Skeptonomics

Minus the amazement about the money multiplier, this proposal published in Yes! Magazine bears a superficial resemblance to mine.  The big difference, of course, is that Brown would have the good citizens assume responsibility for all the liabilities of the banking system she would seize.  This is why I have argued against bank nationalization and for new public institutions to take their place.  A minor note: Germany is a somewhat more substantial instance of public banking than North Dakota.  Not that I have anything against North Dakota.  In fact, we’re having their weather right now in the Pacific Northwest.

Time to shift frames on the auto bailout. The question lurking behind current thinking is “How can these companies make money again producing and selling cars?” This explains the obsession with labor costs, future product lines and the like. The short answer is probably, they can’t. Even if they do everything right from now on, a steadily shrinking car market is the logical implication of serious, grown-up carbon regulation. (I will post on that topic soon, focusing on the news from Europe.)

For an alternative, step back into history and consider the story of Lucas Aerospace, brilliantly chronicled by Hilary Wainwright and David Elliott in The Lucas Plan: A New Trade Unionism in the Making? Lucas made military aircraft and was facing devastating (but socially desirable) cuts in demand for their wares. Seeing the handwriting on the wall, production workers teamed up with engineers and conducted a detailed inventory of their firm’s capacity: what skills and resources they comprised. Then they canvassed a range of nonprofit organizations to find out what kinds of products served important social needs but were not being provided in the market, like improved prosthetic devices and equipment for upgrading railroad crossings. Putting two and two together, they proposed production plans to give the company a new lease on life. The final piece, however, never materialized. The social agencies needed the government to allocate funds for these new products, but the government didn’t come through, and Lucas eventually folded.

You can probably see where I’m going with this. Obama is proposing to spend hundreds of billions of dollars on public projects to restart the economy, and forward-thinking observers, like Jamie Galbraith, are pointing out that we need long-term restructuring, not just a quick burst of stimulus. Who will build the transit systems, smart two-way electrical grids and other components of a clean, green America? If the auto companies are liquidated, we lose a ton of capacity it will be difficult and expensive to replace.

Message to the Obama team: begin formulating the reconstruction plan as a set of receivables and be ready to energize producers from the outset, perhaps with contracts having a loan component.

Message to the UAW and progressive-minded professionals in the auto industry: don’t wait for your top management to shuck the business plans they’ve staked their careers on. Begin a Lucas-like process of discovering what you can produce, and convey this directly to the federal recovery folks.

So five accused planners of Sept. 11 want to confess, avoid a trial, and enter paradise via lethal injection. Their wishes should have no bearing on their cases. First, there is an alarming incidence of false confession, to the extent that, if guilt cannot be established by evidence, confession alone should not be decisive. One of the causes of false confession according to the Innocence Project, by the way, is torture and the threat of torture—not that this would have any relevance to Guantánamo inmates, of course. The second thing to consider is the larger significance of the legal case against these men. The damage done to America’s global reputation and to popular views about justice at home cannot be erased, but the first step toward recovery is a public embrace of the rule of law. If the evidence against them is sufficient, put them on trial. Demonstrate a commitment to truth and fairness of judgment. If they did in fact plot murder against innocent thousands, show the cruel calculation of their planning. And if the evidence isn’t there, the confessions don’t take its place.

Now that stimulus is just around the corner, we are hearing more discussion of what form it should take. There is a general desire to prop up state budgets, so that legislatures are not forced to cut spending on services in the middle of a slump—a good idea. There is also an interest in putting money into roads and bridges, usually referred to as our “crumbling infrastructure”—another good idea. Here I want to broach a third.

The ranks of the unemployed are increasing by as much as half a million a month. Even if we can stop the plunge, we are in for a long, slow season, and the need for structural change in the economy guarantees that large numbers of us are going to have a rough time getting our working lives back on track. The silver lining to this very dark cloud is that it gives us an opportunity to take time out, to go back to school to get new skills, perspectives and perhaps even life goals. Already applications are up at two- and four-year colleges around the country. Meanwhile, however, the credit crunch is making it hard for prospective students to find loans, funding cutbacks are driving rapid tuition increases, and higher education is being starved for the resources it needs to continue at the same level of service, much less the increased level needed to meet the demand.

So the solution is clear: the third big piece of the coming stimulus, overlapping somewhat with revenue sharing, should be a commitment to education—to turn the tragedy of unemployment into the promise of a new beginning. Our universities, community colleges and other institutions have a model that is intrinsically scalable; give them more money and very quickly they will be able to create more seats in more classrooms, with little or no reduction in quality. There is a vast body of economic research that shows that this is one of the most productive investments we can make as a society, one that will bring returns to us as individuals and as a country long after the immediate crisis has passed.

One nice twist to this idea is that it could be accompanied by introducing a new system of tuition financing that works on both the individual and macroeconomic levels. It goes like this: students take out loans from a government agency, but instead of paying back the precise amount they borrowed, they agree to a modest tax surcharge on their earning for several years after they graduate. If they end up with high-paying jobs, they pay back more into the student loan system. If they end up with lower-paying jobs, they pay less. The overall terms, the percent of the surcharge and the number of years, are set so that, over all the graduates combined, the money borrowed is equal to the money returned. This is a progressive approach that scales the financial contribution of those who benefit from college to their ability to pay, and it reduces the pressure on borrowers to take the most lucrative jobs rather than the ones that appeal to their interests and ideals. (More schoolteachers and fewer bond traders would be a small but positive benefit of this approach.) I don’t know who first came up with this idea, but I associate it with the late, great Ben Harrison.

From a macro point of view, instituting this reform at the same time fiscal deficits are being jacked up to pay for the immediate expansion of education sends a strong signal that those deficits are temporary. They will help pull us out of the slump, but over the longer term we are putting in place a mechanism to more fully finance tomorrow’s students. The US Treasury is currently able to borrow as much as it wants at a near-zero interest rate, but this will not last forever. At some point skepticism about the fate of the dollar will start to mount, and it will be necessary to demonstrate that fiscal policy is sustainable. Reforming tuition finance is not everything, but every $50 billion or so helps.

In the same survey of stimulus planning, the NY Times reported on the latest EU fiscal initiative, which calls for contributions of 1.2% GDP on the part of most member countries. This infusion, which is much too small relative to the impending output gap, will still bump up against the Maastricht criteria. What to do?

The monetary affairs commissioner, Joaquín Almunia, said that countries that breached the deficit ceiling of 3 percent of G.D.P. would face official reprimands, but would be given longer than usual to bring their budgets back into line because of the exceptional circumstances.

In other words: we know the criteria are absurd under the current conditions, but we will pretend that they still apply.

The EU has been built on a grand compromise, a broadly progressive stance in social and environmental policy and rigid orthodoxy in economic affairs. As in the academic version, the left got the sociology department and the right was given economics, finance and business. It was a bad deal, since misguided economics can do damage faster than the social workers can clean it up. So now Europe has a central bank with hardly any lender of last resort tools and fiscal guidelines that all but rule out serious countercyclical measures.

The current economic crisis should be put to positive political use. You can’t have a “Social Europe” with double-digit unemployment. (You also can’t have a sustainable Europe without getting the economic part of sustainability in place.) There needs to be a shift within the economic regime, and not just in the balance between “economic” and “social” interests. As for fiscal guidelines, they need to be flexible enough to permit rational economic management, and they also have to be responsive to regional trade imbalances. In fact, to constrain fiscal deficits without managing trade aggregates is to put all the recycling burden on private debt, and we are still in the process of finding out where that leads.

In its latest roundup of crisis management from around the world, the NY Times discusses Chinese monetary policy initiatives. Cutting reserve requirements for banks seems counterintuitive to me, but perhaps there are aspects of banking in China that justify it. What really jumped out, though, is this:

To give banks an extra incentive to lend money instead of hoarding reserves, the central bank also lowered by 0.27 percentage points the interest rates that it pays banks for reserves deposited with it.

That does make sense, and it is exactly the opposite of policy in the US, where the Fed has raised the interest it pays on these reserves. But, of course, we need $400 billion in excess reserves to finance the bailout program, so that losses from bad investments can be transferred to the public. This is so much more important than getting new finance out into a frozen economy.

So Larry Summers will return to government in a key role on Obama’s economic team. It is said that he has a new outlook, less enamored of markets, more concerned with the fate of the bottom 90%. Fine. I’m all for a second chance, or a fifth or twelfth for that matter. I just want to see a Greenspan moment, with Larry facing the cameras and saying “I was wrong. Not just about a few small things or for a short time. I was wrong about the main thing, the idea that markets can be relied on to regulate the economy in the public interest, and I remained wrong throughout my earlier career in government. I cannot undo all the mistakes I made, but by acknowledging them I hope I can convince you I have learned from that experience, and that I will approach the crucial decisions before us with an open, humble and non-doctrinaire mind.”

I feel petty, oh so petty.

Once upon a time, the left (or most of it) thought they had history all figured out: they could interpret day-to-day politics in light of the tectonic shifts in social formations, and they had an endpoint to aim at, a model of an alternative, noncapitalist economic system. For some, this became an excuse for amoralism, the notion that the glorious revolutionary ends justified actions that would be morally repugnant by any other yardstick. The intellectual reflections of this amoralism, the writings on this topic by Trotsky, Merleau-Ponty, Fanon and the rest, are now seen as little more than an embarrassment.

Today the problem is more likely to be the reverse. Lacking a convincing view of history or the potential transformation of the existing order—in other words, lacking the basis for a systematic strategy—activists on the left are at risk of embracing an extreme moralism. If we don’t know how to change society, at least we can separate ourselves ethically: we can be the good people in an evil world.

So much political debate today has the unspoken premise, “How can I protect myself from being guilty?” Not in my name, they say, although the horrors are no less when some other name is invoked. Actually, wanting to not be guilty is a fine emotion, but it should be a springboard to effective, strategic action, not a politics of personal virtue.

In the latest issue of The Nation, Bill Greider expresses what has become the mantra of the left at this moment of high fiscal drama: nationalize the banks. Rather than just injecting passive capital, we are told to take a decisive position in common (voting) stock, so we can change the management, put our foot down on compensation, and generally change the whole modus operandi. It sounds very radical, harking back to the days when socialists saw nationalization of the commanding heights of the economy as the first step toward nationalization of the minor peaks, foothills and ultimately just about anything above sea level.

But it’s a bad idea. If you want the banks, you can have them. After the hammering they’ve taken in the market the last few months, their combined capitalization is a tiny fraction of the Fed’s new, gunky portfolio. And there’s a reason: they’ve got a solvency gap of trillions of dollars. Buy a bank and its liabilities are now yours. If you happen to be the US government, your full faith and credit is on the line for every penny.

There is nothing radical, not to mention equitable or practical, about underwriting the vast quantities of dubious financial instruments that metastasized during the past decade. You want a publicly owned and managed bank to lend against the tide and finance reconstruction? Start a new one.

My restful sleep continues to be disturbed by Willem Buiter, who writes

I am in Slovenia today, talking to bankers, entrepreneurs, managers, politicians, government officials and academics. The story is the same here as in every country I have visited since mid-September 2008: the banks aren’t lending. They don’t lend to each other. They don’t lend to non-financial businesses and they don’t lend to households….The macroeconomic consequences of this lending paralysis are potentially disastrous. It could turn a global recession into a global depression, with many years of stagnation and cumulative declines of GDP of 10 percent or more.

His solution?

I propose the following form of forced lending by banks to non-financial businesses. Every loan that matures during the coming year gets extended/renewed for another year on the same terms as the maturing loan. This applies to both secured and unsecured loans. Likewise every credit line or overdraft facility that expires during the coming year gets extended/renewed for another year. Expiring loans, credit lines or overdraft facilities that had an original maturity of less than a year or more than a year will have the same interest rate for the one-year extension/renewal as the original arrangement.

Yes, force them to lend. This is a rather blunt instrument, I would say. It would roll over some loans that should absolutely not be renewed, and it would not direct financing to new, previously unfinanced projects. I think bankers won’t like it. They wouldn’t like my “Plan B”, creating a public competitive financial entity, either. So which one should it be?

Buiter’s approach has the advantage of using the existing institutions: the same personnel, the same chains of command, the same office layouts—nothing new that could create friction or delay at a time when we particularly don’t need it. My approach would be vastly less expensive for the public (and therefore more feasible in direct financial terms) and would be capable of making more rational distinctions at the micro level. But one way or the other, we have to shift the narrative quickly. What needs to be rescued are not the financial markets but the real economies, the incomes and employment, that are the substance of our standard of living.

The suggestion by Willem Buiter that Britain may already be on its way to a collapse of its currency and possible sovereign default has been making waves in the UK, but deserves attention here as well. First of all, the mechanism he describes is exactly the one I have been harping on for the US:

If there is doubt in the markets about whether the solvency gap of the banking system is smaller than the fiscal spare capacity of the government, we could have a UK public debt crisis. Fear of default would cause an across-the-board rush of out sterling assets. Fear that the authorities would choose to monetise the UK public debt and deficits rather than defaulting, would also cause a sharp decline in the value of sterling.

There are fiscal limits to what governments can do, and pledging to bail out all investors who have claims on the financial system is not the same as being able to actually carry out this pledge. Moreover, a run on sterling would not only signal the failure of the British bailout plan; it would set in motion currency shockwaves that would ricochet through the global economy. Money fleeing the pound would have to go somewhere else, but this somewhere would then find itself on a hair trigger, as fears of currency and default risk escalate. My reference period for the earlier Depression is not 1929, for which there were domestic solutions, but 1931-32, when a cascade of currency runs rendered national monetary policymakers helpless.

Having signed on to Buiter’s main point, I want to emphasize some divergences:

1. Britain’s risk is, like Iceland’s, a function of the size of its banking sector liabilities relative to the economic size of its currency area. It can crank up the denominator by joining the eurozone—if it can. The political impediments in this environment are simply too great, however. If Britain starts to melt, would the euro powers risk their own solvency to save it?

2. The US has a far larger GDP, but its numerator is also much larger, since the epicenter of the crisis was in US-generated assets, all of which matter because the Fed has committed itself to making good on all claims on US financial institutions, whatever their country of origin.

3. The dollar is a reserve currency as the pound is not. This gives the US much more breathing space, and the amount of claims needing to be satisfied would not be altered by a potential devaluation, since it’s all in dollars. What this means, though, is simply that the dollar can hold on longer than the pound; it doesn’t mean the dollar is invincible. It is ultimately subject to the same constraints laid out in Buiter’s analysis (and mine).

4. The British exposure is somewhat less than meets the eye. The City is the repository for an undisclosed but certainly very substantial pool of mideast petro-profits. Their placement is essentially a political, not a market-based choice. No doubt the failed occupation of Iraq has reduced the geopolitical subservience of the Gulf potentates, but it is hard to believe that they would simply withdraw their funds in a crisis. They remain vulnerable domestically—even more so as oil prices fall—and still depend on Anglo-Saxon guarantees of their continued rule.

5. Buiter’s solution, to move first on trimming the claims (haircuts) before assuming public liability for them, is entirely sensible, and roughly equivalent to the asset window I briefly described in my own proposal two months ago. The problem is that he gives no attention to the collapse of the real economy. In fact, he would exacerbate it by cutting back fiscal stimulus, which he sees as unaffordable. Here I think he misses perhaps the most important point: that a principle reason for reversing the bailout strategy is to have the resources to sustain employment and income. Moreover, the finance for renewed growth is essential, and if the strict austerity Buiter (rightly) seeks to impose on financial markets only dulls the private appetite for assuming new risk, a public financial entity must pick up the slack.

Here is the problem in a nutshell: our economic well-being depends crucially on the provision of finance for all sorts of useful purposes—to move goods, launch new enterprises, retool old ones, pay college tuition, buy things like houses and cars that would otherwise take decades of savings. Most of the financial system is privately owned and operated for profit. The profit paradigm of the past generation was based on a systematic bias toward risk, a bias built into all limited liability institutions but compounded by deregulation and hubris. Now the system is reeling under the weight of trillions of dollars in losses. This has led to a seizing up of credit supply and has turned a typical recession into a potential economic abyss.

In the spirit of London Banker, let’s keep our eye on the ball. The financial losses incurred by banks, hedge funds, insurance companies and those who invested in them are their problem. The breakdown of the financial system is our problem. The bailout solutions being pushed in the US and elsewhere are based on the premise that we have to solve their problem first in order to deal with our own. Throw enough money at the financial sector, turn their red ink to black, and some day they will be willing to lend to the rest of us.

How to begin with what’s wrong with this?

1. This is a program for a systematic looting of the public. The 90+% of us who never enjoyed the profit bonanza of the last 20 years are going to pay through the teeth so that the rich get to stay rich. This is perfectly clear in the case of AIG, for instance. We hear about a $150B “investment” of public funds into this company, as if the money were going to, oh, upgrade their computer networks. The word is dishonest: this very large sum, which could do a lot of good things if spent intelligently, is going right through AIG to those it sold credit default insurance (asset swaps) to. Institutions leveraged themselves to the max in order to rake in profits by investing in high-risk, high-return mortgage-backed securities, insuring themselves against default risk by buying CDO’s from a company (AIG) that never had the capacity or intent to actually follow through if defaults became widespread. Seen in its entirety, the process was a scam. Now extraordinary amounts of public money are being transferred to the jilted investors who bought this insurance. We will never see this money again. The value of our public “investment”—80% of AIG’s ultimate capitalization—will be a few percent of what we have paid in, if the firm even survives.

2. By solving the problem of the financial institutions first, the bailout is making our problem worse. It isn’t just a question of banks who get public cash infusions not lending enough, although this is important. Finance that ought to be supporting the real economy is being diverted to the bailout. This sentence is in italics so you will read it two or three times. It is very, very, very important. You can see this in the Fed’s decision to pay competitive interest rates to attract excess bank reserves, which now amount to more than $400B. This is money that, in normal times, would amplify itself through the money multiplier and find its way to borrowers in the real economy. Now it finances the Fed’s acquisition of troubled assets at far above their market value—in other words, bailouts of private investors. Similarly, the Treasury has been selling hundreds of billions of dollars in new issues to finance the bailout, and much of the money it is sopping up would otherwise be available for normal lending.

2a. The corollary is that the world economy is sinking fast and deep. This will mean great hardship, especially in less developed countries were the margin between prosperity and penury is all too thin. It also means that the epicenter of financial crisis will shift toward sectors now being decimated by the downturn, particularly consumer credit and corporate debt. (A side note: this is the real fear about GM. Honda and Toyota can make our cars as energy-efficient as technology allows, and they can do this in their US plants. If GM is allowed to go belly up, however, it could trigger a run on a wide range of corporate debt.) Hence the bailouts, by soaking up credit and bleeding the economy, are adding to the losses that they seek to defray.

3. The resources available for these bailouts are not endless. You wouldn’t know this by following the discussion in the media. Commentators do complain about how expensive it all is, but there is no sense that a limit exists, and that we are at risk of reaching it before the financial system is repaired. But this is exactly what makes people close to the situation very nervous. The rest of the world is buying vast amounts of treasuries. The Fed takes this money and hands it to investors facing losses, receiving in return paper assets that might have value, maybe, sometime well into the future. If those holding treasuries should change their mind, this process cannot be run in reverse. The Fed is in no position to sell its damaged portfolio in order to buy back even a fraction of the huge overhang in public debt. Monetization—settling claims by simply creating new bank reserves—is not an option, because it would almost certainly trigger a run on the dollar, a threat for which no institutional antidote currently exists. What this all means is that the bailout strategy puts us in a race: will we reach our financial limit before the losses that paralyze the system are erased? It is extraordinary to me that this question is not being asked in public.

If these arguments are correct, the bailout agenda needs to be challenged. We are following a course of action that is indefensible from a social justice perspective and at best extremely risky on its own terms. An alternative exists: rapidly putting into place a public system that can make available the finance needed by the real economy. This would mean allowing a large swath of existing wealth-holders to be ruined. Such an option would be unthinkable to those who inhabit the existing world of finance: for them, repairing the system means first of all restoring the profits of investors. There is also a bit of class interest at stake, I would guess. For these reasons, it would take a mighty movement to change the way governments are responding to the financial crisis. I don’t know where this will come from, but for starters it would be nice to see some real live public debate.

Bill McKibben reminds us that we can’t put climate change on hold until we think it’s economically convenient; the natural world has its own priorities, and we don’t get to vote. If you understand why putting a lid on carbon emissions is urgent, you know why it can’t be pushed back to the middle of the to-do list.

But there is another point to be made, crucially. In the end, there is only one resource constraint the government faces in its effort to contain the financial crisis and prevent recession from morphing into depression: the requirement that external deficits be financed. The Fed can wave its wand and create finance out of thin air—so long as this doesn’t lead to a panicked flight from the dollar. As it was in the beginning of the crisis, so it shall be in its long unfolding: dollars going out must find their way back in.

This constraint is invisible at the moment, because treasuries are seen as the safest asset in an unsafe world. In fact, money is flowing in at such a pace that the Fed has had to set up a network of currency swaps to make sure other central banks have enough dollars. But that sentiment will change at some point, perhaps suddenly, and when it does the feasibility of the current free-spending bailout will be in question.

There is no single solution to this problem (although I’ve argued in the past that bailing out the private sector’s old losses to generate new finance makes it worse). One significant step, however, is to push down the US oil import bill as far as it can go. A carbon cap along the lines Obama the candidate advocated last winter would be just the ticket. If we jack up the price of oil through a hard-nosed cap, imports will fall. And, as I also argued in an earlier post, households would benefit if the auction revenues were returned to them more or less in full. Rather than paying out to oil companies and petrostates and never seeing their money again, their payments would be captured by the auctions and handed back to them. Importance for the financial crisis: less oil imports mean a lower current account deficit, and therefore less reliance on external financing. It pushes the resource constraint out.

Sometimes I forget how much pure enjoyment one can get from the economics literature. Consider this:

“The Optimal Jury Size When Jury Deliberation Follows a Random Walk”

Public Choice, Vol. 134, No. 3-4, 2008
Robert Day School of Economics and Finance Research Paper No. 2008-3

ERIC HELLAND, Claremont McKenna College – Robert Day School of Economics and Finance, RAND
Email: ehelland@cmc.edu
YARON RAVIV, Claremont McKenna College – Robert Day School of Economics and Finance
Email: yraviv@cmc.edu

The existing literature does not agree on the optimal jury size. We demonstrate that the probability of type I and type II errors is not sensitive to the number of jurors under the following three conditions: jurors received independent signals about a defendant’s guilt during the evidence stage of the trial; the jurors truthfully reveal their signal before deliberations in the first ballot via their vote; and the jury deliberation can be modeled as a random walk. Since the opportunity cost of jury service is positive, this implies the optimal number of jurors is one.

And why do we need coauthors?

One of the best pieces of reporting to emerge from the bailout insanity is this gem from Joe Nocera of the New York Times. You must read it: doctor’s orders. It makes it crystal clear that Paulson has a plan for his friends in the financial world, but there is no plan for the economy. You can lead a bank to liquidity but you can’t make it loan. For his chutzpah in listening in on a conference call intended only for JP Morgan staff, Nocera deserves a Pulitzer, a Nobel or something.

My first thought on reading this exposé was that we just need to hang on for three more months, when the real cavalry will come to push aside this bunch of imposters. But then I realized that there is no guarantee that Rubin, Summers et al. will have the courage or freshness of vision to do what needs to be done. They too have been shouting “Capitalization, Capitalization”, which may rescue them but falls far short of rescuing us.

I reiterate: we need to put a public financial alternative on the table. Bailing out the financial institutions (a) may not succeed on its own terms and (b) does not deal with the fact that the real economy is plunging. A public entity can step up and provide the credit we need to avoid a suffocating slump, so we are not held hostage to the Jamie Dimons of this world.

And where is the left? They rail against the bailout and the evils of finance capital, but when it comes time for them to put forward a constructive, functional alternative they change the subject. As far as I can see, it comes down to this: either we bail out the existing institutions and somehow browbeat them into countercyclical lending behavior, which they will resist with all their fiber, or we let them go to their fate and put our marbles into a public institution that can do the job. The first is an ethical swamp, reeking of moral hazard, and may well fail. The second is the straightest, fairest, most reliable route to recovery. Please raise your voice for a public alternative. If the bailout fails to prevent a full-bore economic collapse, by the time we find out it will be too late.

The roster of fiction dealing with the innards of the financial system during a time of crisis is slim, but it includes Stead’s House of All Nations. Consider this assessment of the state of paper wealth: “If all the rich people in the world divided up their money among themselves there wouldn’t be enough to go around.”

Recently my Republican opponents have been trying to convince you that there is not one Barack Obama but two. There is the man standing in front of you, a candidate for president who has been speaking out on the major issues of this election, and then they say there is another Obama, mysterious, with a hidden past and secret motives. Their plan is to make you so worried about this mysterious Obama that you will not believe the one you see and hear.

My response is that there is in fact just one Barack Obama, and I’m him. Like most national political figures I have hardly any private life. You can go to my website and see who my advisors are on the economy and foreign policy. In fact, I would recommend this, since who a presidential candidate picks to advise him is a good indicator of what he’ll do in office. And my past is an open book. Actually, it’s a published book, one I wrote called Dreams from My Father. Read it, and find out how I got to where I am.

I will go further. Not only is there just one Barack Obama; there’s one Joe Biden, one John McCain and one Sarah Palin. Everything you need to know about all four of us is on the record. We have all taken our stands on the political issues you care about, and you can check out our performance in office to verify our deeds as well as our words. I encourage you to do this. This election gives us an opportunity to reverse the disastrous direction our country has taken in the last eight years, and it deserves all the careful consideration you can give it. But don’t expect any great mysteries to be revealed. We four candidates are exactly the people you see before you. What you see — and what you vote for — is what you will get.

If that doesn’t get your attention, what does it take? This is the forecast for the coming fiscal year by analysts for Deutsche Bank, cited by Menzie Chinn. OK, most of this will take the form of asset swaps, with the Fed/Treasuring absorbing gunky paper in return for its treasuries, but still. The analysts note that the bulk will be in short maturities, since this is what the market will swallow. Surely I must not be the only observer who thinks this means of financing the bailout and counteracting the incipient recession is extraordinarily fragile. It depends on a level of confidence that must remain high each hour, each day, each month. One reversal and we are all in big trouble.

I don’t think we should adopt policies that generate catastrophic risks when there are alternatives.

The analysis by Floyd Norris in the New York Times is so wrongheaded it is difficult to know where to begin. I could complain about his focus only on banks rather than the shadow banking system, or his conflation of liquidity and solvency threats, or his comparing apples and oranges in measurements of leverage across countries. But the most important error is his claim that the US, by virtue of issuing the world’s reserve currency, has unlimited resources to throw at its financial system:

As the banking system quaked this week in many countries, and various governments took steps to bail out their banks or at least guarantee deposits, one question was asked quietly: Can the governments afford it?

That is not a question for the United States, which can print dollars and has a banking system that is the largest in the world but is small in relation to the national economy.

The last part of that sentence is about the confusion between banks and financial intermediaries (how could a Times columnist make this mistake after all that has happened during the past year?), but it is the first half I want to discuss.

Something like a trillion dollars (give or most likely take a couple of hundred billion) has been spent thus far in the pursuit of a bailout. How is it being financed? Not with money creation. The Fed can, if it wishes, treat its purchase of troubled assets (and institutions) like ordinary open market operations, simply crediting the accounts of sellers held as Fed liabilities. Indeed, it has done some of that in recent weeks, as the following chart shows.

M1 and M2 growth, 3rd quarter 2008 (index, July 7 = 1.00)


Indeed, an expansion of over 10% in M1 within the space of two weeks might be considered extravagant, except that during this same period M2 was up only about a tenth of that. In other words, the Fed is largely offsetting the contractive effects of the credit crunch, slightly erring on the side of greater liquidity. In absolute terms, the Fed’s additional injection comes to about $150B. The remainder of its bailout finance comes from a variety of sources, but essential is the global demand for treasuries, which has jumped by over $2T on an annualized basis in the first two quarters of this year compared to pre-crisis levels. It is difficult to disentangle the official from the private flows, but the latter by all accounts has been dramatic, as the herd rushes to “quality”.

The constraint faced by the Fed is the willingness of wealth holders to continue to skew their portfolios so strongly toward dollars. In an earlier post (“reverse tsunami”), I simplified by assuming that rebalancing will occur only after the crisis is over. Actually, it is entirely possible that this rebalancing (aka “capital flight”) could occur at any time. If it happens it will be triggered by a change in perceptions, that the dollar is not the rock in a raging sea that it previously seemed to be. Some of the factors that could cause this are beyond the control of Bernanke’s crew (such as one or more high profile nonfinancial defaults), but the perception that the US intends to inflate its way out of the crisis would have a similar effect and is clearly related to the “print dollars” option that Norris takes for granted. In other words, open market-style purchases of bad assets is effectively limited by private sector credit contraction. The bad assets are a stock (size unknown) and the contraction a flow, hence no match can be assumed.

A closing word of paranoia: it is difficult to overstate the significance of the financing constraint on bailout strategies. The lesson here is not 1929, but 1931-32, when a series of national currency runs whiplashed the global system and prevented any individual country from taking effective action. A change in sentiment on the dollar, if it occurs, will be sudden, unexpected and massive. An outflow of funds would stop the Fed/Treasury strategy in its tracks and mark the end of any meaningful program to restore financial markets. No one knows what the tipping point could be, or even whether the most enlightened policy can avert it. (In that respect our financial imbroglio resembles the risk of catastrophic climate change.) But its shadow looms over the entire operation, and this is constraint that policy-makers should keep firmly in mind, assuming they are not as clueless about the existential risks we face as current journalistic coverage.

The current financial crisis is the result of very large declines in asset prices, whose epicenter is the housing market. We had a bubble, trillions of dollars in bets were made on the assumption it would continue, and it didn’t. The ultimate cost of a bailout (and therefore its feasibility given limited resources) is, at this point, determined by the volume of net asset deflation minus pre-existing equity of financial intermediaries (which, due to their extreme leverage, was minimal). So far so bad.

But it could get much worse. The world has almost certainly entered into a recession. The current decline in US consumer spending, the first since the sharp V-slump of the early 1990s, is a bad sign. As the downturn picks up speed, it will add to the quantity of distressed assets: new corporate paper gone bad, further declines in equities, even greater distress in housing. This could increase the amount of implicit writeoffs and expose even more counterparties to default risk. The price tag of a bailout would lurch further out of reach.

Consider, for instance, the effect of an announcement by General Motors that it is filing for bankruptcy. For some time the markets have told us this is a 50-50 possibility; with car sales plunging and the apparent desperation of GM management in its merger maneuvers, it has to be an even greater possibility today. This would be taken as a sign by almost everyone that a positive feedback loop from the real sector to the financial sector is beginning to take form, and the consequences would not be pretty.

Of course, no one knows what the future holds in store. We may yet waltz out of this with only a trillion or two in losses to show for our fears of impending doom. That looks like the best-case scenario. As for me, I’m worried about positive feedback and the risk that even the best-designed bailout (better than what is now on the table) will not be enough. This is why I think that what I originally called Plan B, and now stands as Plan C or D—public banking—ought to be given immediate consideration. Why should we pin all our hopes on a bailout that may fail to catch up with its moving target?