A Quarterly Message on Liberty

Winter 2012Volume 10 Number 1

’m going to attempt to bring you a different perspec-tive on the financial crisis today. I’m a real worldbusiness person, who was CEO of a large financialinstitution for 20 years and worked within the bank-

ing industry for 40 years. In that context, I view myself ashaving worked under the Federal Reserve. In theory, CEOsreport to boards, who then report to shareholders. Whilethat’s true of most businesses, in the financial services industry, we only quasi-report to boards, quasi-report toshareholders, and definitely report to regulators.

I’ve known many people who have worked for the Fed.In my experience, they’ve all been guilty of what F. A. Hayekcalled “fatal conceit.” It’s the belief that smart people cando the impossible—and I don’t care how great your mathe-matical models are, you cannot integrate the economic activity of seven billion people around the planet.

JOHN A. ALLISON

IJohn A. Allison is the former chair-man and CEO of BB&T, where hewas named one of the top 100 mostsuccessful CEOs in the world by Harvard Business Review. Hespoke at the Cato Institute’s 29th Annual Monetary Conference in November.

The Real Causes of the Financial CrisisThe Real Causes of the Financial Crisis

2 • Cato’s Letter WINTER 2012

The fundamental question—which I’m going to analyzefrom a human action per-

spective—is what does governmentpolicy incent real world human be-ings to do? I strongly believe that therecent financial crisis, the ensuing re-cession, and the slow recovery werecaused primarily by governmentpolicies. To explain this, I’m going tofocus on two components: regula-tion and monetary policy.

The foundation for regulation inthe banking industry is insurancefrom the Federal Deposit InsuranceCorporation (FDIC). It’s used to jus-tify regulation because the banks aresupposedly being “protected by thefederal government.” In my opinion,FDIC insurance is one of the maincontributors to the financial crisis—with Fed monetary policy errors andFreddie/Fannie’s affordable housingloans being the primary causes.

FDIC insurance has destroyed mar-ket discipline in the banking system.Most of the large institutions thatfailed financed their high-risk lend-ing business using FDIC-insured de-posits. They absolutely could nothave done that in the private market-

place. In fact, if private deposit insur-ance had been in place, it would nothave been available to most of thefailed institutions unless they haddouble or triple their capital. With aprivate deposit insurance fund, I be-lieve that the financial crisis wouldhave been dramatically less severe.

The regulators used fair lendinglaws—designed to eliminate racialdiscrimination in lending—and theCommunity Reinvestment Act toforce banks to make loans to un-qualified borrowers in order to in-crease homeownership. Of course,the primary drivers of excessive in-vestment in residential real estatewere Freddie and Fannie, govern-ment-sponsored enterprises thatwould not exist in a free market.They had $2.5 trillion in subprimeloans where they failed. Banks werenot designed to be low-incomelenders, but we were forced to do

that on a fairly large scale. Itwas a moral crusade—andthere was a decidedly politi-cal aspect as well. The regula-tors aggressively pursuedracial discrimination claimsin the early Clinton andObama years only to reversethese claims after the Repub-lican congressional victoriesof 1994 and 2010. Subprimelending is now viewed as bad,but then it was a moral im-

perative.On safety and soundness regula-

tions, I don’t know of a single casewhere the regulators identified a sig-nificant problem in advance of themarket. They’ve gotten involved a lotof times, and most of the time

I’ve known many people who have workedfor the Fed. Inmy experience, they’veall been guilty of what F. A. Hayek called ‘fatal conceit.’

“

“

WINTER 2012 Cato’s Letter • 3

they’ve made the problemworse. Why is that? Look atpublic choice theory. In thegood times, regulators alwaysunderregulate. The examinersdidn’t identify the problem be-cause they didn’t understandthe business. They had neverlived through bad times before.Even if they had, they would havedone nothing. Why? Politics. It’s notworth bringing heat on the agency.

In the course of my career, everytime we’ve had a correction, the regu-lators have tightened lending stan-dards—even for banks that have goodcredit histories. So, the Fed is current-ly printing money in an attempt toboost the economy, and the regula-tors have tightened up. Why? Ifyou’re a local regulator, the only wayyou can get in trouble is if your bankgets in trouble. It’s a one-sided bet. It’sa classic public choice paradigm.

Finally, the cost of regulation isenormous. If you asked me would Irather eliminate taxes on banks orregulations, it would be a no brainer:regulations. BB&T alone has addednearly a thousand people to its regu-latory staff in the past year. And ofcourse what we’ve done is reduce pro-duction. You can only do so much.

Let’s consider monetary policynext. I’ve asked numerous Fed policydecisionmakers a basic question overthe years: Do central bankers believein price controls? Do they think thatthe government can, for instance, setthe price for automobiles? The an-swer, of course, is no—to which I’veasked a follow-up. When the Fed setsinterest rates, aren’t they setting themost important price in the econo-

my—the price of money? I’ve nevergotten a credible answer.

With respect to human action,the Fed created a number of incen-tives that led directly to the recent fi-nancial crisis. It began in the early2000s, when Alan Greenspan creat-ed negative real interest rates. Thiswas a big deal in the residential realestate market because prices were ap-preciating so rapidly, creating a hugeincentive to expand construction.Eventually, Greenspan—and thenBernanke—started raising interestrates. In two years, they increased thefederal funds rate by 425 percent.This increased the cost of goods inthe banking industry, which wasparticularly destructive becauseright before the Fed started raisingrates Greenspan was warning aboutexcessive savings and deflation.Banks extended their bond portfo-lios on his advice, which createdwhopping losses.

Then, Bernanke did another in-credibly destructive thing: he invert-ed the yield curve. Banks makemoney by borrowing short and lend-ing long. When the yield curve wasinverted, short-term rates were high-er than long-term rates, and bankmargins went negative—whichmeant they were buying watermel-ons for $10 and selling them for $8.

Thomas Jefferson said that each of us has a moral right topursue our own personal happiness.

“ “

What did banks do in response?Knowing that they could makehigher returns by taking more risks,they went out on the risk spectrum.Most of the bad loans were made inthe last part of this cycle—under theinverted yield curve—a phenomenonthat only occurs in response to gov-ernment policy. At the same time,the Fed was adamant that we werenot going to have a recession, whichhad a psychologi-cal effect on banks.Academics talkabout acting in thelong-term on thebasis of perfect in-formation. Well, inthe real world, theshort-term mat-ters and perfect in-formation doesn’texist. So bankswent out on therisk spectrum andmade bad loans.

With China and India’s entry intothe global economy, billions of peoplewere suddenly becoming more pro-ductive. Prices should’ve been in freefall in the early 2000s, but Greenspandidn’t allow that to happen, whichsent a terrible signal to the economy.Those of us in the investment busi-ness didn’t see the resulting hidden in-flation, and by holding prices up, wewere in effect telling the Chinese toproduce like crazy. This drove jobs outof the United States, drove up manu-facturing wages, and encouraged ex-cessive housing consumption.

I’m also convinced that privatemarkets would have come up with avery different interest rate scenario

than the Fed did. Each of us—inde-pendent businesses, maximizingprofits, not a bit concerned for thepublic good—would have created aninterest rate scenario that preventedmany of these economic problems.

But there’s a deeper issue. The Fedsays that it’s currently holding inter-est rates below market rates—whichmeans it’s redistributing wealth fromsavers to borrowers. This arbitrary re-

distribution is un-ethical and very de-structive. That alonewould condemn theFed in my view.

So what shouldwe do? I’m for get-ting rid of the Fed.As long as it exists,the temptation forCongress to bor-row us into eco-nomic chaos willbe there. Congresswill never disci-

pline itself if the Fed can printmoney. We need a private bankingsystem with a gold standard.

If ending the Fed is not an op-tion, I think the second best solutionwould be to cap the growth in themoney supply at 3 percent, as Mil-ton Friedman suggested. A more po-litically acceptable alternative wouldbe to raise capital limits for financialinstitutions and transfer risk fromthe public to the bank shareholders.This would require privatizing FDICinsurance and getting rid of 95 per-cent of the regulations.

The market is based on experi-mentation. The existence of a gov-ernment agency, on the other hand,

4 • Cato’s Letter WINTER 2012

WINTER 2012 Cato’s Letter • 5

destroys the learning process. Ifwe’d had a private financialmarket since 1913, when theFed was created, many of the is-sues we’re struggling withwould have solved themselves along time ago, and we wouldhave a very advanced monetarysystem in the United Statesright now. But we stopped thelearning process.

As important as the policy mis-takes have been, I believe that the realcause of the financial crisis is philo-sophical. More specifically, we gotinto this mess through a combina-tion of altruism and pragmatism,which is what I call “the free-lunchmentality.” The Fed is a classic altru-istic organization. It has been tryingto save indebted borrowers—and fail-ing banks—by driving down rates sothey can get out of trouble. It’s usingpragmatic standards in an “emer-gency” situation. Unfortunately, thisfree-lunch mentality leads to a lackof personal responsibility, which isthe central issue that underlies all ofour financial problems.

Interestingly enough, the solu-tions are philosophical as well.When most people think about life,liberty, and the pursuit of happiness,they focus on liberty. But the world-changing idea was the pursuit ofhappiness. Before the Enlighten-ment, everybody existed for some-body else—for the good of the king,the state, or the church. Nobody ex-isted for their own good. WhatThomas Jefferson said was that eachof us has a moral right to pursue ourown personal happiness. It was thatidea that created the most successful

society in history.One of the main problems in this

crisis has been a failure of leadership.What is leadership? It’s creating anenvironment in which people canpursue their personal happiness—inwhich people are clear about theirpurpose and can use their capacityto think. This environment is thekey to raising self-esteem—whichmeans doing the best you can do,given your level of knowledge andskill. This, in turn, has an enormoussocial implication.

Take an entry-level constructionworker—a bricklayer. He has a verytough life, but he gets somethingvery precious for his work. He gets tobe proud of himself. Take that samebricklayer and give him welfare. He’sbetter off financially, but he loses hispride. He loses his self-esteem. Therehas been a lot of focus recently on se-curity. The Fed is there to make us“secure.” But this is not the land of se-curity. The United States is the landof opportunity—the opportunity tobe great, the opportunity to fail andtry again, and most importantly theopportunity for that bricklayer to livelife on his own terms, to pursue hispersonal happiness. That is theAmerican sense of life, and that iswhat is so precious to protect.

“I believe that the realcause of the financialcrisis is philosophical.We got into this messthrough what I call ‘thefree-lunch mentality.’

“

6 • Cato’s Letter WINTER 2012

What do you see as the biggest threat to theFirst Amendment today?The biggest threat to the First Amendment—and all other parts of the Constitution forthat matter—is the widespread ignorance ofwhat is contained within that document. Wehave witnessed a mostly passive citizenry asthe Constitution has been razed over the lastdecade or so.

James Madison, the father of the FirstAmendment, insisted that “the great right” offreedom of speech must be placed beyond thereach of any branch of government. Impor-tantly, there is a connection between theFourth Amendment—which protects every oneof us from unreasonable searches by the gov-ernment—and the First Amendment. As ourright to privacy has been violated under Bushand now more so under Obama, many Ameri-cans are becoming careful about what they say.

If our government keeps tracking us in somany ways, we will no longer be a self-govern-ing republic dependent on the First Amend-ment, our fundamental freedom.

You recently wrote that the Declaration of Independence and the Constitution “shouldoften be in the rhythm section of the sym-phonies that are our classroom discussionsand debates.” What do you mean by this?There are many problems in education rightnow, but one of the biggest is the fact thatthere are very few civics classes. When I wentto school long ago, you’d learn about theConstitution, about our liberties, about how abig part of our country’s history was dedicat-ed to protecting those liberties.

Now, because of Bush’s No Child Left Be-hind Act, most of the civics classes were doneaway with. The focus is instead on collectivestandardized tests in reading and math. As aresult, our children have little understandingof how this republic works.

Our founding documents are a criticalpart of the learning process. It was ThomasJefferson who told future generations to neverforget who they are: “What spectacle can bemore edifying or more seasonable, than thatof Liberty and Learning, each leaning on theother for their mutual & surest support?”

You recently received the Deems TaylorAward for your book At the Jazz Band Ball:Sixty Years on the Jazz Scene. Do you see a connection between jazz and our civil liberties?In a November Wall Street Journal article, I wroteabout Ehsan Khoshbakt, a young Iranian dissi-dent in his late twenties who has managed towrite a blog about jazz outside of the reach ofthat country’s censors. As a young boy, Ehsancame across a compilation cassette with LouisArmstrong on it, and it changed his life.

“It doesn’t matter if you’re old or young;man or woman; a billionaire or a bellboy; freeor inside a prison; Muslim or Christian, orJew,” he writes in one of his posts. “As long asyou can be part of this democratic conversa-tion known as jazz, you’re in, and nothing elsematters.”

That is the best answer to the question.Ehsan was able to understand what liberty wasonce he heard these musicians express them-selves. Jazz, simply put, is freedom music.

NAT HENTOFF is a senior fellow at the Cato Institute. A cele-brated writer and civil libertarian, he is considered one of the lead-ing authorities on the First Amendment and the Bill of Rights.Hentoff was a columnist with the Village Voice for 51 years, from1957 until 2008. A jazz expert, he currently writes about musicfor the Wall Street Journaland Jazz Times. Hentoff was recent-ly honored with the ASCAP Deems Taylor Award for his latestbook, At the Jazz Band Ball: Sixty Years on the Jazz Scene.

Cato Scholar Profile:NAT HENTOFF

WINTER 2012 Cato’s Letter • 7

or the Cato Institute, 2011 willstand out as a year of achieve-ment, growth, and accom-

plishment. A successful capital cam-paign coupled with a headquartersexpansion will provide the foundationfor a vastly expanded policy reach. MoreCato scholars covering more policy areaswill ensure that Cato keeps ideas aboutsmall government, freedom, and the rule of law in the forefront of our national debate.

We thank you, our Sponsors, for makingthis groundswell of activity possible. But whilewe are proud of what has been achieved, we arealso mindful of how much more needs to bedone—because there are never enough re-sources when one struggles against a statistbehemoth. So we ask you to continue to jour-ney with us.

To be a little more specific about what hasbeen happening . . . Cato’s Liberating the Fu-ture capital campaign is drawing to a close:$44.5 million of our $50 million goal has al-ready been raised and we are on track to raisethe rest. Some of the funds raised are beingused to double the size of Cato’s headquartersat 1000 Massachusetts Avenue in Washing-ton, D.C. Remarkably, this expansion is run-ning on time and on budget. Floors fourthrough seven are now complete and the restof this renovation/expansion will be finishedby March 2012. Our new facility is simplybeautiful and will feature commodious policycenters, an expanded F. A. Hayek auditorium,a new George M. Yeager Conference Center

that will seat 200 people for dinner, the Kenand Frayda Levy Liberty Garden, and theMelvyn Jay Kushner Library.

More important, the new facility will en-able the launch of new policy centers, such as

n Money and bankingn Labor and employmentn Environmental and energy issuesn Government transparencyn And much more!The “more” is only limited by the resources

that we can bring to the task. So we thank youagain for what you have already done and weask you to be a part of the future. As always, wewelcome whatever is comfortable for you: an-nual gifts, gifts to the capital campaign, giftsfor a specific purpose, or planned gifts involv-ing a bequest or a beneficiary designation.

If you wish to discuss gifting possibilitiesplease contact Gayllis Ward, Cato’s director ofplanned giving, at gward@cato.org or 202-218-4631.

F

So Much Accomplished . . . So Much to Do

1000 M

assachusetts Ave., N.W.

Washington

, D.C. 20001

www.cato.org

Non

prof

it

Org

aniz

atio

nU

.S. P

osta

ge

PAID

Cat

o In

stit

ute

Save 50% on all Cato e-books

C ato Institute e-booksare available in a num-ber of formats for your

smart phone, Kindle, andother e-readers. While Catobooks are sold by a numberof online retailers, books can also be purchased anddownloaded directly fromCato.org/store. For a limitedtime, you can take 50% off e-book purchases made atthe Cato store by using thecode EBOOK2012whenyou check out. Offer expiresFebruary 1.

E-resources fromthe

Buy e-books or get more information by visiting Cato.org/store or calling 800-767-1241.Cato Institute, 1000 Massachusetts Avenue, N.W., Washington, D.C. 20001 l www.cato.org