Skeptonomics

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?

This afternoon I co-led a forum on the financial crisis with my Evergreen colleague Peter Bohmer. I had a flash as I was preparing: at some future point we could be in for a reverse tsunami.

Here’s the idea: A real tsunami begins with an outward flow of water. If you’re standing on the beach and suddenly the water line retreats 10 or 20 meters, it’s time to race for higher ground. Now consider the opposite phenomenon. The massive Fed/Treasury spending spree to hold the crisis at bay, thus far unsuccessful, is being financed by a massive capital inflow. Some of this comes from foreign CB’s eager to do their part, but a big part is the result of global capital flight to the supposedly least risky currency. Suppose we get out of this alive and calm returns to the markets. Most of those people are going to want to bring their money back—that’s the reverse tsunami. How do we finance that? The Fed’s balance sheet will be wall-to-wall junk.

OK, just getting to that moment will be a big victory.

Paul Krugman has given us a first stab at a leverage-constrained intermediary-driven model of financial contagion. Its point is well-taken, but in my view it misses a very large piece.

I won’t reproduce the math (all basic algebra), but will make the argument verbally: Krugman’s model captures the effect that a falling asset price has on intermediaries’ portfolio capacity for this asset, assuming a fixed capital requirement: the price goes down, so holdings have to decline too in response to diminished equity. This assumes that the extent of leverage is externally imposed, for instance by a responsible regulator.

As we know, however, such regulators have been in short supply. Rather, desired leverage can be viewed as endogenous, a function of perceived risk. A falling asset price can therefore generate a potential double-whammy: for any given degree of leverage it reduces holdings, and it can also increase perceived risk exposure, reducing desired leverage still more.

If this is correct, one potential irony in renewed regulatory vigor (such as demanding more prudent policies on the part of institutions the government acquires an equity stake in) is that it intensifies deleveraging and puts further downward pressure on assets. Such an effect would not arise in interventions that touched a small corner of the global financial system, like Sweden’s in the early 90s, but it would have to be taken into account in the emerging global rescue. This would be an argument for public banking, as I’ve advocated here before, since such a system could be scaled up to whatever level of finance is deemed necessary, rather than relying on private sector willingness to lend and take positions.

On Oct. 3 I posted a piece that pointed out the similarities between my proposal for public banking and Andrew Feldstein’s. Not only was the general idea roughly the same, we both proposed the same figure for initial capitalization, $300B. Since my proposal appeared three days earlier, I harbored suspicions. I couldn’t find contact information for Feldstein, so I posted my doubts on the website of Joe Nocera, the New York Times columnist who was the source for AF’s proposal. After waiting for two days and not seeing any response, I went public about my suspicions here. I tried to make it clear that I had nothing to go on but coincidence, but in retrospect my writing could be interpreted as leaving a different impression.

What I’ve learned since: (1) Nocera and the Times are justifiably concerned about apparent accusations of plagiarism against one of their quoted sources. (I was contacted today.) (2) Feldstein privately communicated his proposal to Nocera on the same day I posted mine three minutes earlier. Talk about an idea being in the air!

So to set the record straight: the similarity and simultaneity of Andrew Feldstein’s suggestion and mine are entirely and remarkably coincidental. Whatever the truth content of my philosophical musings on the difference between academic and commercial conceptions of intellectual property, they do not apply in any way to this particular episode. And if Feldstein’s investment strategies are as farsighted as his policy proposals, you might want to take a look at his hedge fund.

So now the Fed will directly purchase unsecured commercial paper, something a “real” financial institution does as a matter of course (except during a panic). Because even its resources are limited, it is acting on the liability side of the ledger as well, for the first time offering to pay interest on the deposits of commercial banks. (This also encourages banks to be less than fully lent, offsetting the credit creation implications of the Fed’s buying binge.)

If you put these two items together, you have the beginning of what I called Plan B in my earlier post on the subject. There is no need to bail out the private sector: it is possible to create a publicly owned and operated financial entity to carry on the normal tasks of issuing credit, pooling risk and supporting long-term investment. To go further down this road, the Fed would (a) expand the range of assets it would consider buying, and (b) offer competitive returns on deposits and shares of investment funds. Of course, it would be much better for this operation to be spun off to a new entity to avoid conflicts of interest and operational overload.

The overall situation is still in flux, and in particular it is not clear whether it will be possible to unfreeze private financial channels. It may be that, not only is public banking the best strategy—it may be the only one.

While attention was elsewhere, congress voted to give lend GM, Ford and Chrysler a $25B bailout all their own. I can remember a time not so long ago when that would have been considered real money. Critics protest: why should we prop up Detroit? What about Toyota and Honda, for instance: they produce in this country too, no?

But this misses the point. Toyota and Honda don’t need the money; they’ve been designing and building fuel-efficient vehicles for years. We should reward the Big 3 for binging on SUV’s and starving their research engineers.

It’s official: Henry Paulson is now authorized to begin shelling out the first tranche in his $700B plan to refloat financial markets. Don’t pull your money out from under your mattress just yet, however.

1. This is just a beginning. The writedowns in the mortgage market are estimated at $2 trillion and the bubble is still unwinding. The losses in derivative assets will be greater still. The bailout buys time but it does not constitute a solution.

2. The problem of pricing assets will be enormous. There is a technical problem, of course, in determining the price of something that no one currently bids for, but a deeper issue lurks. The plan was sold on the basis of highly ambiguous wording. It was stated for public consumption that the only problem is liquidity, and that the Fed/Treasury can solve it by offering to buy assets at their hold-to-maturity value. Everyone knows, however, that the real problem is solvency, and that the unspoken intention is to overpay in order to slip cash to players who might otherwise go under. No doubt it is possible to do this quietly, a few billion at a time, like the US military does in Iraq, but this is not big enough or fast enough to rescue the markets. There will need to be big, big overpayments, and in their search for congressional votes the plan’s backers couldn’t hope to ask for such a mandate. This means that everyone connected with the operation will be looking over their shoulders, worrying that, if they follow the unstated intent of the law, they will be held personally accountable.

But look on the bright side: mental illness will now be covered under more private health insurance plans (for those dwindling few that have them), and small timber-dependent communities out here in the Pacific northwest will be able to keep their schools open. So the bill will have some successes to crow about.

This is the title of piece of mine just published in the Post-Autistic Economics Review. I happen to be a fan of science (I’m so pre-postmodern) and would like economics to move in that direction. Let me know what you think.

As loyal readers of EconoSpeak know, on Sept. 24 I posted a relatively substantial proposal that I headlined “Plan B: How to Restore Financial Markets Without a Bailout”. Three days later, I was surprised to see almost the same plan referred to in a New York Times column, but attached to the name of Andrew Feldstein, the director of a hedge fund. What struck me is that, not only were the two key general ideas—the public financial intermediary, the window to acquire distressed assets at market prices—the same, even the initial capitalization was pegged at an identical $300B. (Some of the details revealed in a followup Times blog were different and, honestly, not as good.) In my line of work, this is a prima facie case of plagiarism.

What this probably represents, however, is a difference in culture. In the academic world that I inhabit, there is a strong expectation that all borrowed words or ideas will be attributed to their source. Failure to do this constitutes an intellectual scandal; on the positive side, we try to impress our peers with a bottomless pile of citations. (This is called “scholarship”.)

The business world is different. There the rule is, if it ain’t nailed down you can take it. Having a bright idea and getting mentioned in the Times is worth real money. I can imagine that Feldstein’s fund may get an extra investor or two (or dissuade an existing investor from fleeing) by the halo effect of this publicity. I was dumb enough not to copyright my idea, so what do I expect?

Actually, while I like to have my ego stroked every now and then, and while I would come down hard on any student who submitted a paper that plagiarized, I don’t really care about attribution in this case. I would like this idea to be given a fair hearing, and someone with a hedge fund is likely to have a wider audience than me. In fact, I rather like the notion that an obscure economist can release an idea on some little corner of the web, it can bounce around for a while, and then reappear dressed up in real money.