THE SHAPE OF US POPULISM
The birth of the New Deal
By Henry C K Liu

The New Deal was a continuation of the progressive movement, combining many aspects of the policies of Teddy Roosevelt and Woodrow Wilson. The Democratic Party was still under the control of the Southern conservatives and the political machines of the Northern cities, yet support for Franklin D Roosevelt was strong among organized labor, small farmers and middle-class reformers and the intelligentsia. There was constant conflict between the conservative and progressive wings of the Democratic Party and some of the bitterest opponents of the New Deal were conservative Democrats. Some of the strongest supporters were liberal Republicans.

Franklin D Roosevelt's natural air of confidence and optimism did much to reassure a disheartened nation. His inauguration on March 4, 1933, occurred literally in the middle of a terrifying bank panic, a challenging backdrop for his famous words: "The only thing we have to fear is fear itself." Such inspiring words were a exultant contrast five decades later to Carter's disconcerting "malaise" speech of "crisis of the soul and confidence" to a restless nation facing rising gasoline prices at US$1.25 a gallon, with gold rising to $300 an ounce but with the US enjoying a trade surplus with emerging China for another 14 years.

The US now, with gas at $4 a gallon and gold over $1,000 and a trade deficit with China running to over $200 billion a year, would thank God for the good old days of 1979. Carter desperately imposed wholesale resignation on his entire cabinet in 1979, the third year of his first and only four-year term. In doing so, he deprived himself of valuable support and assistance in dealing with the Iran hostage crisis that cost him a second term.

Capitalism saved - in eight days
Roosevelt, on the very next day after his inauguration, declared a national "bank holiday", closing all banks indefinitely until bankers and government could regain control of the situation, to prevent further runs on banks. Congress was completely compliant and gave the new president virtual dictatorial power in a national emergency. The Emergency Banking Bill, which strengthened, reorganized and reopened all still-solvent banks, was passed overwhelmingly by Congress with little debate.

On March 12, Roosevelt announced that all sound banks would reopen. On March 13, deposits at those banks exceeded withdrawals, a tremendous relief to a worried nation. "Capitalism was saved in eight days," said Raymond Moley, a founding member of the President¡¯s Brain Trust. It was a counterpoint to John Reed¡¯s Ten Days that Shook the World, a chronicle of Russia's October Revolution.

Moley, a professor at Columbia University's Barnard College, had recruited several Columbia professors to form a "Brain Trust" to advise Roosevelt during his 1932 presidential campaign. The group, derisively ridiculed by a skeptical anti-intellectual press, subsequently went to Washington to fill key posts successfully in Roosevelt's New Deal program. Yet Moley broke with Roosevelt in mid-1933 to become a pro-Republican journalist and the most vocal conservative critic of the New Deal.

On April 22, 1970, Republican president Richard M Nixon awarded Moley the Presidential Medal of Freedom with the citation that "his exceptional ability as a political analyst is matched by a deep love of his country, and of the principles of democratic government."

The bank "holiday" demonstrated the need and effectiveness of government intervention in an economic crisis. Hoover had allowed two previous bank panics to run their natural courses, which contributed to over 10,000 bank failures and $2 billion in lost deposits. The bank holiday in 1933 secured Roosevelt's political reputation of decisive action, and convinced both Congress and the public that the New Deal was the right road to follow. Conservatives still consider government intervention as a corrupting element in free markets that encourages rising moral hazard and that government bailouts are the pain killers that will ultimately destroy free-market capitalism. Pain is not punishment; it is a necessary warning against approaching danger. Without pain, free markets cannot self-correct preemptively before it reaches total meltdown.

Many present-day economists, including Stanley Fischer, the MIT-trained former World Bank chief economist and IMF deputy managing director, consider the Fed's intervention in the 2007 credit crisis that escalated into an unprecedented Fed-backed rescue of Bear Stearns as marking a "turning point" in the latest financial market turmoil. Bear Stearns, an investment bank, was normally regulated by the Securities and Exchange Commission, and not the Fed. Yet the Fed's Bear move in March 2008 could be seen as a continuing pattern of escalating central bank market intervention rather than a turning point. Fischer as first deputy managing director of the IMF played a central role in the international monetary agency¡¯s ineffective handling of the Asian financial crisis in 1997 and Russian bond default in 1998, which had added to, rather than moderated, the severity of the damage.

"It is not over," Fischer told the Financial Times recently. "There will be more occasions when we think that the world is going to go to hell in a hand basket. But for the first time since last summer it is clear that the authorities are beginning to contain the financial sector crisis in the US."

Fischer, who left the IMF in 2001 to join Citibank as vice chairman and went on to the Bank of Israel as governor in 2005, told the FT: "My guess is that when the history of this crisis is written, the Bear Stearns rescue will be seen as a turning point. It was done very well and very decisively." The statement sounds very much like famous last words. More likely, history will record the Bear Stearns move as the Fed pushing the panic button.

The Fed intervention was in fact done amid confusion. Information since available on the details of the Sunday, March 16, rescue suggests that the Fed failed to notify Bear Stearns of its abrupt decision over the weekend to make discount window borrowing accessible to investment banks.

Had Bear Stearns been armed with knowledge of the availability of that critical option, it might have gone to the Fed discount window for funds rather than to negotiate with JP Morgan, which as a commercial bank had ready access to the discount window. The Fed insistence on JP Morgan capping the offer price of $2 per share to Bear Stearns was to bring home the impression that the rescue was not a bail-out of Bear Stearns, but a move to prevent a market meltdown from counterparty effects from a Bear Stearns default.

But the deal neglected the fact that Bear shareholder approval was necessary for the proposed transaction with JP Morgan and that such approval was unlikely at an offered price below what Bear shareholders could get in a bankruptcy filing. In the end, JP Morgan had to offer a new price of $10 per share to acquire 40% of the voting shares to ensure Bear shareholder approval, thus diluting the Fed effort to avoid any appearance of bailing out Bear Stearns shareholders. It was anything but a deal "done very well".
Back in 1987, when the Dow Jones Industrial Average dropped by more than 22% on October 19, then Federal Reserve Board chairman Alan Greenspan and E Gerald Corrigan, at the time president of the New York Federal Reserve, executed a cleaner deal in strong-arming all the major banks not to withhold payments for fear of counterparty default because then the number of counterparties was small and their identities were known. In 2008, the number of counterparties was huge and their identities obscured by complex structured finance.

In 2008, Greenspan's successor, Ben Bernanke, and present NY Fed president Tim Geithner executed a messy deal of questionable need. The Fed as a lender of last resort is mandated to support commercial banks and deposit-taking institutions that are critical parts of the retail payment mechanism if failing to do so threatens serious negative externalities in the entire market through contagion effects, such as classic bank run by depositors, even then only if the banks in question are otherwise solvent.

Other institutions are also deemed too important to fail because they play a key role in the wholesale payments, clearing and settlement system and if their failure would cause systemic consequences. Institutions are provided with liquidity on non-market terms or bailouts by the Fed when they face a cashflow problem, but not insolvency, because their failure would trigger a systemic chain-reaction of contagion effects on the entire market.
Bear Stearns did not fall within these criteria. It was not a deposit-taking institution. It played no role in the retail payment mechanism and was of no significance to the proper functioning of the wholesale payments, clearing and settlement system. There was no case for a Fed rescue for Bear Stearns except the risk of systemic contagion effects, in which case the Fed should have nationalized the investment bank at zero price per share and prevented it from defaulting any counterparty obligations. At most, the Fed could grant Bear Stearns shareholders the right to post-receivership claims on surplus value after the Fed as trustee had satisfied all Bear obligations.

Geithner told a US Senate banking committee: "On the evening of Thursday, March 13, 2008, I took part in a conference call with representatives from the Securities and Exchange Commission, the Board of Governors of the Federal Reserve and the Treasury Department. On that call, the SEC staff informed us that Bear Stearns¡¯ funding resources were inadequate to meet its obligations and that the firm had concluded that it would have to file for bankruptcy protection the next morning. Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education and the expenses of everyday life, lower value of retirement savings and rising unemployment."

Under questioning by committee chairman Senator Christopher J Dodd, Democrat of Connecticut, both Fed chairman Bernanke and Geithner said they played no role in setting the price, which was one of the most controversial elements of the deal.

In response to the same question, Treasury Undersecretary Robert Steel said Treasury Secretary Henry Paulson, who could not attend the committee hearing due to a scheduled visit to Beijing to attend the Sino-US strategic dialogue, had insisted during the negotiations that the price should be low because the deal was being supported by a $30 billion taxpayer loan, to make the broader point to the markets that the government did not want to encourage risky behavior by other large institutions, the sentiment known as "moral hazard".

The failure to keep the intended low purchase price turned even Senator John McCain, the Republican candidate for the 2008 presidential election, critical of the terms of the Bear Stearns deal. McCain said on television that he has "always been committed to the principle that it's not the duty of government to bail out and reward those who act irresponsibly, whether they're big banks or small borrowers." The Wall Street Journal reported that McCain "displayed a strong populist streak over the housing crisis this weekend, blasting what he called the 'outrageous' and 'unconscionable' compensation of Bear Stearns and Countrywide executives and their 'co-conspirators'." Mortgage lender Countrywide Financial collapsed in the 2007 subprime meltdown.

McCain was quoted as saying: "I think it's outrageous that someone who is the head of Bear Stearns cashes in millions and millions of dollars in stocks." James Cayne, chairman and former Bear Stearns chief executive, recently sold the vast majority of his stake in the company to JP Morgan at $10.84 a share, generating $61 million. As one of the largest shareholders, Cayne also lost a lot of money with the firm's collapse. His stake was once valued at about $1 billion when the stock was trading at $171.50 per share.

Jacob Frenkel, vice-chairman of AIG, the US global insurance group, who preceded Fischer at the Bank of Israel at like him worked at the IMF, said the Fed had shown it was prepared to broaden dramatically its regulatory "clientele" to preserve the stability of the financial system. "The expansion of its clientele and the expansion of the range of assets have given a huge boost to the confidence of the market," he said. "I think that the last month has been a crossing of the Rubicon." Frenkel seems to be confusing moral hazard with confidence. When Julius Caesar crossed the Rubicon, Rome's days as a republic were numbered.

Still, the Financial Times reported that Fischer also suggested that central banks should do more to try to "prick asset bubbles" to prevent such crises from recurring. "The monetary policy view that you should not react to asset prices is wrong. Asset prices, including stock prices, affect growth and inflation and it is fully consistent with the monetary policy goals of providing price and financial stability to take asset prices into account in setting asset prices." This amounts to a direct challenge to Greenspan¡¯s mantra that it is not the central bank¡¯s role to "prick asset bubbles", only to clean up after they burst.

Closing ranks with Greenspan, Frenkel said a policy to prick putative bubbles would be difficult to implement. "There is no way the Fed or any other monetary authority can prick all the bubbles that come its way. And so the real choice is which system do you want: one in which the Fed pricks three bubbles out of five or five out of three bubbles. Because we know for sure that we will not be able to solve four out of four." This view echoes that of Greenspan, the former Fed chairman now frantically defending himself from being blamed by many for following a policy that allowed serial bubbles to form. Still, most traders would agree that scoring three out five or overshooting five out of three is a preferable strategy than taking all incoming until death.

Greenspan continues to deny responsibility
Greenspan wrote early April in the Financial Times that he is "puzzled" why so many commentators seek to explain the US housing bubble in terms of Fed actions when many other economies with different central banks and different monetary policies also saw rapid house price gains. The answer is simple. The Fed is the head of the global central bank snake, with the fiat dollar as the world¡¯s key reserve currency. The Fed dominates monetary policies of all other central banks, which must be reactive either with compensatory interest rate policy or currency revaluations. When the Fed eases, global liquidity increases and asset prices rise everywhere. Other central banks merely have options on which channel to react through; they do not have the option of decoupling from Fed policy or the dollar.

In early April, Greenspan wrote in defense of his policy, "We will never have a perfect model of risk", explaining that: "We will never be able to anticipate all discontinuities in financial markets. Discontinuities are, of necessity, a surprise. Anticipated events are arbitraged away. But if, as I strongly suspect, periods of euphoria are very difficult to suppress as they build, they will not collapse until the speculative fever breaks on its own. Paradoxically, to the extent risk management succeeds in identifying such episodes, it can prolong and enlarge the period of euphoria. But risk management can never reach perfection. It will eventually fail and a disturbing reality will be laid bare, prompting an unexpected and sharp discontinuous response."

Waiting for "speculative fever to break on its own?" Pediatricians prescribe Motrin to break a child¡¯s high fever because letting the fever run its course can cause permanent brain damage.

Alice Rivlin, first Director of the Congressional Budget Office from 1975 to 1983 and a persistent and vociferous critic of