Questions raised by the Fed’s role in the crisis

The commentary on the crisis information recently released by the Fed has devolved into a dispute about the “correct” way to interpret the data.  But this dispute obfuscates the important questions raised by the Fed’s actions.  A good analogy for understanding what took place is to think of the Fed as the provider of shelter in a storm:

There was hurricane going on outside and the banks needed shelter.  The Fed provided the shelter.  But it turns out the shelter wasn’t just for one night and it wasn’t just for one bank.  The Fed provided shelter to all the banks for months on end.  Some banks were sheltered at the Fed for more than a year.

It is this long-term aspect of the Fed’s “emergency” lending that forces one to question whether this was emergency lending at all.  And raises the following questions:

Did the banks have a duty to construct their own shelters to weather the hurricane?
Or is the Fed their liege lord with a duty to protect them?  If the Fed has a duty to protect the banks in a hurricane, then what is the likelihood that the existence of that duty is the reason the hurricane lasted so long?  (These storms are clearly not acts of God, but entirely endogenous to the actions of the banks.)
By providing such extensive shelter, does the Fed discourage the banks from building their own storm-worthy shelters?

Did the banks pay a fair rate for the shelter?  Did they just do the dishes every night or did they pay a “normal times” market rent of say 5% of the market value of the shelter per annum or did they pay a rate closer to the value to them of the shelter?  Aren’t liege lords entitled to something like a third of their clients’ gross revenue annually in good times and in bad?

What about the decision the Fed makes about who gets shelter?  Does the Fed provide shelter to all the banks, or only to a select few banks?  Should consumers — or non-financial firms — have access to this shelter?  If not, why not?

Failure is the only sure path to a safer financial system

There is a truly egregious error — that reflects the modern anti-capitalist view of financial markets — in an otherwise informative article on the shadow banking system by Kelly Evans of the WSJ.  She writes:

There are two basic ways to make a financial system safer: insurance and regulation.

There is undoubtedly a third way to make the financial system safer:  regular failure of financial institutions.  This is the only proven way to make a financial system safe, since its the one that existed from the 13th century and was the foundation on which the modern financial system was built over more than half a millenium.

Minsky is regularly discussed, but his ideas don’t seem to have actually penetrated the discourse:  stability is destabilizing.  The most stable financial system it is possible to achieve is one with regular bank failures.  The analogy is to the management of forest fires which when allowed to occur regularly have the beneficial effect of clearing the undergrowth, revitalizing the forest, and reducing the likelihood of a truly destructive conflagration.

The problem in our financial system is not an insufficient supply of safe assets, but the concept that there is such a thing as a safe asset.  Keynes’ clear explanation of the ephemeral nature of liquidity debunked this view generations ago. (See Ch 12 of the General Theory, well discussed here).

Regular failures of financial institutions are the best way to ensure that the risks inherent in every financial asset are constantly being taken into account.  It is far more likely to be successful than insurance, which given the political muscle of the financial industry is guaranteed to be underpriced (see the experience of the FDIC, from 1996 to 2006 most banks paid nothing in FDIC premia) or regulation, as the regulators are unlikely to ever have a deep enough understanding of the current structure of the industry (which is always morphing in light of new regulations) to keep banks from making short-term profits while putting the losses to the taxpayer.

The only long-term solution to this problem is financial institution failure, regular, repeated and built into the very structure of the market.

Basel III and bank capital for the long-run

Craig Pirrong and David at Deus ex Macchiato are worried that the minimum capital requirements set by Basel III will face the same problems as those created by earlier versions of Basel:  As banks seek to minimize their capital positions they are all pushed by the regulations into the same trades, this leads to the growth of unregulated financial sectors and crowded trades.

The question I have for proponents of this view is:  Why would a bank seek to minimize its capital position, when the purpose of capital is to protect the firm against unpredicted — or even unpredictable — losses?  There’s a reason Jamie Dimon has been feted for his “fortress balance sheet” approach to the crisis that everyone — including Chuck Prince — could see coming.

Whenever minimum capital requirements are the determinants of bank behavior, that’s a good indicator of a deep structural problem with the financial system, because it means that you have a financial system populated by banks that are more concerned with maintaining profitability in the short-run than with ensuring that the bank is a viable entity in the long-run.  In short, when banks are maintaining only minimal levels of capital, you have pretty clear evidence that repeated bailouts have resulted in the complete perversion of financial system incentives.

Note:  8-22-10 toned down the language a little.

Assume a can-opener …

Chris Edley (via Mark Thoma) writes that Treasury should advance funds to the states:

Of course, when Treasury eventually collected what it was owed, the state would have to cut spending or find new revenue sources. But that would happen after the recession, when both tasks would likely prove easier economically and politically.

Arguments that are premised on the inevitable return of economic growth to rescue us from our folly sound remarkably similar to what was being said in the 20s and early 30s.  (Revisions of German reparation plans and the CreditAnstalt’s bailout of the Bodencreditanstalt bank were expected to work because of the coming economic recovery.)

Given the state of the world economy right now doesn’t it makes sense to work on a solution that can have a moderate degree of success even if we have economic stagnation for a decade or two.

Does anyone really believe that this is a liquidity crisis?

Xavier Gabaix argues that restrained business investment is a natural — and healthy and problematic — reaction to macroeconomic tail risk.  And Brad DeLong responds:

The macroeconomic tail risk that businesses today fear is not a Great Forgetting of technology and organisation or a Great Vacation on the part of the North Atlantic labour force … [These] are the only two “macroeconomic tail risk” shocks I can think of that would make it socially and collectively rational for businesses as a group to refuse to invest in new capacity right now

DeLong’s references make it clear that he persists in viewing our current problems as a liquidity, rather than an solvency crisis.  [Say explains that the Bank of England’s tight monetary policy in 1825 triggered a sharp recession by curtailing the supply of credit firms and causing them to hoard cash.  Mill explains that it was only after the Bank reversed its policy and loosened the money supply that the economy recovered.  And the Kindleberger reference makes the liquidity interpretation entirely clear because a “lender of last resort” only functions because it lends to solvent firms — a condition that Mill also emphasizes.  For more on the crisis of 1825 see here.]

In short, Prof DeLong appears to imagine that if we continue to treat the crisis of 2007 as a liquidity rather than a solvency crisis — eventually the solvency crisis will disappear.  The theoretic foundations of this view are hard to fathom — especially given that our financial institutions have been relying heavily on “liquidity support” for almost three full years — could there be any stronger evidence that we are facing a solvency crisis, not a “panic”?

[The timeline of the 1825 crisis is as follows:  March 1825 Bank of England starts to tighten, December 1825 full blown bank crisis with money center bank failures, met with aggressive lender of last resort action, by June 1826 lender of last resort activities have wound down and by December 1826 monetary measures and bankruptcies have normalized.  See Chart 11 here and Chart 1 here.]

In my view business investment is restrained not because of macroeconomic tail risk, but based on elementary macroeconomic analysis:  As long as policymakers are determined to prevent the bankruptcy of insolvent firms, necessary economic adjustments will be delayed and valuable assets will be entombed in firms without the balance sheet capacity to borrow the funds necessary to realize the value of those assets.  This policy will have the effect of preventing the economy from growing at its natural rate over the next decade and render investment a very dubious prospect indeed.

In short, what’s holding corporate investment back may be uncertainty over future policy and the nature of the institutional structure of the economy.  That is, firms may fear that bad economic policy in the form of using liquidity tools to support insolvent firms until they become solvent — in the next decade or two if ever — (similar to the Japanese “solution” of avoiding the restructuring of banks and firms) is going to cost the economy so much that it really doesn’t make sense to invest in a future without economic growth.

Update 7-7-10: Gabaix points out that it is possible that the future policy that firms are worried about may be a failure to bailout in the next crisis.  Is this the same point I am making or a different one?  Hmm.

And Krugman argues that there’s no need to interject “future government policies” into the discussion at all — a review of data suggests that investment is higher than one would predict in an environment where we simply don’t need that much new construction, etc.

I am happy to acknowledge that I have no way of determining the true source of concerns about the future economic performance, but I hope everyone can agree that too much government intervention, too little government intervention and misdirected government intervention are all on the list of  possibilities.  For which reason the decision-makers who are actually navigating these shoals have all my sympathy.

The government cannot be responsible for systemic credit risk

Brad DeLong‘s latest has me sputtering.  (He seems to have fallen for Caballero’s view that the government has to insure private markets against tail risk by insuring private assets — which I have addressed many times.  Note that DeLong already has a second post up on this topic.)

When there is excess demand for safe, liquid, high-quality financial assets, the rule for which economic policy to pursue – if, that is, you want to avoid a deeper depression – has been well-established since 1825. If the market wants more safe, high-quality, liquid financial assets, give the market what it wants.

The policy “well-established since 1825” to which deLong refers is the Bank of England’s practice of lending generously into a financial panic.  Unfortunately, the historical episodes to which deLong refers are not really comparable to our current situation.

(i) Bankers had personal liability for their debts in England — and because the par value of shares was rarely fully paid up by investors this was effectively true for joint stock banks too.  Thus, when England’s financial system was shaken to its core by the failure of Overend and Gurney (roughly comparable to Lehman Brothers), not one creditor lost a dime.  The panic that ended the bank had been triggered by the sale of the Gurneys’ personal assets to honor debts that they had guaranteed before selling shares.  Even so, shareholders were forced to put in additional funds to honor the firm’s remaining debts.  (Ackrill and Hannah, Barclays: the business of banking, p. 46.)

(ii)  The combination of personal liability and capital calls on shareowners was an effective preventative against “moral hazard” for most of the 19th century in England:  the banking system as a whole simply didn’t issue bad debt — though individual banks could make mistakes, or be mismanaged.  Thus 19th c crises were systemic liquidity crises, not systemic solvency crises.

(iii)  The strongest evidence that the 19th c crises were liquidity, not solvency, crises is that the central bank actions were almost always completed, such that markets had returned to normal, within three months.  The idea of providing extraordinary liquidity over a period of more than a year as the Federal Reserve has done — or worse the practice of allowing the long-term instability of the financial sector to drive interest rates to zero for years — would have been unthinkable.

(iv) In short, the 19th century environment where borrowers were held to extremely high standards is not comparable to our moral hazard ridden financial system.  For this reason, DeLong’s appeal to ancient truths is misguided.

However, the assertion that really set me off is the following:

Creditworthy governments around the world can create more safe, liquid, high-quality financial assets through a number of channels. They can spend more or tax less and borrow the difference. They can guarantee the debt of private-sector entities, thus transforming now-risky leaden assets back into golden ones. Their central banks can borrow and use the money to buy up some of the flood of risky assets in the market.

Which of these steps should the world’s creditworthy governments take in response to the asset-price movements of May? All of them, because we really are not sure which would be the most effective and efficient at the task of draining excess demand for high-quality assets.

I find it ironic that DeLong compares a government guarantee of private debt to alchemy, because those of us who are concerned about the government over-reaching in trying to support the value of intrinsically flawed private sector assets are concerned precisely because we suspect that it a project that is doomed to failure.  While it is certain that governments can spend their resources directly and indirectly reflating private sector asset bubbles, it is far from clear that anything good will come of doing so.

When Bagehot argued that the Bank of England should not be overly discriminating in the bills it purchased, he did so explicitly because he knew that the British financial system was sound and produced only a tiny fraction of bad assets.  Unfortunately the modern US financial system does not meet this standard.  What good can come of putting a government guarantee behind debt that is sure to default?  What reason is there to believe that delaying a default by a year or two or three or four is in the interests of either the debtor or the creditor?

The answer presumably is in the second post:

The hope is that, by Walras’s Law which tells us that excess demands across all markets must sum to zero, that relieving excess demand for AAA assets will produce as a consequence the relief of excess supply and full-employment balance in the markets for goods, services, and labor as well.

The problem with this answer is that it is purely aspirational.  Somehow the government purchase of bad debt is supposed to return the economy to the growth path that existed when the bad debt was being issued and nobody realized how unreasonable expectation of repayment really was.  That is, instead of recognizing that the boom times were just that and that the economy has no choice, one way or another, but to shift to a more sustainable growth path, the formula promoted by  DeLong and Caballero is for government to support asset prices until either (i) growth returns and my view is proven wrong or (ii) the government is no longer capable of supporting asset prices.  My real concern is that neither DeLong nor Caballero take the possibility of (ii) seriously — they are unwilling to consider the possibility that government does not in fact have the capacity to levitate the whole economy.  They don’t appear to have a plan b after we implement their recommendations, and it fails.  In fact, Caballero explicitly assumes the success of his proposal (my emphasis):

Instead, if the government only provides an explicit insurance against systemic events to the micro-AAA assets produced by the private sector, we could have a significant expansion in the supply of safe assets without the corresponding expansion of public debt. Of course there would a significant expansion of the notional liabilities of the government, but it is nearly certain that the ex-post cost would be much less than in any of the real alternatives.

To which I can only say that I agree with the anonymous blogger at Macroeconomic Resilience that Jon Stewart has demonstrated a remarkably accurate diagnosis of our current problems:

Why is it that whenever something happens to the people that should’ve seen it coming didn’t see coming, it’s blamed on one of these rare, once in a century, perfect storms that for some reason take place every f–king two weeks. I’m beginning to think these are not perfect storms. I’m beginning to think these are regular storms and we have a sh–ty boat.

When perfect storms (i.e. systemic crises) are taking place with ever increasing regularity, maybe it’s not a good idea to sign the government up for systemic risk insurance.

In short, I’d sputter much less if DeLong and Caballero would spend a significant amount of their time addressing the problem of bad debt and how to deal with it.  Remember that the US government has already spent almost two years underwriting mortgage refinances at extremely low rates that do exactly what DeLong and Caballero recommend.  The remaining mortgage borrowers are simply not good credit risks (look at the back end DTI here).

The evidence all points to the fact that what we have experienced is a systemic solvency crisis, that we are in a balance sheet recession and that the only way out is to rebuild private sector balance sheets.  There are two basic methods to do the latter:  (i) shock therapy, where bankruptcy wipes out debt and transfers assets to creditors and (ii) decades long stagnation, where private sector debt is rolled over repeatedly — allowing debtors to avoid bankruptcy, pay mostly interest and very slowly pay down their debt.  As long the debt is not wiped out by bankruptcy (or inflation), an economy in a balance sheet recession simply cannot flourish.  Pretending — or praying — that the economy will flourish despite the debt overhang, which seems to me to be DeLong and Caballero’s plan, amounts to extreme risk-taking of the first order and is not the domain of sound governance.

While I am extremely strongly opposed to the government getting into the business of underwriting private credit risk, I do believe there is an important role for fiscal policy in the current crisis.  Supporting the economy by protecting the jobs of municipal and state employees — especially teachers — and programs to help the unemployed, etc., seem to me to be just plain common sense, given the economic straits in which we find our economy today.  Keeping a cap on the federal deficit by allowing children to go uneducated or hungry has never, and will never, be good policy.

On the other hand, I’m a bit of an apostate when it comes to the role of monetary policy at the current juncture.  I think we will get out of the “liquidity trap” sooner if we give savers who want to put their money in safe assets a small return on their funds.  Instead of keeping interest rates at the zero lower bound, and pushing money managers into unreliable and unworthy risk assets, the Fed should raise rates to 1 or 1.5%.  Also we should not ignore the benefits of the bankruptcy process in allowing firms and individuals to get a fresh start while transferring assets to creditors who are not crushed by debt.

At the same time aggressive fiscal policy needs to be used to offset the more nefarious consequences of these policies.  But the overall task must be to help the economy find its new sustainable growth path.  Because zero rates are most definitely not part of this new path, they really only succeed in creating new distortions.  The Fed should give the economy a sustainable baseline from which to work and allow market forces to sort out the details, with relatively generous support via fiscal policy.

Will the rescue of Greece just be another bank bailout?

EBRD Head Warns Against Banks Absorbing Costs Of Greek Rescue

This is in response to German objections to a plan that would require the loans to be junior to existing bondholders (via ZeroHedge).

Query:  Has the IMF ever given a developing country a loan that was junior to existing bondholders?

As in the ’30s it looks like the bailouts will continue — until economic forces make them impossible (e.g. CreditAnstalt).

Who really thinks that postponing crises solves them?

Could Goldman have survived financial collapse?

John Gapper parses Goldman Sachs’ view of the government’s role in saving both the financial system and Goldman, and tries to understand how government intervention could be “indispensable” for the financial system, but not indispensable for Goldman.

I think the answer to this conundrum lies in the system of collateral posting for OTC derivatives (that was put in place with heavy lobbying from Goldman as well other TBTF financial institutions).   As Lehman made clear, what happens when a financial firm is about to fail is that all of its counterparties swoop in and take ever increasing amounts of collateral — leaving shareholders and unsecured creditors with almost nothing.  Thus, in the event of a financial collapse, there will be one or two firms left with almost all the assets of the financial system (that existed prior to collapse).  I think it’s probably a pretty safe bet that the last firms standing will in fact be solvent.

The way I read Goldman’s statements:  We had every intention of managing our collateral demands in the event of a financial collapse so that Goldman would be one of the last firms standing.

Socializing costs: the ICI money market plan

Bloomberg reports on the mutual fund industry’s proposal for socializing its costs:

Under the ICI plan, fees collected from money-market funds would be used to capitalize a state-chartered bank or trust. The facility would purchase holdings at face value from funds during a crisis. That could prevent a fund fielding heavy redemption requests from taking losses because it is forced to sell healthy holdings at a discount.

As a bank, it would also have access to the U.S. Federal Reserve’s discount lending window, according to the ICI, making taxpayers the ultimate backer of money-market funds’ liquidity.

Why on earth should the federal reserve allow money market funds indirect access to the discount window?  So the banks continue to face undercapitalized competition for their deposits?

If the money market fund managers think they need access to the discount window, then they need to turn themselves into banks — and maintain the same capital positions that banks are required to maintain at every point in time.  Hopefully Larry Fink’s opposition to this proposal (per Bloomberg) means the Fed won’t be pressured to take it seriously.

Banks repaying TARP is good

While I agree with commentators like Ed Harrison that the economy and the banks are far from recovery, I don’t understand the claim that banks should not have been allowed to repay TARP money.

Of course, the big banks would be better off with more capital — and some of them are sure to either fail or do more capital raising in the near future.  TARP did provide capital to the banks, but, as the CIT failure demonstrated, it did so in the worst way possible — as a direct transfer from taxpayers to the financial system with nothing close to a fair exchange of assets.

The fact is that reversing TARP is one of the best things the Obama administration has done — especially if there’s another outbreak of financial instability in the next few years.  Given the public’s anger about bailouts, any future government aid to banks is likely to be in the form of DIP lending — which is how TARP should have been structured in the first place.  I say good riddance to a profoundly flawed bailout program.