There is a difference between long term and short term bank creditors.

Long term bank bonds are not inherently liquid (you can resell them, but you cannot redeem them at face value as you can a checking account). Banks do not (usually) have to repay such bonds upon request. Thus, long term bonds are not inherently vulnerable to a run. (They are still vulnerable to an asset price collapse, but this does not necessarily trigger a run on the bank.)

Short term deposits are another story. They are inherently vulnerable to a run.

There is a HUGE difference between these.

A run on short term assets can cause banks to go under overnight, even if they are inherently healthy. This is disaster, but relatively easy for govts. to prevent through relatively safe guarantees. In the current environment, the govt. temporarily increased guarantees so that even holders of large cash accounts have no incentive to run.

The long-term creditor situation is not as safe (theoretically). The govt. is not afraid of a run. The challenge here, however, is that the prospect of bank failure will cause future lenders to refuse to buy longer term bank bonds. The effects of this are not felt instantly, but can still be deadly as credit freezes up.

It’s really in the context of these longer term bank bonds that the recent debate over bailout vs. bankruptcy has taken shape. Very few people are really suggesting that the govt. withdraw its guarantee over short term liquid deposits, particularly those made by small account-holders. Small account holders just don’t have the time or capacity to monitor their local bank; their rational response would be to pull everything out and go to paper cash. And if that happened, this is the outcome:

http://www.runtogold.com/images/nybank.jpg

If taxpayers are to foot the bill, it’s all right (after all, they supposedly also benefited during the fat years) provided taxation is fair. There’s the rub.

Thank you. Your explanation gives me a better understanding of the complexity of the problem. My instinct as a scientist is to “do the experiment” and not bail out the creditors, but I see the hazards of using this approach at this time. It’s a difficult call to make. I agree that the issue of creditor neutralization is important and I hope that it remains a part of the discussion as the system is rebuilt.

It’s not too late to make AIG’s creditor’s suffer.

Since the US Government effectively supports AIG and, at this point, the panic of last fall following Lehman’s collapse has subsided, it seems time to take a second look at the AIG bailout and payment of 100% on it’s counterparties claims. This could be done under the auspices of a prepackaged bankruptcy restructuring which would permit a claw back of those 100% payments to AIG’s counterparties & creditors.

This process could be planned now that sufficient data is available on the counterparties and in most cases on the financial status of each of those counterparties. As a result this could be structured to avoid a cascading series of defaults because the US Government could at the same time, where necessary, inject selective loans to prop up essential US counterparties institutions. It could also coordinate this move with other nations to allow them to do likewise for their own essential counterparty institutions.

This would have at lease three benefits:
1. Make creditors & counterparties suffer to insure that going forward they do a better job of knowing their counterparties or risk suffering the consequences in a future meltdown of the financial system.
2. Significiantly reduce the cost to the US Taxpayer of the AIG bailout.
3. Gain political capital for the Obama administration that will be necessary when they return to Congress for more fiscal stimulus money by demonstrating fiscal prudence in light of what is now known about the use of billions given to prevent the collapse of AIG

Now the loss of US government is increasing everyday and that will cause the higher cost of living of people from the higher government debts and higher tax on taxpayers, not higher tax on private investors. Therefore, I do not understand why taxpayers should pay higher tax to support loss of private investors.

One thing we have seen is the lower welfare of country. Now government will create higher budget deficit and will create higher uncertainty of deficit from unknown loss of bailout. FED has also intervened market by printing money and definitely will create loss from intervention and uncertainty of amount of money expansion in the future.

From the uncertainty of loss of intervention and size of government deficit and size of money printing, the medium-to-long term bond yield is at the highest risk of losses from government new supply from higher deficit and the higher risk of hyperinflation of money printing. If government debt is uncontrolled and FED has to monetize debts more aggressively, the 3% 10-year bond yield is not reflecting the future hyperinflation and new supply of debts. We could not see the sharp increase in inflation in this or next year but we have the higher uncertainty and higher risk of hyperinflation and new bond supply. The medium-to-long term bond yield should move upto 5-10% and is volatile to reflect the uncertainty.

The higher bond yield and uncertainty will create the uncertainty of economic policy and definitely deter the private investment and consumption from the higher risk premium compensation. That will create the long deterioration of growth. We could end up only the stagflation (there is some growth but low) or the depression with hyperinflation (no growth but price will increase sharply because in the long run there is no relationship of price and economic growth)

I absolutely despise sweeping pronouncements about who should suffer, having spent about 2 years leading up to 2008 lobbying my employer for a cash-only options due to some common sense numbers about the housing bubble, and ultimately being saved from the toxic waste in the least-worst choice in the portfolio by the Sep. 19 emergency insurance offered (disgustingly so) to money market funds to prevent the “break the dollar” run. I might well be the only participant in this “plan” that did not loose money in 2008.

I am all for ending the socialization of losses, but to those who swing their Big Brush, let us see the inalienable right to in-service roll-overs of employee contributions at any time to end mandatory “exposure” first. Because the employers and fund administrators sure did nothing to reduce exposure, and could not care less about what the supposed “beneficiaries” think or want.

And that isn’t even starting to get into the issue of pension funds, easily another trillion dollars worth of mandated exposure.

If so, that seems to provide a reasonable explanation for why Geithner et. al. appear to be going to bat for creditors. To me, it doesn’t necessarily indicate that there might not be a balance between haircuts and systemic risk. At the least, it makes the issue trickier than merely saying that creditors must suffer.

The problem with a run on the banks is that they are self-reinforcing. There is _no penalty_ to a massive draw on liquid assets, and so if there is even the _possibility_ that a run might occur, every individual actor has an incentive to _get out first_.

Banks, and any entity that “borrows short and lends long”, are inherently vulnerable to runs. No amount of market discipline solves this problem.

The choices are therefore, allow runs and let the market discipline banks (with worldwide depressions as a normal consequences) or prevent runs through guarantees. If you prevent runs, you need to take steps (e.g. regulation) to compensate for the inevitable moral hazard.

These, really, are the only two pure options.

Of course there are hybrid options – our current system is one of them. Hybrid options have their own problems (e.g. failure to completely remove moral hazard). Certainly governments and central banks have tried for hundreds of years to figure this out. The problems we have today are not new.

A little deflation caused by increasing productivity is not bad. A lot of deflation caused by a self-reinforcing demand crisis is awful.

Try googling “why deflation is bad” – there are a lot of answers.

Here is an example link…

http://www.capmag.com/article.asp?ID=1289

“If you are a borrower, you are contractually committed to making loan payments that represent more and more purchasing power — while at the same time the asset you bought with the loan to begin with is declining in nominal price. If you are a lender, chances are that your borrower will default on your loan to him under such conditions. And it’s not just debtor/creditor relationships: any long-term contract for goods or services denominated in nominal dollars will have the same problem.

The entire economy suffers from the cascading dislocations triggered by these defaults. It’s why “bad falling prices” means monetary deflation isn’t just bad — it’s “ugly.” ”

Gold-standard advocates often defend deflation as “normal” and “healthy”. Historically, major deflationary bouts have triggered dramatic economic dislocations, and often war. Much of the mercantilist policies (high tariffs, manufacturing protection, colonial expansionism) of Europe in the 1600s through the early 20th century was driven by a desire to preserve domestic gold supplies (to help prevent deflation) and to build captured export markets.