This book applies law, logic, and financial history to macroeconomics. Macroeconomics is the branch of economic study that concerns itself with expanding the pie of society. Microeconomics, by far the larger and older branch of economics, concerns itself with expanding the piece of the pie claimed by a particular firm or individual. Microeconomists consider the impact of others’ actions on one firm or individual at a particular moment. Macroeconomists look at an aggregate motion picture created by the millions of offsetting actions that firms and individuals generate for their individual economic benefit.

With one major exception, modest changes in macroeconomic variables all produce offsets. Beginning with Adam Smith in the 1700s, every macroeconomist eventually discovered that one variable—the competitive cost of money, represented by credit spread—consistently increases macroeconomic activity when favorable (low) and destroys economic activity when unfavorable (high). Low and stable credit spreads produce, and are indicators of, financial stability. Every credit crisis begins with a sharp decline in confidence and a commensurate increase or upward spike in credit spreads.

Financial stability is the holy grail of macroeconomics, but it is also a very difficult thing to achieve in a free society. Every respectable economist understands that the world’s ability to sustain long-term growth has been impaired because we have not, to date, solved the problem of sustaining financial stability in a free market. Each time we observe a period of liquidity- driven growth, we convince ourselves that this problem has been solved. Inevitably, it seems, that’s when a new financial crisis or market crash shatters our optimism. The desire for economic prosperity and the freedom to pursue it seemingly ensures acts of fraud and indifference that result in financial instability. Albert M. Wojnilower of Craig Drill Capital wrote in March 2014, “We have booms and depressions not because of lack of economic expertise, but because they are hardwired into human nature.”

The first widely reported effort to remedy fraudulent practices that cause financial crises occurred in the time of Jesus of Nazareth. He observed that fellow Jews celebrating Passover were being overcharged to exchange Roman money for Temple money. Since the days of Moses, it has been considered a fraud to use two measures. That’s the very essence of the term duplicity. As the week of His crucifixion began, Jesus observed how the high priest profited by the fraud and He famously chased the money changers out of the Temple and into the competition of an open market. His action began a tortured journey that created a new religion but also provides a powerful example of the contrast and conflict between free and transparent markets and markets that are corrupt and fraudulent.

Jesus of Nazareth challenged the fraud of the high priest of His day and was killed. After Jesus’ crucifixion, His Jewish backers tried to reform Temple practices, and their next leader was killed as well. That led to a revolt among Jerusalem’s peasants, which got redirected at the Romans who supported the Temple priests (it was convenient for collecting taxes). Rome eventually responded to the revolt by the same tactic used in Carthage—it killed everyone in sight, razed the Temple, and destroyed Jerusalem in 70 CE.

Thousands of people have subsequently sought to free financial markets from similar monopoly practices and frauds. Inevitably, those efforts to impose transparency and fair dealing seem only to foster new forms of financial manipulation that, in turn, generate new cycles of crisis that bankrupt guilty and innocent investors alike. Coming out of what may be the worst worldwide financial market collapse ever, it is challenging for us to suggest that anything can change this depressing cycle of human error. Human beings, after all, are constantly seeking new ways to earn a livelihood. Finance has ever been among the most popular avenues to attain this goal, especially in cases in which the markets can be rigged to increase profits.

In 2013, Fred Feldkamp experienced the same currency exchange scam (in a Christian church, no less) that Jesus saw at the Temple in Jerusalem. In Christian theology, Christ’s prayer on the cross sought forgiveness even for His killers. He said they did not know what they were doing. In that regard, a great deal has changed. Today, everyone can know and expose a money changer’s scam.

We now have data (and means for instant worldwide distribution) that allow victims of fraud to avoid being duped. We have large and liquid markets that provide limitless alternatives to the acceptance of scams. All major equity markets instantly and continuously broadcast the precise level of stock investors’ interest worldwide, throughout each trading day. Most governments, however, continue to concentrate (and/or control) credit allocation and pricing within their banking enterprises, but even that is changing.

Through a process that began in 1971 (and may now be approaching completion), the United States has developed the world’s largest and most open corporate bond market. The operations of the major U.S. banks and federal housing agencies still effectively control the market for mortgage finance, and that remains a significant problem to be resolved. The market for corporate credit, however, is now so large that it is impractical for U.S. banks or even the Federal Reserve to control credit pricing and allocation over the long term.

Daily information relating to U.S. bond market activity is now so accurate that regulators have been able to prove manipulation of several private-sector credit pricing procedures (e.g., the Libor—London Interbank Offered Rate—cases, and more recent commodity and swap index investigations).

The United States suffered several major crises as it created this corporate credit market, but the result is the world’s best hope for gaining and sustaining financial stability. Privately reported daily indices that reveal the temperature of U.S. corporate bond markets were first published in 1987. A breakthrough, however, occurred in 2005. That’s when the U.S. Securities and Exchange Commission (SEC) ordered instant reporting of corporate bond trades. Soon after, FINRA (the Financial Industry Regulatory Authority) began reporting the daily bond indices that were used day by day to monitor the 2007–2009 crisis and to create Charts 9.1, 9.2, and 9.3 in Chapter 9 of this book.

This transparency illustrates how the financial crisis of 2007–2009 became the first worldwide market crash in which every concerned citizen and policy maker could know the precise daily reactions of millions of investors in U.S. corporate bond markets using actual trade information. As we’ve noted, the resulting data summary is published after each trading day.

The data reveals whether bond investors cheered, yawned, or fled in reaction to that day’s policy decisions, eliminating the need to endure the endless speculation over investors’ moods voiced by hundreds of talking heads in the financial media. Instead of having to guess, the data lets everyone follow the money. That knowledge furthers our ability to achieve financial stability, because policy makers can read and understand what the data means. They can frame appropriate responses based on facts rather than biased speculation. The data allows each leader to convert today’s mistake into tomorrow’s opportunity for redemption.

To eliminate crises, moreover, we now know that we must strongly enforce prohibitions on financial fraud by individuals, firms, and nations. Fraud is the force that generates all financial crises. In the first century, Jesus wanted to expose a financial scheme by forcing currency exchange trades into an open market where people could compete and show when a money changer’s price was out of line. The idea carried the risk of Roman interference, taxation, or both. It was therefore rejected by those in charge of the Temple.

That too has changed. Rather than confronting a church that quoted him a 67 percent currency mark-up in 2013, Fred joked with the clerk and paid up. Unlike Jewish peasants in the Temple, he knew the exact amount the fraud was contributing to the financing of the church. Everyone present, including the clerk, smiled at the irony. For Fred, the gift for accepting the mark-up was a priceless lesson. We now have an open-market solution for financial stability—the goal of Moses when he outlawed the use of two measures and of Jesus when He confronted the high priest.

Combining the universal ability to expose fraud with data that instantly reveals investors’ reactions to every policy change lets us open markets and sustain financial stability forever. Attaining that result only requires patient evaluation of all incoming data and the will to remain open to whatever market change is needed if things go wrong. Former Federal Reserve Chairman Ben Bernanke and his colleagues, it seems, are the foremost modern monetary policy practitioners of this theory.

A Goldilocks economy, which is neither too hot nor too cold, occurs when transactions conducted between informed and confident investors generate and sustain low and stable credit spreads. Low and stable spreads correlate with, and create, what academic economists call equilibrium in financial markets. Financial market equilibrium is elusive, however: so much so that many experts say financial stability is an alchemist’s dream. As Ludwig von Mises famously observed, economics is the science of every human action, and is thus impossible to predict (Von Mises 1949).

In 1776, Adam Smith described equilibrium as the state at which the price of a commodity, in all its alternate uses, is equal—that is, determined by one measure. That has been called the most important economic observation in history. It may also be the least understood, and the state itself most difficult to attain. Applied to the role of finance in Smith’s seminal economic treatise, The Wealth of Nations, equilibrium is the state at which the cost burden financial intermediaries impose on the generation and growth of productive assets (defined by Smith as land, labor, and stock in trade) is minimized. Credit spreads represent that cost burden.

Smith called finance the great wheel of circulation. The wheel facilitates conversion of productive assets (and the goods they produce) into money that is either invested in new productive assets or exchanged for other goods and productive assets (thereby increasing demand for new productive assets). Generating new productive assets expands the wealth of nations. Financial markets keep an economy moving and are, therefore, essential to creating wealth. However, with one exception that is pivotal to maintaining financial stability, finance cannot add value. Finance only allows land, labor, and stock in trade to grow efficiently.

Smith observed that any amount by which the cost to maintain finance exceeds the minimum cost of circulating the wheel burdens a nation’s ability to generate wealth. Transactions that generate a low-spread Goldilocks, or virtuous, economy in equilibrium minimize that cost of finance. They are, therefore, essential for nations that wish to maximize opportunities for citizens to succeed and to minimize risk that they will be crushed by a great wheel that circulates an overburden of needless (and often fraudulent) cost in the form of high credit spreads.

Despite the thousands of years mankind has been seeking to establish balanced trading rules and to avoid fraud, only the United States has achieved the elusive state of financial market equilibrium—and this only after a terrible world war. Maintaining financial market equilibrium has been as elusive as harnessing nuclear fusion: Each time the United States has achieved equilibrium in finance we have discovered new means by which dishonest financiers have evaded limits on fraud. In each case, a crisis soon follows and destroys earlier accomplishments, most recently in 2007–2009.

After each crisis, lawyers, traders, accountants, economists, politicians, regulators, businessmen, authors, and other professionals announce the cause of our failure from their perspective. In most instances, experts in one silo attribute the cause to an error committed by some other silo. In truth, all (and none) of us are at fault for periodic market failures. When all sides of the relationship between financial stability and financial crises are examined empirically and empathetically, everybody and nobody can be blamed. That’s because finance causes, and affects, everything. In financial markets, moreover, all things happen at the same time.

We are all human. Try as we may, even with ample use of technology, we will never understand everything that can go wrong in financial markets. If we pretend to be divine, everyone must be forgiven their errors. As flawed earthly vessels, however, we are all guilty of mistakes. Our real hope lies in the ability to overcome and learn from errors, especially blunders that tend to be repeated. As the great physicist and author Freeman Dyson notes:

Mistakes are tolerated, so long as the culprit is willing to correct them when nature proves them wrong. . . . Science is not concerned only with things that we understand. The most exciting and creative parts of science are concerned with things that we are still struggling to understand. Wrong theories are not an impediment to the progress of science. They are a central part of the struggle. (Dyson 2014)

We submit that it is the lack of good data on the perception of investors operating in the financial markets that has made financial stability a problem that heretofore has escaped resolution. Until 2005, the world lacked reliable, widely disseminated, real-time data on how bond investors price debt purchases and sales in response to policy changes. We understood crises in hindsight when we eventually found good data. That’s how Milton Friedman and Anna Schwartz reconstructed the causes of the Great Depression in their seminal 1963 work, A Monetary History of the United States, 1867–1960.

The United States used insight gained from this new data to minimize damage from the crisis of 2007–2009, but preventing crises using the theory of financial stability necessitates immediate data to understand what happens to investor sentiment as a crisis develops. Only then can this theory generate new policy directions that address underlying causes before a crisis triggers an economic collapse.

The problem is akin to what medical doctors experienced before they learned how to accurately measure fevers. Thermometers tell doctors when something is wrong. That’s when they must probe deeper and treat underlying causation before losing the patient. Without data, deciding when and how to medicate is a stab in the dark that can kill the patient rather than fix the cause of disease.

Obtaining accurate and timely financial market data is not simple. Throughout history, bankers carefully guarded specific price and margin data until it was outdated history. For some of those with insiders’ access, having data was a way to control markets or to profit personally. We now know that several markets managed by financial intermediaries (on which investors relied) were manipulated in the years leading up to the Great Depression and the 2008 recession in order to achieve the price results desired by those we trusted to conduct the markets fairly. Until the fall of 2005, a lot of bond market data produced on a daily basis was, in hindsight, nearly worthless for policy planning purposes.

Sometimes we learn from crises. The SEC demanded instant reporting of corporate bond trades as a result of a study it did after the Enron crisis. For those who followed credit spreads using that new data, each and every policy move during the 2007–2009 crisis, good and bad, generated a notable and measurable impact that was revealed by a change in credit spreads. Above equilibrium, each basis point change up (bad) and down (good) in credit spread produces a roughly $10 billion change in the annual wealth-generation capacity of the U.S. economy. When these numbers move too much in one direction or another, policy makers take notice.

Each day, therefore, looking at credit spreads, one could see when mistakes and relief occurred. This new knowledge led to days that were sometimes celebratory and sometimes sickening for investors. For example, credit spreads skyrocketed when the U.S. House of Representatives rejected the Troubled Asset Relief Program, or TARP bill, in September 2008. That meant most U.S. businesses would soon cease to operate. The body blow reversed the instant votes changed and TARP passed. The entire experience of 2007–2013 will be traced later in this book.

Fred began collecting and analyzing available credit spread data in December 1997. He needed a simple way to show Asian finance ministries, using one or two charts, that the Asian contagion of 1996–1997 benignly passed over U.S. credit markets. He was making a speech in February 1998 and needed the audience’s attention before explaining how the United States had developed an effective immunity to that serious crisis. By comparing world markets using credit spreads, the U.S. immunity became obvious and eye-opening.

Being curious, Fred next gathered similar data going back to 1987 and began to track whatever data he could find on credit spreads. In the monotony of daily research, he observed thousands of apparent coincidences between policy moves and credit spreads. The coincidences soon fell into patterns. Using the patterns, Fred learned that changes in credit spreads have correctly predicted the impact of financial-market policy changes on the U.S. economy for 27 years.

In September 1998, Fred used the data to show the SEC how a flawed rule it adopted in April 1998 destroyed the U.S. immunity to financial crises that he had demonstrated to Asian finance ministries in February 1998. That SEC rule had caused the hedge fund crisis of 1998 involving Long Term Capital Management. The September presentation resulted in temporary relief that allowed banks and others to safely unwind the crisis. As the data predicted, when the SEC’s temporary relief ended, the 1998 rule led to the high-tech bubble/crisis. The same rule also undermined the 2004 period of a Goldilocks economy. This eventually led to creation of unstable bank investments that exploded beginning in August 2007 with the failure of several hedge funds sponsored by Bear, Stearns & Co., and then caused the 2007–2009 crisis.

The 1998 SEC rule is terrible. It represents one of the worst pieces of public policy since the Great Depression. By cutting off market access for good structures generated by nonbanks and creating a way for commercial banks to monopolize access to money market funds, the SEC (1) prevented transactions that balanced an earlier bank monopoly in the market for asset-backed securities, and (2) unwittingly encouraged fraud by bankers who learned to manipulate their way into a new monopoly. In spite of our optimism about changes since 2005, we still fear the impact of the 1998 SEC rule will create further contagion in the financial markets.

These problems were, in our view, muted by the extraordinary policy innovations of Fed Chairman Bernanke after 2008. Over his career, Mr. Bernanke has published articles and given speeches describing the transmission of monetary policy through its impact on credit spreads. He clearly gets it. In identical October 2003 speeches, then-governor Bernanke reported on research that he and Ken Kuttner had done relating monetary policy changes to stock market activity. They found anticipated interest rate changes had little impact on stock prices, but that unanticipated changes had a moderate effect, and they wondered why. They wrote:

We come up with a rather surprising answer, at least one that was surprising to us. We find that unanticipated changes in monetary policy affect stock prices not so much by influencing expected dividends or the risk-free real interest rate, but rather by affecting the perceived riskiness of stocks.

Soon thereafter, Governor Bernanke became the primary White House economist and, in 2006, became chairman of the Fed. It also became clear that Vice Chairman Kohn held similar views—they both got it. Let’s hope that their enlightened thinking on credit spreads and markets continues to guide U.S. and worldwide banking authorities in the months and years ahead.

Changes in credit spreads exposed the merit and fault of each event on that awful path to financial Armageddon in November 2008. Whenever Kohn and Bernanke initiated a response, it seemed that the markets recovered. Until the fall of 2008, however, their efforts were consistently overwhelmed by the errors of others, particularly Treasury Secretary Hank Paulson. Changes in credit spreads similarly correlate with each step (and blunder) during the 2009–2013 recovery.

Understanding what moves credit spreads allows us to construct and test policies that allow the United States to create and sustain financial stability. The size of U.S. bond markets and the example that the United States can set will allow the world to do likewise. Through historical data, we know financial crises start with a spike in the spread, a sudden widening of the difference between (1) what high risk borrowers pay for credit, and (2) what high grade borrowers pay. Understanding what generates a spike permits policy changes that reduce the spike before investors panic. With proper rules, incentives created by changes in the credit spread affect the profitability of private-sector transactions that counterbalance the procyclical swings in finance that cause crises. As investors learn to use the theory of financial stability, credit spreads narrow and the magnitude or volatility of credit spread movements lessens. That reduction in the variability of credit spreads generates equilibrium.

Since few economists are active traders, as was John Maynard Keynes, most economists have yet to realize the opportunity permitted by the SEC’s 2005 data disclosure requirements for bond spreads. That’s understandable. Academic economists are renowned for rejecting anything in circulation for less than a few decades. Many economists seem, only recently, to recognize that Irving Fisher solved the problem of a debt-contraction depression in 1933. Part of the reason for this systemic failing among economists seems to be that few of them are truly students of history, especially when it comes to how finance and law interacts with economies.

Fortunately economic researchers now have 27 years of data (more than 5,000 daily data points) with various degrees of reliability by which they can correlate credit spread changes with policy moves and responses in all areas that affect investors’ market behavior. That’s sufficient to model policies that will sustain financial stability. The results of that research will surely modify positions espoused in this book. We accept that.

This book includes three motion-picture graphs (Charts 9.1, 9.2, and 9.3 in Chapter 9) that Fred developed to support the many reports he wrote in response to events of the 2007–2009 panic. The charts are updated through May 2014, comparing daily rates for long-term U.S. Treasury notes, investment grade corporate bonds, and high yield corporate bonds. The charts show how financial stability was lost through errors, then regained after 2008 and sustained after 2012 as these errors were corrected. Each chart follows the money of investment decisions affecting trillions of dollars of assets owned by millions of investors.

The theory of financial stability presented here derives from that data and from the transactions described in the 2005 book Fred coauthored. This market-based solution for financial stability is as old as the invention of money, as mathematically demonstrable as physics, as logical (and theological) as the Golden Rule, as current as modern technology, and as futuristic as the quest to eliminate war and the risk of extinction by global warming. Implementation may be difficult, but the problem must be solved.

So, let’s briefly review financial market history and see how to improve the future.