Submitted by Edward Harrison of the site Credit Writedowns.
Now that the results of the stress tests have been revealed, I would like to share a post with you that I wrote on Credit Writedowns about two weeks ago. In this post, my operating assumption was that the stress tests were a grand charade. Summers and Geithner had no intention of signalling to the marketplace that the U.S. banking system or even individual banks were sick. They were merely biding time for the companies to raise enough capital or to earn their way out of trouble. Time is our friend.
When I read Yves’ compelling post “Details on Banks’ Victory Over Treasury in Stress Tests Emerge” based on a Financial Times story this morning, it confirmed my view. Now, the essence of Yves’ post was a revelation that the Obama Administration has worked out deals with the large U.S. banks in which they will not be required to raise the amounts of capital needed under the recently released stress tests if the can earn their way into a better capital position.
This makes plain a key assumption under which I have long felt the U.S. government under both Bush and Obama has been operating. The fact that American banks could earn their way out of recession is a claim I have made several times (emphasis added).
Under Paulson’s Economic Patriot Act, taxpayers will be on the hook only if these assets the Treasury plans to buy are overvalued. They might even see a gain if they are undervalued. Paulson is clearly betting that the assets are undervalued.
But even if they are overvalued and more writedowns are likely, Paulson certainly believes he can prop up asset prices, at least temporarily. This buys banks time. Time is an valuable asset here because:
- it may give banks enough time to consolidate the industry
- it may allow banks to earn their way out of trouble due to the steepness of the yield curve
- it may give Congress enough time to come up with a new, better plan once the new President comes into office in 2009.
- Bailouts: catching a falling knife (Jan 2009)
Banks can earn their way into a greater capital base by making money on the spread between borrowing and lending. Marshall Auerback wrote a post demonstrating that the Fed is secretly trying to accomplish this (see Bank of America: Bailout hides huge bank subsidy deep in press release text).
First, I should note that Warren Buffett has said Wells Fargo has a pre-tax earnings power of $40 billion. That is enormous. While one should be suspicious whether Buffett is talking his own book, it points out the fact that any bank can ‘earn its way out of insolvency’ if given enough time. Nationalization is but one option. (John Hempton has noted that the Japanese banks actually did not have the benefit of time as their spread margin was so small due to the infamous zero-interest rate policy – you need a steep yield curve).
I should also note that John Hempton has two good articles out recently also arguing that American banks can indeed earn their way out of capital inadequacy because of the net debtor position in the U.S. The excess savings in the Japanese scenario is a principal reason why the banks there have remained under-capitalised zombie banks for so long. See his posts, they are good reads (Why American banks will not wind up looking like Japanese banks – Part 1 and Muddling through – why the American banking system will not turn Japanese – Part II).
I write all of this as a lead in to demonstrate that the stress tests were not tests in the normal sense at all. As Mark Thoma indicated, it was a test on a forced curve, rigged so that everyone would pass. We are simply biding time so that things can get better. Time is our friend. But, if all else fails, there is always Plan B (debt-for-equity swaps, nationalization and FDIC seizure).
Now, here is the post. It is fairly long, but I hope it gives you food for thought.
This is a thought experiment, so bear with me.
I have written repeatedly how I felt that the U.S. Government’s plans to save the banking system were not adequate in the face of a severe capital shortfall in banking.
On one level, I cannot understand the seemingly blinkered view now being taken in Washington by the Obama Administration. However, I do have immense respect for the intelligence and experience of the Obama economic team, which includes Tim Geithner, Christina Romer, and, critically, Larry Summers.
Summers is nominally the Director of the White House’s National Economic Council for President Barack Obama. But, I imagine he has much more influence given his experience in government and finance. Therefore, I have decided to take a different tack and write a post as if I were Larry Summers thinking out loud and laying out a plausible and logical framework which underpins the banking plans of the Obama Administration.
What follows is me channeling my inner Larry Summers. I hope to conclude with some closing thoughts after I step ‘out of character’ and review what my inner Summers has written.
Cue Larry.
In Character
Last year, we witnessed a breakdown in the fabric of the global financial system of a severity that few have anticipated. To be sure, there are those who had prognosticated a calamity of this type. Yet, the large majority of us in economics, finance and government simply did not imagine anything as severe as we have witnessed.
The question I asked myself before taking on my present role is this: Can I help the President restore full confidence in our banking system with a minimum of cost and a minimum of government intervention, cognizant of enormous political constraints. I believe I can. In order to do so, I have to lay out a mental map of what my key assumptions about the global financial system and deflationary environments are and what the key political and legal constraints are as well.
Assumptions
- The economy is self-equilibrating. That means I reject Hyman Minsky. It also means that market forces will naturally bring the (U.S. and maybe the global) economy into line over time. In the interim, some pretty terrible human suffering can take place, but the pain of recession/depression is temporary. Equilibrium will return.
- The natural course of the economy is up. Humans will continue to progress over time. We will use our intelligence to collectively become more productive, grow richer, and increase wealth. As a result, in most instances, time is our friend. We can grow our way out of economic difficulty.
- Government is necessary. The essence of government is to do for its citizens what they cannot do for themselves. In my view, one of those things is to ease (though not eliminate) the suffering associated with economic downturns. This means that it is necessary for government to intervene in periods of severe economic dislocation, not to right self-equilibrating markets, but to hasten the return to equilibrium.
- Government should be limited. By that I mean we must respect a healthy tension between the necessity of government and the limits of government. Government intervention, while often necessary, distorts market forces, and must, therefore, be limited. This certainly means that competitive, deregulated markets are preferable to over-regulation and anti-competitiveness. In finance, we probably got the regulatory mix wrong during the 1990s and that fostered an industry climate which contributed to excesses. This will change, but not in a way that will lead to over-regulation.
- Government stimulus is effective in a deflationary environment. It stops a potentially devastating deflationary spiral, eliminating worst case outcomes that result from dead-weight economic loss. Yes, this stimulus can pull demand forward or crowd out the private sector, both of which are bad. But, ultimately, the priority of government must be to end a deflationary spiral because of the attendant dead-weight loss it creates. (dead-weight loss being economic destruction that should not and would not take place in a non-deflationary environment).
- The U.S. banking system is fundamentally solvent and is suffering from liquidity problems. The last 25 years did see excess where the financial industry in the U.S. grew to outsized proportions. Asset prices rose too high. But, things have overshot. The U.S. is more productive and wealthier than at any time in the past. Our banking system should reflect this. However, liquidity constraints and asset price falls driven now by fear are making our system look weaker than it actually is.
Constraints
- The checks and balances of democracy necessarily lead to a sluggish response in crisis. So be it. That is democracy in action. If I had the power to dictate, I might be able to fashion a financial crisis plan which would work. However, the legislative and judicial branches are going to slow what could be an optimal response by effecting the system’s necessary checks. It is incumbent upon the President to respond to crisis in a manner both respectful and cognizant of these constraints but using all available resources available to him.
- The government cannot fund itself with deficit spending ad infinitum. Contrary to what Dick Cheney claimed, deficits do matter. Debt is a claim on future income and an increase in these claims erodes future growth at the expense of current consumption. To the degree that government finances current expenses with debt — and not tax and income — we should expect an erosion of future growth. This fact sets up a tension between the need for government to spend in crisis and the erosion of future growth this spending might create. When push comes to shove, I choose deficit spending in crisis.
Banking system
So given those assumptions and constraints, the question is how do we deal with this crisis. The first priority must be to forestall a deflationary spiral because that induces a dead-weight loss and extracts a cost of incalculable consequences. The best way for government to end the spiral is to temporarily increase spending or temporarily induce more private sector spending. Is this re-flating the bubble? No, because deflationary forces will continue to extract a price even with these measures in place. The key is to avoid a negative feedback loop, a spiral downward, and the easiest way for government to do this is to increase spending.
But, spending alone won’t get it done. Ultimately, we will need to increase credit availability. Just because people are spending more, does not mean the economy will grow. Growth depends critically on increasing credit in line with the growth of the economy.
I am not one for nationalization of banks or other coercive, non-market based mechanisms of getting lending flowing. The concept that nationalizing banks and re-privatizing them should be a first port of call for a government imperiled by a weak banking system is contrary to the need for limited government. What we need to do is put a number of government-assisted programs into play — cognizant of that healthy tension between limited government and necessary government — and get credit flowing this way.
Let me enumerate some mechanisms:
- First we should try bank re-capitalization. Our first priority must be to have an adequately-capitalized banking system. Absent that, increases in lending are impossible and the system will continue to be doubted. So that’s number one. We can do this through preferred equity so that the government is senior to common equity and receives some compensation for taxpayer money. What’s more is it limits government interference. Remember – most of these institutions are having temporary problems. With enough capital, they can weather the storm. There is no need for heavy-handed government interference.
- If re-capitalization proves inadequate because of depreciated legacy assets, we will need to remove those assets from banks’ balance sheets in a way that promotes price discovery, increases asset liquidity and respects the tension between government involvement and government’s limitations. The PPIP and TALF can help achieve this.
- Moreover, by allowing financial institutions to borrow with a government guarantee, we can ease the funding liquidity constraints as well.
Ultimately, the jump start from stimulus and quantitative easing will start to kick in while all of this is ongoing. The result will be a growing economy and healthier banks. Nevertheless, we should implement some stress tests on institutions to gauge how much capital each institution would need in a worst-case scenario. Those banks faring poorest will need to take remedial action as soon as possible. However, under no circumstances should we ever imply that any individual institution is insolvent. This creates doubt and during times of stress it is not the wisdom of crowds, but the panic of crowds that is on display. Doubts about one institution are likely to have knock-on effects for others creating a systemic problem. This must be avoided at all costs.
Obviously, if these plans do not work out because the economy declines more than expected, we can always fall back to the more coercive, interventionist mode of nationalization. However, that is Plan B only – measures to be taken only if necessary.
I am confident these plans will work. We are already seeing some faint signs of recovery. Mind you, unemployment will continue to rise at a devastating clip. But, by the second half of 2009, we should see some many more signs of recovery and with all of these plans in place, the liquidity crisis will recede into the past.
Stepping out of character
Whew. Now I can step out of Larry Summers mode and move back to Edward Harrison mode – I was starting to believe this stuff.
The truth is that I sympathize with the logic above. There is much to believe in the preceding paragraphs. In a best-case scenario, Summers would be right if this is the line he is taking.
But what about worst-case scenarios? Where I differ is the one line ” in most instances, time is our friend. We can grow our way out of economic difficulty.” The whole edifice depends critically upon that one statement. If this statement turns out to be false, the whole logical construct collapses. I prefer to go — as the Germans would say — “auf Nummer sicher (with the sure thing)” and not have my plan hinge critically on one potentially false assumption.
Time is NOT our friend. Time is our enemy.
- The economy will worsen considerably more. The stress tests indicate a worst-case scenario which is unrealistically optimistic. The necessary corollary of this statement is that the legacy assets which are already impaired will become more impaired. In a worst-case scenario, many institutions will be insolvent.
- Balance sheets will worsen because of commercial real estate loans, credit card loans and other real economy effects as well. This double whammy of deteriorating legacy assets and new asset impairments in a worst-case scenario will overwhelm the programs now in place.
- Political capital will be consumed over time. Americans will tire of this crisis. And, therefore, the natural checks and balances in the system will stymie further efforts. The legislative branch will re-asset itself in the government budget process and in the financial sector oversight process. The judicial branch will be called on to take issue with the turn of events. Obama is not going to get more stimulus. He is not going to get additional funds to re-capitalize banks. And he will not get a free hand in administering these programs already in place. Moreover, the Fed’s quasi-fiscal role will cause a backlash from Congress and risk its independence.
I have other objections but this post is getting much too long in the tooth. So I will leave it to you to make others.
What worries me is that behind Summers’ (and Geithner’s) calculus is a belief that the system is fundamentally sound and that we should not upset the cart. In my view, the last 25 years of U.S. growth have rested mostly on the creation of debt in complete disproportion to the economic growth the debt has engendered. This has meant we have consumed more in the last generation than we could possibly afford without cutting back our standard of living for at least the next generation.
Add in the belief that this is about asset prices overshooting to the downside and a banking system which is fundamentally sound and you have mental constraints which could prove catastrophically limiting.
I will have more to say about this in upcoming posts, but I do hope you enjoyed seeing the other side of the debate.
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Lawrence, care to respond?
Good post. I find it difficult to credit Summers and Geithner with organized thought, so it was good to hear them speak rationally. I agree that we’re stuck, and bad legacy assets are the least of our problems. Nor do I think lending is the issue. There is no point in lending unless borrowers have adequate security and positive cashflow to pay real interest (not nominal dollars that will be worth less a year from now). I don’t think it makes sense to bid up the shares of financial companies at this stage. We have plenty of banks, not enough creditworthy borrowers with order backlogs and pricing power.
Edward,
Not sure about “The economy is self-equilibrating. That means I reject Hyman Minsky.”
As an accomplished bubble-blower, bubble cheerleader, and bubble rentier, Summers may indeed believe this. But the capital injections and guarantees ($12.8T?) that have been needed to stabilize the economy prove Minsky’s thesis in “Stabilizing an Unstable Economy.”
Summers is a power-hungry greedy swine, but he’s probably not that stupid.
Harrison said:
“In my view, the last 25 years of U.S. growth have rested mostly on the creation of debt in complete disproportion to the economic growth the debt has engendered. This has meant we have consumed more in the last generation than we could possibly afford without cutting back our standard of living for at least the next generation.”
Doesn’t this statement prove the necessity for a ‘deflationary’ spiral at this time? And in such a case would it not have been more appropriate to have permitted the failure of the global financial system (a concept I dispute) and substituted government intervention on behalf of harmed individuals rather than the reverse?
Edward,
I may just have to switch over to your blog more often, as I like your take on this matter, which is a matter of valuation and accountability. Does time provide the means for banks to hide from accountability, from fraud, collusion and all their favorite activities?
As some may recall: Private wealth among families in the United States is continuing to decline after dropping by a staggering $15 trillion between June 2007 and December 2008…
There will come a time when banks, appraisers and homeowners all find a new dance to go through on the floor of some ballroom, and the music will change and commerce will move forward, just as time and progress have always done — but in this situation, there is no way in hell that these crooked banks can re-engineer $15+ Trillion anytime soon!
redst8r
your question or comment.
“Doesn’t this statement prove the necessity for a ‘deflationary’ spiral at this time?”
BINGO and this is where the next phase will surprise us all. It won’t end well.
Admirable attempt, but I don’t believe for a minute Summers thinks like this. His “channelled” thoughts would at best be public arguments to keep the pests of accountabilty and vague public outrage from getting too close, and he is way too arrogant to make that much of an outreach effort.
Yes, he knows short term he has to make bondholders and creditors whole or else the whole system will collapse, but his ultimate goal undoubtedly is to use this crisis to further blur the distinction between private and public interest by making government even more of a party in debt to private interests rather than a regulator, and to improve the global power base of private bankers by setting the stage for an IMF synthetic basket as the world reserve currency. It’s crisis capitalism, in other words, in full view, basically unapologetic.
And he’s right, because that’s what everyone seems to want.
I’m very, very happy about the outcome of the stress test – because I think Summers, Geithner, et al. might have just sealed their fate and actually sped up the day that we get a more definitive resolution to the banking crisis, such as nationalization.
As we all know by now, the outcome of the stress test is that the banks are all “fine.” They just need to raise a bit more capital, that’s all, and then earn their way out. But with CRE just starting to implode, mortgage defaults moving up to hit prime/jumbo/Alt A loans, unemployment continuing to increase, credit card bills not getting paid back, wage reductions for many still lucky enough to have jobs, uncertainty about how effective the PPIP will be given how TPG lost their entire stake on WaMu, and so on and so forth, I see a good possibility that in the not too distant future banks will need more capital injection from the government, but crucially, I don’t think Congress will give it to them anymore, not with simmering anger over Paulson’s TARP, the flap over bonuses, and then the results of the stress test. I think the general reaction here will be something like “the stress test showed the banks were supposed to be okay, so why in the hell are banks asking for more money AGAIN!?!?!?!”
Yes, I know the bankers fund a lot of politicians, but I’m betting these guys will be smart enough to realize lobbyist money doesn’t mean a damn thing if constituents vote you out of office. So I think the results of this stress test actually accelerate the ultimate endgame, which I think will be nationalization. Who knows if this will actually happen or not, but this is how I see it.
I think Tim Geithner is a tool who will soon enough receive a massive payoff. Summers is prob just a bit less of a tool due to envy of all the sterling academics in his family. Their embrace of the Big Lie re “legacy” assets is proof (more than evidence) that their loyalties are to Big Finance rather than to the taxpayer.
“Wrong way” Geithner and the more cerebral “Directionally challenged” Summers have made careers out of their screw ups: the Asian banking crisis, deregulation, missing the housing bubble, not seeing the potential for meltdown. It always amazes me that people who are wrong all the time can still be thought of as “experts”. Evidently that word does not mean what I think it means.
Of course, the slow unwind was always a possibility. Allowing banks to overvalue assets, undervalue debt, and overcharge customers certainly looks like a strategy for this to me.
“allow banks to earn their way out of trouble”
Still I take strong exception to this statement. As with “experts” words should mean something and not be just euphemisms. Banks aren’t just in trouble, they are insolvent, bankrupt. And no, they will not “earn” their way out of this situation. They will do it at the expense of taxpayers and their clients, i.e. taxpayers in their role of bank customers.
Additionally, the idea of earning conveys the idea that something of value is being added to the economy. But the “earning” that the banks are doing is the reverse of this. They are taking value out of the economy. They are soaking up resources that could be used much more productively elsewhere in the economy.
It would be much more accurate to say “allow banks to wheel and deal and steal their way out of trouble”. This conveys the true state of affairs.
Time is not “our” friend. Time is definitely “equilibrium’s” friend (if, that is, there really such a thing as equilibrium). Everyone continues to get caught up in “equilibrium” and “growth” and yadda yadda yadda. The economy will survive. It will gravitate to levels that at least seem like equilibrium for long stretches of time.
But the main question on everyone’s mind regarding any policy decision should be “Who are the winners and who are the losers?” Case in point, I’m all for these bailouts (stealth and otherwise) as long as we raise the maximum marginal tax rate up to, say, 60%. But if this bailout (or any other attempt at inflationary policy) continues to enrich the plutocrats at the expense of the vast majority of the world’s population, time is most definitely not “our” friend. (Even though I’m a “have,” I don’t especially want to live in a world like South Africa where there is a small class of “haves” besieged by a large class of “have-nots”; so I will gladly place myself in the “our” category when discussing whether or not time is our friend).
Larry Summers’ Assumptions: #1 & #5, are contradictory and mutually exclusive, leading to Larry’s assumed oxymoronic statement; The weak US economy is in a “self-equilibrating-death-spiral,” it just needs more time. This is why Summers and Geithner present Janus-faced positions, they don’t know what to believe except to save their benefactors, i.e., the banks. Summers and Geithner are on-the-take Wall Street shills which should preclude these paid-off toadies from being in government. President Obama, are you listening, you and the economy are running out of time.
Or to put it another way: Banks have overfished these waters. The government has helicopter-dropped supplies. Crisis averted.
Only you can’t fish like that no more. Maybe this is explains the government’s new-found zest for taxing overseas profits.
“Earn Your Way to Health” – a Parable
One day, American Express woke up and saw it was capital poor. “Oh, woe,” it said.
A little bird appeared in the window. “Cheer up,” it said. “Just borrow (quantitatively eased) money from the Fed for free, and then lend it to Mr. Jones for whatever the traffic will bear.”
American Express bucked up. “I’ll do it! In fact, I have an even better idea.” And so American Express offered Mr. Jones a teaser rate on a very generous credit line. Mr. Jones accepted. Then, when Mr. Jones was too deep in hock to make his payments, American Express offered to roll the loan over, at ten times the teaser rate.
American Express knew that Mr. Jones might lose his job. And then he might go to the bankruptcy court, and American Express might not earn a dime, let alone earn solvency. But he didn’t care. He knew that enough of the other Mr. Joneses would make their payments. And if they lost their jobs, or had their wages cut – or if their employers who also borrowed money didn’t earn that much, it still would be ok. President Obama would come around with another bagful of (virtual) money.
And so it happened. And then Mr. Obama went on the television and said, “If you, and you, and I give all our money to American Express and its banking peers, then surely they’ll earn their way to solvency. And if that doesn’t work, we’ll just repeat the process.”
Thanks for all the comments. Good discussion. I am looking forward to what Leo has to say about the W-shaped recovery tomorrow.
Some of your thoughts on this post and the previous GDP post I wrote made clear that some of you think the middle class has suffered here during the last generation of laissez-faire deregulation. I tend to agree and will re-post some thoughts I had on that score from March of last year along with some statistics highlighting the problem.
The crux of the Giethner-Summers problem are the CRE and credit card writedowns. If we can get over that hump, we may see a cyclical upturn (that’s my baseline scenario). But, the underlying fundamentals are weak, so a VL (i.e sharp upturn followed by an extended relapse) or a W (double-dip) is my read on the longer-term.
Not to build Leo’s post up, I am looking forward to what he has to say about the W-outlook.
Cheers.
Ed
ps. Doc Holiday, do stop by my site too.
“If there were holes in this, the market would have seen it,”
-S&P analyst, quoted in today's Times without the least bit of skepticism.
First we should try bank re-capitalization….. I’m not sure if that would be Summers’ first instinct or not. The Paulson decision to recap the banks to some extent bound the Obama administration. Admitting the banks are insolvent would result in massive losses. I’m sure Summers is a sharp guy and knows about the trap of “sunk costs” but politically declaring $100+ Billion is irretrievably lost (and we’re going to need to spend a lot more for DIP financing for dead banks) 30 days into his presidency might be a tough sell for no drama Obama.
Eric L. Prentis, you said #’s 1 and 5 are contradictory. I could easily see someone arguing that depression is so severe that people take to the streets and civil disorder becomes a real problem. It is only because of this that government must intervene to stop the deflationary spiral. If market forces were allowed to prevail, the whole thing would return to stasis.
Now, I don’t think the economy is self-equilibrating. Minsky is correct because the credit process in fractional reserve banking is inherently unstable. But, the argument that 1 and 5 are not in conflict could be made.
I would like to see Yves thinks inside the skin of Mrs. Clinton next time. :-)
Seriously though, Geithner and Summer see only the banks and concentrate on them. But almost every household who own a house in the US facing the de-leveraging problem in a smaller but no less dramatic, their assets value also devalue over time, without the ability to get free credit at 0.2% like the big banks and the number of those mini-household-banks are in ten of million. How do they regain equilibrium. I imagine every household in the US have a mini Summer talking inside their heads. 10 million Summers with these 6 points you've made, only substitute government central bank and treasury with their own bank&boss at work:
1. The economy is self-equilibrating. That means I reject Hyman Minsky. It also means that market forces will naturally bring my household and possibly other households’ balance sheet into line over time. In the interim, some pretty terrible human suffering can take place, but the pain of recession/depression is temporary.
2.
….
How likely is that 10 mln underwater households can survive when you see 500,000 more of them every month join the unemployment army ?
Get real. It’s denial of some men of more money and letters before their name, but the same drama.
Edward Harrison: Eric L. Prentis, you said #’s 1 and 5 are contradictory. I could easily see someone arguing that depression is so severe that people take to the streets and civil disorder becomes a real problem. It is only because of this that government must intervene to stop the deflationary spiral. If market forces were allowed to prevail, the whole thing would return to stasis.
——-
Edward’s logic is completely backward. Deflation and social spending to ameliorate it through DIP loans to allow businesses to restructure, and benefits for the unemployed, children, elderly, sick, etc won’t cause social unrest.
Summers and Geithner’s plans will cause massive social unrest. Forcing the public to absorbe the losses of banks and insurance companies losses through receiving low deposit account rates, paying high borrowing rates, paying high premiums, and receiving low annuity and insurance payouts will lead to massive anger.
Based on prior correllations between credit spreads and unemployment, the Geithner plan will lead to 20 or 22% unemployment. If unemployment gets to 15 or 20%, I expect we’ll see physical violence and computer attacks against financial execs, regulators, and politicians. And I think the violence will escalate until the bondholders and counterparties of banks and insurance companies are forced to take their losses.
Given enough time, the baby boom will have retired, and the proportion of people working versus those who are retired will be incredibly unfavorable.
“In my view, the last 25 years of U.S. growth have rested mostly on the creation of debt in complete disproportion to the economic growth the debt has engendered. This has meant we have consumed more in the last generation than we could possibly afford without cutting back our standard of living for at least the next generation.”
This problem can and indeed is being addressed by Summers and Bernanke through the systematic devaluation of the US dollar through inflation. The solution happens to fit neatly US objectives: print money to force inflation (to ight deflation and force consumers to spend and all asset prices to rise) And devaluation to improve US export competitiveness (to address political concerns on loss of jobs) and lower real debt burden on the future generation. Admittedly no government has ever succeeded beyond any significant period of time with engineering inflation out of excessive debt and loss of competitiveness, but then no nation has owed such astronomical sums (forcing their roeign creditors such as China to quietly go along or face catastrophic collapse of the gloabla economy should the US government take the step to officially default)in their own currency which is at the same time the global reserve currency. It is not acknowledged that this is indeed a workable solution by economists and US governments, but it is indeed fitting the actions of the last 2 US administrations over the last 10 years.
Re “the middle class has suffered here during the last generation of laissez-faire deregulation”
Bear and Lehman were pure i-banks, assassinated by Goldman, another pure i-bank, so I don’t find it persuasive that repeal of Glass-Steigall was causative.
Weill’s financial conglomerate model killed Citi, so one could argue that laissez faire produced some colossal speculations that were doomed to fail — but 8,400 banks remained pure banks and are prudently managed in most cases.
How anyone can view the GSEs as laissez faire is beyond me. Without agency securitization, I doubt that sub-prime and Alt-A would have existed.
Off-balance sheet SIVs killed Enron and threaten Zions (if I remember correctly), but so did individual rogue traders like Nick Leeson at Barings and Jerome Kerviel at SocGen. How regulation could have prevented sloppy and reckless management, I don’t know. Government is routinely sloppy and reckless. Hank Paulson on bended knee comes to mind.
I’m sorry to quibbble with folks I genuinely like and respect, but the market punishes bad behavior. What it can’t do is stop the Fed and FDIC from rewarding bad actors and Treasury enabling wholesale looting.
“How likely is that 10 mln underwater households can survive when you see 500,000 more of them every month join the unemployment army.”
Those households won’t survive with their standard of living intact, but they will survive. They will walk away and default — then they will learn to live within their means because they won’t be able to get loans or credit. Those of us who aren’t underwater already knew how to live within our means and we don’t feed the debt beast enough to let it get fat.
So Ed, I find this a very interesting and useful thought experiment, for which thanks. It may not be, to it’s last jot and tittle, Summers’ personal mindset in all particulars on the issues raised. It is, however, a thoroughgoing summary of the neoliberal economic Weltbilder (worldview), of which he is a major advocate. Many of these points are standard boilerplate amongst academically trained economists of the last generaton; many accordingly have been advanced fragmentarily by advocates in the media and in government in defense of the present bank stealout. I do not doubt that this is a fair summary of the conceptual backcloth in the Vulcan mindmeld the investment banks have on Prez O and his intimate minders.
Now, you have counterargued against some of these details in closing. I am going to speak briefly to some of the larger picture you painted inside The Head of Larry, and exactly because the numerous false premises in that world view are what drives the dysfunctional policy response coming from this Administration.
Head of Larry: “The economy is self-equilibrating . . . Equilibrium will return.” It is intellectually flatulant for anyone to argue this in the face of copious historical evidence to the contrary. If stated overbroadly, yes, this is true, but no more than a truism. Take some 250 years of ‘modern’ capitalism, and one has an incessant series of booms and busts. Growth does not self-equilibrate: that assertion is simply false. One might argue that over the last 60 years busts have been shallower. The first and obvious argument for why that might be so (though there are important counterarguments to this proposition which I’ll skip) is that improved regulation constrained the booms, and thereby mitigated the busts to a degree. . . . Of course Summers has been one of the half-dozen principle advocates of financial system _de-regulation_, making it logically nonsensical for him to simultaneously argue ‘We’re stable’ while saying ‘Let’s cut the brake line.’ Hmm.
Speaking more broadly, yes, those boom-and-bust oscillations have remain within absolute upper and lower bounds; in that sense, market-driven capitalist economies and their systemic interconnections have been, to this point, system stable. It took MASSIVE public interventions in the 1930s and the 1950s in Europe to hold the downside to that lower bound, evidence which speaks against any ‘systemic stability’ since it was extra-systemic actions which maintained growth even within quite broad parameters. (And lo, the Head of Larry argues below exactly for such extra-systemic intervention, as pointed out by other commentors.) To the extent to which there is any intrinsic economic systemic stability, it is a function of input parameters: so many people means so much absolute minimum demand; so many resources make for so much in extraction costs; etc., etc. What tends to be _destabilizing_ is the behavior of major actors mediating credit allocation at the core of the system; not the only destabilizing factor by any means, but a recurrent one we now experience again. This is a distinciton which HoL cannont get its head around, nor any other neoliberals, either; that the background organization of the economic system may have an inertial stability even while the headline interactions of financial system market makers are, on historical evidence, inherently _destabilizing_if left to the desires of their swollen, green hearts. Anyone arguing for self-equilibrium in economic structures has failed to engage with the facts, is a self-deluding liar, or was the first and became the second when busted by the reality police.
HoL: “The natural course of the economy is up. Humans will continue to progress over time.” There is no historical basis for that assertion, and in fact in every respect otherwise. Knowledge cumulates; humanity as a whole may experience improved relations and conditions; time-specific societies meet their nemesis, their frangibility stressor, or their past due date, one and all, and fade. Pick any political-economic relation anywhere, at any time you want, and follow it down the time line: yup. The falseness of the ‘ever upward’ mythos will demonstrate itself to you. On course, the whole neoliberal charade is predicated upon the corollary that modern capitalism is historically unique, and so follows different trajectories to ‘pre-modern squalor.’ The ‘End of History’ (just pay me up front), and all that. The Dutch, the Brits, the Turks, the Mexicans, and those in Kenya might disagree. For just a few examples.
One could write a book on this point, or read many, and personally I’m more positive about all this than those remarks imply. The point is, though, that this bedrock belief is simply a false myth as posed. We get better in part because we improve our institutional responses, proscribing harmful or dysfunctional behaviors while the school of experience winnows innovation. It’s the ‘institutional responses’ which neoliberals automatically discount while overcrediting those ‘innovations.’
HoL: “Government intervention, while often necessary, distorts market forces, and must, therefore, be limited. This certainly means that competitive, deregulated markets are preferable to over-regulation and anti-competitiveness.” This is another truism; it’s the details which count. When we find, reading the fine print over Summers’ career signature, that things like capital reserve requirements and prohibition of risk concentration are placed by him and his on the ‘over-regulation’ side of the ledger, his credibility and those of his ilk plunges to a negative number. No one who has been so completely wrong about this shoudl be in any way whatsover connected to the workout: this is a huge failing on the part of Barack Obama. (Oh, choosing Summers was an act of political calculation; as such, a brilliant act, Bo Prez is not dumb.)
HoL: “The U.S. banking system is fundamentally solvent and is suffering from liquidity problems . . . The U.S. is more productive and wealthier than at any time in the past. Our banking system should reflect this.” Here we get to the nut which many of us dispute with the claque running US Government economic policy as of Spring 09. Yes, it is probably even true that _the banking system AS A WHOLE is solvent_. However, the key credit intermediaries who have softwired themselves into the heart of the US financial system are, by any reasonable calculus, insolvent, and so much so that they are not coming back. (Even if the total losses from our present crisis as an aggregate number are likely to exceed the capital of the US banking system as a whole, those losses are concentrated against only some of the banks, and in particular against the largest: the system as a whole is in survivable shape.)
It is this constant conflation of the Rotten Few with the Sore but Standing Many which shows the real personal and political agenda beneath the actions of Summers, Paulson, Geithner and the rest. We can save ‘the banking system’ without saving Citi, MS, JPM, or the rest of the thieving oligarchs. It is the latter crew of financial pirates who got it wrong, and who are now holding the national economy hostage to their fortune. It is no easy thing to do in these zombies, but it is doable.
But this constant conflation of ‘the US banking system’ with ‘the claque of Manhattan’ tells us everything about the mindset of Summers and Co.: to them, the Zombies of the Red Masque are the only actors in said system which count. I don’t doubt that he and they really believe this, but it is false, and the distortion of it is what makes their interventions dysfunctional because conceived in delusion. They say ‘the nation’s banks must/must not be [x],’ but what they mean is ‘the Manhattan claque must/must not be [x].’ Those are very different propositions in fact, but the public is deliberately mislead, as much through delusion I think as through intent.
I have no intrinsic quarrel with the points raised regarding the probable utility of stimulus or the unsustainability of endless deficits.
HoL: “The key is to avoid a negative feedback loop, a spiral downward, and the easiest way for government to do this is to increase spending.” Again, the usage is inaccurate, though commonplace [this is not a knock on you Ed, government actors are using this phrasing]. What is meant is a positive feedback loop with negative slope. And I do agree that mitigating a deflationary spiral is and should be the primary concern of government economic policy at this point. No one is quite sure what works; more accuratly, no one is sure what works reliably. But the effort is worth making because the consequence of inaction is ‘more, deeper, and longer.’ Acting to restore ‘the System.07’ is riduculous and will fail. The financial system of 2007 was hugely bubbled, grossly over-leveraged, miserably regulated, and based upon unsustainable consumer debt. Back to the Future isn’t on. And the harder we try, the more money we will blow on fantasy, leaving less for efficacious and necessary interventions.
HoL: “Ultimately, we will need to increase credit availability. Just because people are spending more, does not mean the economy will grow. Growth depends critically on increasing credit in line with the growth of the economy.” Well that is exactly what is NOT HAPPENING, is it, Larry. Over at Baseline Scenario, James Kwak put up an important post in this regard, putatively on the stress tests. He pointed out the important fact that credit provision to the national economy as a whole _continued to decline in Q1 09_ for the seventh consequtive quarter. Nothing in government policy or intervention undertaken to date has begun to restore credit provision to the real economy. Because really the Bank Stealout was not, is not, and won’t be about ‘providing credit,’ but rather is about unjustifiably saving _specific failed institutions_, or trying like hell in the attempt. The whole exercise in faking major bank solvency for the nonce while they grow themselves rich again is predicated on their lending at a profit: that is not happening. The only area of credit provision increasing at all is in prime mortgage issuance, which as one of the sensible commentors to that particular post pointed out is likely largely refis of existing notes. That may help stave off further losses in that area at a minor level if so, but does nothing to resurrect the banking zombies dancing the Red Masque in their Citadel on Wall Street. In short, the HoL is spending all our time and effort and far more money than we have to spend to save a few massive institutions which deserve to fail or be failed on any reasonable standard while pretending that this effort is pursued to ‘restore credit to the country.’ It doesn’t matter whether they believe their own lies here, the actions are false in intent, one reason of many they are ill-done with little likelihood of success and every likelihood of political opposition.
HoL: “I am not one for nationalization of banks or other coercive, non-market based mechanisms of getting lending flowing. The concept that nationalizing banks and re-privatizing them should be a first port of call for a government imperiled by a weak banking system is contrary to the need for limited government. What we need to do is put a number of government-assisted programs into play — cognizant of that healthy tension between limited government and necessary government — and get credit flowing this way.” Here we have it in a few bites: the goal is to avoid government intervention because that is contrary to the values expressed above. All the rest is self-serving windowdressing. No one is arguing for ‘nationalizing all the banks,’ whereas seizing failed banks is standard practice in our putatively up-to-the-minute economy, no? Well, no: not if those banks are run by Friends of the Head of Larry. That is a no-no of the first water. But these Big Dead Uns are fouling the water of the national economy. They are not mediating credit, in part because they cannot given demand drops. The solution is to pull the corpses from the pool, not to pretend that they are not corpses. You can call that policy proposal what you want to: I call it basic common sense. Fairness is another good adjective. Necessity is the obvious label.
I agree with the contention that having the Government own and operate the major credit intermediaries in the country for an extend period is likely not a good idea. Though the Government could hardly do worse that the iBanks have over he last fifteen years, but agreed, let’s not go there: Just kill ’em, and let the rest of the herd thrive. That option doesn’t exist in Larry-space, because they are the world to him and his. But they are not _our_ world, they are just holding our world, our country, and our economy hostage to their failure.
“Growth depends critically on increasing credit in line with the growth of the economy.”
Growth DEPENDS on access to usable energy. And behind that curtain of financial crisis TEMPORARY energy demand destruction is the continuing and steadily decreasing production capacity of the liquid petroleum form of energy. There IS NO ‘recovery’ in our lifetimes. Only, as J. Kunstler so aptly named it, the ‘long emergency’. With the endlessly greedy and operationally ravingly insane elites continuing to hold the reins, that would be the ‘really REALLY long emergency’.
Worldwide economic growth is OVER.
The process of a decades long struggle over access to a now continuously shrinking petroleum energy pie has now begun.
Get out your calculator and a pencil. The world consumes 85 million barrels of oil a day.
One football field = 360′ x 160′ = 57,600 sq. ft.
1 cu. ft. = 7.5 gal.
i bbl oil = 42 gal.= 5.6 cu. ft.
57.600 divided by 5.6 = 10,286 bbl of oil to cover that field 1 ft. deep in oil.
85,000,000 divided by 10,286 = 8,264 ft. = 1 and a half MILES high, the height necessary of a football field sized tank to hold 1 days worth of worldwide oil use. The amount of oil taken from the earth DAILY. Makes that 85 million bbls a day REAL, doesn’t it?
Let that rattle around in your consciousness for a bit … and what it portends.
Economically and militarily Obama is choosing the EASY path, the wrong path, the path that keeps the elites in power and in control of this country. The path that leads to perdition.
Time has run out. Obama was the last chance to salvage a viable future for this country.
The future of this country as a viable democratic republic is rapidly coming to an end, Obama or no Obama,and it will not last another decade(by which time oil production will be ONE THIRD of what it is today).
“Growth depends critically on increasing credit in line with the growth of the economy.”
Growth DEPENDS on access to usable energy. And behind that curtain of financial crisis TEMPORARY energy demand destruction is the continuing and steadily decreasing production capacity of the liquid petroleum form of energy. There IS NO ‘recovery’ in our lifetimes. Only, as J. Kunstler so aptly named it, the ‘long emergency’. With the endlessly greedy and operationally ravingly insane elites continuing to hold the reins, that would be the ‘really REALLY long emergency’.
Worldwide economic growth is OVER.
The process of a decades long struggle over access to a now continuously shrinking petroleum energy pie has now begun.
Get out your calculator and a pencil. The world consumes 85 million barrels of oil a day.
One football field = 360′ x 160′ = 57,600 sq. ft.
1 cu. ft. = 7.5 gal.
i bbl oil = 42 gal.= 5.6 cu. ft.
57.600 divided by 5.6 = 10,286 bbl of oil to cover that field 1 ft. deep in oil.
85,000,000 divided by 10,286 = 8,264 ft. = 1 and a half MILES high, the height necessary of a football field sized tank to hold 1 days worth of worldwide oil use. The amount of oil taken from the earth DAILY. Makes that 85 million bbls a day REAL, doesn’t it?
Let that rattle around in your consciousness for a bit … and what it portends.
Economically and militarily Obama is choosing the EASY path, the wrong path, the path that keeps the elites in power and in control of this country. The path that leads to perdition.
Time has run out. Obama was the last chance to salvage a viable future for this country.
The future of this country as a viable democratic republic is rapidly coming to an end, Obama or no Obama,and it will not last another decade(by which time oil production will be ONE THIRD of what it is today).
The Treasury plan seems to rest on the fact that the banks earnings potential will outweigh the losses banks will incur so that they can build capital. Having read through Fannie Mae’s recent SEC Filing and it makes some gruesome reading. Quite simply if Fannie Mae’s loan portfolio was indicative of other banks residential loan portfolio’s then the stress test did not go any where near far enough. Alt A and Prime loan losses were the real surprise.
Companies are currently paying down debt, and this will ultimately shrink banks market which at some point will squeeze banks earnings. Still I expect the current inefficient subsidization of loans to continue. If anybody wants a bit of a laugh read the FHLB combined financial report and just how much of their assets are priced under fair value. Yes they took some write downs on Lehman Brothers, but not much else.
Apart from investment banks I think there is a good chance banks earnings will stall and that is the real reason why the stress tests are less than useful. The question is will the banks begin to take the foot of the peddle with pushing the market up (boxing the stock).
An excellent examination of our current situation and the core policy assumptions that could drive us (further) over the cliff.
I hope your future looks at the current US economic policy and its weaknesses broadens into areas beyond finance, most especially looking at the auto industry and real estate (both of which have financing components, but seem to be increasingly threatened by more basic economic forces, eg–lack of demand).
Please keep up the good work both here at NC and on your own blog.
A somewhat contrarian view to this would be that Obama and crew are much schrewder than appears in regards to the financial crisis.
In many public pronouncements (including the NY times magazine interview last week), Obama has hinted that he fully understands that finance cannot be the central driver of the American economy going forward.
Could the stress tests be the Obama administration’s 1) “gimme” to the banks to force them to play ball on other issues and 2) a way to wane the financial community’s obsession over whether Citi’s stock has gone up or down 20 cents in the last minute?
Let people talk about “green shoots” as much as they want- if your stock was at 55 bucks not too long ago, a financial “rally” from 2 to 4 dollars isn’t exactly something to write home about. Woo hoo, I recovered almost..well..none of my investment.
Contrary to some others, I see much room for renewed growth in the US- the infrastructure is a mess, energy needs a complete overhaul, there is much that needs to be fixed and tackled that has been left in the shadows of financial alchemy for too long.
It’s just not the sort of growth that will make banks/investment banks filthy rich and/or central to economic activity as has been the case over the past two decades. Anyone who thinks that IB/pure finance is going to lead the next stage of economic activity is deluding themselves- it will be a Return to the Tangible with banks on a tight lease, relegated to, oh, actually serving the physical economy.
The era of Financial Alchemy is over, and Obama seems to know it- but he also knows the ship can’t veer 180 degrees in 2 seconds.
So get people to stop obsessing about banks and finance, quietly set up the framework for investment to channel into tangible and needed areas (as opposed to casino derivatives), and if necessary do the dirty work behind closed doors.
Obama has given the banks some short-term leeway, but you can guarantee they are going to be forced to play ball on some key issues.
Maybe Obama is letting the banks/Wall street live in their own dream world because he is planning to marginalize their traditional self-perceived role as the centre of the universe.
Too optimistic? Perhaps. Too naive? Probably. But I’m usually too pessimistic so I thought I’d try on a different hat for a change.
Besides, think of how badly investors have been burned with all sorts of financial junk products: THIS will limit bank shenanigans more than any government regulation.
A pool of loans based on power generation projects with solid utility contracts over a 20-year period? Sounds interesting, let’s talk.
A smorsgabord of tranched loan pools that are full of bets on other loans hedged by derivatives that are themselves based on bets on loans that were loaned to cover a bet? Get the heck out of my office.