It isn’t clear that they’ll have a lot of value added for the economy as a result of that 5-7 years of work

From:

"Rortybomb

Housing Bubble Leftovers

Posted in Uncategorized by Mike on May 20, 2009

We are in the middle of a Great Recession, but someday we will be out of it. It is very easy to focus on the losses, but what did we gain? James Surowiecki has a column where he says:

There have been three big banking booms in modern U.S. history. The first began in the late nineteenth century, during the Second Industrial Revolution, when bankers like J. P. Morgan funded the creation of industrial giants like U.S. Steel and International Harvester. The second wave came in the twenties, as electrification transformed manufacturing, and the modern consumer economy took hold. The third wave accompanied the information-technology revolution. Each wave, Philippon shows, was propelled by the need to fund new businesses, and each left finance significantly bigger than before. In all these cases, it wasn’t so much that the bankers had changed; the world had.

The same can’t be said, though, of the boom of the past decade. The housing bubble was unique, and uniquely awful. Each of the previous waves had come in response to a profound shift in the real economy. With the housing bubble, by contrast, there was no meaningful development in the real economy that could explain why homes were suddenly so much more attractive or valuable. The only thing that had changed, really, was that banks were flinging cheap money at would-be homeowners, essentially conjuring up profits out of nowhere. And while previous booms (at least, those of the twenties and the nineties) did end in tears, along the way they made the economy more productive and more innovative in a lasting way. That’s not true of the past decade. Banking grew bigger and more profitable. But all we got in exchange was acres of empty houses in Phoenix.

I think this is true. Look at the last boom, the internet one. A lot of people thought thinks like pets.com deserved a giant market share, and splurged accordingly. In the process, we got a lot of investment in broadband capabilities we are just now beginning to stress, as well as a workforce educated in programming and the web, as well as businesses now focused on the web. Employees out of that boom continued to innovate, producing new goods, and will continue to do so. These are good things, and will continue to provide value as we go forward.

I don’t think that is true now. People who were involved in the selling of mortgages, either at the local level or at the Wall Street level, aren’t any more trained, don’t have more productive human capital, than when they started. When people talk about the finance sector collapsing and unemployment being high, I think they tend to think of Wall Street MBAs – so they look at the graduate degree unemployment numbers. I think of some of the kids at my 10 year high school reunion 2 years ago, who started flipping commercial real estate contracts after completing a year or two of community college. It isn’t clear that they’ll have a lot of value added for the economy as a result of that 5-7 years of work. And that definitely aggregates up to the Wall Street kids who, in the words of a friend of Ezra Klein’s, spent “4-6 years driving CDO deals using someone else’s quant models.”

But what about the housing stock? What about it indeed. I want to show two things. A commenter on seekingalpha sent me this:

A video of two guys in Southern California look at some repossessed houses and show the huge damage previous people caused. That house they look at is only 18 months old and it is trashed. This is what I think of with The Exurbs as Nightmare which I mentioned in the previous post.

I also want to follow up with a This American Life episode Scenes From a Recession. It’s an excellent episode overall, but the first episode about the Chicago neighborhood Roger’s Park condo boom, and now bust, stands out.

They follow the plight of condo owners who moved into condo buildings as they were half sold, and the Realtor went bust or fled. So the empty units rot, their pipes freeze, animals and squatters life in the empty space, and they go unsold by the realtor but also unclaimed by the bank holding the lease (since they don’t want to pay the property taxes, they don’t challenge the owner). Orphan buildings. So the building rots, or to use the accountancy language depreciates, ruining the owner’s investment.

Rodger’s Park was not a very desirable place for people to live in the 2000s, if I remember. I knew a few hippies and artists who lived up there for the very cheap rent – people were insane if they thought they were going to flip that neighborhood. And if memory serves, I think about 5 people I knew up there had to move out of their apartments because they were being turned into condos in the ‘04-’06 time frame.

Add to this the huge amounts of investment in housing where people will no longer want to live when oil prices come back (which it already is). A lot of capital, human and housing, has been wasted this past decade as a result of this financial crisis. I hope it can find a better use handling the upcoming health and energy problems we have on our hands…"

Me:

1. donthelibertariandemocrat said, on May 20, 2009 at 4:33 pm

   “It isn’t clear that they’ll have a lot of value added for the economy as a result of that 5-7 years of work.”

   The housing bubble was supposed to solve a problem: namely, providing for retirement. I don’t mean that people wanted a bubble, but that people were panicked about buying a house to provide for their retirement.

   There has been a twenty year barrage of bad news about social security, pensions, etc. Why did people focus on houses? Because they pay rent, which came to be seen as a sucker’s game. Since they already pay for housing, it made sense to them to try and turn this rent into an investment. There was a panic about buying a house for retirement, followed by a panic that people were going to be left behind. That was the story: Get in now, or be left behind.

   Many people really can manage to save much after they pay expenses. Consequently, it made sense for them to try and turn some of those wages into an investment. Sadly, there were told a story without a happy ending by people who took advantage of that panic and fear of a pauper’s old age and being left behind.

   There is no good investment reason for the housing bubble.

   Reply
2. donthelibertariandemocrat said, on May 20, 2009 at 4:34 pm

   Many people really can(not) manage …

   Reply

privatize it when possible at the highest possible price for the taxpayer

From The Baseline Scenario:

"James Surowiecki and Me

with 38 comments

Back when I had time to read The New Yorker, I was a big fan of James Surowiecki. I would always look for his column; if it was there, it was usually the first thing I would read. Unfortunately, he’s no fan of mine.

Surowiecki makes three points about our recent long post on nationalization:

1. If the government were to take over a large bank like Citigroup, it would not be able to sell it into the private sector quickly, but would most likely own it for several years, which constitutes nationalization.
2. Recent U.S. history, by which he means the S&L crisis, shows that the right strategy is “exercising regulatory forebearance, cutting interest rates sharply (which raises bank profit margins), and helping the banks deal with their bad assets” – not bank takeovers.
3. We were misleading in citing the IMF’s $4.1 trillion number instead of the lower $1.1 trillion number for U.S. financial institutions. “I assume they used the $4.1 trillion number because it’s much scarier, and offers a much gloomier picture of the state of the U.S. financial system. Unfortunately, it also offers a much more misleading picture of the system.”

Sigh. I guess it’s impossible to make everyone like me.

I’ll take the points in reverse order.

3. I plead partially guilty to this one (I wrote that section of the post). $4.1 trillion is the IMF’s aggregate estimate of all writedowns by all financial institutions globally. To be honest, I used it because that was the number I remembered, and I was writing fast and late at night. (I do this in my spare time, remember?) The point I really meant to make was that the IMF’s estimate was going up, because the problem had spread into all sorts of lending. You’ll note that I didn’t actually compare the $4.1 trillion to any other number – now that would have been misleading.

When I dealt more specifically with U.S. bank capital levels in another post, I did use the relevant IMF number: $275-500 billion in capital needs. $275 billion is a much bigger number than $75 billion, the bottom-line total of the famous Table 3 of the stress test results. Surowiecki attempts to deal with this in his post called “The Fed and the I.M.F. Agree,” where he reconciles these two numbers. His reconciliation is correct as far as it goes. However, the stress tests were supposed to be for a “more adverse” scenario, meaning more conservative than the expected scenario; the IMF numbers, by contrast, are their expected scenario (see mainly PDF pp. 27-28 and 32-34). Who’s right? Well, Calculated Risk has a chart showing clearly that unemployment is already running slightly worse than projected in the “more adverse” scenario (see the second chart in that post), indicating that the “more adverse” stress test scenario/IMF expected scenario (which are similar, as Surowiecki notes) should be thought of as an expectation, not a conservative forecast. So if you believe that the stress tests were supposed to buffer against the possibility of a worse-than-expected outcome, they aren’t doing it.

There is another major difference between the stress tests and the IMF that deals not with the forecasting question, but with the capital adequacy question. The stress tests calculate capital requirements as a percentage of risk-weighted assets, while the IMF uses total assets (confusingly defined as “total assets less intangible assets” (PDF p. 34, note 39)), which ordinarily will be significantly higher (risk weights are generally less than or equal to one). So 4% of one does not equal 4% of the other. (The IMF’s $275-500 billion range reflects 4% and 6% thresholds.) Citigroup, for example, had total assets, excluding intangibles, of $1,897 billion as of December 31 (the snapshot used by both the stress tests and the IMF), while according to the stress tests it had risk-weighted assets of $996 billion. Who is right I will leave to others to debate, but the stress tests are allowing banks to get by with much less capital than the IMF report implies they should.

2. I am confused by Surowiecki’s interpretation of recent U.S. history. The “regulatory forbearance” he mentions happened early in the 1980s when, among other things, thrifts were allowed to invest in a broader set of assets and were allowed to offer higher interest rates to depositors, deposit insurance ceilings were raised, and capital adequacy requirements were relaxed for thrifts facing insolvency. This may have helped banks survive but, according to a later FDIC report, it also postponed and amplified the later crisis: “With respect to commercial mortgage markets, this legislation set the stage for a rapid expansion of lending, an increase in competition between thrifts and banks, overbuilding, and the subsequent commercial real estate market collapse in many regions.” The early 1990s saw precisely the opposite; the FDIC Improvement Act of 1991, for example, limited regulatory discretion in dealing with struggling institutions.

Forbearance can work, but it is not a cure-all. The FDIC report later contrasts beneficial and harmful forbearance programs, but it criticizes large-scale forbearance programs in no uncertain terms:

Longer-term, wholesale forbearance as practiced by the FSLIC was a high-risk regulatory policy whose main chances of success were that the economic environment for thrifts would improve before their condition deteriorated beyond repair or that the new, riskier investment powers they had been granted would pay off. The latter type of forbearance, which the FSLIC adopted against the background of a depleted insurance fund, is widely judged to have increased the cost of thrift failures.

In addition, the policies of the 1980s played out in a very different economic environment. The assets in question were primarily loans, rather than the complex securities we are dealing with today. And the global economic climate was considerably better than today, which helped banks earn their way out of their problems.

In any case, the bottom line of the S&L crisis was over 1,600 FDIC interventions between 1980 and 1994. (We’ve had 33 so far this year.) The Resolution Trust Corporation was charged with managing the assets of banks and thrifts that had become insolvent, not “helping the banks deal with bad assets.” One can argue about the lessons of the 1980s – particularly about what they mean for large banks – but it’s by no means clear that the policies Surowiecki highlights forestalled the need to take over banks.

1. I think this is one of the more serious criticisms of government takeover of a large bank – namely, that it would take a long time before it could be returned to the private sector. But that doesn’t mean prolonged political control over lending decisions. The important thing about a takeover is that you can clean up the balance sheet, for example by transferring the toxic assets to a separate entity, without having to negotiate with anyone. Once you’ve done that and the bank is recapitalized (no one is saying this will be free), the government’s stock can be put into a trust with an independent board of trustees with long terms. This would insulate the bank reasonably well from political pressure, since the trustees’ legal obligation will be to run the bank for its own long-term benefit, and to privatize it when possible at the highest possible price for the taxpayer.

There is actually an example of this right now: AIG is majority-owned by the government, but the government’s stock is controlled by three trustees who are independent of Treasury and the Fed. This is why the Treasury is forced to negotiate with AIG like any other private party that is looking out for its own interests. On the other hand, Treasury had zero voting shares in Bank of America back in December – yet it felt able to threaten Ken Lewis with replacement if he didn’t close the acquisition of Merrill. My point is that you get government influence either way, regardless of the legal structure. With Bank of America, the source of the influence was the likelihood that B of A would need assistance from the government in the future. With AIG, the source of the influence was yelling and screaming through the media, plus the fact that AIG also needed additional assistance.

I’m not saying that the AIG situation is perfect, just that it is possible to insulate a government-owned entity from political meddling – as the government found out, to its frustration. The mistake with AIG, I believe, was giving it that independence without having fixed its fundamental problems – the ones that cause it to keep coming back for more money. Were the government to take over a large bank, it should clean up the balance sheet and recapitalize first – without negotiating – and then turn it over to an independent set of trustees.

This “big banks are different” issue is a serious one and worthy of consideration. But it doesn’t necessarily justify the application of a completely different set of principles than the ones that are routinely applied to smaller banks.

By James Kwak

Written by James Kwak

May 10, 2009 at 8:00 am"

Me:

The differences boil down to the following ( I don’t believe that we can seize them yet ):

1) How much common stock should the US govt own.
2) How much control should the US govt exert.
3) What to do with the toxic assets.

Geither’s approach is less, less, and sell them now. Since most people seem to be for more, more, and ?, I’m just going to talk about the main problems of the more, etc. Both approaches are messy govt/private hybrids, and share many of the same problems.

If we own more stock, we can run the company. We can appoint trustees, a board of directors, etc. The problems are:

1) We’re no longer creditors, and so could end up losing more money.
2) Foreign govts and investors will presume that the bank is now completely govt guaranteed, and will deem any other action as a default.
3) We will run up against problems of our govt owning foreign companies, which some countries limit or disallow.

Of course, all of these problems can occur under Geithner’s plan as well. I hate to say this, but the more I look at these choices, I realize that they’re more or less the same thing. It’s a matter of emphasis.

donthelibertariandemocrat

May 10, 2009 at 3:55 pm

Reply

But why does that mean that the financial sector should have grown commensurately?

From Reuters:

"Felix Salmon

a good kind of contagious

« Previous Post

May 4th, 2009

The inefficient financial sector

Post a comment (5)

Posted by: Felix Salmon

Tags: banking, economics

Jim Surowiecki thinks that the rise in the size of the financial sector — at least until this decade — makes perfect sense:

The desire to bring back the boring, small banking industry of the nineteen-fifties is understandable. Unfortunately, the only way to do that would be to bring back the economy of the fifties, too. Banking was boring then because the economy was boring. The financial sector’s most important job is channelling money from investors to businesses that need capital for worthwhile investment. But in the postwar era there wasn’t much need for this…

The corporate world was transformed by revolutionary developments in information technology and by the emergence of new industries like cable television, wireless, and biotechnology. This meant that the economy became, and has remained, far more competitive, while corporate performance became far more volatile. In the nineteen-eighties, companies moved in and out of the Fortune 500 twice as fast as they had in the fifties and sixties. Suddenly, there were lots of new companies with big appetites for outside capital, which they needed in order to keep growing. And it was Wall Street that helped them get it… Thomas Philippon, an economist at N.Y.U., has shown that most of the increase in the size of the financial sector in this period can be accounted for by companies’ need for new capital.

I’m sure it’s true that the economy’s capital-raising needs grew sharply between the 1950s and the 1990s. But why does that mean that the financial sector should have grown commensurately? After all, there was just as much “innovation” going on in finance as there was elsewhere; the technology revolution was in many ways driven by the needs of the financial sector. Wouldn’t you expect, in that case, that financial companies would have become more efficient at intermediating between companies and investors? Shouldn’t it have been much easier and much cheaper to issue a billion-dollar bond in 1998 than it was in 1968?

Famously there was something quite cartel-like during the dot-com boom, when the big investment banks all managed to continue to charge an eye-watering 7% underwriting fee for IPOs despite the fact that most of the companies pretty much sold themselves, and similarly-sized bond issues were coming to market at the same time for underwriting fees of about 0.1% or less. And when the likes of Bill Hambrecht tried to break the big banks’ iron grip on the market, they generally failed pretty miserably.

Even so, one would hope and expect that between sell-side productivity gains and a rise in the sophistication of the buy side, any increase in America’s financing needs would be met without any rise in the percentage of the economy taken up by the financial sector. That it wasn’t is an indication, on its face, that the financial sector in aggregate signally failed to improve at doing its job over the post-war decades — a failure which was then underlined by the excesses of the current decade and the subsequent global economic meltdown.

On this view, the seven-, eight-, and nine-figure salaries pulled down by Wall Street folks aren’t a sign of how efficient they are at doing their jobs, but are rather a sign of how inefficient their companies are. As Ryan Avent says:

When you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market."

Me:

I believe that the growth of the financial sector is due to the growth in government backing for it. Take Citi, or whatever the hell it’s called now. How many bailouts or government subsidized mergers has it had?

The financial sector has grown as implicit and explicit guarantees by the government backing it have grown. And, please, no more about free markets or deregulation. What we had was increased leverage backed up by government guarantees.

I’m for Narrow/Limited Banking precisely because this happened right in front of everybody’s eyes, and yet few people, apparently, outside of the people investing based upon it, knew that this was our system. I remember the phrase “Too big to fail” being from the S & L Crisis. Since then, we’ve had a policy of “Too gigantic to fail”. Zero learning curve.

We can’t be trusted. Since I want a market economy, I feel that we need a secure and trusted base upon which to rest it. Otherwise, next time, it will be “How’d they get too big, connected, important, powerful, to fail again?”

The rise in finance had less to do with innovation than subsidization.

- Posted by Don the libertarian Democrat

So let me be clear: for sixteen months now I have been a Swedish-model advocate who wants to guarantee bank bondholders

TO BE NOTED: Grasping Reality with Both Hands:

"Tim Geithner and the Swedish Model

James Surowiecki:

The Sweden Example: The Balance Sheet: Ryan Avent beats me to the punch by pointing out the most important part of today’s Times’ story on Tim Geithner, namely that in the summer of 2008, after the collapse of Bear Stearns but before the meltdown of Lehman Brothers, Geithner proposed having the government guarantee the debts of all U.S. banks. The plan was shot down as politically untenable, but, as Ryan points out, had it been put into effect, we would most likely not have seen Lehman go under or had to deal with the incredibly negative consequences of that failure. More important, perhaps, by reducing the threat of panicked runs on bank debt (since those debts would have been guaranteed), such a guarantee would also have made it easier for regulators and banks to deal in a transparent fashion with the toxic-asset problem. That’s why the very first step in Sweden’s much-admired solution to its banking crisis in the early nineteen-nineties, was, yes, a guarantee of all bank debt. As one of the regulators involved in that effort put it, the guarantee “was provided in order to restore confidence and to ease the immediate pressure on banks,” by ensuring “the stability of the payment system and to safeguard the supply of credit.”

Given all this, Ryan is perplexed that Yves Smith... dismisses Geithner’s proposal... her conviction that any plan to deal with the banking system has to require bank bondholders to take a major hit. In other words, for Smith, the Swedish solution is not the right one. Nationalizing the banks, and wiping out the shareholders, isn’t enough: you have to impose significant pain on the banks’ debtholders, too. Lots of nationalization advocates believe that a debt guarantee is a bad idea. But one of the things that’s made the debate over nationalization confusing is that many of these same people, while arguing that bank debtholders should take a hit, also say that what the U.S. should do is emulate Sweden.... [T]his doesn’t make any sense. At the heart of the Swedish solution was the guarantee of all bank debt, ensuring that bondholders would not take a hit. And the Swedes, at least, thought that guarantee was essential to making their plan work.... [N]ationalization supporters should be clear: if they want to cram down the debtholders, then they don’t want the U.S. to follow the Swedish model. You cannot “Go Swedish” and “wipe out bond holders” at the same time.

There are nationalization advocates who really do want the U.S. to emulate Sweden, including most notably Paul Krugman, who’s said, “Sweden guaranteed all [bank liabilities]. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership.” But many supporters of nationalization are just invoking Sweden in order to prove that there’s a historical precedent for successful nationalization, while at the same time arguing that the U.S. should reject a crucial part...

So let me be clear: for sixteen months now I have been a Swedish-model advocate who wants to guarantee bank bondholders. I thought and think it is the best practical road out of this mess."

wonder why the President and Treasury Secretary have never articulated their strategy as clearly as Jim Surowiecki has.

From:

Tuesday, April 28, 2009 at 2:18 pm

Surowiecki gets bold in defense of Tim Geithner's non-boldness

Posted by Justin Fox | Comments (1) | Permalink | Trackbacks (0) | Email This

Jim Surowiecki, riffing on my post from last week on possible reasons for Treasury's less-than-bold approach to the banking crisis, which was itself a riff on a Ryan Avent riff on a Gary Weiss profile of Tim Geithner (yes, we bloggers are news-gathering dynamoes), writes:

It's true that the administration's approach may not be bold in the sense of being radical, but no one believes that boldness is, in itself, a good thing or that the more radical a solution is, the better it must be. (The Bush Administration's decision to invade Iraq was certainly bold and radical. That didn't make it any less of a mistake.) More important, the boldness issue is really a red herring. Obama's critics' problem with the Administration isn't really that they think it should act more decisively: it's that they think the Administration should act differently.

That's not entirely right. At least some of the criticism of the Administration's approach to the banks comes from people like me who wonder why the President and Treasury Secretary have never articulated their strategy as clearly as Jim Surowiecki has."

Me:

1. donthelibertariandemocrat Says:
   Tuesday, April 28, 2009 at 3:47 pm

   "wonder why the President and Treasury Secretary have never articulated their strategy as clearly as Jim Surowiecki has."

   It's a fair point, but, if I were in the govt, I would assume that only actual improvements are going to do any good at this point. In other words, it's no longer a matter of being convincing in words. Also, if you say, as I do, that the options are limited and ugly, you're likely to be considered a whiner. People will just tell you to shut up and get out then. Besides, Lincoln couldn't convince many people who are disinclined to accept the govt's approach.

   Finally, I've read Geithner make many of the points that people claim that he hasn't. We already have legislation to seize large financial concerns being put forward, and he's admitted plenty of mistakes. I would like Narrow Banking, and that isn't even gaining traction on blogs, but it's hardly only Geithner's fault that I'm not being listened to.

by ensuring “the stability of the payment system and to safeguard the supply of credit.”

TO BE NOTED: From The New Yorker:

"The Sweden Example

Ryan Avent beats me to the punch by pointing out the most important part of today’s Times’ story on Tim Geithner, namely that in the summer of 2008, after the collapse of Bear Stearns but before the meltdown of Lehman Brothers, Geithner proposed having the government guarantee the debts of all U.S. banks. The plan was shot down as politically untenable, but, as Ryan points out, had it been put into effect, we would most likely not have seen Lehman go under or had to deal with the incredibly negative consequences of that failure. More important, perhaps, by reducing the threat of panicked runs on bank debt (since those debts would have been guaranteed), such a guarantee would also have made it easier for regulators and banks to deal in a transparent fashion with the toxic-asset problem. That’s why the very first step in Sweden’s much-admired solution to its banking crisis in the early nineteen-nineties, was, yes, a guarantee of all bank debt. As one of the regulators involved in that effort put it, the guarantee “was provided in order to restore confidence and to ease the immediate pressure on banks,” by ensuring “the stability of the payment system and to safeguard the supply of credit.”

Given all this, Ryan is perplexed that Yves Smith, in her post today on the Times article, dismisses Geithner’s proposal as just another attempt to give Wall Street a handout. In part, this could be because Smith thinks that, in the absence of a systematic plan to deal with toxic assets (which we don’t know if Geithner had), guaranteeing all bank debt would have allowed banks to engage in more risky behavior, knowing that taxpayers would foot the bill. But I think what’s really driving Smith’s attack on Geithner’s proposal is her conviction that any plan to deal with the banking system has to require bank bondholders to take a major hit. In other words, for Smith, the Swedish solution is not the right one. Nationalizing the banks, and wiping out the shareholders, isn’t enough: you have to impose significant pain on the banks’ debtholders, too.

Lots of nationalization advocates believe that a debt guarantee is a bad idea. But one of the things that’s made the debate over nationalization confusing is that many of these same people, while arguing that bank debtholders should take a hit, also say that what the U.S. should do is emulate Sweden. Henry Blodget, for instance, has argued that that we should follow “a tried and true way of fixing banks: The Swedish Model,” and yet he also insists that we should stop bailing out bank bondholders. And Barry Ritholtz has written that when it comes to dealing with the banks we should “Go Swedish. Wipe out shareholders, bond holders, and all the bad debt and junk paper these firms hold.”

Needless to say, this doesn’t make any sense. At the heart of the Swedish solution was the guarantee of all bank debt, ensuring that bondholders would not take a hit. And the Swedes, at least, thought that guarantee was essential to making their plan work. In the U.S. context, maybe we should follow a different approach, but nationalization supporters should be clear: if they want to cram down the debtholders, then they don’t want the U.S. to follow the Swedish model. You cannot “Go Swedish” and “wipe out bond holders” at the same time.

There are nationalization advocates who really do want the U.S. to emulate Sweden, including most notably Paul Krugman, who’s said, “Sweden guaranteed all [bank liabilities]. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership.” But many supporters of nationalization are just invoking Sweden in order to prove that there’s a historical precedent for successful nationalization, while at the same time arguing that the U.S. should reject a crucial part of what made that precedent work. So the news that Geithner wanted the U.S. to take a first step on the Swedish path is unlikely to change their view of him. If anything, it’ll just confirm their assumption that he’s not willing to do what’s necessary.

Posted by James Surowiecki"

And:

April 27, 2009

The Fetishization of Boldness

Justin Fox has a nice post laying out a range of possible explanations for the Obama Administration’s decision not to nationalize some of the country’s biggest banks. Sensibly, the very first explanation Fox offers (and one he says he’s finding more plausible) is that the Administration is following its current strategy for dealing with the banks (a mix of regulatory forbearance and government subsidy in the form of debt guarantees and capital injections) because it believes “it’s the proper course of action, because most banks will be able to earn their way out of their problems if given some time and forbearance by regulators.” Oddly, this simple explanation—that Barack Obama, Tim Geithner, and Ben Bernanke have adopted their strategy because they think it has the best chance of getting the economy back on track while taking the least systemic risk, rather than because they’re stupid, or corrupt, or “cognitively captured”—is one you rarely hear floated these days, even though it is, I think, almost certainly true.

At the same time, Fox echoes one of the most common, but least convincing, criticisms of the Administration’s approach in general, and of Tim Geithner in particular, namely that they’re handling the crisis in a “tentative way” and not being bold enough. This critique has become a commonplace—it’s at the heart of Gary Weiss’s piece on Geithner in the new issue of Portfolio, where Geithner is described as “tentative,” “lacking in boldness and imagination,” and lacking “fresh ideas.”

I don’t buy it. Geithner did flub his first big speech, when he gave markets only a tentative sketch of what the Administration’s bank plan would look like. But from a policy perspective, the Administration has not been tentative at all: in fact, it’s been unwavering in its insistence that, given current market and economic conditions, the risks and costs of nationalization outweigh the benefits. And its alternative strategy may be wrong, but that doesn't mean it’s ill-considered, or halfhearted.

It's true that the administration's approach may not be bold in the sense of being radical, but no one believes that boldness is, in itself, a good thing or that the more radical a solution is, the better it must be. (The Bush Administration’s decision to invade Iraq was certainly bold and radical. That didn’t make it any less of a mistake.) More important, the boldness issue is really a red herring. Obama’s critics’ problem with the Administration isn’t really that they think it should act more decisively: it’s that they think the Administration should act differently. In that context, the personal attacks on Geithner for being weak and hesitant (like the persistent references to him as “Timmy,” as if he were somehow a child) are really just rhetorical gambits designed to make the Administration’s strategy seem weak and hesitant as well. The myriad criticisms of Geithner’s style and connections and the Administration’s lack of imagination all really boil down to the same unvarying argument: the government should nationalize the banks. And as long as the Administration refrains from doing this, nothing it does on the banking front—either stylistically or in terms of policy—will satisfy its critics.

Keywords

• Justin Fox;
• Obama administration;
• Tim Geithner;
• Treasury;
• banking crisis;
• banking system

Posted by James Surowiecki"

two kinds of failure: “sinking the boat” (wrecking the company by making a bad bet) or “missing the boat” (letting a great opportunity pass)

TO BE NOTED: From the New Yorker:

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The Financial Page

Hanging Tough

by James Surowiecki April 20, 2009

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Keywords

Recession;

Spending;

Risk;

Uncertainty;

Corporations;

Kellogg;

Post

In the late nineteen-twenties, two companies—Kellogg and Post—dominated the market for packaged cereal. It was still a relatively new market: ready-to-eat cereal had been around for decades, but Americans didn’t see it as a real alternative to oatmeal or cream of wheat until the twenties. So, when the Depression hit, no one knew what would happen to consumer demand. Post did the predictable thing: it reined in expenses and cut back on advertising. But Kellogg doubled its ad budget, moved aggressively into radio advertising, and heavily pushed its new cereal, Rice Krispies. (Snap, Crackle, and Pop first appeared in the thirties.) By 1933, even as the economy cratered, Kellogg’s profits had risen almost thirty per cent and it had become what it remains today: the industry’s dominant player.

You’d think that everyone would want to emulate Kellogg’s success, but, when hard times hit, most companies end up behaving more like Post. They hunker down, cut spending, and wait for good times to return. They make fewer acquisitions, even though prices are cheaper. They cut advertising budgets. And often they invest less in research and development. They do all this to preserve what they have. But there’s a trade-off: numerous studies have shown that companies that keep spending on acquisition, advertising, and R. & D. during recessions do significantly better than those which make big cuts. In 1927, the economist Roland Vaile found that firms that kept ad spending stable or increased it during the recession of 1921-22 saw their sales hold up significantly better than those which didn’t. A study of advertising during the 1981-82 recession found that sales at firms that increased advertising or held steady grew precipitously in the next three years, compared with only slight increases at firms that had slashed their budgets. And a McKinsey study of the 1990-91 recession found that companies that remained market leaders or became serious challengers during the downturn had increased their acquisition, R. & D., and ad budgets, while companies at the bottom of the pile had reduced them.

One way to read these studies is simply that recessions make the strong stronger and the weak weaker, since the strong can afford to keep investing while the weak have to devote all their energies to staying afloat. But although deep pockets help in a downturn, recessions nonetheless create more opportunity for challengers, not less. When everyone is advertising, for instance, it’s hard to separate yourself from the pack; when ads are scarcer, the returns on investment seem to rise. That may be why during the 1990-91 recession, according to a Bain & Company study, twice as many companies leaped from the bottom of their industries to the top as did so in the years before and after.

Chrysler’s fortunes in the Great Depression are a classic instance of this. Chrysler had been the third player in the U.S. auto industry, behind G.M. and Ford. But early in the downturn it gave a big push to a new brand—Plymouth—targeted at the low end of the market, and by 1933 it had surpassed Ford to become North America’s second-biggest automaker. On a smaller scale, Hyundai has made huge gains in market share this year, thanks to a hefty advertising budget and a guarantee to take back cars from owners who have lost their jobs. Those gains may turn out to be temporary, but in fact the benefits from recession investment are often surprisingly long-lived, with companies maintaining their gains in market share and sales well into economic recovery.

Why, then, are companies so quick to cut back when trouble hits? The answer has something to do with a famous distinction that the economist Frank Knight made between risk and uncertainty. Risk describes a situation where you have a sense of the range and likelihood of possible outcomes. Uncertainty describes a situation where it’s not even clear what might happen, let alone how likely the possible outcomes are. Uncertainty is always a part of business, but in a recession it dominates everything else: no one’s sure how long the downturn will last, how shoppers will react, whether we’ll go back to the way things were before or see permanent changes in consumer behavior. So it’s natural to focus on what you can control: minimizing losses and improving short-term results. And cutting spending is a good way of doing this; a major study, by the Strategic Planning Institute, of corporate behavior during the past thirty years found that reducing ad spending during recessions did improve companies’ return on capital. It also meant, though, that they grew less quickly in the years following recessions than more free-spending competitors did. But for many companies recessions are a time when short-term considerations trump long-term potential.

This is not irrational. It’s true that the uncertainty of recessions creates an opportunity for serious profits, and the historical record is full of companies that made successful gambles in hard times: Kraft introduced Miracle Whip in 1933 and saw it become America’s best-selling dressing in six months; Texas Instruments brought out the transistor radio in the 1954 recession; Apple launched the iPod in 2001. Then again, the record is also full of forgotten companies that gambled and failed. The academics Peter Dickson and Joseph Giglierano have argued that companies have to worry about two kinds of failure: “sinking the boat” (wrecking the company by making a bad bet) or “missing the boat” (letting a great opportunity pass). Today, most companies are far more worried about sinking the boat than about missing it. That’s why the opportunity to do what Kellogg did exists. That’s also why it’s so nerve-racking to try it. ♦

ILLUSTRATION: Christoph Niemann"

I'd be very surprised if either of those things was true.

From the Curious Capitalist:

"Is the Obama economic team dumb, or evil? (Or maybe, uh, neither.)

Posted by Justin Fox | Comments (4) | Permalink | Trackbacks (0) | Email This

James Surowiecki nails something that also bothers me about many of the critiques of the Geithner plan:

Much of the discourse around the Geithner plan, and around the nationalization debate more generally, seems to assume that Obama's economic policymakers don't understand the gravity of the situation or the virtues of nationalization, or else it assumes that they don't really care about improving the real economy. I'd be very surprised if either of those things was true."

Me:

1. donthelibertariandemocrat Says:
   Tuesday, March 24, 2009 at 12:04 pm

   That's been my main problem all along. I like William Gross, but, when this crisis hit and he basically endorsed a version of the current plan, he said this:

   "The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic. Democratic Party earmarks mandating forbearance on home mortgage foreclosures will be critical as well. If this program is successful, however, it is obvious that the free market and Wild West capitalism of recent decades will be forever changed. Future economic textbooks are likely to teach that while capitalism is the most dynamic and productive system ever conceived, it is most efficient over the long term when there is another delicate balance -- between private incentive and government oversight."

   In my view, he underestimated the gravity of the crisis. He focused on economics and cosmetic changes. That's why he seemed to have a tin ear when he said that he'd work for free. The crisis simply needed some investing advice. Conflict of interest and collusion problems eluded his grasp.

   He knew, for sure, given his treasury investing in 2008, that many investors believed that there was an implicit guarantee for the government to intervene, especially after Bear. So he gets how the system was running.It was no Wild West. I'd have been impressed if he'd used that expertise to say that our system is a welfare state in which certain interests dominate. Based on those assumptions, bankers and investors, and the government, got us into a veritable catastrophe. Going forward, we're going to have to break up that relationship, which will take political will and savvy.

   Bernanke and Geithner are saying the right things today. In the case of Bernanke, I simply believe that he has been too slow and deferential. As with Gross, he knows the score, but has been too reticent to spit it out. Reading Geithner's earlier speeches, he seems to have been aware as well.

   I don't know if it's that they want to keep the status quo or are just being pragmatic, but I do believe that they know how the system runs and how broken it is. They have the knowledge to provide real leadership. I'm praying, as with QE, that it is merely pragmatism and real restraints that have tied their hands, and that, going forward, they will make the tough choices.

   Justin Fox is correct in saying that he was among the earliest to talk about the Swedish Plan. To me, that meant acknowledging that we didn't have a method to seize large banks or investment firms, and needed to get going. Whether we had to seize any of them was an open question. It does seem like it has taken a long time for them to acknowledge the obvious, although, in my case, it is true that I believe that they could have given more incentives to the B of A or Barclays to save Lehman. So I've assumed that they made a very bad bet and lost, and I lost a lot of trust in their savvy. Now, I hope that they're on track, because, quite frankly, they're the ones running the show.

It won’t be because they didn’t understand the problem.

From the Economist's View:

"Which Plan is Best?" Follow-Up: Who Can At Least Tolerate the Geithner Plan?

James Surowiecki reacts to the post "Which Plan is Best?":

Who Can At Least Tolerate the Geithner Plan?, by James Surowiecki: Most of what’s been written about Tim Geithner’s plan ... has been, unsurprisingly, negative, since Geithner’s plan does not involve the preferred solution of most bloggers and pundits: nationalizing the banks. But there are some interesting exceptions. The most useful post in terms of understanding the thinking behind the plan is Brad DeLong’s FAQ. ... And Mark Thoma of Economist’s View, who is actually an advocate of nationalization, has nonetheless written two excellent posts explaining why there are problems in the market for toxic assets and why the Geithner plan, while not ideal, could work in solving them.

Thoma’s conclusion to his second post, which comes after his analysis of three options for dealing with the banking system (the original Paulson plan, nationalization, and now the Geithner plan) is especially interesting:

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none—to me—is so off the mark that I am filled with despair because we are following a particular course of action…

So I am willing to get behind this plan and to try to make it work. It wasn’t my first choice, I still think nationalization is better overall, but I am not one who believes the Geithner plan cannot possibly work. Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There’s still time for minor changes to improve the program as we go along, and it will be important to implement mid-course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work.

I’m biased in this regard, obviously, because I think the costs of nationalization likely outweigh the benefits, and that in any case it would be very difficult for Obama to get Congress to authorize the trillion dollars or more the government would need to take over America’s biggest banks. And I agree with Thoma that the Geithner plan could work. But what I like best about his conclusion is something else: his implicit recognition that the people who came up with this plan — Geithner, Larry Summers, and Ben Bernanke — are well-versed in the problems of the banking system and serious about trying to solve them, rather than being either oblivious or corrupt. Much of the discourse around the Geithner plan, and around the nationalization debate more generally, seems to assume that Obama’s economic policymakers don’t understand the gravity of the situation or the virtues of nationalization, or else it assumes that they don’t really care about improving the real economy. I’d be very surprised if either of those things was true. The Geithner plan may be a mistake. But if it turns out to be a mistake, it’ll be one because Geithner and Bernanke made an incorrect evaluation on how much the banks’ toxic assets are really worth, and/or because they overestimated how expensive and arduous nationalizing a big bank would be. It won’t be because they didn’t understand the problem.

Posted by Mark Thoma on Monday, March 23, 2009 at 06:12 PM"

Me:

"But if it turns out to be a mistake, it’ll be one because Geithner and Bernanke made an incorrect evaluation on how much the banks’ toxic assets are really worth, and/or because they overestimated how expensive and arduous nationalizing a big bank would be."

This is not exactly my fear. My fear is a GAO report or study in the future that says that the government's actions led to our overpaying for the assets, at the same time as Pimco, et al, do very well on the plan.

In other words, it isn't a simple matter of numbers. It's also going to be a reckoning of how this crisis was handled. At that point, if the reckoning is very negative to the government in any way, and we haven't addressed the underlying problems to any significant degree, people will demand a much different arrangement of our system. I'm just concerned that, by then, people could actually have given up on even the best parts of our financial system.

Posted by: Don the libertarian Democrat

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

The reality is that our current problems are more the result of Wall Street’s stupidity and recklessness than its corruption

From the Economist's View:

"links for 2009-03-07

• Building walls with US trading partners - Ed Glaeser
• Do not rely on bankers - Ester Duflo
• Stimulus too small? Networks rarely raised the issue - Media Matters
• The Bankers Drank Their Own Kool-Aid - The Balance Sheet
• It's a Dirty Rotten Job but Someone's Got to do it - Angry Bear
• Employment decline worst since Depression - Woodward and Hall
• Private Debt Collection of Federal Taxes a Thing of the Past - ataxingmatter
• Fed's Hoenig: 'Too Big has Failed' - Calculated Risk
• Financial Market Turmoil: The Challenges Ahead - Dudley - FRBNY
• Myron Scholes says blow ‘em all up - The Curious Capitalist
• Dueling forecasts - macroblog
• What is his evidence? - Richard Green
• An Entrepreneur Stimulus Plan - Forbes.com
• Does Mars Have Burps of Life, or Burps of Rock? - Discover Magazine
• Employment Report - Spencer
• Broader Unemployment Rate Hits 14.8% - Real Time Economics
• A Carbon Tax Is Better Than Cap-And-Trade - Bruce Bartlett

Posted by Mark Thoma on Saturday, March 7, 2009 at 12:06 AM "

Me:

"The reality is that our current problems are more the result of Wall Street’s stupidity and recklessness than its corruption (though there was plenty of that). And dealing with that problem is quite a bit more challenging."

I don't buy that, but , even if I did, I'd be more worried about Fraud, etc., because that's a crime and needs to be investigated and prosecuted or it will continue. But let's get to the real point.

No one is saying that Wall Steet types expected Debt-Deflation or even to lose money. Just like Madoff, they probably thought that things would work out, or that it was worth the risk. Saying that they were hopeful that whatever they were doing would work isn't very profound. Of course they did.

The question is what allowed them to take such enormous risks. Surowiecki doesn't believe in moral hazard at all. The fact that the government had been intervening in financial crises since the S & L Crisis doesn't seem relevant to him. To me, that defies belief, especially when you see how the investor class reacted to Lehman. They were betting on the government intervening. In fact, they were demanding it. The major banks believed that their lobbying had bought them an insurance policy for government aid if there was a crisis. They believed that, as in the recent past, the intervention could be costly but would be contained if the government intervened. They did not have to foresee this specific crisis to have been acting on implicit government guarantees. That's silly. They simply expected government aid if they got in trouble. Since we now know that the FDIC had no plans in place in seize a large bank, and we don't let banks go bust in this country, what does Surowiecki think that the plan was if a major bank became insolvent? It was obviously to merge the insolvent large bank with another large bank, at whatever cost to the taxpayer that was needed.

Also, no one is saying that this is all fraud or criminal behavior, many of the problems seem like negligence or fiduciary misconduct. They are civil problems.

As for the risk wasn't known, that's just silly. They were looking for investment vehicles that allowed lower capital requirements. That makes them inherently riskier than other investments. Robert Rubin has a quote saying that he knew exactly that. They knew that these were risky investments.

CDSs and CDOs are not hard to understand as to RISK. It is difficult to do the math that creates tranches and statistical data for prediction, but the risk is easy to explain. They are an attempt to use high leverage, and that's not hard to explain. Just as in the subprime loan business, wall street types misled investors as to the risk.

Here's a paper from 2005 that I found on the web long ago from 2005:

http://www.msfinance.ch/pdfs/AnnelisLuescher.pdf

You're telling me that highly educated millionaires couldn't find sources like these on the web or find someone to give them another side to these investments? I don't believe that. Would that have meant that they wouldn't have tried these investments? No. They would have. But they would not have invested the amounts that they have. That's the point. They were consciously overlooking and underplaying risk because the rewards were so great. The Kool Aid, as Surowiecki calls it, was, at the very least, a reckless investment strategy that's now being fobbed off as stupidity, just as in the S & L Crisis. Fortunately, although not at the time, we now have a lot of resources that have shown us that much of the so-called stupidity was actual fraud.

Finally, I sold my house early last year because there was a housing bubble. If I could see that, then I have to believe that some of these Wall Street types could as well but ignored it.

Posted by: Don the libertarian Democrat | March 07, 2009 at 09:03 AM

A couple more points about Surowiecki. Note this quote:

http://www.princeton.edu/~markus/research/papers/liquidity_credit_crunch.pdf

"To see this, consider a bank that hypothetically holds two perfectly negatively correlated BBB-rated
assets. If it were to hold the assets directly on its books, it would face a high capital charge. On the other
hand, if it were to bundle both assets in a structured investment vehicle, the structured investment
vehicle could issue essentially risk-free AAA-rated assets that the bank can hold on its books at near zero
capital charge."

I could be reading this wrong, but this helps understand why banks held onto some of these tranches.

Finally, could anything be more helpful to selling risky crap than having someone say that it's AAA and they're investing their own money. One could imagine Mr.Surowiecki helping to sell Madoff or Stanford by saying, "Look! Look! They're investing their own money! How could it be a Ponzi Scheme?"

Perhaps that was part of the pitch.

Posted by: Don the libertarian Democrat | March 07, 2009 at 11:33 AM

Hazardous Materials? Jim Surowiecki on overblown moral-hazard concerns.

From Felix Salmon:

"Extra Credit, Monday Morning Edition

Why stimulus spending should go to public art

Bailouts for Bunglers: Paul Krugman on why the government should nationalize.

Hazardous Materials? Jim Surowiecki on overblown moral-hazard concerns.

OpenTable files for IPO, finally: And it might actually make sense, even in this market.

Me:

"The patchiness of the moral-hazard argument doesn’t mean that we should simply rubber-stamp another bank bailout; that may be both unjust and a poor strategy for whipping the financial sector into shape. But it does mean that the failure of Lehman Brothers was an unnecessary and costly sacrifice to moral-hazard fundamentalism. It also means that we should not sit quietly by because we fear that government action today will lead to reckless market behavior years from now. Moral hazard has its costs. But, so far, our fear of it has proved much more expensive."

I agree about Lehman, but not about moral hazard. It's very important. However, it must be swift, explicitly expected, principled, and onerous. We've had none of these. Lehman was free market policy for the hell of it. Read a chap named Bagehot. Pronounced Sinj'n.

However, by nationalizing some banks, we can both do the right thing and scare the hell out of the bankers. A moral hazard enema, if you'd like. And if you would, see a therapist.

By DonthelibertarianDemocrat Posted: Feb 02 2009 10:36am ET


Response to ccm Feb 02 2009 10:15pm ET

Although the Bank usually in the end supplied the market, its “faltering way”
caused needless uncertainty and more severe panics than if it communicated clearly
that it could be counted on (Bagehot 1873, 64). According to Bagehot, the rules—
to lend freely at penalty rates on sound collateral—under which assistance would be
provided should be stated also.

The public is never sure what policy will be adopted at the most important
moment: it is not sure what amount of advance will be made. The best
palliative to a panic is a confidence in the adequate amount of the Bank
reserve, and in the efficient use of that reserve. And until we have on this
point a clear understanding with the Bank of England, both our liability to
crises and our terror at crises will always be greater than they would
otherwise be. (1873, 196–97)

http://www.independent.org/pdf/tir/tir_07_3_wood.pdf

Bagehot’s Lender
of Last Resort
A Hollow Hallowed Tradition
—————— ✦ ——————
JOHN H. WOOD

My last try.

By DonthelibertarianDemocrat Posted: Feb 03 2009 00:12am ET

"seems like doing live electrical work while wearing a blindfold and standing in a pool of water."

John Quiggan:

"In which I disagree with Paul Krugman

By jquiggin | January 21, 2009

As James Surowiecki points out here, my views on what’s entailed in bank nationalisation differ significantly from those of Paul Krugman[1]. Krugman, like quite a few other advocates of nationalisation, has in mind models like the Resolution Trust Corporation and the Swedish nationalizations of the 1990s, where the government took insolvent institutions into temporary public ownership, liquidated the bad assets and returned them to the private sector( THIS IS MY POSITION ). These solutions worked well because the global financial system as a whole was solvent and liquid, even though some sectors (US S&Ls, Swedish banks) were not.

What’s needed in the present case is not only to fix the problems of individual banks, problems on a much bigger scale than have been seen before (even in the leadup to the Great Depression, the financial sector played a smaller role in the economy than in the recent bubble), but to reconstruct a failed global financial system. It’s kind of like rewiring an electrical system in near-meltdown, while keeping the power on (this is possible, but tricky and dangerous). The job is likely to be much slower than the rescues mentioned above, and the institutions that emerge from it will be very different from those that went in.

But, contra Surowiecki this time, this only strengthens the argument for nationalisation. Financial restructuring is going to be a huge challenge, involving both a radical redesign of national regulations and the construction of an almost completely new global financial architecture. To attempt this task while leaving the banks under the control of discredited managers nominally responsible to shareholders whose equity has, in the absence of massive transfers from taxpayers, been wiped out by bad debts, seems like doing live electrical work while wearing a blindfold and standing in a pool of water.

fn1. Krugman is well-known for being right when lots of others have been wrong, so take this into account in assessing the arguments."

I don't agree with Quiggan, but I agree about leaving the current management in place being foolish beyond belief. Where are the shareholders?

having the government take over going enterprises will encourage investors to put their money in one of two places: mattresses or government bonds.

From James Surowiecki:

"What Does Insolvency Mean For a Bank?

John Hempton questionsPaul Krugman’s explanation of why banks like Citigroup are already effectively bankrupt, even though they’re still in business. Krugman says that as soon as a bank’s liabilities are bigger than its assets (that’s not technically true of Citigroup right now, but might very well be if Citigroup marked down its assets to their true market value), it’s “bust.” Hempton, by contrast, argues that it’s more complicated than this, for a simple reason: banks get a much bigger return on their assets (that is, their loans) than they have to pay for their liabilities (which include, among other things, their customers’ deposits). They earn, say, three per cent on their assets, while paying just one per cent on their liabilities, which means that as long as it can avoid a bank run, even a bank with bigger liabilities than assets can earn significant profits, profits that over time close the gap between assets and liabilities, so that after a few years, a supposedly “bust” bank can suddenly become solvent again, without any additional injections of capital. As Hempton points out, this is the way the biggest Japanese banks were able to return to solvency in the nineteen-nineties.

Now, this doesn’t mean that the current state of affairs is fine—the only reason a bank can avoid a bank run is because of myriad U.S. government guarantees( TRUE ). And as Hempton himself says, this math doesn’t say anything about whether we should take over technically insolvent banks. But Hempton’s analysis does speak to the fact that bank insolvency doesn’t always look like a typical corporate bankruptcy. Typically, when you think of a company being bankrupt, you think of it being unable to pay its bills or meet its payroll, being unable to get credit to order new inventory, and so on. Circuit City, for instance, is closing its doors because it literally doesn’t have the money to keep them open. But that’s obviously not the case with major banks, which have access to the Fed’s discount window (meaning it can borrow money to meet its obligations), and which are still generating significantly positive cash flow. They can be insolvent and still, in most respects, do business as usual.

Shutting a bank down is usually, then, in some sense a judgment call on the part of regulators. That’s O.K.: it’s an inevitable part of a fractional-reserve banking system with federal-deposit insurance. But many of the proposals for bank nationalization seem to imply that regulators should start declaring banks that are technically solvent (like Citigroup) insolvent, with the government getting to take all of the banks’ assets as a result of what regulators decide( A FAIR POINT ). (An alternative is what William Buiter proposed in Britain, which is having the government essentially pay to acquire the big banks( OK ).) This, at the very least, does seem like it creates room for political mischief( THAT'S OUR SYSTEM ). More important, having the government take over going( BUT NOT WITHOUT LARGE GOVERNMENT SUBSIDIES. THAT'S HARDLY GOING. ) enterprises will encourage investors to put their money in one of two places: mattresses or government bonds.( COME ON. THERE ARE THOUSANDS OF OTHER BANKS. BY THE WAY, BUSINESSES FAIL ALL THE TIME FOR ALL SORTS OF REASONS. DOES THAT ENCOURAGE PUTTING YOUR MONEY ELSEWHERE? )

Posted by James Surowiecki"

There are certainly problems with nationalization, but I submit that they are more manageable than the alternatives. That' all.