Monday, 09.22.08
Not Buying It
Chip Somodevilla/Getty Images
We are embarking on the most radical transformation of the American economy since the New Deal, committing hundreds of billions in taxpayer money to save banks and other financial institutions from the consequences of their own bad investments. This, we are told, is the cost of averting a crisis. But I sure wish someone would explain to me exactly what crisis we're trying to avert.
What's clear is that a bunch of financial institutions have made mistakes and lost money. What's unclear is why anyone (other than the owners and managers) should care. People make mistakes and lose money all the time. Restaurants fail, grocery stores fail, gas stations fail. People pick the wrong stocks, they buy the wrong cars, and they marry the wrong spouses without turning to the Treasury for bailouts.
So what's special about banks? According to what I keep reading, it's that without banks, nobody can borrow, and the economy grinds to a halt.
Well, let's think about that. Banks don't lend their own money; they lend other people's (their depositors' and their stockholders'). Just because the banks disappear doesn't mean the lenders will. Borrowers will still want to borrow and lenders will still want to lend. The only question is whether they'll be able to find each other.
That's one reason I feel squeamish about the official pronouncements we've been getting. They tell us bank failures will make it hard to borrow but never that bank failures will make it hard to lend. But every borrower is paired with a lender, so it's odd to state the problem so asymmetrically. This makes me suspect that the official pronouncers have not entirely thought this thing through.
In the 1930s, a wave of bank failures did make it hard for borrowers and lenders to find each other, and the consequences were drastic. But times have changed in at least two relevant ways. First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent. Second, as any user of match.com can tell you, the technology for finding partners has improved since then. When a firm wants to raise capital, why can't it just sell bonds over the web? Or issue new stock? Or approach one of the hedge funds that seem to be swimming in cash? Or borrow abroad?
I know, I know, the rest of the world is in crisis too. But surely in the vast global economy, it should be possible to find someone capable of introducing a lender to a borrower. (Note that I'm not talking about going to foreign lenders, though that's another option. I'm just talking about the same American borrower and American lender who would have found each other through Bear Stearns finding each other through Barclays instead.)
In other words, I'm not sure these big Wall Street banks are really necessary, and I'm not sure we'd miss them much if they were gone. Maybe there's something I'm missing, but if so, I think it should be incumbent on Messrs. Bernanke, Paulson and above all Bush to explain what it is.
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As far as I understand it is not the consumer banks but investment banks that are in trouble - so in theory all 'investment' will halt? possibly but as you pointed out may other financial institutions are available / ready to invest in these businesses.
Besides most of the invesment banks just trade paper back / forth earning commission/fees and are not realy investing directly into these ventures so we may be OK if some of these guys dissapear.
I'm not sure these big Wall Street banks are really necessary, and I'm not sure we'd miss them much if they were gone.
Then taking the economic analysis to another level we should ask: If Wall Street banks aren't necessary then why do they exist? Why hasn't Prosper.com or PayPal turned Goldman Sachs and Morgan Stanley into fossils?
The answer is minimizing transaction costs.
Believe everybody should go and read Chapter 7, the Great Contraction, from Friedman's "Monetary History of the United States" --- BEFORE shooting off their mouths on whether there should be or should not be the "bailout." Friedman showed that the Federal Reserve allow the destruction of 1/3 of the quantity of money in circulation, causing the Great Depression of the 1930s. The Federal Reserve has clearly read the book and understands the consequences; maybe you should too.
It's the same old story ... the rich elite are being bailed out. The US economy would be better off if the banks who got involved in the scurrilous mortgage practices paid the price. The Fed will just print more money, the dollar will weaken, inflation will follow and the taxpayers will pay the price. Paulson's prediction that the US economy would have seized up is just over-dramatic nonsense.
But every borrower is paired with a lender, so it's odd to state the problem so asymmetrically.
There's where you went wrong. The way our banking system works, the problem IS asymmetric. The amount of money being borrowed is not equal to the amount of wealth being offered for capital investment, it's ten times greater. This is called "pulling money out of thin air" or sometimes "fractional reserve banking".
Let's say you deposit a $1000 paycheck in the bank. Most of that money, $900 of it, will be lent out to someone else. But when it's lent out, the person who's borrowing it doesn't take it in cash; it's simply recorded as a deposit into his bank account. But then, because he's accounted as having made a deposit, the same money can then be lent out AGAIN, $810 this time, to some other borrower... and then based on HIS deposit, $737 will be lent out to someone else, and so forth. The net result of all this is that ten times as much money is being borrowed as is being lent!
This is why fractional reserve banks are fundamentally unsound, and why it is non-trivial to eliminate them from today's economy. The real capital assets simply don't exist to support all the borrowing which has been done against them. Getting rid of the banks will mean that people who want to borrow money will have to find people who actually have some- so the scale of investment would be tightly linked to the scale of real savings. This would be a very good thing but it'll be a huge change from the current state of affairs: We've built a huge tower of cards out of money with no real assets behind it, and now the tower is crashing down.
Most of the above commenters are right. You also made 2 other errors:
1) "Lenders will still want to lend" Will they? In a panic, lenders may choose to hide their money, in gold or offshore banks or in their mattress. This means that borrowers can't get access to their money.
2) "The only question is whether they'll be able to find each other." It's not a question of finding - it's a question of matching. Most "lenders" are saving relatively small amounts of money in checking accounts, savings accounts, etc. For a borrower to go out and find them would be very difficult: small borrowers don't have the resources to find these lenders, and big borrowers would have to collect hundreds or thousands of savers to fill their needs. The internet is not the solution to every problem. Frankly, I would hope that our banking system is somewhat more effective than match.com.
The long-run costs of the recent bailouts far exceed the costs of the crisis that Bernanke and Paulson are trying to avert. (Though the long-run costs will not be associated with their names, which suggests they are covering their own rear ends.) The disaster being averted consists of (1) private losses to people who gambled with their own money; (2) private losses to other stakeholders in some large (and some small) financial firms; (3) a possible recession.
The long-run costs of averting this disaster consists of (1) a huge tax increase to cover a massive increase in government debt; (2) a large step toward socialism; (3) reasonable expectations by other firms, even in other industries, that they, too, will be bailed out. (Think autos, airlines, pension funds in many industries, etc.) (4) Reasonable expectations by "Main Street" to be bailed out - think small business firms that fail, workers who lose their jobs, the long-term unemployed, city and county governments that fail. especially as the federal government cuts spending and joint-financing of local projects, and raises federal taxes, crowding out the ability of localities to raise tax revenue; (5) Greater risk-taking by business firms across the spectrum, with the expectation that they keep the gains but get bailed out of any losses.
I say let it burn. If we try to separate cause from effect, we will only make things worse down the road.
Ya get one of these with every Bush presidency, so it seems. HW had his S&L Bailout, now W is trying to outdo him by bailing out every zillion dollar banker and insurer on Wall Street.
Let it burn. These people need what they got coming to them.
To those above who think that Steve is not aware of fractional reserve banking, he is fully aware of how fractional reserve banking works. That is why he says:
First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent.
I agree with him, one of the reasons that the big investment banks got into trouble is that their old fee business was drying up. They acted badly and should be killed to allow more efficient, perhaps web based business to take over their old business.
Leaving aside for a moment the factthat banks were forced by the gvt to lend to unqualified buyers, you also ignore the point that lending will dry up b/c banks can only lend a certain % of their assets. As these toxic loans that sit on bank's balance sheet gets negatively marked to market, and their asset base shrinks, so too does the amount of capital that they can lend.
"...First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent...."
I can't help but think that this is somewhat like saying that " The high mortality rate of Emergency Room accident cases is due to a 30% contraction in the blood supply, which is something that can easily be prevented by the Red Cross.
Regards, Don
What they have said is that they need to buy these bad loans so that banks will have more money to lend. Now, who are they going to lend this money to? The people who can't make their mortgage payments now? Does not make sense.
Your take sounds right to me.
On the BAILOUT:
If enacted, these are the 32 words (33 if "non-reviewable" is counted two words!) will give the next adminstration (either McCain or Obama) TOTAL CONTROL over the US economy:
"Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."
I say throw them all out and start over!
What's fascinating about this debate is the way that many educated and articulate people allow themselves to fall into intellectual and linguistic traps when commenting on clear and coherent blogs such as yours.
Well, the bailout has nothing to do with liquidity. Banks have access to money. The FED is pouring billions into the system. And they offered it to ALL banks (via TAF). So it's really psychological. Banks don't want to lend money because they're afraid of not being paid bank. This might be a real phenomenon, but I don't see how the bailout really solves this. Perhaps it's a psychological boost. But that's a very, very expensive psychological boost.
The bailout process will take MONTHS, and it's really only taking bad debt off the balance sheet of banks (to forestall a downward spiral in real estate prices). I just don't see why this is the best approach. There should be another solution that provides banks with an incentive to lend money. What that is, I don't know. But it's not this $700 billion bailout.
A few quick points to make.
This is not about making funds available to banks so that they can in turn lend. Household and corporate balanace sheet need to be fixed. Folks do not need to spend, they want to save.
The multiplier effects and/or money velocity are very difficult to target in a de-leveraging environment. Just look at Japan.
Its no coincidence that Hank used to work at Goldman Sachs and that the 'plan' was contrived the same week that Goldmans's and Morgan Staley's stock started to go down the tubes after they made the 'mistake' of letting Lehmans go.
The implications and objectives of the 'plan' are a farce to democracy. Hank, wants to be made the financial emperor or dictator of whats best to Americans because they are too stupid to figure out whats really going on.
Tha party is over.
This crisis has been a long time coming and it's high time we let the banks fail. To do otherwise would promulgate the decrepit financial system that's been in place for some time; a system which exemplifies the principle of "survival of the unfittest". Personal responsibility is personal responsibility. It's what our free market capitalist system is supposed to be founded upon. Why should we hold the most irresponsible of bankers to a completely different standard than the rest of us??
People critical of this blog either don't understand the author's comments, or haven't read even read the article. Great job, Steve! Just don't laud the Federal Reserve's ability to prevent a contraction in the money supply. The arrogance of the modern day money-for-nothing fractional reserve banking system- all centralized in the hands of the very few- is what created this problem in the first place.
The last post is right, the banks already have the means to borrow from the fed, (which no one is relly mentioning by the way). The 1930's depresion was also funded by the fed the reason the money supply dropped was not because the fed did not supply liquididy but because the gov regulated prices so they could not drop and no one would borrow money at to high of prices. We need to let prices fall to the right level (whatever that might be) so we can go on with good investments and let the bad ones go. If we bail out then we are just letting the fed remonitize the problem they already created and it will come back to bite us in the a__ down the road. The fed created the bubble and is trying to create another instead of letting if pop. It dose not matter if it was housing or dot.com or tulips it was still a bubble and has to pop. What we realy need to get rid of is the fed so we can go to a natural business cycly not the big boom and bust of the fed.
I'm not buying it either, Steve. Without the bailout, changes will come to us, but overall the market will find equilibrium on its own. Upping this country's national debt by 7% in one fell swoop doesn't make sense to me.
And everyone in this country should be very wary when W wants something "passed quickly." He did this to us with the Patriot Act, The Detainee Bill, the FISA extensions, and now this. Be very, very wary.
The market is the most efficient tool to fix this kind of problems, problems caused by the same federal institution, The Federal Reserve Bank the same institution that promise to protect our economy. This bail out is the destruction of wealth from the American Tax Payer and the destruction of future generations, and why? Because we are already into a 10 trillion debt and with more to come after this bail out. I hope the the people the we put in government to protect our interest are wise enough to understand the implications the this bail out will bring to our future generations. (our kids).-
Friedman has one view, here is another:
http://www.lewrockwell.com/rothbard/rothbard183.html
Murray Rothbard cites Ludwig Von Mises and says that the contraction of the money supply is exactly what was needed. he states that it was the government intervention that kept the Depression going for so long, by trying to keep wages up, etc.
So you have two viewpoints: Friedman says more inflation will save us, Rothbard/mises say that is a necessary correction.
Which side do you think has been forecasting this crash for years? The Austrian economists, like Rothbard and Mises (Rothbard and Mises are deceased)
Who do you believe?
The bailout really shows that all these guys REALLY DON'T believe in the free market!
They really believe that people could not possibly work things out without government & Fed bailouts.
That, if everyone on Wall St knew for sure that they were on their own, they would all just fall apart, they could not possibly put their heads together, pool their resources and get it sorted out!
We people could never learn to live within our means and would all just starve in the streets without them.
I don't know how people survived and did business in the millenia before 1913!
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http://en.wikipedia.org/wiki/Liquidity_trap
"Milton Friedman suggested that a monetary authority can escape a liquidity trap by bypassing financial intermediaries to give money directly to consumers or businesses. This is referred to as a money gift or as helicopter money. The term helicopter money is meant to portray the image of a central banker dropping money on people from a helicopter. Political considerations make it difficult for a monetary authority to grant the money gift, because individuals and firms not receiving free money will exert political pressure."
The ironic thing about this proposal, is that by proposing it, Paulson helped and possibly saved the market late last week. Opposition to the proposal will inherently make the situation worse (as it did today). Dodd and company should have waited a few days before making serious criticism of the proposal. It would be best if everyone would assume the bill would go through, while the financial companies heal from their vulnerabilities.
Posted by Robert | September 22, 2008 9:19 PM