End of the Week: Banks; Health Care; the Fed; and California

It seems that the entire week has drifted sideways: nothing of note occurred to suggest that the economy’s trajectory has changed. We are still declining, albeit at a slower rate. The problems remain the same: unemployment, high debt, and a very weak banking system. The next few weeks are crucial. If the recovery is to take hold later this year we must see definitive evidence of that change soon. In particular businesses have to stop contracting and restructuring, and consumers have to start spending. At the moment the only part of the economy preventing collapse is the government. But the cost is monumental: if other sectors don’t get involved soon our prospects dim markedly and next year will be grim.

“Let me leave you with one thought to ponder this weekend: should we nationalize California?”

Having said that most people, including myself, still think that the most likely course for GDP is a very modest improvement in the fourth quarter this year followed by slow to moderate growth throughout 2010.

Plenty of things could derail the recovery, but here I want to focus on the ‘big issues’ still facing us as we clean up our mess:

• The banks. We now have three kinds of banks. Those that are dead in all but name. Those who are alive, but too small to be bailed out. And the behemoths who could destroy us all any time soon. Citibank and Bank of America are the obvious examples of ‘dead’ banks. They exist at the whim of the taxpayer. Neither is making much money, and both are very vulnerable to any sort of new credit default increase stemming from the economy’s intractable unemployment outlook. Both will remain effectively nationalized for some time: it was revealed only this week that B of A has been operating under Fed ‘Memorandum of Understanding’ [‘MoU’] for a while. An MoU is a very severe form of regulatory censure that essentially forces a bank to take steps to remedy problems – presumably the regulators thought the bank was moving too slowly to rectify its more glaring issues, like the inadequacy of its management. As for ‘poor old Citi’ – well enough said. The sooner they tear that place apart and make it manageable once again the better.
• I feel bad for the medium sized financial firms. No cares about them anymore. We seem to have run out of both patience and money, so any smaller bank that gets itself into trouble will most likely have to go through bankruptcy. Ultimately I think that’s a healthy situation: the sooner banks have to behave sensibly and manage risks with a view to absorbing the consequences of failure, the better off we will all be. Banks are an essential part of a capitalist economy, but they cannot be allowed to exploit taxpayer fear of a banking system collapse to feather their own nests. They have to understand that our guarantees come with strings: like really intrusive regulation.
• And I mean intrusive. Which gets us to the big question: is anyone going to rein in the behemoths? Right now it appears not. There is now a ‘big two’: Goldman Sachs and JP Morgan Chase, both of whom are taking full advantage or our largesse in order to lard their own pay. I find it astonishing that these two organizations are so socially insensitive that they announce record bonus awards while millions of regular Americans are being fired as a direct consequence of the ineptitude and greed of the big banks. And let’s be clear: the banks were right in the center of the collapse. Their folly and obscene risk taking was a root cause of our crisis. For these two banks to profiteer so openly and greedily at trough of public fiscal and bail out cash is a horror to watch. It simply reinforces my thought that bankers at these places are too arrogant to be trusted: they are willfully exploiting their status as ‘too-big-to-fail’ to game the system and privatize all the gains while shoveling the losses our way. It has to stop.
• But it won’t. The reason these two behemoths survived as well as they did was not simply skill. They are also incredibly well connected politically. Both have their fingerprints all over the administration’s reactions to the financial crisis: Bear Stearns, and AIG are the prime examples.
• The lesson? We will not achieve long term GDP stability with our current economic and regulatory framework – the big banks must be tamed, at whatever the cost. Otherwise they will have captured us in true ‘oligarch’ style. An example? The ‘Sovereign Credit Default Swap’ market. Sovereign CDS’s are a stupid concept: they are insurance policies against the default by a national government. They make sense only in emerging world economies. But the market that has ‘recovered’ is that for US and UK CDS’s. There can be nothing more indicative of the speculative nature and gambling tone of the big bank trading desks. My question is this: if the US government defaults on its debt – which what some of these traders are insuring against – which bank will be liquid enough to make good on the insurance? By the time the US government goes down the entire credit system is most likely gone before. The only reason to buy this rubbish is to gamble. This is just one example of the folly that pads the profits of the behemoths. They are taking huge bets, knowing we will clean up after them. As I said: this has to be stopped.
• My suggestion? Enforce huge capital requirements against all derivatives. In some cases really marginal derivatives should carry a capital requirement of more than 100%. I am all for financial innovation, but these schoolyard yahoos are not innovating they are playing games with our money. So we should put a burden on them: innovate all you want, but some of these products are beyond the pale. Some should be publicly ‘non-guaranteed’ – meaning a failure in its market would not be seen as as reason for bail out. Or they should be covered by huge capital burdens. Preferably both. Only by deliberately withdrawing our guarantee of the gambling can we impose discipline on the children on those trading floors.
• Now: health care. There has been a lot of discussion about the costs of reform. Most of the information I have seen quoted is simply right wing rhetoric. The Congressional Budget Office has now ‘scored’ the proposed legislation and come up with a cost of about $1 trillion over ten years. In my view that’s cheap. The Bush tax cuts cost us about $1.7 trillion. The difference between the two is not just that health care is cheap by comparison, but that we are actually getting something for our money! The Bush tax cuts went predominantly to the top 5% of taxpayers – a very small number of citizens – whilst the CBO estimates that about 35 million people will benefit from health care reform.
• I have mentioned this before, but rationing is a red herring in the health care debate. We already ration health care. All we are discussing is how to alter the way in which we ration it. In this vein I highly recommend Peter Singer’s recent New York Times article on rationing. Singer is a philosopher who deals with ethics and all the complications associated with making ethicalchoices. His article cuts away the garbage from the ‘rationing’ canard.
• Getting health care reformed is essential not just from a public policy perspective, but from a GDP perspective. We allocate way too much of our annual wealth to health care. In order to re-establish our competitive position and in order to be able to invest in future oriented and wealth generating assets like education, we need to disinvest in health care. So cutting costs is vital to our economic health. The first step towards cost cutting is to get a viable public option in place to break up the health insurance pricing cartels that exist in most states.
• Finally in todays round-up: the Fed. Next week will provide a big moment in this crisis. Bernanke is going to testify before Congress about his plans to undo some of the massive and highly unconventional things the Fed was forced to do in order to stave off depression. Unwinding the Fed’s balance sheet is primary within that.
• Under ‘normal’ circumstances the Fed has a very small balance sheet. This recession it was forced to ramp up its assets so it could pump reserves into the banking system. The problem is that these reserves could result in inflation once the economy gets going again – don’t forget that I don’t think there is any danger of inflation just yet because the economy is so far below capacity. At some point, hopefully not too far off, the economy will be growing and those extra reserves will need to be drained back out. Since the pumping-in process was so unconventional and unprecedented there is huge doubt about the Fed’s plans to reverse course: both from a timing and practical point of view. So Bernanke is scheduled to explain how he proposes to do that ‘draining’. But, and please mark my words, he will absolutely not be talking about when the draining will take place. I am sufficiently skeptical about the ability of the media to differentiate between the ‘how’ and ‘when’ questions that I expect a flurry of articles on Thursday next week expounding on disappointment or confusion about what Bernanke has just said. Right now all we sensible folk need to know is how he can roll back his monetary support. As long as he explains that we will be happy.
• Lastly on the Fed: There is significant opposition brewing towards the administration’s plan to give the Fed a much larger role in the new financial regulatory set up. This opposition is led by people like Paul Volcker. I am on the side of the opposition in this one. One of the few inarguable facts to emerge from this crisis is that the Fed’s ability to analyze, let alone regulate, the big banks and financial markets was flawed. the analysts there are exceedingly bright people, but they are of the same mindset as those in the banks. They all believe that same economic theories and the technologies that rely upon those theories. Consequently there is no renegade view and no heterogeneity of opinion. Or not enough. In contrast the Fed gets very high marks for its monetary policy in the crisis itself. So my vote would go to a reform that reduces the Fed’s regulatory role and which leaves it to focus on monetary policy. This is not what the administration is pressing for. Like so much of what the Obama team proposes their reform is a ragbag of bureaucratic kluges. It is not reform. Let’s hope the opposition wins on this count.

Let me leave you with one thought to ponder this weekend: should we nationalize California? The parallels with GM are extraordinary. Years of bad management. Horrendous financial outlook. Total lack of willpower to resolve its own crisis. And now it has been forced to issue IOU’s to ‘pay’ its creditors. the place is a terrible mess. I have no idea about how we do this: but yes, we should nationalize California.

Enjoy the weekend everyone.