The Little Dutch Boy

Alan Blinder explains:

A Misguided Federal Reserve, or One That Saved the Day?, by Sudeep Reddy, WSJ Economics Blog:  The most controversial presentation at the Kansas City Fed’s annual symposium came from ... Willem Buiter. ...

Mr. Buiter slams the Federal Reserve, European Central Bank and Bank of England for what he says was a mishandling of the financial crisis and monetary policy over the past year. He gives the worst markets to the Fed...

Few participants at the Jackson Hole event appeared to support Mr. Buiter’s view. Even those displeased with some specific Fed actions probably back the Fed’s overall approach: trying to tackle the financial crisis to prevent much deeper trouble in the wider economy.

Assigned the task of critiquing the paper was Alan Blinder, the former Fed vice chairman, who gave high marks to the central bank. Mr. Blinder brought his point home to the crowd with a tale of a little Dutch boy (Mr. Buiter was born in the Netherlands), entertaining the crowd of international central bankers, academics and Wall Street economists:

One day a little Dutch boy was walking home when he noticed a small leak in a dike that protected the people in the surrounding town. He started to stick his finger in the hole, but then he remembered his moral hazard lesson. “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout. And doing that would just encourage more shoddy construction. Besides, the dumb people who live here should never have built their homes on a floodplain.” The boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned, including the little Dutch boy.

Mr. Blinder continued: “You might have heard an alternative version of this story circulating around the Fed.”

In this kindler, gentler version, the little Dutch boy, somewhat desperate and very worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. … It was painful. The little Dutch boy would much rather have been somewhere else. But he did it anyway. And all the foolish people who live behind the dike were saved from the error of their ways.

Comments

[truth telling is numero uno]

Buiter says openness and accountability are the best guards against regulatory capture(greenspan/benake put).

Blider says central bankers should not tell the truth(to the public)

Who should we believe........Buiter or Blinder?

Is there any contest?

[Mark Thoma]

Not really. Blinder has a far, far greater reputation.

And that's not what Blinder is saying, Mr. Truth Telling. At least characterize things right (also, the term "put" is a really poor description of what the policy actually is - on that point see DeLong for a convincing takedown of the idea there was a Greenspan put, it's posted here somewhere).

Ah, here it is, DeLong:

"...The idea of an important "Greenspan Put" lost plausibility as the Federal Reserve did not take steps to lower interest rates as the NASDAQ fell, but instead waited until it saw signs of slackening investment growth. How could anyone in the aftermath of the NASDAQ crash could speak--as John Makin does--of the Fed as providing "free insurance for aggressive risk-taking"?..."

More here:

http://delong.typepad.com/sdj/2005/07/a_greenspan_put.html

[Mark Thoma]

I think this commentmay have been intended for this post.

[Lafayette]

Success has many fathers but failure is an orphan

The lack of mea culpa from the Fed is indicative of a "can do no wrong mentality" long since ingrained in its mentality - particularly over the glorious Greenspan years.

No government institution, excepting, perhaps, the Supreme Court, should have such a long tenure within which silly notions become embedded ... simply because those notions are not confronted/tested by the reality of market conditions. Frankly, why did the Subprime Mess not happen earlier in Greenspan's shift?

Because he, and the Board, were better managers of their responsibility? Or because, luckily for them, the market conditions were not right? That is, the Cancerous Profit Greed -- at the base of the subprime manipulation -- was just in its infancy. As we are learning, the two Fannies bought the fraudulent mortgages onto their books only relatively recently (three to four years ago).

Had I been Greenspan and had I known of the defective underpinnings of subprime mortgages that seemingly abounded in the economy ... I would have taken retirement. And, were I Greenspan and had I not known of the defective subprime mortgages, I would have been derelict of my duties. The Fed should have known, since it has a mortgage market oversight responsibility. It is not just a bystander – like the little Dutch boy walking underneath the dike.

I will grant Greenspan the fact that he did mention in testimony to Congress that the Fannies were taking on too much of the toxic junk -- and Congress blithely ignored his words of preventive wisdom. After all, weren't the two Fannies simply acting according to their Charters by helping to bring home ownership to more American's? -- as they would typically crow to anyone who would listen.

So, if the search for mea culpas is fashionable, let's also look beyond the nerds who were hoodwinked, beyond the incompetent agents doing the hoodwinking, beyond the financial engineers bundling/selling the Toxic Waste to the two Fannies and the World -- thereby hoodwinking everybody. Let's look to the people who we elected to represent us in Washington.

But, I hear no mea culpas coming from there either. Do you?

Dictum: Success has many fathers but failure is curiously an orphan.

[Blissex]

«In this kindler, gentler version, the little Dutch boy, somewhat desperate and very worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. … It was painful. The little Dutch boy would much rather have been somewhere else. But he did it anyway. And all the foolish people who live behind the dike were saved from the error of their ways.»

There are two important problems with this version:

* The builders of the shoddy dike and of the houses on the floodplain, and those who financed them at junk rates, and the whole foodchain that raked it in on these projects get to keep all the bonuses, capital gains, luxury lifestyle and positions of power they have gained; "F*ck you, I am fully vested".

* While the little boy loses a finger in the original dutch tale, in this version he just suffers some discomfort, but in our reality a lot of stupid losers have to pay a lot of money through bailouts and inflation to ensure that the astute winners get away with it all, keeping all the power and money they have vested themselves in.

Blinder's tale is a celebration of moral hazard; his moral is that if an astute winner does a sufficiently shoddy job creating large enough risks, they are going to get away with it, and the sacrifices by stupid suckers like the little body are trifling compared to the goal of ensuring that the winners keep the money and power they have created for themselves.

What is missing in all these stories is *deterrence*.
Somebody steals their lawnmover? Well, a few years in the slammer to deter this from happening again. A cashier embezzles $100? Make sure they are blacklisted so they never find a job again. Wall Street CEOs and local Republican bizmen make billions on a gigantic ponzi scheme financed by the Fed? Well, for everybody's sake let's ensure they get away with it, save for a few idiots who get thrown to the wolves. Deterrence? That's a nasty word when applied to the best brightest in the nation.

Then according the the usual propagandists there is no need for state retribution; the market will punish the bad guys by causing them large losses. But no, of course that is too harsh -- the state will bailout those losses, and the story has a happy ending for everybody.

Except that it does not -- because that is just the usual Republican narrative: that one can lower taxes on the productive members of society, fight 2-3 wars, bail out the same productive members of society, and all will be fine, no need to start thinking negatively about blame and deterrence. The flaw in it is that deleveraging has to be paid for by someone, through higher inflation or a direct reduction in income.

In the end this is a classic application of business thinking to the "prisoner's dilemma".

In it each of two prisoners can choose to help each other (cooperate) or screw each other (betray), but if one helps and the other screws, the latter wins big.

From the point of view of a businessman, a master of the universe, the way to win is clear: make sure that the vast mass of stupid suckers always chooses "help you" (bailout), even if he always chooses "screw you" (ponzi scheme).

How you do that? Well, generous campaign donations to the politicians who represent the interests of the suckers, and splendid sinecures for those like Blinder who openly advocate that the suckers choose "cooperate" every time the winners take home the loot after choosing "betray".

[One Step Back]

Once a leak starts, it has to be plugged. The problem came one step back when negative interest rates during boom times caused the dike to crack and spring myriad holes in the first place.

[Blissex]

«One day a little Dutch boy was walking home when he noticed a small leak in a dike that protected the people in the surrounding town. [ ... ] somewhat desperate and very worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. … It was painful. The little Dutch boy would much rather have been somewhere else. But he did it anyway.»

«The Fed should have known, since it has a mortgage market oversight responsibility. It is not just a bystander – like the little Dutch boy walking underneath the dike.»

That's another element of shameless distortion used by that shyster Blinder to sugar coat the story.

As you say he conveniently omits that far from being heroic innocent little boys, Greenspan, Bernanke, Paulson should have been the guys checking the quality of the dike and making building houses on a flood plain illegal or put safety measures in place.

Instead of encouraging and financing the building of the shoddy dike and of the houses on the flood plain, and turning a blind eye crooning "the market knows best, I am just the central banker".

Also, as above, in the original dutch tale the little boy loses a finger, never mind "It was painful. The little Dutch boy would much rather have been somewhere else".

Also people like Blinder, Bernanke, Greenspan, Paulson, have not been sticking *their* finger in the dyke, they have been sticking other people's money in that dike.

Distorting the story in such ways tells me that Blinder is just engaging in intellectually dishonest propaganda, with clever omissions and perversions.

Let's rewrite the story:

One day a rich central banker was being driven home and he noticed a small crack in one of the dikes that his loose money policy had financed at low, low, low rates to keep Republican campaign donors happy, and this might threaten the flood plain on which many houses had been built. He did not worry, because he was sure that the market had correctly calculated the strength of the dike, and the risk to the houses had been priced into their valuation, and he would not second guess the market. Indeed the cracks were just probably painted there by naysayers (he thought of Roubini) because the market could not have failed to price in all the appropriate risks and precautions.

However just in case he told about the crack to his friends who had built the houses on the flood plain below and they started liquidating their exposure to flood risk by dumping it on suckers (their clients and shareholders) and to cash in their options. They all had houses on shiny hills or abroad, and they did not have any direct exposure to flood risk.

The following day the rich central banker passed by the same spot and this time the crack had become a hole and there was a fair trickle of water coming out of it. Other people had gathered to look at that and they were scared. So he decided action was needed as not all his friends would have been able to liquidate their indirect exposure to flood risk, and told his driver to stop, got off the car, asked everybody present who looked like a low income worker to give him all their money, and stuffed the hole in the dike with it; but that looked like delaying, not stopping the trickle, so he also phoned his office and told his staff to lend money to his friends against the full value of houses on the floodplain using taxpayer's money as quickly as possible, before the dike burst.

Then the central banker got back to his car, and told the driver to continue on the trip to the airport for the flight to Jackson Hole.

[hari]

The concept of moral hazard in hi fi sector is more egregious than the analogy of the *little Dutch boy*, as Blinder knows too well about AGs *put option* and how the market rode it.

Dutch dikes, from a historical perspective, have not always proven to be *water-tight* and there is plenty to read about it from Simon Schama's *The Ebarassment of Riches*. However, whatever the purpose of Blinder analogy is purported to dismantle (ie. policy critique from Buiter/ex-BoE), the dikes have been the saviour of these lowlands for centuries -technology transfer being the end-product of Dutch dike innovation - to boot.

Buiter's critique of AG/BBs actions - or lack thereof - are not easily refuted unless, of course, you're an orthodox believer in so-called free market laissez faire capitalism.
Having made a total mess of US monetary policy over the last three decades of deregulation and whatnot - Blinder & Co must take their professional responsibility and incapacity to stop of the *leaks* in the system, as a manifest sign of professional incompetence.

[Lafayette]

Some get away with it

bliss: but in our reality a lot of stupid losers have to pay a lot of money through bailouts and inflation to ensure that the astute winners get away with it all, keeping all the power and money they have vested themselves in.

If this is a call for justice, then we can all sympathize with the notion. What galls most, as regards such consummate greed, I submit, is the fact that some get away with it handsomely.

Go into a bank, steal megabucks ... see where it gets you. Certainly not in a large house on the Hamptons, nor even a small house in the Caymans.

If we, as a nation, accept such White Collar Criminality because it is coated in a veneer of "business as usual", then we are really and truly the fools they take us to be.

[Blissex]

«If we, as a nation, accept such White Collar Criminality because it is coated in a veneer of "business as usual", then we are really and truly the fools they take us to be.»

Ah much better than that -- a lot of Usians *dream* of being white collar criminals themselves, and have only admiration for the *winners* who get away with it. Who would not want to be another Mozilo or Cayne?

Think of all the wannabes who bought houses to flip on 0% down, or all those who refinanced to fund consumption.

[Lafayette]

bliss: Think of all the wannabes who bought houses to flip on 0% down, or all those who refinanced to fund consumption.

I will agree that the greed is pervasive in the population as a whole. Not everybody may touched with it fully ... some think that it is natural to "better their lot in life in any way possible". This sort of greed is fairly commonplace.

So, yes, if a nerd is sucker enough to believe a proposition for "nothing down" ownership of property, then that sucker probably deserves to get fleeced. However, how does one discern the sucker from the simply gullible? That is, as regards the latter, those who were simply naïve enough to truly believe that the risk involved was negligible, largely because the risk was never intentionally fully explained.

Naive is an altogether different character trait of an individual. Such people are credulous, gullible.

The greedy know they are being greedy and do so willfully, with premeditated calculation. They condition themselves with such nonsense as “Well, if I don’t do it, someone else will”. As if that made greed acceptable. And, within a nation that adulates wealth, greed can even, in some circles, be considered as "good".

We’ve lost our sense of right and wrong in many ways that determine or prompt our behaviour. Such a fault is not really economic in origin, it is more psychological since it is a matter of personal values.

But economics does show all too well when such behaviour has a negative outcome, that is, Income Unfairness.

[robertdfeinman]

As long as we are dealing in fairy tales he's one of my own:

A person walks into the doctor weighing 500 lbs, with congestive heart failure and diabetes and says: "doctor give me a pill to solve my problems". The doctor says, "first we have to examine how you got into this state so that I won't ever see another patient like you in the future". He then proceeds to convene an international conference during which time the patient dies.

I'm sure there is some value for academic studies on what went wrong, but once things have gone too far a pill won't help.

The value of various derivatives has been inflated for several decades now (financial "innovation") and the air is leaking out of these virtual products. There is no way to stop this, but there are various choices that can be made as to who suffers the biggest losses.

So far the tendency seems to be to preserve as much of the wealth of those who participated in the financial sector, especially the professional investors. The money to do this is coming out of the treasuries of the affected countries. This means that those who will ultimately pay the bill will be the tax payers.

This will be some combination of deflated currency, a drop in the standard of living, higher taxes and a lower rate of growth of the economy, especially in social services and infrastructure. Hardly anyone will complain because how can you complain about growth that didn't happen five or ten years from now?

Is there any plan to make the greedy pay rather than the public at large? If there is I haven't heard it.

[donna]

Yes, but in the Netherlands, they also teach all the kids how to swim.

[James]

Buiter raises some valid points that deserve serious consideration.

What has followed so far resembles an academic departmental cat fight.

The notion that Brad DeLong has debunked the Greenspan put is funny. It demonstrates the principle that the current 'school' of economic thought has calcified into mere self-perpetuation.

At second thought, it supports Buiter's contention that the Fed (and a good part of the economist community) have a sort of fatal attraction to Wall Street that guarantees policy errors.

[RW]

I've always appreciated Blinder's work and consider him more right than wrong on most matters economically liberal and will not question his integrity or motives now (after all I hardly know the man other than through his writing) but I'm forced to agree with the more skeptical comments above.

I do not fully agree with Buiter's analysis (central bank leaderships are political appointees are they not?) but the "Little Dutch Boy" metaphor does not work at all: The Fed was not a passerby, it was a statutory and regulatory partner in the architectural specs, planning, construction and maintenance of the dike; it was aware of problems in that structure before the surface cracked and the leaks (plural) were revealed and it must also have been aware of the potential for failure under systemic stress.

A more accurate analogy would compare the credit/solvency crunch to New Orleans/Katrina with the Fed playing the part of the Corps of Engineers and FEMA: Bernanke comes out looking better than Brownie for a number of reasons but the institution(s) he represents none-the-less shared responsibility for the integrity of the system _before_ it failed as well as after.

Notice I say shared. One analysis I would dearly love to see is what Greenspan's options were once it became clear President Dubya had not only dug his heals in on tax cuts but, with a fully compliant congress to back him, was determined to expand those cuts and institute other policies that guaranteed federal deficits would explod even if he hadn't also been a warmongering fool. IOW what are the options when fiscal discipline is abandoned leaving only monetary policy to compensate? Anything other than interest rate cuts?

That aside the Dutch Boy metaphor is simply a red herring: It deflected a rather intense critique sufficiently to allow guests at Jackson Hole to return to their canapés and wine in a more convivial spirit; Blinder proved himself socially adept but his comments are not worth defending in any terms other than that.

[groucho]

Not really. Blinder has a far, far greater reputation.

Mark, reputation for what? The central banking "blue code of silence"?

It's shameful as well as immoral to hear insiders disrespecting honest outsiders(such as Buiter).

The core problem of the western financial system is it has become crony capitalism and DISHONESTY has become the "rule of law".

It is pathetic...............

[roger]

Blissex - I love your version!

I've noticed the parallel in the atmosphere of the Bush boom and its aftermath with the war in Iraq. In the same way the gated community crowd of policy makers cast themselves in the heroic mold, as if they were putting themselves in harms way by advocating and mismanaging a war - when of course they would only profit by the opportunities it afforded them on the homefront, while putting hundreds of thousands of real volunteer soldier's lives on the lines, and millions of civilian Iraqi lives - so, too, does Blinder's comparison reek of the pseudo-heroism of the entrenched. Here's the FED using other people's money to support the wealthiest people in the world, and here's its image: heroes stuffing holes in dikes.

The elite have to confuse their proxy heroics - their "sacrifices" - with real heroics in order to sustain their self image, and, more importantly, in order to spin that image before the public. After all, if the public caught on, there might be discontent. This is where economists are so important. The media, which is entrusted with the job of anaesthetizing discontent, turns to them as the medieval kings used to turn to the Church. The economists love to assure us that it is the market itself, the hand of god, that has graciously endowed us with a heroic elite of brilliant managers and "risk takers" who amply deserve their incredible cut of the national product because, well, how can you even gain a metric to judge heroic activity? Why, the billion per accrued by the top hedge fund managers, who contribute zip to the real economy - does anybody really think that capitalism was suffering from an investment drought before deregulation and the financial sector's search for profits brought about securities "innovations" - have to be put in terms of some transcendental usefulness. Otherwise, we start asking questions about the whole system. For instance, we start asking why, if the financial sector is so grossly mismanaged that the Fed needs to loan it astonishing amounts of money at astonishingly low rates, we need the sector at all? Cut out the middleman, and let the Fed loan to us all if they are really so good at it.

When a leak opens up in the dike of the average American life - when credit card debts become overwhelming, when sickness strikes, when, due to those wonderful free trade policies that have shifted high paying manufacturing jobs out of the States, layoffs result - there is no talk about the Fed putting fingers in dikes then. The addendum to too big to fail is too small to count. That principle has another name - the aristocracy. Livy, Machiavelli, Locke, Montesquieu, Jefferson all knew its features very well, and knew that it signaled the end of a Republic. Well, their vision is scoffed at now, cause we live in the "Great Moderation". Which is actually the great slide towards the end of Democracy.

[FOMC...or how the scribblers destroyed a nation]

Blinder scores a few points with this observation:

``Willem's papers don't pull punches, they have attitude,'' Blinder said. ``You have to give credit to a guy with the nerve to come here with black bears on the outside and the FOMC on the inside and be this critical of the Federal Reserve.''

who's zoom'n who?

[Bruce Wilder]

L: "We’ve lost our sense of right and wrong in many ways that determine or prompt our behaviour. Such a fault is not really economic in origin . . . "

Lafayette goes to the heart of the issue, which is not the mechanics, but the ethics of institutional policy. This is an argument about which "morality" ought to guide the governance and functioning of banking and finance.

(A while back, I think Mark Thoma posted something on the work of a scholar, who was studying how people attach moral analysis to a limited array of decision-contexts, but not others, and how these constellations switch. Google as I might, based on my vague recollection, I haven't been able to find it, again. If someone could help me out, with a pointer, I would appreciate it.)

If you don't credit the "moral analysis" on its own terms, it seems to be a debate about the relation of precedent to moral hazard problems, or about the wisdom of letting sunk cost considerations dominate prospective choice. For economists, used to supposedly dispassionate functional or mechanical analysis, putting aside value-laden "moral analysis" has a certain appeal, but carries its own hazards. Chief among these hazards is a prospective, subjunctive, "future"-orientation, that invites -- indeed, demands -- an excess of counterfactual speculation and projection. If you free yourself from the obligation to fully confront even the recent past, to look squarely at what happened, by taking the dodge that it makes no sense to make everyone suffer "unnecessarily" for past failures, you also free yourself, and everyone else in the room, from the need to accept that you all might have been wrong -- not just factually wrong about how the world works, but morally wrong, in the sense of failing to do one's duty, in the established institutional context.

The macroeconomic policy consensus about what (moral) duty requires of central bankers (or just plain bankers) has been under a sustained assault for thirty years. Bernanke has a view of his moral duty, which has been clearly expressed in his historical writings, and which can be fairly expressed, imho, as being that the New Deal reforms were destructive and unnecessary, because a timely inflation could have kept the plutocracy comfortably in place. It is hard to look at his present actions, and not see current Federal
Reserve policy as his reactionary conservatism in action.

It is 1932 redux, but the theory is that catastrophic "monetary" events are like neutron bombs -- they leave the buildings standing, and so if we handle things correctly, we can just re-people the cityscape, and go on as before. Bernanke believes that the banking system can be re-capitalized, and we can just go on, and the wealthy elite will not have to give up the out-sized share of national income and wealth that they have re-claimed, since Reagan and the Republican Revolution ended the Great Compression. And, Bernanke thinks this would be a good thing. Evidently, in his way, so does Blinder.

The mission of corrupt agents of the plutocracy, like Tyler Cowen (see Mark Thoma's recent post), is to prevent a restoration of New Deal structural reforms, which would would curtail the very wealthy from fleecing and oppressing the poor and middle classes, through the financial and banking systems, (not to mention the structuring of employment incentives -- we are all highly productive fruit pickers, now, and damn that minimum wage).

Alan Blinder's mission in life, evidently, is to be a place-holder for real liberals -- a Central Banker equivalent to such Time Magazine "liberals" as Joe Klein -- who will offer timely support to the Plutocracy's main men, and generally protect the left flank of the Counter-Revolution in its darkest hour so far. Willem Buiter, a High Tory fool from wayback, though, is allowed to offer canonical criticism from the Right. If Marx were alive, he would have a field day pulling apart this Pushkin Village debate. Only an unreconstructed Austrian could offer even more ridiculous criticism than the Tory Buiter, and I am sure we will hear from them as well.

What we will not hear much of, though, is criticism of the policy of re-structuring the financial system to facilitate upward redistribution of income and wealth. At least not from the heights occupied by the likes of Blinder, or say, Larry Summers, who plays a similar role: someone regarded as "safe" by Wall Street's Masters of the Universe and their sponsors.

Even the simply obvious flaws in the financial system's institutional structure -- for example, the extraordinary compensation offered the leading lights of Wall Street -- will receive little sustained criticism. The level of compensation is incompatible with any institutional containment of "moral hazard". It cannot be left unchallenged and unreformed, without guaranteeing a new, worse crisis in the near-future. But, if even someone with Paul Volcker's prestige dares say it, it will receive little attention. To ignore such a giant elephant in the room, is, at the least professional incompetence, but, hey, keeping attention away from focusing on such matters is the central mission of people like Tyler Cowen, and part of the job description of Larry Summers or Alan Blinder.

A detached analysis of the neutron bomb theory of monetary catastrophe has its uses. I, certainly, would not want to implement either Buiter's High Tory vision, or the even more oppressive Austrian vision, of the "moral" value of using an economic contraction to actually increase the blood flow from the middle classes to the super wealthy. Intense economic suffering doesn't make us stronger. I don't think that what is wrong with the neutron bomb theory should be remedied by increasing the carnage among the middle classes.

But, we should be aware that we are not hearing a critique of recent policy from a position of uncensored good will.

[Blissex]

«Willem Buiter, a High Tory fool from wayback, though, is allowed to offer canonical criticism from the Right.»

I liked the general tenor of the comment, but the above bit is a bit too critical. It is difficult not to like someone who amidst other arguments writes plainly that:

“Throughout the 12 months of the crisis, it is difficult to avoid the impression that the Fed is too close to the financial markets and leading financial institutions, and too responsive to their special pleadings, to make the right decisions for the economy as a whole,” Willem Buiter.

Sure, he also advocates letting blood run in the streets, but that is indeed the correct solution.

«I, certainly, would not want to implement either Buiter's High Tory vision, or the even more oppressive Austrian vision, of the "moral" value of using an economic contraction to actually increase the blood flow from the middle classes to the super wealthy. Intense economic suffering doesn't make us stronger. I don't think that what is wrong with the neutron bomb theory should be remedied by increasing the carnage among the middle classes.»

Ah sure, but there are three theories:

* Bernanke: no contraction, but let the costs of deleveraging be paid by the unproductive bottomost 80% of the country to bailout the productive 20%, in the form of inflation.

* Buiter: let the contraction happen, and let the bottomost unproductive 80% pay the cost of deleveraging, in the form of deflation.

* #3: Let the contraction happen, and let the wealthy leveraged scammers pay the price, while the middle class is protected by a moderately generous safety net.

I prefer #3, because bankruptcy is the most important tool for economic progress (I believe that the real distinction is not between capitalist/socialist capital, or market/planned economies, but between economies with bankruptcy and without), and that other Austrian, Schumpeter, was right about creative destruction.

However Usian voters detest #3, because the dark skinned hordes would have to be protected too (that equal protection clause is very inconvenient, and the white middle class was disgusted by its starting to be enforce in the 60s).

[Blissex]

«Even the simply obvious flaws in the financial system's institutional structure -- for example, the extraordinary compensation offered the leading lights of Wall Street -- will receive little sustained criticism. The level of compensation is incompatible with any institutional containment of "moral hazard".»

Very well said. Those with access to Wall Street jobs or the corner office jobs get in effect a very, very valuable option: at worst they earn good of money, but if there is a bubble or they don't get caught "tunneling" they earn enormous money very quickly, which as you point out, means that the larger the beta, the more they stand to gain.

[bullbust]

Brad Delong debunked the Greenspan put? Are you nuts?

Do you remember the panic 0.75 cut on Jan 22nd this year? The Greenbum put is alive and well.

Are economists so crooked and unprincipled to suck up to this? This straw man of rates, forgetting all about the Fed as regulator. All flowing from the free-market kool-aid. How much more will you subject the public to plunder for the sake of your crackpot theories?

Setting up straw men and demolishing them so that no-one can question their actual doings. These unprincipled hacks put up the strawman choice as always between (a)bailout and (b) no-bailout.

There is another choice (c)punitive bailouts. Where the pigmen pay for their risks, and the public pays less. Do you ever hear of that from these kool-aid peddlers?

http://www.nakedcapitalism.com/2008/08/buiter-provokes-wrath-at-jackson-hole.html

Buiter has taken a bold position, The Fed needs to be able to explain why what is good for Wall Street is also good for the economy as a whole. The sort of questions that Buiter is raising are notably absent from the media and US-based first rank economists. The Bloomberg story may not give a full enough account to be certain, but the responses to Buiter's charges do not seem persuasive. They amount to disputes over analytical methods and assertions that everything is working fine (after providing a $400 billion fix with no withdrawal plan and getting support from foreign investors equivalent to $1000 a person. So what's your next act?).

It will take some time to see if events prove Buiter right. And as Cassandras like Nouriel Roubini know, it can sometimes take longer than you anticipate for bad policies to finally yield the expected dismal harvest.

The free-market economist crowd supports the bailouts, not because the system will collapse, but because the alternative will leave them no choice but to admit their past blunders. It will expose the kool-aid they have peddled since Greenspan and co. How much more thuggery will economists do to deny their past mistakes?

Alternatives - like the Roubini plan for GSE bailouts - are there. Those make the pigmen pay too, and cuts the public's bill. But then that means admitting that the mudbloods like Roubini was right, and that's verboten for these pureblood wizards.

The economist hacks will fight tooth and nail. They are true believers.

Which is why they should not be lined up and shot, but ridiculed and made fun off. Ridicule is their worst terror.

[Blissex]

«something on the work of a scholar, who was studying how people attach moral analysis to a limited array of decision-contexts, but not others, and how these constellations switch.» Some relevant links, probably not the one you sought though: http://www.freeweekly.com/2007/01/18/why-we-cheat http://living-great.com/feature2.shtml http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1025984 http://dir.salon.com/story/books/review/2004/02/23/making_good http://atheism.about.com/b/2006/01/29/morality-of-rich-vs-poor-in-america-book-notes-the-cheating-culture.htm

[Bruce Wilder]

blissex: "Sure, [Willem Buiter] also advocates letting blood run in the streets, but that is indeed the correct solution."

As blissex points out, the tricky part is "whose" blood.

I will demur that I don't know that the wealthy, with some highly leveraged investments, are the main culprits. There's a logic in making them bleed, as a warning to others not to make common cause with crooks -- not that human history suggests that warning will long be taken to heart. But, the real bad guys are mostly the hired help, with no real skin of their own in the game, who have been able set up highly risky, arcane schemes and take the money and run, before those arcane schemes collapse. (The really bad guys are the architects -- men like Sanford Weill, Phil Gramm and Angelo Mozilo) -- show me one of those guys, who isn't more akin to a mobster aspiring to run a Las Vegas Casino, than a rich guy trying to skim cream from arbitrage in a temporarily riskless carry trade or some highly leveraged game of musical chairs.)

There's also an valid argument to be made that it can be hard to distinguish between legitimate high-risk ventures and variations on Ponzi schemes and the like. Which is why I think some kind of Glass-Steagall wall is necessary as a bedrock regulatory principle, and superior to consolidating regulation in a single super-regulatory, which has to, somehow, exercise superior judgment in supervising the management of every kind of financial institution. Creating separate categories of financial institutions, each on its own bottom, can prevent a single calamitous event from threatening the whole system. It can also help to limit the competitive scope given to predatory financial practices. If we have a strong thrift sector, it prevents the proliferation of payday lenders. Universal banks, by contrast, benefit from coordinating fraud and predation; Citibank closes a branch and the sister loan shark division, CitiFinancial opens one; WaMu appraisers cover for WaMu loan officers handing out LTV stinkers, etc.

The GSEs were corrupted into becoming servants solely of the consolidating giants like WaMu and Countrywide, instead of pursuing their traditional role of supporting small and medium-size community and regional banks. So, now we are in danger of losing many small and medium-size banks, who, deprived of mortgage-lending, over-invested in commercial real estate and construction loans.

Separation walls are critical to creating a sustainable competitive equilibrium, which does not devolve into universal predation. Separation walls are also necessary to creating regulatory agencies with a mandate and focus, which is manageable. And, to leaving some part of the industry free of the "dead hand" of regulation (which is, I think, a legitimate concern albeit not a religious imperative), without exposing the whole economy to the potentially lethal hand of bankers with the ethical fortitude of Jack the Ripper.

I don't offer these ideas about the proper course of regulatory reform from any egotistical notion that I, alone, know best. These are not clever, original thoughts. These are a kind of bargain basement assortment of basic considerations. If reform proposals don't acknowledge excessive compensation, don't acknowledge the salience of fraud and predation in the mortgage bubble, and don't advocate separate heterogeneous banking spheres, sheparded by separate regulatory agencies, then beware!

If all the talk is, instead, of the "housing bubble" (like people just started overvaluing housing spontaneously, like the legendary tulip bulbs), and consolidating regulation in a superagency or the Fed able to supervise every player in the single, giant pool of financial institutions, chances are good we are listening to claptrap and b.s.

[blogging changes everything]

Mark, though probably not too much to your liking there are some extraordinary comments on this blog.

Congratulations to all!

[gordon]

So there isn't any choice other than (a) bail out the existing banking/credit system (with all its imperfections) or (b) endanger the "real economy" by allowing bankrupt banks, retail lenders, hedge funds etc. to fail?

Actually, Alan Blinder himself suggested a different sort of response back in February this year, when he proposed reviving the Home Owners' Loan Corporation (HOLC), a New Deal initiative aimed at reducing foreclosures. What happened to that idea?

And roger suggests: "Cut out the middleman, and let the Fed loan to us all if they are really so good at it". roger isn't the only commenter over the last few months to make this kind of suggestion. The idea is simple; prevent a damaging credit crunch by lending to creditworthy persons (including businesses). Very simple. I put forward my version of this idea (The Commonwealth Bank of the United States) here and here.

Well, here it is again. Maybe we should just call it "The third way".

[Lafayette]

Blinder with blinders

Excerpted from: Bloomberg News Bernanke, Buiter, Draghi Diverge on How to Forestall Crises

"We shouldn't delude ourselves into thinking we are going to build a panic-proof system,'' former Fed Vice Chairman Alan Blinder, who attended the conference, said in an interview with Bloomberg Television. ``But there are choices between less and more panics, more virulent ones, less virulent ones, and that is the way we want to push the system.''

Oh, Mr. Blinder, so the panicking that repeats itself like an every seventh-year itch is "business as usual"?

This guy is blinder and blinder.

[gaius marius]

this is a rather unfortunate analogy by blinder. while it must greatly assuage the egos of the central bankers involved, elevating their role to the heroic, it is false.

a more honest analogy would be to replace the dike with a dam -- holding back not a passing storm surge but the accumulating force of a river. while storms pass and their effects are transient, rivers continue to flow -- and the force of their retained water, rather than abating, inexorably grows.

central banking policy over the last seventy years (more acutely the last twenty) have prevented at each potential intersection the credit market from reaching the clearing prices of maximum pessimism in the flood times, which were deemed "irrational" and "unnecessary". in this revised analogy, the policy aim has been not to maintain the dam but to narrow the spillways designed to ensure that the force of the water behind the dam does not endanger the dam itself, the better to moderate the highwater downstream. the absence of those episodic full-force events over a long span has already encouraged the buildup of systemic (as opposed to cyclical) debts, which have grown so large as to represent a mortal threat to systemic integrity -- the accumulated water behind the dam is very high now, and forcing the dam to crack. this leaves men like bernanke with the opportunity to cast themselves as heroes as they, while feverishly filling the cracks with their fingers, manage also lay the last few bricks to seal up the spillways completely.

central bankers like bernanke and blinder talk about moral hazard like it is a potential problem; this highlights just how narrow their view and tenuous their grasp of the underlying reality is, deluded by decades of apparent success that really amount to consistently storing up bigger trouble for the future. moral hazard has been a problem in practice at least since monetary policy became a countercyclical weapon in the 1930s.

i sympathize with blinder's view -- if rates are raised, the dam may well break. but what blinder does not seem to realize -- even in the shocking light of graphs like this -- is that if the dam isn't allowed to break today, it will shortly overtop and come crashing down anyway. the problem isn't being alleviated; it is being capacitated. their little dutch policy, far from having nobly attempted to save the ageing baby-boom generation from "unnecessary" pain, will have surely imperiled and summarily washed away both them in their dotage and their children besides.

[anne]

Foolish questions I have no answer for. Why should it matter in terms of fluid dynamics or wall construction whether the boy stuck his finger in the dike? What if the boy did not stop the water, would the dike have burst and if so what would have been the cause? I have to ask.

[Blissex]

«their little dutch policy, far from having nobly attempted to save the ageing baby-boom generation from "unnecessary" pain, will have surely imperiled and summarily washed away both them in their dotage and their children besides.»

But perhaps not -- the crucial aspect of the mountain of debt is that it is largely owed to foreigners, and in dollars.

The big issue in the USA are the gigantic unfunded retirement (except Social Security, which is fairly OK due to being somewhat mean) and health care liabilities (both government and private) of the baby boomer generation. Having those covered by foreigners, and then saying, "goodbye, and thanks for all the trillions" and leaving it at that may be a cynically good idea, and anyhow makes Wall Street and CEOs very rich.

If the USA elites thought their country was in secular decline, they might as well have a policy of becoming sooner rather than later a gigantic debtor, and then essentially renege on that debt (via currency depreciation or just outright denial).

If you owe China ten billion, it is your problem, if you owe China a trillion, it is China's problem. :-)

That recently an economist close to the Chinese government has issued clear, hard and direct threats (something very un-Chinese) to the USA government about explicitly reneging on its foreign obligations means something.

I think that the Chinese could accept to be screwed with a slow long term fall of the dollar value, as that would save face (as in any case they know very well they have been doing loss-leading vendor financing), but not anything abrupt.

[groucho]

"I think that the Chinese could accept to be screwed with a slow long term fall of the dollar value, as that would save face "

Blissex, no face saving needed by the Chinese they have known all along what the game has been. And in fact they come out ahead under all scenarios(whether the US defaults ala Russia or the printing press)

what china has wanted and is getting is a TURBOCHARGER to their industrialization process. Which they got by vendor financing(what Bernanke calls the "savings glut")....which I personally disagree with because which came first the artificially created credit CB/fractional reserve commercial banking or the cash settlement?

I believe the artificial credit comes first than the trade imbalances come into play. Credit is the leader, cash to recycle is the follower. Richard Duncan spelled out the financial recycling system a long time ago in "the dollar crisis".

At the end of the day, China speeds up its quest to be a superpower by a few decades. The loss on dollar assets is a rather small price to pay. And with the coming nationalization of the GSE's maybe they only take very small haircuts, as you suggest.

[gordon]

gaius marius, thanks for the link with the graph.

[Lafayette]

An appropriate aside

Bliss: That recently an economist close to the Chinese government has issued clear, hard and direct threats (something very un-Chinese) to the USA government about explicitly reneging on its foreign obligations means something.

It should not go without attention that Russia invaded Georgia in the midst of the Olympics. It should also not go unnoticed that China continued its repression in Tibet during the Olympics.

Expect both of these autocracies to get obdurate as regards foreign policy, now that the Olympics are out of the way. Russia because it has gone heady with oil income and China because it believes it's destiny is greatness. Just the opposite is happening, which bears the hallmark of (ex-KGB apparatchik) Putin's consummate arrogance.

Both will be major worries for the next PotUS. Medvedev says he would like to avoid another Cold War, but would not particularly care if it happened. This remark is asinine, given that no one is menacing Russia's sovereignty.

But, Russia has Europe (with the exception of France) by the short and curlies due to gas dependence. I smile to see the German Left so outspoken at Chinese interference in Tibet, but who were also the ones to have militated for a non-nuclear Germany (which has actually passed legislation to close down nuclear plants).

Which leaves Germany up sh*t-creek without a paddle. Pure idiocy, it was.