Financial Stability Ch 20: Wisdom Without Repeating History's Mistakes

Book: Financial Stability: Fraud, Confidence and the Wealth of Nations
Authors: Frederick L. Feldkamp and R. Christopher Whalen
ISBN: 978-1-118-93579-8

Part Four of this book opens with a big-picture chapter that tries to pull everything together. Feldkamp and Whalen zoom out from 4,000 years of fraud law to the last 40 years of U.S. financial market reform. The message is blunt: we have made enormous progress, we blew a lot of it, and the fix is simpler than the politics around it.

Forty years of an experiment nobody tried before

The United States has only spent about one-sixth of its national life building a legal foundation for stable financial markets. Nobody had tried to replace bank monopolies controlled by kings and priests with deregulated free markets before. In that short window, the world sorted out trade imbalances and population shifts that would have crushed earlier civilizations.

Look at the data from the last 200 years. Health, wealth, and life expectancy improved faster than at any point in human history. Much of that happened in just the past 40 years. The Marshall Plan is the moral anchor here. Forgiving prewar debts and rebuilding former enemies instead of punishing them was benevolence in action. By 1973, those same enemies were selling products that outcompeted U.S. manufacturers. That is not failure. That is the pie getting bigger for everyone.

The $67 trillion hole

Here is the crisis in one number. In 2006, accountants and businesses told the world there was $67 trillion more equity invested than actually existed. The gap was shadow banking: off-balance sheet liabilities that nobody disclosed. When the bubble burst, that hidden debt became a $67 trillion hit to equity. Worldwide stock values dropped by about two-thirds.

The money did not leave Earth. Some people took it from others and parked it where it could not fund productive investment. A lot of the subprime boom was illegal. A lot of the rest was innocent but irrational exuberance. The error was disclosure and corruption, not the idea of sound disclosed debt.

Irving Fisher explained the debt-contraction spiral in 1933. We were heading there again until central bankers, especially Ben Bernanke and Don Kohn, showed they understood what was needed. Leaders dragged their feet for over a year after Bernanke’s September 2007 warnings. We fell into a deep hole. Six years later, a central bank bridge spans that gap. Before the bridge comes down, markets need real repair.

Transparency and freedom, nothing fancy

The authors say the United States has solved the ancient mysteries of financial stability. We just have not implemented the reforms to sustain it. All that is required: transparency plus freedom of exchange without fraud. Experts have said this for two millennia. Dictators, monopolists, and human inertia blocked it.

The real hurdle ahead is confidence. The world may need $2 to $4 quadrillion in debt and equity savings over the next 40 years to fund capital goods for climate change, energy transition, and population growth. That sounds insane until you remember the only constraint is trust.

Evil vs. folly, and J.P. Morgan’s lesson

Smart investors guided by self-interest but lacking benevolence are more dangerous than outright evil. Evil can be exposed and fought. Folly is illogical and hard to spot. Fighting folly is harder than fighting evil because perpetrators think they are doing well for themselves.

J. Pierpont Morgan understood this before the 1907 panic. Banks hid leverage in undercapitalized trust company subsidiaries and reported net values before consolidation was required. When the pyramids fell, Morgan had leverage available that others did not. He bought assets at fire-sale prices. That crisis pushed him to help create the Federal Reserve in 1913 as a lender of last resort so he would not have to shake down friends again.

But Morgan may have gotten greedy. He helped structure a Fed that could not pay interest on free reserves. Louis Brandeis understood how secret common-law pledges let lenders keep collateral fruits while depositors got wiped out. When 1929 hit, the constrained Fed could not play Morgan’s 1907 role. Transparency reforms demanded by the Supreme Court blocked the old tricks. The United States took a long path through debt deflation into World War II.

It took more than 60 years of law reform to force fair transparency on collateral pledging and kill off-balance sheet shadow banking. The finish line: credit spreads stabilizing near the complete-market ranges in Charts 9.1, 9.2, and 9.3. Hit that equilibrium and the world can build on U.S. market expertise for reconciliation, wealth, and living standards.

Crisis as opportunity (for victims, not fraudsters)

The Chinese character debate about crisis meaning opportunity is mostly semantics. When fraud is exposed in a crisis, rescission becomes a full remedy whether the fraud was intentional or innocent. In rising markets, rescission barely helps because victims do not want the old asset back. Crisis flips that. Good times are when governments must enforce transparency and anti-fraud rules aggressively, because private parties have weak remedies and procyclical behavior makes the next crash worse.

Forty years of democratizing money control failed in part because we misdirected benevolence. That is a reason to learn and try again, not to give up or revert to bank monopolies.

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