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Monday, September 15, 2008

Paul Krugman: Financial Russian Roulette

Paul Krugman wonders why we were "so unprepared for this latest shock" to the financial system:

Financial Russian Roulette, by Paul Krugman, Commentary, NY Times: Will the U.S. financial system collapse today, or maybe over the next few days? I don’t think so — but I’m nowhere near certain. You see, Lehman Brothers, a major investment bank, is apparently about to go under. And nobody knows what will happen next.

To understand the problem, you need to know that the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by ... the “shadow banking system.” Depository banks, the guys in the marble buildings, now play only a minor role...; most of the business of finance is carried out through complex deals arranged by “nondepository” institutions, institutions like the late lamented Bear Stearns — and Lehman.

The new system was supposed to do a better job of spreading and reducing risk. But in the aftermath of the housing bust and the resulting mortgage crisis, it seems apparent that risk wasn’t so much reduced as hidden: all too many investors had no idea how exposed they were. ...

And here’s the thing: The defenses set up to [protect the financial system]... only protect the guys in the marble buildings, who aren’t at the heart of the current crisis. That creates the real possibility that 2008 could be 1931 revisited.

Now, policy makers are aware of the risks... So over the past year the Fed and the Treasury have orchestrated a series of ad hoc rescue plans. Special credit lines ... were made available... The Fed and the Treasury brokered a deal that protected Bear’s counterparties... And just last week the Treasury seized control of Fannie Mae and Freddie Mac...

But the consequences of those rescues are making officials nervous. For one thing, they’re taking big risks with taxpayer money..., much of the Fed’s portfolio is ... in loans backed by dubious collateral. Also, officials are worried that their rescue efforts will encourage even more risky behavior in the future. After all, it’s starting to look as if the rule is heads you win, tails the taxpayers lose.

Which brings us to Lehman... Like many financial institutions, Lehman has a huge balance sheet — it owes vast sums, and is owed vast sums in return. Trying to liquidate that balance sheet quickly could lead to panic across the financial system. That’s why government officials and private bankers ... spent the weekend ... trying to ... save Lehman, or at least let it fail more slowly.

But Henry Paulson, the Treasury secretary, was adamant that he wouldn’t sweeten the deal by putting more public funds on the line. Many people thought he was bluffing. I was all ready to start today’s column, “When life hands you Lehman, make Lehman aid.” But there was no aid, and apparently no deal. Mr. Paulson seems to be betting that the financial system — bolstered, it must be said, by those special credit lines — can handle the shock of a Lehman failure. We’ll find out soon whether he was brave or foolish.

The real answer to the current problem would, of course, have been to take preventive action before we reached this point. Even leaving aside the obvious need to regulate the shadow banking system..., why were we so unprepared for this latest shock? When Bear went under, many people talked about the need for a mechanism for “orderly liquidation” of failing investment banks. Well, that was six months ago. Where’s the mechanism?

And so here we are, with Mr. Paulson apparently feeling that playing Russian roulette with the U.S. financial system was his best option. Yikes.

    Posted by on Monday, September 15, 2008 at 12:33 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (105)

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