bailouts

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Oh How They Are Mistaken!

In today’s Financial Times is an op-ed by Frederic Mishkin, a former Federal reserve Board governor advocating a benign attitude towards the current asset price run up that has all the worrying aspects of a bubble in the making. He urges us not to confuse what he sees as two kinds of bubble: the first, such as the hi-tech stock boom of the 1990’s leaves the banking sector largely untouched because it was concentrated in the equity values of the notorious ‘no-hope’ companies that popped up every day back then. The people who were burned were the folks who fell for the hype – they deserved to be taken for a ride, and many fell flat as a result of their gullibility. It is the second kind of bubble Mishkin describes that he argues calls for policy level push back. These second bubbles are dangerous because they are fueled by and feed back into a parallel credit boom. It is this feedback that creates the danger since it implies the accumulation of vastly overvalued assets within the financial system.

To me this is just too nuanced to make sense.

The second type of bubble is indeed the one we just suffered through. Or rather was the kind foisted upon us by the incompetence and greed on the big banks. For those of you who want to dig deeper into the instability of finance I suggest a reading of Minsky’s Financial Instability Hypothesis. He articulates what, I think at least, Mishkin is trying to say. Finance is inherently unstable and therefore needs constant and vigilant regulation. bankers cannot be trusted to make socially sound investments or judgements because they are prone to waves of speculation. Unless a particular wave crashes and deflates asset values it is amplified by the next. Each larger subsequent wave attracts more bonus driven short term investing by bankers who starve the real economy of capital and divert cash into the creation of what ends up being a monstrous asset bubble. Eventually, as we all know, the bubble burst and the bankers come hat in hand to the taxpayers for help. We clean it all up, and the bankers start all over again.

The problem I have is that there is no way to tell whether a run up in asset prices is a type ‘A’ or a type ‘B’ bubble. And given the ability of banks to manufacture ‘synthetic’ assets in the conference rooms of their lawyers and accountants, I am not sure there is a difference anyway. The credit and asset markets are so intertwined nowadays I don’t think a policy maker should regard any sudden escalation of asset prices as benign: I suspect the banks will find a way to lose money somehow.

Then again there is always the fact that Mishkin himself is tainted by his own inability to understand banking. Take this quote from one of his speeches:

‰ÛÏMore recently, developments in the subprime mortgage market have raised some additional concern about near-term prospects for the housing sector‰Û?. While these problems have caused undeniable hardship for many families and communities, spillovers to other segments of the mortgage market or to financial markets in general appear to have been minimal.

Variable-interest-rate loans to subprime borrowers account for a bit less than 10 percent of all mortgages outstanding, and at this point the expected losses are relatively small. Moreover, because most subprime mortgages are securitized, the risks associated with these loans are spread widely.

Banks and thrift institutions that hold mortgages are well-capitalized, and exposures of individual banks to possible subprime losses do not appear to be large. On the whole, some borrowers may find credit more difficult to obtain, but most borrowers are not likely to face a serious credit constraint.‰Û?

Fed speech Aril 10, 2007

Not to pick on him too much, but that’s horrible forecasting.

This leads me to another point: the really big problem we all have at the moment is that the folks being quoted and sought out by the press are, by and large, the same folks who missed the problems of 2005 through 2007. They are wedded to the theories that brought the economy to its knees. While I am all for giving people a second chance, they need to prove their competence. Too many of them are maintaining a high profile at a time when they ought to be beavering away correcting the errors in their theories.

I would throw Geithner, Bernanke, and Summers into this bucket also. None has a stellar record and all are far too close to the old ways of Wall Street to be able to sense what truly went awry.

That’s why I am a fan of paul Volcker at the moment. He seems to ‘get it’.

Bankers are perennially ‘rent seeking’. They rig the game to their own advantage. They cannot be trusted. They reward themselves for playing in a game where the odds are stacked in their favor and then claim to be ‘smart’ and thus worthy of those rewards. They seem to forget the trillions of losses they impose upon the rest of us.

I am afraid that people like Mishkin provide cover for the antics of bankers by trying to be too clever.

There may be a ton of different kinds of bubbles.

I don’t care.

Bankers should be prevented from playing in any of them.

Letting a bank get involved in an asset bubble is like giving matches to a pyromaniac and then wondering why there’s a fire.

Bankers just can’t help themselves. Take Citibank for example: all of the asset bubbles of the past thirty odd years – most have been explosions of Third World debt – have a common theme. Lax regulation in the epicenter of the trouble and an over eager credit provider trying to cash in on the ‘opportunity’. Citi has managed to impale itself on at least three of these bubbles, and has been bailed out each time. The cost to the taxpayer has been enormous. And the bank has never learned.

Bankers like those at Citi [or Goldman etc] just aren’t grown up enough.

Someone has to take the matches away.

That would be us.

Re-regulate the banks.

Now.

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Break Up The Banks: Part 2

My my.

The heat has turned up around this issue. Maybe there’s something in it.

As I wrote yesterday I am a firm believer in reducing the scale of our banks. In a nutshell my view is premised on the ability big banks have to destabilize the economy and on their associated ability to exert undue influence on our legislative process. in short I see mega banks as anti-social and anti-democratic.

Extending this little bit: the big banks represent the only aspect of our economy where we, the people, have an interest in preventing failure as a matter of course. This aversion to failure does not flow through to all banks. On the contrary we allow small banks to fold up an a regular basis: nearly 100 small and medium sized banks have been allowed to fail this year and their assets have been dealt with by the FDIC according to well established and easily implemented guidelines. It is only the large banks who operate with carte blanche freedom to screw up royally and yet be bailed out. This is moral hazard writ large – egregiously large – and must end.

Why?

Because the banks know they will not be allowed to fail. So they can indulge in all sorts of gambling activities with impunity. The managers and traders can arrange to pay themselves vast bonuses safe in the knowledge that they have no ultimate responsibility for their actions. The behavior of Goldman Sachs and AIG should be adequate warning to us all in this regard. The one is larded with astonishing hubris – its CEO yesterday claimed that increased income inequality produces social benefits in the long run, to which I can best respond by paraphrasing Keynes: ‘in the long run we are all dead’. The second seems to be stuffed with an unreconstructed rentier class attitude which motivates its managers – that might be too generous a term given the obvious lack of management at the place over the past decade – to develop a sense of entitlement: they are aghast that we might find multi-million dollar bonuses for failed portfolio managers and traders somewhat galling.

As long as these organizations are allowed to persist they will always exert an extraordinary and disproportionate effect on policy makers. This means that monetary policy will be tilted towards avoidance of failure for these banks as a priority over other policy options that could benefit us all. Whilst policy makers live in fear of the results of the incompetence that seems to pervade Wall Street we cannot expect them to act on our behalf. they will protect the banks first. And the devil can take the hindmost – that’s you and me.

Which raises the non-economic issue: the very existence of private organizations large enough to wreck the way of life of all of us disturbs the balance of our democracy. They can, and do, act as oligarchs. They expect legislative bias in their favor. The flood the legislative process with cash – corruption by any other name. In times of crisis they expect to be at the front of the queue for government aid and bailouts.

This is decidedly unhealthy were it to persist for too long. My view is that it already has thus persisted.

So the question now becomes what to about anti-social and anti-democratic organizations.

My solution, as you know, is to get rid of them.

This is not an unknown or untried solution. Standard Oil is the obvious case in point. Economically the break up of Standard Oil was probably a wash: the resultant smaller organizations all did well for their shareholders and this gain offset any lost rent seeking that the larger quasi-monopoly can be presumed to have had. Socially America at large was much healthier subsequent to the break up: a huge source of political disruption was neutered and its corrupting influence watered down. More to the point, by breaking up Standard Oil we ended up with a more competitive and more vigorous oil industry – there were more players in the market so the public had more choice and costs were forced down accordingly.

Others are far more cautious and seem committed to protecting the banks integrity.

Daniel Tarullo, a Governor of the Federal Reserve Board, came out yesterday and opposed the ‘provocative’ idea of breaking up the banks. In particular he doesn’t see any advantage to splitting the gambling and lending activities apart in the way that the old Glasss Steagall Act did. His objections all seem very weak to me:

First, he argues that no one has offered up how we would break the banks apart, and so the idea remains a ‘provocative idea’ not a ‘solid proposal’. That’s bureaucrat speak for ‘we don’t have a plan yet so nothing exists’. Apparently only things that are planned for can be discussed. That’s just silly of course. The whole point of floating the idea is to elicit responses and start to planning process. the notion that the idea should be killed simply because we have no current plan is absurd. Let’s make a plan.

Second, he argues that separating the gambling and lending parts will not eliminate risk of losses. Duh. No one said it would. This is what we call a red herring. Of course it won’t eliminate lending risks. But it will isolate the two forms of banking risks from one another and prevent them from compounding each other. Moreover, since we are now acutely aware of the huge volatility in gambling risk, we should act fast to stop that volatility from undermining the capital base of the lending risk and thus freezing up the flow of credit into the economy. The objective of pulling the two risks apart – into what I call separate commodity and gambling banks – is to minimize the ability of the gamblers to stall the economy.

The social purpose of banking has to be pre-eminent in our regulatory attitude. That purpose is to allocate scarce capital against competing end requirements. Banks are the mechanism that we have for that allocation. Privately owned banks are better than publicly owned banks – they are supposedly immune to political favoritism – and so our regulatory regime should ensure the safety and soundness of the private banking sector. But only insofar as it performs its social task well. Once it wanders off into other activities – gambling on securitized or obscure derivative products that do not assist the allocation of capital, but exist only to generate bank profit – then our regulatory interest should drop to zero. We simply shouldn’t care if Goldman Sachs blows itself up by taking too much risk – what they do mostly doesn’t touch regular people at all, so why should regular people bail it out?. But we should care if Citicorpscrews up and doesn’t keep making those credit card or small business loans. Pulling out the gambling bits of Citicorp and selling them off to private gamblers makes sense in this case.

So the defense of social purpose is a big driver of our need to limit banks to specific types of banking: that way we can limit the extent of our underwriting.

Third, Tarullo argues that hiving off the gambling would simply move the problem and not resolve it: there would still be ‘too-large-to-fail’ gambling banks like Goldman cluttering up the regulatory space.

Not necessarily.

Once we start untangling the web of counter-parties and deliberately convoluted subsidiary relationships that the banks have put in place to reduce their tax payments – nice corporate citizens that they are – I think we will find that the bulk of the bloat is fiction. All banks could be much smaller if they were prevented from trading at the pace they do. Current bank balance sheets are pumped up in size by the constant inter-bank trading of gambling products. This activity generates profits and thus bonuses, but doesn’t n=move capital into the real economy. It stays within the financial sector. By putting a fence around the gambling banks we can force them, to pay the full cost of the underwriting insurance of their gambling activities – we can withdraw our support completely. The margins on this churn of gambling products is usually wafer thin, if the banks then had to price in the underwriting cost – private bail-out insurance – the profitability would be eliminated and the volumes collapse back to those derivatives and securitized packages for which there is a social value: futures on commodities for example. So separating the gamblers from the lenders is just the first step I envisage. It enables the second: the elimination of any public support for the gambling activities.

The irony is that most defenders of the banks espouse free market principles. All I am arguing is that we should force the gamblers like Goldman Sachs, whose managers constantly spout their pride in being tough players in tough markets, to play in markets that are, in fact, free. In particular they should play in markets free of government support. If they do well, then great. If they sink, then great too. I love the democratic power of markets. What I don’t love is the hypocrisy of managers who talk tough and play soft – while paying themselves as if they were playing tough.

So Tarullo’s whole speech seems to me to be a hurried attempt to throw up a few ill thought through roadblocks. That he felt the need to do so is re-assuring. It means the break up argument is worrying the establishment.

Speaking of which: today’s Wall Street Journal carries an op-ed piece by Professor Charles Calomiris arguing against break up also – I doubt the WSJ would carry a pro-break up piece, but that’s another argument. As I would expect the professor makes a much more nuanced and better case than Tarullo’s more political version.

But he still misses the main point.

Calomiris focuses his defense of mega banks on their ability to operate and provide services across global markets. Breaking them up might jeopardize this ability. Plus, he says, the scope advantages of the huge banks enables them to mix products and package them attractively for those same customers. Finally he cites research that shows the cost of equity underwriting has fallen significantly since the abolition of Glass Steagall.

But none of these arguments defends against my main attack: the political power of mega banks to disrupt democratic determination of economic policy.

His preferred solution to the ‘too-big-to-fail’ problem – and he acknowledges that it is a problem – rests on our ability to legislate powerful restraints on bank activity – by adding capital requirements, raising transactions costs, limiting affiliations etc. Since all these regulatory actions would represent a threat to the personal gain of the managers now running the mega banks – profits would be reduced – the professor seems, naively in my view, to assume that the banks would not resist. Or that they could not derail such legislation. Or that they could simply re-locate enough of their operations to lax regulatory regimes and thus avoid the restrictions of American law. They already avoid tax laws this way, why not regulatory restrictions too?

I think the professor misses what has happened during the past year. The administration has trodden very politely around any strong regulatory measures. Regulators seem to ape the opinions of the banks. People like Geithner spend more time on the phone with top bankers than they do talking with non-bank experts. In short there is no evidence that the banks would fail to stop strong legislation.

Calomiris’ solution presumes a compliant industry. There is no evidence of such compliance. On the contrary there is ample evidence of corruption and undue influence. And that simply serves to support my claim that they are already disruptive and so need breaking up.

As for the global arguments: on paper they seem strong. In reality they melt. Even a trimmed Citicorp could manage its global clients. And, surely, the increased competition represented by the existence of more banks, as would be the case after the break up of the mega banks, would add to and not diminish, the cost and innovative advantages that Calomiris attributes to the existing structure. It is contorted pleading to argue that advantages of scope and scale will inevitably outweigh the advantages of more free market competition. Economic theory – screwed up as it is – is not something we can cherry pick to support our arguments. It either works or it doesn’t, in its entirety. If this is true then the professor needs to explain why market forces – something he teaches about every day in his academic life – suddenly appear frail in the face of mega banking.

On the topic of theory: Calomiris sees fit to throw into the mix the work of Oliver Williamson who won the Nobel Prize last week. Williamson works on the theory of the firm and is particularly interested in the question of where the firm’s limits should be. In other words what determines a firm’s size? Calomiris argues that Williamson explains why firms get larger – it is cheaper than having smaller firms all contract with each other in the open market. But this is a superficial reading of Williamson. The deeper and more accurate reading is that it is cheaper for firms to grow only when the cost of information is excessive. Thus large organizations economize on information. Calomiris needs to explain why, in the modern electronic financial market place, where transactions costs are negligible, economizing on information costs automatically implies large banks. I don’t see in any of Williamson’s work an argument saying that such growth is automatic. On the contrary, Williamson seems to support the efficacious nature of markets and is simply seeking to explain the existence of business firms by highlighting the fact that ongoing uncertainty inhibits free markets from performing the way textbooks argue they should. In my mind Williamson hews more closely to New Classical orthodoxy than either his inspiration – Ronald Coase back in the 1930’s – or Calomiris’s interpretation would indicate.

Either way putting Williamson’s name into an op-ed about mega banks seems to be a tawdry effort to beef up his argument’s intellectual heft, rather than giving it actual substantive support.

Anyway: the break up the banks effort flows as much from the social and political argument about their disproportionate power as it does from pure economics. For far too long we have bowed down to the purist economics crowd: they are the ones who brought us the derivatives business in the first place, as well as the wonderful risk models that blew up last year. Their credibility is shot.

In the end this discussion comes back to our attitude towards the bank’s power.

I just cannot reconcile the existence of the concentration of such power in so few hands with the continued health and vibrancy of the American system of values and institutiuons.

That’s why this is important and discussion should not be restricted limited arguments such as either to Tarullo’s bureaucratic view, or Calomiris’ economics based view.

But at least there’s discussion. That’s a good start.

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Break Up The Banks

When it comes to bank reform the Obama administration has constantly rejected any action that might be construed as radical. This is despite the radical nature of the problem. The crisis last year exposed to all of us just how vulnerable the entire economy is to the peculiar and often predatory activities of the country’s largest banks. That these banks screwed up royally is beyond dispute. That they contrived through their collective incompetence to sink the world economy into such a deep recession that many of us feared a repeat of the 1930’s is also beyond dispute. That they destroyed trillions of dollars of wealth – both for their shareholders and for those unfortunate enough to exist within their orbit – is unequivocally one of the worst examples of disastrous management in history. All these things have had enormous and ongoing ramifications: the cost to us all is almost incalculable and will reverberate for a generation at least.

The implosion was epic.

It called for radical reaction.

“When three current, or former, chief central bankers all agree I think we should take notice.”

But all we have seen is deference and an almost supine attitude towards the banks. Every time a radical solution has been proffered it has been set aside politely as potentially ‘destabilizing’ for those precious financial markets whom we dare not ruffle. Poor things, these bankers have sensitive feelings and might get scared if we thrash them the way they deserve it.

Remember the call for nationalization? It was set aside as being ‘un-American’; as being too radical; as being … well, upsetting. Upsetting for whom? The little dears who run the banks and their shareholders. Those nice folks on the trading desks who funnel all that money into their bonus pools.

So instead of surgery we were given something roughly equivalent to the old ‘take an aspirin and see me in the morning’ routine. We, or rather those in power, did as little as they could.

First they slowed down the conversation and avoided anything that could disturb the bankers whose jitters were charted daily in all the financial media. We all started to speak more softly and in more understanding tones about the vast complexity of finance and banking – all that sea of toxic waste was misunderstood. It wasn’t toxic if you looked at it correctly. We, on the outside, simply were not in the position to make snap judgements about the value of those CDS’s, CDO’s, MBS’s and the other denizens of the alphabet soup down on Wall Street. So we were told by the likes of Tim Geithner. As he tried to calm down the firestorm of anger we discovered not only that our best and brightest bankers were dumb as all hell, but that they seemed to think we would pay for their trillion dollar errors without exacting a reciprocal cost. Which we did. Urged on by the likes of Geithner, Summers and the other ‘experts’ who ran in fear of the industry’s woes.

The next ploy, after the soothing talk, was to institute that famous set of ‘stress tests’ to evaluate the soundness of the top banks. That the tests were rigged in favor of the banks is obvious when we examine the measures of economic distress used. What is less known is that the regulators who administered the tests had little hope of getting enough support, time, or information from the banks to make the tests anything but a flimsy cover for a pre-determined fix. There was no way that those tests would have produced a result that could have fueled the call for nationalization, or even any other form of milder intervention.

Instead we forked over gobs of cash at favorable rates to plug the gaps that the banker’s incompetence had blown throughout their various balance sheets.

Then we all sat and watched while the Federal Reserve Board and the Treasury department contrived to flood the economy with enough cash – liquidity in banker speak – to float the universe. We all gamely pretended that this cash would end up as loans to regular folks who, after all, were the ones providing it. But those of us who understand a little more knew that would never happen: the banks were always going to hoard the cash. They’re scared, and frightened people tend to sit on safe piles of cash. So no sooner had the Fed doled the cash out than the banks stuffed it straight under the mattress – or their equivalent, which is the Fed’s own vault. So much for stimulating lending.

Then we had to endure the recriminations and faux effrontery as AIG traders were paid extortionate bonuses not to leave the business they had ruined and then handed over to us to bail out.

After that came a round of accounting ruses designed to help the poor banks report profits even though there were none. Along with that came other accounting changes to turn preferred stock into equity – which is simply re-branding one form of capital and calling it something else, as if semantics were a way of injecting cash. We were led to believe that this ruse suddenly implied the banks were well capitalized. Believe it if you wish. I don’t. But even better: test it for yourself. Apply semantics to your next bank statement. Talk to it. If you urge it hard enough perhaps you can put a lot of zeros after all those ones you see. Nonsense. From where I come from adding cash usually requires some to be handed over, not simply to change the name of what’s there already.

But that only serves to show how little I know.

All the while this tinkering was going on we watched as the Fed held interest rates so low they scarcely register on anyone’s scale. That’s good for us, but it’s better for the banks who have to borrow: it helps them make profits. And that’s what the administration was hoping would happen.

You see, the strategy all along has been to buy time. Do nothing radical, and buy time. Time heals, as we all know. As long as the taxpayer safety net was in place the banks could earn, or as I just suggested rig, profits and thus replace the capital they had blown on the gambling schemes that had threatened to sink them.

That’s what happened – banks started to report profits and the administration breathed a great sigh of relief. It had managed to avoid doing anything disruptive. The great financial markets started to repair themselves and by the late summer we had all begun to forget those calls for reform that had seemed so urgent late last year and early this.

Were the banks grateful for being left untouched?

Not one bit.

First they started to resist, mightily, the administration’s one real reform: the introduction of a consumer protection agency within banking. It would, we were told, stifle innovation. Given the fruits of the last great wave of financial innovation – toxic derivatives – most of us probably would agree that less rather than more innovation from these clowns is preferable. But money talks and banks have lots – courtesy of us. So Congress has begun to water down consumer protection, and the likely legislation, when, and if, it is signed into law will afford plenty of leeway for the industry to continue to produce impenetrably worded and dubiously useful products for our benefit.

Second they all started to announce that they were going to reward themselves for a job well done. Bonuses are back with a vengeance. This after only a year since the entire industry had to be saved from its own stupidity. Nothing is a better statement of the shattering hubris of bankers than the indignation they all express when we, the folks who saved their skins, question the social value of those bonuses. It is also a statement of the political security that the banks feel that they can flaunt their pay in our faces even while unemployment keeps rising and the tab for bailing them out remains unpaid.

That security is provided by the administration’s demonstrable bias towards the banks. Nowhere throughout this sorry saga has there been a line drawn in the sand. Every time a crisis appeared the solution chosen was then one most beneficial to the banks. Not once was the public anger allowed to lap over into action. Instead we have been treated to a steady diet of public statements about how wrong those bonuses are coupled with a deeply compliant and non confrontational attitude behind the scenes.

The inevitable result of this inaction, and the unwillingness to ruffle those magical markets, has been to compound the problems that gave rise to the original crisis.

The flood of liquidity sloshing about will, unless it is syphoned off via restrictive policies, flow through the traders hands into whatever scheme they next create, making another bubble a near certainty.

The ongoing taxpayer safety net remains in place, at no cost to the banks. So the socialization of bank losses and the privatization of bank profits rumbles on – as those insulting bonuses indicate. We are still on the hook for the banks inability to play nicely or safely with our money. Remember this: we provide blanket insurance to the financial industry nowadays, we underwrite their capital. If they screw up again we will pay. But we exact no fee for this unbelievable benefit. None. We are reduced to ineffective complaints about pay and bonuses. Complaints that are treated with derision by the industry.

And not least: all of the big banks have become bigger. Our problems are much larger than before. If you thought bailing our the banks was expensive last year, just wait for the next bail out. We all learned how dangerous a bank that is too big to fail is – just one can destroy an economy as large as ours, which is why we can’t let it fail. Imagine the damage an even larger bank could do.

Which brings me to this:

Break up the banks.

The only practical way to resist the banking industry’s control over us is to legislate them away. Compel them to deconstruct themselves into smaller and therefore manageable pieces. There is no other way to avoid being bankrupted by the gambling they all do. It is urgent that we force the big banks to scale down in the way that Standard Oil was broken up in the past.

I had given up on this possibility – as usual the Obama administration sent out word that it wanted to avoid a clash with the industry.

Then I read that no less a free market guru than Alan Greenspan advocates just that – break up the banks he argued in a recent speech. Next came his predecessor, Paul Volcker – break up the banks he suggested in an interview this week. But both these men are out of power. They are not sitting in on the policy meetings, so even though their voices carry weight, they will not be able to carry the day. They need help from the inside.

Enter Mervyn King.

He is the current head of the Bank of England.

His mantra?

Break up the banks.

His ill tempered and forceful speech to a banking industry conference this week has set the world on fire. His advocacy of radical surgery will be very hard to ignore since he actually can force action.

The big banks, not just here, but worldwide, have grown to the point where they dictate economic policy. We run scared every time they sneeze. They syphon off capital that should be flowing to industry and to consumers and channel it into ever more arcane and useless vehicles that serve no social value whatever, And they expect us to pick up the pieces every time they screw up.

Enough.

It’s time for some old fashioned capitalism.

Make them pay for their own mistakes.

Let them fail. Let the bankers go bankrupt on their own dime not ours.

For us to be able to allow such a failure, we need the banks to be smaller. A lot smaller. We can break them up. We could even continue to underwrite the socially valuable parts – the consumer and business lending operations, or ‘commodity’ banks deserve our help since they help fund the economy. The gamblers … well let them rot in their own mess.

So don’t just break the banks up. Separate the businesses along the old commercial [good] versus investment [bad] banking lines that used to exist before deregulation muddied the waters.

This makes sense because the two kinds of banking are as different as night and day. Society needs dull and boring commercial banks. We don’t need those gamblers with their securitized mumbo jumbo and derivatives a-go-go that seem to serve only the pay checks of the gamblers themselves and their coterie of hangers- on like the accountants, lawyers, and rating agencies who all have a hand in that same till.

When three current, or former, chief central bankers all agree I think we should take notice.

It is time for Obama to channel Teddy Roosevelt and break up the banks.

But I’m not holding my breath.

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Interest Rates and Bank Lending – What Lending?

Well not quite none. The point being that loans to businesses by commercial banks have been declining steadily for three months, at something like an annualized 28%. So while a lot of media attention has been given to all the shenanigans banks are playing with their retail customers – people like you and me – the bigger news is that they have put the squeeze on business like no tomorrow.

This is not good.

For about three decades banks had become steadily less important as sources of credit to business. The old fashioned bank loan was replaced a long time ago by things like commercial paper. The reason was simple: after the real estate debacles of the late 1970’s most banks had worse credit ratings than their premier customers. That meant those customers could borrow more cheaply from the credit markets than the banks could. The only problem was that there was no vehicle available for these customers to access those markets. In stepped the investment banks with products like commercial paper and within years most major corporations had dispensed with the traditional banking relationships of yore. The big banks lost both customers and income streams which drove them into searching for other ways to make a buck. The boom in credit cards and so on was partially fueled by this sequence of events.

Fast forward to last year: the market for products like commercial paper is referred to as the ‘shadow banking system’. It is a shadow because it performs the same kind of function as regular banking – moving money from people who have a temporary excess to people who have a temporary shortage – but is beyond the reach of the regulatory system. It is in the shadows.

This parallel ‘shadow’ system was, we were told for years, a wonderful phenomenon imbued with all the usual magical powers that free markets are supposed to possess: it was cheap, efficient, and unbiased. Its capitalist motivation drove it, its advocates claimed, to allocate capital in the most socially efficient way possible. And certainly better than the stodgy banks.

Call me skeptical but the results are in and the shadow banking system looks a lot less robust than it used to. All that cash flowing into mortgage backed securities etc probably wasn’t the wisest, most efficient or socially beneficial allocation available. But that’s just me. Those Wall Street wizards obviously know much more than I do.

The relevant part of this, to our story today, is that the shadow system was what froze up last year. So much for that Efficient Markets Hypothesis.

This freeze left most major companies, and a ton of not so major ones, exposed to cash flow problems. Their most important source of cash dried up and withered away in a few days. They faced a massive liquidity crisis.

In stepped the Federal Reserve Board who, acting as lender of last resort, pumped trillions of cash into the banks in order to flood the economy with liquidity. This flood is why we have so few, if any, bank panics. There have been no ‘runs on the bank’.

Since the Fed has to run things through the banking system, and not through the shadow system where it has no [or little] regulatory control, all this cash went to the banks, who were suddenly awash with cash. They still are.

Before I go on I should clear up what might be bothering you: if all the banks were awash with cash why did we need to bail them out?

That’s because the banks had two distinct problems.

We bailed them out because their assets stunk and were exposed as worthless. Or worth very little. Accounting rules require banks with useless assets to right the value of those assets down to the level that they could command were they sold in a market. These right-downs cut into bank capital. And if you right off enough you eliminate capital and through the bank into insolvency. An insolvent bank is one whose assets are wroth less than it owes its depositors. It was to prevent insolvency that we handed out vast sums of taxpayer money – that cash was used to bolster capital and thus allow the right down of assets without having to close the banks down.

So problem number one was a solvency issue. TARP fixed that. Or has so far.

The second problem is one of liquidity.

This arises when customers ask for their deposits back and a bank doesn’t have enough cash on hand to meet those demands. Ordinarily a bank would sell assets to raise the cash it needs. But in an economy riven through with fear it might not be possible to sell those assets. This would set in motion a classic bank run. A bank subject to this could have loads of good assets to sell and may have tons of capital. It simply doesn’t have cash. It is illiquid.

What’s this got to do with the decline of bank loans?

The problem is that we have masses of liquidity. As I mentioned above the Fed flooded the economy with cash in order to prevent banks runs. The banks, for a very short while back last fall, used that cash to provide loans to businesses. In effect the banks moved back into their old way of doing business: they issued bank loans to customers who had been getting their cash from the now defunct shadow system.

But recently the banks have stopped doing this. They obviously are concerned about making loans to businesses who may not weather the recession. Since the banks are still knee deep in toxic assets they naturally are afraid to add more. So they stopped lending.

Hence that dramatic decline in lending.

The implications are profound. Without credit the economy will have a very difficult time getting back on its feet. In fact it won’t. As long as credit contracts the economy will most likely sputter at best. So that 28% decline in business loans looms very large across any optimistic forecast for GDP growth. I would argue it undermines any credible chance of getting a sustainable recovery at all.

The double whammy of prolonged high unemployment and a frightened banking system will most assuredly prevent long term recovery. All our policy actions need to be targeted at resolving those two conundrums.

You might ask – at least those of you who are still with me – what happened to all that liquidity?

Well.

The Fed flooded the economy with cash. The banks said ‘thank you’ and deposited in the safest place they could. After all the purpose of the cash was to provide liquidity. Where is that safest place? The Fed. That’s right. The banks have deposit accounts at the Fed that they can access to pay depositors when they need extra cash. And that’s where most of the flood of liquidity ended up. Back in the same vaults it came from.

Phew.

Now this represents a different problem.

One that you will be hearing a lot about, especially as the first signs of growth emerge.

Here’s why it’s a problem:

When the Fed prints a ton of money – which it did this year – that money could find its way into the pockets of people who then try to spend it. As I just told you this is not a problem at the moment because the banks have stuffed all that cash in the Fed’s own vaults.

But.

What happens when things start to look good?

That banks will start to lend. Surely you will shout: that is a good thing! Well, yes and no.

As long as the economy is producing lots of things to buy, the answer is yes. The money will be there to let us buy all those new things. But if the economy is producing fewer things than we have the money to buy – there is too much money chasing too few things – then we will drive up inflation. That’s where inflation comes from. Too much cash and not enough stuff to spend it on.

And that’s a huge concern.

All the efforts the Fed made to prevent a liquidity crisis could now turn and bite back as rampant inflation.

This is why we will be hearing arguments from conservative economists that the Fed should raise interest rates sooner rather than later. Rising interest rates will slow that rate at which the banks can shovel all that cash out as loans – loan demand will be reduced because the loans cost more. That would allow the dispersal of all that liquidity without driving up inflation.

The risk of this?

That the Fed moves too soon and raises rates too early. That would kill any incipient recovery. That’s what the Fed did in 1937 with the result that the Depression lasted a couple years longer.

My own view is that the flood of liquidity is nowhere near being inflationary at the moment for two reasons: first, as I have told you, the banks are simply sitting on it and not lending. The trend in bank loans is exerting exactly the opposite pressure – it is deflationary not inflationary. Second: the economy is operating so far from capacity that we are a very long way from being at the point where there is excess cash and no stuff available to spend it on.

Combine these two arguments and I simply cannot see a reason to raise rates any time soon.

But I am not at the Fed.

There is a very strong and growing camp in the Fed that is arguing for a rate increase fairly soon.

I think they’re nuts. Those loan figures support me.

There are only two ways to explain those loan numbers. Either, as I have been talking about here, the banks are sitting on the cash for fear of future losses. Or there is simply no demand for loans. Given the drastic decline in industrial capacity utilization we have seen through this recession, this latter cause is highly probable. Add them together and we arrive at a water tight defense of low interest rates.

Bernanke will have to opine regularly on the virtues of tighter money, but once he’s back at the Fed he’ll have to keep the money spigot wide open.

Our problems are not done yet.

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Federal Deficit – The Ugly News

Just a quick note. The Congressional Budget Office published their estimate of the Federal deficit for the fiscal year just ended. The details are sparse, but the news is ugly. Given what we know so far the deficit will come in at around $1.4 trillion for fiscal year 2009. That’s awful. It represents an astounding 9.9% of GDP which makes it the largest deficit, proportionately, since 1945. So in a year of records, most of them unwanted, we can chalk up another.

Both sides of the Federal ledger have been hammered – there was no single cause for the deficit. Except of course for the recession.

The CBO estimates that spending rose about 17.8% year on year. Three culprits can readily be identified: TARP, which contributed an increase of $154 billion; support for Freddie Mac and Fannie Mae, which added $91 billion; and the stimulus plan which has added over $100 billion so far in spending.

Revenues dropped drastically too: personal income tax receipts fell $230 billion, or 20.1%; while corporate income tax receipts fell $166 billion, or over 54%. Overall revenues were down about 16.6%, from $2.5 trillion to $2.1 trillion.

What do we make of this?

Well I think we shouldn’t panic.

These are indeed terrible numbers if they were sustained over a few years. They highlight the need longer term for policy changes to control spending and increase revenues. I have said it before: there are tax increases down the line. Having said that, we should not imagine that future deficits will be anything like last year’s. There are massive extenuating circumstances. As there should be in a recession. Tax revenues are very sensitive, obviously, to employment levels and profits. It is no surprise that receipts have shrunk dramatically. But they will naturally increase, also dramatically, as the recovery gathers momentum [if it does]. Similarly 2009’s spending is an aberration: we layered on a huge one time stimulus plan, and we have had to finance the bail out of the failure of our banks to manage themselves as adults. The budget was hit by a near ‘perfect storm’ of fiscal maladies. Add in the increase in the costs of government programs that are supposed to be natural ‘counter-cyclical’ measures – things such as unemployment assistance – and it is easy to understand why the deficit mushroomed the way it did.

Now is not the time for fiscal conservatism. Nothing could be more damaging to the economy than an attempt to get the budget back into balance. As I have siad here many times: the private sector has collapsed in our economy, without government spending we would almost certainly have fallen into the abyss of a fully fledged Depression. The cost of avoiding that dire result is the current deficit. The cost of going into the abyss would have been far, far greater.

Plus not all the deficit is attributable to the current crisis. We had opened up a structural deficit previously. Those failed Bush tax cuts knocked a hole in tax receipts, but the then Republican administration failed to cut spending. On the contrary it added hugely to spending. The failed Medicare legislation is a good case in point: by biasing that extension of care in favor of the health insurance and drug industries the Bush administration deliberately added several hundred billions of expenses to the program’s cost. This was after having cut revenues. It was an act of fiscal recklessness we had not seen since Reagan. Recall it was Reagan who set us on this path of fiscal imbalance: he also failed to rein in spending. It is an irony of epic proportions that the two worst offenders with respect to fiscal wantonness were the two most conservative presidents of the modern era. Long gone – or should be – is the notion that the Republican party is the party of sound fiscal management. Their efforts to destabilize the Federal government, what they called ‘starving the beast’ was always half hearted. they could easily sell the tax cut half. But they always lacked the political courage to sell the spending cut half. They refused to rein in defense spending, and they avoided coming clean on their desire to eliminate the entitlement programs that comprised a large part of the rest of the budget. They realized that Americans actually like those entitlements. So the GOP was reduced to a one dimensional and therefore dishonest and reckless manager of our national finances.

The echo of that dishonesty is still with us: are large part of the current deficit has nothing to do with the crisis, bail outs or the stimulus. It is the result of the Reagan/Bush ideological attack on government. That we have yet to clean up that mess is lost within the larger story. The failure of the entire GOP ideological enterprise – that free market mentality – has left future generations an expensive burden. Today’s CBO report merely outlines this year’s accounting of that failure.

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