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Example #3: Misconceiving and Misprescribing Interest Rates
Why have governments and most market participants misconceived, misdiagnosed and prematurely hailed the end of the bust? Perhaps because they misconceive, hold in contempt – indeed, in many instances utterly ignore – the natural rate of interest. As detailed in The Robinson Crusoe Ethic Versus the Distemper of Our Times, the rate of interest, when not manipulated by a central bank, is determined by individuals’ time horizons (or “time preference”). The shorter the time horizon the higher the natural rate (and vice versa); and the rate of return on investment tends towards the rate of time preference. In the absence of interference, in other words, interest rates accurately co-ordinate the actions of – and convey accurate signals to – borrowers and lenders. Under these conditions, to use the apt phrase of Roger Garrison, interest rates “tell the truth about time.”
Conversely, and as detailed in two sets of circulars (Is Australia Really a Low-Inflation Country? and Inflation and Deflation: Some Dissenting Thoughts for Value Investors), interest rates fixed by central banks not only tend to decouple the actions of borrowers and lenders, and thereby to deviate from the truth about time and money (i.e., the natural rate of interest): in retrospect it is clear that at critical junctures subsidised bank rates have unintentionally imparted damaging falsehoods about these phenomena. These critical junctures, when interest rates are arguably far lower than would be the case in a free market, appear more and more to include the years since the mid-1990s.
More generally, and not incidentally, the cardinal sin of central bankers is not just that they create credit backed by thin air rather than hard savings. Even more fundamental is their conceit. They pretend to know – and journalists and market participants assume that they know – what no single person or small group of people, no matter how diligent and intelligent (as central bankers undoubtedly are), can possibly know: the appropriate rate of interest at which credit (including bank reserves) should be lent and borrowed. But not everyone deifies central bankers. Some, indeed, alert them to the invidious consequences of their actions. As Alan Abelson wrote in Barron’s (11 November), “oh, come on, [Dr Greenspan], give us a break. Own up to the fact that what really ails this poor shaky old economy is the pervasive and toxic fallout from the bursting of the greatest speculative bubble in the history of this fair land. A bubble – and let’s not be modest here and deny it – that is largely your creation through the agency of your beloved institution, the Federal Reserve, that nurtured it and sustained it and resolutely neglected to even acknowledge its existence, much less do anything to contain it.”
Example #4: Misplaced Faith in Financial and Corporate Regulation
During 2002 many demanded to know what had gone wrong with corporate accounting. They assumed that something was awry and supposed that stricter laws and more regulation would put things right. More apt, according to Holman Jenkins (The Wall Street Journal 16 January 2002), is the question “what has gone right since we handed accountants the federal gravy train of the mandated annual audit of public companies? Folks, this is not the first time auditors have failed to step forward and blow the whistle on some intransigent management, warning investors to run for their lives.”
Jenkins notes “accountants didn’t blow the whistle on Cendant, Waste Management or Rite Aid, the savings and loans of the 1980s or the casualties of the go-go 1960s. They haven’t blown the whistle on any sizeable company, ever, at least not until problems were already apparent to everyone. So why the professions of surprise at every Enron that comes along?” In America (and analogously in Australia, Britain and Canada) this problem has been apparent since 1937. In that year pharmaceuticals maker McKesson & Robbins collapsed and congressional investigators were flabbergasted to learn that the laws regulating the securities industry and establishing the Securities and Exchanges Commission, etc., that Congress had promulgated just a few years before did not direct accountants to anticipate and detect fraud.
According to Jenkins, “cries have gone up in Enron’s wake for more ‘oversight’ and new regulations, as if somehow piling on more rules can finally turn the frog into a prince … But the auditors themselves are hired, fired and paid by the very companies they’re supposed to be scrutinising, which ought to strike anybody as an inherent conflict.” Jenkins concludes: “the profession’s drippy rhetoric would have you believe accountants work for the public good or the Gods of Absolute Accounting Purity (GAAP), but this is silly. They make a living selling a service to involuntary customers who are going through the motions to satisfy a federal mandate. The annual audit is a service truly valued by no one: it doesn’t catch crooks and it doesn’t benefit honest companies either, because it provides no proof or assurance to investors about the accuracy and completeness of a company’s books. When a ritual has so emptied itself of real meaning as to become positively dangerous to its participants, it’s time for a rethink.”
Stephen Cohen (The Australian Financial Review 26 November) concurs. “The shortfall in ethical performance is … exacerbated by the introduction of more regulation … Not only are we trying to take care of ethics with regulation; worse, it has become the case that when corporate people think about corporate ethics, what they think about are only the rules and regulations … Trouble occurs when what is required is reduced to black-letter prescription, and is removed from the level of judgment and professional appraisal … [Accordingly], reliance on more black-letter law and regulation will not solve the problem, and runs a substantial risk of making it worse.”
Nobel Laureate Ronald Coase, (whose 1937 article The Nature of the Firm outlined the fundamentals of the business enterprise and has become one of the most influential works in the history of economics) adds more general grounds to rethink this issue. “When I was editor of The Journal of Law and Economics, we published a whole series of studies of regulation and its effects. Almost all the studies – perhaps all the studies – suggested that the results of regulation had been bad, that the prices were higher, that the product was worse adapted to the needs of consumers, than it otherwise would have been. I was not willing to accept the view that all regulation was bound to produce these results. Therefore, what was my explanation for the results we had? I argued that the most probable explanation was that the government now operates on such a massive scale that it had reached the stage of what economists call negative marginal returns. Anything additional it does, it messes up” (see also Letter 31 and Of Morals and Markets: Some Thoughts for Value Investors).
...continued in Part III
 
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