My view is that the crisis that we're in now is precisely the same crisis we've been in since at least the S&L crisis.

From Interfluidity:

"When did the crisis begin?

I like reading James Surowiecki, because he's smart, and because I tend to read exactly the same facts he reads and draw precisely the opposite conclusions.

In two recent Surowiecki posts (here and here), Surowiecki points out that during the banking crises of the early eighties and early nineties, banks were arguably as insolvent as our banks are today, but hey, with a little time and without any radical changes, everything turned out great.

The means by which banks recover their rude health, if you give them time, deserves a critical review. I mean to pen some nasty polemic about that, but for the impatient, Yves Smith tells much of the story (with all too little nastiness). See also here, and think about how much poorer people who run credit card balances have paid over the years on loans tied to the "prime rate".

The fundamental difference between my perspective and Surowiecki's is that I don't think those previous recoveries were real. My view is that the crisis that we're in now is precisely the same crisis we've been in since at least the S&L crisis. We've had a cancer, with some superficial remissions, but fundamentally, for the entire period from the 1980s to 2008, our financial system in general and our banks in particular have been broken. They have profited from allocating capital poorly, from funneling both domestic loans and an international deficit into poor investments (current consumption, luxury housing) rather than any objective that might justify arduous promises to repay. We all got a reprieve during the 1990s, because internet enthusiasm persuaded many investors to fund our consumption via equity investment, which we could wash away relatively painlessly in a stock market crash. Debt investors don't go so quietly. Thanks to the cleverness of our banking system, we have a very great many lenders, both domestic and foreign, who've invested in trash but who demand to be made whole at threat of social and political upheaval. That is the failure of our banks. That they are insolvent provides us with an occasion to hold them accountable, and to reshape them, without corroding the rule of law or respect for private property.

(Incidentally, I don't think that the problem is overconsumption or that austerity is the solution. I think we can afford to throw a perfectly good party, but it has been easier to put everything on the credit card than to come up with smart ways to pay for the economy we want in real time.)

Surowiecki seems to believe that if we could resolve the current crisis in pretty much the way we resolved the previous crises, that'd be okay. For me that's the second-worst-case scenario, after a major social collapse. Because I know that a superficially reformed financial system, both in terms of banking and international architecture, will continue to do great harm, permitting imbalances and injustices that will bring a serious collapse or a dangerous war if they are not addressed. We are fortunate, very fortunate, that things have pretty much held together so far, and for that people whom I usually criticize, Messrs Bernanke, Paulson, and Geithner, deserve some credit. But if they manage to "save the world" like that famous committee did during the LTCM crisis, with a lot of empty talk but no real changes once the crisis had passed, we will be here again, and we won't get lucky forever. This is a very serious business.

There are profound economic problems in the United States and elsewhere that our financial system has proved adept at papering over rather than solving. Those of us who've played Cassandra over the years have been regularly ridiculed as just not getting it, as economic illiterates and trade atavists. Unfortunately, as Dean Baker frequently points out, the people who could never see the problems are the only ones invited to the table when the world cries out for solutions. The solutions on that table are those Surowiecki tentatively endorses, weather the storm, take some time to repair, the temple is structurally sound. But the temple is not sound. We either build a decent financial system, or suffer real consequences, in unnecessary toil and lost treasure, in war and conflict over false promises set down in golden ink.

The banking mess and the high unemployment rate are not the crisis, they are symptoms. This is not "dynamo trouble", it is a progressive disease, and what is failing is the morphine. Those of us who believe that financial capitalism is a good idea, that it could be the solution, not the problem, do their cause no favors by resisting radical changes to a corrupt and dysfunctional facsimile of the thing. We need to approach financial capitalism as engineers, and to largely rearchitect a crumbling design. If we don't, we may be so unfortunate as to suffer yet another superficial remission. But error accumulates, and error on the scale now perpetrated by national and international financial institutions is unlikely to be without consequence."

Me:

"My view is that the crisis that we're in now is precisely the same crisis we've been in since at least the S&L crisis."

That's it. That's why looting is now being understood, finally, to be a cause. It's been a taxpayer funded joy ride for the financial sector. No wonder middle class wages are stuck.I keep referring back to Pizzo's "Inside Job". If you just read that and Fisher's "Debt-Deflation" essay, you'll have a better handle on how we got here and why it's so bad this time. It's working for me.

3.14.2009 12:18pm

Frankly, I think that's all the (non-negative) "franchise value" that's left in Citi, and several of its peers.

From Interfluidity:

"Our financial system is not the same as "our" big financial institutions

I've just listened to NPR's recent interview of Timothy Geithner. Adam Davidson did a great job of trying to get answers from Mr. Geithner. I felt sorry, at a personal level, for our Treasury Secretary, a very smart man imprisoned in a series of talking points, desperately afraid of the consequences of holding an honest conversation.

As an aside, we've come to take it for granted that policymakers ought to be circumspect for fear of provoking traumatic moves in the markets. But isn't that dumb? Markets are supposed to be about aggregating and revealing information. In what sense is it "more responsible" to hide information or ideas so that markets do not move on them? And if markets do misbehave so wildly that public officials can no longer afford to be candid because of market consequences, does that suggest an incompatibility between the kind of financial markets we have and open democracy?

Anyway. Taking for granted the constraints of the interview, what struck me most was Geithner's repeated conflation of our "financial system" and our "institutions". Mr. Geither's unspoken assumption is the fixing our financial system implies ensuring that incumbent troubled financial institutions are "strong". But that's not right. Our financial system is composed, in part, of financial institutions, but it is supposed to be larger and more robust than any specific firm. Three years ago, Mr. Geithner would have readily conceded that financial institutions are supposed to come and go, rise and fall, succeed and fail as a matter of market discipline, and that our system is made stronger by that flow of creation and destruction than it would be if some state-manged cadre of crucial banks were at its core. Of course, we all knew three years ago that some institutions had become "too big/complex/interlinked to fail", but we viewed that as unfortunate, and would have foreseen that if any of those banks got badly into trouble, the goverment would be forced to intervene and resolve the bank at some taxpayer cost, as it had in the case of earlier TBTF banks. Three years ago, no one would have suggested that the strength of our financial system and the strength of Citibank are inseparable.

We should not let this verbal slip go unchecked. The idea that certain large, politically connected private firms are essential to commonweal and must be supported at all costs by the state is quite the essence of "Mussolini-style Corporatism". Fixing our financial system is not the same as rescuing any one or several financial institutions. Household names can, do and should come and go in a capitalist economy, and it's pretty clear that quite a few familiar financials have failed the market test. What's good for Citibank is not what's good for America.

Did you catch this bit from Warren Buffett's letter?

Funders that have access to any sort of government guarantee – banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella – have money costs that are minimal. Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.

This unprecedented “spread” in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status. Government is determining the “haves” and “have-nots.” That is why companies are rushing to convert to bank holding companies, not a course feasible for Berkshire.

Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.

"Lemon socialism" has costs beyond the direct cost to taxpayers of socializing losses. It prevents assets from being shifted from inefficient to efficient firms, and penalizes healthy, well-managed companies by forcing them to compete against subsidized competitors. I don't see how preventing healthy good banks from harvesting the organs of our megabanks "strengthens our financial system".

I think it's time to move beyond the nationalization/preprivatization debate and start talking about how to replace rather than reorganize failing firms. That doesn't mean that we would shutter all of Citi's branches. It implies having troubled banks continue to operate in a kind of run-off mode (something like Arnold Kling's #2) while the government backstops some obligations and seeks buyers for the bank's assets, operating as well as financial. In other words, it's time to move beyond nationalization and talk about state-managed liquidation. I look forward to an America with a strong financial system. I think that's more likely in a world where Citi's logo goes all retro chic like Pan Am. Frankly, I think that's all the (non-negative) "franchise value" that's left in Citi, and several of its peers.

Steve Randy Waldman — Sunday March 1, 2009 at 5:12pm "

Me:

Don the libertarian Democrat (mail) (www):

That might be true for Citi or AIG, but here's Ken Lewis last week:


"KEN LEWIS:
02:58:00:00 Well, the-- the-- the downsize is that you-- downside is that you don't-- that you don't win. And so, you've got a company that may be bankrupt that you've got to take. Or that you get sued for a jillion (PH) dollars and-- and so that's-- they just thought the downside was so severe that-- and-- and the-- the hit to the system, in us not doing it-- and then-- and then the interrelationship between-- you know, what's good for America's also good for Bank of America. 'Cause we're so intertwined that it just made sense."

Are you saying that he's deluded?

This proposal ensures that US taxpayers, in aggregate, get what they pay for when they rescue a bank.

From Interfluidity:

"Bank insolvency: tips & tricks

So, your banking sector is basically insolvent, and your economy is teetering on the brink. No question, that's a rough situation. Never fear, Interfluidity is here. With the help of this uncredentialed blogger, you can turn your banking system around, save civilization as we know it, and still have time to do the laundry.

1. Never, ever feed the zombies!

   Zombie banks beg for money. They are very clever. They come up with ways you can give them money while pretending not to give them money, such as guaranteeing their assets, guaranteeing new debt issues, or buying up assets at "hold to maturity" values. Just say no! A healthy financial system cannot be run by zombies. "Rescuing" insolvent banks makes about as much sense as tying string to the arms of a loved one's corpse so it can come to the dinner table as a marionette. For a while that may be comforting (or not), but pretty soon it's sure to smell really bad, and it's gonna ooze. If you think you have engineered a miraculous turnaround, you have only made matters worse. An undead bank is an abomination. It will pretend good health but hide a rot. It will afflict you, over and over and over again, with harrowing near insolvencies (cf Citibank). Dead banks must be allowed to die.

2. Help private individuals save good banks.

   A bank is insolvent if no one will save it. Do what John Hempton recommends for a hypothetical, troubled GothamBank:

   The government could inject some capital into the bank as a temporary subordinated loan. A third party could then be appointed... to produce fair accounts for Gotham. Ten weeks should do it... The management of Gotham can go to the markets. If the management can raise [sufficient private capital to ensure the bank's viability] then the shareholders keep Gotham. Sure existing shareholders might get diluted — but at least they get to have a decent go at keeping their capital stake. If they can't or won't fund the bank in full knowledge of its position then it is nationalised.

   The government might go a step farther: It could provide loans at near-Treasury interest rates to creditworthy individuals willing to commit capital to ailing banks. Individuals who take the loans would agree to hold the bank's shares until the loan was fully paid.

   In effect, the government would help bail out tenuous banks. But it would require private citizens to certify banks' viability by putting their wealth on the line first. Investors would have to accept personal bankruptcy before taxpayers take a loss. (Of course, investors could skip the loan and put up cash if they prefer.) If investors fail to provide capital on these terms, then a bank is clearly not worth keeping alive. There can be no question that the bank is "illiquid but not insolvent", since the government has offered liquidity on generous terms to help get the deal done.

   (For the record, I view this procedure as too generous. As far as I'm concerned, banks that have extracted asset guarantees from taxpayers — yes, that means Citibank and Bank of America — have conceded their insolvency and been purchased by the state. If private capital swoops to the rescue now, the new owners will benefit from a substantial public transfer. Nevertheless, in deference to people's heebeegeebies about the government owning what it pays for, I'd put up with that if we had a fair procedure for evaluating and enforcing bank solvency going forward.)

3. Nationalize, reorganize, privatize spin-off to taxpayers.

   Insolvent banks become wards of the state. They are nationalized. The "N-word", as Paul Krugman put it may seem un-American, but any time a US bank fails, it is taken into some form of receivership by the FDIC. Often the operations of the dead bank are quickly merged with a healthy bank so we can pretend we live in a capitalist utopia. But that doesn't change the story. The old bank is nationalized, its good assets are sold to another bank (which pays by assuming dead-bank liabilities), and the FDIC takes control of what remains. When we talk about "nationalizing", say, Citibank, we are asking nothing more than that it should be treated like Suburban Federal Savings Bank, CenterState Bank, and MagnetBank were this very weekend. There is not actually any controversy over nationalizing banks. There is controversy over nationalizing large and politically influential banks, and there is controversy over having banks operate for more than a brief period under direct control of the state.

   Obviously, banks that had Robert Rubin on their boards are entitled to no gentler treatment than Suburban Federal enjoyed this weekend. The trouble with big banks is that they are too big to be merged into someone else, but are deemed too "systemically important" to be liquidated. That means if the FDIC takes such a bank into receivership, it would have to operate under state control. Americans are legitimately nervous about this. What we need is some means by which the government could commit to restoring banks to private ownership after they are reorganized and recapitalized.

   Henry Blodget suggests we

   refloat the banks immediately, so the government is not in the business of forcing banks to make stupid loans or determining what is and isn't appropriate for people to get paid.

   But refloating is hard. If the government were to rush-sell a generously capitalized bank with a one-shot whole-company IPO, taxpayers would end up with a raw deal. No private owner would sell a large firm this way, because it would be a very dumb thing to do. (IPOs typically only offer a fraction of a firms shares, and are known to fetch poor prices. The famous IPO "pop" goes to flippers, not to the firm or its original shareholders. There's a deep literature on the phenomenon of "IPO underpricing".)

   Here's an idea. The government should commit to fully reprivatizing nationalized banks (really their sliced-up and reorganized successors) within a year of taking a bank into receivership. But rather than selling the reorganized banks, the government should structure the divestitures as spin-offs. The government should distribute equal numbers of shares to every adult US citizen. Individuals could decide whether to hold the shares or sell them. The new banks would be publicly listed, so they'd quickly have frenetic market prices like every other firm. The government would spread the transfers out over several months. (People who need immediate cash will sell their shares as soon as they get them. If everyone gets shares at the same time, motivated sellers might flood the market and end up selling at a crappy price.) To promote efficient pricing of the new banks, prior to the spin-off the government would remove hard-to-value "toxic" assets into asset management companies, which would not be privatized, but managed conventionally to maximize taxpayer value.

   This proposal ensures that US taxpayers, in aggregate, get what they pay for when they rescue a bank. It puts banks into private hands while avoiding the corruption and theft of public wealth that invariably attends privatization. It would function as a mild "stimulus" — even though no public cash would be disbursed, the distributed shares would increase consumption. (Liquidity constrained individuals would sell their shares to savers, whose cash is then mobilized to buy stuff.) Having the government recapitalize banks and then give them away might seem rough on the budget, but it's far less costly to taxpayers broadly than offering windfalls to zombie bank shareholders and management by subterfuge, which is our current practice. If the exercise were made revenue neutral by raising taxes to recoup the recapitalization cost, the whole thing would amount to a flat transfer, which is good policy anyway.

---

Incidentally, the Winterbug post inspired an intense comment thread. The extraordinary JKH offered a view of public finance that has tax payments as purchases of government equity, and state benefits as equity buybacks. The analogy is interesting, quite because it is imperfect. "Compare and contrast" is a fruitful exercise. The spin-off idea owes something to this perspective.

Steve Randy Waldman — Sunday February 1, 2009 at 5:27am "

Me:

Don the libertarian Democrat (mail) (www):

"The government should distribute equal numbers of shares to every adult US citizen. Individuals could decide whether to hold the shares or sell them."

I know I shouldn't be such a pessimist, but I see rampant fraud come calling. There will be funny ads saying that the shares can only be sold to X, redeemed by Y. Also, you won't be happy with who ends up owning these shares. Do they then control the banks again?

I know that it shouldn't, but it also reminds me of schemes whereby reservations were split up into parcels or shares, only to end up leaving the tribe homeless.

You'd need a massive education campaign and lots of advisers to make sure that people weren't shafted. Hell, we can't even stop mortgage renegotiation fraud going on right now!

"We nationalize because, in a capitalist economy, investors get to keep the profits they endow, even when the investors happen to be taxpayers."

From Interfluidity:

"Nationalize like real capitalists

It will come to no surprise of readers of this blog that I favor nationalization of failed, systemically important banks. But James Surowiecki and Floyd Norris have a point. We absolutely should not nationalize as a means of persuading banks to issue credit more freely. If the government (idiotically) wants looser lending than banks are willing to provide, it oughtn't take their money and lend it. The government can lend its own damned money (well, our own damned money) if it thinks that profitable loans are not being made, or that for the good of the economy unprofitable loans must be made.( A GOOD POINT )

The reason to nationalize a bank is because the bank has failed and its former owners have no legitimate claim to its assets. The government has been forced to offer support with public money, thereby purchasing the corpse fair and square. We take the bank into public ownership because taxpayers who have been conscripted to accept extraordinary losses are entitled to whatever gains follow the reorganization they finance.( I AGREE )

When a bank is nationalized, shareholder equity should be written to zero, and existing management should be handled as roughly as the law allows. If we have a bit of courage, we should impose haircuts or debt-to-equity conversions on unsecured creditors( I AGREE ), but I don't think we have that kind of courage. "Toxic" assets should be revalued at pennies-on-the-dollar market bids or else written to zero and hived into "bad banks"( I AGREE ). Once we have a conservative valuation of the assets and know exactly what is owed, we'll know how much public money would be required to cobble a robustly funded bank from the wreckage. However, if we recapitalize "too big to fail" banks without restructuring them, we will quite deserve our next mugging( TRUE ). We had better cut these monsters into little, itty, bitty pieces. We should embed strict size and leverage limits into their itty, bitty charters, restrict their ability to recombine, and then hire management to run the little things on strictly commercial terms. Hopefully we will change what it means for a bank to run on commercial terms — We should create a tax and regulatory structure that penalizes scale and leverage across the board. Better yet we should decouple the payment system from risk investment by reorganizing banking functions into "narrow banks" and credibly not-guaranteed investment vehicles. But whatever the banking industry comes to look like, nationalized banks should be recapitalized once, then managed to compete in it, and for no other purpose. Taxpayers should seek to extract maximum value from their eventual privatization. But should any of the reorganized banks seek a second helping of at the public trough, they should be ostentatiously permitted to fail. Rather than an implicit government guarantee, successors of nationalized banks should face a particularly itchy trigger finger( THIS IS ESSENTIAL ).

Having nationalized "banks" make loans that prudent managers of a well-capitalized bank would not make is just a way of obscuring a subsidy and ensuring permanent quasipublic status by requiring on-going guarantees, bail-outs, and capital injections. Further, putting easy-lending public banks in competition with ordinary thrifts would resuscitate the destructive dynamic we have just put behind us, wherein bank managers must match the idiocy of their most foolish counterparts or watch their businesses wither.

If we want to stimulate the economy, put idle resources to work, stoke animal spirits, whatever, we should do that with some combination of transfers, investment subsidies, inflation, and public works( I AGREE ). But if we are dumb enough to force-feed credit into the economy, let's not hide that behind a bunch of puppet banks( I AGREE ). And let's keep it very clear that we are not confiscating private firms in order to make them tools of the state. We nationalize reluctantly, when we have had no choice but to inject public money (or guarantee assets, which amounts to the same thing( TRUE )) in banks that otherwise would have failed( THAT'S IT ). We nationalize because, in a capitalist economy, investors get to keep the profits they endow, even when the investors happen to be taxpayers.( A GOOD POINT )

---

Some nationalization links

• Buiter — Time to take the banks into full public ownership
• Clusterstock — More Cries For "The Swedish Model" To Fix Banks, Why Are We So Afraid To Fix Banks The Right Way?
• Cowen — Why bank nationalization is a last resort, Is the Sweden plan so much better?
• Dillow — Arguing about bank nationalization
• Drum — Kevin Drum Smackdown Watch, Nationalization Revisited, Nationalization
• Fama — Government Equity Capital for Financial Firms
• Fox — Why hasn't the government nationalized Citigroup? Hank Paulson's sort of answer, The case for nationalizing Citigroup and Bank of America, and getting Robert Reich a fact checker
• Free Exchange — Why not nationalise?
• Hempton — Nationalisation after due process
• Jones — Nationalisation linkfest
• Kedrosky — Bank nationalization: Why Are We Pretending?
• Krugman — Wall Street Voodoo
• Gaius Marius — nationalization now!
• McArdle — Why not nationalize, like Sweden?
• Quiggin — What to do with nationalised banks?
• Salmon — The Urgent Financial Crisis Facing Obama, Insolvent Banks: Why a Debt-for-Equity Swap Won't Work, Felix Salmon Smackdown Watch, More on Bank Nationalization, Why Nationalization is the Best Alternative, Why We Should Nationalize Now, Nationalize Citigroup and Bank of America
• Surowiecki — Nationalization will not be easy, Where would bank nationalization stop?
• Yglesias — The grain

Update History:

• 20-Jan-2009, 7:00 p.m. EST: Eliminated an artless overuse of "guaranteeing" by changing to "ensureing"."

Since I agree, there's not much point in commenting any further.

"We won't let people starve, so why not fund a basic income, however miserly"

Interfluidity on some kind of fevered roll of insight:

"Expand transfers, not credit

I have a little secret. Please don't tell anyone. I am glad that the banks, for all the hundreds of billions of dollars we are giving them, are not lending. That is not because I want banks to improve the quality of their balance sheets. On the contrary, I don't want banks at all, at least not banks anything like what we've had( AGREED ). I don't want to "use all of our resources to preserve the strength of our banking institutions". Since we have already bought and paid for our nation's banking institutions, we are within our rights to, um, transition them to a different business model. Let's do that.( LIKE WHAT? )

But credit is the lifeblood of a capitalist economy, right? I keep hearing that line. It's a dumb line.

Credit, also known as debt, is one of several arrangements by which a party with the power to command resources but lacking aptitude or interest in managing a productive enterprise delegates wealth to another party who is capable of creating value but unable to command sufficient resources. You would be forgiven for not noticing, given how habitually we misuse credit, but supplying credit is really just a subspecies of the practice that used to be called "investing". There are a variety of other arrangements that serve the same economic function. Perhaps you have heard the terms like "common stock" and "cumulative preferred equity"? In fact, credit is to investing what heroin is to painkillers: Unusually appealing, in a certain way. Hard to kick once you're on it. Almost certain to, um, cause problems, eventually. Our overall goal ought not be to kickstart the credit economy, but to kick the habit and move towards financing arrangements that are more equity-like than debt-like. That's going to be hard to do, because historically, we've subsidized the hell out of debt financing, especially bank credit, and alternatives are underdeveloped. But with the exception of war, no still-practiced human institution provokes catastrophe as regularly or as grandly as the misuse( HERE'S THE KEY TERM ) of debt. We ought to phase out banks as we've known them since before Bagehot's time, and move to a regime of what are lately referred to as "narrow banks" (banks that lend only to the government that issues the currency of their deposits). We should encourage the development fine-grained equity markets and local-market investment funds to replace bank financing.

The rush to ramp up "consumer credit" is particularly dumb. Usually, financial investing involves funding wealth generating projects in exchange for a share of the anticipated wealth. Consumer credit funds current consumption in exchange for a share of, um, what exactly( SOCIAL STABILITY )?

In theory, there's a good answer: consumer credit funds current consumption in exchange for a share of anticipated future wealth that is believed to be endowed already. Economists talk about consumption smoothing, how it may be optimal for a consumer whose income is volatile to borrow during periods of low income and repay (or save) during periods of high income in order to maintain a constant standard of living. That's very well in models where consumers know the true distribution of their future income, where the spread between borrowing and lending interest rates is not very large, and where consumer preferences are time-consistent. In practice, none of these conditions hold even approximately. As we are learning, the future is a very uncertain place. Consumers, like Wall Street quants, may inadequately extrapolate the distribution of their future income from recent observations. They have no access to the true distribution. The interest rates consumers pay for unsecured credit (think credit card rates) are often several times what they receive on money they save. In the world as it is, consumers ought to borrow only to counter severe downward shocks to income, pay off borrowings quickly, and build buffers of precautionary savings, since the cost of dissaving is much less then the cost of borrowing. (You lose 4% interest on your CD, rather than paying 12% interest on your credit card.)( I CAN'T ARGUE WITH THIS. IT'S MY PERSONAL PHILOSOPHY. )

Some consumers behave this way, but very many do not, suggesting that consumers are myopic, overvaluing consumption today in a manner that they themselves will come to regret in the future. If consumers are myopic, if self-today has different preferences than self-tomorrow, then whether taking on credit is a good idea is beyond the comfort zone of positive economics. Credit availability creates winners (self-today) and losers (self-tomorrow), while interest payments reduce the size of the overall pie available to the time series of selves. In the way that economists suggest "free trade" to be good — winners, losers, gains overall — myopic consumers imply that the absense of a credit constraint is bad. Thank goodness the banks aren't lending!( TO WHOM? )

There are obvious wrinkles and objections — What about credit for cars, or home mortgages, or education? The analysis changes when the borrowing is exchanging one pre-existing long-term liability for another. (We are born short basic shelter, and, in much of America at least, short a cheap car as well.) Education can be viewed as an ordinary, wealth generating investment project that in theory could be equity rather than debt financed, but that might be too tricky in practice. It's not my intention to suggest that consumer credit is always bad( GOOD ), only to defend the commonplace notion that for many people and under many circumstances, even loans that will be never be defaulted can be positively harmful, and as a matter of policy we should not be exhorting( OF COURSE NOT ) banks to issue or consumers to accept credit.

But if we let consumer credit contract, and if investment demand is derived from consumption demand, doesn't that spell macroeconomic disaster? There is an alternative. It is called "transfers". What's good about credit from a simple Keynesian perspective isn't that loans get repaid tomorrow, but that they get spent today. If what consumers would do with funds would be better for the economy than what banks are doing with funds, we ought to stop the massive transfers of funds from buyers of government debt to banks, and transfer the funds directly to consumers. If you think that Americans consume too much, and that we need to grit our teeth and endure a "reduction in our standard of living", fine. I disagree, strongly, but at least you're consistent. Then the government shouldn't transfer to anyone, banks shouldn't be encouraged to lend, consumption, investment, and GDP should be allowed to fall until we find a new level. I think that's foolishly pessimistic, though. Americans may need to change the mix of our consumption, but overall I think our standard of living is not only supportable, but improvable, and that our goal should be to get the rest of the world to live as well as we do, rather than to reconcile ourselves with some pseudomoral poverty. The world is full of human want, which we should strive to meet by working to increase our capacity to produce. Problems arise when want and purchasing power are misaligned. We can improve that by redistributing some of the purchasing power from those with lesser to those with greater use for current consumption. If that sounds Commie to you, note that is precisely the function that consumer credit traditionally serves, just without all the residual claims, a large fraction of which will prove to be illusory (at least in real terms). That is, transfers are just a more honest way of doing precisely what a credit expansion does, except without the trauma that comes from learning that much of the money lent to fund current consumption will never be repaid.

I'm trying to come up with a reasonable opposing view, a case for pushing consumer credit but opposing transfers. Perhaps you can help, because I just can't do it. One might argue on philosophical grounds against coercive transfers, but coercive transfers are a precondition of restarting bank lending, and we've already made transfers to banks on such a scale that banning them now would be like robbing a jewelry store, then piously arguing future looters should be shot. One might argue that bank lending is "smarter" than public transfers would be, that the patterns of consumption and investment that result from private sector credit allocation will lead to superior productive capacity and more sustainable patterns of consumption than direct transfers. Given the awful quality of aggregate investment this decade and the volatility now faced by consumers who were recently credit flush but who under any reasonable lending standard must now be credit constrained, it is hard to be enthusiastic about the special wisdom of bank-mediated credit allocation.

Of course, once we start redistributing purchasing power, there's the thorny question of who gets what. I have an answer to that, it is my new mantra. Transfer flat. Cut checks to every adult in the economy of interest, regardless of whether they pay taxes or have a job. Flat transfers are easy to understand and they pass the smell test for "fair"( I POSTED ON SUCH A PROPOSAL EARLIER ). As an income source unrelated to work, flat transfers increase workers' bargaining power with employers by reducing the cost of refusing a raw deal. (Supplementary income is a better means of enhancing labor bargaining power than unionization, which serves the same purpose but may limit the flexibility and efficiency of production.) Finally, flat transfers align purchasing power in the economy with the problem that we want markets to solve — We want an economy that serves some people dramatically more than others, in order to preserve incentives to produce and excel. But we also want an economy that meets every person's basic needs, even those of people who are unable or unwilling to offer marketable goods or services. We won't let people starve, so why not fund a basic income( THAT'S MY VIEW ), however miserly, rather than relying on an inefficient social services bureaucracy or taxing the virtuous by relying on charity?( I PROPOSE A GUARANTEED INCOME )

Tax Pigou and progressive. Transfer flat. Encourage equity. Contain the banks.

Steve Randy Waldman — Saturday January 17, 2009 at 10:28pm "

I can't say I disagree. As you know, a guaranteed income with health care is my ultimate goal.

"Export subsidies do not diminish international commerce, they, um, subsidize it. "

From Interfluidity:

"Compete to give, give to compete

'Tis better to give than to receive.

A nice sentiment, surely. But is it good economics? My takeaway from China's experience is that it is, or it can be. There are lots of ways to spin China's policy of limiting the appreciation of its currency in order to promote export-led capital formation and growth. One story is simply that the policy amounted to a export subsidy: Purchasing power was withdrawn from Chinese workers and transferred to dollar and euro spending foreign consumers.

It's unmistakable that the policy "worked", in some sense. China's growth, along with the scale and pace of change in that country, have been remarkable.( TRUE )

I've mulled over the question of subsidy before. Simple economic reasoning suggests that subsidies harm the subsidizers and help the subsidizees. Yet nations often do subsidize their exports, overtly and covertly. Instead of welcoming cheap goods with open arms, the recipients of the subsidized merchandise usually complain, and sometimes slap on "anti-dumping" tariffs to keep cheap goods from being too cheap. Economists often tsk-tsk at all this, blaming both the subsidies and the tariffs on rent-seeking politically connected manufacturers. It's all "protectionism", they say.

A fair review of the history of "protectionism" would be much more mixed than the economic mainstream would like us to believe, with their stories of comparative advantage and expanding production possibility frontiers. (Thankfully, economists like Dani Rodrik and Paul Krugman weave more nuanced tales, but still "protectionism" rates somewhere just below coprophagia on the economic profession's list of distasteful things.) In some times and places, trade barriers have served to isolate and impoverish people. In other times and places, tariffs have protected infant industries that grew into powerhouses in countries (like the United States) that otherwise might have remained agricultural backwaters( IN THOSE DAYS, TAXES WERE MUCH LOWER OVERALL. ). That said, I think we should avoid tariffs, not in deference to economic pseudoscience, but because they are stultifying. Intercourse across borders is a per se good. A mixed-up, intermingling world is better than one made up of insulated national tribes( THAT'S FOR SURE ). We should avoid tariffs not because of their adverse economic consequences, but despite their potential economic benefits.( THEY DO HAVE ADVERSE ECONOMIC CONSEQUENCES. AGAIN, HISTORICAL COMPARISONS ARE OF VERY LITTLE USE. WE USE THEM FOR THEIR NARRATIVE EFFECTS, WHICH HELP US TELL OURSELVES STORIES ABOUT HOW THINGS GOT BETTER IN THE PAST, AND WILL DO SO HERE AS WELL. THIS IS, IN FACT, AN IMPORTANT PART OF THE RECOVERY PROCESS, WHICH DEALS LARGELY WITH HUMAN SENTIMENTS. )

But subsidy is a different story. Export subsidies do not diminish international commerce, they, um, subsidize it. From a libertarian perspective, there is a strong case against tariffs. Trade restrictions prevent free people across borders from interacting as they wish. But subsidies restrict no one. Sure, libertarians might complain of the wealth expropriated to fund the subsidy, but that critique applies to nearly all functions of modern government. Until we abolish public schools and the NIH, there's no reason we shouldn't have export subsidies.( IT WOULD DEPEND UPON HOW USEFUL THEY WERE. )

The more serious case against subsidies is that they are "distortionary". But for even the most ham-handed sort of subsidies, where governments favor particular firms or industries, it is not at all clear that this is so. Investment is not a "distortion", even though it involves accepting an up-front cost. When local governments offer tax abatements, free infrastructure, and other perqs to attract economic activity, there's a clear payoff from taxpayers to particular private parties. Yet sometimes( THIS IS TRUE ) these inducements do pay for themselves, in financial terms as growth increases the long-term tax base by more than the upfront costs, and in nonfinancial terms as residents reap direct and indirect benefits from prosperity of place. Sure, governments make poor investments sometimes, whether corruptly or out of innocent miscalculation. Firm managers also make bad investments( TRUE ), and sometimes their motivations in doing so are not aligned with the welfare of shareholders. Sometimes firms are large, and capable of investing on a scale that deters potentially superior upstarts from entering a market. But we don't prohibit corporate investment as "distortionary". In both the public and private sector, restricting investment implies preventing potentially welfare-enhancing projects from taking root. Subsidies, when they are not a form of corruption, are a form of investment( TRUE ). We should be very careful in designing public subsidies to private parties, since the potential for crooked dealing is obvious. But forbidding subsidy outright is prima facie welfare destructive. Preventing governments from internalizing the external benefits their communities would receive from economic development would itself be "distortionary". (I dislike the language of optimality and distortion favored by economists. But when in Rome...)

The example of the United States is often held up as a model of a free-trade zone, as a reducto ad absurdiam. If protectionism is such a good idea, asks some supercilious hypothetical interlocutor, why shouldn't we have tariffs between Tennessee and Alabama? Of course we don't, and shouldn't. But Tennessee and Alabama can and do compete in bidding wars with firms deciding where they ought to put their factories. The "free trade" that has worked so well among the 50 United States is actually a trade regime involving ubiquitous and competitive subsidies. Maybe that's not a flaw, but a feature.( TRUE )

At this moment, there's a fear that "Smoot-Hawley", "beggar-thy-neighbor" protectionism will take hold, condemning us to a depression more harmful than the one we already face. If insufficient aggregate demand is the problem, then competitive tariffs are a negative sum game: They not only confine demand within borders, but they eliminate demand that would otherwise exist for goods and services that could be provided internationally. So, the fear of tariffs is not misplaced.( GOOD )

But competitive export subsidies are a different thing entirely. If the people from whom funds are borrowed or taxed would otherwise have saved, then export subsidies can increase effective aggregate demand. A trade war in which the nations of the world strive to outgive one another in order to help support their own industries would amount to a collaborative global stimulus. Angloamerican economists are tut-tutting over how "surplus countries"( SAVER ) aren't doing their part in stimulating domestic consumption. Instead, export-heavy nations are stimulating consumption elsewhere, by stepping up their export subsidies( TRUE ). If China wants to support American consumption, then why shouldn't America support Chinese consumption? Rather than digging holes again and filling them back in again, why not give the world's "bottom billion" perishable gift cards redeemable for US goods and services, and let the jobs follow?

I don't think this is only a matter of "depression economics". It really is better to give than to receive, even in good times. But it is impolite to give but then refuse the gifts of others. And it is best to be up front about what you are doing. Making "loans" that are unlikely to be repaid is the worst form of giving. Everyone ends up unhappy when the inevitable comes to pass.

I started with the example of China, and I'll end with it. A year or two ago, China looked unstoppable, but suddenly conventional wisdom is that chickens are coming home to roost. China has subsidized exports, but its subsidy has been synthetic, implicit and deniable, and therein lies its problem. As Brad Setser has described for years, in order to maintain a "crawling" currency peg, China's central bank has been forced to purchase US dollar assets on which it must expect an eventual loss in real terms. China's subsidy to foreign consumers has been hidden in this overpayment. China's policy of giving worked very well for it, but executing that policy by pretending to lend rather than to give has put the nation in a bind. The technocrats responsible for China's huge currency reserves must continually expand their losses by purchasing more dollars to keep the value of the dollar high and hide the costs of subsidies already granted. If they do not, the exposure of large financial losses might create a firestorm of domestic outrage. China's central bank might be able to hide reserve losses by engineering a large domestic inflation, so that its US dollar portfolio does not lose value in nominal terms. In either case, even though the development gains were almost certainly worth the financial cost of China's export support, China's leaders face a problem since they pretended there was no subsidy when in fact the subsidy was very large.( TRUE )

It would have been better for China as well as for its trade partners (who face traumatic currency devaluations) if its policies had involved explicit, sustainable, and broad-based subsidies to foreign consumers. Explicit subsidies paid over time are more politically palatable than sharp losses suddenly revealed. China's covert, financial-engineered subsidies relied upon complex chains of financial intermediation, which eventually could not withstand the stress. China is still trying to subsidize, but lending to the US Treasury no longer translates to increased consumption by American consumers( IT WILL ). China's approach to subsidy contributed to instability in the financial arrangements of its customers, which has unsurprisingly boomeranged, creating economic instability in China.

Here is my proposal for the WTO. I know it will be greeted enthusiastically. Explicit export subsidies in the form of time-limited direct-to-consumer vouchers redeemable towards substantially all of a country's domestically produced goods and services should be deemed permissible, and the inevitable bureaucracy should be created to quibble over the terms of the institutionalized subsidy. Nations may choose to opt out of the program, but if they wish to offer subsidies, they must accept all other nations' subsidies. (Nations may accept subsidies without offering them, though.) Each subsidizing nation then sets an annual lump-sum amount, which is distributed in the form of equal-valued vouchers to adults in all participating nations worldwide. (Goverments that cannot brook direct-to-consumer payments would be excluded both from offering or accepting subsidies under the program.) Vouchers would be transferrable, but redeemable only by non-residents of the issuing country, for delivery outside of the issuing country. (Yes, for electronically deliverable services that might be hard to enforce. But that's what we have bureaucracies for.) In particular, subsidy vouchers could be bought and sold on organized exchanges, so that recipients who need food more than imports could sell them, for example to entrepreneurs hoping to purchase foreign capital goods at a discount.

I know this will grate on some of my "free-trade" luvin' readers, but please compare this proposal with the actual status quo rather than hypothetical optimization problem. Governments will subsidize, sometime corruptly, sometimes mistakenly, and sometimes because it is a good idea that they do so. This scheme does not directly address narrowly tailored subsidies (e.g. US farm subsidies), but it does provide an alternative and "less distorting" means by which nations can broadly support their tradable industries while picking winners and losers as little as possible. It will also provide an alternative to the current practice of synthetic subsidy via currency and financial market intervention, which has led us to the brink of depression and dramatically increased the likelihood of serious conflict, economic or otherwise, between major powers. Since governments will always subsidize, we should try to devise and institutionalize least-harmful-means by which governments can do what they will (and sometimes should) do. This proposal avoids government picking of winners and losers, encouraging governments to subsidize tradables very broadly defined but let markets fill in the details. It prevents governments from targeting and undermining tradables production in particular countries. It avoids the obscenity of the current decade, wherein the mechanics by which export subsides were arranged meant that the wealth transfer went primarily towards the consumption of the already wealthy (owners of real estate or financial assets). The aggregate demand required to mobilize China might have been generated by entrepreneurs building factories in Africa rather than homeowners buying lawn furniture in America. Also, the structure of the proposed subsidy means that poor countries can choose to accept it as a form of foreign aid whose direct-to-consumer requirement might limit corrupt misuse, and whose breadth renders the subsidy less harmful to domestic producers than, say, dumping underpriced grains onto the market in the name of charity.

I think this is a pretty good idea. Tell me why I am wrong."

But he's answered his own question. When some things are made explicit, they won't work. That's why they were done in the dark in the first place. China is not going to admit subsidizing the American consumer, or any other foreign consumers for that matter. On the contrary, allowing the US to default makes much more sense. China can argue it is our fault, and that there was nothing else that they could do. You might as well expect magicians to show how their tricks are done while they're doing them, as to expect China to openly declare their economic strategy.

"Personally, I think morality play deserves a much larger place in economics than it currently has"

From the always interesting Interfluidity:

"Krugman's "hangover theory", revisited.

I'm trying to write something hard, and failing. I'll keep trying. But this is easy, and I cannot resist. Paul Krugman is once again attacking "hangover theorists", the idea that booms of a certain kind inevitably beget recessions. I do not buy the traditional Austrian story of hangovers — that misallocations and depletions of capital (including human capital) necessarily take time to undo. But I think that now and in his original piece, Krugman is far too quick in his dismissal of the idea that there must be something about some booms that makes subsequent recessions pretty hard to avoid( I AGREE ). Krugmans writes that "[a] recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time( MOVE TO SAFETY. NOT FLIGHT. )." It is rather surprising, isn't it, that "whatever reason" almost always happens subsequent to years of unusual prosperity? Choose your poison — if you don't like the Austrians, go with Hyman Minsky — but if we don't acknowledge the relationship between some kinds of booms and the bad times that follow, we'll have a hard time preventing those bad times( GOOD POINT ).

Krugman is absolutely correct to inveigh against the "morality play" that sometimes seeps into the Austrian rhetoric surrounding recessions. Personally, I think morality play deserves a much larger place in economics than it currently has( I AGREE. IT'S CALLED POLITICAL ECONOMY ), but a fable in which masses of innocents suffer to absolve the sins of the reckless wealthy is hardly moral(GOOD POINT ). The "hangover theory" is best described as an immorality play, which we are watching unfold before our eyes this every moment as financial assets are relentlessly supported while the value of a pair of hands is let to plummet.

However, recessions and depressions do follow booms, and there are reasons for that. Austrians have their vices, but a vice of Keynesians is to underestimate the role of information. Krugman points out that the hangover theory...

doesn’t explain why there isn’t mass unemployment when bubbles are growing as well as shrinking — why didn’t we need high unemployment elsewhere to get those people into the nail-pounding-in-Nevada business?

The obvious answer is that when there is a boom, entrepreneurs know into what sector resources must be reallocated, and pull already employed workers from existing jobs into the new big thing. During a bust, from a God's eye view, the same process must occur: resources must be shifted out of some sectors and into others( RIGHT NOW, OUT OF HOUSING ). But entrepreneurs are only human. They do not know to where resources might be productively employed, only that they cannot be productively employed where they are. This is the asymmetry, I think, that explains mass unemployment during busts.( TRUE. PEOPLE ARE MOVING INTO NEW JOBS )

Krugman also points out that the hangover theory...

doesn’t explain why recessions reduce unemployment across the board, not just in industries that were bloated by a bubble.

I think that this gets to the point about why it is that only certain kinds of booms lead to great and terrible busts. Industries rise and fall all the time, in good times as well as bad. In the 1980s, there was a great boom in the recording industry owing to the advent of compact discs. The boom eventually went bust, but mass unemployment did not ensue. Hangovers result not from booms in and of themselves, but from booms which result in unhealthy concentration of the aggregate investment portfolio( I WOULD SAY RUNS LEAD TO THE REALLY AWFUL DOWNTURNS ). US capital, viewed as a whole, was overly concentrated in housing and construction this decade. China's capital has been overly concentrated in exports and construction( THERE'S NO REAL "OVERLY" ). Traditional portfolio theory views the menu of investments as fixed, and suggests that investors diversify among them. But in the aggregate, there is only one portfolio extant at any point in time. The art of "macro portfolio theory" is to control the evolution of that portfolio so that it remains reasonably efficient. The easy answers don't work: Micro portfolio choices don't necessarily compose into a dynamically sane macro portfolio( TRUE ). We have reason to be skeptical of very heavy-handed industrial policy. So we have work to do.

I'll end with an intuition: I think that there's a trade-off between microlevel diversification and macro-efficiency. Barry Bosworth warned that "diversification devalues knowledge". One reason that micro portfolio choices fail to compose is because it is often sensible for investors to "buy the market". Every individual has a unique information set, and ideally we would want all that decentralized knowledge "priced into the market" independently of the judgments of others. However, each individual knows that her own information is profoundly uncertain and incomplete, and that the market represents an aggregation of the judgments of millions of others. So, as passive-investment types have been telling us for more than a decade, it may be optimal for individuals to ignore their own information and defer to the judgement of the market-ex-me. (This is a kind of "information cascade".) But, each person who defers to the market increases the concentration of investment decision making, and decreases the breath of information that is priced into the market( I NEED MORE ABOUT THIS ). If the aggregate portfolio is disproportionately by the decisions of a relatively small group of people, there is no reason to suspect its quality would be better than that decided upon by a bureaucracy of planners( THERE MIGHT BE ). There is reason to suspect, in fact, that it would be worse, because at least the planners know they should at least pretend to serve a broad public interest, while private decisionmakers might quite legitimately think they're just trying to get a piece of next year's bonus pool.( THIS IS TOO GENERAL A STATEMENT )

In sum, I think there is a tension between micro diversification and macro diversification. If we want to maintain a well-diversified aggregate portfolio, it may be necessary to restrict the degree to which the portfolio of firms and individuals can be diversified. This implies forcing individuals to bear more risk than they would otherwise choose, in order to reduce systemic risk( THIS I AGREE WITH ). We might be better off by letting individuals shed risk via some form of social insurance( I AGREE ) while forcing investment choices to be sharp, than by encouraging people to blur the information they present in their portfolio choices in order to diversify and hedge."

The goal is to have a system that stops runs without guaranteeing everything. Bagehot's Principle's do just that.

"Let the printing presses turn and the helicopters fly, but please don't confiscate my gold."

Interfluidity has a response to the Hamilton post:

"Fedthink

James Hamilton has an excellent post on the Federal Reserve and its changing balance sheet today( IT WAS EXCELLENT ). If you haven't been following this stuff obsessively, it's probably the single best primer to get up to speed( TRUE ).

To my mind, there are three signal facts about the brave new balance sheet:

1. The size of the Federal Reserve's balance sheet has ballooned, more than doubling over a period of three months. If we take the FOMC at its word for it, it's not going to shrink anytime soon. Given new programs already announced, we should expect the Fed's balance sheet to continue to grow. ( OK )
   
2. On the asset side, only a small fraction of the Fed's holdings are now US Treasury securities. Excluding securities lent to dealers, just 12.5% of the Fed's assets are Treasuries. The Fed has expanded the scope of its lending, from depository institutions, to primary dealers, to money-market funds and commercial paper issuers, to issuers of asset and mortgage backed securities, and very soon to private investment funds that invest in asset-backed securities. The Fed also periodically lends to support firms in, um, special circumstances, such as JPM/Bear and more recently AIG. ( OK )
   
3. On the liability side, the Federal Reserve has dramatically increased the degree to which it funds its activities with zero-maturity bank reserves, upon which it is now paying interest( YES. I'M NOT AS HAPPY WITH THIS ).

The Federal Funds rate is now effectively zero. We have hit the so-called "zero bound".

There are many ways of trying to make sense of all this. One broad-brush view is that for all its radicalism, the Fed is just a thermostat. As the private sector delevered, the Fed had to lever up (McCulley). As foreign central banks shift their portfolio from agencies to Treasuries, the Fed has to shift its portfolio from Treasuries to agencies (Setser)( TRUE ). More broadly, as the private financial sector has become unwilling to issue short-term, liquid liabilities against long-term illiquid assets, the Fed has had to do so to avoid a disorderly collapse of asset prices (see Kling)( OK ). One might imagine a canoe carrying a wild beast (that would be our "rational" private markets). The beast writhes and bends, and the Fed must throw its weight in the opposite direction to force the tipping craft upright despite all the upheaval.

"Stability" — price stability, financial stability — are to my mind like "liquidity": qualities widely considered virtues that are often actually vices. Nevertheless, the Fed pursues these goals, and in the immediate term, the thermostat analogy works pretty well. I don't doubt that we'd have tipped into steep deflation, outright collapse of core financial institutions and an in-the-streets economic crisis without the Fed's extraordinary measures( I AGREE ). Had the Fed not played thermostat from 2001-2003, perhaps( MAYBE ) the beast would have been chastened by a mild dunking, and today's heroics might have been less inevitable. But it was stability über alles then, when the bubble first tried to burst, and now we are where we are.

So, thanks to the Fed, things are better than they might have been. But I think there is as much to squirm about than to celebrate in how the Fed has comported itself.

On the asset side, as has been widely noted, the Fed has been taking on extraordinary levels of credit risk. We do not know against precisely what collateral the Fed is extending its trillions in loans, and how conservatively that collateral is being valued( TRUE ). We wish Bloomberg luck in their lawsuit. (ht CR, Alea).

We do know that the Fed is becoming ever more brazen about its risk-taking( YES ). When the Fed made a non-recourse loan in connection with the collapse of Bear Stearns, Chairman Bernanke was summoned by Congress to discuss the unusual move. A non-recourse loan is economically something between lending and purchasing. The Fed has the authority to lend to whomever it pleases under "unusual and exigent" circumstances, but it is not empowered to spend outright what are in the end US taxpayer dollars. Anticipating objections, Dr. Bernanke was very careful during the Bear debacle to ensure that since the taxpayer would "own" most of the downside, it would also capture the upside. Still, he was called to account for what was widely understood to be an unusual move of very questionable legality. But now, under TALF, the Fed will extend non-recourse loans to just about anyone. The Fed will assume much of the downside, while private investors capture the upside. In my view, it is not quite legal for the Fed to extend non-recourse loans, and the practice should be curtailed. Non-recourse loans should be approved by Congress and executed by the Treasury department. The recipients of loans from the Federal Reserve should be bankrupt before taxpayers take losses( HERE I AGREE ). Remember, the Fed is an an unelected technocracy "cognitively captured" (as Willem Buiter puts it) by the sector it purports to regulate. Yes, Congress sucks. But the Fed sucks too, and the rule of law does matter.

For all of that, it is the liability side of the Fed's balance sheet that is most interesting. The Fed is financing its gargantuan balance sheet expansion by conjuring unsterilized bank reserves. A year ago, there were less than $18B of reserves deposited at the Fed. Today there are $800B. A year ago the Fed wasn't paying interest on bank reserves. Today it is.

Interest rates are, for the moment, excruciatingly low. But a subsidy to the banking system, once put into place, will be quite hard to dislodge( IT'S A PROBLEM ). So, let's imagine that the Fed will pay interest on bank reserves in perpetuity, that it will pay such interest at or near the risk-free short-term interest rate, and that the expansion of the Fed's balance sheet is more or less permanent. How large a subsidy to the banking system do the interest payments on reserves represent? Some problems are arithmetically challenging, but not this one. The present value of a perpetual stream of market-rate interest payments is precisely the amount of the principal. Therefore, the present value of the Fed's de facto commitment to pay interest to banks on $800B of freshly created reserves is $800B. We fought and wailed and gnashed our teeth over potentially overpaying for TARP assets. Meanwhile, we are quietly allowing the Fed give away, as a direct, literal subsidy, more than the entire $700B that Paulson was allowed to play with. Note there is no question about this being an "investment": The interest payments that the Fed is now making to banks on its suddenly expanded balance sheet are not loans. The banks owe taxpayers absolutely nothing in return for this windfall.

Now the bankers will object, as they always do. Bankers have forever cried that they are required to hold reserves at the Fed, that to be forced to lend their cash interest-free to the central bank is a hidden tax. I hope we all understand by now that the pronouncements of the banking industry are about as reliable as a monthly statement from Bernie Madoff. The reserves in the banking system are created by the Fed, and the quantity outstanding is now enough to cover banks' regulatory and settlement needs many times over. This is not in any sense "their" money. It is money the Fed printed in order to pursue its own objectives. The banks have no right whatsoever to earn interest on this money( TRUE ), and absolutely do not merit an $800B subsidy. Further, the core rationale for paying interest on reserves has disappeared entirely. Originally, the Fed wanted the power to pay interest on reserves so that it could expand its balance sheet to pursue "stability" goals without stoking inflation by letting the short-term interest rate fall to zero( TRUE ). Now the short-term interest rate has fallen to zero, and the dominant concern is that we are in a "liquidity trap". Yet we are still paying the banks 25 basis points to hold this freshly created money at the Fed. James Hamilton, towards the end of his piece, points out that this is counterproductive. I want to point out that it is also obscene( OK ).

Now I have to admit that, personally, I feel a bit caught out, bent out of shape, gypped, by the whole paying-interest-on-reserves thing. A long while back, I argued against giving the Fed this power, because I knew they would abuse it. During the TARP debate, I did a one-eighty. At least the Fed, I reasoned, would only lend taxpayer money. If we took losses, the institutions that shoved them onto us would go down first. Paulson clearly wanted to assume bank liabilities outright by overpaying for toxic assets. Having the Fed lend taxpayer money seemed like a better deal than letting Paulson give it away. The cost of paying interest on reserves, when I had written about it previously, was about only $11B in present value terms, insignificant in the grand scheme of things. (By the end of September, when I flipped, reserves had already grown to $100B... but I missed that.) Now we have the worst of all worlds: Not only has our corrupt, dysfunctional banking system won the small subsidy it has long lobbied for, but the size of that subsidy has grown by almost 8000%. The Fed is no longer lending only to financial institutions that would have to go under before taxpayers eat their losses. Under TALF, the Fed will lend to anyone who owns the kind of securities whose prices the Fed wants support. The borrowers will take the upside, while taxpayers eat the downside( A PROBLEM, YES ). (Does anybody know what kind of leverage the Fed will support under TALF? I've looked, but haven't found.) The non-recourse lending that was extraordinary and barely legal when Bear went down is now the new normal, except that the Fed no longer bothers to ensure an upside for taxpayers. By institutionalizing non-recourse lending, the Fed has arrogated the power to do everything the original TARP would have done, except without the opportunity for people like me to write Congress in anger.

Despite all this, I am becoming rather Zen about the Federal Reserve lately. I have some sympathy( AS DO I ): They are dancing to a tune that they no longer call, struggling to keep pace with an accelerating beat. The Bernanke Fed is clever and inventive, delightful as spectator sport. So many trillions of dollars have been spent or committed or guaranteed, that the amounts have gone meaningless( THAT'S HOW I FEEL ). I think that the current financial system and the Fed itself are quite doomed, and I'm less inclined to get bent out of shape by the particular ordering of the death throes( HERE I DON'T AGREE. WE'LL GO BACK TO BAGEHOT. I GUESS THIS MAKES ME A CONSERVATIVE OF SOME SORT.). There will be a great crisis. Hopefully it will only be a financial crisis. I'd prefer it to be an inflationary rather than a sharp deflationary crisis, both because I think that a great inflation would be less destructive( I AGREE ), and because that's the way my own portfolio tilts. So really, I should root for the Fed. Let the printing presses turn and the helicopters fly( THAT'S MY POSITION ), but please don't confiscate my gold.

Since the current Fed loves bold and unorthodox action, I thought I'd end this with a (sort of) constructive suggestion. As the composition of the monetary base changes from mostly currency in circulation to largely electronic reserves, the zero-bound on nominal interest rates can be made to disappear. How? Simple: Rather than paying interest on reserves, the Fed can tax them( WE'VE PREVIOUSLY CONSIDERED THIS AND STAMPING ). If banks were taxed daily on their reserves, banks would compete to minimize their holdings, and interbank lending rates would go negative. With a high enough tax, banks could be made desperate to lend, even though in aggregate the banking system has no choice but to hold the reserves. Presumably, banks would pass costs to depositors by eliminating interest on deposits, increasing fees, and ceasing to offer term CDs. Money in the bank would go from what everyone wants to something nobody can afford to hold. People would strive to minimize transactional balances, and invest any savings in money markets or stocks or bonds, anything not subject to the tax. (This is similar in spirit to a suggestion by Arnold Kling.)

Of course there would be tricky consequences: Gresham's law would kick in, as people would hoard physical cash to avoid the tax. Coins and bills would cease to be used for exchange, but would be held as stores of value. That would introduce some friction into small transactions: we'd end up using debit cards to buy candy bars, accelerating our transition to a cashless economy. But electronic money would be legal tender, and the appreciation of paper money would be no more relevant to the overall price level than the fact that older "wheat pennies" are worth much more than 1¢. With a sufficiently large electronic monetary base, there need be no zero-bound on nominal interest rates, and we can use "conventional" monetary policy to fight deflation by letting nominal rates go negative. I laugh in the maw of your liquidity trap."

I'm letting this go( ALTHOUGH IT IS FUN TO THINK ABOUT ), because I see a different future for the Fed and banks.

“It is not exactly a bailout,” he said in a conference call this morning."

The bailout, excuse me, investment that just keeps giving. Floyd Norris in the NY Times:

"Why do people insist on saying things that are obviously untrue?

Edward M. Liddy, the chief executive of A.I.G., says the latest bailout is just a normal transaction.

“It is not exactly a bailout,” he said in a conference call this morning.

“The terms of the relation are commercial in nature,” he said, adding that everything was being done at “market interest rates.”

Does he want us to believe that there was anyone in the private sector that would have financed A.I.G. on these terms? Does he really think we will believe there is anyone in the private sector who would have financed this company on any terms?

It is sad to see that the plan is for A.I.G. to stay in business forever. This is a company that should be wound down. Instead, it appears that the government will remain an investor for years and years, helping one insurance company compete with others that are not government-subsidized."

I'm very weary. AIG forever. God spare us.

Floyd Norris again. I wonder how he's feeling:

"The most interesting part of the American International Group bailout today is the securities lending part, which I will get to later. It is happening because A.I.G. gambled with collateral that it was expected to put in safe investments. Having lost the gamble, it turns to Uncle Sam."

This is so important to me but it's not getting noticed. AIG only made these risky investments because it believed that the government would intervene if these investments backfired. Either the FED or government could not let AIG go down, and it looks like they were right. When Liddy says that it's not a bailout, he's right. It's collecting on the implicit government guarantees that it always expected. It's the governments job, according to AIG, to help them when they invest poorly. We taxpayer's just don't get it. That's our system. Listen carefully: We've had a system of implicit and explicit government guarantees to intervene in a finacial crisis. And here's the thing: A guarantee is a guarantee. The system of investments and banking is based upon these guarantees. If we don't change them, it always will.

"But the rest of the paragraph is misleading or wrong. The inability of company executives to answer the question is appalling. This deal will appeal to everyone in the market. It is only the government that is at risk...

The government will get just one percentage point over Libor on its investment, although it will be repaid first, if all goes well. If somehow there are profits, the government gets two-thirds, and A.I.G. the rest.

If there are losses, A.I.G. will take the first $5 billion, and the government the rest.

For A.I.G., this limits the possible losses from the venture...

A.I.G. guaranteed they would pay off. This makes good on the guarantee, courtesy of the taxpayers...

Again, all will make money if the market price is low enough. They will lose if it is not low enough to cope with future defaults.

Much will depend on whether the market values are fair or not. A.I.G. will calculate them, under government oversight."

This is all self-explanatory. My brother couldn't give me this deal.

More from Alea:

"AIG announced agreements with the U.S. Treasury and the Federal Reserve to establish a durable capital structure for AIG, and facilities designed to resolve the liquidity issues AIG has experienced in its credit default swap portfolio and its U.S. securities lending program."

I'm collecting a scrapbook on this debacle.

From Interfluidity:

"What kind of society is compatible with an economy managed by a cadre of large, politically connected firms whose operations and those of the state are intimately connected, and which cannot be permitted to fail since that would bring "chaos"? Friedman would have remembered. "Mussolini-style corporatism" can't be quarantined at the corner of Liberty Street and Maiden Lane. Trillion dollar bail-outs represent claims on scarce resources. If times get hard, the idea of scarcity will become a lot less abstract. The state will be called upon to enforce "property rights", including rights to the property that the state is right now giving away (and which in turn are being given away to the truly deserving). First there are economic emergency measures. Later there may be emergency measures of a different sort. Mixing my libertarians, there is more than one road to serfdom.

It is so odd, how we are becoming inured to these sums, $150 billion for AIG, $140B in tax breaks to encourage consolidation into bigger and more dangerous banks, the hundreds of billions in equity infusions under the modified TARP plan, etc. The Fed's balance sheet has expanded by more than a trillion dollars over the course of several weeks, almost all of which is used to offer one form or another of covert subsidy to financial firms. A bit hyperbolically, I thought, I once compared the scale of the Fed's interventions to the direct cost of the Iraq War. Now that seems quaint. The scale of the government's response to the financial crisis now completely dwarfs the direct costs of that war, as well as any plausible estimates of the indirect (financial) costs. (Obviously, the real costs of war are not financial, and run much deeper than our economic problems. I hope the comparison doesn't seem flip.)

Of course, we are constantly told, all of this is an "investment", no money has been spent, the taxpayer may even turn a profit.

That's an argument that sounds reasonable only until you give it a moment's thought. Nearly all "government spending" (outside of entitlement transfers) is investment. When we build schools, run head start programs, buy fighter jets, and fund our court system, that is not "consumption". We don't do those things because we enjoy them, but because they create ongoing payoffs that we believe outweigh the opportunity cost of our funds."

He seems to be missing the point. This catastrophe is a once in our lifetime investment opportunity for the taxpayers. What about guarantees is hard to get through our heads?

"That cost may be quite large. A commonly held view is that yes, the Fed's interventions are extraordinarily expansionary, and yes that could lead to inflation sometime far in the future. But for now we have D-leveraging, D-flation, D-pression to worry about. The Fed retains its traditional tools to fight inflation with, when the time comes. It will be able to sell Treasury bonds for cash and "mop up" all this "liquidity" it has "injected" into "the system".

But wait. The Fed doesn't hold very many Treasury securities any more (see Kady Liang). It would have to sell off some of the other stuff. Maybe we get lucky, and by the time we need to fight inflation, all those "money good" CDOs turn marketable again. Maybe not, though, and then the Fed will have little choice but to tolerate a great inflation or watch its own balance sheet implode. When the inflation comes, bright investment bankers will have already converted the bonuses we paid them into real property. It will be ordinary savers, and especially workers without bargaining power, who will be stiffed with the bill.

I think either a great inflation or a catastrophic deflation are pretty much unavoidable. It's the distributional effects that have me white hot with rage. We are sowing the seeds of inflation by making those most deserving of catastrophe whole, while doing nothing for those whose wages may soon achieve purchasing power parity with the emerging world. I'm actually cool with inflation — hey, all my money's in gold. A sharp inflation would be a kind of large-scale Chapter 11, a systemic debt-to-equity cramdown, debtholders get their claims devalued but the firm's nation's economic life goes on. However, inflation is a wealth transfer, and we should be conscious of from whom and to whom. For every dollar of Federal largesse that goes into the Wall Street bonus pool, three dollars should go into extremely generous unemployment benefits, paid sabbaticals for workers to return to school and retool, anything and everything to give people bargaining power to negotiate higher wages without all the hassle a union. Let's pass the "Take this job and shove it act of 2009".

Because the only thing worse than a great inflation with a wage/price spiral is a great inflation without one."

Great to know.

Justin Fox adds to the fun:

"The original AIG loan was arranged in a couple of days as markets shuddered after Lehman Brothers' bankruptcy. Its terms were meant to be pretty draconian, incentivizing the company to break up and sell off its parts to quickly repay the loan. Funny thing, though: In the middle of a financial crisis people don't want to pay top dollar for financial companies, even pretty good ones like AIG's insurance subsidiaries. Plus, it turns out it wasn't just AIG's derivatives-trading arm, AIG Financial Products, doing dumb stuff. The WSJ reports that AIG's securities-lending business took the collateral put up by short sellers that borrowed securities from it, and put it into mortgage securities that now it can't sell. Smart!

The government's dilemma is that the people at AIG responsible for this mess really do deserve to be tarred and feathered, or maybe drawn and quartered. There's ample reason to be punitive. But once they made the decision that AIG was too systematically important to fail--and I'm not saying that was the wrong decision--the Fed and Treasury needed to structure their bailout in a way that allowed AIG to survive, at least until the financial situation improved dramatically. They didn't do that the first time around, which is why they had to restructure the deal on Sunday."

I agree that it seems that way, but I go with Buiter.