"Financial Crisis Resolution"

How should policymakers respond to a financial crisis?:

Financial crisis resolution: It’s all about burden-sharing, by Charles Wyplosz, Vox EU: An old and familiar debate is back. Should taxpayers bail out the US banking system, quite possibly the British and European ones as well?

There are two standard views on the multi-trillion dollar question of who pays for getting us out of the financial crisis.

• One view is that the situation has become so desperate that ordinary citizens will in any case be paying a high price for the crisis; throwing money at banks right now might lower the overall burden by preventing a deep, protracted recession.
• The other view is that banks ought to be left hanging to pay for their sins. Governments ought to be worried about their taxpayers, not bank shareholders.

In fact, we don’t have that much choice.

Too big to fail: the Bagehot rule

It has long been a poorly hidden secret that large banks cannot be left to go bankrupt. Walter Bagehot, a 19^th century economist and editor of The Economist, designed the solution that remains as relevant today as it was then. The Bagehot rule is that the central bank ought to lend freely to a failing bank, against high-quality collateral and at a punitive rate (see Xavier Vives’ Vox column).

The modern version of the rule adds that shareholders ought to bear serious costs and the managers ought to be promptly replaced. This is exactly what happened with Bear Stearns last March, where another bank, JP Morgan, was used as the conduit for the operation. The cost to the taxpayers was a $1 billion guarantee and a $29 billion loan to JP Morgan guaranteed by Bear Stearns assets. We don’t yet know if this was a taxpayer-financed bailout. If JP Morgan redresses the situation within ten years, the taxpayers will make a profit. If not, US taxpayers will have borne the burden. Bear Stearns shareholders were almost completely expropriated.

As the US economy keeps limping and the housing market deteriorates, most observers believe that there will be many more bank failures. Indeed, in early July, a large Californian mortgage lender, IndyMac, went belly up and was also subjected to Bagehot’s recipe. The possibility that some very large financial institutions, and many smaller ones, will follow provides urgency for the current debate.

The Larry Summers school of thought: Don’t scare off the investors

One school of thought – let’s call it, fairly I think, the Larry Summers School – is that the Fed has been far too tough with Bear Stearns. It has scared investors and managers alike. The result is that investors are now unwilling to provide much needed cash to banks that must rebuild their badly depleted balance sheets while bank managers strenuously resist acknowledging their losses and continue selling their toxic assets. As a result, the whole banking system is in a state of virtual paralysis, which means that borrowing is both difficult and costly.

Lowering the interest rate, as the Fed vigorously did, does not even begin to redress the situation. This all leads to a vicious circle where insufficient credit drags the economy down, which leads to more loan delinquencies, which further impair banks ability to lend. Memories of 1929 immediately come to mind, when the Fed made matters considerably worse by clinging to financial orthodoxy.

This school of thought fears that the same fascination with high-minded principles turns a bad crisis into another nightmare of historical proportions. The Larry Summers School wants the Fed to lend freely and more generously with the goal being to reassure potential investors. If that is done, so goes the argument, banks will be able to rebuild their balance sheets and resume their normal activities. This would signal the end of the now 1one-year old financial crisis as a virtuous circle unfolds – more loans, a resumption of growth and the end of the housing market decline, healthier banks, and more loans.

The Willem Buiter school of thought: They ran into a wall with eyes wide- open

The other school of thought – let’s call it, a bit unfairly, the Willem Buiter School – sees things in the exact opposite way.

The crisis is the result of financial follies by financial institutions that bought huge amounts of products that they did not understand – the infamous mortgage-backed securities and their derivatives – parked them off-balance-sheet to avoid regulation, and made huge profits in doing so. In short, they ran into a wall with wide-open eyes.

Once the all-too-well foreseen crisis erupted, these institutions kept hiding the extent of their losses as long as they could – they are still playing that game – and started to lobby for a bailout from their governments.

The classic credit cycle:  Look who’s crying now

This school notes that the crisis is part of a classic credit cycle that involves excessive risk-taking in good times and ends up in tears. The question is: whose tears?

The challenge is to ensure that these are not the taxpayers’ tears. Indeed banks are in a unique position. They used to call for a bailout to protect their depositors, but deposits are now insured in all developed countries. Still, because bank credit is the bloodline of the economy, we cannot let our banking system sink. But once banks know that they can play the high-risk, high-return game, pocket the profits, and let taxpayers face the risks, bailouts provide a temporary relief but set the ground for the next crisis.

Wilder and wilder parties

Bank of England Governor Mervyn King nicely sums up the situation: “'If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time, the parties will become wilder and wilder.” Bagehot principles can be applied when one or two banks fail, but when the whole system is under threat, this is no longer an option.

Which school is winning with policy makers?

Both schools have developed consistent views. The dismaying part of the story is that they lead to radically different policy implications.

So far, the monetary authorities have been closer to the Willem Buiter School view, but things may be changing. The most recent bailout of Fannie Mae and Freddie Mac is clearly a soft rescue operation, with no set limits and, so far at least, no penalty on shareholders and managers. Even though Fannie Mae and Freddie Mac are very special institutions with a federal mandate, the Larry Summers School is right to see some glimmers of hope and therefore must be taken seriously.

In most respects, we have gone through a very classic credit boom- and bust cycle. Two cases from the 1990s are worth pondering.

• Following years of fast bank credit growth accompanied, as should be, by housing price bubbles, bank crises started in 1990 in both Japan and Sweden. The Swedish authorities reacted swiftly, bailing out most banks at a cost to taxpayers estimated at some 4% of GDP, but shareholders were essentially expropriated.
• The Japanese authorities protected their banks with generous loans, even as some banks were serving dividend payments to their shareholders.

Sweden recovered in three years and, nowadays, Swedish banks are not found among those that indulged in mortgage-backed securities. Japan has still not recovered from a nearly twenty-year long “lost decade” and, nowadays, several Japanese banks have already failed under the weight of the toxic assets that they acquired, once again.

Figure 1: GDP Growth in Japan and Sweden

Source: Economic Outlook, OECD

Conclusions

Of course, there is more to it than this simple comparison, including the accompanying macroeconomic policies. But three unmistakable messages emerge.

1) Be merciless with shareholders and gentle to bank customers.

2) Either way, taxpayers are always the losers.

3) Bagehot had it all right.

---

Peter Englund, “The Swedish Banking Crisis: Roots and Consequences”, Oxford Review Of Economic Policy 15 (3): 80-97.

I have some sympathy for Summer's position, but only if regulation - which isn't mentioned as part of the policy prescriptions suggested above - plays a role in limiting risk taking. The party doesn't have to get "wilder and wilder" if the party poopers, i.e. the regulators, impose limits to how long the party can go on, restrict how much alcohol can be present, have bouncers to evict those who break the rules, etc.

Comments

[hari]

I suspect the excessive exuberance which accompanied last three decades of free market capitalism, principally the globalization of US hi fi sector, has come home now for ransome money and public rescue....

Why not, and inspite of Bagheot's 19th Century principle, find ways and means to clean the financial mess for once and re-introduce the age old regulatory control of the now larger than life-size global hi fi sector.

While at it, try and realign the majour trading currencies.

Can it be done? Of course! It requires political will power to undo the creative destruction of foot-loose capitalism under the slogan of globalization.

It's time to call it a day and punish the culprits...and set some good examples.

[JKH]

"We don’t yet know if this was a taxpayer-financed bailout."

This is the problem with Buiter's "solution". It's a rush to judgement driven by an unhealthy obsession with imposing a value of 0 on the stock of the existing shareholders. A similar obsession grips the critics of the Bear Stearns "bailout" (also a "don't yet know" situation.) Risk is not a binary function that gets triggered to 0 by indignation.

says...

Excellent article. We need more of these along with the implied research agenda of understanding what went wrong and how to prevent its recurrence. Economists have to do some serious soul searching and ask how our vaunted higher education system did not produce more people who saw this coming. The discussion of relevant episodes in Japan and Sweden provide a much needed perspective and an implicit acknowledgment that we can and should learn from other countries. Sweden has a long tradition of innovative policy dating back to gold backed currency and the Great Depression. Along these lines maybe we'll see an article exploring what is it in Canadian banking regulation that prevented this crisis in Canada. Perhaps this crisis will inject a much greater humility about the limits of our knowledge, in particular, the delicate balancing of markets and regulation and the need for comparative economic history and complete disclosure of the limits of our knowledge and extent of disagreement on issues such as this.

[maynardGkeynes]

The problem with Summer's position even [IFF] "regulation...plays a role in limiting risk taking.." is and always is regulatory capture. Add in the USA, legislative capture (eg, lobbying $$$ spent by Fannie and Freddy combined with the traditional pork barrel process of the Congress, ie, 'it's ok as long as my district gets its part of the spoils and I get re-elected.')

says...

previous entry was from george.colpitts@gmail.com

[Todd Harrison]

Financial companies are desperate for capital but their stock prices are so low that any issuance would be dilution death for the companies. The government is desperately trying to keep the financial system together. Add that up and you get the possibility of a great manipulation.

How would the government engineer a rally in financial stocks so that these companies can sell stock to raise capital at a reasonable or at least palatable dilution level?

It might go something like this. Since financial stocks are in such trouble they have heavy short interest; this is natural and well known and can be used to their advantage. A clever “berry” might think to introduce confusing rules that raise the cost of borrowing short stock and temporarily confuse shorts into covering and not shorting more. And this is precisely what the SEC did.

It just so happened that the new SEC rules came conveniently the day before many of these financial companies were to report earnings. If just some how these earnings were really good the match would be lit on the kindling.

So far banks have miraculously come through on their end of things. Wells Fargo (WFC) and JPMorgan (JPM) reported better than expected beaten down earnings. Things must be getting better just as the companies need capital.

What a coincidence.

But if you look at how the banks “beat” their earnings the coincidence becomes clear. WFC took the unprecedented step of extending charge-off acknowledgment from 120 days to 160 days. And JPM was even more aggressive. It actually lowered its loan loss reserves quarter to quarter.

The list of financial companies where shorting regulations are being enforced/enhanced is precisely the banks and dealers (and FNM/Freddie Mac (FRE)) that have access to the Fed's balance sheet (dealers through the PDCF and FNM/FRE through the recently-allowed access to the discount window). So we can speculate on the nature of the "coincidence": Perhaps the Fed is getting worried about the value of all that collateral these dealers have posted to the Fed balance sheet and must boost the capital of these companies to protect that value.

And now on cue FRE, a $5 billion market capitalization company wants/needs to issue $10 billion in new stock? Doesn’t that sound a little crazy? Well get ready for others to do the same because the banking system needs capital desperately and the government is there to help.

But help at the expense of who?

says...

If only the system, which enables next items are introduced, it solves the problem that nobody has ever solved historically .

1 Extract the bubble portion from asset(that caused the bubble) of balance sheet from every insolvent economic units.
2 Functioning 1 in order, by using original fund of FRB to banks, with multipier effect which diffuses to every insolvent economic unit. So there is no burden to tax payer.
3 FRB may become insolvent, in exchange for the economy to become sound. But it's easy to take over FRB by another new FRB, with the credit of the US.

For details, please see:

http://reversewealtheffect.blogspot.com/

[kthomas]

hari, would that it were so easy. Punishment for whom? Congress is weak, the President is a moron, and K-Street call the shots.

Joe American gets higher fuel costs, higher food costs, higher housing costs, little job prospect, and relief in the form of a phony stimulus package cheque that costs more money to print and mail to Joe than the value fo the check itself.

The US Govt is there to serve the wealthy.

[ddt]

"Along these lines maybe we'll see an article exploring what is it in Canadian banking regulation that prevented this crisis in Canada."

There are a lot of good policies that can be learned from Canada, but IMO, banking is not one of them. The Canadian system is an oligopoly of 5 banks (BMO, CIBC, Scotia, TD, RBC) that are run very conservatively (except for CIBC).

pros:
- conservative banking culture
- stability
- branch service is maintained in small communities where it is unprofitable (their end of the deal for being given an oligopoly)

cons:
-high fees for ATMs etc., because this is where they make their money in boring banking
- lack of funding for new innovative businesses. most venture capital for projects in Canada is actually raised in Boston.
- while they are protected at a certain size, they cannot merge to become more globally competitive

Also, Canada is not out of the woods yet. Our solution for allowing people to buy bubble inflated houses was 40 year mortgages. The government has recently came out and reduced it to 35 years (i think) to clamp down on the housing bubble. There is a lag between what happens in America and what happens in Canada, and our housing market is looking an awful lot like USA circa 2005.

[Lafayette]

Third time around

MT: The party doesn't have to get "wilder and wilder" if the party poopers, i.e. the regulators, impose limits to how long the party can go on

This is true, but the implications are a long, long way from the Party King, Greenspan, and his Sky's-the-limit Party Boys. A sea change of mentality at the Fed is evidently necessary.

Concentrating on core inflation blinds one to the mess-in-the-making from loose credit, particularly in the housing market. Meaning what?

Meaning, I submit, that the Fed has to broaden its horizons when it tracks inflation. Housing price inflation should probably play a far larger role in the future in terms of triggering inflation larms.

Then there is the fact that there were three accomplices to the fraud. The first being lax controls on mortgage brokering agents, whose loans should henceforth be audited (and a discipline instated for those who transgress guidelines). The second being the banks who packaged the toxic waste, which they KNEW was toxic waste. And the third was the accrediting agencies that blessed the toxic waste as triple-A investment vehicles to be sold on to gullible investors who believed the agencies.

All the way down the line, fraud done cries out for justice. But, where are the perp-walks?

The Fed is not blameless. They had the purview responsibility to supervise credit markets and they failed at their duty. But, resolving the crisis?

Only the lender of last resort can solve the crisis. That lender is the taxpayer. But, we can make sure that this sort of mindless mess does not repeat itself. It's only the third time around since the S&L fraud ...

And, as Modern Bagheot suggests, "The modern version of the rule adds that shareholders ought to bear serious costs and the managers ought to be promptly replaced." Not just replaced, but indicted for negligence.

[Joe]

I agree with the conclusion.

JKH

One of the most significant factors regarding the morass we were experiencing was leverage. Given the D/E ratios, 0 is a workable assumption in many cases. Let's move on to more important aspects of the problem.

Zeroing out shareholders may change their attitude of benign neglect toward management and maybe a beneficial evolution in American business structure.

At the end of the day it is also just. It helps make the fix palatable to the American public and goes some of the way to mitigating the specter of future moral hazard.

As to the views of Summers, what amount of private capital is possible? What part of $trillion to $1.6 trillion is needed? Is it in the realm of possibility that private capital can sure up the banks?

No. Once we stabilize the banking and financial sector and also do the re-regulation that is now obviously needed, private capital will reassess based on new circumstances.

[Joe]

One thing, I must add.

We have a big problem and there are no painless solutions.

All I have to add to that, good job republicans (sarcastic font) and hopefully good riddance to the radical wing of the party. I assure you, the pleasure was all yours. I long for the day when you are a distant memory.

After your the passing of your leadership, I'll probably be able to forego the PTS therapy. Not that that was not a near run thing.

[david]

Ownership and management, yadda yadda. Seems worth adding to this article the fact that banks aren't really people, and the people driving banks into the ditch are going to be very rich for the rest of their lives. The conclusions should begin: be merciless with management. Heads on pikes. They, not the shareholders, are the people driving the cars. (I'm pretty okay with little mercy for shareholders too.)

[Joe]

David

I haven't thought through whether action against management is legally feasible. The law is the law and if a lawyer can devise a theory (they all have theories) to effect some retribution on responsible management and mitigate the load on taxpayers, go for it!

Perhaps someone can define some specifics?

[Bruce Wilder]

I suspect kthomas has it right: "Congress is weak, the President is a moron, and K-Street call the shots. . . .
The US Govt is there to serve the wealthy."

When England was a true and pure plutocracy, 1689-1832, there were two very loose political "parties", the Tories and the Whigs, both creatures and servants of the very, very, very rich. The Tories were strict and inflexible authoritarians, supporters of royal authority; the Whigs were a bit looser and more individualistic and pragmatic. The Whigs were cynical hypocrites; the Tories were righteous hypocrites. Summers is a Whig, and Buiter is a Tory. But, neither envisions a workable system, which doesn't feed parasitically on the middle classes.

Charles Wyplosz desperately wants us to not notice that he poses a choice between tweedle-dee and tweedle-dum. Mark Thoma notices that regulation goes unmentioned. That would be by design, I think. If Wyplosz mentioned regulation, he would draw too much attention to the massive regulatory failure and the orgy of fraud and predation in mortgage lending and securitization. He would not be able to maintain the fiction that all is normal, with references to the ancient Bagehot and "classic credit cycles".

My own view is that we can live without plutocracy, very nicely, thank you very much. Show them the guillotines, and let's move on.

The Whigs, for me, are the more sympathetic characters. Walpole and Burke and Macaulay. So, I am naturally more sympathetic to Larry Summers than to the unreconstructed Tory, Willem Buiter, who always seems to me to be wrong about everything.

But, both labor under the delusion that the system is not so broken, that it will not have to be rebuilt. The system of mortgage securitization is broken. And, there's no point in rescuing it in its current form -- its current form doesn't work.

Bagehot did not know anything about mortgage securitization. So, relying on him for advice is a non-starter.

And, this is not the end of a classic credit cycle.

This is about an emergent institutional super-scheme for mortgage banking -- the economic equivalent of a biome. The emergent design is seriously faulty, and, now, we have to deliberately design a scheme that might actually work.

That means a completely revised institutional and regulatory structure: we need to revisit the chartering of Fannie and Freddie; we need to revisit Glass-Steagall, and the definition of various types of banks; we should reconsider the wisdom of universal banks (giant financial conglomerates); we need to revisit how securitization happens from mortgage broker thru to the investment funds that buy them.

Everything in this system broke down. The accounting rules that should have prohibited hiding liabilities in SIVs; the incentive structure bearing on mortgage brokers; real estate appraisal was corrupted; Fannie and Freddie ballooned into irresponsible giants; the ratings agencies and monoline insurance outfits went crazy; derivatives trading is out-of-control topsy-turvy; I could go on and on.

This emergence through faulty innovation of novel financial arrangements, which prove not to work very well cannot be answered by simply saying we need regulators, who will try harder "next time".

"Too big to fail" and arguments about whether it is cheaper to rescue than to suffer collapse, miss the point, miss the moment.

The system has broken down. And, the consequences, although very serious, are not so catastrophic, that we can not afford to fix the system, to redesign it . . . now.

If we pretend that it has not broken down completely, and patch it together for another go, without undertaking fundamental reform, "next time" will come on pretty completely, but we won't have the resources to fix it.

We've had a pretty easy time of it, in large part because the Arabs and Asians have loads of dollars that they don't know what to do with, and are, somewhat reluctantly, willing to sink some part of those dollars into the Big Banks. Those guys are not going to make that mistake, twice. So, if we don't get realistic about fixing our broken mortgage banking system in a fundamental reform, "next time" will come, and it will be really ugly.

[hari]

@ Joe -

Why have a Congress elected by the sovereign - if you can't protect the taxpayer from this type of profligate behaviour by the previleged classes?

Nonesense to claim that in a democracy there is no way to punish the bastards! German Courts have just last week started sentencing the first CEO/Post for Millions of taxable income safely put away in Lichtenstein....

[hari]

@ kthomas -

Above also in response to your response.

[Joe]

hari

I don't disagree with your sentiment but I need you to chart the course.

Using the stupid, ignorant, liar paradigm. Many times being stupid or ignorant is a valid civil or criminal defense.

Can you prove management lied?

Rightfully so,in our system, you need proof beyond reasonable doubt to impose retribution.

Just saying.

[hari]

@ Joe -

Agree! That's the crux of Congressional investigations and hearings - those guys are paid by taxpayers to protect the law of the land. Or are we all getting dumb-downed?

[guppy]

If more SWFs invest in large banks, Summers' "don't scare off the investors" might be the only allowed solution. Wouldn't do to have Dubai or China hacked off at the US when their equity goes to zero during the restructuring of a major bank.

[Jas Jain]

What if the crisis was purposely created by willful negligence of the private sector and was purposely allowed to take place by the Bush administration and the Fed chairmen Greenspan and Bernanke?

BTW, I pointed this out in 2003 and coined the term Bankrupters and Fraudsters of New York City. Wall Street was fully complicit in the crime. What born-and-bred American dopes, including economists, are in denial about is that the economy has been criminalized via finance. “Finance does not lend itself to innovation.”! Along the same lines my earlier comments to a list…

“…the question is who will bail out the government?”

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2008/07/17/MN8Q11OT2M.DTL

There will be no government to bail out! By this I mean the American govt, i.e., the system of govt as it exists today, will collapse just like the Soviet system or the Nazi govt. I wish to make one thing crystal clear: Before an American is trained to be anything – a rocket scientist, a brain surgeon, a lawyer, a doctor, an economist, an engineer, an accountant, etc. – he, or she, is bred to be an irremediable dope with blind faith in the system. Such a dope is incapable of admitting that the financial crooks, perennial debt pushers and schemers, have taken full control of the system and the only choice that the dopes have, at the federal level, is to vote for one of the acceptable agents of the crooks. One has to be a dope to believe that a bad system can be changed via a vote. How did the bad govt come to power in the first place?! The current system will not be in existence in another 25 years. Could it collapse in ten years? Yes, but it will take a longer duration of widespread misery and decimation of the middle-class before it no longer can survive. Some form of fascism, including Nazism, is the most likely outcome. Born-and-bred dopes will vote for a demagogue like Hitler in droves after a decade or two of misery at the hands of financial crooks and schemers. Election of liberal Obama during the worst phase of misery might be a perfect set up for a right-wing reactionary. I don't mean to imply that Obama is worse than McCain (for one, he is lot smarter than a dimwit McCain). BTW, I have no horse in this race. I will watch the dopes fight it out from the sidelines.

Democracy always ends with abuses of the moneybags who end up controlling most of the wealth, the media, the govt, and people’s heads. Evil form of govt exists in many forms and in the US it has taken the financial form. The current system is good at breeding dopes and promoting crooks to power. The system has reached its end-phase.

Jas

[Andrew Hartman]

Did any of you read the front page story in today's Times about the credit junkie/handbag shopper? The one who got her
son to cosign a mortgage so she could keep on spending? Does
she get a cell next to Jimmy Cayne? Remember folks: the
American middle class got and blew the money. That fact alone
would make me pause on the way to progressive heaven.

[Blissex]

«the Arabs and Asians have loads of dollars that they don't know what to do with, and are, somewhat reluctantly, willing to sink some part of those dollars into the Big Banks.»

So far they have know very well what to do with those dollars:

* Keep the dollar high to keep demand for their exports high as an alternative to subsidizing exports directly.

* Subsidize the war in Iraq via purchases of treasuries at extraordinarily high prices to get the favor of the Republican party.

[GK]

Which ever bailout plan is finally agreed upon it should start with the Disgorging of profits from the Corporate Officers, Boards and Traders. Empty their bank accounts, make then sell all their homes around the world, say bye-bye to their retirement plans and all their expensive toys.

I was at a business conference this weekend where I overheard a die-hard Republican and died-in-the-wool lefty agreeing that these bankers and brokers should be hung from lamppost along Wall Street to make sure this never happens again.

If lawmakers listen to financial lobbyist, instead of their constituents, on the structure of the bailout they will in for a rude surprise this November.

[Bruce Wilder]

Jas Jain has a point. Take a look at this: Given a Shovel, Americans Dig Deeper Into Debt - NYTimes.com

The plutocracy has been pressing to transform the banking and financial system from the conservative New Deal scheme to provide support for a middle class life, complete with home ownership and retirement with a pension, into Casino America, where ordinary people are given a brief, entertaining few years of false hope for a good life on their way into a lifetime of debt peonage.

"Casino America" is a fairly accurate appellation for the financial sector, as envisaged by Phil Gramm and friends. The thing is, lots of people like casinos; they are popular, people flock to them. It is a form of theft, which many victims find "entertaining".

It is a real political challenge to persuade a democracy that a national addiction to gambling is not a formula for a good life.

It's a Wonderful Life is a very popular movie, but, somehow, most people miss the point that Lionel Barrymore's Henry F. Potter is a Republican.

[Bruce Wilder]

Andrew Hartman: "Remember folks: the
American middle class got and blew the money. That fact alone would make me pause on the way to progressive heaven."

So, you are in favor of Casino America?

[roger]

Gretchen's article made me remember that it was the Dems, in 1979, I believe, who began abolishing the usury laws. At the time, this might have seemed like a little thing, but it was a crucial piece of the puzzle in changing the economy in the eighties. If the bargaining power of labor had been simply crushed, with no credit sweetener, the Reagan revolution would have died in the country club. It was important to create the ownership society, i.e. a society in which ownership was, for the vast mass of people, liquidated. This solved the huge problem of the seventies slowdown - as the Marxists say, the margin of profit for the corporations fell to a crisis point. The traditional solution is, of course, to extract more profit by lowering labor costs. Unfortunately, however, we no longer are a mostly agricultural society driven by a few technologies, like the railroads - this is consumer capitalism, and the consumers can't just be immiserated. So a sort of triangle was created, between credit, growth, and inequality. The more the economy grew, and the more the productivity was absorbed by the upper 5 or 1 percent, the more we needed the lower 80 percent, with its shrinking share of the national wealth, to see that growth as advantageous to itself - and what better way to do it than knocking down barriers to credit?

In the Bush boom, however, the game of musical chairs stopped. The upper 1 percent absorbed, basically, all productivity gains, and the bottom 80 percent, over 8 years, has taken home about the same amount. Bubbles serve different purposes - the asset bubble obviously was meant to disguise and exploit this inconvenient fact. Now that it is shredded, we will have to disguise it in another way. The best way is to evoke puritanical bouts of shame directed at the borrowers. It is a wonderful way to avoid discussing who has profited over the last decade, and I figure it will last for some time.

[Blissex]

«It is a real political challenge to persuade a democracy that a national addiction to gambling is not a formula for a good life.»

The American Way is that WINNERS win, and losers LOSE (red skinned losers have lost most of their population and their country, dark skinned ones their liberty for two hundreds of years and then their chances at a fair life for another hundred, so every other loser really shouldn't complain that much).

Most Usian voters believe themselves winners, and good riddance the losers Devil take the hindmost 80-99%!

This fabulous article shows very clearly how some losers thought themselves winners (retire early, live large on a 10% withdrawal rate) and who the real winner was:

www.businessweek.com/magazine/content/08_28/b4092000132397.htm

«His pitch, they say, was similar to Kazacos': Retirees could safely take out 10% a year without cracking their nesteggs. "He told us we'd be millionaires," says 70-year-old Bob Yates, a machine operator at Xerox who retired 10 years ago with $420,000 and now has $56,000.»

«Kazacos lives in a $1 million house with an elevator on nearby Lake Conesus, where he has hosted lavish July 4 fireworks displays. He also owns investment properties, including two on Sanibel Island, Fla., worth a combined $1.69 million, and an $877,800 condo in Hilton Head Island, S.C.»

«Mark Congdon of the advisory firm Horizon Group remembers losing prospective clients to Kazacos for years. For most people in retirement, Congdon would put 10 years' of living expenses into safe investments and allow them to take out no more than 4% a year from their accounts. "It was amazing how many people ended up telling me they're going with Mike Kazacos," says Congdon. "One of the reasons was that I wasn't allowing them to withdraw enough."
According to the lawsuit and interviews with former colleagues and customers, Kazacos' financial maneuvering was more aggressive. These people say his strategy seems to have boiled down to one goal: moving money into and out of various accounts to generate maximum fees.»

This story is the embodiment of the American Dream: the winners who create wealth for themselves and their corporations by doing what it takes get rewarded big, the gullible losers who gamble and try to do the same without having the skills get punished hard.

That's America folks :-).

[Blissex]

«The upper 1 percent absorbed, basically, all productivity gains, and the bottom 80 percent, over 8 years, has taken home about the same amount. Bubbles serve different purposes - the asset bubble obviously was meant to disguise and exploit this inconvenient fact.»

The asset bubbles have been used first for that, and then to make the populace forget about being into a quagmire of two and a half very expensive wars financed entirely with tax cuts.

Anyhow, good comments, except for this:

«The best way is to evoke puritanical bouts of shame directed at the borrowers. It is a wonderful way to avoid discussing who has profited over the last decade,»

Ah sure, but the losers who thought themselves winners tried pretty hard to conspire with the real winners to screw themselves, as my previous quote shows. When 60% of Usians voters think they will end in the top 1% and f*ck everybody else, it is sort of hard to blame the top 1% for taking advantage of that: to a significant extent the mean, greedy, stupid Usian middle classes have been begging for it for 20-30 years.

[Blissex]

«the mean, greedy, stupid Usian middle classes have been begging for it for 20-30 years.»

I forgot: and racist, or sort-of-racist ("black americans have been treated unfairly, but let's just hope that none of them moves into my neighbourhood") Usians have very gladly voted for the dismantling or downsizing of the New Deal when black americans were allowed to join it, out of horror that *their* security and benefits would be exploited by the parasitical welfare queens and strapping young bucks.

I can imagine the propagandists and market researchers sponsored by the real 1% laughing their way to the bank... For having found that the way to persuade the sheeple to vote to cut their own safety net was as simple and cheap as talking points linking it to the darkies.

[Joe]

Jas Jain

It wasn't a secret conspiracy lauched by masterminds. All that has happened in the last 40 years is completely explainable in the normal realm of human and group behavior.

The analysis could fill a book so obviously I can't give an even cursory explanation here.

Suffice to say the traditional representatives of capital and the rich couldn't make much headway with the post depression electorate with there economic idealogy which was based on the the pre-progressive era position that business should be given free reign to operate as they saw fit and this would be best for America. The right was self delusional and venal and capitalist have what it takes to make the venal rationalize their actions. They ignored the lessons of American history from the industrial revolution through the great depression and it was a lucrative career option. Witness the right-wing billionaire funded think tanks where they are comfortably ensconced when the Democrats take power.

Because their economic agenda would not sell with those who remember or were affected by the great depression, the right had to find a different product to sell. Witness the southern strategy, appeal to evangelicals, McCarthyism not to mention building Osama into an existential threat necessitating war against Iraq. Remember Karl Rove happily exuberant at the electoral windfall that the Iraq war would provide.

Examine how this country's situation and circumstances has changed in the last 150 years and it is not surprizing that politicains, who claim that the citizens can go on as they have and not change with the times, have an appeal.

The Republicans electoral strategy though was not what they were really about; that was lip service. Witness James Dobson's reaction to the return the evangelicals have gotten for their unquestioned support of the Republicans.

Is your contention that American's are brainwashed dubes correct? We are simply too busy to gather the information and think about it. Their paitence and trust is not a bottomless well though. Even the totally distracted can't help but notice what has been wrought by the Republican/Reagan revolution. Many of the people in the Bush 2 administration were thought to be crazy by the Bush 1 administration. They just weren't smart enough to not overplay their hand. Bush 2 was no where near astute enough to know the difference.

If your want an example of where this country goes from here, we have an example. The last time this happened, the American people threw out the people that put us in a predicament and a very smart politician did what was necessary to gain the support of the American people. That politician was FDR.

There are conspiracies concieved everyday but the secret ones, by their nature, preclude big ones that affect a lot of people.

Some not insubstantial investigation and thought demonstrates that what has happen to America was evident to those who cared to do the investigation and think about it.

It is completely explainable by orthodox politcal science. Espousing wild unfounded conspiracy theories just muddy the water.

[Andrew Hartman]

Bruce Wilder:

No, I am not in favor of a CASINO SOCIETY. My point is that greed and stupidity were rampant on all sides, including those people "progressives" say they care so much about: the stressed middle and working classes. You've said
the same thing yourself: 98% of Americans are "dumb as a post" and the top two percent should be robbed and shot because they're so reprehensible. You may be right. But certainly neither
one of us is a candidate to lead the masses out of the wilderness.

[gorobei]

The creator of figure 1 should be taken out and shot. "Growth" type charts should usually be plotted as simple totals on a log scale, not YoY % changes -- I can't even tell from that chart if Japan's total growth was more or less than Sweden's. Worse, it uses linear interpolation between yearly datapoints - that makes no sense and misleads the viewer.

[dd]

For anyone paying attention to "It's a Wonderful Life," Mr. Potter wins. He has the money stolen from the S&L and it won't survive another go-round. As a child I wondered at the ridiculous outcome. Why didn't the citizens storm Potter's bank instead of meekly handing over more cash to save the defunct S&L? Really it's a horrid movie meant to pacify the indebted as they wait for angels to work miracles rather than neutralizing a sociopath intent on destroying society.

[gorobei]

dd,

I think that was sort of the point of the movie. You can't magically kill all the psychopaths and get a Utopia. All you can do is small acts. Their cumulative effect can be large.

It's a much more realistic movie than the modern "kill the evil boss and everything will be perfect from now on" fantasies.

[Bruce Wilder]

gorobei: "It's a much more realistic movie than the modern 'kill the evil boss and everything will be perfect from now on' fantasies.

I am more concerned about the modern political lesson, "Elect the Worst President Ever, so Henry F. Potter becomes Treasury Secretary, a winner-take-all utopia ensues, and if you don't like you are a loser and whiner in a mental recession".

[Bruce Wilder]

Andrew Hartman: "greed and stupidity were rampant on all sides"

Populating our society with human beings will tend to have that effect.

[Joe]

What a dour group! We need to edify and encourage our fellow human beings not insult them.

The argument can be won but we to refine it then make it succinct and concise (take a lesson from Madison Ave.).

Griping serves no useful purpose.

[Linda]

Blissex: "When 60% of Usians voters think they will end in the top 1% and f*ck everybody else, it is sort of hard to blame the top 1% for taking advantage of that: to a significant extent the mean, greedy, stupid Usian middle classes have been begging for it for 20-30 years."

I disagree. How did the 60% get that idea? Who benefited from that idea? In addition to all their borrowing and spending, what else resulted? A bunch of people who voted contrary to their own best interests. I don't think it was mass hysteria or self-initiated delusion. I think it fits in perfectly with roger's triangle theory.

[Lafayette]

Stinks to high heaven

BW: Show them the guillotines, and let's move on.

I would suggest that showing them the guillotine is VERY dissuasive, but actually lopping off a few heads is more so.

A number of banking chieftains have fallen on their swords since the Sub-prime Mess blew up in our faces last summer. Which doesn't go nearly far enough. And, despite the need for enhanced regulatory measures, nothing will have been done to address the acute greed that prompted and promoted the Mess.

May I remind us that this is the fourth in a series of financial fraud since that of the S&L industry?

Why is it that we can opine that Zero Tolerance is necessary to curb errant delinquents, but the white collar variety in their skyscraper offices get away with massive fraud? I've seen no responses to that question.

Perhaps there will be indictments/convictions once obtaining the necessary evidence has been accomplished. Let's hope so.

Somebody must flush the Wall Street toilet -- it stinks to high heaven.

NB: And I maintain, of course, that the best cure for Acute Greed is confiscatory Marginal Taxation. That's the sort of guillotining that's really effective.

[Linda]

I would have thought any fool would understand the ramifications of credit card debt greater than one's annual income, or of buying a $500K home with zero down and $2000/month payments, but obviously they didn't. And should they be blamed? When those who purport NOT to be fools encouraged them ? When predatory forces massed to convince them to mortgage their futures? You see ads urging people to contribute to IRAs and 401ks, extolling the virtues of compound interest, but how often does the Average Joe hear about about the flip side of compounding? Does AJ hear anything about compounding debt? He hears about consolidation, re-fi's and "lower monthly payments." He hears about the deductibility of HELOCs.

Why were they tempted? They wanted more than they could afford. Why? OK, human nature, Joneses, etc., but ALSO what did they see every time they looked at tv, a billboard, a magazine? People "like them" driving new cars, eating at fine restaurants - overseas!, traveling, buying the latest electronic gadget, remodeling their kitchen, maybe their whole house, to the tune of tens of thousands of dollars. What did they hear? "Ownership society," "Shop to show your patriotism," "It's YOUR money!" Not to mention the implicit message in responses to pleas for the needy: "If they can't afford it, they're losers."

There's something in human nature that manages to turn that into both a yearning and a sense of entitlement. If those people can have that life, then why not me? The answer ("because you don't have the money") to that question (with examples) might have helped, but who offered it? Talking heads on tv shows that "nobody watches." If you complained about the glorification of excess, you were not only a "bleeding heart liberal," you were also an un-American party-pooper.

I don't mean to lay blame solely at the feet of the current crop of politicians, corporate types and media. This is bigger and deeper than that. Putting the pieces together takes more than a 30 second campaign ad - longform in today's media - or a blogpost. When no serious attempt is made to educate people about the basics of household finance, much less the downsides of the latest mortgage or investment scheme; when intelligence is ridiculed, especially by comparing it to wealth (If you're so smart, why aren't you rich?); when "News" includes the latest product innovations and the latest plastic surgery techniques; something is wrong with the picture.

It's human nature to look around at what others are doing. If you see something that seems like it would work in your favor, absent legal or moral complications, you adopt it. On a Main Street level, the results are fairly obvious.

It makes sense that the powerful in business and government would operate in the same way. Maybe they do some market/behavioral research first, or consult the literature. When they see how many consumers are ignorant, and that that leads them to spend more, borrow more, (or vote contrary to their own interests), they see opportunity. When they see that guilt stands in the way of increasing consumer debt (and without debt, consumers have limits), they work hard to create a sense of entitlement. When they see that stagnant income is standing in the way of spending, they make credit easier and easier and tout the benefits of "creative" financing. There is no incentive to working towards a better educated population of consumers. There is incentive to keep them ignorant and "needing" to borrow. And this is but one example of the ways in which those who advertise, those who market, those who want to retain power, can manipulate to get what they want.

[hari]

If you take seriously some of the commentary in this thread, so far, is it conceivable that a generic cabal-class shift has taken place in hi fi sector during this past decades of libertarian free market drumbeat?

From a behavioral perspective, can we also find if there is a *generic* type of cabal that's not only colluding and fermenting the hi fi sector but also getting entrenched and becoming ever-so-secure in dictating their plans based on access to the teller (budget cash flow)?

May be academics should start thinking of the impossible ie. America is being high-jacked by an entrenched capitalist mafia and that it should be exposed for what it is....

[Eric Dewey]

Hmmm...good to see so many well-educated minds working hard all weekend (again!).

Mark notes the absence of "regulation" in the article, and Hari speaks of "political will" - good points, both. Others wonder if legal action is available. Others point out, correctly, that the lack of financial restraint by the middle class is itself a large part of the problem.

As an attorney and career compliance officer financial services I can assure you that there are laws already on the books which, if enforced, would have done much to reduce the scope of this disaster.

However, the political will to enforce these laws has been lacking in large part because of the fact that imposing financial discipline slows growth in the short-term, which causes short-term pain to all parties. Thus the Democrat/Whigs and the Republican/Tories both play short-term power games, with the results we see today (and also saw during the boom).

What will change if new laws are enacted, or additional regulators hired?

This illustrates the fatal flaw of the classical economics: the failure to adequately understand and distinguish between short-term and long-term economic rationality, or to define a medium-term alternative, tends to undermine the political will necessary to take painful measures in the short-term.

Too many economists, and politicians, take Keynes comment about the long term too literally. Yes, "we're" all dead in the long term, in the sense that everyone alive today will die, or even that someday the human race will become extinct.

But how far off is that long-term reality? And, not coincidentally, how much do we care about the lives our children, or their children, etc., will be required to lead?

Camus pointed out that the only valid question confronting humanity was the question of suicide.

Indeed. Should we, on behalf of future generations "suffer the slings and arrows of outrageous [economic] fortune, or take arms against a sea of [economic] troubles, and by opposing, end them?"

Anyone? Anyone? Bueller?

[hari]

@ Eric Dewey -

The difference between EU and USA when it comes to short-term decision-making is, for me, as a former staff of EU, simply the (political) fact that only at (top) Director-General level appointments inside EU are *selected* to accomodate equity between members of the club. Whereas, in US, with advent of each (new) Admin there is always a huge turnover of political appointees....In fact, your decision-making system is more or less *leased* to political parties and their cronies.

Otherwise, how in the world can one explain the lack of *political will* to regulate/oversee the hi fi sector - if, as you say, laws are there already on the books?

[Eric Dewey]

Good point, hari - and one that needs to be raised more often in the USA. I think that does go a long way toward explaining the differences with Europe, which, although it is certainly affected by the mortgage problems, doesn't seem to be struggling in the larger economy to the same degree.

What's really difficult to watch, for those here in the US with the vision to see, is the fact that there's a lot of political will to get change done but so little leadership. IMHO this is why "the people" are flocking to Obama - and also why the elites that supported Clinton are not. He has the potential to be a real leader, which is not really what the moneyed classes want.

[Lafayette]

They are legion

ED: What will change if new laws are enacted, or additional regulators hired?

And what would change if those who were delinquent in not applying the laws were brought to justice and tried? Malfeasance no longer has any meaning in America?

It would be a salutary lesson for others and a fresh start in the matter of applying/enforcing regulatory measures.

This is Massive Fraud that was conducted. If we let people get away with it, believe me, it will only come back to haunt us again. The Subprime Mess is just another in a long history of past financial scandals.

Finally, this mess -- like those past -- was born of personal greed for riches. A return to increased marginal taxation and that incentive no longer exists to tempt the poor souls who think lucre is the way of the world. And, with this last wannabee generation, they are legion.

Reckless Ronny opened a Pandora's Box and we are paying the consequences. Confiscatory marginal taxation WILL solve the problem.

[Tax Lawyer]

Don't any of you know that the solution is restoration of the middle class, via corporate taxes on outsourced overseas labor? A payroll tax in lieu of the corporate income tax would change the multinational's compensation structure, to favor domestic employees. This and maybe a tariff on imported goods where they don't stand up to scrutiny in the labor and OSHA-like practices. This would allow overseas labor to be able to extract wage increases or job safety protection, which would make the U.S. labor force appear cheaper than it is to the multinationals by increasing overseas costs of production.

[Oupoot]

It is interesting how communities and societies develop deterrants to activities that are not to the benefit of the community / society in general. In more traditional societies like old Europe, Asia and Africa, this is through social means: shame, losing your honour, community ostrasization, etc.

These deterrants dont apply to the US and most other parts of the Anglo-Saxon world (or more specifically, where urbanisation has caused the collapse of long-held community structures). Thus, for an outsider, it appears that in the US there is no shame in defrauding society, but only shame in being broke/victim, with a concurrent lack of social support structures. AFAIK, the deterrant mechanism in the US is the legal / regulatory system and its associated punishments. But, from the comments above, the legal / regulatory system is not sufficient protection against white collar crime, and can itself become easily corrupted. Indeed, society often reward those white collar criminals by settling out of court and/or selling the book and movie rights to their story. For example, how many corrupt managers feel ashamed of fleecing monies from their clients or the populace? The only solace the victims has is that they may be caught and brought to justice, but as others have pointed out, even that is not guaranteed. Certainly not Kenneth Lay or others at Enron & Worldcom. Yes, some of the managers on Wall Street were fired, but not after getting severance pay worth millions. In effect, they dont really need to work again, so what deterrant is getting fired really?

Could the legal/regulatory system be strenghtened to act as deterrant for activities not benefiting society in general (such as white collar crime) for example longer and more severe sentences/financial penalties for managers, directors and regulators, freezing and liquidating of assets, etc? Mark Thoma strongly believes so, but not many others in these comments above. Indeed, Economics favours financial deterrants, but countless examples would show that these type of deterrants often favour the very rich (who can simply pay the penalty / costs). Would it have helped stopped Kenneth Lay and associates from doing what they did if there were a very good chance (e.g. evidence only have to show very strong probabilities rather than proof beyond reasonable doubt) that they will loose their houses, investments, yachts, planes, etc and had to go live in an apartment in the Projects? (I would assume his wife & kids would have put sufficient pressure on him to avoid any such situation). And if not, what other means will communities or society at large develop to act as deterrant in future? There are enough historical examples: reorganising goverment such as the French and US Revolutions, development of labour unions in Europe in mid-1800s, etc. Indeed, Karl Marx was not so far off the mark when he said the capitalist system is corrupt and would fall in on itself. But yet, it has survived more than 150 years, countless revolutions, 2 World Wars, Communism, and many more since those gloomy predictions.

[Scott]

I have an opposite view on this issue, however i'd like to debate the other side too, get in contact with me if anyone would like to.. as this is an important crisis currently

- Scott