The Bank Run Next Time (Frankenstein’s Monster)

Think about the current and potential future pressure on our largest banks like this.  The underlying problems are deep, but the “run” comes from the credit default swap market, and presumably from experienced professional investors – many of whom used to work in the largest banks. 

The big banks helped set up these markets.  They trained many of the people who are now engaged in speculative attacks on these banks.  And the excessive bonuses of yesterday form the capital base for many hedge funds that now lead the attack.

In my Economix column at NYT.com this morning, I explore the ironies and emphasize the dangers.  The system may have a tendency to self-destruct, but don’t think that the costs to the rest of us will be anything less than huge.

57 responses to “The Bank Run Next Time (Frankenstein’s Monster)

  1. i’m not sure why you are thinking about ‘speculative run’ here. just taking the worst case, CDS 5Y on senior bonds is pricing about 6% now. if you assume a (high) recovery of 50% this gives approximately 12% default probability per year. do you think that is unreasonable?

    i think that the relatively high CDS spread is probably representative of the market’s belief that either default or nationalization without full guarantee payment of bonds is a real possibility for Citigroup. this is simply a function of the fact that TARP funds are running low as is political will to prop up the banking sector.

  2. Bill Bradbrooke

    Good point, q!

    There may, however, be the political will to impose regulation that (a.) makes executive incentives back-end loaded and performance based, (b.) the gives a regulator authority to seize and dismember institutions that fail stress tests, (c.) that makes the overall leverage of the institution a part of the stress test, and (d.) imposes reserve requirements and requires registration of all “synthetic” securities.

    That would help reduce the threat of systemic risk, and with these regulations in place we indeed would be wise to follow Simon’s advice and limit the size of financial institutions.

  3. FDIC insurance helps prevent bank runs, but there is another tool in the arsenal: The central bank discount window.

    Historically, even sound banks could be brought down by a mere temporary lack of confidence (a “panic” or “run”) because of the duration mismatch between their assets (e.g., home loans) and their liabilities (deposits). As Bagehot explained, this risk can be wholly mitigated by a central bank that stands ready to “lend freely at a penalty rate” during a panic.

    The Fed’s discount window is the embodiment of this principle. Any bank can go there for a short-term loan against its long-term assets to meet immediate cash needs… provided it is actually solvent. I doubt it ever even occurred to Bagehot that anybody would have any desire to prop up insolvent banks; the goal of providing liquidity is to prevent the solvent banks from being destroyed, too.

    With sufficient liquidity provision — and the discount window already provides this in infinite quantity — you can be certain that solvent banks will survive and only insolvent ones will fail. I would call this a desirable outcome, but the Treasury and Fed disagree. every program they have launched from the beginning of this crisis is trying to address the solvency problem; i.e., transfer the losses to the public fisc.

    I would be less outraged if they simply admitted that was what they are doing, instead of continuing to pretend that “illiquity” is the problem they are trying to solve.

  4. Excellent bold ominous essay Simon! Could you please post a new picture of recent CDS history for US treasuries.

    Problem even with your bold statement, is that without decrying some of the previous bailouts, our current administration is further tarnishing the reputation of the dollar thus, when people are blinded by their own self dealing, they lose regard for their fiduciary duty.

  5. Nemo, the “providing it is actually solvent” may not be an issue these days since we are obviously in the dark about solvency since the results of the stress tests are being withheld! Looks like solvency isn’t what keeps a bank open these days!

  6. i think you are right — the willingness of the treasury/fed to take on risk and loss has only increased since the initial TARP was proposed.

    part of this is just politics. none of the govt parties — treasury, fdic, fed — can come out and say ‘xyz is insolvent’ unless they simultaneously are set to fix the problem through major recapitalization or nationalization or more explicit guarantees. the reason: publicly admitting the problem would cause a bank run. if they were going to let a bank fail, they would do it by saying nothing, so that they wouldn’t be seen as responsible for the run.

    that being said, i don’t see how anyone would see the most recent TARP round at citigroup as providing liquidity. it did not provide additional liquidity. it was a recapitalization. it was too small scale to ultimately matter, but it was a recapitalization.

  7. Isn’t this an argument for the Bulow Plan, which would hive off the going concern business from the legacy asset/liability business? Would you care about a speculative attack on a run-off closed-end fund?

  8. on re-regulating the industry, we’ll just have to see what happens over time. nothing i’ve seen so far has given me reason to be hopeful. i say that from many angles, from the composition of the obama team (esp summers) and the IQ of the us congress. but we’ll see; that chapter hasn’t been written.

    personally, i’m not sure that a limit on institution size is useful. small institutions can (and will) fail en masse during macroeconomic disruptions when they are economically more or less equivalent. so i think an institution size limitation could give us a false sense of security.

  9. middle world guy

    I guess the Fed and Treasury’s definition of solvency is different than yours or mine. It all comes down to how one prices those toxic assets. Since most of those toxic assets are housing of some kind, how do we best prognosticate the future of housing?

    If you have a brutal outlook on housing (like I do), how many banks are solvent? What would be the unit of time that differentiates a temporarily illiquid bank with a structurallly insolvent bank that has no hope of balancing their books in the near future?Unfortunately, I believe the Fed is plugging in the same rosy numbers for housing as the Obama is using for their budget.

    I’m sure there were a lot of worthy housing projects and renovations/additions done during the boom years. I can’t help but think though that a much higher percentage of the development was “junk” than the mainstream thinking is willing to admit. Classifying something as junk is a tough choice and one that can be put off indefinitely with the help of the Fed and the Treasury. Welcome to the age of Zombie Banks, they will be with us for a very long time.

  10. Glass-Stegall was good though, at least you had the separation of the traditional bank functions separate from investing and investment banking…the way it is without Glass Stegall, it makes my head swim when i think of what a clear conflict it is to let primary dealers function as an agent for the fed on behalf of the treasury right in the middle of their own proprietary desks…this is such an insider trading scam, and to think it has gone on for 10 years now…

  11. Well, the idea that the principal institutions of finance capitalism will be destroyed by their own internal contradictions has been around for awhile. Or to mangle another thought from the same canon, give a man a big enough bonus, and he’ll buy himself a rope stout enough to hang his former employer.

    These thoughts, however, are emphatically not part of the current policy dialogue and do not even derive from the received Keynesian scripture.

    Perhaps its time to put the politics back into political economics?

  12. Bill Bradbrooke

    Like you, I believe that the size of the institution is less important than the quality of the regulation. However, Simon has witnessed the unholy alliance of financial and political institutions in emerging market nations and has had to deal with it as lender of last resort. He is urging a size limit as a way of breaking up a culture of contol that a Washington/Wall Street ‘oligarchy’ has established. I just cannot say he is wrong.

  13. Bill Bradbrooke

    The two, solvency and illiquidity, are related. The issue of insolvency became apparent early with Countrywide and the 2 Bear hedge funds that failed, i.e. early 2007. Fear of insolvency lead institutions to suspend normal lending practices, causing illiquidity. This in turn has lead to structural economic damage, falling production & rising unemployment. The question of insolvency remains, however, if normal flows of credit do not resume, this question will be answered overwhelmingly in the negative. In Bahehot’s day asset classes were more straightforward. There was no trading in ‘synthetic’ securities, for instance. Are you sure you want an answer to the solvency question before liquidity has returned? The Fed doesn’t, Treasury doesn’t, I don’t.

  14. i can’t say he is necessarily wrong either. i don’t believe that his reasoning is definitive. i don’t know the right answer and i haven’t thought it through yet.

    i am suspicious of easy answers, and i think that ‘smaller is better’ is a statement that requires careful analysis as opposed to a statement that is obvious on its face.

  15. If the solvency issue can’t be solved for certain firms, then the scandal will have completed, and at that point the liquidity issue won’t have a resolution because our country won’t have the credit left to make a facility–this is why from day one when AIG was given the free ride verses receivership, it was a tip off in my mind that something very wrong was taking place… our government could have made a bank facility for the whole system and let kept business going while the mess was cleaned up.

    But, the whole idea of nationalization being evil was used very cleverly by fed and treas as a reason to let the trillions now go out to throught the federal reserve system and maybe never again to be seen… Not that every penny spent has been wrong, but clearly, not taking AIG into receivership, the whole TARP 1 facade, the cash infusions, the overpaying for assets, backstops, PPIP and probably other things i forgot or don’t know about.

  16. Here’s the thing I don’t get – you (Simon & James), Paul Krugman, Robert Reich, etc. etc. are essentially saying things look really bad and we’re in for a world of hurt.

    Obama, the banks, the general media, all seem to be saying things are “looking up”.

    Now I am fans of you guys, so I lean toward your view, however what is the disconnect here? If you guys are right, we’re basically just waiting for the (very big) shoe to fall, whereas they make it sound like we might be on our way out of this mess.

    I’m inclined to almost believe we’re seeing propaganda. All of a sudden all of the banks plus Obama and a few others start saying how things are looking up. To me it literally looks coordinated – like someone said, “Tomorrow you go out and tell people it’s rosy. We say it together to give it strength. We say it enough that it brings back confidence and makes itself true.”

    Are we victims of a giant coordinated snow job? And if so, since a large part of the problem is “confidence”, does this lie actually have a chance of making itself true? That is, convince everyone that it’s all ok, so they spend like it’s ok, and thus rescue the economy?

    Or are things so intrinsically broken that this is just an uptick before yet another huge string of downticks?

    On the one hand, even if it’s a lie I’d like it to work. But on the other, nothing will have changed and the fundamentally unbalanced system remains (both in terms of bank size, political power, unregulated markets, and wealth stratification).

  17. Well noted, Nemo.

    The question is why Fed and Treasury are so aggressively transfering value to banks.

    SJ proposes one explanation – the oligarchy. Certainly, part of the explanation.

    Here is another: money supply and asset values. The Fed has made itself dependent on banks to sustain the money supply (via leverage). A collapse in asset values in a highly leveraged economy will do brutal things – probably worse than the Great Depression due to less subsistence agriculture, an even higher ratio of debt to GDP, and increasing specialization of labor and physical assets.

    Asset values are not a liquidity issue (aka, finding someone to buy the asset at a fair price quickly). They are a wealth issue, and contrary to belief among Friedmanomicons the economy does not quickly rebound from catastrophic depressions. Witness 1873. Depression lasts 5 years, and several years later the recovery is anemic (then gets hit again).

    One could say tough luck to the debtors – we’ll simply see massive waves of bankruptcies/unemployment and eventually obscene consolidation of wealth into the hands of a handful of financiers who started the catastrophe in cash. Except the federal govt. is now a massive debtor, and its income consists of taxes, and the impact of a 5 year depression on the federal balance sheet would essentially destroy it.

    So the federal govt. needs to reflate asset values or face dire consequences. Except that it can’t seem to find the political will to just print money by itself (not the amount that is needed to prevent implosion), so it is relying on banks. Banks, recognizing how “needed” they are to achieve this, find themselves with more bargaining power than they deserve – and use it.

  18. James Twiner

    as regards this, wasn’t their once an aphorism about not taking out a loan for a house more than 5x one’s yearly salary? Think about that and then think about what it means in terms of “natural” or “reasonable” housing costs. There are a great many people in very inflated homes by that measure.

    What goes up must …

  19. James Twiner

    our economy has functioned for most of a generation as a giant confidence scam … I mean game. We really are, I think, hearing people “clap louder” in the public sphere because they are afraid to admit to us (and possibly themselves) that structural change will be necessary. After all, nothing is more conservative (in the original sense) than a banker, and what we have right now seems to be a government of bankers, by bankers, and for bankers.

  20. Erich Riesenberg

    The point is not that smaller banks don’t fail, it is that when small banks fail they get put into receivership. When megabanks fail they get tax money. And, it is a relatively easy regulation to enforce. Simple minded seems a big bonus when it comes to banking.

  21. Erich Riesenberg

    Yes, income versus housing costs and housing ownership costs versus rental costs are the basic measures of house price reasonability.

  22. statsguy – many countries have tried many times to “print” their way out of economic trouble. I know of many disastrous results, but I am unaware of any success stories. Are you?

    On an intuitive level, I fail to see how surreptitiously taking resources out of the hands of productive people who for the most part honestly accumulated them (i.e. savers) and giving those resources to reckless people who for the most part dishonestly accumulated their “assets” can help an economy. I can see the many ways it can hurt. When you do this via inflation it seems even worse than direct transfers because it compounds the economic damage by distorting price signals.

  23. Fundamentally I’m inclined to agree, though I don’t know if it’s “by and for bankers” as it were, but rather, “by and for the monied interests”, but in the end it yields the same effect.

    Compared to Bush, Obama is the messiah, however despite his pre-election rhetoric, I don’t really see any substantial change. The power structures remain and I see no attempt, even modestly, to change them.

  24. The beauty of de-regulated free market capitalism. Eating of their own or like the dog who eats his own tail, arse and continues to devour half of his entire being until he becomes stuck, can’t move, out of options.

  25. Yes, but somehow the dog’s owner always ends up ok and we the little people end up with the dogs arse…

  26. Actually come to think of it, we end up with what comes *out* of the dog’s arse!

  27. Bill Bradbrooke

    I don’t disagree, Erich, having banks – investment and commercial – small enough to be put into receivership is desirable. I’m just looking at a slightly different problem, namely: what happens to our financial system when it over-commits (and takes onto its collective balance sheet) a class of asset that suddenly and unexpectedly becomes worthless and hedges collapse? If we don’t prevent this from happening again, even if we break up banks into smaller entities, I think we’ll still be vulnerable to syetem wide failure. I wish Simon would comment. If shrinking banks is more important than policing markets for derivatives (by requiring registration and setting reserve requirements), and assessing risk and policing leverage in our financial institutions, there has to be a reason. Maybe Simon has already addressed this and I missed it.

  28. The speculators can be viewed as a predatory species, culling the weak animals from the herd. Thus, they are performing a service, doing what the Government has been unable or unwilling to do. Although it may not be the best way to bring down the zombie banks, it may be the only mechanism which will actually be successful. The sooner it happens, the sooner a real recovery process can begin. I think the best that individuals can do is to take steps to protect themselves from the consequences and to watch in detached amusement.

  29. If things were genuinely looking up, what details would be worth concealing?

  30. StatsGuy —

    glad to see this perspective, which i agree with.

    the fed is worried about debt-deflation above all.

    we’re not out of the woods yet when it comes to that.

  31. some guy in a cube

    Sorry, but excessive risk-exposure in the form of a few extremely large financial corporations reflects very poor systems design.

    At that speed, one pothole, and they’re done.

    A positive outcome of this crisis is that the weakness of such a system is laid bare, and it is stunning. I always had assumed these smart people knew what they were doing.

  32. Tom – Might you suggest which steps might best be taken to protect ourselves from the consequences?

  33. I guess what I’m implying is it isn’t actually looking up. If I’m understanding things correctly many of the largest banks are essentially insolvent. When they say they’re “making profits”, that’s by conveniently excluding huge swaths of their portfolio. They say they’re making “billions”, but that’s by papering over the trillions effectively hemorrhaging elsewhere.

    As far as the outside economy goes, much of the uptick is by virtue of the government throwing money at it. Now that is good, because it says maybe it’s at least having the effect desired, but it’s way too early to denote real progress. It’s kind of like saying someone is “alive” when they’re on a vent – the real question ultimately is, can the survive without the vent (and this vent is going to go away eventually)?

    I don’t doubt that there is some actual positive news out there, but the 10,000 lb elephant in the room is these banks, and Simon/Kwak/Paul/Reich/etc. are saying that elephant may well keel over, which is like the nuclear option. In the mean time there seems to be a concerted effort to say, “Don’t look at the massive devastation over there – look at this (comparatively) tiny good news over here!”

    I guess that leaves 2 questions for me:

    1) Is this actually coordinated propaganda instituted by the administration in concert with the private sector?

    2) If enough people believe this fiction, given the state of the banks, can it actually become the truth? Or is this like new whitewalls on a car with a blown engine?

  34. My fear is the vast majority of us cannot protect ourselves from the consequences. That perhaps is the one argument for supporting even Obama’s flawed plan.

    We ought to do this another way, but most of us cannot afford these things to take their natural course. So if Simon/James/Paul’s tack is politically implausible, we had better hope Obama’s crappy plan still succeeds.

  35. I have responded to this several times – I’m not about to argue against the moral virtue of saving.

    I will argue that when given a choice between inflation and deflation (or even a significant risk of deflation), most sane people will advocate inflation. And to those who would assert that the risk of deflation was a falsehood, please note that the expected 5 year inflation rate these days is still rather low by historical standards IN SPITE OF extremely aggressive action by the Fed. Without that action, where would we be?

    Moreover, I think many people would heartily contend against the assertion that people who have hoards of cash these days are uniformly virtuous, and people who are in debt are mostly “dishonest”. A few years ago, it was easier to convince people that anyone who had money deserved it. With the spectacle of outsized CEO pay and undeserved banker bonuses (for creating “value” that ultimately proved massively destructive to the country), many Americans just do not believe that argument anymore. They suspect that the vast increase in wealth disparity between rich and middle class may indeed be resulting from a system that is fundamentally unfair.

    And as to the “dishonesty” of indebted Americans, consider any college student who is paying obscene rates to usurous banks who colluded and sent kickbacks to admissions/finance offices. Or a family stuck with credit card debt due to aggressive marketing campaigns, with rates that later increased to 30%, or many (foolish, but not necessarily dishonest) people who took out ARM loans at the encouragement of uber-economist Alan Greenspan, or many folks who incurred debt due to medical bills and unemployment.

    As to printing their way out of a depression, here are two examples: US 1930s, and Nazi Germany.

    Many falsely lay blame for Weimar era hyperinflation at the feet of the money press (the real cause was external debt obligations amounting to 1/3rd of total national income, as per the Treaty of Versailles, which were impossible to repay). These same folks tend to forget that Hitler was able to achieve Germany’s rise to power largely by jettisoning the advice of mainstream financial wizards – and while the rest of Europe maintained strict monetary policies, Hitler printed money, enforced exchange restrictions, and forced a re-industrialization of Germany. In other words, the utter blindness of then-conservative economic theory paved the way for Hitler’s near victory in WWII, as many other nations wallowed in gold-standard-worshipping depression.

    http://www.zum.de/whkmla/region/germany/nsger19331939.html

    And finally… I find it very hard to take the “inflation distorts price signals” argument seriously when Friedmanomicons aggressively defend recent “free-market” price movements in commodities, stocks, etc. Exactly how, praytell, was oil’s rise to $147 a distortion-free price signal? Exactly how does the Efficient Market Hypothesis explain the ridiculous volatility of the last year? (Or a 9% unemployment rate along with a 15% underemployment rate, when only 18 months ago we had rates that were nearly half…) Exactly how did the price of AAA mortgage backed CDOs reflect their underlying value?

    Attacking inflation-targeting policies as immoral (particularly when targeting moderate inflation at a time when the world is at severe risk of depression due to a debt-heavy balance sheet recession) requires a view of morality not shared by most americans, and also ignores considerable empirical data.

  36. middle world guy

    Nothing goes down in a straight line, there are lots of zigs and zags along the way. I think people who are more pessimistic about the economy are taking a much longer and holistic view of the situation.

    Certainly the economy could be “psyched” up for several years. But something feels different this time. There is just too much accumulated rot in our economy, and at some point, basic physics has to take over.

  37. middle world guy

    Not sure exactly how your money-printing scheme operation would work, but that would be a dangerous game indeed.

    The ones that would be most protected against inflation would be those “in-the-know”, i.e. bankers and other elites. By the time average americans got their extra cash (in whatever form that happened) they would have no new purchasing power. Banks might lose value on fixed contracts, but they would still own the claims against the assets. This is why modern banking is so insiduous – deflation, inflation, whatever it doesn’t matter. Bankers win every time.

  38. The mistake you made, sir, was not factoring in greed, by the guy’s in the good suits. We were all stupid….
    AA

  39. I’m hoping that NONE of your plans involve ANY investment capital from foreign investors. I’m from “overseas”, and I can tell you, without question, that NONE of my friends who got burned in your last scam have NO INTENTION of ever investing in any “american schemes”…ever again. Thats done. Not going to happen again. So…I hope your big recovery plans don’t incorporate ANY investment from any pension plans from northern Europe. Thats not going to happen again, not in your lifetime, anyway. Nope. Thats OVER.
    AA

  40. Bear:
    You ask a good question that I would like to be able to answer for myself. I don’t really know what the consequences will be. All I have read is of the “you don’t want to go there” variety. If anyone knows of some thoughtful discussions which attempt to paint a realistic picture of the consequences, I would be interested in hearing about them. The only thing I have done is to take out some insurance against currency debasement and inflation (buying some assets which benefit from inflation) in case the Fed is forced to dramatically ramp up its money printing more than it already has.

    Matt:
    My fear is that the Obama plan is just postponing the day of reckoning and will end up costing the taxpayer a lot of money. If you accept this, then the question becomes whether you want to face the consequences now or later. I hope that the plan works but if there is anything I can do to protect myself in case it doesn’t, I want to do it. We can support the Obama plan if that is the only option, but that won’t affect the probability it will succeed. It just does not seem that a “modified Obama plan” is in the cards. If the plan doesn’t succeed, that may turn out to be for the best in the long run anyway.

  41. adios amigos

    A family built a house, and it cost $200,000. They kept it for 5 years, and sold it for $300,000. The family that bought it, lied on their mortgage application, put “nothing down” on the house, got a mortgage anyway, and then it went into foreclosure. Who made a $100,000 profit from this transaction? Was it:
    a. The Bank?
    b. The buyer who lied on the mortgage application?
    c. the seller of the house?

    So….why are you all so furious at the bankers?
    AA

  42. Because the bankers live in a $3 million dollar house.

  43. I disagree that “TARP funds are running low”. In fact, I’d bet the TARP has a surplus. Goldman along with others are now applying to pay back the Treasury quickly. There is no lack of good news in this earnings season. All major and minor bank announcements so far are extremely positive. Make no mistake this TARP money is coming back to US quickly…
    http://mast-economy.blogspot.com/2009/04/no-basis-for-earnings-fear.html

  44. It’s obviously the bank in your example (or whoever underwrote the mortgage). Here’s my reasoning…

    The underwriting institution wrote the mortage knowing full well that the buyer had ZERO equity in the house. The underwriting institution also ASSUMED that the house would not loose value.

    Now the buyer obviously is not someone anyone would want to do future business with, but it’s the banker’s (or underwritter’s) own stupidity for making poor business decisions and doing it on a grand scale – multiply that transaction by hundreds of subdivisions.

  45. silly things

    Don’t Hate The Playa Hate The Game!

    Start with cleaning up the regulation that allowed this mess to happen.

  46. Not really – for most people, the largest single expense they have is mortgage, and currently US citizens are converting to fixed 30 years at a rapid clip (if they have enough equity). If inflation kicks in (big IF… note that both consumer activity and producer price index came in well below expectations today), then one major class of beneficiaries are indebted homeowners. If banks have to pay high rates to get deposits, we have a replay of the S&L crisis, but if banks have access to low interest rates from the Fed, we have printed money going to homeowners with debt (with banks skimming off the top, which is part of the Fed plan to let banks “earn” their way out of the crisis). That is the reality, in plain english, and that is what I currently think is happening. Which, IMO, is better than the alternative of deflation (which, given the producer price read today, is still a risk – particularly internationally).

  47. its not the end of the economy… people will eat and sleep with or without a super economy… the question is will we, the host of a parasitic system continue to be openly decieved about our contributions ‘to a greater end’ and our actual value ‘what our return on investment is’… the banks are not investing in the american economy as a whole, and the neglect of our jobs and wealth is leading to despair and broken ballence sheets for the working class people… it is not the banks job to juice profits and pocket bonuses, cook the books until they can buy a new boat, insure junk to absolve risk and buy a new company to downsize/ship overseas… the banks liquidated america, america should liquidate the banks in kind… AND as for goldman saks they have had the stage shine for them for to long and are out of dirty tricks… we should make them an example that when you stand in front, YOU DO GET COUNTED

  48. middle world guy

    Certainly what we went through last fall, and are still going through now to some extent, was a severe deflationary cycle. The destruction of debt and the lack of new debt issues suffocated a lot of cash out of the system. I don’t think anybody seriously argues against the basic premise of injecting liquidity into the system under this scenario. We know it can be done without causing future inflation.

    The important thing is to distinguish between legitimate banking and the type of banking that got us into this mess. The liquidity has to support real banking and somehow punish those responsible for all the capital destruction. Somebody has to take a big hit. What we are doing is lifting all boats, and thereby paying for the capital destruction through inflation. I can’t buy into your argument that inflation will somehow help the periphery more than those with better access to power and wealth. For example if housing prices go up because of inflation, homeowners due indeed spend less of their real income on housing (assuming a fixed rate mortgage), however this is probably offset by the rise in other costs of good and services – like business that pay a higher rate of rent and simply pass on that cost to their customers. Inflation is essentially a regressive tax.

  49. statsguy – if I recall the history correctly, Hitler did not exactly honor Weimar debt. As for the US, although there were ups and downs, the depression wasn’t considered over until after a huge war in which the US was the only major economy left standing and after draconian controls in the economy that wouldn’t be tolerated in peace time.

    There are many examples of failed inflations you choose to ignore.

    You seem to imply that inflation is, if not the only way to reduce debt burdens, the best way to do so. I have not seen any support for this. Unreasonable debt burdens (including student loans) can be cancelled without taking indiscriminately from others.

    Similarly, the widespread unjust enrichment can be addressed with clawbacks, rather than indiscriminately taking from those even you would likely agree earned their cash honestly.

    As for the economic distortions you cite, they can more easily be explained by central bank manipulations than market failures.

    Perhaps your biggest omission is in ignoring the disastrous results we are witnessing from “successful” central bank efforts to inflate asset prices. Your solution to same is much more of it. Please.

  50. Previously we’ve had the discussion on inflation being a regressive tax (https://baselinescenario.com/2009/04/06/inflation-prospects-in-an-emerging-market-like-the-us/)

    The commonly accepted wisdom that inflation is always regressive does not hold in all times and places, although on average and across countries/times it tends to be true.

    Let’s begin with this: Inflation disproportionately helps those who owe fixed rate debt and who own non-cash assets. Deflation does the opposite (and generally causes mass bankruptcy too). For most middle class americans, their house is their most important asset, and they still owe a mortgage on it. Compared to historical norms, the Debt-To-GDP ratio is HUGE, and much of this debt is owed by consumers. Keep these datapoints in mind.

    Regarding the (relative) beneficiaries of inflation, it depends on who gets the money that is being printed (and printing can involve the issuance of below-market-rate loans), the ratios of debt/cash-based-assets/non-cash-based assets in different economic strata, and the expectedness of inflation (which can allow hedging). It may also depend on wage laws (does minimum wage keep up, or not) and other factors.

    For consumers with fixed rate debt who own houses, inflation is generally good (so long as rising interest rates don’t destroy house prices too much).

    For indebted (poor) consumers who have variable rate debt, we tend to think inflation is bad, but even worse is skyrocketing credit-card rates _during_ deflation. That’s what’s happening now, and it’s crushing consumers, and is being implemented by banks who are taking advantage of consumer inability to shift debt. (Previously, if banks raised credit card rates, a consumer could shift debt to a new card or take out a HELOC; now they are trapped, and the bank wants to build loan loss reserves through rate hikes/fees even though _they_ can borrow money at a subsidized 0.25% from the Fed courtesy of taxpayers.)

    If one believes that the PRIMARY PROBLEM now is not restoring “liquidity”, but doing something about the crushing debt that is destroying spending power (debt that was not spent on investment, and that was likely incurred to maintain consumption by offsetting declines in median real incomes over the last 30 years), then inflation seems a lot better than deflation. I continue to refer to Roubini’s lovely summary:

    http://www.rgemonitor.com/roubini-monitor/254419/20_reasons_why_the_us__consumer_is_capitulating_thus_triggering_the_worst_us_recession_in_decades

    One major question which is being overshadowed by the inflation vs. deflation debate is HOW the printed money gets spent – on cheap loans to banks to reflate the consumer-driven spending spree, or on real investments in infrastructure/energy/research, etc.

    I do not see the big companies in the private sector leading the charge to invest in the areas of the economy that most people want to invest in. Case in point:

    http://www.nytimes.com/2009/04/08/business/energy-environment/08greenoil.html?_r=1&pagewanted=all

    And the Obama Administrations 150 billion dollar investment over 10 years (15 billion a year) is certainly a vast improvement, but still pales next to to _annual_ oil company investments in drilling/discovery/field operations.

    Not when we will need _massive_ investments to maintain sustainable growth in 10-15 years. Obama’s energy/infrastructure plan just isn’t ambitious enough. If we had dedicated 900 billion (aka, TARP + AIG) to energy & infrastructure over 5 years, imagine what _that_ would have done.

  51. @Nonim

    All of your points about targeted efforts are well taken, but unfortunately targeted efforts are:

    1) Slow – painfully slow
    2) Very hard to politically implement due to countervailing forces (e.g. the institutions which own the student debt)
    3) Often impossible (you can’t clawback what someone has already spent)
    4) Very hard to agree upon and execute, often requiring significant administrative capacity from a deliberately gutted and handicapped bureaucracy

    Regarding the “disastrous” results of the central bank (in the last 6 months), they are strongly preferable to what would have happened if the Fed and other central banks had not intervened. Paulson – for all his cleptocratic abuses – was right that the system nearly imploded catastrophically. The crime was that in order to get the semblance of stability, we had to payoff the culprits.

    The IDEAL response (which I’ve oft-stated), is coordinated global quantitative easing (printing money), dedicating the resulting funds to a massive state-led investment in infrastructure/energy/environment, and a permanent reduction in capital/asset ratios (to prevent an inflationary rebound when velocity picks up and simultaneously stabilize the system going forward).

    No such luck….

    Other topics:

    Regarding Hitler…

    Remember, the Depression brought Hitler to power. Hitler did not create the Depression. Political instability and totalitarian regimes are directly linked to the failure of free-market democracies to confront massive economic downturns.

    Hitler not only repudiated Weimar debt (which had already been restructured after it proved impossible to pay), he also inflated to fund his war machine, implemented strict currency controls, harsh penalties on black market activity, reduced trade (punishing imports, and effectively exports through the overvalued Mark), repressed organized labor…

    A whole host of anti-free-market measures. Indeed, the _same sorts of things_ China is currently doing (successfully).

    Contrary to EVERYONE’s predictions that he would fail, he did not.

    The result was dramatic and rapid reduction in the 30% unemployment rate he inherited, which won him tremendous credibility and thoroughly undercut the credibility of his free-market gold-standard-loving opponents. And, of course, he used that credibility to wipe out millions of people and nearly destroy the world. Perhaps if the competing philosophy had accepted greater need to intervene in the currency to save the global economy, they could have won that credibility instead… alas, we shall never know.

    But your general argument appears to be that the currency controls and draconian policies caused the incredibly rapid German recovery… Or that they are a necessary consequence of inflation. I struggle with both of these, particularly if inflation is coordinated and/or conducted modestly by world reserve currencies.

    As to other cases where inflation failed, many of those cases can be linked to foreign denominated debt (Latin America) and/or corrupt regimes (Zimbabwe). It’s impossible to really know without better econometric models whether the inflation was a cause or an outcome. Nor did most of these cases occur during an era of global devaluation-risk.

    Having said all of this, currency controls should be unnecessary with proper coordination in international monetary policy. (Where does the money flee, except into non-currency assets which is exactly the goal in a debt-heavy economy.) Without international coordination, the US should still be able to employ unilateral QE due to its (remaining) status as a reserve currency, and because its debt is denominated in dollars. The US does not need an overvalued currency (like Nazi Germany sought), except to purchase specific items from abroad (e.g. oil, which is why a massive investment in energy is needed). Also, lower-valued currency facilitates exports, helping both us and dollarized export economies.

    Finally, if you want a less frightening example of inflation helping the poor, consider wage-led inflation in Europe in the 1950s through 70s… The debate still rages about whether or not it “worked”…

  52. I was referring more to the US than Nazi Germany. Other than the debt repudiation I am not sufficiently familiar with Hitler’s economic policies to assess, but I think it’s clear that all-out war causes such distortions that it’s hard to generalize. Also, as in the US in the 20s, bubble economies can last for years, and I wouldn’t be surprised if Hitler created his own bubble economy which was largely for war preparation.

    Are you prepared to argue that the many latin american inflations, for example, were successes? Were any of them?

    How about our own recent massive asset price inflation, driven by an accommodative Fed and a kleptocratic regulatory regime? How likely would we be facing the current crisis without that inflation? You may be familiar with a somewhat famous quote from Thomas Jefferson about inflation leading to deflation leading to widespread dispossession.

    What gives you confidence that the next wave of inflation, which you advocate, won’t lead to an even bigger hangover?

    How many times do we have to go through this highly dysfunctional and destructive cycle?

    I agree that it would be more effort to actively unwind the unmanageable debt load we collectively have, but I think it’s worth it as it would allow us to break the vicious cycle. If we accompany a resolution regime with strict limits on the ability of the Fed and banking system to create money-from-nothing, which inevitably cause bubbles that inevitably burst, we can end up with a sound economy based on solid, sustainable productivity.

    If, instead, we again resort to inflation, we’ll just continue a dysfunctional pattern. Enough is enough!

  53. adios amigos

    adam,
    No, it wasn’t the bank….it was the (c)seller who received the $100,000 “profit”. Not the bank, certainly not the buyer.
    AA

  54. adios amigos

    Matt,

    Have you ever tried to set a log on fire with one, small match? In no time, the match burns down, and the big log has not yet caught fire. “Bailot Nation” is a lot like that. I don’t believe the central governments efforts can even feasibly be large enough to get the log burning…..again. Small match – big log problems are pretty much impossible to overcome without the help of friends who own blow torches. Those friends are having their own problems right now, and they no longer trust you with fire anyway. I think it leaves you out in the cold…..and without a fire.
    AA

  55. I’d have to say “the bank”, if anyone. Hopefully they were smart enough to securitize this mortgage before it went into default, and made a few $ on that process. Clearly the buyers made a bit too as they had someplace to live until they were evicted – perhaps a few rent-free months…
    You want us to pick c. the seller, but I wonder what they did with there $100,000. Invest in mutual funds or a new house – probably not $100,000 any more…

  56. Would it be true to say that the key unresolved issue log-jamming the recovery is no realistic valuation of derivatives and acceptance of these valuations by all parties?

    Then let the market apply valuations next week! Not so hard my friends. I suggest the market value all offending derivative packages by quoting CDS coverage! All invalid nonsense such as possible later price improvements will be met by the most impartial, objective, unbiassed, non-crony assessors.

    Now if the people assigned responsibility to clear up this mess for us are similarly impartial, objective, unbiassed and not playing the crony card, we will know where we stand, the price of the fix and can nail this to the people holding the baby. Then the President tells derivatives holders to put the money on the table today!

    OK Mr.Geithner go to it. No more taxpayers money handed to the banker’s fraternity!

    If you bankers and R.O. merchants require assistance to understand this I will provide coaching and slow learner assistance.

  57. Deleveraging is a bitch. No easy answers. Lots of thoughtful discussions above, but all I see is pain.

    To paraphrase a recent Obama quote, the reason we’re giving money to banks is because they can use leverage to get the economy moving again. Yes he said this.

    Contrary to what Obama says, there are only two ways to get out of an excessive debt situation (debt that can never be paid off which is where the US is now). Deflation or inflation. My thinking is most governments don’t survive a massive inflation (aka hyper style inflation). Deflation will be long and painful with lots of armed hungry people out there. Both options are less than ideal for any government and neither will be pretty.

    With some $500 trillion in derivatives floating around the world, who holds these things. Where are they. Toxic assets on this scale should be called Weapons of Mass Financial Destruction (who said that).

    All I know is that things aren’t good, I don’t think the government has a realistic clue on how to deal with this mess. Helicopter Ben is on the loose, I hope it works out for my kids, but I certainly don’t understand how this can end well. So I think the government has chosen the shovel and hope method, as in shoveling money out of helicopters and hope things get better.