"And Now the Great Depression"

The financial bailout plan looks more likely now that there has been a "breakthrough." Barry Eichengreen says even with a plan in place, the crisis won't end quickly and double digit unemployment is "not out of the question":

And Now the Great Depression, by Barry Eichengreen, Vox EU: A couple of months ago at lunch with a respected Fed watcher, I asked, “What are the odds are that US unemployment will reach 10% before the crisis is over?” “Zero,” he responded, in an admirable display of confidence. Watchers tending to internalize the outlook of the watched, I took this as reflecting opinion within the US central bank. We may have been in the throes of the most serious credit crisis since the Great Depression, but nothing resembling the Depression itself, when US unemployment topped out at 25%, was even remotely possible. The Fed and Treasury were on the case. US economic fundamentals were strong. Comparisons with the 1930s were overdrawn.

The events of the last week have shattered such complacency. The 3 month treasury yield has fallen to “virtual zero” for the first time since the flight to safety following the outbreak of World War II. The Ted Spread, the difference between borrowing for 3 months on the interbank market and holding three month treasuries, ballooned at one point to five full percentage points. Interbank lending is dead in its tracks. The entire US investment banking industry has been vaporized.

And we are in for more turbulence. The Paulson Plan, whatever its final form, will not bring this upheaval to an early end. The consequences are clearly spreading from Wall Street to Main Street. The recent performance of nonfinancial stocks indicates that investors are well aware of the fact.

So comparisons with the Great Depression, which have been of academic interest but little practical relevance, take on new salience. Which ones have content, and which are mainly useful for headline writers?

First, the Fed now, like the Fed in the 1930s, is very much groping in the dark. Every financial crisis is different, and this one is no exception. It is hard to avoid concluding that the Fed erred disastrously when deciding that Lehman Bros. could safely be allowed to fail. It did not adequately understand the repercussions for other institutions of allowing a primary dealer to go under. It failed to fully appreciate the implications for AIG’s credit default swaps. It failed to understand that its own actions were bringing us to the brink of financial Armageddon.

If there is a defence, it has been offered Rick Mishkin, the former Fed governor, who has asserted that the current shock to the financial system is even more complex than that of the Great Depression. There is something to his point. In the 1930s the shock to the financial system came from the fall in the general price level by a third and the consequent collapse of economic activity. The solution was correspondingly straightforward. Stabilize the price level, as FDR did by pumping up the money supply, and it was possible to stabilize the economy, in turn righting the banking system.

Absorbing the shock is more difficult this time because it is internal to the financial system. Central to the problem are excessive leverage, opacity, and risk taking in the financial sector itself. There has been a housing-market collapse, but in contrast to the 1930s there has been no general collapse of prices and economic activity. Corporate defaults have remained relatively low, which has been a much-needed source of comfort to the financial system. But this also makes resolving the problem more difficult. Since there has been no collapse of prices and economic activity, we are not now going to be able to grow or inflate our way out of the crisis, as we did after 1933.

In addition, the progress of securitization complicates the process of unravelling the current mess. In the 1930s the Federal Home Owners Loan Corporation bought individual mortgages to cleanse bank balance sheets and provide home owners with relief. This time the federal agency responsible for cleaning up the financial system will have to buy residential mortgage backed securities, collateralized debt obligations, and all manner of sliced, diced and repackaged paper. Strengthening bank balance sheets and providing homeowners with relief will be infinitely more complex. Achieving the transparency needed to restore confidence in the system will be immensely more difficult.

That said, we are not going to see 25% unemployment rates like those of the Great Depression. Then it took breathtaking negligence by the Fed, the Congress and the Hoover Administration to achieve them. This time the Fed will provide however much liquidity the economy needs. There will be no tax increases designed to balance the budget in the teeth of a downturn, like Hoover’s in 1930. Where last time it took the Congress three years to grasp the need to recapitalize the banking system and provide mortgage relief, this time it will take only perhaps half as long. Ben Bernanke, Hank Paulson and Barney Frank are all aware of that earlier history and anxious to avoid repeating it. 

And what the contraction of the financial services industry taketh, the expansion of exports can give back, what with the continuing growth of the BRICs, no analogue for which existed in the 1930s. The ongoing decline of the dollar will be the mechanism bringing about this reallocation of resources. But the US economy, notwithstanding the admirable flexibility of its labour markets, is not going to be able to move unemployed investment bankers onto industrial assembly lines overnight. I suspect that I am now less likely to be regarded as a lunatic when I ask whether unemployment could reach 10%.

Update: Brad Delong comments.

 

Comments

[hari]

This time he has got the focus of the crisis in full grip including the potential unemployment @ 10%. I don't find anything to argue against his conclusion. Except there is a serious need now for policy makers to raise their horizon globally and try to not get to fixed on domestic policy constraints - it may be that the solution long term is a global financial strucuture which can be readily supported by all including BRICs.

How US comes out of this situation - close to depression or whatnot - is going to tell a lot about the capacity of the system to correct its hitherto reluctance to challenge its basic assumptions about globalization and its impact on macroeconomic policy.

[James Kroeger]

Absorbing the shock is more difficult this time because it is internal to the financial system. Central to the problem are excessive leverage, opacity, and risk taking in the financial sector itself.I actually heard Stiglitz say yesterday that he believed it was better to plow the $700b into unemployment insurance and other stimulus initiatives rather than into Wall St. just to keep the gambling casino going. Paying attention Krugman & Thoma?

Just how bad would it get on Main St. if Congress spent $1-$2 trillion dollars on infrastructure and on a [temporary bypass] Taxpayers' Bank [that would provide loanable reserves to all productive, non-financial enterprises and households] instead of on the bailout of the financial sector? I suspect Main Streeters would barely notice the carnage on Wall Street while trillions of dollars of paper wealth are wiped out.

One thing is certain: we wouldn't see any 10%+ unemployment on Main St. because big increases in government spending and household spending and investments by non-financial firms would sustain an economic boom at the same time that the financial sector is collapsing. Isn't that actually the best way to handle this mess? Main St. is saved. The moral hazard problem is fixed in the best way possible. Most people are not suffering at all, in real terms.

Don't spend another taxpayer dollar on Wall St.; put all of the bailout money into Main St.

[Miscellaneous]

"...the current shock to the financial system is even more complex..."

Perhaps too complex for central planning.

"The ongoing decline of the dollar will be the mechanism bringing about this reallocation of resources."

Its hard to imagine foreign loan default via currency debasement making China et al fall over themselves in a rush to extend new loans to recapitalize our system.

"In the 1930s the shock to the financial system came from the fall in the general price level...The solution was correspondingly straightforward. Stabilize the price level..."

Oh boy. So encouraging surplus farmers to grow more food than the nation could possibly eat solved the problem. The situation may have been a bit more complex back then too.

[anne]

http://economistsview.typepad.com/economistsview/2007/01/the_new_deal_an.html

January 10, 2007

The New Deal and the Great Depression

Rates of Unemployment

1929 -- 3.2%
1930 -- 8.7%
1931 -- 15.9%
1932 -- 23.6%
1933 -- 24.9% (20.9%) Roosevelt becomes President
1934 -- 21.7% (16.2%)
1935 -- 20.1% (14.4%)
1936 -- 16.9% (10.0%)
1937 -- 14.3% ( 9.2%)
1938 -- 19.0% (12.5%) Recession
1939 -- 17.2% (11.3%)
1940 -- 14.6%
1941 -- 9.9%

Numbers in brackets correct for employment in New Deal programs.

Thomas M. Geraghty
University of North Carolina

[anne]

"Oh boy. So encouraging surplus farmers to grow more food than the nation could possibly eat solved the problem."

Right, it surely surely surely did help lots.

[anne]

http://www.huppi.com/kangaroo/Timeline.htm

The New Deal and the Great Depression

Rates of Contraction & Growth

1930 - 9.4%
1931 - 8.5
1932 -13.4
1933 - 2.1 Roosevelt era, contraction ends
1934 + 7.7
1935 + 8.1
1936 +14.1
1937 + 5.0 Recession begins, May
1938 - 4.5 Recession ends, June
1939 + 7.9

[Why no Republican Plan?]

The Republican plan of zero capital gains tax and insurance on mortgage back securities made sense.

The rejection of it means one could only come to 2 conclusions.

1)The financial crisis is not about banks lending to each other , rather they are all insolvent.

2)Given that banks are all insolvent no one would want to invest stock of financial institutions even if the capital gains tax is Zero.

I guess they hope by recapitalizing banks this way that financial institutions won't create a downward spiral by liquidating assets. But why shouldn't they liquidate assets if they know a recession is comming?

[obey]

Kroeger, I hadn't heard Stiglitz - where can I see his comments?

I ask because I've been thinking the same for some time. I can't see the ultimate cost of the bailout being any less than USD 200 bn, and that sum spent on a well-aimed stimulus plan could by definition prop up GDP by 1.5%, mitigating the effects on main street of the 'adjustments' in the financial sector.

I find it extraordinary that anyone still saying that the Paulson plan can make a profit isn't being laughed out of the room. The banks have written down roughly 480 bn on the mortgage based securities. Hatzius (Goldman Sachs) estimates that this reflects a projection that house prices have already bottomed. If house prices fall another 10%, the losses on these securities will be estimated to be 630 bn, and if they fall 20% the losses will be 870 bn. The ultimate bottom is probably somewhere between these two. The moral of the story is that the banks' marks - for whatever reason - are wildly optimistic, and Paulson explicitly intends to buy at a price above those marks.

Another point that doesn't make any sense is the idea that Treasury can better afford to hold these securities than the banks because the government can borrow money at 3-4%. But the banks holding these securities are currently borrowing at the Fed discount window at under 3%. So the securities have a greater hold-to-maturity value for the banks than they do for Treasury.

The Paulson plan is a huge waste of money even with the equity stakes included. The financial sector needs to contract massively, and the financial stocks will be almost worthless when the equity warrants can be ultimately exercised.

[David]

My plan......come November I am going to vote against EVERY incumbent, party affiliation is a non-issue. POTUS, well take your pick because neither candidate is qualified.

We have the power of the revolution in our hands.......our votes.

[James Kroeger]

Kroeger, I hadn't heard Stiglitz - where can I see his comments?I didn't see the comments, or I would have linked them. I actually heard his comments---of all places---on Lou Dobbs' Saturday evening show (CNN) while channel surfing for news. He was a guest along with a couple of other economists discussing the bailout. My 'quote' is actually my paraphrasing of what I heard. I'll look into it further...

[Wake up]

Obey:

The Paulson plan is a huge waste of money even with the equity stakes included.

Equity warrents and caps on executive pay are canards that the Democrat party are using to sell this bailout.

[Anon]

Kroeger, quoting Stiglitz, makes a good point. I think the reality is that we can't afford to use this money domestically, that the $700 billion is needed to bail out our foreign lenders, thus keeping up the critical flow of funds from overseas and maintaining some semblance of dollar strength.

[James Kroeger]

Look for the transcript of the show here in another day or two. The last transcript they have posted is dated 9/26/08.

[obey]

Kroeger - THanks!

[Lafayette]

Key clauses in Paulson Plan revision

NYT (this morning): In some cases, the government would receive an equity stake in companies that seek aid, allowing taxpayers to profit should the rescue plan work and the private firms flourish in the months and years ahead.

The White House also agreed to strict oversight of the program by a Congressional panel and conflict-of-interest rules for firms hired by the Treasury to help run the
program.

It is imperative that the SOBs who got us into this mess do not profit from it once the bailout is complete. There IS residual value in the properties, which will revive along with the economy. That should benefit the Treasury and not Wall Street.

See, cooler heads ARE prevailing after all. It seems ...

WU: Equity warrents and caps on executive pay are canards that the Democrat party are using to sell this bailout.

That remains to be seen. There is, for the moment, no evidence of what you claim.

What would you have us do? Go duck shooting?

Keep cool, Raoul.

[Noni Mausa]

Another form of unemployment also worries me, because it flies under the radar. Suppose the rate stays at 6, 8 or 10% cumulatively, but the employed individuals have shifted to lower paying jobs? Or their wages are frozen or reduced, while inflation marches on? Then you don't need 24% unemployment to have your depression -- you can have an employed depression, with every spare dime going to cover housing and utilities and every worker at the edge of destitution...

Oh, wait ... never mind.

Noni

[Rinse and Repeat]

"...that the $700 billion is needed to bail out our foreign lenders..."

I think this newly to be borrowed money is earmarked to buy stuff mostly from domestic institutions. US banks don't have enough deposits to meet domestic credit demand. They use the small deposits they have to make a few loans, and then sell the loans overseas. With the sales proceeds, they make a few more loans for subsequent resale. If no one will buy the loans already on the banks books, they can't make any more loans. The small deposit money was all used up making the loans on already on the banks' books.

The program is designed to buy the loans already on the banks' books, so banks can use their tiny deposits to make a few more new loans for resale. They are hoping that someone will buy the new loans. Otherwise the system will still be shut down.

Only one major nation uses this system.

[obey]

Yes, as Lafayette says, we should just trust this administration to
1. interpret wisely the 'some-equity-stakes' clause as meaning 'equity-stakes-insuring-against-significant-losses'.
2. find wall-street consultants with no interest in a bail-out of wall street
3. make a profit on buying marked-to-magic securities.

After all, they'd never lie when they say some massive government outlay would ultimately be self-financing. (with the minor exceptions of budget deficit projections, tax cuts, Iraq war)

THEY CAN BE TRUSTED. During their hearings Bernanke only lied once - when he said these securities were marked to market, and Paulson only lied once - when he said he always wanted oversight. Ok, its perjury - but this is a serious crisis, so just roll with it.

In Bushies we trust...

[ken melvin]

http://mobile.nytimes.com/article;jsessionid=DE5BE1142B1D797A8266F0ED777E534D.w6?a=233677&f=19&single=1

[baileyman]

kroeger said: "I actually heard Stiglitz say yesterday that he believed it was better to plow the $700b into unemployment insurance and other stimulus initiatives rather than into Wall St. just to keep the gambling casino going."

I see this as a matter of investment in assets with yields. The USA can put the funds into many projects with productivity effects, yield. There is no yield from putting it into financial assets.

[ddt]

voices of sanity:

Brad Delong:

"There are three options:

Do nothing.
Bailout (a la Paulson)
Nationalization (a la Sweden 1992)
Do nothing was last tried in 1929-1932. The result was called the Great Depression. Let's not do that again. Let's decide between bailout and nationalization.

Nationalization has the best chance of avoiding large losses and possibly even making money for the taxpayer. And it is the best way to deal with the moral hazard problem."

http://delong.typepad.com/sdj/2008/09/time-not-for-a.html

Steve Waldman - Real Capitalists Nationalize:

"There's a beautiful irony here. The superficially private-sector-friendly Paulson Plan is likely to entail socializing losses and undermining the incentives that give capitalism its efficacy and its legitimacy. Outright nationalization, on the other hand, may look like a Commie statist plot, but strengthens the "invisible hand" in the long run, as long as the nationalization is temporary."

http://www.interfluidity.com/posts/1222502979.shtml

Paul Krugman:

"Brad DeLong says that Swedish-style temporary nationalization is the right answer to a financial crisis; he’s right. I haven’t been clear enough about this, it seems, but it’s where my basic diagnosis leads: the problem is insufficient capital, you want to inject capital, but you don’t want it to be a windfall to existing stockholders — hence, take over and recapitalize the failing firms. By the way, that’s what we did with AIG 10 years days ago."

http://krugman.blogs.nytimes.com/2008/09/28/the-good-the-bad-and-the-ugly/

[Republican Talking Points]

Didn't you get the memo? Repeat after me: Hoover just about had the economy fixed when that liberal usurper FDR took over, then the Dems screwed up everything for the next 80 years and caused the current crisis. Any questions?

[James Kroeger]

This desperate, all-out effort to save Wall St. is a travesty of justice. The medicine being prescribed at extraordinary cost is nothing more than a Resuscitation Hope that ultimately seeks nothing more than to continue---and thus reward---a failed financial model.

Why is it so important that this corrupted mess survive? Are they trying to tell us that a privately-owned banking sector driven by profit-hungry risk takers is the only kind of banking system that can give us prosperity? Well, we know that isn't true. Look at China's astounding 35+ years of uninterrupted economic growth. It seems their state-owned banking sector has been able to accommodate all of the monetary needs of their extraordinarily dynamic economy.

I'm not saying we should copy China's approach to banking. I'm just saying that it is insanity for us to settle for a failed approach to providing our economy's need for loanable funds. Why should we ever again tolerate being subjected to economic terror like this? Why should we ever again put ourselves in a position where the rich manipulators of Wall St. are able to blackmail us into paying them a huge ransom, or else their going to blow up the whole economy?

One thing that a Taxpayers' Bank would be able to provide to Main Street is all of the loanable funds that private banks are unable to lend at this time because of the mess they got themselves into. A Taxpayers' Bank---owned and capitalized by the taxpayers---would fill the role of a 'heart-lung machine' that the patient can be hooked up to while blood flow is cut off to the damaged heart and repairs are carried out. Main Street would hardly notice the absence of the private banks.

Once the collapse bottoms out, the survivors will be in a position to start lending again, at a much lower level. They (or that single bank) should feel free to borrow and lend money again, perhaps finding a niche in the more risky sorts of customers. At such a time, Congress will have to finally decide to either re-privatize the Taxpayers' Bank (for some insane reason I can't think of) or simply continue with a mix of public and private banking.

Please don't tell me that no economist has ever thought of such an approach. Why was it ever rejected?

[a]

"Then [the Great Depression] it took breathtaking negligence by the Fed, the Congress and the Hoover Administration to achieve them."

Well, that's in hindsight of course. At the time all three thought they were doing *exactly* the right thing.

I'd like to offer a slight modification to Minsky's theories, not admittedly as elegant. This is the cycle I see:

1/ There is a crash in the economy.
2/ Post hoc explanations are offered as to why the crash occurred.
3/ Policies based on these explanations are implemented, and the economy improves. Correlation is thought to be causation.
4/ Greater intelligence or understanding is posited for the present generation, over previous ones.
5/ The system is then made more complicated, so that even if there *were* better understanding, the new system surpasses current understanding.
6/ The system crashes again.

[yamada]

"Corporate defaults have remained relatively low, which has been a much-needed source of comfort to the financial system."

Bubble is created by high-powered money with multiplier effect.
But recaptalizing by tax to each financial entity is realized one by one. And though the entities that are recaptalized by tax must think it priceless, what happens if each entity, for this thinking, avert risk asset and change it into safety asset such as “cash”, to maintain good equity ratio? It leads to credit crunch and high corporate defaults.
Though recapitalization is helpful, we must not forget that bubble-burst means disappearance of principal from asset side on balance sheet of each entity.

I still think next system is needed:

Bubble is caused by peoples’ expectation that the price of asset(real estate) will soar in future, with pouring high-powered money to the asset side of economic units’ balance-sheet. So, to solve this problem, such asset bubble on economic units’ balance-sheet must get ridden of, by the new system as below. Though it may be seen contradictory, high-powered money enables to work this new system. Please remember, no one has ever invented the solution in history.

1. Every economic unit’s(including banks) assets that caused the bubble(real estate or CDO et al) on balance sheet should be evaluated on mark to market basis by the authorization of a third party(maybe auditor), which brings about some insolvent(i.e. debt section surpasses asset section on balance sheet) economic units.
2. FRB decide to write off a certain amount of the loans to the banks, which amount distributed to each bank according to the amount of each banks’ insolvency, calculated on 1.
3. Every bank that gets profit from written off should next enforced to, by using the profit from written off as original fund, write off its loans to its each debtor, according to the amount of insolvency of each debtor. If the bank is unable to use all the written off profit it earned, the remainder is taxed all.
4. Other economic unit that gets profit from the written off by the bank should next enforced to, by using the profit from the written off as original fund, write off it’s loan(or trade claim) to its each debtor, according to the amount of insolvency of each debtor. If the economic unit is unable to use all profit it earned, the remainder is taxed all. These processes are to be repeated operationally.
5. In consequence, the bubble portion of the targeted asset is extracted from the economy, and is transformed to tax.
6. The tax claims is finally assigned to FRB. It’s up to FRB how they dispose of their above claims, considering the situation of economy, of each bank and of each economic unit. Talking about the latter two, as a option the FRB should examine the possibility of the bank’s and economic units’ turnaround, together with the other creditors, remaining desirable debt to the bank’s and economic unit(empirically it's ten to fifteen times annual earnings before interest, taxes, depreciation and amortization, known as EBITDA, of the economic unit), writing off the rest debt, with taking into account the value of disposable collateral(that do not accrue earnings), of guarantor and of consolidated basis.
7. Every write off must be supervised and tracable by centralized function of the system. So every write off must be executed through this function. Every write off may be done through this function, which exist on internet for access.
8. For cross-border. For each non-residential economic unit, the amount of write off should also be calculated in the same way as 4. , on the only cause from specific asset depreciation in the resident country. Economic unit that will be written off should next write off in the same booked currency. In case profit of the written off exists on the non-residential economic units, it's taxed and absorbed by the foreign(=non-residential) government and handed over to the sovereign(=residential) government of the currency, based on treaty.
9. In case inflation expectation exists, the system enables FRB to on one hand raise benchmark rate to cope with inflation expectation, on the other hand restructuring the balance sheets of economic units.
10. FRB should carefully watch the rate of the number of insolvent economic units to the number of all economic units in the US, when deciding the amount of the loans(trade claim) written off on 2.
11. As a result, FRB may bankrupt because FRB paid for asset depreciation to save financial system, the new second FRB shall be established which take over the first FRB. Or else FRB print greenbacks(bring about profit) correspond to the write-offs, which return to FRB as tax claim, so these greenbacks could be stored to the safe in FRB forever.

For further details, please see the blog as below:

http://reversewealtheffect.blogspot.com/

[anne]

http://www.nytimes.com/2008/09/23/business/worldbusiness/23krona.html?ref=business&pagewanted=print

September 23, 2008

Stopping a Financial Crisis, the Swedish Way
By CARTER DOUGHERTY

A banking system in crisis after the collapse of a housing bubble. An economy hemorrhaging jobs. A market-oriented government struggling to stem the panic. Sound familiar?

It does to Sweden. The country was so far in the hole in 1992 — after years of imprudent regulation, short-sighted economic policy and the end of its property boom — that its banking system was, for all practical purposes, insolvent.

But Sweden took a very different course than the one now being proposed by the United States Treasury. And Swedish officials say there are lessons from their own nightmare that Washington may be missing.

Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.

That strategy kept banks on the hook and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

"If I go into a bank," said Bo Lundgren, who was Sweden's finance minister at the time, "I'd rather get equity so that there is some upside for the taxpayer."

Sweden spent 4 percent of its gross domestic product, or 65 billion kronor, the equivalent of $11.7 billion at the time, or $18.3 billion in today's dollars, to rescue ailing banks. That is slightly less, proportionate to the national economy, than the $700 billion, or roughly 5 percent of gross domestic product, that the Bush administration estimates its own move will cost in the United States.

But the final cost to Sweden ended up being less than 2 percent of its G.D.P. Some officials say they believe it was closer to zero, depending on how certain rates of return are calculated.

The tumultuous events of the last few weeks have produced a lot of tight-lipped nods in Stockholm. Mr. Lundgren even made the rounds in New York in early September, explaining what the country did in the early 1990s.

A few American commentators have proposed that the United States government extract equity from banks as a price for their rescue. But it does not seem to be under serious consideration yet in the Bush administration or Congress.

The reason is not quite clear. The government has already swapped its sovereign guarantee for equity in Fannie Mae and Freddie Mac, the mortgage finance institutions, and the American International Group, the global insurance giant.

Putting taxpayers on the hook without anything in return could be a mistake, said Urban Backstrom, a senior Swedish finance ministry official at the time. "The public will not support a plan if you leave the former shareholders with anything," he said.

The Swedish crisis had strikingly similar origins to the American one, and its neighbors, Norway and Finland, were hobbled to the point of needing a government bailout to escape the morass as well.

Financial deregulation in the 1980s fed a frenzy of real estate lending by Sweden's banks, which did not worry enough about whether the value of their collateral might evaporate in tougher times.

Property prices imploded. The bubble deflated fast in 1991 and 1992. A vain effort to defend Sweden's currency, the krona, caused overnight interest rates to spike at one point to 500 percent. The Swedish economy contracted for two consecutive years after a long expansion, and unemployment, at 3 percent in 1990, quadrupled in three years.

After a series of bank failures and ad hoc solutions, the moment of truth arrived in September 1992, when the government of Prime Minister Carl Bildt decided it was time to clear the decks.

Standing shoulder-to-shoulder with the opposition center-left, Mr. Bildt's conservative government announced that the Swedish state would guarantee all bank deposits and creditors of the nation's 114 banks. Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.

Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years.

Then came the imperative to bleed shareholders first. Mr. Lundgren recalls a conversation with Peter Wallenberg, at the time chairman of SEB, Sweden's largest bank. Mr. Wallenberg, the scion of the country's most famous family and steward of large chunks of its economy, heard that there would be no sacred cows.

The Wallenbergs turned around and arranged a recapitalization on their own, obviating the need for a bailout. SEB turned a profit the following year, 1993.

"For every krona we put into the bank, we wanted the same influence," Mr. Lundgren said. "That ensured that we did not have to go into certain banks at all."

By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

More money may yet come into official coffers. The government still owns 19.9 percent of Nordea, a Stockholm bank that was fully nationalized and is now a highly regarded giant in Scandinavia and the Baltic Sea region....

[Matt Dubuque]

Matt Dubuque

Lehman was not the first primary dealer to fail.

Has everyone forgotten Refco?

Matt Dubuque

[anne]

http://select.nytimes.com/2005/10/16/business/16gret.html?hp&pagewanted=print

October 16, 2005

If Refco Isn't Scary, What Is?
By GRETCHEN MORGENSON

SECURITIES regulators and pundits say that there will be no financial market tremors emanating from Refco Inc., the enormous commodities and financial services firm that, after more than 30 years in business, hit the skids last week. Maybe so, but it seems incomprehensible that a financial domino this big can topple without making a sound. Refco, after all, was one of the largest players in commodities, derivatives and United States Treasury markets, operating in 14 countries and serving more than 200,000 clients.

Financial market tremors or not, there is plenty to be afraid of in the Refco mess. First, of course, is the frightening spectacle of the company's chief executive, Phillip R. Bennett, hiding a personal loan from Refco worth almost half a billion dollars from his shareholders, as described by prosecutors in their suit charging him with securities fraud. Then there is the inability of Refco's auditors or investment banks to notice the repeated shuffling of this loan on and off the company's balance sheet.

Watching a company that went public just two months ago sink from sight is also disquieting, of course.

But scariest of all may be the fact that supposedly savvy institutional investors who are fiduciaries - TIAA-CREF and Oppenheimer Funds, for example - bought Refco's shares in spite of the hair-raising risk factors detailed in the prospectus.

One example was the disclosure that Refco's internal auditors reported two significant deficiencies in its internal financial controls. Refco, for example, lacked "formalized procedures for closing our books." Sounds like a big deal, no?

Refco also said that it was found to be deficient in its ability to prepare financial statements "that are fully compliant with all S.E.C. reporting guidelines on a timely basis."

This is the way investors live now: a financial services company's inability to prepare its own financial statements does not preclude financial institutions from buying its stock.

Wait, there's more. Refco told prospective investors that it was under investigation by both the United States attorney in New York and the Securities and Exchange Commission. The S.E.C.'s inquiry centered on Refco Securities, its brokerage subsidiary, and its chief executive, Santo C. Maggio.

At the time of the offering, the prospectus said, Mr. Maggio was near a resolution of the matter and was ready to accept an order from the commission suspending him from any supervisory duties at the firm for one year. Nevertheless, "while complying with the restrictions of such supervisory suspension, Mr. Maggio would continue to work for us and Refco Securities in his current capacities," the prospectus said.

Isn't Wall Street wonderful? Where else would a chief executive about to be suspended for a year by his regulators keep the top job?

Such nightmare risk factors as those enumerated by Refco might not have been a deal breaker for potential investors if they liked what they saw on its financial statements. But warnings signs showed up there that the sophisticated investors shrugged off.

For example, as of February 2005, Refco Inc. had just $150 million in equity supporting $49 billion worth of assets. That's one thin slice of equity: 0.3 percent of assets. Equity at Bear Stearns by comparison was 3.5 percent of assets last year.

Readers of Refco's offering statement also found that the company had significant - and growing - derivatives contracts, carried off its balance sheet. As of February 2004, those arrangements totaled $69 billion and were made up of currency contracts, swaps and options. In February 2005, the contracts totaled $127.5 billion, and in May they stood at $150 billion. Given that Refco admitted to difficulties in preparing its financial statements, how confident could a prospective investor be in the company's ability to track the value of these contracts?

The company's capital expenditures of $14 million last year also seem ludicrously low. This is a company that has to manage information for hundreds of thousands of accounts, and as a serial acquirer of companies, was integrating many new systems into its own. All this would require sophisticated financial management systems.

Compare Refco's capital expenditures with those of Lehman Brothers, for example. Lehman spent $400 million on capital expenditures in 2004, or 3.4 percent of net revenues. Refco's $14 million in capital expenditures last year represented 1 percent of net revenues....

[RN]

James Kroeger is right, imo. The problem with the Paulson Plan is that it's paying bubble-induced prices for assets with taxpayer money, to solve a problem which is merely one of frozen liquidity. Liquidity MAY be unfrozen to the extent desired by this plan, though this is still very much an open question. But the lingering effects of the derivative purchases by the taxpayer could have very detrimental long-term effects.

Yes, we have a fear-induced liquidity freeze, and yes, Fed/Treasury purchases of assets will put some confidence in the solvency of counterparties back in the system.

But the unavoidable arithmetic problem is that while home prices revert to mean X (let's say X is a reasonable home value based on median wages), the mortgage debt on them is at X+n and, levered derivatives on that debt is X+n+m. The taxpayer, who under this plan will be forced to pay some version of X+n+m, will be buying at least part of a bubble. This is why Krugman, et al, are so worried about price paid.

For unless it could be done perfectly (and it can't - the people building this plan are shooting in the dark, and further, wildly favoring expediency over effectiveness) this is the reason the taxpayer will never make a profit off this deal. Home prices will revert to somewhere near historical mean (and I believe they'll do so with meaningful overshoot, given the tightening in lending standards), and taxpayers will continue to owe an inflated version of that.

And as we all know, the US taxpayer can't even afford current programs, as the fiscal deficit (>$410B) demonstrates. And then there's the entitlements problem going foward. The CDS on US debt is already more expensive than that for McDonalds, and serious doubts among foreign creditors are being expressed, as recent Bloomberg stories have discussed. And material loss of confidence in US assets by our heretofore reliable foreign creditors would make the current problem look like a mosquito bite.

So James Kroeger is right. The bazooka should be aimed squarely at stimulus in the real economy not the bubble derivative economy sitting on top of that. We need to provide people with a better shot at paying the mortgages on which these derivatives are based, not just purchase the derivatives at some version of bubble prices. That's the best way to have the bubble value evaporation be borne by old Wall St - built to make bubbles, and which will, in the unstoppable creativity of capitalism, rebuild itself rather quickly with new and more sustainable business models- , while protecting the real economy from whatever excessive shocks might come from simple liquidity issues.

With stimulus to help the real economy muddle through, the bubbles will sort themselves out, the burden falling more closely (and equitably) on those who created it.

[Lafayette]

obey: THEY CAN('T) BE TRUSTED.

So, what exactly DO you suggest? Concretely. Rationally. We punt? This ain't no football game.

We do what Ronnie did to the Russians in the nuclear disarmament treat: "We trust them ... but we verify anyway".

That is what the Congressional Finance Committees are for -- and they will have the GAO go through the books, especially of those companies in which the US holds an equity share. This "off-book accounting idiocy" will stop dead.

No one will wait for Bernanke's Show & Tell before the House Finance Committee.

[obey]

Kroeger is wrong on one point. Wall Street is not in a position to black-mail anyone. Wall Street, as in Wall Street stockholders, can and should be wiped out in a Swedish style nationalization-stabilisation-privatisation plan. Everyone sensible seems to agree that to the extent the government should be involved, this is the way to do it. Crisis resolved.

The only thing that stands in the way of this approach is Paulson, who - if you read between the lines of what Barney Frank and others are saying - refuses to implement such a wipe out of his erstwhile colleagues. If anyone is doing the blackmailing it is Paulson. And that may well be the case.

Another way of looking at it is that Wall Street is not so much in the business of blackmail, but rather that of bribery. Congress has been paid good money over the years to funnel a few hundred billion dollars in the direction of Wall Street. Washington democrats present the whole debacle as blackmail, but they have had ample time to formulate an appropriate mechanism to take care of systemically important teetering banks. Most likely no one is getting blackmailed - Congress is just selling out.

[im1dc]

Add my name to those who support James Kroeger's Stiglitz post.

I can add only this to the discussion: A non-scientific Online Poll on AOL this morning asks 'Do you Support the Bailout, Yes or No.'

The current results are "59% No" and "41% Yes" with "133,467 Votes" thus far this Sunday morning.

Gosh, you have no idea how much I wish those in D.C. were reading this blog and listening to Dr. Stiglitz.

That they aren't tells us from whom the inside the Beltway political class take their marching orders.

REDUX:
James Kroeger says...

"Absorbing the shock is more difficult this time because it is internal to the financial system. Central to the problem are excessive leverage, opacity, and risk taking in the financial sector itself.

"I actually heard Stiglitz say yesterday that he believed it was better to plow the $700b into unemployment insurance and other stimulus initiatives rather than into Wall St. just to keep the gambling casino going. Paying attention Krugman & Thoma?

"Just how bad would it get on Main St. if Congress spent $1-$2 trillion dollars on infrastructure and on a [temporary bypass] Taxpayers' Bank [that would provide loanable reserves to all productive, non-financial enterprises and households] instead of on the bailout of the financial sector? I suspect Main Streeters would barely notice the carnage on Wall Street while trillions of dollars of paper wealth are wiped out.

"One thing is certain: we wouldn't see any 10%+ unemployment on Main St. because big increases in government spending and household spending and investments by non-financial firms would sustain an economic boom at the same time that the financial sector is collapsing. Isn't that actually the best way to handle this mess? Main St. is saved. The moral hazard problem is fixed in the best way possible. Most people are not suffering at all, in real terms.

"Don't spend another taxpayer dollar on Wall St.; put all of the bailout money into Main St."

Amen.

[James Kroeger]

I wonder if Congressional Democrats realize that the House Republicans have now given them the political cover they need to start considering alternatives, like those suggested by Brad DeLong, Paul Krugman, and the Swedes. You see...before, when "The Republicans" (in the form of Paulson/Bernanke and the Bush Administration) approached the Democrats, begging them to go along with their plan, Congressional Democrats sensed that if they were perceived to be obstructing the plan, the Republicans would crucify them as being responsible for the destruction of the economy.

But now, House Republicans sense that there just might be a way for them to get re-elected in November----in spite of the worthlessness of the Republican brand---if they take a populist position opposing the bailout in the interest of the taxpayers, tapping into the popular resentment they're hearing in emails and polls. Political desperation is driving them, but what this does for Congressional Democrats is make it impossible for Bush Republicans to blame the Democrats for raising objections. The political ground shifts, and both parties are suddenly free to compete for the support of The Little Guy on Main Street.

To me, that means there's hope. There is no guarantee that whatever the senior leadership agrees upon by tomorrow, is going to be approved by the House assembled, not if most Republicans decide to vote against Wall St. and a good many Democrats agree to do the same. If, as Pelosi is throwing up her hands, DeLong and Krugman and Stiglitz and a few other "Democrat Economists" start endorsing a variation of the Swedish Option, Congressional Democrats may begin to realize the opportunity they have to insist on some profound changes in the interest of the taxpayer and economic justice.

The stock market may start trying to crash while this is unfolding, but then the Fed has all the resources it needs to bail out just about anyone in the near term, by simply buying up equity. If the Dems are smart, they may actually succeed is destroying the the perceived credibility of Republican Economic Mythology for at least a few generations....

[Walt]

a, there has not been a crisis that seriously imperiled the US banking system as a whole for 75 years. Not much of a cycle.

[Karl]

http://www.youtube.com/watch?v=lsC2k9opOP0

[ddt]

a thorough analysis of the Swedish approach, courtesy of the Federal Reserve Bank of Cleveland:

"Conclusion
We have analyzed the resolution of the fi nancial crisis that hit Sweden during the 1990s in terms of four traits that are essential to a successful crisis resolution in a developed economy: transparency, independence, the maintenance of market discipline, and the restoration of credit fl ows. Transparency is necessary to gain credibility in the market. Independence of the agencies charged with resolving the crisis protects the resolution process from political pressures, prevents politically connected forbearance, and guarantees that taxpayers’ money is used to save viable banks and borrowers, not the well connected ones. Policies that preserve market discipline are critical for reducing the likelihood and severity of future crises. Finally, it may be necessary to rehabilitate the real sector because the fi nancial sector’s troubles may cause a credit crunch that damages healthy fi rms. Without healthy borrowers, bank restructurings will fail to restart credit flows. The keys to successful rehabilitation are to use incentives that separate viable from nonviable borrowers and to dispose of seized collateral as quickly as possible."

On the Resolution of Financial Crises: The Swedish Experience
By O. Emre Ergungor
http://www.clevelandfed.org/research/PolicyDis/pdp21.pdf

[anne]

http://www.nytimes.com/2008/09/28/opinion/28sun1.html?ref=opinion&pagewanted=print

September 28, 2008

Don't Blame the New Deal

This year's serial bailouts are proof of a colossal regulatory failure. But it is not "the system" that failed, as President Bush, Treasury Secretary Henry Paulson and others who are complicit in the calamity would like Americans to believe. People failed.

For decades now, antiregulation disciples of the Reagan Revolution have eliminated vital laws, blocked the enactment of much-needed new regulations, or simply refused to exercise their legal authority.

The regulatory system for banks, securities, commodities and insurance is unwieldy and in need of modernization. The system has gaps, like the absence of regulation for "innovations" such as credit default swaps, the insurance-like contracts now valued at $62 trillion whose destructive potential prompted the bailouts of Bear Stearns and the American International Group.

But the failures that have landed us in the mess we are in today are not mainly structural. To assert that they are masks deeper failings and sets false terms for the upcoming debate on regulatory reform.

Under a law passed in 1994, for example, the Federal Reserve was obligated to regulate banks and nonbank lenders to curb unfair, deceptive and predatory lending. Alan Greenspan, the former Federal Reserve chairman, ignored his responsibility, even as junk mortgage lending proliferated in plain sight.

Mr. Greenspan later said the law defined "unfair" and "deceptive" too vaguely. If so, he should have asked Congress for clarification. Instead, he did nothing — and the Republican-led Congress did not question him. When Ben Bernanke took over as Fed chairman in early 2006, the negligence continued. It was not until mid-2007, after the housing bubble had begun to burst, that federal regulators offered guidelines for subprime lending.

The systematic dismantling of laws that called for regulation also contributed to the current crisis.

In 1995, Congress passed a law that restricted the ability of investors to sue companies, securities firms and accounting firms for misstatements and pie-in-the-sky projections. That helped inflate the dot-com bubble and contributed to the Enron debacle. It also engendered a sense of impunity that helped to foster the excessive risk-taking so prevalent in the mortgage mess.

Then, in 1999, Congress dismantled the Glass- Steagall Act, a pillar of the New Deal, which separated commercial and investment banking. That enormous change was undertaken with no thought or effort — or desire — to regulate the world that it would help to create. Now we know that an entire "shadow banking system" has grown up, without rules or transparency, but with the ability to topple the financial system itself.

But perhaps no deregulatory effort had more catastrophic effect than the 2000 law that explicitly excluded derivatives, including those credit default swaps, from regulation under the Commodity Exchange Act of 1936.

And there is probably no greater missed opportunity than the reform of Fannie Mae and Freddie Mac passed by the House in 2005. If the law had been enacted, the takeover of those companies may have been avoided. It failed in large part because President Bush wanted to fully privatize them and feared that if they were adequately reformed, privatization would lose steam.

Indeed, it was in the Bush years that antiregulation and deregulation found full expression, fueled by an ideology that markets know best, government hampers markets, and problems will magically fix themselves....

[obey]

Lafayette - you ask "So, what exactly DO you suggest? Concretely. Rationally. We punt? This ain't no football game."

Well, DeLong presents three options
1. do nothing
2. Swedish nationalization
3. Paulson plan

For some reason the Batman and Robin of progressive finance (Krugman and Delong) opt for 3 on the grounds that 2 won't fly politically. It seems that me and others prefer - in the absence of (2) - a fourth option involving a stimulus plan for the so-called 'Real' economy. I suppose we can start calling it the Stiglitz-Kroeger plan. It avoids the massive moral hazard problems with the Paulson plan, is administratively much simpler (we have done this before...), avoids executive branch power-grab, etc.

The main objection, I guess, is that THE SKY IS FALLING. And I just don't see it. Nobody has given a convincing model to show how disruption on Wall Street translates into chaos on Main Street. One possibility could be that mortgage rates rise, but the mortgage market is already de facto nationalised with the conservatorship of Fannie and Freddie. Another possibility is that corporate debt rates will rise. And they are rising. But I haven't seen an account of how pumping up Wall Street brings them back down again. The era of cheap borrowing is over. It rested on the business model of borrow-short-lend-long-and-leverage-to-your-eyeballs. And to all appearances, that business model is dead.

[roger]

Kroeger's ideas about using a bank to directly infuse cash into the system where it is needed is starting to occur to other people - at last! Joe Nocera's NYT column mentions a similar plan by "Andrew Feldstein, who runs Blue Mountain Capital Management, a hedge fund that specializes in credit instruments."

Feldstein usefully divides the objectives of the Government into two parts:

"The government has two valid objectives. Provide assistance to struggling homeowners; and stabilize the US financial system, which is tilting toward a meltdown of epic proportions. Of course the objectives are related. Banks are struggling in large part due to defaulting mortgage borrowers. Support to those borrowers might improve asset quality. At the same time, the credit freeze is disabling corporations and consumers, undermining the economy, which further worsens the prospects for all Americans."

He then points out that the plan's first objective is to be met by propping up bad banks, and the second objective is addressed only indirectly.

"It might be more productive to separate the two objectives. Assistance to struggling mortgage borrowers might be provided directly (as opposed to hoping that indirect assistance via struggling banks will find its way to the desired place).

A better way to achieve the objectives of restoring financial stability might be to adopt the inverse of the Administration’s proposal. That is, create a new “good bank” owned in whole or part by the government.

- Create a new entity with access to the Fed discount window and other liquidity facilities (all secured by good collateral)

- The good bank’s mandate will extend to high quality assets only. Corporate bonds and loans, prime mortgages, etc. To ensure a limited life to the entity, and avoid competition with private sector banks, this good bank would only purchase assets originated prior to September, 2008.

- With $300bn of equity capital the fed might provide leverage of 20x (again only against good collateral). This would provide $6 trillion of balance sheet for “good assets”. The government could provide some or all of the initial equity capital – creating upside for taxpayers when the government later sells its stake. There would likely be strong interest from private investors in the equity capital of this institution."

Actually, I think there is another "good" that could come out of Feldstein's bank. By taking away the mortgage market from the commercial banks, they are provided with both elbow room and an incentive to extend credit where they can, to remain competitive.

There are a lot of things that have to be done to reform the financial services sector. Derivative trading has to be relocated to a more transparent, institutionally established locus, rather than the adhoc network of clearing houses by which it currently works, and the derivatives have to fall under a regulatory watchdog, probably different from the SEC. That's for starters. But something like Kroeger's suggestion is starting to be expressed on the sidelines. Who knows, it might start moving to the center after the 700 billion dollars fall into the black hole - since it is evident that 700 billion is way too little to prop up the present system.

By the way - why is so little attention being paid to the outrageous conflict of interest between Goldman Sachs and the Treasury Department in the account of the AIG takeover in the NYT today? Turns out that Lehman's problem was that they didn't have an ex Lehman head at Treasury.

[anne]

http://www.nytimes.com/2008/09/27/business/27nocera.html?ref=business&pagewanted=print

September 27, 2008

Markets Can't Wait for Congress to Act
By JOE NOCERA

Finally, I've been hearing a number of interesting ideas that could well turn out to be better than the Paulson plan. One of the most intriguing ones comes from Andrew Feldstein, the chief executive of Blue Mountain Capital Management, a hedge fund that specializes in credit instruments. He proposes that instead of buying bad assets that are crippling the balance sheets of the nation's banks, the government should establish a "good bank" that would buy only solid assets.

By setting up such a bank — Mr. Feldstein envisions having the government put up $300 billion and taking an equity stake, so that taxpayers can profit when it is sold after the crisis passes — the government would make it possible for credit to "again flow to deserving borrowers." Bad banks might eventually fail — but they would have a place to sell their good assets as they liquidate. Healthier institutions could once again start lending. Taxpayers would face much less risk.

If the country had more time, I would argue that we put ideas like that into the sunlight and see if they flower. But we don't have any more time. Nine days ago, the financial markets were staring into the abyss; the only thing that pulled them back was the news that the Treasury and the Federal Reserve had come up with a bailout plan.

And the only thing that has kept them from falling back is the expectation that the plan will be approved quickly....

[anne]

Balancing the criticism which is due, many months have come and gone since Senator Clinton was fruitlessly proposing important assistance for troubled homeowners but there was never a comparable proposal by the leading Democratic presidential candidate nor has there been any proposal beyond generally accepting the terms of Secretary Paulson now that the problem has exploded to crisis.

There has been no mention of a Swedish style of rescue by the Democratic leadership, nor will there be. Rather there appears to be an acceptance that the rescue we will have will limit economic planning for the coming Administration and Congress.

[Dr. Jim Sadler]

"This time the Fed will provide however much liquidity the economy needs."

What if the Treasury is not able to borrow the money it would like? At some point, the party is going to come to an end.

[Bruce Wilder]

BE: "Achieving the transparency needed to restore confidence in the system will be immensely more difficult."

And, the Paulson Plan, which was clearly bad, will now be replaced by a modified-Paulson Plan, which is still bad, but less clearly so. The lack of transparency is being wielded as a political cudgel.

BE: ". . . what the contraction of the financial services industry taketh, the expansion of exports can give back, what with the continuing growth of the BRICs, no analogue for which existed in the 1930s. The ongoing decline of the dollar will be the mechanism bringing about this reallocation of resources."

This is where BE's analysis turns into wishful thinking, which ignores the main issue.

The U.S. is facing a major reallocation of resources, but the centerpoint of that reallocation is household consumption, savings and wealth. U.S. wages have declining in real terms; the declining dollar and rising commodity prices will tend to reinforce that trend. The wealth effect of a loss of home equity and the shift to a positive domestic savings rate, will reduce consumption spending further.

Further reduction in real wages of only a percent or two, combined with a swing to positive in the savings rate will overwhelm the forex effect on exports.

The recession ahead may not become the Great Depression, but it will be fairly serious.

Noni: "Suppose the rate stays at 6, 8 or 10% cumulatively, but the employed individuals have shifted to lower paying jobs? Or their wages are frozen or reduced, while inflation marches on? Then you don't need 24% unemployment to have your depression -- "

Exactimundo!

Obey: "If house prices fall another 10%, the losses on these securities will be estimated to be 630 bn, and if they fall 20% the losses will be 870 bn."

I think you are wildly optimistic. First, there's a substantial lag time between a fall in house prices, and the acknowledgement of securities losses by major firms. Maybe, I'm not understanding what you intend your figures to mean, but my general view is that we are only about half way through the full realization of losses by banks.

The recession will reveal the on-going crisis in commercial real estate, creating a second wave of bank and business failures. If Noni is right, the big banks will also face some major losses on the whole panoply of credit cards, car loans, student loans, etc. It's not just about house prices, when a major recession gets going.

[roger]

Bruce, you should add to your list the coming downturn in government jobs - the biggest employee in the nation by far. Here's a little factoid from USA today: "The USA has nearly 88,000 units of government, mostly local, that employ 22 million." Without government hiring over the last year, unemployment would certainly have gone up another point.

So how is this going to continue, given: a, the kneejerk tax cutting crowd, which might well overturn Mass.'s income tax, and the limit on state and local borrowing, sometimes enshrined in law and otherwise enshrined in the market on munis?

[anne]

http://www.nytimes.com/2008/09/28/us/28ballot.html?hp&pagewanted=print

September 28, 2008

Massachusetts Proposal Would Repeal Income Tax
By PAM BELLUCK

GRAFTON, Mass. — Given the opportunity to get out of paying state income tax, who wouldn't jump at the chance?

Certainly Ruth Gregoire would. Ms. Gregoire, 71, a retired employee of a fire sprinkler company, dipped into chocolate ice cream at Swirls and Scoops and pronounced the no-tax idea "very nice."

Lakis Theoharis, 56, the owner of the nearby Pepperoni Express, said: "I'm for the repeal of the tax. To me, the smaller the government, the better for the citizens."

And Rich Masterson, 39, a trucking company supervisor, said, "I would love to see that!"

That view is exactly what most state and local officials in Massachusetts are afraid of. Amid the whirlwind presidential election, Massachusetts has a ballot contest of its own this November that could drastically alter — some would say cripple — state government.

At issue is Question 1, which would eliminate the state income tax. It would save the average taxpayer about $3,600 a year. Annual revenue from the tax is about $12.5 billion, roughly 45 percent of the state's budget of about $28 billion.

"These are tough times for everyone as it is, and if Question 1 passes, things will become exponentially more difficult," said Leslie A. Kirwan, the Massachusetts secretary of administration and finance.

Ms. Kirwan added that because some state programs cannot legally be cut, others would face cuts of 60 percent or more. The loss of billions of dollars from Question 1, she said, would devastate state services.

Gov. Deval Patrick, a Democrat, has called the ballot measure "just a dumb idea."

And elected leaders across the state are worried....

[anne]

http://www.cbpp.org/3-13-08sfp.htm

September 26, 2008

Facing Deficits Many States Are Imposing Cuts That Hurt Vulnerable Residents
By Nicholas Johnson, Elizabeth Hudgins and Jeremy Koulish

Summary

Continuing economic problems have created budget problems in many states, leading some 22 states to reduce services to their residents, including some of their most vulnerable families and individuals. Examples of enacted and proposed cuts to state services include:

* Public health programs: At least 14 states have implemented or are considering cuts that will affect low-income children's or families' eligibility for health insurance or reduce their access to health care services....

[Remember Congressional leaders just chose not to vote on legislation to extend health care insurance to 3.8 million needy children, and both Presidential candidates are pledged to cut taxes.]

[anne]

http://www.cbpp.org/3-13-08sfp.htm

September 26, 2008

* Programs for the elderly and disabled: At least 11 states are cutting medical, rehabilitative, home care, or other services needed by low-income people who are elderly or have disabilities, or significantly increasing the cost of these services....

* K-12 education: At least 13 states are cutting or proposing to cut K-12 and early education....

* Colleges and universities: At least 17 states have implemented or proposed cuts to public colleges and universities....

* State workforce: At least 19 states have proposed or implemented reductions to their state workforce....

[im1dc]

A memorable quote from today's Maureen Dowd Editorial:

"Who would have dreamed that when socialism finally came to the U.S.A. it would be brought not by Bolsheviks in blue jeans but Wall Street bankers in Gucci loafers?"

Clever, but I'm not laughing.

[anne]

http://www.nytimes.com/2008/09/28/opinion/28dowd.html?ref=opinion&pagewanted=print

September 28, 2008

Sound, but No Fury
By MAUREEN DOWD

OXFORD, Miss.

It was quite a memorable moment in history for the M.B.A. president and the nominee of the party of business. Who would have dreamed that when socialism finally came to the U.S.A. it would be brought not by Bolsheviks in blue jeans but Wall Street bankers in Gucci loafers?

[anne]

Through the 1920s, and a faltering agricultural sector and generally increasing income and wealth concentrations showing limited gains by ordinary workers, there were an average of 600 banks failures a year, but from 1930 to 1933 there were 10,000 bank failures or about 40% of the total banks in 1929. The initial banking run occurred late in 1930 followed by 2 more and stopping when Roosevelt became President in March 1933 and immediately called on an activist Congress for a bank holiday and reform by consolidation of the banking system.

[anne]

The question that Mark Thoma has suggested in different forms is whether resolving the banking crisis in 1930, or even recognizing the coming banking crisis in 1928, would have significantly limited the economic crisis. I would argue, yes, but the recession in agriculture would still have become a recession in the industrial sector by 1930 and in the absence of a New Deal-Keynesian approach to resolution a lingering recession would have been experienced.

Interestingly the country faring best in recovery from what did become an international Depression was Sweden, which used a Keynesian approach early early.

[OilyGasMiner]

I love the analogy of “the Fed.. is very much groping in the dark.” We are displaying no confidence in our actions, and the level of uncertainty as infected our entire economy. Which has only been strengthen by Paulson and Bush’s remarks of the detrimental effects that would ensue if we didn’t utilize the bailout plan. With our staggering debt levels, and trade deficit nearing the $7Trillion mark Further Reading, double digit unemployment would seem very plausible at this stage. Though it would perhaps initially trigger a further meltdown of our economy. It would be very useful for rapid growth in our productivity and efficiency rates. Why? Well simply put, with the cot of living increasing, and pay remain the same, job cuts WILL occur. Companies will then find new and amazing ways to do the same tasks they once did with less people.

[obey]

Bruce - the estimates of the losses on subprime related securities are from Jan Hatzius conveyed by Krugman at his Princeton presentation. As I understand it they incorporate projections regarding the percentage of defaults/forclosures given different possible trajectories for the housing market. Roughly, the banks' current evaluations of the value of their subprime books suppose rather optimistically that house prices have already bottomed. So Bernanke's suggestion that somehow the hold-to-maturity value is above the current book value of these securities involves him supposing that house prices are going into a steep climb. So you thought I was being optimistic...

[anne]

http://www.nytimes.com/2008/09/29/business/29bailout.html?hp&pagewanted=print

September 28, 2008

Breakthrough Reached in Negotiations on Bailout
By DAVID M. HERSZENHORN and CARL HULSE

Officials said Congressional staff members would work to finalize the language of an agreement and draft a bill to be brought for a vote in the House on Monday.

[Essentially Secretary Paulson's plan will be passed with no significant economic stimulus beyond the financial system rescue as such. I would suggest there will continue an employment but possibly not a general recession for quite a while, as long as credit flows as quickly renewed and continued.]

[anne]

"Where last time it took the Congress three years to grasp the need to recapitalize the banking system and provide mortgage relief, this time it will take only perhaps half as long."

This is a puzzling passage, because mortgage relief proposed by Senator Clinton a year ago was ignored then and little mentioned as a serious political possibility since. There is little New Deal sensitivity in terms of an economic stimulus.

[anne]

http://newdeal.feri.org/misc/keynes2.htm

December 16, 1933

18, Norham Gardens
Oxford, England

In response to the New York Times' request for his views on the American outlook, Keynes has written "An Open Letter to President Roosevelt," which is scheduled to appear in the Sunday issue of December 31st and is to be syndicated in other parts of the United States.

So that you may see what he has to say before it is published, Keynes this morning sent me the enclosed copy of his article, which I hasten to get off directly to you through Miss LeHand (without forwarding it through the pouch) in the hope that it may catch the Bremen, which leaves tonight.

Yesterday's Times carried illuminating extracts from Wallace's Annual Report. What a good Secretary of Agriculture you have!

With warm regards,

Faithfully yours,

Felix Frankfurter

Hon. Franklin D. Roosevelt
Enc.

[anne]

http://newdeal.feri.org/misc/keynes2.htm

December 16, 1933

An Open Letter to President Roosevelt *

Dear Mr. President,

You have made yourself the Trustee for those in every country who seek to mend the evils of our condition by reasoned experiment within the framework of the existing social system. If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out. But if you succeed, new and bolder methods will be tried everywhere, and we may date the first chapter of a new economic era from your accession to office. This is a sufficient reason why I should venture to lay my reflections before you, though under the disadvantages of distance and partial knowledge.

At the moment your sympathisers in England are nervous and sometimes despondent. We wonder whether the order of different urgencies is rightly understood, whether there is a confusion of aim, and whether some of the advice you get is not crack-brained and queer. If we are disconcerted when we defend you, this may be partly due to the influence of our environment in London. For almost everyone here has a wildly distorted view of what is happening in the United States. The average City man believes that you are engaged on a hare-brained expedition in face of competent advice, that the best hope lies in your ridding yourself of your present advisers to return to the old ways, and that otherwise the United States is heading for some ghastly breakdown. That is what they say they smell. There is a recrudescence of wise head-waging by those who believe that the nose is a nobler organ than the brain. London is convinced that we only have to sit back and wait, in order to see what we shall see. May I crave your attention, whilst I put my own view? ...

* Keynes

[Noni Mausa]

Bruce Wilder: If Noni is right, the big banks will also face some major losses on the whole panoply of credit cards, car loans, student loans, etc. It's not just about house prices, when a major recession gets going...

If? What you mean, if? Ah am always right, it is ze little grey cells working, working, working...

If the credit cards collapse and the other major losses come to pass, is this necessarily a problem for the banks? Can we make a case that no, it wouldn't be?

Look at the banks and credit card companies as hot air balloons. What holds them up and powers them is pure hot air -- the hope, choices and/or effort of millions of American workers and investors, converted to money and thus skimmed.

In the absence of the hot air, the balloon deflates, but is not destroyed -- not even if the thing crashes. The silk and basket and ropes remain, waiting for the multitudes to recover from their latest fleecing and begin generating all that hot air again, to be harnessed for another flight.

Between flights, what do balloon pilots live on? The money skimmed during each flight. I would guess that the rougher the anticipated crash, the more shameless the skimming before each crash.

Noni
cynicaler-than-thou

[ken]

Acedemics have no clue.

Bill Gross says that he can value get a good look at the underlying mortgages for any mortgage security and put a reasonable price on it in ten to fifteen minutes. Having once been in the business of bond trading and having done this myself I know he is right.

His estimate is that the fire sale prices are about twenty cents on the dollar but he believes the government can pay about sixty five cents on the dollar and recover about 80 cents on the dollar, if held long enough.

[anne]

Ken:

"Bill Gross says that he can value get a good look at the underlying mortgages for any mortgage security and put a reasonable price on it in ten to fifteen minutes."

Please reference, if possible.

[anne]

Ken:

"Academics have no clue."

What is the point of such a comment, since there is nothing strange about what Gross is saying only how the estimates are developed should be explained?

[ken]

James Kroger, restarting the Bank of the United States, for the third time, will not be any more popular than it was the first two times. Besides we already have Fannie Mae and Freddie Mac on ice and soon ready to go back into the private/public domain. Perhaps a state like CA or NY should do its own version of the GSEs. They are large enough. Heck California's economy today is probably as large as the entire US economy was back in the 70's when FNM and FRE were granted their public corporation charters by congress.

[ken]

anne, Gross's comments are in Barron's.

[obey]

A nice piece from the University of Chicago on the relationship between Wall Street and Main Street:
http://caseymulligan.blogspot.com/2008/09/wall-street-will-drown-alone.html

Bottom line: Wall Street can collapse and main street will be just fine.

[Julio]

Noni Mausa,

"If? What you mean, if? Ah am always right, it is ze little grey cells working, working, working..."

Yep, from what I've seen, your average is about as good as H.P.'s ;-)

[Julio]

"Rather there appears to be an acceptance that the rescue we will have will limit economic planning for the coming Administration and Congress."

Yes, I think a significant proposed modification to "the plan" was the idea to limit the amount that could be spent between now and the end of this administration.

[BJ Feng]

James, you keep on making the same mistake the left always makes, assuming that the government will be able to execute a plan to perfection. There is no evidence that a state run banking system can avoid making bad loans, the Chinese banks made trillions of Yuan in bad loans, the government had to inject an untold sum of money (Chinese govt. is not transparent) to clean up balance sheets before the big banks went public. If anything, the government has a greater incentive to make bad loans to help "those who can't afford homes" buy homes. Politicians can look good by extending credit to everyone, which will bring prosperity for a time. When it all blows up, they can always blame someone else, and just raise taxes or issue more debt.

We already have a National bank in Freddie and Fannie, which provide cheap mortgages to Americans. It's amazing that I can borrow more cheaply than a large company like The GAP, or famous brands like Las Vegas Sands or Virgin Media Finance. It was stupid to make them quasi governmental entities, but you've seen all the past quotes by Congressmen pressing for Freddie and Fannie to do more and extend even more credit to people regardless of circumstances. The prudent Congressman who calls for stricter guidelines and less lending to the poor (the rich can afford those loans) will be hammered, so he keeps silent while pressure mounts.

Financial crises cannot be avoided. We've had them as far back as history shows, from Roman times, to Tulip Mania, to the South Sea Bubble to 1929, no system of government has ever been able to prevent a financial crisis once credit and leverage enter into the equation. No, we can't go back and establish a creditless society, I don't think our modern economy could work without fractional reserve banking.

I don't think a National Bank would prevent a future crisis. When mania strikes, there is a lot of pressure to continue on adding fuel to the fire. If the FED had acted even earlier to raise rates and burst the bubble, they would have faced a firestorm of criticism for "causing" the downturn. Politicians are the least sheltered from public opinion and criticism. To think that they could or would steel themselves against the wishes of their constituents at a time when it isn't absolutely necessary is flawed thinking.

[Denis Drew]

I like the "inflate our way out of it" part of Delong's comment...

...perfect timing with my megalo plan to shift 12.5% of overall income share from top 3 percentile incomes back to the lower 90 percentile incomes (2001 numbers; may be worse now) by what amounts to using inflation (plus some serious top taxing) -- by doubling the minimum wage and instituting sector-wide labor agreements in this, one of the last economies in the first world (or even second or third world) yet to institute it. With 40% of overall income now spent by the top 10 percentile (up from 27.5% over previous decades) there is plenty of headroom to carve share back -- and it would be providential if the usually feared inflation were actually doing double duty. All things come to he who is megalomaniac.

[BJ Feng]

"A better way to achieve the objectives of restoring financial stability might be to adopt the inverse of the Administration’s proposal. That is, create a new “good bank” owned in whole or part by the government."

I don't see how this plan would solve the current crisis. Good assets like T-bills are still being used by banks for collateral, and they can be sold on the open market without any problem. There is no crisis with good assets, they remain good. Now if you strip banks of the good stuff, then everyone knows they're left with just junk and they collapse immediately. I just don't understand this proposal, what will it accomplish?

No, the "bad bank" is what we need. Only the government can afford to hold on to toxic assets because it has unlimited ability to borrow (just about) and cannot go bankrupt. If banks can't borrow due to concerns over their assets, they have to declare bankruptcy, the government can never go bankrupt, it can always start issuing one trillion dollar notes Zimbabwe style to pay off loans (the point is that it can't go bankrupt).

The banks need to get rid of their toxic assets, not their good assets. Once they accomplish that, others will trust them enough to lend and invest new capital into the banks, averting a wave of bankruptcies. Maybe I haven't been told the entire plan because the "good bank" plan is so ridiculous, illogical, and downright stupid that I can't believe anyone would bother to publicly call for such a plan. This is a type of plan you think of after drinking a liter of hard liquor. Boy, those who issued the plan must have a terrible hangover right now, along with the embarrassment one feels after behaving like a drunkard in public.

[Betsy L. Angert]

Dearest Mark . .

I thank you for this discussion and the many you share on the subject. As an article you referenced days ago stated, credit crisis' occur when people are unable to repay loans. Thomas Jefferson also spoke of this situation.
Never spend your money before you have it.
~ Thomas Jefferson

I, however, place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared.
~ Thomas Jefferson
The Great Depression was not technically the first drastic economic decline. I fear it will not be the last.

Early in May 2008, Entrepreneur Berkshire Hathaway Chairman Warren Buffett warned us in an interview with the German magazine Der Spiegel, we are in for a "long, deep recession," "Perhaps not in the sense that economists would define it. But the people are already feeling the effects. It will be deeper and last longer than many think."

I sense this is accurate for all the reasons mentioned in this essay. I also theorize, since there are more people on the planet, more money is exchanged, and the extent of interchange is more extensive, economically we may be in new territory. However, an aspect of this Greater Depression will not differ. For me, this credit calamity and those in the past have a common thread, avarice, and the allowance for debt.

Our founders were unable to bail us out from ourselves. Warren Buffett may be able to save Goldman Sachs from itself. However, I fear he cannot rescue the country or its citizens from financial failures.

I invite your review and reflections . . .
Bailouts Blaze; Exuberance Explodes
Let the Bailouts Begin

Betsy L. Angert
BeThink.org

[Lafayette]

The clique of Wall Street Robber Barons

Look at the small print. Here's Paulson's going-away gift to his fellow Robber Barons. From CNN Money: Limiting executive pay: Curbs would be placed on the compensation of executives at companies that sell mortgage assets to Treasury. Among them, companies that participate will not be able to deduct the salary they pay to executives above $500,000.

They also will not be allowed to write new contracts that allow for "golden parachutes" for their top 5 executives if they are fired or the company goes belly up. But the executives' current contracts, which may include golden parachutes, would still stand.

What a hero our Hank Paulson is, having saved for the Golden Boys their Golden Parachutes. Somebody set up a monument to Hank on Wall Street, cuz he surely deserves it.

Write your Congressman and get this Golden Parachute nonsense out of the bill! They deserve NO REWARDS for the calamity they have brought down upon us.

[Lafayette]

Other needs for future profits

BLA: However, I fear he cannot rescue the country or its citizens from financial failures.

He doesn't need to. Besides the financial heft necessary is probably beyond any one person, which is why the Federal government is the creditor of last resort.

Saving individual citizens from "financial failures" is an altogether different matter. The Toxic Waste (TW) that is at the heart of the matter are non-productive debt. That is, houses have either been foreclosed or people are no longer making monthly payments.

In either case, the residual value of the property is still there. It is only the ability to generate revenue that is dormant. That revenue generation will come back if two things happen. First, the payments are reduced to acceptable proportions (for those who no longer are making them, but still reside in their houses). Secondly, for the foreclosed houses, that they be resold at "fire sale" prices -- that is, a significant mark down from their original market price. But, for credit-worthy customers, this will require the economy to recover as well as a considerable period of time. We cannot have yet another Subprime Mess Redux.

The American economy is a brilliantly resilient animal. It will recover and in fairly short fashion. But, the credit mechanism must be first un-seized. That can likely happen if the TW is purchased by the American government and taken off the books of the remaining investment banks and other investors who may have purchased the "Triple-A Junk".

That is the purpose of the "bail-out" or "buy-in", call it what you will according to your point-of-view.

What we have is a Great Occasion to do some good for the American middle and lower-middle classes that are victims of this well-oiled fraud. Bush and his fellow Replicants nixed the Dem idea that any future profits be used for low-cost housing. They wanted it returned to the Treasury, so voting its expenditure will require Congressional approval once again.

Maybe they are thinking of the future cost of invading Iran or North Korea or China ... God know where or who. Whenever the Replicants want to do a little favor to their friends by boosting Corporate Welfare, they go to war.

[James Kroeger]

James, you keep on making the same mistake the left always makes, assuming that the government will be able to execute a plan to perfection. There is no evidence that a state run banking system can avoid making bad loans, the Chinese banks made trillions of Yuan in bad loans.Well, I suppose you could also say that there is plenty of evidence that privately-owned banks are unable to avoid making bad loans, as well. Wouldn't you agree?

No one is reaching for perfection, but economists have always been interested in establishing the proper incentives. The private banking sector has been responding to the wrong incentives, and it is not possible for them to be confronted by the proper incentives as long as the government is willing to bail them out for their errors. Of course, they have never feared that they would not get bailed out, so they didn't modify their behavior appropriately. Why do you want to give them the wrong incentives?

[Lafayette]

Sure as hell does

JK: Of course, they have never feared that they would not get bailed out, so they didn't modify their behavior appropriately. Why do you want to give them the wrong incentives?

I rather think that they were so confident that nothing could go wrong; they did not think for one moment that a failure could happen. This is tantamount to ingrained stupidity.

The banking industry has basically only two models. One is Risk Aversion, the other is Risk Management. The twain should never, ever meet. Lowering the firewall between them, which was the purpose of the Glass-Steagal act, gave birth to the sub-prime mess. The various manipulations of "off-book" operations and the increased leveraging of the investment banks fed the fire that ultimately consumed them.

And, now the taxpayer is the asked to play fireman. OK, when any business situation this critical to the economy gets this bad, Uncle Sam is the lender of last resort.

What remains to be seen, however, is whether the denizens of Wall Street have understood the seriousness of the calamity they provoked. Paulson's insisting that the Golden Parachutes remain indicates that it isn't.

The agreement simply stipulates that NO NEW PARACHUTES can be written -- but the old ones remain. Which means, effectively, that these Robber Barons will be rewarded for wrong doing.

What kind of "meritocracy" does that make of American Finance? A laughable one, I suggest.

En passant

What lesson will our children understand of the sub-prime mess? Will they think, "What the hell - I go to Wall Street, make fifty megabucks (Golden Parachute included), maybe go to jail for five years and come out with a hundred megabucks in-the-pocket. That's ten megabucks a year. Not a bad salary for doing jail time, isn't it?"

Crime doesn't pay? Sure as hell does ...

[Lafayette]

And now this, hot off the press, from Bloomberg: The bill has a section aimed at limiting the pay of executives at companies that take advantage of assistance by prohibiting tax deductions for officials that exceed $500,000, which is half the normal deductible limit. It also allows ``clawbacks'' of money already paid to executives at troubled companies and forbids so-called golden parachutes.

This is first news of a "Clawback"? What does that mean? The Robber Barons get to keep their Golden Parachutes, or not keep them? It seems perfectly logical that companies having the Treasury buy unproductive debt instruments and thereby return their balance sheets to health, cannot ALSO expect that management keeps its year-end bonus OR any parachutes as people are laid off.

Someone remind these nerds that Golden Parachutes and bonuses are Premiums for Performance. There is barely any performance, except on the downside, to find in Investment Banking today ... or will there be tomorrow.

[anne]

Thanks to Ken:

http://online.barrons.com/article/SB122246748703380411.html?mod=googlenews_barrons

September 29, 2008

Making A Mint
By JONATHAN R. LAING

Despite the public outcry over the bailout bill, taxpayers and the Treasury are likely to come out ahead.

[What is not clear though is how distressed debt is to be valued.]