http://www.iie.com/events/event_detail.cfm?EventID=109
http://www.petersoninstitute.org/publications/pp/20090309johnsoncline.cfm

They are really good and well worth your time.

I worry, though, that this crisis is just the first indication that many of the economy’s assets (namely financial services firms) are being carried on the books at values higher than is justified by their ability to generate real production. Specifically, I think a great deal of the value that appears to have been “created” in the financial system over the last many years was actually extracted from productive industries and the taxpayers. We’ve happily counted this “production” as part of our economy and even begun to divert otherwise productive resources (mostly in the form of smart people) to this sector. By propping up the financial system we’re effectively doubling-down (or quintupling-down) on these assets.

This is fine if they really are productive. In the kindest scenario, all the financial engineering is actually making capital more productive in real terms. This is clearly true in some cases. The farmer who can effectively hedge his exposure to price fluctuations can focus his efforts on growing food rather than worrying about prices and will be more productive. Great. Putting everyone’s retirement in stocks through 401Ks probably marginally improved the efficiency of the public equity markets making firms’ cost of capital lower so they could do more projects. Cool.

At some point, however, the deals become zero-sum. Do you really think the capital market efficiency added by allowing hedge funds (or bank’s prop trading desks) to operate is anywhere close to the amount they make? No, they’re mostly extracting value from other parts of the economy (probably mostly suckers like me with my 401K).

The exact point at which financial engineering moves from being productive to being extractive is an empirical question and I’m sure it will vary over time and place, but I would argue its much less than the ~20% of GDP and 40% of corporate profits we’ve been running at. Pre-crisis this might have seemed reasonable, now it seems highly unlikely.

Another option is that financial services are such a large proportion of our (and the UK’s) economy because that’s where our competitive advantage lies and we’re doing it for the rest of the world, somewhat improving their productivity but mostly extracting value from their productive industries. Not sustainable, but Ok for a while I guess.

So, if the majority of the financial engineering is productive, full speed ahead with the recovery. If it’s not but we’re using our competitive advantage to extract from the rest of the world… we can still continue with the recovery but should limit how much we depend on FS going forward (eventually the world will wise up). In these scenarios there is some danger on the edges with regulatory capture and the debt we’re taking on to do it, but in nothing we can’t deal with in the long run once the economy is back on its feet.

If, however, the assets are actually worth far less than we think – if the profits of the major financial firms are based primarily on extracting value from domestic industry and the taxpayer rather than creating value – we need to be extremely careful rebuilding our economy on that foundation. In this scenario, the push to get the economy running again will be like telling a guy with two broken legs to walk it off… the adrenaline of the massive infusions of taxpayer money may even let us take a couple of steps, but we’re eventually going to come crashing down again and will have done even more damage in the interim.

The administration is understandably terrified of this scenario… hell, I’m terrified of this scenario but in my mind it is the most likely explanation for what we’ve seen. And as someone who believes this, it’s obvious to me the first step has to be to break the stranglehold of the banking oligarchs so that they’ll stop extracting and distorting our economy away from productive uses. If we reveal this scenario to be the case, the stock market will crash, the credit markets will seize up, people will lose their jobs… there will be blood. But, to quote Warren Buffet: “the most important thing to do if you find yourself in a hole is to stop digging.” If we don’t then the next time we find ourselves with an opportunity to turn this thing around, we’ll be starting out much deeper.

Here is my take. I am not suggesting we wait until the economy has fully recovered before we address the regulatory shortcomings and structural issues with the banks. In fact, as I mentioned in previous post, I’ll likely start to support these efforts if the improvements in the economy continues for another quarter or so (~Sept).

Most people have suffered huge financial lost during this crisis. Employment recovery will also be long and gradual. Therefore, for many the pain is deep and the hardship will be long. Quite frankly, it is very unlikely that people will forget this experience in a few years. We have time to do things right.

Anyway, around Sept is my date to supporting effort to revamp the financial system. What is yours?

Let me also elaborate a bit more on what is wrong with the efforts of Simon Johnson and James Kwak.

We had Lehman in mid Sept 08. As a result of systemic risk of Lehman, we’ve been in the deepest recession since the Great Depression. Since I started reading baselinescenario in mid Jan 09, SJ and JK has been pushing for nationalization of banks, wiping out the investors, forcing bondholders to take losts, breaking banks apart, and generally threatening banks’ survival. SJ and JK were pushing strongly to have these actions take place *immediately*. SJ and JK were *not* merely laying the groundwork. SJ and JK were very critical of Geithner for not following their suggestion.

Do we really think the world can take another Lehman like shock gracefully any time in the last 6 months?

Well here is one of many data points to consider. Larry Summer mentioned around March that the stock market after correcting for inflation has dropped to 1970s level! Or put it another way, people in the stock market is predicting with their money that the world economy is heading toward the deepest and darkest abyss of our collective living memory! Should we shock the economy one more time just to make sure we do deep dive into the abyss?

Let’s also look at the impracticality of the efforts being pushed by SJ and JK. My previous post already list all the hurdles SJ and JK will face. The evidences are overwhelming that nothing will get resolve quickly or efficiently. What would happen to the economy if we now have to deal with all these additional fear, uncertainty and doubt?

Now let’s take a look at whose lives are SJ and JK messing around with. Who do you think are the biggest shareholder in say Citibank, BA, etc? The biggest investors are the ordinary folks with their retirement accounts and pension plans. Had we nationalized these banks, then these ordinary folks would have ride down with the market crash but will not get to ride back up during the recovery. This is when the real serious wealth transfer happens!

I have also written the technical problems with the suggestions SJ and JK are pushing. I’ll just quickly summarize here. First, SJ and JK’s suggestions are pro-cyclical and will exacerbate the crisis. Second, SJ and Jk’s suggestions have significant inconsistency with historical experiences.

At any rate, I hope the schedule I had in mind sounds reasonable. However, if you disagree, please let me know where to optimize further.

I guess you got to an even more fundamental disagreement than the one I was getting at. To answer it: I think the most important challenge for our society today is that of placing our economy on a firm foundation for sustainable growth.

Unfortunately, the analogy for the world economy is not one house in a neighborhood where we can put out the fire then go crash on someone’s couch while we rebuild and redesign the fire code. We have to put out the fire and rebuild the foundations at the same time because we’ve seen time and time again that once the fire is out we choose to throw a little party instead of doing the hard work of fixing the foundation. You assert it’ll be different and we’ll fix the core problem once the fire is out. If it was as simple as “bad regulation” maybe that would be possible, but Simon and James have presented tons of evidence and arguments that the power of the banks itself helped to undermine the foundations. I don’t see how pouring money into them and playing nice while they rebuild that power will allow us to do so. This is another fundamental disagreement between us.

Your stance that anyone who argues for punishing the banks now “are narrow-minded and insensitive to the suffering of their fellow man” is a cheap shot. The disagreement is about pain now vs. pain later. We got out of the last recession relatively pain-free (at least from a GDP-growth perspective, as for the pain felt by the middle-class family, I question that) by setting up the debt bubble that got us into this one. There is a lot of desire to talk our way out of this mess as well, so you’re probably right, if everyone shuts the hell up and lets Geithner and the banks tap-dance their way out of this, we “get out” of this recession more quickly. It’s all about your time-frame for “economic recovery”… if you’re just looking to the next peak you want one thing, if you care about the next many cycles and think this is a unique opportunity to counter the power of the financial oligarchs, another. Neither is looking to expand human hardship to prove a point. We just (fundamentally) disagree on the time-line we should focus on.

FUD (what is this, Slashdot?) implies false fear, uncertainly and doubt; sewing discord to achieve some ulterior motive. The fear and doubt on the part of myself (and I imagine Simon and James) is quite real, sincere, and focused on the problem at hand. That we are fearful about something different than you (long-term sustainability vs. short-term crisis) means we disagree; not that we are disingenuous, irresponsible, and insensitive to the pain of our fellow man while you are honest, responsible, and caring.

What do you think is the most important challenge for our society today?

I think the most important challenge is to turn around the economy as quickly as possible. Figuring out rather our banks are illiquid or insolvent is by far not the most important issue. This is because cleaning up our banks is “not necessary (or actually sufficient) for a rapid economic recovery”[Simon Johnson].

http://krugman.blogs.nytimes.com/2009/04/02/japans-recovery/
http://www.iie.com/events/event_detail.cfm?EventID=109
http://www.petersoninstitute.org/publications/pp/20090309johnsoncline.cfm

The last 2 are debates between Simon and his colleagues at the Petersen Inst. They are excellent and have a lot of information on how the US got out of past financial crisis.

I agree with you “market confidence itself is not an indicator which of the assumptions (illiquidity or insolvency) is true.” But that isn’t my point. My point in the original post was “rebuilding confidence will allow banks to earn their way out of their problem. It is the least costly to the taxpayers.” This will help with the economic recovery. Clarifying liquidity vs. insolvency is unimportant (this evident from our past financial crisis). However, fanning fear, uncertainty and doubt (FUD) for our financial system will hurt the recovery. To get a deeper understanding you have to listen to the debates above.

Here is my beef with SJ and JK:

At the root of my disagreement with SJ and JK is a question of *priority*. In my view, we should turn around the economy first. Reworking our financial system and the financial regulations is second. If a house is on fire, put out the fire first and than worry about changes to the fire code and the code’s implementation!

It is understandable for an ill informed layman to worry about the health of our banks; especially true with all the FUD in the media. However, it is unforgivable for Simon Johnson and James Kwak to fan the FUD. They pursuit their bank agenda ignoring

1. Potential additional shocks to the economy (repeat of Lehman)
2. Higher total cost to society (deeper recession and longer recovery)
3. Undermining the investor and business community confidence
4. Undermining the public confidence of those working hard to turn the economy around (Treasury, Fed, and FDIC)
5. Legal limits
6. Political limits
7. Inconsistency with historical experience (financial crisis are not new)

I won’t repeat each of SJ and JK’s ideas on banks here. You’ll have a better understanding of the problems if you reread the old posts from SJ and JK and my comments. I think SJ and JK are doing more to hinder the economic recovery than to help it (keep in mind SJ and JK also write for a number major media outlets). Trae, you wanted an enumeration of things Geithner did better than baseline scenario. This partial list should do.

Also if you need more convincing what the priority should be just consider the unemployment rate and the human hardship this implies. People who argue that we must punish the banks at all cost right now are narrow-minded and insensitive to the suffering of their fellow men.

There are now some encouraging signs of improvements in the economy. I am hoping may be in another quarter I can stop criticizing SJ and JK. I’ll instead rethink with them how to rework our financial system. In case you are curious, I’ve always thought bad regulation was one of the root causes of this crisis.

Please let me know what is your priority.

The Chrysler bankruptcy is a good example of why the bailouts are flawed, with bondholders perhaps insisting on a bankruptcy to cash in their AIG-government sponsored CDS.

Anyone who believes middle America benefits from the survival of the banks on Wall Street, I have a mountain top in Peru I’d like to sell them.

Ward
Cusco, Peru
http://www.lifeinperu.com