There is an interesting interview in Barron's with two hedge fund managers called Shorting the Economic Recovery.



The fund managers who correctly predicted the housing collapse and the rise in gold, now predict the economy's next leg down. The second theme in the article is on capitalism, fractional reserve lending and what the government should have done.



Here are some interesting interview snips pertaining to capitalism and fractional reserve lending. The rest of the article is by subscription only.



PERHAPS ONE OF THE greatest failings in the run-up to the financial meltdown was a lack of perspective -- an inability by many market participants to see the big picture. Not so with Kevin Duffy and Bill Laggner, principals of the Dallas-based hedge fund Bearing Asset Management. With the help of their proprietary credit-bubble index, developed in 2004, the managers sounded early warnings on housing and credit excesses, and capitalized handsomely on their forecasts by shorting Fannie Mae, Freddie Mac, money-center banks and brokers, builders, mortgage insurers and the like.



Students of the Austrian school of economics, which espouses a free-market philosophy that ascribes business-cycle booms and busts to government meddling with interest rates, the pair is solidly in the contrarian camp, believing that the worst for the markets may be yet to come.



Barron's : You've said that perhaps the most redeeming feature of capitalism is failure. Please explain.



Duffy : Any healthy system needs a way to correct error and remove waste. Nature has extinction, the economy has loss, bankruptcy, liquidation. Interfering in this process lengthens feedback loops. Error and waste are allowed to accumulate, and you ultimately get a massive collapse.



Capitalism is primarily attacked by two groups: utopians who wish to impose a more "compassionate" system, and political capitalists who want to enjoy the fruits of success without bearing the pain of failure. They use the coercion of the state to gain privileges, at the expense of everyone else.



As a country we've become less tolerant of economic failure. The result has been a series of interventions, such as meddling in the credit markets, promoting homeownership and creating a variety of safety nets for investors. Each crisis leads to an even greater crisis. The solution is always greater doses of intervention. So the system becomes increasingly unstable. The interventionists never see the bust coming, then blame it on "capitalism."



Barron's : What would you have done differently as the credit bubble was bursting and the Fed and the Treasury were declaring that the world would come to an end without an $800 billion bailout package?



Duffy : Allow those who essentially bet wrongly to fail, instead of bailing out people with friends in high places.



Barron's : What about the argument that a financial panic would have ensued and crushed the little guy?



Duffy : The little guy actually has been crushed. The little guy is always going to be the last one in the soup line. So he will get a bone tossed to him, like cash for clunkers. But if you are Goldman Sachs or if you have got essentially the red bat-phone to Washington, D.C., you are first in line.



Laggner : There is still a multi-trillion dollar shadow banking system that FASB [the Financial Accounting Standards Board] wants to address next year. The central planners have already spent $3.15 trillion on various bailouts, credit backstops, guarantees, etc., and given approximately $17.5 trillion of government commitments, etc., while allowing many of these institutions to remain in place, with the same people running them.



Barron's : What else could have been done?



Laggner : We could have isolated the money centers and put them in temporary receivership. Then, we could have created -- with a mere $100 billion -- a thousand community banks. If you believe in fractional reserve lending [in which banks lend multiples of their deposits], something we don't support, they could have created a trillion dollars in new credit that would have flowed to small and medium-sized businesses. Those are the parts of the economy that are choking.



Barron's : What kind of financial reform would you like to see?



Laggner : We don't believe in a central bank. The idea that banks can speculate with essentially free money from the [Federal Reserve], which ultimately is the taxpayer, and that when they lose money the Fed bails them out and then passes that invoice to the taxpayer -- that whole model is broken and needs to go away.



Duffy : To get to the heart of the problem, we need to address fractional-reserve banking, which is causing the instability. We have essentially socialized deposit insurance and prevented the bank run, which used to impose discipline on this unstable system. At least it had some check on those who were acting most recklessly. Until we address the root of the problem, we are going to have a series of crises, greater responses and intervention, and more bubbles -- and the system will keep perpetuating itself.

Misguided Blaming Of Capitalism

The interventionists never see the bust coming, then blame it on "capitalism."

Fractional Reserve Lending Disaster

Excess Reserve Recap



1) Lending comes first and what little reserves there are (if any) come later.

2) There really are no excess reserves.

3) Not only are there no excess reserves, there are essentially no reserves to speak of at all. Indeed, bank reserves are completely "fictional".

4) Banks are capital constrained not reserve constrained.

5) Banks aren't lending because there are few credit worthy borrowers worth the risk.