Rose: “Looking back, what are the mistakes, and what should you have done more of? Where were your instincts right but you didn’t go far enough?”

Geithner: “There were three broad types of errors in policy. One was that monetary policy here and around the world was too loose for too long.  And, that created just this huge boom in asset prices; money chasing risk; people trying to get a higher return; that was just overwhelmingly powerful.” 

Rose: “Money was too easy.”

Geithner: “Money was too easy, yeah . . . . Real interest rates were very low for a long period of time . . . .”

There you have it. Pretty simple. And yet it is the first time I can recall that any U.S. executive branch official, spanning the Bush and Obama Administrations, has admitted monetary policy was even one factor, let alone the central factor, leading to the crash. This is very big stuff.

Some of us have been saying this for years, and even warned of the potentially severe consequences as the monetary errors were building. Few predicted the exact course of extraordinary events over the last 18 months, but it was clear to me in August 2006 the size of the monetary mistakes would have big repercussions:

It is these periods of transition, where the value of the currency is changing fast, but before price changes filter through all commerce and contracts, when financial and political disruptions often take place.

So Geithner, who’s had some rocky moments, gets real credit for admitting a crucial and central truth of this historic economic event, heretofore banished from polite conversation by an omertà of the economic brethren.

Yet why, among the endless lending, spending, and Tarping (unending?), does monetary policy not even get a mention when we talk about building a more robust economic system for the future? Obviously the Fed and Treasury are taking unprecedented and, I would even say, bold and creative actions to relieve the immediate crisis.

But when we contemplate a new financial order, when the the G20 meets in London to supposedly consider a Bretton Woods II, when economists begin revising their models of risk and politicians fantasize of new regulatory strictures on banks, hedge funds, investors, and lenders — when we gab about full-proof prevention of such trauma in the future — why do the key players neglect to even gently raise the “overwhelmingly powerful” central error of the whole episode?

New computer models. International super-regulators to spy and pierce bubbles. A rich new slush fund for IMF bureaucrats. Austere new pay limits for private finance. Cramming down mortgages. Propping up banks. All talk of money. Yet no mention of . . . the dollar.

Credit’s fiercest disciplinarian is sound money. The best regulator of risk is a stable currency. Far more than the new policy contraptions proposed by Davos dreamers and Gaussian copula critics, it is the elemental simplicity of a low-entropy dollar that can once again be the steadfast foundation for dynamic creativity and the measuring stick and promoter of real economic value.

(Hat tip: Social Security Institute)

UPDATE: See The Wall Street Journal’s excellent editorial on this important concession. 

Here we should look to three historical examples where aggressive monetary expansion was wedded to an aggressive fiscal policy: the U.S. during the mid-1930s, Germany through the 1930s, and Japan in the early 2000s. In each case there was a recovery, although policy errors led to significant setbacks. These episodes can help assess U.S. growth prospects, and the risks to a sustainable recovery.

The Great Depression in the U.S. came in two stages, a downturn from 1929-33 in which real GDP collapsed by 26.5% and unemployment rose to 25% from 3%, and a relapse in 1937-1938, with a 3.4% decline in real GDP and a rise in unemployment to 19% from 14%.

The first stage of the depression was associated with a collapsing equity bubble (1929), protectionist tariff legislation (1930), contractionary monetary policy (1931) and a sharp rise in tax rates (1932). Between 1934 and 1937, however, there was a rapid recovery, in part due to the severity of the downturn that preceded it. Real GDP expanded by 9.5% per annum, while the unemployment rate fell 11 percentage points.

The recovery was spurred in no small part by monetary policy. In 1933-34, the dollar was devalued against gold to $35 per ounce from $20.67 per ounce, which allowed the Fed to push reserves into the banking system. This allowed the Fed to finance FDR’s deficits with the printing press. After falling at an average rate of 6.7% per year from 1930-33, the Consumer Price Index rose by an average 2.7% per year from 1934-37.

In contrast to the somewhat better news in the household sector, the available indicators of business investment remain extremely weak.

But it is these key business sectors that are most important for a U.S. — and global — economic recovery. As important as stabilization of the housing sector is, we are not going to be led out of the recession by another housing boom. Nor should we desire that. We need real productivity-enhancing innovation, which is largely enabled by non-real estate investment and entrepreneurship.

Among the myriad policy actions being taken in Washington this year is a potential overhaul of our communications strategy, under the aegis of the FCC’s new Broadband “Notice of Inquiry.” The first goal of this plan should be to to encourage the continued investment in leading-edge information technologies. Broadband communications especially makes all our businesses in every sector more productive and also connects an ever larger number of citizens, especially those who may be struggling the most in this tough economy, to the wider world, improving their prospects for education, health, and new jobs in emerging industries.

Information and communications technology (ICT) accounts for an astounding 43% of non-structure U.S. capital investment, totaling $455 billion 2008. In this new FCC communications policy review, we should do everything possible to keep this huge source of American growth rolling. Any policy obstacles thrown into the path of our information industries would not only reduce this crucial component of absolute capital investment, which is already under strain, but also diminish and delay all the positive cascading follow-on effects of a more networked workforce and world.

Last September, Wachovia was the last domino to fall in the horrific sequence of financial firm failures — Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, AIG, Washington Mutual, and finally Wachovia. The Federal Deposit Insurance Corporation forced its acquisition by Citigroup. The deal was that Citi would pay a measly $1 per share of Wachovia, and the FDIC would invest $12 billion and insure Citi against any losses above certain threshold.

Then Wells came on the scene. It offered to buy Wachovia for $7 a share and told the FDIC that it didn’t need any investment or any guarantees. Believe it or not, Citi had the gall to sue to block Wells’ offer even though in every dimension it was superior for Wachovia stakeholders and for the American taxpayer.

You have to wonder what the FDIC was thinking in the first place. Citi had to take two huge capital injections from the U.S. Treasury under the TARP program in order to survive, and it had to have the Federal Reserve guarantee $300 billion of its toxic assets. So what was the point in having a bank that screwed up take over Wachovia?

Inquiring minds want to know. Maybe Wachovia wasn’t in trouble at all in September. Maybe it was always the diamond in the rough that it now so clearly is in Wells’ hands, and the whole idea was really to prop up Citi with Wachovia, not prop up Wachovia with Citi.

But now, even though Wells was conservative and well-managed during the boom, and could help lead the way out of the crash, it is nonetheless forced to comply with all the silly restrictions imposed by Treasury’s TARP.

no good deed goes unpunished. Back in October when Treasury Secretary Henry Paulson first implemented the new TARP program, he forced every major bank — including Wells — to take TARP money whether they wanted it or not. Wells Chairman Richard Kovacevich told Paulson no, but the Treasury Secretary said it was Wells’ patriotic duty to take the taxpayers’ money like all the rest. So Wells played the good soldier and took the money.

And now it’s sorry it did. Now, because it took government money it didn’t even want, its executives have been made subject to new compensation restrictions enacted by Congress and enforced retroactively. The idea was to make sure that the risk-happy fools who created the financial crisis in the first place now don’t benefit at taxpayer expense — but surely Wells shouldn’t be punished: it was one of the good guys.

Wells’ Kovacevich isn’t shy about complaining. In a speech last month, he said “Is this America — when you do what your government asks you to do and then retroactively you also have additional conditions? If we were not forced to take the TARP money, we would have been able to raise private capital at that time.”

Kovacevich isn’t fond of the Treasury’s latest rescue schemes either,  especially the “stress tests” to be applied to the 19 largest banks including Wells. He said, “We do stress tests all the time on all of our portfolios. We share those stress tests with our regulators. It is absolutely asinine…”

This crash is going to look much different upon reflection, isn’t it?

the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. . . .

The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.

1) To the political process all big numbers look alike; above a certain number the money becomes purely symbolic. The general public has no ability to feel the relative weight of 173 billion and 165 million. You can generate as much political action and public anger over millions as you can over billions. Maybe more: the larger the number the more abstract it becomes and, therefore, the easier to ignore. (The trillions we owe foreigners, for example.)

2) As the financial crisis has evolved its moral has been simplified, grotesquely. In the beginning this crisis was messy. Wall Street financiers behaved horribly but so did ordinary Americans. Millions of people borrowed money they shouldn’t have borrowed and, not, typically, because they were duped or defrauded but because they were covetous and greedy: they wanted to own stuff they hadn’t earned the right to buy.

On the Line

But now that taxpayer money is on the line the story has changed: innocent taxpayers are now being exploited by horrible Wall Street financiers. The guy who defaulted on mortgages on his six spec houses in the Nevada desert has turned himself into the citizen enraged by the bonuses paid to the AIG employees trying to sort out the mess caused by his defaults.

3) The complexity of the issues at the heart of the crisis paralyzes the political processes’ ability to deal with them intelligently. I have no doubt that, by the time this saga ends, we will all know what happened to every penny of that $165 million in bonuses and each have our opinion of the morality of it.

I doubt seriously we will ever understand the morality of the $173 billion payment that is the far more serious issue. For instance, Goldman Sachs, which received about 8 percent of the pile, or $13 billion, has claimed publicly that the money was, to them, a matter of indifference, as Goldman had hedged itself against a possible collapse of AIG — by making bets against AIG.

Taxpayers have already put up $173 billion, or more than a thousand times the amount of those bonuses, to fund the government’s AIG “rescue.” This federal takeover, never approved by AIG shareholders, uses the firm as a conduit to bail out other institutions.

(1) the Chinese people are less likely to revolt en masse in bad times than is often suspected. Even now, things are a lot better than ever before.  Fallows quotes one Shanxi province party official:

Do you understand? If it had not been for Deng Xiaoping, I would be behind an ox in a field right now. . . . Do you understand? My mother has bound feet! 

(2) China has at least a very good shot at achieving a truly innovative economy. Listing several new high-tech firms producing the best voice-recognition software he’s ever seen and some of the world’s most advanced batteries for everything from iPhones to new electric cars, Fallows writes: 

In Beijing, in Shanghai, in Shenzhen, and elsewhere, I’ve recently visited companies that are trying to use the disruption of this moment to enter wholly new markets and do what so few Chinese firms have yet done: make high-tech, high-value products that bring high rewards.

These largely mirror my own views. In fact I couldn’t help but notice Fallows’ concluding sentences:

Many Chinese companies will fail or make mistakes under today’s intense pressure. But many are using the moment to prepare for their next advance. The question for Americans to think about is how we are using the same moment.

Here were the final sentences of my economic history of China’s 30-year rise, released during last summer’s Beijing Olympics:

What seems undeniable is that the next hundred years will be a Chinese century. The biggest question for politicians and business leaders in the U.S. is whether, through a recommitment to entrepreneurial capitalism, it will be another American century as well.

The real credit, however, goes to Brian Wesbury, who’s been pounding away and comments on video here. To Steve Forbes, with his bold Wall Street Journal op-ed that opened the floodgates on the matter last week. And to David Malpass, who identified the mark-to-market problem over a year ago in early 2008.

The S&P 500 is up more than 10% since mark-to-market reform looked possible.