It’s an honor to be on this panel with all these distinguished people. But I’m afraid I was invited because I’m considered soft on bailouts. That’s a terrible reputation to have. What is it they say about poker? “If you look around the table and you can’t tell who the sucker is, it’s you.”

The case for bailouts is usually systemic risk. You do it, not for the bailout-ee, but to limit the collateral damage, damage to the whole “system.” The case against bailouts is that by saving management and owners from the consequences of their excessive risk-taking or bad decisions, you create moral hazard and encourage similar behavior by others.

In most of the so-called bailouts during the Panic of 2008—bunched together in September 2008—the decision-makers were not saved or rescued. Top management, directors and stockholders generally lost their jobs and much of their wealth, and were maligned in Congress and by the press.

They didn’t benefit from a “heads I win, tails you lose” proposition. They had won for a while; then they lost.

Future decision makers under similar circumstances will remember both sides of that coin and not want to go there. Public humiliation is not something you want to emulate.

Mr. Paulson, in fact, seemed eager to fire people at the top who had done no wrong specifically so that he could not be accused of creating moral hazard. The CEOs of Fannie and Freddie were following policies mandated by Congress and were not the same CEOs in place during the earlier accounting scandals. I believe the fired CEO of AIG had been on the job only a few months. And Ken Lewis of Bank of America has learned that no good deeds go unpunished.

Moral hazard did get us into this mess. The making and securitizing of subprime mortgage loans and selling those mortgage bonds all over the world was the mother of moral hazards, since mostly independent unregulated mortgage brokers made the credit decisions and unsuspecting owners of the bonds—misled by their AAA ratings—bore the risk.

Many pundits who were saying “let ‘em fail,” “let ‘em fail” later said letting Lehman Brothers fail was the biggest mistake of the crisis. I tend to agree.

There were a lot of tall dominoes, standing close together. I’m not sure the system could have survived many other failures like Lehman’s, which cost me about 40 percent of my little portfolio.

Given time, I’m sure the Treasury’s TARP program could have been better designed and executed, but under the circumstances I think it’s working pretty well for almost 700 banks caught holding mortgage-backed securities and other assets no longer trading. We only hear of the top nine or the top 19.

I won’t try to defend TARP’s use outside the financial system or the way Congress has used it to fan and pander to our worst populist instincts, to demonize bankers, and as a pretext to expand government power, violate contracts and private property rights. It has been shameful.

The public, egged on by politicians, regards TARP as the Government spending their money to support “evil doers.” Most people have no idea that the Treasury will be able to sell its preferred stock and warrants received from banks, likely at a profit.

There will be losses here and there, on individual transactions and banks, but, overall, I won’t be surprised if taxpayers come out ahead net. The Treasury has earned about 18 percent on the banks that left the program early.

The Federal Reserve’s extraordinary lending last year and security purchases this year are even more likely to earn a net profit for taxpayers. The Fed generally turns over about 90 percent of its earnings to the Treasury’s general fund. Those earnings are rising significantly with the expansion of the Fed’s balance sheet, and those earnings will benefit taxpayers. Even the individual losses here and there, to the extent there will be any, would not be a loss of existing money, but only a loss of the new money created by the transaction—an opportunity cost loss.

Skeptics make much of the Fed’s expansion of bank reserves and money and take it for granted that it will be highly inflationary. Possibly, but I doubt it.

New money must be spent before it can cause inflation. Banks are holding most of their new reserves idle as excess reserves because they are scared to death. And the public has similarly reduced the velocity, or turnover, of money sharply. With the velocity of money collapsing, and credit shrinking, rapid money expansion has not been inflationary. So far, rapid money growth has been needed to forestall deflation.

Despite some pick-up lately, both the Consumer Price Index and the Producer Price Index remain below year-ago levels. Prices for the year are down, not up.

The trick for the Fed will be to adjust money growth as velocity returns toward normal—the exit strategy.

Chairman Bernanke’s study of the Depression has convinced him that tightening monetary policy prematurely is a greater danger than tightening too late. Most pundits on financial TV seem to assume the opposite.

During the Depression the Federal Reserve increased reserve requirements on banks to “mop up” banks’ excess reserves. The banks reacted by contracting credit further. It turned out that the reserves were not considered excess by the banks themselves. They wanted an extra cushion against uncertainty.

Today, the pundits are urging the Fed to make the same mistake—to “mop up’ excess bank reserves before they are used for loans and investments that might create inflation. But the banks are holding those excess reserves voluntarily—for the same reasons they did during the depression, as precautionary balances. Just because they may be excess reserves in a regulatory sense doesn’t make them excess in a more real sense.

While I give passing marks to the Treasury’s capital injections into banks and to the Fed’s direct and indirect lending, I put the massive stimulus program on the other end of the spectrum. It reminds me of hunting wild hogs with a shotgun rather than a rifle. There is a lot of firepower, but it’s diffused–not focused enough. It has probably prevented some layoffs at the state and local levels, but at a huge cost in money, deficits, and debt.

The Fed made loans and the Treasury made investments. The stimulus program, however, was old-fashioned spending. Money spent, money gone.

The deficit as a percent of GDP has tripled and outstanding debt is headed above its recent level of about 40 percent of GDP.

Instead of targeted marginal tax-rate cuts to stimulate the private sector, we face the prospects of repeating a huge mistake made during the depression—raising taxes in a weak economy. Not only the expiration of the Bush tax-rate cuts, but also additional taxes to finance new government programs.

In the 1937-38 period during the depression, the government raised taxes to finance new government programs already put in place. They wanted to balance the budget. We face the prospect of new taxes for existing programs and new programs yet to come.

Another negative feature of the Depression that we seem to be copying is class warfare against business leaders. How that is supposed to help anything is a mystery to me. But, to my knowledge, even Roosevelt didn’t think to have a pay czar.

Another depression-era mistake we’re in danger of repeating is protectionism. We haven’t gone as far as the Smoot-Hawley tariff increase yet, but we are on a slippery slope in that direction, with the violation of the NAFTA agreement on Mexican trucks, tariffs on Chinese tires, and buy-American policies spread all over the stimulus bill.

Will we ever learn?

Then why is it that virtually all the commentary on the dollar on financial TV and in blogs fails to mention the balance of payments when discussing the dollar? The dollar is considered super-important these days while the balance of payments isn’t considered important enough to mention. That’s like saying the price is important, but supply and demand don’t matter.

Instead, a strong dollar is treated as both the evidence of U.S. economic strength and a major cause of it. A weak dollar reflects and causes economic weakness. This relationship is either taken as self evident or is based on historical periods when the economy and the dollar were strong together or weak together. Unfortunately, these conclusions are the opposite of what economy theory teaches.

Other things equal, a primary result of an exogenous weakening of the dollar is an increase in foreign demand for U.S. exports, since they are now cheaper in terms of foreign currencies. A weaker dollar also makes foreign exports (U.S. imports) more expensive in dollar terms. Therefore, the weaker dollar will stimulate U.S. exports and depress U.S. imports. This increase in net exports (U.S. exports minus imports) adds to total spending as measured by GDP. If GDP is at recession levels, a weaker dollar helps pull us out of recession.

I don’t deny that many other economic variables have an influence on these relationships. However, the relative price change brought about by changes in the exchange rate are considered dominant among economists who study the matter.

The positive jolt to domestic GDP caused by a depreciating home currency is well known all over the world. That is why during a global slump such as we are in today we have to guard against competitive devaluations where each country tries to boost its economy through depreciation or devaluation which has the opposite effect on its trading partners. The term of art is “beggar thy neighbor” policies, sometimes called “beggar my neighbor” policies.

While the competitive advantages of currency depreciation are widely understood around the world, most of the talking heads on financial TV seem to believe that the opposite is true for the United States. They imply that a stronger dollar will lead to a stronger economy and a stronger economy will lead to a stronger dollar.

Apparently forgotten is the pressure U.S. officials put on China in the not-too-distant past to let the yuan appreciate, which would effectively depreciate the dollar against the yuan. I wasn’t in favor of pressuring China on that point, but at least those who did understood that a more expensive yuan and less expensive dollar would help restore more balance to trade between those countries. Today’s proponents of dollar appreciation are pulling in the opposite direction. It is amazing to me that China has completely turned the tables on us by arguing that it is us with the weak currency while touting their own artificially weak currency (roughly pegged to the dollar and protected also by exchange controls) as a potential reserve currency.

I’m changing focus now. Pay attention.

While a weaker currency helps a country pull out of a recession, a strong currency is beneficial if there is no recession, or shortage of aggregate demand. A strong currency relative to those of your trading partners helps consumers by making imported goods and services cheaper in the domestic currency. The added competition from imports also lowers the price of many domestically produced goods and services. A strong currency puts pressure on producers, exporters, and potential exporters to remain competitive, which isn’t always possible. Businesses may fail and jobs may be lost.

A strong currency generally harms producers and exporters. To repeat: a strong currency generally helps consumers and harms producers.

So, how do you choose which group to help?

The answer is you don’t. Under our system of market-determined exchange rates, the rules-of- the-game call for hands off. Keep the float clean, not dirty. Government tinkering with a floating currency opens it up to intense lobbying by pressure groups that is best avoided.

In the quandary of whether to favor consumers or producers, importers or exporters, a couple of points should help. One is no matter what we do for a living, we are all consumers. Even those harmed as producers will be helped as consumers. Another question to ponder is this: Who is an economy for, consumers or producers? I think the answer is consumers. This is similar to the question, do we work to eat or eat to work? Or, do we import to export or do we export to import. I think the unstated consensus in a democracy is we work to eat and we export to import. Consumption is the end; production is the means. A more totalitarian government, like China, is usually tempted toward mercantilism, which includes a higher priority on exports than imports.

So, my conclusion is there is a strong argument to be made for a strong currency. It just doesn’t apply in the midst of a deep recession when the main problem is inadequate aggregate demand. Many people who don’t acknowledge that are, in my opinion, trying to avoid sounding “Keynesian.”

I’ve said this many times before. My position on a strong dollar is similar to St.Augustine’s position on chastity in his famous prayer: “Lord, make me chaste, but not just yet.” My prayer is, “Lord give us a strong dollar, but not just yet.”

“The financial services sector has enjoyed a fine summer rally, but I just can’t get too excited about a bunch of financial stocks leading the market higher.

I mean, we are talking about banks, for heaven’s sake. These are the same charlatans and ne’er-do-wells who got us into this mess in the first place.” (Emphasis added)

Where to start?

First, let me simply say that, in my 36-year career with the Fed, I met many, many bankers. I don’t recall any that would fall into the category of charlatans and ne’er-do-wells. Not any.

What about “who got us into this mess in the first place”?  Most of the subprime loans were made by nonbank and unregulated mortgage brokers who sold them to major New York investment banks for securitization and resale as mortgage-backed securities. The commercial banks implicated in that process were mainly those who had previously merged with investment banks or mortgage companies. Citi and Chase come to mind. You can probably count them on the fingers of one hand.

Virtually all of the 8,500 or so banks in the country were victims of the “mess” rather than the cause of it. Many had purchased MBSs as liquid, conservative investments that yielded a bit more than Treasury securities. By the way, they were rated AAA, and the bank supervisors approved. As trading in MBSs froze because of the toxic mortgages in the underlying mortgage pools, too-strict application of mark to market accounting rules forced drastic write-downs that destroyed billions of dollars of regulatory capital. Many failed unnecessarily. And, since FASB didn’t make its modifications of mark to market rules retroactive, many more may fail because of that. Bankers were the victims of the mess, not the villains.

To call these pillars of communities all over the country charlatans and ne’er-do-wells adds insult to injury.

The timing was odd, however, and awkward, for the Governor since it was so soon after an FOMC meeting in which he didn’t dissent. It looks like he’s trying to have it both ways. Of course, it’s always possible that he and the Chairman together are trying to have it both ways.

One phrase in the piece scares me. He said

“. . . policy makers should continue to communicate as clearly as possible the guideposts, conditions and means by which extraordinary monetary accommodation will be unwound, including the removal of excess bank reserves.” [Emphasis added.]

As I’ve written here before, the treatment of “excess” bank reserves is fraught with danger, as the Fed’s experience in the Great Depression demonstrates. The reserves may be excess in the sense that they exceed the amount required by the Fed. However, they may not be excess in the minds of the bankers. Under the recent unusual circumstances, as with the Great Depression, bankers may think extra reserves are needed. If so, premature attempts to drain those reserves may lead to an unanticipated bank contraction. That happened during the Depression when the Fed raised reserve requirements to “mop up” excess reserves.

The Fed has a new tool—the payment of interest on reserves—that may help them navigate around the rocks, but it had better be sure that its view of those reserves is shared by their owners.

What’s going on here? It’s not just that the debate will be over different degrees of government intervention into areas of business not normally under government jurisdiction. More scary is the idea that we might be morally bound, or even influenced, in such matters by the other 19. I didn’t get to vote for those guys. How did they get a vote on my banker’s pay?

I was already thinking along these lines, but I wasn’t exorcised enough to blog about it until today, when I heard Daniel Hannan speak at an NCPA event in Dallas. Mr. Hannan is a member of the British Conservative Party and an elected delegate to the European Parliament, an institution he highly disapproves of.

Mr. Hannan recently became a You-Tube sensation by verbally cutting his Prime Minister, Gordon Brown, off at the knees during the latter’s appearance at the EU Parliament. A more eloquent spokesman for individual liberty and democracy than Mr. Hannan is not likely found today.

I can’t recall all that he said well enough to report it here, but I will quote one startling statistic that he gave. He quoted a credible source as estimating that up to 84 percent of the legislation enacted by member EU governments in recent years was passed to implement decisions first taken by the European Parliament. Increasingly, Europe is governed by an international civil servants they had no opportunity to vote for.

I hope the G-20 enjoy their visit to Pittsburg. Let them discuss the issues and go home feeling good about themselves. Let us not, however, put any weight whatsoever on the result of those discussions. We can make our own mistakes, thank you very much.

The only really sensible investment advice I know of came from Will Rogers, who is alleged to have said:

"You buy your stock.
When it goes up, sell it.
If it don't go up, don't buy it."

Advice I just don't get includes the following:

People are very optimistic; so stocks will decline.

People are pessimistic; it's a good buying opportunity.

Stocks go down in September and October.

You can't beat the market; it's all priced in.

You've got to do your homework.

Go with the momentum.

The Dow is 5½ points below Fair Value.

Sell in May and go away.

Cash is king; stay liquid.

If you're out of the market a few days, you can miss the run-up.

The trend is your friend.

It's a random walk.

Should Bernanke be Reappointed?

I'm asked that a lot these days. My answer is "Yes, of course, and he should be given a medal for saving our financial system." Then comes, "But he, or the Fed, didn't see the crisis coming," or, "The Fed caused the crisis by creating the real estate bubble." There are more "ors," but let's start with these two.

The Fed didn't see the crisis coming.

Nobody with the authority to do something about it saw it coming. Not the Fed; not the SEC; not the banking regulators (OCC, FDIC or OTS); not Congress. In fact, Congress kept giving Fannie and Freddie quotas to meet to expand home ownership among low income people.

The Fed created the real estate bubble with easy money.

If we're talking about 2002 and 2003 here, the Fed was leaning against a weakening economy experiencing disinflation and threatening outright deflation. This was true to a lesser extent after the Fed began a gradual tightening in June 2004. Few bother to explain how a monetary policy leaning against economic weakness and promoting disinflation in the broad economy is creating rapid inflation in only one sector.

The real estate bubble didn't cause the crisis anyway.

Have we already forgotten the moral hazard created by the making and securitization of subprime loans? The financial crisis was caused, not by too many loans, but by too many bad loans and the sprinkling of those bad loans into mortgage backed securities all over the globe. Many things made the contagion worse, but they weren't the cause of the crisis.

(I first learned that people take the wrong lessons from crises during the S&L crisis in Maryland in 1985. Ohio had a major problem with privately insured S&Ls. Maryland had a similar system; so a silent run on Maryland's state chartered privately insured S&Ls began immediately, eventually prompting the closing of 102 of them. A few problems, including fraud, were uncovered during the examinations to reopen them. Those few problems were taken to be the cause of the crisis even though the crisis and the closings had occurred months earlier.)

Notice how the same type thing is happening now. We rarely hear about subprime loans any more. Instead, the problem is attributed to greed, Wall Street, the banks, executive compensation, corporate meetings in Vegas, company planes, the Bush Administration, and so forth.

We've seen recently that many people have no such qualms about criticizing what they regard as corporate excesses, especially in corporations that have received public assistance. What amazes me is the crowd's certainty that such practices are bad for business. Corporate attempts to rationalize them as profit maximizing fall on deaf ears and get hostile reactions. Detroit executives criticized for flying corporate jets to Washington knew better than to argue; they hopped into their ridiculous little green cars for the next trip.

What I find interesting is that while my instinct is to defend these corporate practices, I really don't believe that most of them are profit maximizing. And that heresy didn't just start with the present crisis.

I've long believed that corporate meetings don't have to take place in the most expensive hotels. I've long believed that many corporate meetings are unnecessary and unnecessarily costly. The telephone works pretty well; so does e-mail.

Highly-paid, over-burdened CEOs can probably justify travel on the corporate jet, along with colleagues to fill it up. But that perk goes a long way down the corporate ladder, and, at some point, becomes wasteful for the corporations. It's an indirect way to pay corporate officers who are already paid very generously.

I believe in pay for performance, but I have a hard time believing that axiom legitimately leads to multi-million dollar salaries. Show me a CEO making $50 million, and I'll be happy to replace him for half that amount and feel lucky to get it. Of course, I would be replaced in the same way. What I don't understand is why the talent pool doesn't drive those wages far down from where they are.

I believe in the logic behind bonuses for outstanding performance. I would probably work a little harder and a little longer to make the bonus, but I would do that if the bonus were under six figures. Over seven figures wouldn't be necessary to get me hopping. I'm not sure what I would do differently if a million dollar bonus were at stake rather than a 100,000 bonus. I would try as hard as I could for the smaller one. What more could I do but develop an ulcer.

I think the same considerations apply in athletics. I don't know what Tony Romo is making and what his bonus arrangement is, but what is he supposed to do? Try harder? What is a highly-incentivized coach supposed to do differently? Put in more touchdown plays?

I lost the 1970s to one of my son's junior tennis. I hit balls with him most days, took him to his tennis lessons, and took him to tournaments. One of the tennis mothers always said when watching her daughter's matches, "I need a wet rag on my head." I too always needed a wet rag on my head when watching my son play.

I mention this to say that I learned a lot about tennis back then, which, I believe, applies to sports in general.  One thing I learned is that doing better isn't usually a matter of trying harder. Training harder might help, but trying harder in a match usually doesn't. First, they are already trying to do their best. Trying harder just tenses you up and costs you timing and control. What is desired is to "find the zone," which is some sense means trying less hard. Stop thinking too much. Tell the little voice in your head that's always second guessing you to shut up. Let your body play. Get in the zone. (Read Inner Tennis.) I don't think tennis is unique in this respect.

With that as introduction, here is my question. Would my son have played better and won more matches if I had offered him a $100 bonus per win? If not, what about a $1000 bonus. Will Tony complete more passes for a $1 million bonus? I think not. But the Monday morning quarterbacks will say he isn't trying hard enough.

I want a bonus. A large bonus! But the dirty little secret is that I'm working almost as hard now without one and working as smart as I know how.

Don't try to apply this to progressive income taxes. If I had a single job and no other prospects, I might work as hard if the marginal tax rate is high as if it is low. But I would be less interested in overtime, less interested in a second job, less interested in more consulting, more corporate boards, or more speeches. But, in any of these endeavors, I'm going to be doing the best I can no matter how high or low the marginal income.

Like Mae West, I've drifted. (She used to be pure as snow, but she drifted.) My point is that I agree with the populace who doubts the value of high salaries, bonuses, and perks. On the other hand, I don't plan to join the populist mob. It's just not my business.

In the process, Mr. Paulson clarified that he had reminded Ken Lewis, the CEO of Bank of America, that the Fed, as the primary regulator of his holding company, had the authority to remove management and the board if he did something they regarded as stupid as well as harmful to the bank, the financial system, and the economy. Of course, Mr. Lewis knew that already, as do all bankers.

But, apparently the members of the Congressional committee apparently didn’t know that, and didn’t want to. They wanted to accuse somebody of something, or everybody of everything. I couldn’t figure out which, or what wrong they were trying to right.

Just for the record, banks and thrifts are closely regulated and supervised. Their primary regulator (supervisor) assigns to them following examinations what used to be called a CAMEL rating, which, like everything else originating in Washington, has expanded. It is now a CAMELS rating, an acronym formed from Capital, Asset quality, Management, Earnings, Liquidity, and, now, Sensitivity, presumably to interest-rate changes (sort of an ongoing stress test). Anyway, the letter in question here is M for management.

Management is not entirely independent of the others. For example, a bank with low asset quality, inadequate liquidity, etc. would not likely be rated a 1 (the highest rating) or a 2 (the second highest) in M for management. (5 is the lowest rating.) On the other hand, the examiners do make some judgments regarding whether other weaknesses may have been caused by unforeseen conditions or “extenuating circumstances,” as we might say in Texas without the final g, or whether they attribute most of the other problems to weak management.

Sometimes, the banks’ boards of directors take the hint and make management changes; sometimes, they react to more than a hint from the examiners and their bosses back at the office (ultimately Washington).  My point, which once again belabors the obvious, is that management changes made in response to supervisors are common. Let me repeat that: COMMON.

I imagine there were some former bank executives watching the hearings today pulling for the Congressman trying to turn that common practice into a scandal.

I will say this regarding Mr. Paulson and Mr. Bernanke. Mr. Bernanke displayed remarkable skill and innovation in dealing with the financial crisis. But, he was also lucky to have a hulking former offensive lineman up front blocking for him- even if the lineman in question did hone his blocking skill at Dartmouth. I’d take him- if Lynn Hauss were not available.

Way to go, Hammering Hank!

I sat next to Ben Bernanke for almost three years at the FOMC table when he served as a Fed Governor. This was before he became Chairman of the President's Council of Economic Advisors and later returned as Chairman of the Board of Governors of the Federal Reserve System, appointed by President Bush. The cliché, "a gentleman and a scholar," was surely coined to describe Ben Bernanke. He seemed to be the quintessential Ivy League, high I.Q. nerd. I saw no bully in him. No attitude. Just a gentleman and a scholar.

He shocked me when he told me he was from South Carolina and had worked at South of the Border. I grew up in neighboring North Georgia and was familiar with South of the Border. As I recall, snakes were one of the tourist attractions. We had more in common than I ever dreamed, except, of course, for the high I.Q. and SAT scores. Not that he ever mentioned either. I inferred his high I.Q. from his career progression- which obviously required high-powered math skills- and learned of his almost-perfect SAT scores from a network TV special.

A digression: I once thought I'd caught a glimpse of my I.Q. score across the table from my high-school records and was very pleased with myself- until I discovered the number was my weight rather than my I.Q. So, I don't know officially. On two occasions during my Fed career when it seemed like all my colleagues were on the wrong side of an issue that seemed obvious to me, I considered the possibility that I might be the dumb one and bought a self- take I.Q. test from the book store to check myself out. They were inconclusive given the difference between being smart and being wrong, but the experience did leave me feeling better about myself. I've had a third "pocket IQ test on my desk for a year now unopened. I guess I don't want to push my luck.

Anyway, that was a digression. This is about Ben Bernanke, whose intelligence and integrity- and memory- are not in question in my mind.

However, most frustrating to me is the cynical question, so what?  As I indicated to Larry Kudlow in the interview posted two-days ago, so what if he played hardball in the cause of holding the financial system and the economy together. The fall and winter of 2008 was a national emergency the equivalent of war. If he- and Ken Lewis-did what they had to do in the national interest, I applaud them both. In any case, TARP money was provided to make the deal work, and present indications are that it is working well.

Somehow, this reminds me of the news over the week-end that the CIA may have had a secret plan to deal with terrorists. Well, duh! Shame on them if they hadn't. Both are examples of no good deed going unpunished.