governor of the British bank. Instead, they blithely reversed four years of policy by lowering the Fed funds rate to 4.75 percent. Just a few weeks earlier, Bernanke had called inflation Public Enemy No. 1. Now, by cutting the cost of money (something he looks set to do again next week), he was inviting it to dinner. And by encouraging risky behavior, he was asking for trouble — and he’ll probably get it.

If people always behaved sensibly, they would borrow only what they could pay back. The economy would boom only when it was producing jobs, and not because it was awash in easy money. Industries would not glut their markets, and investors would not make daft decisions out of greed.

But people do make bad calls. They foul up. When the price of money rises and the economy contracts, their errors get corrected. That’s the good news. The bad news is that there are always enough people to argue that it’s the Fed’s job to ease the pain of such contractions. Those arguments have usually carried the day. Since World War II, the practice has been to use monetary policy to smooth the downside of the business cycle — lowering interest rates to make money easier to borrow.

What the economy faces now, however, is a far cry from what it has faced in the past. In the first 25 years after World War II, the average ratio in the U.S. economy of periods of growth to periods of recession was only about 5 to 1. Over the next 25 years, the downturns got softer and even less frequent. And now, we seem to have rollicked our way through an expansion longer than any in the preceding era. Either we are suddenly moving toward the perfection of mankind, or there’s a large batch of errors we’ve yet to clean up.

And the batch grows by the day. Never before have so many people owed so much money in so many different ways.

When you make a mistake with your own money, you may go broke, you may despair, you may even kill yourself. Not to sound callous, but the damage rarely goes much further than that. Make a mistake with borrowed money, on the other hand, and it sets off a chain reaction of losses. You lose money, the lender loses money, savers lose money and the investors who bought shaky financial instruments tied up with the original debt lose money.

This is where central banks are supposed to come in. At first, Mervyn King judged that adding a few more straws might break the British economy’s back. Then, under pressure, he decided to load on a whole other bale. He had called it right the first time.

In theory, a central bank is set up to keep economic order. But in practice, when central bankers intervene in the economy, it is a bit like intervening in a street brawl: Results can vary. Central banking is a pretty imprecise science. At best, it is marginally and occasionally effective; at worst, it is a disastrous fraud.

It’s easier to yield to temptation than to resist it. Paul Volcker, the Fed chief from 1979 to 1987, was the last one who could stomach a recession. Determined to correct the macroeconomic blunders of the 1970s, he jacked nominal interest rates up to 20 percent. Politicians were outraged, and the public was horrified. Volcker’s effigy was burned on the steps of the Capitol. But his forced correction worked: Inflation fell from 12 percent to 4 percent. After the smoke cleared, the U.S. economy was ready for its biggest boom ever.

But since Volcker left the Fed, interest rates have generally gone down, and American consumers have taken advantage of it to borrow and spend. In the process, they have become addicted to cheap money. Now total credit has grown from 150 percent of gross domestic product to 340 percent. In fact, Americans carry so much debt that if Bernanke were to raise interest rates even to 10 percent, as he clearly should, they’d probably scorch him for real.

There was a time not so long ago when it looked as though central planning might actually work. The figures coming out of the Soviet Union showed remarkable — almost unbelievable — progress. Later, it became clear that the numbers were rigged.

Looking at how cheap money is these days, one wonders: Are we following in the Russians’ footsteps? For although almost all economists now admit that markets do better than government bureaucrats at setting prices and allocating resources, central banks continue to rig the most important price of all: the price of money.

In the real world, you can’t create something out of nothing, and debts must always be paid — although not necessarily by the people who incurred them.

When the Bernankes of the world set the price of money too low, they set off an explosion of error. People build houses for buyers who can’t afford them, they add capacity for customers who don’t exist, they speculate on trends that are sure to end.

Don’t take our word for it; just open your eyes. What we see in the U.S. economy today is largely the consequence of the Fed’s wimpy decision to keep rates low after the micro-correction of 2000-01. The economy had walked backward for only a single quarter — not even enough to qualify as an official recession. Still, the Fed panicked, yanking rates down to an emergency low of 1 percent for more than a year. The result? The biggest housing boom in U.S. history, accompanied by more bad decisions than a joint session of Congress. Lenders over-lent. Consumers over-borrowed. Builders over-built. And the dollar crashed to its lowest level ever.

Instead of wiping out bad decisions, the Fed’s rate cuts keep the cheap money flowing, letting errors compound and spread. Instead of sticking the losses to the people who deserve them, it redistributes even bigger losses to bystanders: innocent savers, hapless householders and dollar-holding, dollar-earning chumps everywhere. That’s the problem with meddling in markets: Once you get started, it’s hard to stop.

Irrational People
William Bonner and Lila Rajiva 10.25.07, 6:00 PM ET

Bill Bonner and Lila Rajiva

No prejudices are more dangerous than those you didn’t know you had. And no one is more likely to crash into them than one who believes he is impartially examining the facts. That is the trouble with theories about man that assume he is a rational decision maker. All the evidence we have points to the contrary.

What rational commuter, for instance, would buy a Hummer? People buy them not to get somewhere but to tell others that they have already arrived. And what reasonable man would waste his time going to the polls? The rate of return is so uncertain and so remote, he would do better buying a lottery ticket.

But even otherwise insightful writers make the mistake of assuming that when people make choices, they either make rational choices or honest mistakes. Malcolm Gladwell’s best-selling book, Blink, for example, observes that rapid cognition–instinctive reaction without prolonged deliberation behind it–is often the best way to make decisions. He cites approvingly a group of art experts who were able to tell at a glance that a Greek statue was a forgery.

But there are other instances when the results of rapid cognition don’t meet his approval. While only 3.9% of adult men in America are over 6′2″, almost a third of all American CEOs are 6′2″ or taller.

There must be some mistake, says Gladwell. People ought not to pick tall men to lead companies simply because they are tall. In response, we ask, why shouldn’t they? People who choose tall mediocre CEOs over short extraordinary ones may actually be expressing a real preference, even if they explain it away later as a bias. The preference may be rooted in genetic drives that find tall males inherently more likely to dominate and succeed in the reproductive game. Or people might have an aesthetic preference for an imposing appearance. Or they might intuitively feel tall leaders might be better at gathering followers. This might be what people really want, and not a CEO who can increase company profits.

Gladwell himself recognizes this when he notes that in speed-dating the kind of men women actually pick is very different from the kind they say they want. Yet, then he goes on to find decisions based on such hidden emotions and preferences unacceptable in certain cases–say picking a CEO or a member of a symphony orchestra–because they don’t accord with his idea of how these decisions should be made.

The same bias afflicts research into economic decision-making.

In 2005, Princeton Professor Daniel Kahneman conducted an experiment comparing the performance of people with a kind of brain damage that inhibited their emotions to the performance of “normal” people at guessing the results of coin flips. Those with “normal” brain function lost their shirts. Their emotions made them make mistakes, said the researchers.

This August, researchers at the university of Maryland studied stock traders and came to the opposite conclusion. Hot heads who experienced greater emotional intensity when faced with their decisions turned in better performances. Emotions helped them maximize returns. Score one for Jim Cramer.

What is more telling than the contrary results of the experiments is that, in both cases, researchers assumed that the participants were simply trying to maximize their returns. It is true that many may have thought they were doing so. But their actions betrayed other motives, such as, a desire to play it safe, or to have fun.

If human beings only did things out of economic self-interest, then buying stocks when prices are high or investing in subprime mortgages would be mistakes. But if investors, like everyone else, are expressing other, more complex and subtle motives, then their bad economic decisions might be bringing them other rewards. They might want the security of being part of a crowd. They might want to feel smart, or cool. They might invest to make money. Or not to lose it. To make a point. Or to make a better world.

Yes, “good leaders” probably do come in any size. But it may not be a “good leader” (whatever that is) that people are looking for when they pick CEOs or Presidents.

As it is not necessarily economic self-interest that men are pursuing when they enter the investment markets.

William Bonner and Lila Rajiva are the authors of Mobs, Messiahs and Markets .