"!*#\ӣ$%&?!!!"

Should the government help AIG?:

Should AIG be funded by the Fed?, by Willem Buiter: AIG, the largest US insurance company by assets, is reported to have asked the Fed for a $40bn ‘bridge loan’ to tide it over while it sells assets and attracts new equity. Unless such support is forthcoming, the company fears a downgrade by the rating agencies before it can shore up its capital base. Such a downgrade could further weaken its balance sheet, leading to a downward spiral and possible bankruptcy. While waiting for a Fed decision, AIG’s regulator, NY State Insurance Superintendent Eric Dinallo gave it special permission to access (i.e. to raid) $20 billion of capital in its subsidiaries to free up liquidity.

My first reaction to these stories was !*#\ӣ$%&?!!!

The activities of AIG that have got it into trouble are the provision of default insurance on mortgage-backed securities through a range of derivative contracts...

If an insurance company like AIG has become a highly leveraged financial institution deemed by the Fed to be too large, too interconnected or too politically connected to fail, and if it is as a result granted access to Federal Reserve resources..., then there has to be a regulatory quid-pro-quo. AIG is not a bank. It is not ... regulated at the Federal level at all. Insurance ... is regulated at the state level. So a financial institution that is large enough to cast a significant global shadow is regulated by some provincial official in New York State. ...

I hope the Fed will tell AIG to go away... But should the Fed decide that it is now responsible for all highly leveraged institutions it deems systemically important, then significant regulatory authority and oversight of the Fed over AIG should be (part of) the price. The bridging loan should also be priced punitively and be secured against the best assets in the AIG group. The regulatory regime should involve serious capital requirements, liquidity requirements, reporting and governance requirements as well as the creation of a special resolution regime for AIG should it, in the view of the regulator (the Fed), be at risk of failing...

But before any money is lent by the Fed to AIG, even on the conditions outlined above, I would like to have the social cost-benefit analysis of this proposed transaction explained to me. Where is the market failure? Where are the systemic externalities associated with requiring AIG to sink or swim on its own? If the Fed were to provide funding to AIG, then, unless a convincing public interest/social welfare case is made (and I have not seen a single sensible argument in support of such an act), I would have to conclude that the political economy of the US had become one of crony capitalism and socialism for the rich and the well-connected.

Another view:

Wall Street’s Next Big Problem, by Michael Lewitt, Commentary, NY Times: ...When Lehman Brothers filed for bankruptcy on Monday, it became the latest but surely not the last victim of the subprime mortgage collapse. ...

But there is a bigger potential failure lurking: the American International Group, the insurance giant. It poses a much larger threat to the financial system than Lehman Brothers ever did because it plays an integral role in several key markets: credit derivatives, mortgages, corporate loans and hedge funds.

Late Monday, A.I.G. was downgraded by the major credit rating agencies (which inexplicably still retain an enormous amount of power ... despite having gutted their credibility with unreliable ratings for mortgage-backed securities during the housing boom). This credit downgrade could require A.I.G. to post billions of dollars of additional collateral for its mortgage derivative contracts.

Fat chance. That’s collateral A.I.G. does not have. There is therefore a substantial possibility that A.I.G. will be unable to meet its obligations and be forced into liquidation. ... Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression.

A.I.G. does business with virtually every financial institution in the world. Most important, it is a central player in the unregulated, Brobdingnagian credit default swap market that is reported to be at least $60 trillion in size. ...

If A.I.G. collapsed, its hundreds of billions of dollars of mortgage-related assets would be added to those being sold by other financial institutions. This would just depress values further. The counterparties around the world to A.I.G.’s credit default swaps may be unable to collect on their trades. ... More failures, particularly of hedge funds, could follow.

Regulators knew that if Lehman went down, the world wouldn’t end. But Wall Street isn’t remotely prepared for the inestimable damage the financial system would suffer if A.I.G. collapsed.

While Gov. David A. Paterson of New York ... allowed A.I.G. to borrow $20 billion from its subsidiaries, that move will only postpone the day of reckoning. The Federal Reserve was also trying to arrange at least $70 billion in loans from investment banks, but it’s hard to see how Wall Street could come up with that much money.

More promisingly, A.I.G. asked the Federal Reserve for a bridge loan. True, there is no precedent for the central bank to extend assistance to an insurance company. But these are unprecedented times, and the Federal Reserve should provide A.I.G. with some form of financial support while the company liquidates its mortgage-related assets in an orderly manner.

The Fed cannot afford to stand on principle. The myth of free markets ended with the takeover of Fannie Mae and Freddie Mac. Actually, it ended with their creation.

I agree with Willem Buiter that it would be best if we understood the market failures or the systemic externalities associated with the failure of AIG, that would allow us to better determine the appropriate course of action. But one thing to learn from this crisis is that financial markets are sufficiently interconnected and sufficiently complex so as to make it difficult to fully understand the risk we face with any action (or inaction). It's like trying to evaluate one of those opaque, sliced and diced, repackaged derivative securities we've heard so much about, nobody knows for sure how much risk is associated with the failure of AIG.

In that environment, and realizing that all past calls that the unfolding crisis would be contained -- that the crisis would not spread and endanger the broader economy -- have been wrong even with spreading walls of containment, my inclination is to play it safe. Unless we are very certain that telling AIG to "go away" will not endanger the overall economy, then protect jobs and the economy first and foremost by ensuring, minimally, that an orderly liquidation occurs. But Willem Buiter's right about the follow-up to any action, any help needs to be followed by "a regulatory quid-pro-quo."

Update: From Dealbook:

The prospects of a private market solution to the deterioration of the American International Group appeared to be faltering on Tuesday, as talks involving the Federal Reserve and several banks turned to the possibility of using government money to shore up the ailing insurance giant, people briefed on the negotiations said Tuesday morning.

Fed officials were still meeting with A.I.G., JPMorgan Chase, Goldman Sachs, Morgan Stanley and others at the Federal Reserve Bank of New York Tuesday morning to discuss possible options. It isn’t clear that any solution, including one involving government money, will emerge, this person said.

If a financing solution is not reached, A.I.G. may file for bankruptcy as soon as Wednesday...

Comments

[a]

And I respectfully disagree! We've now bailed out financial institutions 6 times since the crisis began, and every time it's had no effect - the problem is still there and just gets worse. We bailed out Lehman and - nothing so far has happened. The market went down yesterday not because of Lehman but because of AIG, which was already a problem *before* the non-action on Lehman and would still have been a problem had there been a government bail-out. BAC's purchase of MER stinks, especially if it's backed by Mom & Pop depositors' funds.

What the bail-out people are doing is throwing good money after bad. It is having the effect of supporting an inefficient system which *was* and *still is* doing immense damage to the real economy (by siphoning off wealth in the form of high salaries and bonuses, without adding any value).

Those people who want to help the real economy, I beg you, help the real economy *directly*: fund work programs, provide free health care, get food to people. There's not much money left in the American kitty, and it's being squandered away by panic-driven officials.

[Mark Thoma]

You actually don't disagree, you just think you know for sure that a collapse of AIG won't spread. I said if we are certain of that, then don't intervene. But I don't think that degree of certainty is warranted, and that argues for intervention.

And you don't really know what would have happened had the Fed and Treasury not acted in the past, so your assertion that past intervention did nothing is without basis. Things could have been - and I'm fairly certain would have been - much, much worse than they are without the Fed's actions (and in the end, the Fed may not be able to save the day, we'll see, but that doesn't mean they shouldn't try, so the mere fact that things haven't suddenly gone back to normal is not proof of policy ineffectiveness). Again, you think you know what would have happened had policy been different, hence the confident assertion, but there's no way you can know for sure since we didn't actually run the alternative scenario. I don't think you realize how serious a crash would be, it doesn't seem that way anyway, and things may get pretty bad even without one. When you are running the world, you can risk people's lives with your over confidence, but I'd like people in charge to be more cautious.

As for the fiscal policy steps you've outlined, I've advocated those as well, in one form or another - but fiscal policy alone isn't enough, and the steps you outline aren't politically viable with the current administration anyway. There's plenty of money left to do these things, but it's a matter of political will and right now it's not there. The US is not broke. Go read The Wealth of Nations.

Nobody's talking about supporting the system going forward as it is - that's what all the talk about regulation is all about - and that doesn't argue against intervention anyway. We have what we have, intervening now doesn't mean we will have the same system later, it's part of an orderly unwinding - protecting the overall economy first - before rebuilding on a more solid foundation.

[ndd]

Prof Thoma, surprisingly for an economist, aren't you leaving out an important counterbalancing issue? You say:
Unless we are very certain that telling AIG to "go away" will not endanger the overall economy, then protect jobs and the economy first and foremost by ensuring, minimally, that an orderly liquidation occurs.

Here's the countervailing issue: How much will it "endanger the overall economy" if more taxpayer funds, which are also not infinite, are expended to prop up one zombie corporation after another. First there were the investment banks and "EZ Ben's Drive up pawn shop and Discount Window", then Bear Sterns, then Fannie and Freddie, then (proposed) Lehman, now AIG... And tomorrow it will be WaMu, Wachovia, GM, Ford, and a slew of others, all making the same argument you make in your post.

At some point we have to consider whether the damage done by even a systemic financial meltdown might cost less to the taxpayers and the long-term economy than continuing to bail, bail, bail, until as Mike Shedlock and others quip, you get to a situation that is "too big to bail" -- but the taxpayers are still on the hook for $Trillions due to the failed attempt.

[Craig Huber]

No offense, but the "talk of regulation" has been just that... "talk", and mostly coming from people largely outside the corridors of power, not those within. With the usual excuse of "let's get thru the crisis first, then we'll figure out how to manage things better."

As the saying goes: I was born at night, but not _last_ night. Regulatory planning and imposition of controls needs to start happening now, while the leverage to force it upon these oh-so-bright financial titans still exists, or it will go right back to business-as-usual once the crisis has passed... with the blessings of all but a few naysayers, who can again be safely marginalized (until the next major screwup).

There have been nowhere near enough mea culpas yet to convince me that "this time, it will be different." That gratuitous shot at the GSEs in the NYT editorial quoted above is a good example of just one line of excuses that will come down the pike, I suspect.

These !@$#@!s are doing more to bolster the rep of socialism than any true socialist ever did.

[a]

"You actually don't disagree..." Good! We agree, no problem there.

"you just think you know for sure that a collapse of AIG won't spread." I didn't say that, and I don't know that. On the contrary, I believe the contrary. I think a collapse of AIG (because AIG is *really* big) will spread, and a lot of firms won't survive.

"And in the end, the Fed may not be able to save the day, we'll see, but that doesn't mean they shouldn't try..." I think you are underestimating the cost of them trying.

"Again, you think you know what would have happened had policy been different, hence the confident assertion, but there's no way you can know for sure since we didn't actually run the alternative scenario." I'm not sure which confident assertion you think I've made, but you seem pretty confident in saying that the bail-outs are at least as good as the alternative, that the Fed helping is at least as good as non-helping. So, you are appealing to "alternative scenarios" to justify certain policy, yet you admit we can't run the alternative scenario - so how do *you* know?

"When you are running the world, you can risk people's lives with your over confidence, but I'd like people in charge to be more cautious." I'd certainly agree about preferring more caution in our leaders. I humbly submit that that is the exact opposite we have seen.

"As for the fiscal policy steps you've outlined, I've advocated those as well, in one form or another ..." Good! We agree. There *is* a question of timing - I'd wait longer than you and I wouldn't do it to stop recession; I would do it to help people live their lives with a minimal amount of decency.

"There's plenty of money left to do these things, but it's a matter of political will and right now it's not there. The US is not broke." Well, I didn't say it was broke, I said there wasn't much left in the kitty. But anyway... The US is a massive debtor. Agree or disagree? The US is running a massive trade deficit. Agree or disagree? If the US were not a massive debtor, it could probably continue to run a massive trade deficit. If the US weren't running a massive trade deficit, then it could probably maintain its position as a massive debtor. But it's both. So it needs to roll over debt at the same time that it needs foreigners to send us their oil (to keep our cars running) and their goods (to keep up our lifestyle) in return for paper called dollar bills. Let me ask you this, and I use "broke" here to mean "in a dangerous situation vis-à-vis its debt, where foreigners may no longer be willing to finance its debt or its imports". Do you think it's impossible for the US to go broke? Or do you think it's just a question of quantity, that the current level of debt and the current level of the deficit is just not enough (Japan has a bigger governmental debt etc.) to constitute being broke? Or are you just saying, that if push comes to shove, the US could get by with a lower standard of living?

[bakho]

Financial services are still about 20 percent of GDP. No doubt it will "underperform" this year.

http://www.iii.org/financial2/today/gdp/

I am not too sure that AIG is asking for a full bailout? Rather they seem to be asking for credit to buy time? Wasn't it last Sunday that AIG found out that donations to politicians don't guarantee government help?

[Robinia]

There is surely enough potential harm out there to give pause-- it is only natural that we would repeatedly be seized by fear, and want to avoid collapse of markets at any cost. But, I worry that we do not sufficiently value the dangers of the new regime that we are building through successive punts. Not just the cost to our children; much as the huge amounts the taxpayer is on the hook for are daunting, the socialization of these costs through inflation and global revaluation of currencies will lessen the impact, or at least dull it, over time.

No, my concern is, frankly, creeping fascism. As a New Yorker, I was shocked yesterday to learn that my State's insurance regulations can be waived at will by a political leader because markets are threatened, and it seems important to him to try to save AIG. I was disheartened as well by statements in the press that, perhaps, Paulson was less likely to arrange a bailout for Lehman Bros. than Bear because Lehman Bros. had a history of donating primarily to Democrats.

Nobody's talking about supporting the system going forward as it is - that's what all the talk about regulation is all about - and that doesn't argue against intervention anyway. We have what we have, intervening now doesn't mean we will have the same system later, it's part of an orderly unwinding - protecting the overall economy first - before rebuilding on a more solid foundation.

Is the "solid foundation" from which we will later build a few consolidated companies in very close contact with government regulators (and so in a perfect position to accomplish regulatory capture)? We have seen that excessive global interconnectedness of titan multinational companies is very, very dangerous to the orderly operation of markets. The idea that we must continue to arrange consolidations, and then give governments more regulatory power, just raises the stakes-- and, some greedy bastard will go for the grab, count on it.

No, decentralization is the key here. The right regulatory frame for the long haul is progressive taxation that mitigates against consolidation of wealth. All the money in one pile just simply can't be insured against all the hungry who want it. Where's Teddy Roosevelt when you need him? Time to break up those trusts and bring those plutocrats back to earth. The foundation upon which we should rebuild is the entrepreneurial spirit of the people-- and we can unleash that with a national health insurance plan that does not require that people work for a mega-company goliath in order to afford healthcare.

[Ryan]

Bakho,

Seems AIG will likely raid its subsidiaries, which may be enough to avert disaster (I wouldn't count on that though). Ironic, as it is my understanding the source of their problems are the subsidiaries. Most likely, they will scrap American General, and try to sell it off (if anyone is brave enough to buy it) first, and then go from there.

What an insurance company was ever doing in CDOs and derivatives in the first place is completely baffling to me. Insurance companies, aside from the prospect of attracting customers, are about the closest thing to guaranteed profit one can get.

[merkury]

"But should the Fed decide that it is now responsible for all highly leveraged institutions it deems systemically important"

Yes. I think it is already implied or is a part of their authority to begin with?

[wjd123]

Unless we are very certain that telling AIG to "go away" will not endanger the overall economy, then protect jobs and the economy first and foremost by ensuring, minimally, that an orderly liquidation occurs. But Willem Buiter's right about the follow-up to any action, any help needs to be followed by "a regulatory quid-pro-quo."--Mark Thoma

Not knowing is the problem. No one wants to endanger the whole economy, but why do we have to wait to start regulating. Why does the federal government need a quid-pro-quo to act if endangering the whole economy is a possible problem. Why not start by passing transparency regulations and sending in the auditors to do a deep audit on risk management. For instance have derivatives been leveraged past the point of having any value?

Yesterday I heard that Lehman had its equity leveraged 30 to 1. How is that done? It just seems insane. What kind of signs does the government need before it is willing take action. Ok, unraveling can cause problems for the economy, but the government has to know what it's unraveling before it can know what problems the economy will face.

[ddt]

LIBOR blew out last night. Get ready for the Fed to do something 'creative' today.

[Ryan]

WJD ,

Promoting transparency now and having deep audits is most likely just going to reveal a closet full of skeletons, which might set off panic. I'm inclined to believe we are in a damned if you do, damned if you don’t scenario.

Perhaps a mandate requiring firms to convert to covered bonds might be a short term approach to regulation, but the fact is that there already exists a lot of bad paper. Regulation generally addresses risk proactively, not reactively. Until firms and household can start to renegotiate mortgages and get book value to reflect real value, no amount of regulation is going to make a difference.

[groucho]

"When you are running the world, you can risk people's lives with your over confidence, but I'd like people in charge to be more cautious."

Mark, If you want those in charge "to be more cautious" than allowing failure to take place becomes the precursor of said caution.

Think of "Rocket Science"; you test the rocket and then do forensics on the eventual failures. This is how the learning process evolves. Some say repetition is the mother of learning, I say failure is the father.

As far as so called "systemic risk"; allow failure and you remove systemic risk, moral hazard and the current "tragedy of the commons" economy.

When you hear "Failure" think "Good".

[me]

Maurice R. "Hank" Greenberg , American hero ala Bernie Ebbers, and like Kenneth Lay was a Bush pioneer.

[Mark]

Take a deep breath. We will continue operating under extreme uncertainty with little or no empirical light to guide us on a hazard strewn path.

[hari]

Mark is right on AIG...

It's too big a fish in the financial pond, if you don't know it. I've some knowledge of their operations in Europe with Zurich has their control centre. From managing mutual funds to hospital insurance, AIG is spread all over Europe with enormous investments. Often it played as a reference point for other similar financial houses...it'd be difficult to say the least to disentangle their market penetration and diffusion - insurance being central to their business.

Paulson will not find it easy to overlook AIGs tentacles - as he did with Lehman (too highly leveraged!). Me thinks he'll get NY/Fed to find a solution without disrupting the market.

[dWj]

"Orderly liquidation" is exactly what Chapter 7 of Title 11 is designed to effect.

[hari]

AIGs cross-holdings will not be easy to disentangle, Greenberg's mastermind fits my definition of a Cabal.

[jim]

Giving "A Bridge to Nowhere" a new meaning.

[Bernard Yomtov]

Giving "A Bridge to Nowhere" a new meaning.

Thanks, jim. A light moment in the middle of all this is very welcome.

[ddt]

I've also dealt with AIG fairly extensively in a past life, selling their commercial lines policies in Canada. I wonder what the scene is like this week in my old office. Pretty hectic I imagine.

As an aside, I've noticed that a lot of the insurers' stocks are getting whacked as well this week. I think that this is one area where eventually you will see some great buying opportunities. I'm keeping an eye on ING. From what I know of their Canadian operations, they are the most well-run, competitive company in the market and have that large base of deposits to fall back on. They are also sitting on a multi-billion dollar war chest ready to snap up distressed competitors. Whenever I see some light at the end of the tunnel (probably a year or two at least) they are one of the names I would purchase.

[hari]

ddt - remember before ING got into banking...it was the primer insurance house of Holland! I would not be suprised if they somehow get involved with AIG pieces in Holland and rest of Europe.

[Patrick]

From what I understand, AIG is on the ropes largely because they're on the hook for CDS payoffs. Again, my understanding is that the CDS's are by and large for speculation, and their usually held by parties who don't even own the underlying asset(s)... Ok, so why not get congress to nullify them? Better that a bunch of hedge funds and speculators lose out than to put the taxpayer on the hook for billions if the whole firm comes crumbling down.

[Patrick]

Just to add one thing to my last post: Of course, it would be conditional on the board firing management, and some kind of punitive financial measures (fines or higher taxation for a number of years or something like that).

[Alex Tolley]

Although the US is not Japan, isn't all this propping up banking institutions just what Japan did after 1990 and left them with a flat economy for over a decade?

Obviously no-one wants a financial implosion, but is fear of change resulting in maintaining the status quo the desired outcome? Assuming AIG is kept afloat, and even assume we get regulations that are enforced, what will change for AIG? It will plead it is too big to change quickly, let them take a decade or more to move into regulatory compliance. In the meantime, other insurers may not be able to compete on a level playing field and the very instruments that are so toxic to the system are maintained.

Are we sure that rapid change and new players is a worse idea than maintaining teh current mess?

[Mark]

I think, as others have noted, that although vast, federal resources to bail out these companies are not limitless. How much more bad risk is the public sector capable of taking on? How do we know that a failure (and potential bailout) of someone even larger and more important than AIG isn't right around the corner? If we run out of bailout funds and someone even more important than AIG fails then we are sunk.

And where does the bailout of non-banking firms end? GM and Ford have been in trouble for years but no one has come to their rescue (granted, they haven't been on the verge of bankruptcy). They provide thousands of valueable, high paying, high benefit jobs. I'm sure AIG does too but why should their workers get saved while the line workers at GM and Ford are on their own?

[Robinia]

Are we sure that rapid change and new players is a worse idea than maintaining the current mess?

Actually, the experience of rust belt cities practicing "job retention" oriented economic development over the past 3 or 4 decades would be evidence favoring the phoenix approach-- crash and burn followed by rebirth.

States like NY gave mega-incentives to companies like Kodak and IBM to "retain" high-paid jobs in their economies.... as those same firms systematically responded to market forces that were inexorably shipping jobs out of the state. Yesterday, NY's Governor put the state's insurance fund on the line to buy AIG an afternoon's worth of stock buoyancy.

Faith in fundamentals means recognizing losing games, QUITTING THEM, gathering your resources, and trying something new. It's time to see that some of these venerable old firms are engaged in endeavors that are worth much less than we had previously thought.

[roger]

I'm surprised that you, professor Thoma, as an economist - and thus having a respect for efficiencies - are even considering this new, wasteful form of feudalism when the old feudal system, in which we allowed the wealthy to directly collect taxes, was so much more efficient. Assigning tax money directly to our plutocrats instead of going through the fed would not only be more efficient, but it would certainly mean jobs jobs jobs. The plutocrats would have to hire, for instance, more chauffeurs to bring the money to their manses.

Luckily, the communist alternative, in which you "bridge loan" forty, fifty, seventy, one hundred billion dollars directly to consumers - is not being considered. Because that would provide money to all the wrong people - people who the economists regard, rightly, as human cattle, er, capital, and who don't understand the benefits of the glorious system of the Great Moderation. After all, look what it has brought us: "But one thing to learn from this crisis is that financial markets are sufficiently interconnected and sufficiently complex so as to make it difficult to fully understand the risk we face with any action (or inaction)" If they can't be grateful for THAT, why should they get dessert?

[knzn]

Dude, the market failure is sticky prices.

The reason to bail out big players is to protect the financial system. The reason the financial system needs to be protected is that a collapse of the financial system could lead to a severe deficiency in aggregate demand which would result in a depression. [Insert reference to the early 1930's here.] The reason that aggregate demand deficiency can lead to a depression is (at least according to traditional Keynesian thought) that prices (and/or wages) are sticky. Hence market failure.

Bailouts are essentially a form of preemptive fiscal policy (even when they are carried out by the monetary authorities, who would typically sterilize the monetary impact of a bailout by reducing open market operations). It's much better than ordinary fiscal policy because the impact is more precise and predicatible, and there is no problem with timing. (In other words, you know that, if you let the institution fail now, the economy will get weaker, so you know at exactly what point in time the fiscal stimulus -- in the form of a bailout -- is required. Contrast this with ordinary fiscal policy, which is often undertaken too late, when the economy is already recovering.)

When interest rates are high, bailouts are not really necessary (just as a fiscal stimulus is not necessary) because the monetary authorities are in a position to offset the impact of weakness in the financial system by cutting interest rates. (I would argue that bailouts should sometimes be done even when rates are high, to reduce the uncertainty associated with subsequent policy actions, but that's a more subtle argument.) When rates are low, bailouts become a very important policy tool that, in my opinion, is being underutilized.

[Creative Destruction]

Capitalism is not about propping up companies with a poor business plan. It is about creative destruction. Companies with the best business plans succeed, and companies with crummy business plans go out of business. Many old line financial companies have completely and utterly destroyed their reputations. This is a really bad business plan. Successful companies build business over the long run by treating people honorably.

Propping up bad business plans results in a smaller total pie, as resources are wasted instead of being put to productive use.

[MiniMax]

The strategy of minimizing the chance that the maximum possible possible disaster will happen is often employed. The problem is that no small group really understands how the total system works, which is why centrally planned economies never worked out. Employing minimax under these circumstances can result in tremendous resources being diverted from their most efficient use. Care should be exercised.

[Daniil]

Why should Fed give money to a company which turned down private equity purchase, because they would've lost control? That's what should happen anyway - control should not stay with those that run AIG into trouble.

[ddt]

hari -

I'd be proud to have ING as a flagship national company too :)

Unlike Citigroup-Travellers, their insurance-banking merger might prove to be well-executed and prescient. Here in Canada I think that they were the original bank pushing high-interest savings accounts, and it seems like they've been very successful. In retrospect it looks like a wise move, now that everyone else is scrambling to offer the same kinds of savings accounts in order to bolster their capital base.

Also, I really like their reports and corporate culture. As an investor these are the kinds of things I find reassuring:
Q2 2008 Report:

‘ING continues to weather the turmoil in credit markets well, as writedowns on pressurised assets remained limited in the second quarter. We are, of course, not immune to the challenging environment around us, and the sustained weakness across financial markets put pressure on earnings,” said Michel Tilmant, CEO of ING. “We took advantage of the brief market rally in April to reduce our equity exposure. Nonetheless, equity gains net of impairments were significantly below the exceptional levels realised last year. Combined with lower real estate and private equity valuations, lower investment results accounted for the vast majority of the profit decline. Interest income in the banking business rose strongly, despite competition for deposits. Risk costs increased, but remained below over-the-cycle norms. Costs remained under control in mature markets, while we continued to invest to support growth.’

‘All capital and leverage ratios are well within target. The Group has EUR 3.9 billion of spare leverage capacity after the completion of ING’s EUR 5 billion share buyback and the payment of last year’s final dividend in the second quarter. In line with our policy to pay an interim dividend equal to half of the previous year’s total dividend, our interim dividend
has been set at EUR 0.74 per share, to be paid fully in cash.’

"Liquidity
ING’s liquidity position remained sound during the second quarter. ING is regarded as a safe haven with a well diversified funding base, of which 56% consists of customer deposits. ING Bank’s short-term funding costs in the money market remain well below LIBOR."

http://www.ing.com/group/showdoc.jsp?docid=039176_EN&menopt=ivr|qtr

[SGC]

I haven't read all the comments, but it seems to me that you folks are completely overlooking the real issue here.

It was widely reported AIG had a deal on Sunday with a consortium of private equity shops that it rejected, because it would have risked giving up control of the company.

From the WSJ: Another complication lies in the wording of that key paragraph in the Federal Reserve Act. The Act states that before agreeing to a loan “the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions.” That might be a deal breaker with AIG, which turned down a capital infusion from a group of private-equity firms led by J.C. Flowers & Co. because an option tied to the offer would have effectively given them control of the company.
http://blogs.wsj.com/economics/2008/09/15/can-the-fed-help-aig-will-it/

If AIG did indeed turn down a workable deal on Sunday, what we are looking at is a case of moral hazard on a dangerous scale.

[knzn]

(Continuing from my previous comment)

Another market failure here has to do with the possibility of a speculative bubble. I'm not sufficiently acquainted with bubble theory to pinpoint the market failure, but obviously bubbles are a bad thing. (In the simplest version, which is possibly the most accurate, the market failure is simply the irrationality that causes people to extrapolate current trends into the future.)

I'm referring specifically to a bubble in money. One way to look at the early 1930s is that there was just such a bubble. Instead of spending money to build factories and such, investors saw that the value of money was rising, and they expected it to keep rising, so they held most of their assets in the form of money.

A collapse -- even a partial collapse -- of the financial system could lead to another "money bubble." With Treasury bill yields nearing the zero floor, the Fed is using up the major tool it has to discourage the holding of money. Should a bubble develop, the Fed will have little power to impede its progress.

An ounce of prevention...

[James Kroeger]

You actually don't disagree, you just think you know for sure that a collapse of AIG won't spread.No, Mark, the cogent assumption is not that a collapse of AIG wouldn't spread; the cogent assumption is that even if it did, the 'horror' of the collapse that everyone is saying we should fear would simply NOT BE ALL THAT HORRIBLE. That is to say, if we had enlightened people running our federal government, the 'horror' would not be all that bad for the Average American and it would be over so quickly, people would wonder what the big deal had been that everyone had been so worried about.

Let's go through this a step at a time... How would the Average American be hurt by a complete collapse of the financial sector of the economy? The answer is that he/she would be hurting only if aggregate demand were drop as a consequence of banks lending less money and businesses spending less money. Without intervention by Congress, businesses that are too heavily leveraged would go out of business and many people would lose their jobs. But if the federal government were to increase its spending enough (by taxing the rich and spending that money on infrastructure & human capital) aggregate demand could not only be maintained, we could also easily increase AD if that is what we wanted to do.

To maintain aggregate demand at the levels we desire, it might be desirable for Congress to create taxpayer-owned banks that would buy up the assests of failed private banks at fire-sale prices, fully capitalize them with public funds, and then provide whatever loanable funds might be desired by borrowers. If loan demand is inadequate to maintain aggregate spending at the desired level, then Congress can simply spend more money on public investment.

So what's the problem? What's the horror? The evil geniuses who created our private financial markets would suffer massive losses because they did not prepare themselves for excessive risk. They would lose Big Time, as they should. Within a month of two after such institutions fail, the government could be replacing them with publicly owned entities that have no reservations whatsoever about lending to would-be borrowers.

It would all be over within 6 months and very few people would be unemployed while competing firms buy up the assets of failed firms. As long as demand is strong, everyone would be working and pumping money into the economy at the same time that the few remaining players in the privately-owned financial sector are finding new ways to make a living while competing with The Taxpayer's Bank (one that is not interested in maximizing profits while taking on risks that everyone else must pay for, but only in serving the public interest) and which writes the rules that they must abide by.

(If a reminder is necessary: the Great Depression continued on as long as it did for only one reason: the Federal Government did not spend enough money to eliminate unemployment until World War II began and then unemployment dried up almost over night. Roosevelt's Congress did not authorize enough spending because too many members of the opposition and of the banking community warned that the consequences of 'inflating' the economy would be disastrous. Too bad they listened. Millions of people suffered terribly for no good reason.)

So help me out, Mark. What is this horror that you fear that justifies throwing more billions of dollars at rich people?

[Eric Dewey]

Mark, wouldn't it make more sense for the Fed and Treasury to be thinking forward to when a large actor such as AIG were to fail, rather than trying to stop them from failing?

Yes, the human cost of a failure at AIG would be huge - there's really little question about that.

To use a medical epidemic analogy (WARNING: no medical, statistical, or epidemiological expertise exists in the following):

AIG (and any business that relies on complex derivatives) is like a person who has a virulent plague that recurs from time to time. This plague will always be with us (because we're taking about human nature, here). The plague can be avoided only by going on a strict macrobiotic diet. Once it breaks out, it can controlled only by isolating those infected and letting them die out as quickly as possible, then promptly but carefully disposing of their remains.

Some further, critical policy considerations:

1. if the number of people infected is so large that their remains can't be quickly and carefully disposed of, the plague will disappear for only short time, and will then reoccur in an even more virulent form. 50% of the experts on the plague predict that at some point not far away, this process will be so powerful that the world's population would be reduced by 25-50% or more.

2. the infected people can be cured but will always be a carrier of the plague.

3. If knowledge that the plague can be cured gets out, the leading experts predict that 50% of the population will refuse to go on the macrobiotic diet that will save their lives (lack of political will).

In this scenario, which I submit is not terribly unlike the current financial crisis, the question presented to the policy makers is: should they cure AIG, a leading member of the community who is known to have the plague? Or should they allow AIG to die and then dispose of their remains?

[macburger]

I would like to see a few simple pre-condition for all bailouts.

1)Surrender of all past exec bonuses for the last X years.

2)Capping of total exec compensation to that of the average company worker, till the bailout is payed back to the Fed/Treasury.

Are they game?

[ddt]

SGC - exactly. they have some gall turning down that offer then turning to the Fed.

I commented on that in the Russian Roulette thread.

[anne]

There was a different approach suggested in several forms early on, which was that the focus be on protecting individual households and communities as it was apparent that mortgage defaults were coming, defaults generally having nothing to do with lack of concern or carelessness or speculation by a household, and that these defaults would harm the economy for an extended period of time.

The idea was suggested initially because of difficulties being found in African American communities, but the problem had to spread and was spreading while the idea was ignored. Hillary Clinton suggested a household and community based approach.

[Alex Tolley]

knzn: The reason to bail out big players is to protect the financial system. The reason the financial system needs to be protected is that a collapse of the financial system could lead to a severe deficiency in aggregate demand which would result in a depression.

This is the C21st. Are you really telling me banks are the only intermediary to ensure lending is achieved? I appreciate that when banks were sparse and communications were by carrier pigeon that you needed local expertise for lending. But this is not true today. Credit cards are used for purchasing, only needing automated systems to provide levels of credit and ensure payments are made. Are banks really needed for standard loans for larger projects, such as construction? As we saw in the go-go 1920's, the 1970 S&L crisis and today, intermediaries are prone to distort their basic functions and screw up royally.

The reason Lehman failed has next to nothing to do with the way the broader economy works. It has all to do with pathological financial engineering to extract sufficient crumbs from huge transaction volumes to transfer to the institution's owners. This same pathology has infected insurers like AIG who wanted to get in at the trough.

So I repeat, do we really need these agencies? Sure, new regulations (returning to Glass-Steagall) will help by constraining activities, although we will periodically see these regulations repealed on the usual 60 year cycle. But just maybe we can get over our fears and re-think what mechanisms we really need to ensure the economy flows well. Maybe we really don't need banks at all, and different banking functions really should finally be kept separate when we do use the various institutions.

[anne]

For years, studies showed the ways in which African American households were so often being sold the most expensive mortgages no matter the history of the household. The New York Times now and again discussed the problem extending to as early as 1994, from 1999 on. Not only African American households, but Latino and older households were especially subject to the most problematic mortgage marketing.

Focusing on households and communities early on could have, might have, been effective, but the idea was ignored or even laughed at when Clinton spoke to the matter while other preferred letting the market be the market.

[roger]

Mr. Kroeger, interesting suggestion. An alternative to the new feudalism - but with a fatal flaw. After all, who, exactly, would benefit from your suggestion? The unwashed and unworthy masses. Are you aware that many of them could not even find Davos on a map? Really, it would destroy the joy of being an economist. No more invites to swank conferences addressed by super successful businessmen. No more the heady feeling of watching one's students, after a quick course in how to operate a calculator, going off to make big bonuses on hedge fund trading.

With casino capitalism, where the house kindly lends the big gamblers money after they have spent it all on investments in destroying, oh, say a desert environment in order to put up spec housing, things are oh so much more efficient. And, on the bright side, the losers, or consumers or whatever you want to call those drab people, get much cheaper plastic toys from China. Plastic ducks, many of them, even - hence, the name, the lucky ducky class.

Surely you can see that the inverted New Deal we have going today is benefiting the people who have, after all, been paying a pretty penny to get the system they wanted - from the glorious think tanks (one can just imagine the wonderful papers that will flow out of the Milton Friedman center at the University of Chicago analyzing the current crisis and finding - surprise! - that it was due to overregulation) to economic departments like that at George Mason university, a wholly owned subsidiary of the Koch Foundation, to a compliant and servile congress, in which every member has the right to retire to the corporate board or lobbying group of his or her choice. It is the bestest system in the whole world - I mean, even Jonathan Swift could not dream up a better one.

[Winslow R.]

I dislike the sense I'm getting the Paulson prefers the idea he just happened to be in the wrong place, at the wrong time and this financial crisis isn't his fault.

He holds the bazooka, it his his choice whether to use it or not. Congress/president gave him the power to lead. History will be the judge of whether he acted a leader or manager.

So far he strikes me as a lousy manager. Kind of like his boss.

[Winslow R.]

James wrote: "To maintain aggregate demand at the levels we desire, it might be desirable for Congress to create taxpayer-owned banks that would buy up the assests of failed private banks at fire-sale prices, fully capitalize them with public funds, and then provide whatever loanable funds might be desired by borrowers. If loan demand is inadequate to maintain aggregate spending at the desired level, then Congress can simply spend more money on public investment."

Agreed!

[James Kroeger]

...who, exactly, would benefit from your suggestion? The unwashed and unworthy masses. Are you aware that many of them could not even find Davos on a map? Really, it would destroy the joy of being an economist.Perhaps it would :)

What I don't understand is why even 'democrat' economists cannot be shamed into challenging the framing of their Republican cohort.

They claim to actually care about 'the little guy' but then they refuse to expand their imaginations beyond the parameters set by Wall Street and the Republican godfathers of the economics profession.

Is it because they hate America? Or just Average Americans?

[macburger]

Buiter:
The activities of AIG that have got it into trouble are the provision of default insurance on mortgage-backed securities through a range of derivative contracts

So there is the IB creating this mortgage security backed by subprime. Toxic. POS.

In comes AIG. Writes insurance for this POS. AIG collects premium.

Voila. POS security now becomes AAA

IB pigman sells AAA security (formerly POS) to investors.

Pigman earns commission, bonus and runs with the loot.

AIG books premium as income and profits. AIG execs get bonus and run with the loot.

Now AAA (POS formerly) in MBS investor's hands, comes out of the closet. Screams to the MBS investor "I'm a piece of $#%@?>!"

Investor is now hitting on AIG to pay up.

AIG has big fat zero in its kitty. AIG could never have shown profits in the past, if it had to reserve against the true claims against the POS. So now AIG wants the govt to pay the MBS investor.

AIG exec - "Please, Mr Govt, can you help us? We would like to keep our loot"

I say the govt should agree.

But only if the govt lines up the AIG execs and the IB pigmen against the wall and let the public have at them.

[Bruce Wilder]

knzn: "Dude, the market failure is sticky prices."

That's a good insight. I'd like to amplify and extend.

Administrative pricing is a fact of market economies, and a necessary instrument of administrative efficiency. In vast areas of the economy, the gains from technical or administrative efficiency routinely dwarf the potential gains from allocative efficiency, so we accept "sticky prices" and a modest degree of allocative inefficiency, to achieve large administrative efficiencies. So, it is not "simply" a "market failure" like fraud or externalities, which can be cured, and should be cured; there's more of a dilemma involved.

AIG is a dilemma, precisely because a sudden, large change in market value is coming into conflict with the bounds of the model used by the administrative regime. Market volatility has exceeded the ability of the administrative regime to attenuate risk and impose, or maintain, administrative control. Do we take the administrative regime apart, or do we try to prop up the market price and "buy time" for market values to return within the bounds needed by the administrative regime?

On the whole, I don't think it makes sense in the present circumstances to "buy time" and hope for the best. Simple bank-of-the-envelope calculations indicate that U.S. real household income must decline, and the value of U.S. residential housing and commercial real estate will continue to decline substantially.

a.. is correct to point out that very large allocational inefficiencies cannot be usefully resisted. U.S. debt loads -- public and private, governmental and household -- and the payments deficit combine with the declining real estate asset values, to force the acceptance of allocational adjustment, even at the cost of dismantling administrative organization.

I keep putting the numbers up in comments, because the numbers matter to dictating the context. Roughly $1.2 trillion to $2 trillion in financial securities value has disappeared, or will disappear within the next 18 months, (and that's only a slice of the $6 to $8 trillion in real estate asset values that have, or will, disappear). These are not precise estimates, but they don't have to be; they indicate the orders of magnitude and indicate, clearly, that this allocational shift cannot be resisted, within the scope of Fed or Treasury resources.

I would think it would be clear, from all rational points of view, that all that can be usefully achieved, at this point, is to "buy time" time for orderly dismantling. "Buying time" for its own sake, is just prolonging the pain, or a cover story for off-loading the pain from the super-wealthy to the middle class home owner/wage earner/taxpayer.

Administrative regimes exist, in part, to attenuate risk, and when you take them apart, that risk attenuation function ceases to exist. The dismantling can, itself, be a shock to the system. It does not seem wise to allow large administrative regimes (aka long established corporate institutions) to collapse willy nilly. These administrative regimes ordinarily provide a lot of stability, by attenuating risk and, their sudden collapse can expose many actors to large, unexpected risks. We don't want administrative regimes, which are doing a good job of delivering administrative efficiency and productivity, to break down unnecessarily, solely in response to the secondary explosion in risk, which follows from a disorderly dismantling of administrative regimes, which are no longer sustainable, given the demands of allocational efficiency.

But, simply "buying time" and hoping, against hope, that the situation can be rescued over time, can also be crazy. The guys, who run these large institutions are overconfident Masters of the Universe; their promises should not be believed in these circumstances. $1.2 trillion is a lot of money, even divided among hundreds of thinly capitalized institutions. Lehman and Bear were doomed, because under any plausible scenario their equity was zero.

AIG, the parent, is probably doomed; I don't know details, but if an insurance company needs a $75 billion line of credit, even if it is the 18th largest corporation in the world, that cannot be good. For New York State to allow them to weaken their insurance units "to buy time" is foolish. The Fed has suspended Rule 23a, so that insured deposits can be mined to finance the black hole -- particularly, I imagine, the thinking was that the insured deposits of Bank of America can be used to cure Merrill Lynch. This does not seem like a wise course to me. It doesn't take much imagination to see that WaMu and Wachovia will fail -- must fail -- as ARMs goes from bad to worse over the course of 2009 -- that could well be enough to wipe out the FDIC's $50 billion. We don't need to be putting BofA or Citigroup on the watchlist.

It does not seem wise to allow large administrative regimes (aka long established corporate institutions) to collapse willy nilly. These administrative regimes ordinarily provide a lot of stability, by attenuating risk and, their sudden collapse can expose many actors to large, unexpected risks. We don't want administrative regimes, which are doing a good job of delivering administrative efficiency and productivity, to break down unnecessarily, solely in response to the secondary explosion in risk, which follows from a disorderly dismantling of administrative regimes, which are no longer sustainable, given the demands of allocational efficiency.

We might want to give some thought to some order of magnitude estimates of how much the financial sector is going to shrink. If the financial sector is 20% of the U.S. economy, and that is, in our present circumstances, way too large, then part of the deal in the present crisis is to accept shrinkage.

[Bruce Wilder]

Macburger is right: fiscal policy and judicial process ought to be used to recover the gains captured on the run-up, to finance the run-down.

[hari]

A bit off the AIG train-wreck...

I think it's now high time BO speaks to the nation about the consequences of this financial crisis and how it affects the individual voter...sort of like he did on Rev Wright.

What I've seen from this morning outlets on campaign, I am not satisfied with BOs performance on the economic crisis. He can do much better in a more focused discussion of the meltdown and how he intends to deal with it, if elected.

Can he throw in a name or two...of qualified individuals who may be part of his cabinet and provide some credibility of his leadership in a crisis.

McBush is running the news hour right now... and it must stop!

[vorpal]

The financial sector is 20% of the market.

Doesn't that strike anybody as perverse? The actual value they provide to people is zero. People don't go to the bank for pleasure... or talk to their investor to get a hamburger...or buy insurance to fix a broken leg.

20% is too high. I say, let 'em crash.

[don]

Just to repeat some good comments - The Treasury is not a bottomless pit. Mark, you think it is risky to let AIG fail. But think what would happen if the Treasury had to reschedule a debt repayment. How could this happen? Well, right now real interest rates are very low (negative, actually). If global economies turn down, excess global saving (particularly in Asia) could dry up and real interest rates could rise. The interest burden on the considerable U.S. debt would rise dramatically. The U.S. could try to renege on its debt through inflation, but lenders would catch on and the inflation premium would rise dramatically (and the dollar fall precipitously).
What could Ben or the fiscal authorities do then?

[ndd]

James Kroeger:

Thank you, thank you, thank you! You have said far more eloquently what I have been saying for almost a year now: the complete collapse of Wall Street does not have to mean disaster for Main Street. Old, over-leveraged, collapsing investment houses can be replaced with new, properly regulated and capitalized (from public money if necessary, with an ownership stake) investment houses.

The meltdown has not metastasized too much to Main Street yet. Putting more fingers in a spewing dike will not stop it and will only be counter-productive.

[macburger]

Leaving all that, the supreme question of the moment should be

DO YOU WANT YOU SOCIAL SECURITY PRIVATIZED?

This is the right time to scream and shout, till that question is heard by everyone.

Don't let this opportunity pass by.

[im1dc]

My car insurance is with one of AIG's subsidiaries.

Bailout AIG and do it NOW. It's is in the interest of the country to prevent the nation's largest insurer from going bankrupt.

I'm not being selfish or self centered here. I assure you I have only the interests of the every American and the US economy in mind. We must save America from the "systemtic risk" that would occur if AIG were to file bankruptcy.

Now about that bridge....

[S Brennan]

None of these bailouts would bother me so much if people of a certain social status (the same folks that are calling for handouts here) wouldn't be so gleeful when telling people born to less fortunate parents that they need to suffer the consequences of their "bad decision" to drop from the wrong birth canal.

Also Mark, I agree with the above poster, let's see some meaningful reform before we hand the bums more cash to go buy another bottle.

Really, name me any charity that asks less of freeloaders than the Federal Government. 20% of the economy? I'm not sure all these financial jobs are worth saving. And after all, isn't this the same crowd that always touts retraining for others...how about a little "retraining" for these folks...I hear Wal-Mart is looking for store greeters.

[Different Mark]

BOG leaves fed funds rate at 2%:
http://www.federalreserve.gov/newsevents/press/monetary/20080916a.htm

[James Kroeger]

...the complete collapse of Wall Street does not have to mean disaster for Main Street.No it doesn't, but do you think you could get a 'not Republican' economist like Mark Thoma to discuss such options on his blog?

Why oh why oh why are Democrat-leaning economists seemingly bereft of ideas on how to challenge the economic myths perpetuated by Republican economists?

Don't any of them really understand the power and ultimate implications of the Balanced Budget Multiplier?

[Patricia Shannon]

Mark Thoma,

Do you have any ideas on how we can keep the collapse of firms like AIG from badly damaging our country w/o rewarding the leaders of these companies who were responsible for the problems?

[Winslow R.]

Don wrote "The Treasury is not a bottomless pit."

Not true.

Don wrote: "Mark, you think it is risky to let AIG fail. But think what would happen if the Treasury had to reschedule a debt repayment. How could this happen? "

Never need happen.

Don wrote: "Well, right now real interest rates are very low (negative, actually). If global economies turn down, excess global saving (particularly in Asia) could dry up and real interest rates could rise."

Most global savings are in the form of U.S. government deficit spending. A lack of aggregate demand by the U.S. government (lack of deficit spending) would lead to lower U.S. interest rates.

Don wrote: "The interest burden on the considerable U.S. debt would rise dramatically."

Wrong, just the opposite. To get your outcome, just the opposite would need to happen. Large deficit spending by foreign governments so they were no longer dependent upon U.S. deficit spending could lead to inflation if sufficiently large.

Don wrote: "The U.S. could try to renege on its debt through inflation, but lenders would catch on and the inflation premium would rise dramatically (and the dollar fall precipitously).

What could Ben or the fiscal authorities do then?"

Raise taxes as exports would be going through the roof.

[James Kroeger]

If global economies turn down, excess global saving (particularly in Asia) could dry up and real interest rates could rise.There seems to be some confusion behind this point.

When economies 'turn down' it is because those economies are experiencing a drop in aggregate spending.

When people/firms/governments spend less of their income it is necessarily true that their savings increase (= money not spent).

Precisely the opposite of what you are suggesting is true, all else equal.

[knzn]

Alex Tolley:
Are you really telling me banks are the only intermediary to ensure lending is achieved? Of course not. In any case, AIG isn't even a bank. But let's leave that aside: banks (and insurance companies, etc.) are what we have. Maybe we need to build a new financial system that relies less on such leveraged institutions, but right now the financial system is leveraged by such institutions, and if we allow the structure to collapse, that will have a deflationary impact (not necessarily enough to cause actual deflation, but that's a risk). We've seen this effect already in the collapse of the mortgage market, which has led to deficient aggregate demand. To the extent that we allow other credit markets to collapse, the deficiency will get worse. If we could be confident that it would only get a little worse, I would say go ahead and let some big institutions fail. But we can't be confident about that. It could get quite a lot worse, and that's a risk I don't think we should take.

[BJ Feng]

From what I understand, if AIG collapses and can't pay out the insurance due to main street folks, other insurance companies are required to pay into a fund that will pay out most of what AIG owes to those people. That's in most states, New York requires insurance firms to pay into a fund first, but the New York governor just allowed AIG to tap into that fund.

I also think that AIG should not receive a government bailout. AIG is just the tip of the iceburg, we absolutely cannot create the impression of an implicit government guarantee on certain firms, otherwise smart Wall Street people will take advantage of that to demand government help before they step in, even if they were going to step in anyway like BOA did with Merill.

In case you haven't heard, Paulson is using his power and influence. He's told the various big players to step up and honor the obligations of failed companies, they've already agreed to do that for Lehman. This is in their best interests anyway. What Paulson can do is reduce the free rider problem by "coaxing" firms that want to contribute nothing, yet will benefit.

Government should only bail out if there is significant risk to the entire system. And the entire concept of risk depends upon loses, if firms are sheltered from loses, then risk management just becomes something learned in the classroom. That includes counterparty risk. Firms have to take that into account, the likelihood that the other party will honor their agreements.

Counterparty risk was largely ignored, but after this crisis, firms will have a better understanding and reduce counterparty risk. That is very good for the market overall because it's a self-policing mechanism. It prevents idiot firms like AIG from taking on too much risk and guaranteeing too many assets because at some point, people will stop doing business with AIG due to the risk that the insurance they get from AIG won't be honored. Of course that requires a more transparent disclosure of what is on their balance sheet. Reforms are needed here to show what companies have so that others can make a determination if they want to do business with another company that is already on the hook for hundreds of billions of guarantees.

[Alex Tolley]

knzn: "We've seen this effect already in the collapse of the mortgage market, which has led to deficient aggregate demand."

Let's be a bit more clear here. Firstly demand was in excess during the real-estate boom. Currently inventory of homes has reasonably stabilized and transactions are within levels of a few years ago. Actual demand for houses is higher, but lending institutions won't lend unless you are extremely creditworthy.

So whilst we have lending institutions - banks and S&Ls - they are not doing their job now, so why support them without substantial systemic changes? Why not let people borrow directly from the government and bypass these intermediaries? Are you saying the government cannot create the same multiplier effect as banks? The 1930's were bad, but the government did pour money into public works programs w/o using the banks. The rise of private finance such as VCs and Angels for large investments and micro-investments for small loans are indications that the system could be very differently structured.

It's hard for me to understand what role banks really play anymore, they collect deposits and charge you for the privilege. The real-estate loans were repackaged so they weren't even on the books of the local bank, they just collected the transaction fee and shipped the loans on to other investors.

I think it is not unreasonable to ask what would really happen if:

1. almost all retail banks disappeared and a few, highly regulated, national banks were allowed to operate within the space of vanilla banking. Maybe even a nationalized bank to simply keep track of transactions.

2. investment banks disappeared. That might definitely be more problematic, but again, strongly regulating their businesses so that they could not play games with the economy outside of financing firms with commercial paper.

Insurers are a different matter, but they could be regulated to prevent a "too big to fail" syndrome. We are already seeing that health care carriers could be removed, so perhaps we should just have insurers like Lloyds to handle unusual risks.

[SGC]

Having thought about the situation a little, I think the problem is this: It doesn't make sense for the Fed to make a loan to AIG.

It may be the case that AIG has to be saved, but then it should be done in a way that sets a standard for all the bailouts that will follow. Congress has been incredibly supportive of Paulson and the Fed. If there is a bailout of AIG now, it needs to be a bailout that envisions the bailout of the whole financial system.

Based on the Fannie and Freddie precedent, aid to AIG should probably involve Treasury taking a preferred stock position in the company.

[James Kroeger]

knzn:...if we allow the structure to collapse, that will have a deflationary impact (not necessarily enough to cause actual deflation, but that's a risk).By 'deflationary impact' are you saying 'a continuing decline in asset prices?' If so, then why is that a problem IF aggregate demand is maintained through government-owned lending institutions and increased government [economic] investments?

The Great Deflation of the Great Depression was caused by a collapse of aggregate demand, caused by a dramatic increase in unemployment. That would not happen if aggregate demand were maintained/increased.

If we were to use the powers of Congress to maintain aggregate demand, or even bump it up a bit while financial entities are allowed to collapse, then what sort of 'deflationary impact' event would you foresee happening then?

Would it be so tragic that it would justify a socialism-for-corporations intervention? Who would be the people that we'd need to protect in such a scenario?

[anne]

http://krugman.blogs.nytimes.com/2008/09/16/eh-aiiii-gee/

September 16, 2008

Eh? Aiiii! Gee …
By Paul Krugman

So the markets think that the toughness in tough love is pretty much over — big rally today on expectations * that the Fed, which didn’t bail out Lehman, will bail out AIG.

* http://bloomberg.com/apps/news?pid=20601087&sid=a5MxgwA.XQaU&refer=home

[anne]

Krugman would seem to have it just right; the Federal Reserve cannot allow AIG to fail, the cascade of credit losses and the losses to the insured would simply be too dangerous to allow. The analogy would be the failure of a Japanese city bank during the 1990s, which could not be allowed.

[James Kroeger]

It's hard for me to understand what role banks really play anymore, they collect deposits and charge you for the privilege.This may be the kind of comment that Mark Thoma, et al., would dismiss utterly, but I think it emphasizes a legitimate point.

The 'service' that a bank provides is not something so arcane that a govt. bureaucracy could not easily imitate it with reasonable efficiency. Without the goal of profit maximization, fewer risks would be taken. Seems a good reason to put the financial sector primarily in the hands of the federal government.

But wouldn't we lose a great deal if we did not put all financing decisions in the hands of competitively-driven, profit-seeking privately-owned organizations? I say, like what? What exactly has competition between private banks and insurance companies done for our modern economy?

The standard answer in textbooks is that they are inspired to create new financial innovation, and innovation is a great thing, isn't it? The only problem is that financial innovation played a big role in creating this huge mess (e.g., debts instruments created that hid true risk levels).

How exactly has such innovation benefited society?

Is it an act of profound blasphemy for an economist to acknowledge that society really doesn't benefit in any special way from having a privately-owned and managed financial system, compared to the publicly-owned alternative?

Or am I actually wrong about this and the actual truth is that our current system is far superior to anything Congress could put together in the name of the American people?

[Supply and Demand]

"If we were to use the powers of Congress to maintain aggregate demand..."

Domestic demand is already far higher than domestic productive capacity. We collectively consume more than we make. More demand? Perhaps we should find some way to encourage domestic business to start making stuff people actually want, instead of demanding that Congress buy the unwanted stuff currently being made.

[James Kroeger]

...the Federal Reserve cannot allow AIG to fail, the cascade of credit losses and the losses to the insured would simply be too dangerous to allow.Are you implicitly claiming here, Anne, that the government could not protect the interests of the insured by offering to take over and make good their current policies? That's how you protect the little gal while allowing the marketplace to put the appropriate amount of fear into the hearts of corporate managers, isn't it?

If there ever a time when we can allow an insurance company to fail?

[hari]

AIG is not a q' of solvency but liquidity....It's operating in 130 countries and is operating a profitable business of one trillion dollars, as I understand.

Seems somehow bridging finance will be forthcoming upto $+70B. Will Fed guarantee it or what, we've to wait see the form in which it is instrumentalized - because the asset base is still sound inspite of pressure on stock price.
The market pressure may also be based on rumours more than factual info on what's going on....

Contrarian-wise shld AIG be forced to file Ch 11 it'd impact world-wide and may not be in national and/or international interest. Ratings agency may have to hold up for a while to allow the market to allow liquidation possible. +100K people are employed in its operations world-wide....

[Winslow R.]

James wrote: "Or am I actually wrong about this and the actual truth is that our current system is far superior to anything Congress could put together in the name of the American people?"

I'd let the American people decide.

Instead of funneling the lending of new reserves through corporations funnel them through the American people. Let the American people decide whether they would like to put those newly created reserves into a corporate bank, GM, Ford, a new tractor, an education or a home loan.

It is hilarious to me that we find it necessary to funnel new reserves into corporations (including foreign owned corporations) at 10x to 50x the value of their capital yet have no liability beyond that capital.

The Fed will not even lend 1x the value of an American citizen ($250,000) to that citizen.

[James Kroeger]

Perhaps we should find some way to encourage domestic business to start making stuff people actually want, instead of demanding that Congress buy the unwanted stuff currently being made.Let me clarify...

It would be absurd for Congress to buy 'unwanted stuff currently being made.' What Congress should start buying more of is more highways, modernized highways, state-of-the-art sewerage systems, a cleaned up environment, more teachers, more classrooms, smaller class sizes, an improved quality of education, more police officers, national health care, etc., etc., etc.

If Congress threw enough money at these REAL Investments=improvements in the quality of the lives of Americans [instead of at rich people], all excess unemployment would be 'soaked up.' Everything about it would be good.

[Bruce Wilder]

There's a pure monetarist view of the Great Depression, which says it was an accident of extremely bad Fed policy, and there's a pure Keynesian view -- not so different, really -- which says, that the economy fell into a general equilibrium with very high unemployment, from which no practical adjustment in the money/price structure (sticky prices) could restore full employment of resources in any finite period of time.

Lots of economists have trouble really believing the Keynesian story, in part because sticky prices seems like such an implausible deus ex machina to people, who are trained to think of markets reaching price equilibrium. Keynesian theory has a big hole in it, which was awkwardly papered over by Hick's IS/LM kludge. We don't really have a good story about exactly how much "money" -- especially how much "money" in its various extended forms of financial securities -- an economy needs to have, to function effectively and make full use of available resources.

The facts of the American economy in the 1920's and 1930's and 1940's, even in the absence of a comprehensive theory, do suggest that the course of economic development had left the economy with a massive problem of meso-economic allocation. Huge areas of the country were mired in hopeless, helpless poverty and underdevelopment, and a huge part of the population was stuck on the farm, where labor was not needed, and where increasing product market risk was combining with declining incomes to create more grinding poverty. The sudden deflation after 1928 revealed, as much as it created, that a large part of the country and of the population was essentially outside of the modern, money economy, with no way to get back in.

I think the economic policies of Reagan and Bush and Bush were aimed at pushing more and more people to the margins of the money economy and of the contracting (in terms of real resource demand) industrial economy. There's a real danger, which I don't think anyone adequately understands, in a deflation, of leaving the economy without sufficient money in its extended forms, of leaving the economy without sufficient financial services, and of leaving a lot of people and resources outside of the modern economy. There are lots of conservatives, who would be OK with that: the little people are just there to buy junk at Wal-Mart, earn the minimum wage (if there is a minimum wage), pay outrageous interest rates at payday lenders, and generally serve as a moral object lesson for ne'er do well sons, who cannot be elected President.

All of that said, I am a liberal, and I think, rather than endorse the efforts of reactionaries like Paulson and Bernanke to rescue failed conservative policy, we ought to be turning our imaginations to the question of how to better allocate resources. The Bush Boom choice of investing in an expansion of health care and a hole in the Iraqi desert, and financing consumer spending from a housing bubble and faulty, often fraudulent lending practices, while letting manufacturing Midwest become a desert, is a bust.

Surely, there's an alternative. Surely, it is not a choice of simply propping up failure, or accepting a bigger failure.

I agree with James Kroeger: we need to be thinking about using fiscal policy to push a massive meso-economic re-allocation away from finance, away from real estate, away from health care and toward the future.

[NLS]

We need to start terraforming Mars.

[don]

To me, the important question is still whether yet another attempt to forestall a reckoning from needed asset price adjustments will not build a bigger problem.
Winslow R.: The U.S. Treasury is a bottomless pit? Maybe if all debt were internal, but it is not. See Brad Selzer's web site. A dollar plummet caused by inflation will not spur exports, but I agree its real significance is milseading in my statement.
PK seems to have been caught out today. It's not partisan to argue that McCain's position is empty when he argues that reforming executive pay is a needed part of any reform package?

[Cynthia]

Given that Bear was much smaller than Lehman, the argument that Bear was too big to fail, while Lehman wasn't, does wash. But given that Bear was far more involved than Lehman in the mortgage market and given that a healthy mortgage market is so essential to keeping our overall economy healthy, then it's more accurate to argue that Bear was too important to fail.

Let me also add that because Fannie and Freddie are the biggest players in the mortgage arena and especially because they are the only players in the 30-year-fixed arena, there was no way in hell the Fed was gonna let Fannie and Freddie fail.

But it's still very much up in the air whether the Fed will deem AIG, the biggest player in the insurance industry, too important to fail. My hunch is that Paulson and Bernanke are quite likely to request a taxpayer bailout for AIG simply because to let AIG fail will, in all likelihood, make Fannie and Freddie fail, too.

In all honesty, though, I wouldn't mind seeing a lifeline thrown to AIG just so long as we cut off all of our military adventures abroad!

[Bruce Wilder]

hari: "AIG is not a q' of solvency but liquidity."

An large profitable insurance company would never have a liquidity problem it couldn't solve, easily and routinely. Wake up, and smell the coffee!

The parent AIG is bad refuse. Flush it away.

Just saw on CNBC, that Samsung just bought SanDisk. This is what we ought to be worried about: that foreign companies are going to be buying all the good assets left in the American economy.

[anne]

Cynthia:

"Given that Bear was much smaller than Lehman, the argument that Bear was too big to fail, while Lehman wasn't, does wash. But given that Bear was far more involved than Lehman in the mortgage market and given that a healthy mortgage market is so essential to keeping our overall economy healthy, then it's more accurate to argue that Bear was too important to fail."

[Right; and the credit ties of AIG are similarly too profound to turn away from. There is no choice now but a backing of AIG.]

[Bruce Wilder]

don: "It's not partisan to argue that McCain's position is empty when he argues that reforming executive pay is a needed part of any reform package?"

I think it is partisan, and it is also the truth.

Partisanship is useful to the society's politics, because it means that there is always an ambitious group ready to criticize its rivals.

McCain's admission is part of McCain's general schtick of playing the principled maverick. Partisan Republicans are going to pretend that they wouldn't fight a genuine reform tooth-and-nail, McCain is going to pretend that he wouldn't himself make any real reform proposal pretty toothless, and Democrats are going to call them on it.

Democrats tell the truth about Republican thievery and lies, and the Republicans whine about it. That's partisanship working as it should. Doesn't happen enough, if you ask me.

[Bruce Wilder]

NLS: "We need to start terraforming Mars."

Or, open a soylent green factory on Maiden Lane.

[Oupoot]

OK, so let AIG fail. Who is going to lose out? Yes, certianly the employees of AIG and everyone in the AIG "value chain" - my guestimate would be about 4 persons for every 1 AIG employee. OK, not so bad, only about 480,000 persons (across the globe) who may be quickly reabsorbed into the economy (or not).

But also the many persons/institutions that invested in AIG debt & equities with their savings, whether that is retirement, pension fund, medical insurance, individual deposits, etc. that invested in AIG backed securities. In additon, many central banks and overseas investors (such as oil exporters, China, Japan, Korea, etc). Yes, all those persons who hold AIG issued debt. OK, they are rich, they can afford to loose 50-70% of their investments that is tied up in AIG, right? But what about Joe Schmo in the street who loose his life insurance, funeral insurance, fire insurance, malpractice insurance, etc. And how many other insurers will suddenly become insolvent if their assets/capital suddenly decrease and/or products/services covered by AIG reinsurance? Suddenly everyone may decide its better to have personal savings (to act as insurance against adversity) than to have any kind of group/social insurance. In economic terms, this is highly inefficient.

OK, so the Treasury/Fed just allowed AIG to fail and the loans/debt they had is wiped out (optimistically, investors & creditors maybe receiving 10c to the $1). So too with many other debt in the fin sector created over the past few years. However, currently the US dont really have enough domestic resources/financial assets/savings to provide the necessary capital for new loans/investments that so many on this forum is calling for. (A move out of group-type insurance to individual insurance/savings dont create additional savings.) Most of this capital reside with foreigners at the moment. Even if the Fed were to lend directly to the man in the street, who is going to lend the money to the Fed?

The US (whether govt or private sector) will need these same investors that they so royally scr**d over to lent them money so they can finance new loans (through public or restructured private banks/financial institutions). Highly unlikely that these foreign investors will do this without a very high risk premium.

There are two options basically: write off some of the debt by letting firms fail using the market system, or maybe through a govt action(good luck in deciding/fighting it out which investors are to take the loss of this write down). This will be fast, but highly problematic & which Mark feels may cause much greater harm as the ripple effects throughout the real economy is an unknown unknown. This also means that trust with investors will have to be rebuild which takes years, there will be a high risk premium for a few years, etc. But recovery may be much more quickly.

Alternatively agree to repay debt faster than it is being accumulated. Sounds simple enough but it will require severe fiscal and monetary policy (what the IMF has advocated to many countries in the developing world over the past 30 years). the result will be an underperforming economy for a number of years. The impact of the "restructuring" (or call it what you like) is thus spread over a number of years, with the unknown unknowns better managed. But the recovery is very slow.

The question: which option is better? Over the short term (2/3 years), certainly the 2nd option, but I would hazard a guess that over the medium to long term (20 years), the net impact would be the same.

[Bruce Wilder]

Let's not exaggerate. The financial failure of the AIG parent holding company is not going to mean the failure of every AIG unit. Insurance regulation means that most AIG units rest on their own bottoms, and will go on about their business, solvent and fully functional, regardless of what happens with the AIG parent concern, which made some really bad derivatives bets, probably as a way of enriching insiders.

By all means, a conservatorship, to ensure as orderly an unwinding as possible, but bankruptcy is a necessary financial institution for a good reason, and this is the reason. If bankruptcy, as it is currently instituted, is inadequate, then a special-purpose, ad-hoc conservancy may become a useful template for bankruptcy reform. But, let's not go forward, pretending that anything can usefully salvaged by "buying time" with either the money of the U.S. government or with insurance policyholders of insurance subsidiaries.

If reality brings down other large institutions, that's the way it is. Let's cope with reality, as best we can. If the U.S. banking system is insolvent, it is insolvent. Pretending otherwise is not a useful guide to policy, and hoping something will turn up, is not a plan.

[Alex Tolley]

BW: "An large profitable insurance company would never have a liquidity problem it couldn't solve, easily and routinely. "

Correct. BUT, insurers go through a routine cycle of moving away from profitable underwriting and market returns on investments to a mix of unprofitable underwriting and super profitable investments. This then unfolds in a series of company failures.

Wouldn't surprise me if AIG is just being more 'sophisticated' with this second mix, resulting in relatively illiquid 'investments'.

[BJ Feng]

"The 'service' that a bank provides is not something so arcane that a govt. bureaucracy could not easily imitate it with reasonable efficiency. Without the goal of profit maximization, fewer risks would be taken. Seems a good reason to put the financial sector primarily in the hands of the federal government."

James, it is the profit the motive and fear of negative profits, or losses, that makes efficiency possible. How would government determine what interest rate to charge for various loans? How would they determine the best allocation, and more importantly, WHO would bear responsibility for bad decisions and what would the consequences be? I seriously doubt that a government run system would be more efficient or less risky. I suppose there would be a set of stats that would "qualify" someone for a loan, but you know that methods to game those numbers would pop up immediately, and political pressure to ease loaning standards for the "poor" who can't qualify.

The government can't go bankrupt as long as Americans have wealth. Profits reward firms that make good decisions and losses punish those who don't. The good decision-makers survive and get stronger, the bad ones go away. That's why Bank of America was able to take over Merrill and Countrywide. That's why Goldman Sachs, which announced a billion dollar profit while Lehman booked over 3 billion in losses, is still alive while Lehman is dead. Profits and losses enforce discipline, those without go away after failure.

If the government can't fail, then what is going to stop them from making bad loans? There are a lot of "risky" loans that finance socially good projects. Like someone who wants to build an apartment complex in Compton or Harlem. The bank may require a 10% interest rate to compensate for that risk. They will set the interest rate so that out of 100 or 1000 such loans, they can make a profit given the expected failure rate. Without the profit motive, would government make such loans? How would they figure out what to charge? And if the government monopoly sticks only to low risk loans, the economy will suffer, where would a "small" developer go for a $10 million construction loan? He can't issue bonds and may not have the connections to get private equity or hedge funds to notice. A government run banking system would be a terrible idea.

[ddt]

breaking news:

Fed to Give A.I.G. $85 Billion Loan and Take 80% Stake
http://www.nytimes.com/2008/09/17/business/17insure.html?ref=business

In an extraordinary turn, the Federal Reserve agreed Tuesday night to take a nearly 80 percent stake in the troubled giant insurance company, the American International Group, in exchange for an $85 billion loan, according to people with knowledge of the negotiations.

The Federal Reserve and Goldman Sachs and JPMorgan Chase had been trying to arrange a $75 billion loan for the company to stave off the financial crisis caused by complex debt securities and credit default swaps. The Federal Reserve stepped in after it became clear Tuesday afternoon that the banking consortium would not be able to complete the deal.

Without the help, A.I.G. was expected to be forced to file for bankruptcy protection.

The need for the loans became necessary after the major credit ratings agencies downgraded A.I.G. late Monday, a move that likely to have forced the company to turn over billions of dollars in collateral to its derivatives trading partners worsening its financial health.

Until this week, it would have been unthinkable for the Federal Reserve to bail out an insurance company, and A.I.G.’s request for help from the Fed of just a few days ago was rebuffed.

But with the prospect of a giant bankruptcy looming — one with unpredictable consequences for the world financial system — the Fed abandoned precedent and agreed to let the money flow.

[James Kroeger]

Even if the Fed were to lend directly to the man in the street, who is going to lend the money to the Fed?

I'm sorry that you somehow missed the memo, but there is never a time when the Fed needs to borrow money. If it wants to spend new money created out of thin air with a keystroke to buy some paper assets, then that is what it can and does do. That is how open market transactions are carried out, according to Fed economists. There is no 'account' of limited size that the Fed debits in order to pay for Treasuries in circulation. Having been reassured this in phone conversations with two different Fed economists, I am now quite confident that it is true.

What this means is that there is no limit to the amount of money The Fed can inject into the loanable funds market. If savers were to suddenly pull all of their money out of banks and put it in their mattresses instead (equivalent to a dramatic reduction in savings), The Fed would still be able to easily maintain the supply of loanable funds or even increase it by simply buying every sort of debt instrument offered in the credit markets. Even if The Fed bought up all of the nation’s debt---something that would never happen---if there was still a shortage of loanable funds, it could maintain/increase the money supply by buying buildings or land or anything else it fancies.

Whatever your other concerns may be, this is not one that you should worry about...

[BJ Feng]

Bear Sterns received government help because it happened so suddenly. After Bear, market participants should have been aware of counterparty risk and taken steps to make sure they were not over-exposed to any one party. This is why Lehman and AIG can be let go without a complete financial meltdown. Bear was the canary in the coal mine, and there was enough time afterwards to prepare. Sure there will be damage, but nothing like an unexpected disaster would wreck.

[James Kroeger]

If the U.S. banking system is insolvent, it is insolvent. Pretending otherwise is not a useful guide to policy, and hoping something will turn up, is not a plan.That was so awesomely well stated, Bruce. Thanks.

[Zimfed]

Just ask the Zimbabwe Fed how well this works.

[BJ Feng]

James, there is a limit where the FED's actions would stop being effective. If ever the dollar's value becomes seriously impacted by FED injections, then further injections would just devalue the dollar, the FED trying to purchase an asset by creating X dollars would suddenly find that the asset's price had increased and more dollars would be needed. In the end, you'd have a Zimbabwe type situation where the government can't keep up with asset prices no matter how much they try to print.

[James Kroeger]

If the government can't fail, then what is going to stop them from making bad loans?Uhh...perhaps a desire to make wise decisions with respect to maintaining the money supply for the optimal benefit of the American people? Another incentive would the be scrutiny of the press and whichever party happens to be out of power. No one seriously thinks that if the Treasury Department were put in charge of the central bank, everyone who now cares deeply about the money supply would stop really caring about it? Are you suggesting that a government-run central bank would be inscrutable? How would they be able to pull such a thing off? Congress would allow it to do everything in secret? Not very likely, B.

[Bruce Wilder]

Alex Tolley: "BUT, insurers go through a routine cycle of moving away from profitable underwriting and market returns on investments to a mix of unprofitable underwriting and super profitable investments. This then unfolds in a series of company failures."

Which is why the State of New York has a regulatory regime to segregate the investments needed to secure policyholders from the depredations of the holding company management.

My only point was that AIG, obviously, does not have a "liquidity" problem. It has a solvency problem.

We can address the solvency with a government loan, and permission to cheat the policyholders for several years, in order to pay it back. Just like the Fed gave Bank of America permission to use its base of insured deposits to finance "liquidity" to cover Merrill Lynch's insolvency.

What I don't understand is why we have to obscure these machinations, unless it is because these are manifestly bad choices, and we don't want to scare people by admitting that risk and insolvency is being passed off onto masses of policyholders, in violation of wisely-imposed government regulation, in the case of AIG, or onto the FDIC in the case of BofA.

[Bruce Wilder]

breaking news

This is a Constitutional Crisis of the first order.

[Patricia Shannon]

How wonderful. I am a part-owner of AIG

[Alex Tolley]

"How wonderful. I am a part-owner of AIG "

And you didn't even have to call your broker.... :)

[James Kroeger]

...there is a limit where the FED's actions would stop being effective. If ever the dollar's value becomes seriously impacted by FED injections, then further injections would just devalue the dollar, the FED trying to purchase an asset by creating X dollars would suddenly find that the asset's price had increased and more dollars would be needed.
In the scenario we are talking about lending is drying up because banks are afraid to lend and loan demand is drying up. If the Fed injects funds by buying debt instruments in such an environment, inflation would not heat up and there would be minimal pressure on the XR for that reason.

If the economy recovers so well that it is beginning to get seriously overheated, then the Fed would start selling securities, wouldn't it? So why are you suggesting that something could possibly possess the Fed to continue buying, instead?

[Winslow R.]

"Even if The Fed bought up all of the nation’s debt---something that would never happen---if there was still a shortage of loanable funds, it could maintain/increase the money supply by buying buildings or land or anything else it fancies."

Just to keep things clear, please call these actions fiscal not monetary policy. The Fed crosses from monetary policy into fiscal policy as soon as it starts spending rather than lending. It crosses into 'potential fiscal policy' as soon as at lends against collateral other than tsy secs.

The Fed, an unelected body, should not have either of these powers. Just the fact that they are 'spending' screams that the monetary policy tool is broken.

[Ryan]

"Leaving all that, the supreme question of the moment should be

DO YOU WANT YOU SOCIAL SECURITY PRIVATIZED?

This is the right time to scream and shout, till that question is heard by everyone.

Don't let this opportunity pass by."

Well I am 24, so between the time I retire and now, the market has a lot of upside potential. In other words, hell yes I'd like privatized social security. At the current rate, I probably won't get any.