A great piece on the gold standard

Grant (via the Mises blog), writing in the WSJ-

For most of this country’s history, the dollar was exchangeable into gold or silver. “Sound” money was the kind that rang when you dropped it on a counter. For a long time, the rate of exchange was an ounce of gold for $20.67. Following the Roosevelt devaluation of 1933, the rate of exchange became an ounce of gold for $35. After 1933, only foreign governments and central banks were privileged to swap unwanted paper for gold, and most of these official institutions refrained from asking (after 1946, it seemed inadvisable to antagonize the very superpower that was standing between them and the Soviet Union). By the late 1960s, however, some of these overseas dollar holders, notably France, began to clamor for gold. They were well-advised to do so, dollars being in demonstrable surplus. President Richard Nixon solved that problem in August 1971 by suspending convertibility altogether. From that day to this, in the words of John Exter, Citibanker and monetary critic, a Federal Reserve “note” has been an “IOU nothing.”

The improbable and the impossible

Sherlock Holmes, the brilliant detective who was invented by Arthur Conan Doyle while swatting flies in his clinic, made a very profound statement in one of his stories. He said – “when you have excluded the impossible, whatever remains, however improbable, must be the truth.” He drew a line between possibility and probability, thus stating the obvious. But, apparently, US Treasury Secretary Geithner hasn’t read Holmes. From Reuters-

Treasury secretary Timothy Geithner on Tuesday said difficulty in setting a value on banks’ toxic assets was a continuing hindrance to their ability to lend and borrow.

On this, Lucas Engelhardt of the Mises blog writes-

Apparently, Secretary Geithner has discovered that it is “hard” for the government to “set” the “value” of toxic assets. (Pardon my quotation marks.)

I’m sure he’s right, given that he’s simultaneously trying to:
1. Set the value so that the banks look solvent.
2. Set the value so that the assets can be sold without bank balance sheets deteriorating.

The problem, of course, is that establishing (2) requires that we value the toxic legacy assets according to what they can actually be sold for. Something economists like to call the market price. But, (1) requires that we value the toxic legacy assets above the fair market prices. No force of will or “clever” policy can change that fact.

So, it seems that Geithner has realized that a task that is logically impossible is “difficult”. At least his understanding is moving in the right direction.

I am not sure I get Engelhardt’s point. Geithner requires that most banks are “solvent” after the toxic assets are removed from their balance sheets. He also requires that taxpayers are not being “swindled.” That’s what the whole “public-private” “partnership” is about. But the banks “are” insolvent if the assets are valued at “market price” – they will go kaput. So the assets will need to be valued at way above “market price” to keep them solvent. I guess that takes care of (1). But isn’t (2) (1) rephrased, or is it a “I am insolvent to the tune of 10 billion dollars, and I don’t want to go beyond that” statement?

Whatever it is, Geithner’s “plan” is impossible purely on the insolvency-swindle dichotomy. If he pays way over the “market price,” (it can’t be determined unless there “is” a market) the taxpayer is being swindled. If he pays less, the banks are insolvent. Not difficult, but impossible. He should either worry about the taxpayer, or about the banks, or simply leave the matter to the market which will then fix the problem in its own ruthless way – by bringing down a few thousand banks.

If we call Holmes’ statement Holmes’ Razor, then “For me, the impossible is merely ‘difficult’” would be Geithner’s Razor. He should be careful with it. Otherwise he might nick someone, or something.

—

I read the comments on the above blog post and found a link to this crazy idea by a top economist, who’s a … Keynesian. The only things that need “targeting” are such economists and the central banks. That’s why you shouldn’t trust the government, or its currency. But you can’t trust gold either – not because of any problems with value, but because of thieves like FDR who could throw you in jail if you didn’t surrender the gold. As long as you have a State, particularly the crooked one of present day, you are bound to be fucked either way. A funny but spot-on comment – “Hey Mankiw — how’d you like a negative salary this year?”

A hired gun

Alan Greenspan, former Chairman of the US Federal Reserve, and the man everybody blames for the current financial crisis – the “housing bubble” that was a “result” of his loose monetary policy in the first half of this decade, was a close friend of Ayn Rand. In 1966, he wrote an essay – “Gold and Economic Freedom”-

A fully free banking system and fully consistent gold standard have not as yet been achieved. But prior to World War I, the banking system in the United States (and in most of the world) was based on gold and even though governments intervened occasionally, banking was more free than controlled. Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession. (Compared with the depressions of 1920 and 1932, the pre-World War I business declines were mild indeed.) It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post-World Was I type of disaster. The readjustment periods were short and the economies quickly reestablished a sound basis to resume expansion.

But the process of cure was misdiagnosed as the disease: if shortage of bank reserves was causing a business decline-argued economic interventionists-why not find a way of supplying increased reserves to the banks so they never need be short! If banks can continue to loan money indefinitely-it was claimed-there need never be any slumps in business. And so the Federal Reserve System was organized in 1913. It consisted of twelve regional Federal Reserve banks nominally owned by private bankers, but in fact government sponsored, controlled, and supported. Credit extended by these banks is in practice (though not legally) backed by the taxing power of the federal government. Technically, we remained on the gold standard; individuals were still free to own gold, and gold continued to be used as bank reserves. But now, in addition to gold, credit extended by the Federal Reserve banks (“paper reserves”) could serve as legal tender to pay depositors.

When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve’s attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain’s gold loss and avoid the political embarrassment of having to raise interest rates. The “Fed” succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed.

In 1961, he spoke about “Antitrust”-

“Competition” is an active, not a passive, noun. It applies to the entire sphere of economic activity, not merely to production, but also to trade; it implies the necessity of taking action to affect the conditions of the market in one’s own favor. The error of the nineteenth-century observers was that they restricted a wide abstraction — competition — to a narrow set of particulars, to the “passive” competition projected by their own interpretation of classical economics. As a result, they concluded that the alleged “failure” of this fictitious “passive competition” negated the entire theoretical structure of classical economics, including the demonstration of the fact that laissez-faire is the most efficient and productive of all possible economic systems. They concluded that a free market, by its nature, leads to its own destruction — and they came to the grotesque contradiction of attempting to preserve the freedom of the market by government controls, i.e., to preserve the benefits of laissez-faire by abrogating it.

The crucial question which they failed to ask is whether “active” competition does inevitably lead to the establishment of coercive monopolies, as they supposed — or whether a laissez-faire economy of “active” competition has a built-in regulator that protects and preserves it. That is the question which we must now examine.
[...]
The churning of a nation’s capital, in a fully free economy, would be continuously pushing capital into profitable areas — and this would effectively control the competitive price and production policies of business firms, making a coercive monopoly impossible to maintain. It is only in a so-called mixed economy that a coercive monopoly can flourish, protected from the discipline of the capital markets by franchises, subsidies, and special privileges from governmental regulators.

To sum up: The entire structure of antitrust statutes in this country is a jumble of economic irrationality and ignorance. It is the product: (a) of a gross misinterpretation of history, and (b) of rather naive, and certainly unrealistic, economic theories.

As a last resort, some people argue that at least the antitrust laws haven’t done any harm. They assert that even though the competitive process itself inhibits coercive monopolies, there is no harm in making doubly sure by declaring certain economic actions to be illegal.

But the very existence of those undefinable statutes and contradictory case law inhibits businessmen from undertaking what would otherwise be sound productive ventures. No one will ever know what new products, processes, machines, and cost-saving mergers failed to come into existence, killed by the Sherman Act before they were born. No one can ever compute the price that all of us have paid for that Act which, by inducing less effective use of capital, has kept our standard of living lower than would otherwise have been possible.

In 1963, he wrote about “The Assault on Integrity”-

Protection of the consumer against “dishonest and unscrupulous business practices” has become a cardinal ingredient of welfare statism. Left to their own devices, it is alleged, businessmen would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings. Thus, it is argued, the Pure Food and Drug Administration, the Securities and Exchange Commission and the numerous building regulatory agencies are indispensable if the consumer is to be protected from the “greed” of the businessman.

But it is precisely the “greed” of the businessman or, more appropriately, his profit-seeking, which is the unexcelled protector of the consumer.

What collectivists refuse to recognize is that it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product. Since the market value of a going business is measured by its money-making potential, reputation or “good will” is as much an asset as its physical plant and equipment.
[...]
It requires years of consistently excellent performance to acquire a reputation and to establish it as a financial asset[...] Thus the incentive to scrupulous performance operates on all levels of a given field of production. It is a built-in safeguard of a free enterprise system and the only real protection of consumers against business dishonesty.
[...]
To paraphrase Gresham’s Law: bad “protection” drives out good. The attempt to protect the consumer by force undercuts the protection he gets from incentive. First, it undercuts the value of reputation by placing the reputable company on the same basis as the unknown, the newcomer, or the fly-by-nighter. It declares, in effect, that all are equally suspect and that years of evidence to the contrary do not free a man from that suspicion. Second it grants an automatic (though, in fact, unachievable) guarantee of safety to the products of any company that complies with its arbitrarily set minimum standards.
[...]
Government regulations do not eliminate potentially dishonest individuals, but merely make their activities harder to detect or easier to hush up. Furthermore, the possibility of individual dishonesty applies to government employees fully as much as to any other group of men. There is nothing to guarantee the superior judgment, knowledge, and integrity of an inspector or a bureaucract—and the deadly consequences of entrusting him with arbitrary power are obvious.
[...]
Capitalism is based on self-interest and self-esteem; it holds integrity and trustworthiness as cardinal virtues and makes them pay off in the marketplace, thus demanding that men survive by means of virtues, not of vices. It is this superlatively moral system that the welfare statists propose to improve upon by means of preventative law, snooping bureaucrats, and the chronic goad of fear.

(All three essays are available in the book – Capitalism: The Unknown Ideal)

Here was a man who was absolutely against regulation – at least he wrote and spoke about the issues involved like he was. And then he went ahead and joined the very Federal Reserve, the very Regulator that printed paper and called it money, and controlled competition among banks, and sanctioned fraud under the guise of “fractional reserve banking.” But he has an out. He is supposed to have told a colleague “to distinguish carefully between what he believes personally and how he acts as chairman of the Fed.”

To the present, according to Greenspan, in March of this year, he said – “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief.” In a NYT article that “takes a hard new look at a Greenspan legacy”, he is quoted as saying-

“In a market system based on trust, reputation has a significant economic value. I am therefore distressed at how far we have let concerns for reputation slip in recent years.”

and

“Risks in financial markets, including derivatives markets, are being regulated by private parties.”

and

“There is nothing involved in federal regulation per se which makes it superior to market regulation.”

He is right most of the time, except for when he is in a state of “shocked disbelief.” He shouldn’t be in such a state because he should know that under the system he was working, institutions could palm off doubtful loans to Mae and Mac and earn “commissions” for their services, banks no longer needed to have any reputation or manage risk like they would have had to, if they were on their own – the Fed allowed them to “create credit”, they were “too big to fail” – government rules had replaced the need for reputation. Now all that the businessmen had to do was to make money without bothering to create trust in the market – the government had done the dirty work for them. As Andrew West writes in the aftermath of the Enron-Arthur Anderson fiasco-

I suggest that Alan Greenspan, forty years ago, identified the most fundamental cause of auditors’ current moral and professional grayness. Government regulation has diminished the value of establishing one’s reputation on the free market, and thus reduced the benefits of differentiation. Why compete to be the “best” governmental-form-filler-outer? When standards are seen as government-authorized, there is little reward but great risk in deviating from or going beyond those standards. Of what value are notes one makes on the margins of one’s IRS Form 1040?

Greenspan is responsible for the mess because he accepted the job of Fed Chairman, because he chose a job that necessarily meant an intervention in the market – distorting the market. Once he does that, he has no business being shocked at the different ways in which such intervention influences people’s behavior. However, placing the entire blame on him is unfair. Intervention in the market is bad – it is a statist idea. But Greenspan was simply a hired gun, one among many; it was the government that hired him.

“[Atlas Shrugged was written] to glorify the real kind of productive, free-enterprise businessman in a way he has never been glorified before. [But] I make mincemeat out of the kind of businessman…that runs to government for assistance, subsidies, legislation and regulation,” Greenspan’s close friend Rand is supposed to have said about her magnum opus. Sadly, those are the only ones that are left. A system of government intervention can never make people virtuous. But there are two things it can do better than no other system can – strip some of them of their virtues – break them, and make beggars out of the rest. Greenspan is an example of the former.

False dilemma

Bernanke spooked a lot of people when he said, “we may not have an economy on Monday.” He should have been a behavioral psychologist instead of an economist, because along with Paulson, he is doing a nice job of presenting what is essentially a false dilemma – providing two options and saying that these are the only ones available – and watching how the guinea pigs react. And they are reacting. The support for the bailout among Americans seems to share an inverse relationship with the rise and fall of the DJIA. And the Congressmen are caught between a rock and a hard place-

Mr. Altmire said many of his constituents were outraged that tax dollars would be put at risk to stabilize financial firms run by wealthy executives. He said he had not yet decided whether to switch his vote to yes when the House votes again on Friday, though he does support a provision added by the Senate to increase to $250,000 the limit for bank deposits that are federally insured.

His Republican opponent, Melissa Hart, whom Mr. Altmire beat by 4 percentage points two years ago, said she would criticize his stance on the bailout either way — if he remains opposed he is pandering to voters in a tough election year; if he switches his vote, he is flipping to help pass a bad plan.

What would you call that?

Proof that those who run the financial sector are not capitalists comes from the rantings and ravings of the Morgan Stanley CEO-

“There is no rational basis for the movements in our stock or credit default spreads,” Mr. Mack wrote in a companywide memo on Wednesday. Mr. Mack lashed out at the people he felt were responsible for Morgan Stanley’s woes: the short-sellers, who profit by betting that a stock will fall.

Like most Wall Street firms, Morgan Stanley over the years had handled transactions for short-sellers, despite complaints by other companies that short-sellers unfairly ganged up on their stock. Nevertheless, Mr. Mack called Senator Charles E. Schumer, Democrat of New York, and Christopher Cox, the chairman of the Securities and Exchange Commission, pressing them to ban short-selling.

Logically speaking, there are only two reasons someone would sell shares in the stock market – a)they need the money to fund something else, b)they have bad feelings about a company. And short selling is a legal method of announcing (b). If someone feels that a company is solid, they would immediately buy the stock in spite of the inherent dangers in catching a falling knife. And the short seller would go bust trying to cover his position. So banning short selling artificially allows share prices to stay high. And that is what the SEC did.

This New York Times editorial demands that the US government should do something to stop the slide in house prices, forgetting that a majority of people buy houses that they could afford, and that those who thought that they could binge on borrowed money without suffering a hangover should suffer the consequences of their actions. And its attracting a lot of comments. One reader says-

I’ve been paying on my mortgage for four years. When I bought my house, I put 20% down (which I had saved for years) so as to obtain reasonable mortgage terms. Now I owe $370,000 on a house whose value is now estimated at around 425,000. (A year ago it was over $500,000.) So, I’m not “under water” by the terms of the bailout. But most of my mortgage payments have gone to interest expense.

My neighbor bought his similar house two years ago with no money down, and an ‘Option ARM’. He paid $520,000 and now owes about $510,000. He stopped paying anything on his mortgage several months ago. Now the “Hope for Homeowners” bailout (which the NYT supports) proposes to replace his mortgage with a new one valued at $382,500 so that he will have 10% equity.

So, essentially, the plan is to take $127,500 out of my pocket and put it in his. How is this theft constitutional?

Meanwhile, we’re near the bottom of the real-estate food chain. What about the rewards for Wall Street gamblers, whose wealth makes ours trivial by comparison?

We’re told that we have to do all of this, so that our Nationwide House of Debt Cards can be propped up a bit longer. But why do we punish some people and reward others, without any attention to their responsibility, or lack thereof?

This is bound to be repeated all across the country. Rather than let the market sort itself out, the Government will come in and arbitrarily declare some people winners and others losers. It’s not even as good as “arbitrary” –the Government will specifically reward those who behaved irresponsibly, or worse. Everyone else gets punished.

In what way is this really a template for a just, sustainable society?

and another-

Has the Times editorial page gone insane? We’re in a financial crisis from loaning money to unqualified borrowers during a housing bubble, and the Times manages, somehow, to find the logic to propose that the government loan more money to unqualified homehowners, while simultaneously keeping housing prices artificially inflated.

Obviously, it’s the Times belief that bubbles should never pop, equity should never decrease, and no borrower is ever unqualified. And you people have the gall to blame the free market for this nonsense?

The shit keeps piling on with no end in sight. There is one thing though. Any plan that requires the government to buy mortgages – either by borrowing hundreds of billions of dollars or magically creating them, is flawed. All I can say is – find another one.

A huge number of laws and practices worldwide have to either change or be scrapped if the world has to move to a free market economy; bankruptcy laws, for example. A company or individual should not be allowed to hang creditors out to dry by claiming bankruptcy protection, like what happened in Lehman’s case-

The problem posed by the Lehman bankruptcy was not the losses suffered by hedge funds and other investors who traded stocks or bonds with the firms. As federal officials had predicted, that turned out to be manageable. (That was one reason the government did not step in to save the firm.)

The real problem was that a handful of hedge funds that used the firm’s London office to handle their trades had billions of dollars in balances frozen in the bankruptcy.

Diamondback Capital Management, for instance, a $3 billion hedge fund, told its investors that 14.9 percent of its assets were locked up in the Lehman bankruptcy — money it could not extract. A number of other hedge funds were in the same predicament. (When called for comment, Diamondback officials did not respond.)

As this news spread, every other hedge fund manager had to worry about whether the balances they had at other Wall Street firms might suffer a similar fate. And Morgan Stanley and Goldman Sachs were the two biggest firms left that served this back-office role. That is why Mr. Ackman’s investors were calling him. And that is what caused hedge funds to pull money out of Morgan Stanley and Goldman Sachs, hedge their exposure by buying credit-default swaps that would cover losses if either firm couldn’t pay money they owed — or do both.

Government interference necessarily distorts markets and creates moral hazards and perverse incentives. That is why free marketeers keep screaming laissez-nous faire! Leave us alone! If you are one, you will oppose the bailout. If you aren’t, you will support it. There is no third choice. And yes, this is not a false dilemma.

Crisis

There are two sides to the current crisis that has enveloped the financial world – a crisis of liquidity and a crisis of credit. The liquidity crisis resulted from lack of immediate access to funds to meet liabilities that were due yesterday; the credit crisis resulted from large scale defaults on low quality home loans.

Liquidity
There is one cardinal rule when it comes to finance – never use short term funds to fund long term assets. And businesses that have their feet on the ground understand this – the manufacturer, the retailer, the service provider (their primary assets are people, but still). Everyone in fact, except most of the banking and financial sector. Why is the rule so important (although the names are self explanatory, an explanation will do no harm)?

Short term funds – loans – need to be paid back within a short period of time (the normal classification is anything that is payable within one year is “short term” and everything else – “long term”). So you should only use it to create assets that can be liquidized on demand or within a short period of time. Long term funds, on the other hand – whether your own money or money that is borrowed – is repayable or available to you over a significantly longer time frame. So, if an investment has to go into construction of a building, or buying machinery, or doing similar stuff, care needs to be taken that you are not obliged to return the entire money whenever the lender demands it. This requires that you either embark on the project on the strength of your own equity, or on the basis of a long term loan where the lender cannot demand that you pay up the entire money at once – something that cannot be done because all your funds are locked in a long term venture. The asset classification may vary depending on the business, but the classification still exists. And when someone fails to follow the rule, they end up with a “liquidity crisis”.

Every business more-or-less understands and follows this rule – that is why they differentiate between fixed assets and current assets; equity and long term funds, and current liabilities. And that is why they have a concept of working capital – the difference between current assets and current liabilities, a difference that is generally positive and which is therefore funded either through equity or through special funding in the form of cash credit facilities from banks. Every finance professional worth his salt knows about it, and the bankers even more so (but only when it comes to their debtors) – they will have a fit if you tell them you have a negative working capital – that you are funding your fixed assets from money payable to creditors or from your cash credit facility.

The problem in such a case does not result from the quality of assets – the business is still solvent, but from a mismatch in the time taken to liquidate an asset and the time when a liability needs to be repaid. It is a kind of asset-liability mismatch – a time-based one.

Banks, however, believe that they are exempt from this rule – that they can use demand deposits and lend the money for 10-20-30-year periods. Consider how your average bank operates. They accept “deposits payable on demand” – whether in the form of balances in a current account, or savings account, or a “fixed deposit” – the interest rate offered decided by the rules that govern each account; and they lend the money to businesses and individuals for long term uses. This is a serious mismatch and a disaster waiting to happen – a consequence of the “fractional reserve system” that banks follow, and the only reason banks can get away with this is because of an implicit government guarantee in the form of support from the Central Bank. If, for example, the Federal Reserve and similar central banks across the world were to be dissolved, modern banking will be history by next weekend. But the Central Bank and so called Deposit Insurance Corporations mask the perpetual liquidity crisis by guaranteeing enough funds in case of a bank run one one hand, and if a bank fails because it has to engage in a fire sale of its assets, guaranteeing a minimum amount that would be paid to every deposit holder. If you want to compare this with something you can relate to, think about the overbooking that hotels and airlines indulge in. The only difference is they don’t go bust when the chickens come home to roost – their business model does not depend on a balancing act.

Hence, fractional reserve banking, central banks and deposit insurance corporations are “solutions in search of a problem”, and these solutions fail when the problem raises its ugly head. The answer to this is full reserve banking and stripping government of its “monetary policy” making authority. Banks have to keep at hand a sum equivalent to all demand deposits they are liable for. The only money they can lend is that which they receive specifically for such a purpose. This system will raise the cost of banking, but will eliminate the need for central institutions controlling banks. A beneficial effect of this will be the elimination of inflation – a pernicious side-effect of government control on money supply.

Credit
Credit is a much simpler concept. When a prospective borrower meets a lender, in a free market, the lender will lend only if he is reasonably sure that he will get his money back. If the borrower defaults, the lender loses his money. And interest is the reward that the lender gets in return for taking this risk. So the whole system will work as long as people keep paying up the loans that they borrowed, and the scale of operations of banks and companies help them absorb the few losses that are inevitable when lending is done on a large scale.

The problem appears when lenders don’t pay attention to the risk profile of their borrower, either because of their increased risk appetite, or because they are forced by government to grant loans so that people can buy homes. Even in this case, when multiple defaults occur in a particular category of borrowers, as long as the loans are present on the books of the original lender, it is the one who would take the hit, and in a worst case scenario, it would go bankrupt.

The Current Crisis
In the present “credit crisis”, banks and other financial institutions threw caution to the winds, put their loans in a single basket and sold the basket in pieces to other companies who piled up even more complex financial instruments on top of them and sold them to another series of buyers. A pyramid was built on a fragile foundation, and the foundation collapsed when people who were granted loans way above their repayment abilities started defaulting. The shock wave was felt throughout the system and most banks and credit rating agencies realized that they had no idea of what they were holding and how to measure its risk or value-

ONE of the fastest-growing and most lucrative businesses on Wall Street in the past decade has been in derivatives — a sector that boomed after the near collapse of Long-Term Capital.

It is a stealth market that relies on trades conducted by phone between Wall Street dealer desks, away from open securities exchanges. How much changes hands or who holds what is ultimately unknown to analysts, investors and regulators.

Credit rating agencies, which banks paid to grade some of the new products, slapped high ratings on many of them, despite having only a loose familiarity with the quality of the assets behind these instruments.

Even the people running Wall Street firms didn’t really understand what they were buying and selling, says Byron Wien, a 40-year veteran of the stock market who is now the chief investment strategist of Pequot Capital, a hedge fund.

“These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models,” Mr. Wien says. “You put a lot of equations in front of them with little Greek letters on their sides, and they won’t know what they’re looking at.”

Mr. Blinder, the former Fed vice chairman, holds a doctorate in economics from M.I.T. but says he has only a “modest understanding” of complex derivatives. “I know the basic understanding of how they work,” he said, “but if you presented me with one and asked me to put a market value on it, I’d be guessing.”

Such uncertainty led some to single out derivatives for greater scrutiny and caution. Most famous, perhaps, was Warren E. Buffett, the legendary investor and chairman of Berkshire Hathaway, who in 2003 said derivatives were potential “weapons of mass destruction.”

And the market for these financial instruments vanished overnight leaving financial jargon like “mark-to-market” meaningless. As a reader of The Telegraph points out – “You can’t mark to a market that doesn’t exist.”

Most companies would have suffered losses but could still make it through if they did not suffer from a “liquidity crisis”, like AIG found out – even while being solvent – just – it had no money available to pay off creditors who demanded additional collateral. When Bear Stearns was being rescued in March 2008, this is what I said-

If the subprime mortgage crisis, and the Federal Reserve coming in with a huge bailout package for affected banks was bad idea, the Bear Stearns distress sale, underwritten by the Federal Reserve is worse. Conventional wisdom, and most pink papers, favors bailouts so that the overall banking system remains unscathed by such crises. But the fact of the matter is, bailouts fix the symptoms, not the cause. The main problem hardcore capitalists and libertarians (at least I do) have with bailouts is that those responsible for the mess don’t pay a financial price. If the tax payer has to pay for the financial jugglery done by employees of investment and commercial banks, and if the only thing that prevents people from losing their trust in banks is the backing of the government in the guise of the infallible Federal Reserve with an infinite credit rating, then a private banking sector makes no sense. In that case, nationalizing all banks should be the way to go.

There is a hint of sarcasm if you read a bit further, but my position is clear, and I stand by it. The crisis is a result of persistent government interference in the market, and the market failing to understand risk. And hence shareholders, bond holders, everyone who has invested in companies that took bad decisions should pay the penalty and take a hit. If they are not willing to do that, then the answer is not a bailout but a 100 % nationalization of the entire US banking and insurance sector. If companies don’t appreciate the free market but seek handouts on every available opportunity, socialism is what they deserve. And Bush can learn valuable lessons from Indira Gandhi on this one.