"What happened to the global economy and what we can do about it
Tyler Cowen, co-author of a prominent independent economics blog, has an article in The New York Times explaining “Why Creditors Should Suffer, Too.”
What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.
But in both the bailouts and in the new proposals [for financial regulation], the government is effectively neutralizing creditors as a force for financial safety.
I couldn’t agree more (except for the bit about the regulatory proposals, and that’s just because I haven’t read them closely). We need creditors who will pull their money or demand tougher terms from financial institutions that are doing things that are either too risky or just plain stupid; that’s theoretically a more efficient and cheaper enforcement mechanism than regulatory bodies.
Cowen also has an accurate read of the current situation:
This poses a very difficult public relations problem for the government, because the Federal Reserve and the Treasury do not want to discuss the importance of the creditors too publicly right now.
Why not? It would be bad precedent, and mind-bogglingly expensive, to promise to pick up all future obligations to major creditors. At the same time, any remarks that threaten to leave creditors hanging could panic the markets. So silence reigns.
Or, there’s an implicit expectation that creditors of large financial institutions will be protected, but that expectation periodically wears off and has to be bolstered by some confidence-boosting measure, but that measure can never be an explicit guarantee . . . and so on.
Cowen has some suggestions for how to fix this problem in future regulation. But what should we do right now? As long as the ongoing, ever-changing bank bailout leaves existing entities (a) under current ownership and (b) out of bankruptcy court, no force on earth can make the creditors suffer without their consent. So either we need to accept that creditors get a free pass this time, or we need to relax one of those constraints.
By James Kwak
Again, it’s about assumptions. After Lehman, what I saw was a Calling Run, the first stages of Fisher’s Debt-Deflation Spiral. In order to stop it, the government needs to guarantee everything, hoping, of course, that the guarantees stop the panic and allow for an orderly unwinding of losses.
As near as I can tell, the government has been doing that without saying so explicitly. But only the government can stop a Calling Run, because only the government has the resources to be believed that it could backstop the run. It’s akin to FDIC stopping a bank run.
Short of those guarantees, investors will continue in the Flight To Safety, with no natural or predictable stopping point. Pure dread man.
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To the extent that the creditors are:
1) Insurers ( We’ll bail them out )
2) Pensions ( We’ll bail them out )
3) Countries ( We’ll pay them much higher interest )
4) Holders of large amount of US credit ( The might help cause a stop )
we’re in a bind here. For now, I’ve said game over. At the very least, a huge haircut or default in the current situation would have real negative consequences.
I’ve said we should move on and use our energy to reform the financial system going forward. If the opportunity arises, and we’re not shooting ourselves in the foot, I’d be the first person to favor the creditors eating the losses. Not because it won’t have negative consequences, but because taxpayers eating the losses has more negative consequences.
I believe that William Gross takes the opposite view, and feels that it’s better for the taxpayers to take a hit in the long run than creditors, who are essential as investors in our markets. It’s a defensible position, but I disagree. I could also be misunderstanding him.
Everything depends on the assumptions that you make. I assume that we can’t yet seize the large banks or put them in some kind of bankruptcy. After all, we seize banks.
If we become majority shareholders and run the banks, I believe that we’ll then be on the hook to the creditors. I could be wrong.
So, we’re in a bind. I’d prefer that we admit it and get on with it.
By the way, if we’re going to have a Lender Of Last Resort, I don’t see any way to rule out intervention in a financial crisis. That’s why I favor narrow banking and a penalty for the increasing size of banks, and a very rigid application of Bagehot’s views, in which we apply moral hazard quickly and consistently. Of course, people have been saying that they’re committed to his views since he expressed them.
Also, to the extent that bondholders are people who have loaned money to US businesses, I don’t think that it’s a great idea to call for their heads. It’s enough to remind them of the risks involved in investing. Oddly, I’d like investors to keep investing in the US. Oddly.