More catching up - McCully at Pimco

This snippet from Paul McCulley's latest musing at Pimco has been laying around on my desktop in the form of a text file for a little while now - forgotten in the days leading up to last week's holiday travel and subsequent gorging on turkey and cranberry sauce.

[Can you really gorge on cranberry sauce? Few of us seem to like the stuff. Is it just there to add color to the Thanksgiving table?]

Some consideration was given to dispatching this to the Recycle Bin, but, after having another quick look, it is clear why it was saved in the first place.

I fully recognized this risk [of a credit bubble] back in 2004, but downplayed it because I explicitly thought that the Fed and other financial regulators would “enforce quantitative rules on growth in levered players’ balance sheets, so as to prevent unbridled growth in credit creation via the carry trade.” How could I have been more wrong?

Financial regulators, with the Fed’s full support, did, to be sure, restrain the growth of Fannie and Freddie’s balance sheets. But the Fed went the exact opposite direction away from those institutions, cheerleading an explosion of growth in the levered balance sheets of what I’ve dubbed the shadow banking system – the whole alphabet soup of levered non-bank intermediates. They funded themselves not with insured deposits, but asset-backed commercial paper and reverse repo, with no access to the Fed’s discount window in the event of a drying up of such funding (also known as a run), only access to (less-than-complete) back-up lines of credit with conventional banks.

Former Fed Chairman Greenspan would, no doubt, argue that he was not a cheerleader for the explosive growth of the shadow banking system, merely a cheerleader for Adam Smith’s invisible hand of markets, which birthed and nurtured non-bank levered intermediaries. I could counter that he doth protest a bit too loudly, but it would be a useless exchange; Alan believes what he believes, just as I do, and I respect him for that.

Another in a growing list of economic professors wrote this morning. In my reply, I (mostly) joked that I feared for his profession. It seems that economics in the post-Greenspan era has very little to do with Adam Smith anymore.