Paul Krugman: It's a Miserable Life

Paul Krugman on "new-fashioned bank runs":

It’s a Miserable Life, by Paul Krugman, Commentary, NY Times: Last week the scene at branches of Countrywide Bank, with crowds of agitated depositors trying to withdraw their money, looked a bit like the bank run in the classic holiday movie “It’s a Wonderful Life.” ...

But bank deposits up to $100,000 are protected by the Federal Deposit Insurance Corporation. Old-fashioned bank runs just don’t make sense these days.

New-fashioned bank runs, on the other hand, do make sense — and they’re at the heart of the current financial crisis. ...

Traditional banks ... lend out most of the money depositors place in their care, keeping only a fraction in cash. ... Banks get in trouble ... when some event, like a rumor that major loans have gone bad, leads many depositors to demand their money at the same time.

The scary thing about bank runs is that doubts about a bank’s soundness can be a self-fulfilling prophecy: a bank that should be safely in the black can nonetheless fail if it’s forced to sell assets in a hurry. And bank failures can have devastating economic effects. ...

That’s why bank deposits are now protected by a combination of guarantees and regulation. ... But these ... apply only to traditional banks. Meanwhile, a growing number of unregulated bank-like institutions have become vulnerable to the 21st-century version of bank runs.

Consider the case of KKR Financial Holdings..., a powerhouse Wall Street operator. KKR Financial raises money by issuing asset-backed commercial paper ... used by large investors to temporarily park funds — and invests most of this money in longer-term assets. So the company is acting as a kind of bank, one that offers a higher interest rate than ordinary banks...

It sounds like a great deal — except that last week KKR Financial announced that it was seeking to delay $5 billion in repayments. That’s the equivalent of a bank closing its doors because it’s running out of cash.

The problems ... are part of a broader picture in which many investors, spooked by the problems in the mortgage market, have been pulling their money out of institutions that use short-term borrowing to finance long-term investments. These institutions aren’t called banks, but in economic terms what’s been happening amounts to a burgeoning banking panic.

On Friday, the Federal Reserve tried to quell this panic by announcing a surprise cut in the discount rate, the rate at which it lends money to banks. It remains to be seen whether the move will do the trick.

The problem, as many observers have noticed, is that the Fed’s move is largely symbolic. It makes more funds available to ... old-fashioned banks — but old-fashioned banks aren’t where the crisis is centered. And the Fed doesn’t have any clear way to deal with bank runs on institutions that aren’t called banks.

Now, sometimes symbolic gestures are enough. The Fed’s surprise quarter-point interest rate cut ... at the height of the crisis caused by the implosion of the hedge fund Long-Term Capital Management, was similarly a case of providing money where it wasn’t needed. Yet it helped restore calm to the markets, by conveying the sense that policy makers were on top of the situation.

Friday’s cut might do the same thing. But if it doesn’t, it’s not clear what comes next.

Whatever happens now, it’s hard to avoid the sense that the growing complexity of our financial system is making it increasingly prone to crises — crises that are beyond the ability of traditional policies to handle. Maybe we’ll make it through this crisis unscathed. But what about the next one, or the one after that?

_________________________
Previous (8/17) column: Paul Krugman: Workouts, Not Bailout
Next (8/24) column: Paul Krugman: Seeking Willie Horton

Comments

[Firozali A.Mulla MBA PhD]

Sir
I have the book by Joseph E. Stiglitz “Making Globalization Work"
The same author has written two books The Roaring Nineties and Globalization and Its Discontent.
How is this possible that in the book “Making Globalization Work" the reviewers have commended the book on the back cove about the other book. I.E "Globalization and Its Discontent".
Is he forcing himself to state that we cannot do this but then on the second thought from the Thomas Friedman’s The World is Flat he is trying the trip of the Indian contraries and tell us, “ Look fellows. We can do it. I do not know how, but we can if we try. I mean the books contradict one another.
The Roaring Nineties is fine but the other doesn’t make any sense except trying a think tank fro the readers. He has no put anything new in this book.
Russia restores Soviet-era strategic bomber patrols - Putin -2
Put simply we are back to the era of John F. Kennedy. We are back to the “Who has more arms”. Simple. The one who has more rules the world. And we talk of democracy and helping the poor. That is a big laugh. You cannot help poor when you want arms race on. You have one coin you spend on arms or poor. Putin is protecting his area as USA tries to put the nuke in EU.
I am surprised at the EU’s comments. There are no comments by the EU at all. The Poland or any country within the vicinity will have the nuke pointed at the Putin’s land. So what does Putin do? He arms himself. This is pure logic.
Why does The Bank of Tanzania want deposits from the commercial banks? Is there a shortage of cash in the BOT?
Then the minister of Finance states that all the goods, commodities tagged in US dollars ought to be removed and the local currency marked.
Would that help BOT.?
I doubt. The price tag change is not just getting the local currency in dollars any way as the quote will be in Tanzania Shillings multiplied by the rate of the day of the dollar that is set by the Bank Of Tanzania. That too is arbitrary as no one knows how this is done? In fact I gave a speech on how banks create money and the role of the Bank Of Tanzania, there two staff from the Bank of Tanzania who had no knowledge at all of the creating money, the real economical term is when you put 50,000 in the head office and if the head office transfers20, 000 to the Brach the Bank has 70,000. That is 50,000 in the head office and 20 000 in the Brach. This does not get into many heads. This is called creating money.

Are we dealing with honest people here? I doubt.

I thank you.
Firozali A.Mulla MBA PhD
P.O.Box 6044
Dar-Es-Salaam
Tanzania
East Africa

[Robinia]

Indeed, PK, "it's not clear what comes next." That, whether the Bernanke move works over the weekend, until the end of the month, or for another decade until another Long Term Capital Management type situation comes along.

We've scaled up a system of passing the buck-- sending the risk along to the next guy-- until we have sliced and diced the risk so small that a film of it covers everything, like the bathtub ring in the Dr. Seuss book "The Cat in the Hat Comes Back." Time to pull something entirely different out of that hat, like a small idea with huge transformative power.

What will the future value? The work of analysts who could puzzle their way to genuine progress toward economic system advancement, a Keynes or three for our time. Crisis management is a necessity, but insufficient. Economic system innovation is badly needed, as our technological advancement has outstripped our primitive, emotional system of property holding and exchange, threatening the future in very tangible ways. It is absolutely impossible to have blind faith in an invisible hand, when it feels like an invisible foot kicking you in the butt. Time to move beyond Adam Smith.

As my husband tells me "There's a great weight on your shoulders-- and it's your head." Put on your thinking caps, boys and girls, PK. Posterity calls.

[bakho]

These "new" financial institutions exist to avoid the very regulations that have been used to prevent the "problems" they are now experiencing.

The money and assets don't just "evaporate". However, many people who have been making returns of 15-20% "on paper" really have not because that rate of return is unsustainable.

[Alex Tolley]

But bank deposits up to $100,000 are protected by the Federal Deposit Insurance Corporation. Old-fashioned bank runs just don’t make sense these days.

Deposits yes, but investments not necessarily. In the 90s I recall being asked by my bank if I would like to move my money from deposit to a non-FDIC covered short-term investment. I think the same was happening in S&Ls - removing deposits from FSLIC coverage. Given the innovation in retail banking, I wonder just how much of the deposits turn out to be uninsured on reality.

[op]

firozali mon amour

[op]

award for
re-circling the cavity

robina noting
we need

" a small idea with huge transformative power "

[Winslow R.]

Krugman must be in the 'building consensus' phase through education.

The political process of leading people to start thinking there 'might' be a problem with the financial system is excruciatingly slow.

Go at it Krugman, you political animal, I know you have a solution to propose in there somewhere.

My guess we will never hear it unless a 'real' bank fails.

[richard]

I think others have made the comparison between derivatives and other financial services products and sausage making, but I think the analogy could again be repeated.

Like the meatpacking industry, it is efficient: nothing in processing meat (bones, hides, non-meat products) is wasted, and there is a market for everything. Similarly, the financial services industry saw bonds could logically be sliced into products with differing risk characteristics, and each had a market ready to purchase them.

The issue with both is what falls through the cracks. In the meat packing industry, sometimes there are health and safety issues as a redefined meat product is exchanged from vendor to vendor. So too for financial services, and there is the same moral hazard that the safety issues conveniently fall between one vendor and another.

[op]

problem

hi fi spec
can become a society wide
" threat game "

where scare stories about the game gone mad
lead to socialization of risks
while
the game's rewards remain privatized

[save_the-rustbelt]

Investors in hedge funds and private equity were assumed to be sophisticated investors who did not require government regulation or government bailouts.

No one anticipated that millions of home owners would get dragged into the unregulated markets.

Oops.

Now how do we get clean up the mess and who pays the bill?

And methinks the subprime market was full of fraud, who goes to jail, who gets sued, and again, who pays the bill?

[op]

richard its not just the wide spread risk

its the leverage gambles
by the big closed hand holding
hedgery

holding what??
in this case x dollars of shit
ie
over valuaed
MBSs
that like a re animated
jumping bean
have an awakened risk factor inside

[op]

the second fact
needs to be kept firmly seperate

the house lots of america
are now teetering atop
what is fast looking to be
a serious valuation mirage
held up by tinker belle dreams

the meme here is simple

put in place

" mirage is real confirming"
fed cash

the two bail outs are nicely cabled together
by the media

pk and his noble ilk

are screaming quietly

save the lot owners
let the hedgery explode

uncle ben however
wants the hi fi institutions
to mediate his
tinkering at the edges

tinkering

as millions of households totter on the brink

of course
looking at this as a former medium scale
employer

big nuts
make those with small balls
work harder in job land

[William Smith]

Let me through this one out.
If the problem is decreasing capital in the market where interest rate cuts are ineffective in a way similar to a liquidity trap, would change Reserve Requirements be a GOOD choice? I can see that they would help banks inject more money overnight into capital markets, but they would make banks more vulnerable to runs themselves and the money would go into investments that might be taking a dive anyway.
So, the question is whether changing traditional bank reserve requirement is a "Good" strategy at this point?

[Robinia]

Winslow R., Op-- am not just pointing to what new idea is not there yet to clean up the mess, but, rather, as Winslow points out, trying to work w/Krugman to build consensus, educate (and challenge) that one is indeed needed.

All big ideas start small; some even originate with people who are not big. Think.

[donna]

No, the problem in the financial industry is people were sold entrails and were told it was steak.

[op]

bob reich has a fair run down on
how in the future
we oughta
reg this whole boom bam

goes to show

its a lot easier to prevent
this type of shit slide
then to comprehend it
let alone fix one
deep in progress

[op]

mr smith

i like your brain waves

but again we run u against the politese of the system

gentle ben
working thru the banks
to get a result uncle could get directly n more surely and socially more cheaply

like single payer health

single prime residence capped mortgage holder

[anne]

Through the years, Republicans have fought to weaken or end the government support for Fannie Mae and Freddie Mac which allows the companies to offer reduced cost mortgages. Fannie Mae has especially been active in expanding mortgages to relatively lower income households and supporting the ability to pay the mortgages. Limiting Fannie Mae, leaves lower income individuals turning to commercial sub-prime lenders whose object is to bundle mortgages and create an impossible distance from the homeowner in a time of difficult.

Fannie Mae just offered to buy sub-prime mortgages with the object of relieving the difficulties of financially troubled home owners. Immediately Fannie Mae's proposal was administratively rejected.

[anne]

As I noted on the previous Paul Krugman thread, and as Max Sawicky notes today, * the Administration actually reduced housing vouchers in the wake of the hurricane disaster along the Gulf Coast. Now we have an immediate turning away from Fannie Mae and Freddie Mac helping home owners having difficulty with mortgages. Why am I not surprised.

* http://maxspeak.org/mt/archives/003250.html#more

[anne]

http://maxspeak.org/mt/archives/003250.html

August 20, 2007

THE POVERTY OF BUSHOSOPHY
By Max Zawicky

In the wake of Katrina, the Administration disdained the expansion of housing vouchers, a device they ordinarily extoll as a replacement for more direct provision of public benefits, because they did not want to feed a public program. So people were stuck in costly motels or crappy, health jeopardizing temporary housing.

The Administration is currently watching imperiled mortgage holders twist in the wind, rather than offer remedies. A potential expanded role for the government-sponsored enterprises Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation are rejected out of hand....

[This is Republicanism....]

[James Killus]

A while back there was a posting here on Moral Views of Market Society. There were 7 comments, with the major point being that economics-as-a-science has no business producing a moral philosophy, and trying to use it for that purpose undermines the economic analysis, devalues economics as a science, and tends to result in bad policy decisions. I hope that I am doing no injustice to those commenting on that thread (and it was fewer than 7 people as 4 of those comments were me and wjd123).

It is enlightening to then take a look at the recent posts on the present financial crisis. There are scores (possibly hundreds) of comments. Try going over those comments and find any that aren't making moral judgments of one sort or another (mine included).

Certainly it is true that there is probably some criminal activity in the mortgage industry, and some poor judgment, even disregarding 20/20 hindsight. So some moralizing is probably inevitable.

But the Fed, for example, is not really a criminal justice agency. Should "punishment of the wicked" be part of its mission? Or is this just another handy place to vent? Inquiring minds want to know.

[op]

"moral judgments"

are class judgements moral judgements

i have an open class point of view

once that stand is taken
science steps in

whats best for the bottom two thirds of jobsters

is that morality or amorality ???

[Nate]

"Does government have any business bailing out anyone who made irrational decisions because of their ignorance?"

A moral question or economic question?

[James Killus]

op,
The usual weasel wording is that science is "amoral," and can be used for good or ill, depending upon the user.

In actual fact, knowledge (e.g. science) informs moral judgements, as matters of fact in legal action inform the verdict. And in the same fashion that lawyers try to limit the facts that are entered as evidence, so do people try to manipulate facts to bolster a moral case (just as they try to manipulate a moral argument to favor their own interests). There is also the fact that one's factual view of the world tends to affect ones moral judgments; generosity is easier when there is no famine afoot.

My question about this particular financial crisis is general. We are seeing the result of a number of practices that attempted to deal with financial "risk." Is taking a risk automatically "poor judgment?" That seems harsh. How about shifting risk from oneself to others, or taking a personal risk that also affects others? Now the morass deepens, as each of us does this every day, to varying extents. How about if the original risk is unknown and the degree of avoidance, intensification, and transfer is also unknown?

Alternately, how much of the current matter is simply a "Now I've got you, you SOB," which is to say, a demand for punishment greater than the crime, because one is attempting to make up for past frustrations?

I don't know the answers to these questions, but I do know that I'm more comfortable with meting out punishments when the tool being used isn't the banking system. Sometimes it is the ruler that breaks and not the knuckles, and burning down buildings is not an effective way of punishing rats.

[James Killus]

Nate,

I'm unable to find an antecedent to your quote, "Does government have any business bailing out anyone who made irrational decisions because of their ignorance?" It seems like an ill-posed question in any case. No one ever has complete knowledge, so ignorance always exists. "Irrational" is usually taken to mean making a bad decision when one has knowledge that a "rational" person would use to make a different decision.

Willful ignorance is another matter, of course, as is the case when someone is ignorant due to being misled.

[op]

not to play anne's noble role

but one of my favorite mad science bloggers
m chinn
has this triumph
sampled from A&R :

"Let me say that while I allow that there might have been a rational stochastic bubble in the housing market...
...a paper by George Akerlof and Paul Roemer in the Brookings Papers in Economic Activity 1993(2),

"Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society's expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incetive to pay themselves more than their firms are worth and then default on their debt obligations.

Bankruptcy for profit occurs most commonly when a government guarantees a firm's debt obligations. The most obvious such guarantee is deposit insurance, but governments also implictily or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. These arrangements can create a web of companies that operate under soft budget constraints. To enforce discipline and to limit opportunism by shareholders, governments make continued access to the guarantees contingent on meeting specific targets for an accounting measure of net worth. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values.

...

Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government gurarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters' current extractions with no regard for future losses...."

[Alex Grey]

Lombard Street Research in today's Financial times (Alphaville):

"However, if the fallout from the current financial market turmoil has begun to hit US banks’ profits and importantly capital, it would not matter how much reserve money the central bank will be providing. Lower policy rates are unlikely to prevent a severe credit crunch, the slumping of broad money growth and the downswing of the already fragile real economy. At present it is difficult to assess the extent to which the banks are exposed in terms of their capital. They have exposure to the CDOs, the defaulting mortgages themselves, the special purpose vehicles that were created for the securitisation of debt and the hedge funds that funded holdings of the “toxic waste” with debt. But considering that
this credit crunch comes at a time when the global economy is stretched to the limit by large financial imbalances, the danger to the health of the US banking sector and its economy is pertinent."

[reason]

The Producers anyone?

My idea the other day was that the main lenders could end up winning by deliberately setting up subprime lenders knowing they would go broke. The housing prices would be bid up, mortgages would be extended (equity extraction) and eventually interest rates would rise. So long as the subprime lenders were limited liability, had moderate capital and were selling the mortgages to other suckers who cares if they go bankrupt.

[billy]

But the Fed, for example, is not really a criminal justice agency. Should "punishment of the wicked" be part of its mission? Or is this just another handy place to vent? Inquiring minds want to know.

Punishment of the wicked? There are many who would argue so, but this is not about punishing the wicked.

The two moralistic arguments being made today are

(1)help for the needy
(2)Punishment for the wicked.

(1) This is merely a cover. The needy are much better off with a cleaner bankruptcy and recovery mechanism.

(2)Punishment of the wicked is demanded by many. The counter-argument, that punishment of the wicked is not a viable operating principle is just another side of the same coin. Both sides ignore the fact that the subject being argued - the punishment - is a side-effect.

If a sane policy requires X, and X results in the punishment of the wicked, you cannot argue that X is wrong because X is a "punishment of the wicked" policy. And that goes even if there are people advocating X because they want to see "punishment of the wicked".

The facts are simple.
-Housing prices are totally disconnected from income.
-This has resulted in a bizzarre situation where people are sitting on huge paper gains, totally out of proportion to anything they could've earned.
-People who have huge paper gains don't want it to disappear.

This is an untenable situation. Everyone cannot cash out this paper gain.

The flippers and serial refinancers who have to be punished and the needy and the hedgies who have to be helped (as claimed by each side) are mere bit players in this drama. This is mostly about the vast middle and their illusionary equity.

One need not make any moralistic judgment, about bailing out lenders, helping the needful, punishing the reckless, and still make the case that housing prices have to come down to reality.

Quite the opposite - it is to keep prices high, or to cushion the fall, that one has to make moralistic judgments.

[kthomas]

billy, good post.

[robertdfeinman]

Wasn't one of Krugman's points that it isn't the regulated banks that are in trouble, but the unregulated hedge funds and brokerage firms?

So implying that FDIC insurance led to bad behavior doesn't seem to follow. In addition to providing insurance FDIC is also suppose to supervise (along with other agencies) how the insured banks do business. So blaming the government in this case is incorrect.

On the other hand bailing out the hedge funds is another issue. The US has a long history of helping out firms that engaged in risky behavior. Doesn't anyone remember Chrysler? Before that we used to send in the marines to preserve the assets of United Fruit.

So what's different this time?

[evagrius]

I'm curious as to what effect all this will have on the informal banks that exist for home mortgages.
What I mean is that a substantial number of people have obtained loans through "family" banks. Those people are usually Chinese.
The Chinese immigrants in the U.S. often buy homes through family/clan "banks".

[prostratedragon]

How times change:

The man, thinking his nightmare surely must be over, reaches into his pocket, searching for ZuZu's petals. Instead he finds the broken strands of Carlota Valdes's necklace ...

The next iteration, anyone?

[James Killus]

The two moralistic arguments being made today are

(1)help for the needy
(2)Punishment for the wicked.

(1) This is merely a cover. The needy are much better off with a cleaner bankruptcy and recovery mechanism.

(2)Punishment of the wicked is demanded by many. The counter-argument, that punishment of the wicked is not a viable operating principle is just another side of the same coin. Both sides ignore the fact that the subject being argued - the punishment - is a side-effect.

I think those might be moral arguments rather than moralistic ones.

"The needy" might be better off with better bankruptcy laws, but that is not within the Fed's powers. I'm not sure of the "needy" label, anyway. Perhaps there were some destitute people getting NINJA loans, but most of them were in the cash-strapped lower middle class. "No Income" probably meant that they were laid off in the tech crash, or the manufacturing bust, or whatever, and looking for alternatives to working retail.

But I absolutely agree that a large part of this is people not wanting paper profits to disappear, and a desire to prop up house prices. People have been taught for years that their homes are an "investment" (as opposed to a way to avoid getting wet in the rain). It's hard to kill two birds with one stone. A few years of flat housing prices might concentrate the attention on the lowlier fowl rather than the golden geese.

Nevertheless, it's extraordinarily difficult to navigate a sane monetary policy in the face of deranged fiscal policy, and that case should be made more often.

[Winslow R.]

I'm not sure where James is headed as our country has no universal moral code. I see morals as a form and function of a particular section of society. I'm sure the 'banking society' finds their moral code intact as long as no real bank fails. Both Bernanke and Greespan repeat this with glee.

Perhaps they see nothing morally wrong with a special society built upon a government subsidy.

The Fed will do its best (tinker at the margins) to keep any large 'real' bank from failing while allowing unreal banks and citizens to fall like flies until inflation is under control.

Where the rubber hits the road will be the time, if ever reached, when a large bank is going under, yet inflation remains elevated. It may never become public which bank would have failed as the bailout will be on a nonbank entity such as LTCM. At that point the Fed will be tested as all their rhetoric they've espoused over the years will either stand strong or bend to the banker's will as they have repeatedly in the past.

op wrote: "Bankruptcy for profit occurs most commonly when a government guarantees a firm's debt obligations.

Great passage! With international banking the playing field is that much larger.

reason wrote:"My idea the other day was that the main lenders could end up winning by deliberately setting up subprime lenders knowing they would go broke."

The goofy part is the ownership remains so convoluted and twisted that responsibility remains hidden even after the fallout unless you have a nobel price as in LTCM, like those were the only guys responsible.

[Bruce Wilder]

rdf: "Wasn't one of Krugman's points that it isn't the regulated banks that are in trouble, but the unregulated hedge funds and brokerage firms?"

bakho: "These 'new' financial institutions exist to avoid the very regulations that have been used to prevent the 'problems' they are now experiencing."

The bank and securities regulation scheme instituted as part of the New Deal, which included the FDIC, was effectively repealed over the course of the 1980's and 1990's, and replaced by "financial innovation".

The FDIC is kind of pointless at this point; banks as they now exist face almost no risk. The rate of bank failure in the U.S. is indistinguishable from zero. All of that risk, previously borne by banks, went out into the financial markets. The FDIC's insurance function was replaced by the Hedge Funds.

The analogy to a bank run distracts from the real issue, here. A better analogy could be built around imagining the banks mostly doing fine, when the FDIC, itself, suddenly failed.

People, who were previously relaxed about their bank deposits, would look at their bank with a newly jaundiced eye.

Our actual banks have enjoyed their highly profitable, relaxed and risk-free life over the last ten years of financial innovation. I'd say many of them are nervous that all of that risk that they exported to the financial markets might come rushing back at them. Ditto for lots of pension funds and other institutions, whose expectations of risk were decreased by their investments in their own, private FDIC-like hedge funds. All of a sudden their insurance is gone with the wind, risks are higher.

[James Killus]

Winslow R,
I do not believe in a universal moral code either. Still, I'm confused by your comment:

Perhaps they see nothing morally wrong with a special society built upon a government subsidy.

Do you see something wrong with a special society built upon a government subsidy? Doesn't that describe, for example, the military? The judicial system? TVA? Fire departments? Surely there is something there that you find worth keeping.

[Winslow R.]

James wrote: "Surely there is something there that you find worth Do you see something wrong with a special society built upon a government subsidy? Doesn't that describe, for example, the military? The judicial system? TVA? Fire departments? Surely there is something there that you find worth keeping."

Good question, but Banks don't claim to be part of the government sector. Any of the institutions you mention making profits? Look at the government barriers to entry starting a bank vs. any other private enterprise. Yes they provide a service that takes almost no effort yet everyone needs.

[Stephen Heyer]

billy: "-This has resulted in a bizzarre situation where people are sitting on huge paper gains, totally out of proportion to anything they could've earned.

"-People who have huge paper gains don't want it to disappear...

"... This is mostly about the vast middle and their illusionary equity."

Everyone is frantically trying to ignore the line of elephants in pink tutus and g-strings dancing the Can Can through the living room and this is probably the lead dancer... err... elephant. You know, the one all the good, moral, concerned citizens are trying the hardest not to see.

After all, it wouldn't do to have to admit that the very thing poisoning the economy, nation and next generation was all your capital gains, all that wealth that sort of appeared out of nowhere just because you bought a McMansion at the right time. Oh! And of course your politicians at all levels followed policies that caused housing prices to rise, policies they new would course you to reelect them.

Besides which, they had their own investment properties.

Great post billy.

[op]

winslow

the line "Bankruptcy for profit occurs most commonly when a government guarantees a firm's debt obligations "
is great
but the baby is in that bath water too

ie
the social network
of interconnected "bottom lines"
requires upper layers that impose
on all benefiting principles
risk shares proportional to their rewards

this is obviously far from adam
as redacted by the neoclassical holy joes

the best budgets for firms
and
jobsters households
are not hard budgets
but socially optimal taxed and subsidized budgets

no
uncle playing hear no evil speak no evil see no evil
is not optimal
not when
asset markets can start goin' south
and keep goin'

killer
what exactly is this fiscal madness of which you speak ???

i think along with alot of horse sense
u may have taken some kool aide
in too

some where along the way

you gotta have a credit system and a forex rate that supports chock full employment
but
fiscal policy is the key to
a full throttle
macro policy for the national economy

my guess we're talking
here
prolly a mid term structural deficit
reaching toward 3/4 of a trillion dollars per annum
even with a balanced trade dollar

[James Killus]

Winslow R.,
Most military funding goes to purchasing equipment and materiel from for-profit companies. I know, the "Masters of War," war-profiteers argument may apply, but the same thing applies to firetruck manufacturers, construction companies for government buildings, and environmental consultants, to name a few.

Intriguingly, the Fed is the only major government agency that I know of that is independent of "taxpayer subsidy," as it fully funds itself on interest from the money that it loans to banks, suggesting that at least some of the money flows the other way. I'm not sure what that does to the "subsidy" argument, other than to note that I don't completely understand banking, money, and finance, but then, I don't think anyone does.

I will note that, if the Fed continues to focus on keeping inflation under control, then the logical result of the segregated economy, with its asset price inflation and speculative bubbles, is a regular, illusory "creation of wealth" (i.e. paper profits), followed by burst bubbles and "creative destruction" (i.e. paper losses). And I know some guys who are still sitting on boxes of Howard the Duck, Issue #1. Maybe they'll be worth something someday.

[dd]

"Maximize the looters' current extractions with no regard for future losses."
Not so sure the Fed isn't protecting the too big to fail looters and betting the MMFers believe they are safe. Hope not; but it's a sucker's bet.

[Winslow R.]

"but the same thing applies to firetruck manufacturers, construction companies for government buildings, and environmental consultants, to name a few."

Not quite as the ability to do any of these things is wide open to the general public. Sure some may take a 4 year degree, but not 10's of millions of dollars to even open the smallest of operations. To reach prime dealer status requires much more.

"Intriguingly, the Fed is the only major government agency that I know of that is independent of "taxpayer subsidy," as it fully funds itself on interest from the money that it loans to banks, suggesting that at least some of the money flows the other way. "

Not intriguing at all as the Fed has been given the power by congress to print paper money. The Fed mostly purchases treasury debt with this money which throws off quite a bit of interest (near 800 billion of securities with about 25 billion in interest - from recollection don't quote me -sorry don't have the time to google). After keeping 3 or 4 billion they return the rest to the government. Not very mysterious why they are able to 'fund themselves'.

http://en.wikipedia.org/wiki/Federal_Reserve

[ilsm]

There have been too many salesmen dealing in snake oil.

The idea of covering long term debt with short term has been scarey for me for a couple of years.

The whole world is covering short relying on the presses to keep the snake oil dealers for being hanged or rode out on the rail.

[Cassandra]

Housing "Zaitech"??!?!, (which is what the Japanese called financial engineering before it was discrediited wholesale) was from the outset perhaps the most absurd form of macroeconomic experimentation.

Let's see if it makes sense: Drive short rates to nearZIRP....encourage everyone to borrow short & lend long...encourage people to refinance with low prevailing rates to help consumption.... keep rates near zero, and inflating house prices.... encourage more refi and equity extraction to support more consumption that is beyond current incomes and unsustainable...continue to keep short rates too low and real rates negative.....now encourage those that can't to borrow "short", further increasing house prices .... encourage more equity extraction based new higher prices....at the expense of US competitiveness say nothing but encourage foreign official buyers to hold USD reserves and buy US mortgages to keep long rates from rising and killing the golden goose...(now it gets silly) pool together lots of sub-prime and other paper backed by now-vastly inflated assets and tranche it up to (after paying appropriate fees to rating agencies) obtain better ratings and thus insure continued marketability further boosting house prices and yet more equity extraction to support unsustainable expenditure over income. All the while, the Fed defends its position ruminating over how to spell "b-u-b-b-l-e", and even if you can spell "it", that doesn't mean you can recognize it concurrently, or that you might not be wrong, with "wrong" defined as the possibility that the actual course of asset prices might in fact inflate larger, longer, and rounder and more inclusively than anyone (even cynical economists ) thought possible.... before it goes B-A-N-G!!.

Just as there were no shortage of informed critics of the Iraq war before the invasion, so too have there been persistent and voicifierous critics (and Cassandra's) of the perils and wastefulness of housing zaitech. Morally, however, it's a slippery slope, and if the govt decides "the little debtor people" (and some Jumbo debtor people) who made ill-timed purchases and [repeated?] ill-considered equity withdrawals are deserving , so too should they recompense the "prudent saver-people" who've inadvertantly and through no fault of their own, seen the real value of their savings deteriorate as result of persistant fiscal yawn, negative real interest rates and a PBoC-neutered bond market. But, after making them whole, who, then, would remain unrecompensed?

[Lafayette]

AG: "But considering that this credit crunch comes at a time when the global economy is stretched to the limit by large financial imbalances, the danger to the health of the US banking sector and its economy is pertinent."

Oh? How so?

The global economy is sprinting ahead at a rate of 5% per annum. Does this mean that the sub-prime mess will throttle it?

The current thinking, erroneous to my mind, is that the mess will suppress economic activity. But, how so? One would think that China's output is directed to only one economy ... which is far from the fact. China is a diversified global trader. Besides, so far, the US economy is showing no signs of weakening all that much.

But, we are told, "Well, just you wait and see!" OK, let's wait and see. Then what?

This is what it then may be: A tempest in a teapot. There will be some financial loses, some bonuses will not be paid at Goldman, Sachs (alas, alas), and it will be a bit more sad Christmas for the "Masters of the Universe". Well, comeuppance has taken its time ... let them sweat a bit. (Do 'em good.)

The question remains, will the sub-prime mess fundamentally change global economic activity ... meaning that Chicken Little was evidently right; the sky IS falling down upon us?

Please, someone explain how this mess is truly cataclysmic and not just a bit of stupidity on the part of some lenders, more stupidity on the part of some banks buying unqualified risks (that will result in some bank losses and/or bankruptcies) and a huge dent in the Fed's integrity (since it had the responsibility of supervising the idiots that were packaging under-assessed high risk instruments for resale - not to mention the risk-assessment agencies who under-assessed the risk).

And, the stock markets, which are the only barometer of public sentiment in the matter, are behaving emotionally. Well, with such monumental negligence, one might think it only normal.

Still, anyone ... please do explain (in simple terms, thank you very much) how the earth has stopped turning on its axis. And life as we know it is definitively doomed to extinction.

Has a cloned Godzilla appeared in major global capitals? Methinks not.

[James Killus]

Me:
but the same thing applies to firetruck manufacturers, construction companies for government buildings, and environmental consultants, to name a few.

Winslow R:
Not quite as the ability to do any of these things is wide open to the general public. Sure some may take a 4 year degree, but not 10's of millions of dollars to even open the smallest of operations. To reach prime dealer status requires much more.

Now you're just being silly. Entering the market for manufacturing firetrucks, or becoming a player in large construction projects requires far more than 10's of millions of dollars. And--you're going to have to trust me here--it takes more than a four year degree to become a serious environmental consultant.

Federal subsidies and preferential regulations permeate the U.S. economy. Don't try to pretend that there is some sort of "free market" case to be made against some particular Fed policy.

Lafayette,
The financial variations on Mel Brooks' line, "Tragedy is when I get a paper cut; comedy is when someone else falls into an open manhole cover and dies" applies here. A fair number of people, including me, have made the point that the current mess is characterized by uncertainty. No one knows which assets have become worthless, which are merely illiquid, and which still have some value, albeit below the value that they were leveraged for. So some amount of that "paper wealth" that Billy referred to earlier has gone away. No one wants it to be their assets that have lost value, and everyone wants to pass the negative bucks to someone else.

Sign on a Hedge Fund Door: "The Buck Pops Here."

[Winslow R.]

James, try and be civil.

James wrote: "Entering the market for manufacturing firetrucks, or becoming a player in large construction projects requires far more than 10's of millions of dollars."

Yes but these are market restrictions not government restrictions. Is there any government law restricting you from building fire trucks? Is there any government law restricting a contractor from being a player in a small or large construction project? Again, I believe laws regarding the opening of the smallest bank is too restrictive.

James wrote: And--you're going to have to trust me here--it takes more than a four year degree to become a serious environmental consultant.

Yes entry into many occupations are regulated by the government usually those having a direct impact on physical human health and safety. Last time you went to your banker for a checkup was hopefully about your finances.

James wrote: "Federal subsidies and preferential regulations permeate the U.S. economy."

I agree but it doesn't make it 'right'. No regulations are as onerous as those for banking or even close for that matter. A 'serious' environmental consultant will have no problem opening up a storefront. A 'serious' banker will have a multitude of restrictions mostly monetary.

James wrote: "Don't try to pretend that there is some sort of "free market" case to be made against some particular Fed policy."

I'm not sure what you mean by this. Given the Fed's charter which gives them the ability to purchase almost any asset class they desire, there is the potential to have a 'fed market' replace any 'free market'.

James I appreciate your willingness to debate. My guess is you have never seriously considered starting a bank so you have not looked into the requirements. The requirements having little to do with integrity, knowledge, experience or intelligence. The basic requirement for even the smallest bank owner is to be extremely rich. Why?

This is a start if your interested in reading more.

~$10 million to start a bank.
http://www.banknbox.com/

~$50 million - $100 million to be a primary dealer
http://www.ny.frb.org/aboutthefed/fedpoint/fed02.html

[James Killus]

Winslow R., if you consider someone's calling one of your statements "silly" to be uncivil, you have no future on the internet.

But I am conflicted in that judgment. Given that you have tied your argument into so many knots that I can no longer grasp what you are trying to say, perhaps you do have a future on the internet.

However, to clear up a point of information, lest someone here think that you have any idea of what you are talking about, the barriers to entry to environmental consulting are primarily market-driven, with a major part of the market perception of worth being education and experience. The only government regulations that I know of that have a direct impact on certain sorts of consulting would be requirements for a P.E. certification. In certain health-related venues an M.D. would be required, but those are very rare.

There are quite a few professions where there are significant regulatory barriers to entry, including physicians, lawyers, airline pilots, and truck drivers. You might also try looking at the bonding requirements for major construction projects before you get snooty about starting banks.

[Winslow R.]

James wrote: "I can no longer grasp what you are trying to say..."

My fault, as clearly stating my thoughts is sometimes an issue.

James wrote: ".... the barriers to entry to environmental consulting are primarily market-driven, with a major part of the market perception of worth being education and experience."

I agree and that was the point I was trying to make bankers don't need experience, just money.

There is usually always one banker, or someone with knowledge of the banking industry, in the initial group. This is not a requirement....

http://www.banknbox.com/

"You might also try looking at the bonding requirements for major construction projects before you get snooty about starting banks."

Yes, I am more aware than I care to help you realize. The ability to purchase contract and license bonds negate the requirement for net worth, something a aspiring banker is unable to do.

[Lafayette]

JK: A fair number of people, including me, have made the point that the current mess is characterized by uncertainty. No one knows which assets have become worthless, which are merely illiquid, and which still have some value

Caveat emptor

I have made the same point elsewhere, so I can hardly disagree. The dispersion of risk has masked its original identity. Nobody now knows today who really owns it. so, institutions are reluctant to loan to other institutions who may be at high risk. The financial engine therefore seizes.

Furthermore, however, I would suggest that at work was another factor, more akin to the social dynamic (or frenzy) of a Ponzi scheme.

This mess happened at time when the US was flush with easy money. People foolishly believed that they could use easy/cheap money to aggrandize their personal wealth (in real estate). They thought that the market for real estate was literally printing money on its endless upward revaluation.

They underestimated totally the risk involved and, particularly, how a Ponzi scheme works. That is, additional new money invested in the scheme balloons prices, which attracts even more investors, which further balloons prices ... until the unsustainable price level pricks the balloon. And, everyone panics.

One must presume that these people were financially naive enough not to understand that they were playing with fire. Many got burnt, but that is the fault of who? Themselves. (Or, it is the fault of the brokers who did not fully inform them of the inherent risks.)

Caveat emptor. Or, "There's a sucker born every minute". Take your pick.

The question remains: What to do in an America where Ponzi-scheme dynamics happen all too often. After all, this is the second one in a decade, isn't it.

Any proposals? Anyone?