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Straight Talk On The European Financial Mess

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The European sovereign debt crisis has generated an enormous amount of nonsensical coverage by the news media.  Most of this coverage appears targeted at American investors, who are regularly assured that a Grand Solution to all of Europe’s financial problems is “just around the corner” thanks to the heroic work of European finance ministers.

Fortunately, a number of commentators have raised some significant objections about all of the misleading “spin” on this subject.  Some pointed criticism has come from Michael Shedlock (a/k/a Mish) who recently posted this complaint:

I am tired of nonsensical headlines that have a zero percent chance of happening.

In a subsequent piece, Mish targeted a report from Bloomberg News which bore what he described as a misleading headline:  “EU Sees Progress on Banks”.  Not surprisingly, clicking on the Bloomberg link will reveal that the story now has a different headline.

For those in search of an easy-to-read explanation of the European financial situation, I recommend an essay by Robert Kuttner, appearing at the Huffington Post.  Here are a few highlights:

The deepening European financial crisis is the direct result of the failure of Western leaders to fix the banking system during the first crisis that began in 2007.  Barring a miracle of statesmanship, we are in for Financial Crisis II, and it will look more like a depression than a recession.

*   *   *

Beginning in 2008, the collapse of Bear Stearns revealed the extent of pyramid schemes and interlocking risks that had come to characterize the global banking system.  But Western leaders have stuck to the same pro-Wall-Street strategy:  throw money at the problem, disguise the true extent of the vulnerability, provide flimsy reassurances to money markets, and don’t require any fundamental changes in the business models of the world’s banks to bring greater simplicity, transparency or insulation from contagion.

As a consequence, we face a repeat of 2008.  Precisely the same kinds of off-balance sheet pyramids of debts and interlocking risks that caused Bear Stearns, then AIG, Lehman Brothers and Merrill Lynch to blow up are still in place.

Following Tim Geithner’s playbook, the European authorities conducted “stress tests” and reported in June that the shortfall in the capital of Europe’s banks was only about $100 billion.  But nobody believes that rosy scenario.

*   *   *

But to solely blame Europe and its institutions is to excuse the source of the storms.  That is the political power of the banks to block fundamental reform.

The financial system has mutated into a doomsday machine where banks make their money by originating securities and sticking someone else with the risk.  None of the reforms, beginning with Dodd-Frank and its European counterparts, has changed that fundamental business model.

As usual, the best analysis of the European financial situation comes from economist John Hussman of the Hussman Funds.  Dr. Hussman’s essay explores several dimensions of the European crisis in addition to noting some of the ongoing “shenanigans” employed by American financial institutions.  Here are a few of my favorite passages from Hussman’s latest Weekly Market Comment:

Incomprehensibly large bailout figures now get tossed around unexamined in the wake of the 2008-2009 crisis (blessed, of course, by Wall Street), while funding toward NIH, NSF and other essential purposes has been increasingly squeezed.  At the urging of Treasury Secretary Timothy Geithner, Europe has been encouraged to follow the “big bazooka” approach to the banking system.  That global fiscal policy is forced into austere spending cuts for research, education, and social services as a result of financial recklessness, but we’ve become conditioned not to blink, much less wince, at gargantuan bailout figures to defend the bloated financial institutions that made bad investments at 20- 30- and 40-to-1 leverage, is Timothy Geithner’s triumph and humanity’s collective loss.

*   *   *

A clean solution to the European debt problem does not exist. The road ahead will likely be tortuous.

The way that Europe can be expected to deal with this is as follows.  First, European banks will not have their losses limited to the optimistic but unrealistic 21% haircut that they were hoping to sustain.  In order to avoid the European Financial Stability Fund from being swallowed whole by a Greek default, leaving next-to-nothing to prevent broader contagion, the probable Greek default will be around 50%-60%.  Note that Greek obligations of all maturities, including 1-year notes, are trading at prices about 40 or below, so a 50% haircut would actually be an upgrade.  Given the likely time needed to sustainably narrow Greek deficits, a default of that size is also the only way that another later crisis would be prevented (at least for a decade, and hopefully much longer).

*   *   *

Of course, Europe wouldn’t need to blow all of these public resources or impose depression on Greek citizens if bank stockholders and bondholders were required to absorb the losses that result from the mind-boggling leverage taken by European banks.  It’s that leverage (born of inadequate capital requirements and regulation), not simply bad investments or even Greek default per se, that is at the core of the crisis.

Given the fact that the European crisis appears to be reaching an important crossroads, the Occupy Wall Street protest seems well-timed.  The need for significant financial reform is frequently highlighted in most commentaries concerning the European situation.  Whether our venal politicians will seriously address this situation remains to be seen.  I’m not holding my breath.


 

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Grasping Reality With The Opinions Of Others

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In the course of attempting to explain or criticize complex economic and financial issues, it usually becomes necessary to quote from the experts – often at length – to provide an understandable commentary.  Nevertheless, it was with great pleasure that I read about a dust-up involving Megan McArdle’s use of a published interview conducted by Bruce Bigelow of Xconomy, without attribution.  The incident was recently discussed by Brad DeLong.  (If you are a regular reader of Professor DeLong’s blog, you might recognize the title of this posting as a variant on the name of his website.)  Before I move on, it will be necessary to expand this moment of schadenfreude, due to the ironic timing of the controversy.  On March 7, Time published a list of “The 25 Best Financial Blogs”, with McArdle’s blog as number 15.  Aside from the fact that many worthy bloggers were overlooked by Time (including Mish and Simon Johnson) the list drew plenty of criticism for its inclusion of McArdle’s blog.  Here are just some of the comments to that effect, which appeared on the Naked Capitalism website:

duffolonious says:

Megan McArdle?  Seriously?  I’ve seen so many people rip her to shreds that I’ve completely ignored her.

Is she another example of nepotism?  Like Bill Kristol.

Procopius says:

Basically yes, although not quite as blatant.  Her old man was an inspector of contracting in New York City.  He got surprisingly rich.  From that he went to starting his own contracting business.  He got surprisingly rich.  Then he went back to New York City in an even higher level supervisory job.  He got surprisingly rich.  So Megan went to good schools and had her daddy’s network of influential “friends” to help her with her “job search” when she graduated.  Of course, she’s no dummy, and did a professional job of networking with all the “right” people she met at school, too.

For my part, in order to discuss the proposed settlement resulting from the investigation of the five largest banks and mortgage servicers conducted by state attorneys general and federal officials (including the Justice Department, the Treasury and the newly-formed Consumer Financial Protection Bureau) I will rely on the commentary from some of my favorite financial bloggers.  The investigating officials submitted this 27-page proposal as the starting point for what is expected to be a weeks-long negotiation process, possibly resulting in some loan modifications as well as remedies for those who faced foreclosures expedited by the use of “robo-signers” and other questionable practices.

Yves Smith of Naked Capitalism criticized the settlement proposal as “Bailout as Reward for Institutionalized Fraud”:

The argument defenders of the deal make are twofold:  this really is a good deal (hello?) and it’s as far as the Obama Administration is willing to push the banks, so we have to put a lot of lipstick on this pig and resign ourselves to political necessities.  And the reason the Obama camp is trying to declare victory and go home is that it is afraid that any serious effort to deal with the mortgage mess will reveal the insolvency of the banks.

Team Obama had put on a full court press since March 2009 to present the banks as fundamentally sound, and to the extent they needed more dough, the stress tests and resulting capital raising took care of any remaining problems.  Timothy Geithner was even doing victory laps last month in Europe.  To reverse course now and expose the fact that writedowns on second mortgages held by the four biggest banks and plus the true cost of legal liabilities from the mortgage crisis (putbacks, servicer fraud, chain of title issues) would blow a big hole in the banks’ balance sheets and fatally undermine whatever credibility the officialdom still has.

But the fallacy of their thinking is that addressing and cleaning up this rot would lead to a financial crisis, therefore anything other than cosmetics and making life inconvenient for the banks around the margin is to be avoided at all costs.  But these losses exist already.  The fallacy lies in the authorities’ delusion that they are avoiding creating losses, when we are in fact talking about who should bear costs that already exist.

The perspective taken by Edward Harrison of Credit Writedowns focused on the extent to which we can find the fingerprints of Treasury Secretary Tim Geithner on the settlement proposal.  Ed Harrison emphasized the significance of Geithner’s final remarks from an interview conducted last year by Daniel Gross for Slate:

The test is whether you have people willing to do the things that are deeply unpopular, deeply hard to understand, knowing that they’re necessary to do and better than the alternatives.

From there, Ed Harrison illustrated how Geithner’s roadmap has been based on the willingness to follow that logic:

More than ever, Tim Geithner runs the show for economic policy. He is the last man standing of the Old Obama team.  Volcker, Summers, Orszag, and Romer are all gone.  So Geithner’s vision of bailouts and settlements is the one that carries the most weight.

What is Geithner saying with his policies?

  • The financial system was on the verge of collapse.  We all know that now – about US banks and European ones too.  Fed Chair Ben Bernanke has said so as has Bank of England head Mervyn King.  The WikiLeaks cables affirmed systemic insolvency as the real issue most demonstrably.
  • When presented with a choice of Japan or Sweden as the model for crisis resolution, the US felt the Japan banking crisis response was the best historical precedent.  It is still unclear whether this was a political or an economic decision.
  • The most difficult political aspect of the banking crisis response was socialising bank lossesAll banking crisis bailouts involve some form of loss socialisation and this is a policy which citizens find abhorrent.  That’s what Geithner meant most directly about ‘deeply unpopular, deeply hard to understand’.
  • Using pro-inflationary monetary policy and fiscal stimulus, the U.S. can put this crisis in the rear view mirror.  Low interest rates and a steep yield curve combined with bailouts, stress tests, dividend reductions and private capital will allow time to heal all wounds.  That is the Geithner view.
  • Once the system is healthy again, it should expand.  The reason you need to bail the banks out is that they have expansion opportunities abroad.  As emerging markets develop more sophisticated financial markets, the Treasury secretary believes American banks are well positioned to profit.  American finance can’t profit if you break up the banks.

I would argue that Tim Geithner believes we are almost at that final stage where the banks are now healthy enough to get bigger and take share in emerging markets.  His view is that a more robust regulatory environment will keep things in check and prevent another financial crisis.

I hope this helps to explain why the Obama Administration is keen to get this $20 billion mortgage settlement done.  The prevailing view in the Administration is that the U.S. is in a fragile but sustainable recovery.  With emerging markets leading the economic recovery and U.S. banks on sounder footing, now is the time to resume the expansion of U.S. financial services.  I should also add that given the balance sheet recession in the U.S., the only way banks can expand is via an expansion abroad.

I strongly disagree with this vision of America’s future economic development.  But this is the road we are on.

Will those of us who refuse to believe in Tinkerbelle face the blame for the next financial crisis?


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Getting Cozy

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April 1, 2010

This week’s decision by the United States Supreme Court, in the case of Jones v.Harris Associates received a good deal of attention because it increased hopes of a cut in the fees mutual funds charge to individual investors.  The plaintiffs, Jerry Jones, Mary Jones and Arline Winerman, sued Harris Associates (which runs or “advises” the Oakmark mutual funds) for violating the Investment Company Act, by charging excessive fees.  Harris was charging individual investors a .88 percent (88 basis points) management fee, compared to the 45-bps fee charged to its institutional clients.

In his article about the Jones v. Harris case, David Savage of the Los Angeles Times made a point that struck a chord with me:

Pay scales in the mutual fund industry, like those in banking and investment firms, are not strictly regulated by the government, and as the Wall Street collapse revealed, investment advisors and bankers sometimes can earn huge fees while losing money for their shareholders.

In 1970, however, Congress said mutual funds must operate with an independent board of directors.  And it said the investment advisors for the funds have a “fiduciary duty,” or a duty of trust, to the investors when setting fees for their services.  The law also allowed suits against those suspected of violating this duty.

But investors have rarely won such claims.  In Tuesday’s decision, the Supreme Court gave new life to the law, ruling that investment advisors could be sued for charging excessive fees.

But the court’s opinion also said such suits should fail unless there was evidence that advisors hid information from the board or that their fees were “so disproportionately large” as to suggest a cozy deal between the advisors and the supposedly independent board.

The lousy job that boards of directors do in protecting the investors they supposedly represent has become a big issue since the financial crisis, as Mr. Savage explained.  Think about it:  How could the boards of directors for those too-big-to-fail institutions allow the payouts of obscene bonuses to the very people who devastated our economy and nearly destroyed (or may yet destroy) our financial system?  The directors have a duty to the shareholders to make sure those investors obtain a decent dividend when the company does well.  If the company does well only because of a government bailout, despite inept management by the executives, who should benefit – the execs or the shareholders?

Michael Brush wrote an interesting essay concerning bad corporate boards for MSN Money on Wednesday.  His opining point was another reminder of how the financial crisis was facilitated by cozy relationships with bank boards:

Here’s a key take-away from the financial crisis that devastated our economy:   Bad boards of directors played a big role in the mess.

Because bank boards were too close to the executives they were supposed to police, they did a lousy job of spotting excessive risk.  They allowed short-term pay incentives such as huge options grants that encouraged bankers to roll the dice.

Michael Brush contacted The Corporate Library which used its Board Analyst screener to come up with a list of the five worst corporate boards.  Here is how he explained that research:

The ratings are based on problems that can compromise boards, including:

  • Allowing directors to do too much business with the companies they are supposed to oversee.
  • Letting the CEO chair the board, which is supposed to oversee the CEO.
  • Overpaying board members and keeping them on too long.
  • Allowing directors to miss too many meetings to do an effective job.

These and other red flags signal that a board is entrenched — too close to management to do its job of overseeing the people in the corner offices.

*   *   *

The big problem with bad boards is that they’re unlikely to ask CEOs tough questions, act swiftly when it is time to replace a CEO or tighten the reins on pay and perks.  And bad boards hurt shareholders.  Several studies have indicated that the stocks of companies with weak boards underperform.

I won’t spoil the surprise for you by identifying the companies with the bad boards.  If you want that information you will have to read the full piece.  Besides — you should read it anyway.

All of this raises the question (once again) of whether we will see any changes result in the aftermath of the financial crisis that will help protect the “little people” or the not-so-little “investor class”.   I’m not betting on it.



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Building A Consensus For Survival

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March 29, 2010

In my last posting, I focused on the fantastic discourse in favor of financial reform presented by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, in a speech before the U.S. Chamber of Commerce.  In addition to Hoenig’s speech, last week brought us a number of excellent arguments for the cause that is so bitterly opposed by Wall Street lobbyists.  On the same day that Thomas Hoenig delivered his great speech to the U.S. Chamber of Commerce, Deputy Treasury Secretary Neal Wolin also addressed that institution to argue in favor of financial reform.  I enjoyed the fact that he rubbed this in their faces:

That is why it is so puzzling that, despite the urgent and undeniable need for reform, the Chamber of Commerce has launched a $3 million advertising campaign against it.  That campaign is not designed to improve the House and Senate bills.  It is designed to defeat them.  It is designed to delay reform until the memory of the crisis fades and the political will for change dies out.

The Chamber’s campaign comes on top of the $1.4 million per day already being spent on lobbying and campaign contributions by big banks and Wall Street financial firms.  There are four financial lobbyists for every member of Congress.

Wolin’s presentation was yet another signal from the Treasury Department that inspired economist Simon Johnson to begin feeling optimistic about the possibility that some meaningful degree of financial reform might actually take place:

Against all the odds, a glimmer of hope for real financial reform begins to shine through.  It’s not that anything definite has happened — in fact most of the recent Senate details are not encouraging – but rather that the broader political calculus has shifted in the right direction.

Instead of seeing the big banks as inviolable, top people in Obama administration are beginning to see the advantage of taking them on — at least on the issue of consumer protection.  Even Tim Geithner derided the banks recently as,

“those who told us all they were the masters of noble             financial innovation and sophisticated risk management.”

Yep.  That was our old pal and former New York Fed President, “Turbo” Tim Geithner, making the case for financial reform before the American Enterprise Institute.  (You remember them — the outfit that fired David Frum for speaking out against Fox News and the rest of the “conservative entertainment industry”.)  Treasury Secretary Geithner made his pitch for reform by reminding his conservative audience that longstanding advocates of the “efficient market hypothesis” had come on board in favor of financial reform:

Now, the recognition that markets failed and that the necessary solution involves reform; that it requires rules enforced by government is not a partisan or political judgment.  It is a conclusion reached by liberals and by conservative skeptics of regulation.

Judge Richard Posner, a leader in the conservative Chicago School of economics, wrote last year, that “we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.”

And consider Alan Greenspan, a skeptic of the benefits of regulation, who recently said, “inhibiting irrational behavior when it can be identified, through regulation,   . . .   could be stabilizing.”

No wonder Simon Johnson is feeling so upbeat!  The administration is actually making a serious attempt at doing what needs to be done to get this accomplished.

Meanwhile, The New York Times had run a superb article by David Leonhardt just as Geithner was about to address the AEI.  Leonhardt’s essay, “Heading Off the Next Financial Crisis” is a thorough analysis, providing historical background and covering every angle on what needs to be done to clean up the mess that got us where we are today — and to prevent it from happening again.  Here are some snippets from the first page that had me hooked right away:

It was a maddening story line:  the government helped the banks get rich by looking the other way during good times and saved them from collapse during bad times.  Just as an oil company can profit from pollution, Wall Street profited from weak regulation, at the expense of society.

*   *   *

In a way, this issue is more about human nature than about politics.  By definition, the next period of financial excess will appear to have recent history on its side.

*   *   *

One way to deal with regulator fallibility is to implement clear, sweeping rules that limit people’s ability to persuade themselves that the next bubble is different — upfront capital requirements, for example, that banks cannot alter.  Thus far, the White House, the Fed and Congress have mostly steered clear of such rules.

Congratulations to David Leonhardt for putting that great piece together.  As more commentators continue to advance such astute, sensible appeals to plug the leaks in our sinking financial system, there is a greater likelihood that our lawmakers will realize that the economic risk of doing nothing far exceeds the amounts of money in those envelopes from the lobbyists.



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The Best Argument For Financial Reform

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March 26, 2010

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, spoke out in favor of financial reform on Wednesday in a speech before the U.S. Chamber of Commerce.  The shocking aspect of Hoenig’s speech is that it comes from the mouth of a member of the Federal Reserve’s Open Market Committee (FOMC) which sets economic policy.  Beyond that, Hoenig brutally criticized what has been done so far to tilt the playing field in favor of the megabanks, at the expense of smaller banks.  Here are some choice bits from what should be mandatory reading for everyone in Congress:

As a nation, we have violated the central tenants of any successful system.  We have seen the formation of a powerful group of financial firms.  We have inadvertently granted them implied guarantees and favors, and we have suffered the consequences.  We must correct these violations.  We must reinvigorate fair competition within our system in a culture of business ethics that operates under the rule of law.  When we do this, we will not eliminate the small businesses’ need for capital, but we will make access to capital once again earned, as it should be.

*   *   *

The fact is that Main Street will not prosper without a healthy financial system.  We will not have a healthy financial system now or in the future without making fundamental changes that reverse the wrong-headed incentives, change behavior and reinforce the structure of our financial system.  These changes must be made so that the largest firms no longer have the incentive to take too much risk and gain a competitive funding advantage over smaller ones.  Credit must be allocated efficiently and equitably based on prospective economic value.  Without these changes, this crisis will be remembered only in textbooks and then we will go through it all again.

Hoenig’s speech comes at a time when the Senate is considering a watered-down version of financial reform that has been widely criticized.  Economist Simon Johnson pointed out how any approach based on U.S. authority alone to “resolve” or break up systemically dangerous banks would be doomed because “there is no cross-border agreement on resolution process and procedure — and no prospect of the same in sight”.

Blogger Mike Konczal expressed his disappointment with what has become of the Financial Reform Bill as it has been dragged through the legislative process:

It’s funny, I know what a good financial reform bill becoming a bad financial reform bill looks like through this process.  I’ve seen bribes and more bribes and last-minute giveaway changes.

The notion that bribery has been an obstacle to financial reform became a central theme of Karl Denninger’s enthusiastic reaction to Hoenig’s speech:

All in all it’s nice to see Thomas Hoenig wake up.  Now let’s see if we can get CONgress to stop opening the bribe envelopes, er, ignore the campaign contributions for a sufficient period of time to actually fix this mess, forcing those “big banks” to get that leverage ratio down to where it belongs, along with marking their assets to the market.

Thomas Hoenig provided exactly the type of leadership needed and at exactly the right time to give a boost to serious financial reform.  We can only hope that there will be enough responsible, ethical people in the Senate to incorporate Hoenig’s suggestions into the Financial Reform Bill.  If only  . . .



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Dumping On Alan Greenspan

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March 22, 2010

On Friday, March 19, former Federal Reserve chair, Alan Greenspan appeared before the Brookings Institution to present his 48-page paper entitled, “The Crisis”.  The obvious subject of the paper concerned the causes of the 2008 financial crisis.  With this document, Greenspan attempted to add his own spin to history, for the sake of restoring his tattered public image.  The man once known as “The Maestro” had fallen into the orchestra pit and was struggling to preserve his prestige.  After the release of his paper on Friday, there has been no shortage of criticism, despite Greenspan’s “enlightened” change of attitude concerning bank regulation.  Greenspan’s refusal to admit the Federal Reserve’s monetary policy had anything to do with causing the crisis has placed him directly in the crosshairs of more than a few critics.

Sewell Chan of The New York Times provided this summary of Greenspan’s paper:

Mr. Greenspan, who has long argued that the market is often a more effective regulator than the government, has now adopted a more expansive view of the proper role of the state.

He argues that regulators should enforce collateral and capital requirements, limit or ban certain kinds of concentrated bank lending, and even compel financial companies to develop “living wills” that specify how they are to be liquidated in an orderly way.

*   *   *

. . . Mr. Greenspan warned that “megabanks” formed through mergers created the potential for “unusually large systemic risks” should they fail.

Mr. Greenspan added:  “Regrettably, we did little to address the problem.”

That is as close as Greenspan came to admitting that the Federal Reserve had a role in helping to cause the financial crisis.  Nevertheless, these magic words from page 39 of “The Crisis” are what got everybody jumping:

To my knowledge, that lowering of the federal funds rate nearly a decade ago was not considered a key factor in the housing bubble.

The best retort to this denial of reality came from Barry Ritholtz, author of Bailout Nation.  His essay entitled, “Explaining the Impact of Ultra-Low Rates to Greenspan” is a must read.  Here’s how Ritholtz concluded the piece:

The lack of regulatory enforcement was a huge factor in allowing the credit bubble to inflate, and set the stage for the entire credit crisis.  But it was intricately interwoven with the ultra low rates Alan Greenspan set as Fed Chair.

So while he is correct in pointing out that his own failures as a bank regulator are in part to blame, he needs to also recognize that his failures in setting monetary policy was also a major factor.

In other words, his incompetence as a regulator made his incompetence as a central banker even worse.

Paul La Monica wrote an interesting post for CNN Money’s The Buzz blog entitled, “Greenspan and Bernanke still don’t get it”.  He was similarly unimpressed with Greenspan’s denial that Fed monetary policy helped cause the crisis:

This argument is getting tiresome.  Keeping rates so low helped inflate the bubble.

*   *   *

“The Fed wasn’t the sole culprit.  But if not for an artificially steep yield curve, we probably would not have had a global financial crisis,” said John Norris, managing director of wealth management with Oakworth Capital Bank in Birmingham, Ala.

“Greenspan and Bernanke are missing the point.  It all stems from monetary policy,” Norris added.  “If you give bankers an inducement to lend more than they ordinarily would they are going to do so.”

From across the pond, Stephen Foley wrote a great article for The Independent entitled, “For the wrong answers, turn to Greenspan”.  He began the piece this way:

The former US Federal Reserve chairman, the wizened wiseman of laissez-faire economics, shocked us all — and probably himself — when he told a congressional panel in 2008 that he had found “a flaw in the model I perceived is the critical functioning structure that defines how the world works, so to speak”.  He meant that he had realised banks cannot be trusted to manage their own risks, and that markets do not smoothly self-correct.

But instead of taking that revelation and helping to point the way to a new, post-crisis financial world, he has shuddered to an intellectual halt.  It is the same intellectual stop sign that Wall Street’s bankers are at.  The failure to move forward is regrettable, dangerous and more than a little self-serving.

These reactions to Greenspan’s paper are surely just the beginning of an overwhelming backlash.  The Economist has already weighed in and before too long, we might even see a movie documenting the Fed’s responsibility for helping to cause The Great Recession.



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