The American Spectator

The Public Policy

Mark to Market Means Mayhem

By Brian Wesbury & Robert Stein on 12.8.08 @ 6:08AM

Following the announcement by the National Bureau of Economic Research that a recession in the U.S. began last September, both Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke gave speeches.

Mr. Paulson said, "We are actively engaged in developing additional programs to strengthen our financial system so that lending flows into our economy." Chairman Bernanke laid out additional steps the Fed could take to lift economic activity, including the purchase of Treasury bonds to boost the money supply.

As has been typical in the past year, every time the government comes out to explain what it will do to save the day, the markets stumble. The Dow Jones Industrial Average fell 670 points and financial stocks had one of their worst days ever.

What is most amazing about this crisis is that the government is unwilling to address one of the root causes of investor fears -- mark-to-market accounting. For some reason, normally stalwart free market thinkers are willing to support trillions of dollars of government intervention, but are unwilling to support a suspension of mark-to-market accounting. They trust government solutions more than private sector solutions.

This has happened before. In the 1970s, when inflationary pressures were rising because of excessively easy monetary policy, the government tried everything but tightening money to fix the problem. A partial list includes: wage and price controls, windfall profits taxes, tax hikes, credit controls, WIN buttons, and price caps on energy products.

None of this worked because inflation was a monetary phenomenon. But every convoluted attempt at fighting inflation that did not address the real problem created even more problems elsewhere. The end result of all of this was stagflation as government interference in free markets undermined growth.

Milton Friedman, who understood the problem, and proposed the solution that was eventually put in place by Paul Volcker, was considered too narrow-minded. Many thought that inflation was intractable and something we would have to live with.

Sadly, it seems that the U.S. government is repeating a similar error all over again. Conventional wisdom argues that the problems we face are fundamental in nature. That this is a classic case of an economy gone awry, and that the only way out is for government to bail us out.

But every new government bailout or injection of liquidity is designed to offset the pain caused by Sarbanes-Oxley, FASB 157 and mark-to-market accounting. And even more sadly, it is these convoluted attempts at bailing out the economy that pushed the economy into recession.

The decision to let Lehman Brothers fail caused the financial system to freeze up. Money under mattresses appeared safer than money in the bank. For the first time in roughly 100 years the velocity of money (the rate at which money changes hands) collapsed in September. As a result, real GDP in the fourth quarter of 2008 could well fall 4%.

This reality led the Treasury to propose a huge $700 billion facility to purchase troubled assets. The idea was to encourage more lending. Purchasing troubled assets would set a floor under their prices, provide liquidity and protect capital at financial institutions. It was the first real acknowledgement that the downward spiral of asset prices, and fair value accounting, were harming the financial system.

The plan never got off the ground. Instead, the Treasury invested directly in banks. But this has not encouraged any more lending because the vicious cycle of illiquid markets, fire sale prices, a weak economy, and fair value accounting is impairing, or threatening to further impair, capital. In fact, Citigroup, which received $25 billion from Treasury back in October, came back for more because the falling value of assets threatened its capital ratios.

So last week, the Treasury announced another investment in Citigroup, and also insured $306 billion of its troubled assets. This arrangement is designed to limit the possibility that falling asset values (and fair value accounting) could push Citi into bankruptcy.

To understand this process, imagine that a forest fire one mile to the east of your home in Montecito, California, was being blown your way by the Santa Ana winds. How much would your home be worth at that moment? How about the loan on the books of your lender? Then imagine that the wind shifts to come from the ocean, your house is saved, and its value is unimpaired once again. Which set of books is right?

The only difference between this example and today's economic crisis is that no matter what price we place on the house, it will not affect the direction of the wind or power of the fire. But because marking-to-market impairs capital and therefore the financial system as a whole, it is causing the fire to burn hotter and the wind to blow harder. Marking to what might happen forces the system to accommodate losses that may not occur in reality.

Letter to the Editor

topics:
Economics