Economist's View

links for 2008-09-22

• A Measure of Hope (Development) - Paul Collier
• Crisis Draws Attention to McCain Social Security Plan - WSJ.com
• Foreign Banks Hope Bailout Will Be Global - NYTimes.com
• Democrats Set Bailout Conditions - NYTimes.com
• Fed Pre-emptively Ends Regulatory Debate - Real Time Economics
• Why Paulson is right (maybe): Saving the system from bankers - Vox EU
• A Prescription for Recovery - Robert H. Dugger
• WSJ on WaMu - Bronte Capital
• Let me Get this Straight - İyigün Blog
• Open Mindedness, Corruption of the Mind, and ... ‘Truth’, Part 2 - EconTech
• What should the Top Unsolved Problems in Economics Be? - YouNotSneaky!
• Where did we go wrong? - Dani Rodrik
• Bank Rescue a Political, Bureaucratic Nightmare - John M. Berry

More links

• Paulson bailout - Econbrowser
• Wishful Thinking - Arnold Kling
• The ARISE Act - Interfluidity
• Were the Agencies responsible for the current crisis? - Brad Setser
• Why the Cost of the Bailout Doesn’t Matter, part 1 - knzn
• McCain, the GSEs, and the Crisis - The Bellows
• Paulson stops thinking, starts acting - Bronte Capital
• Bad - Interfluidity
• What Wall Street Should Be Required to Do - Robert Reich
• Institutional Economics and the 21st Century - İyigün Blog
• Designing the Garbage Pail Agency - The Reality-Based Community
• More and different - including a debt-for-equity swap - Willem Buiter
• Excess of responsibility - Paul Krugman
• Illiquidity and Uncertainty - knzn
• Paulson's Plan Is Necessary And Costly - Capital Gains and Games

"Payback Time"

Richard Baldwin:

Payback time, Free Exchange: Here's my gut reaction to the weekend’s historic decisions by the US financial authorities.

The losses created by the Captains of Finance’s excesses are being socialised in America; Europe will almost surely be forced to follow suit. There is no alternative (although ... Luigi Zingales has an idea for reducing the impact on taxpayers, see today’s Vox column).

Capital markets must function smoothly if life as we know it is to continue. The last time the "capital" got taken out of "capital-ism" (the 1930s), we saw the resurgence of some very nasty pair isms—communism and fascism—not to mention a monstrous economic downturn. I’m not predicting anything like that. Just pointing out the sort of stakes we’re playing for.

I have two hopes.

First, I hope we can do something about the privatisation of the gains – and not just the financial-institution shareholders. The Captains of Finance who set up this house of cards should pay. ...

The trio of "conflict of interest", billion-dollar losses and an army of lawyers could write an ending to this storyline that would fulfill my hope. It would look like what Hollywood action films call “Pay Back Time”. Executives hounded by lawsuits for years and ultimately stripped of their personal wealth. Just the sort of step that might help assure that this mother of all bailouts is not sowing the seeds of the next crisis.

Second, I hope the American electorate understands how the Bush administration’s policies are directly responsible for allowing the leverage ratios to get so much higher than normal. If John McCain (a man very much in the Bush mold on this score) is elected, we can expect more blind trust in unregulated markets.

Obama should develop some attack adverts connecting the Bush administration and Republican legislators to investment bank greed and taxpayer bailouts. No evidence needed. People want to believe it.

This bailout has revealed the Hurricane Katrina-sized incompetence on the part of the Bush administration. As with Katrina, the worst failure was the wishful thinking in the years before the storm hit. Thank our lucky stars that Hank Paulson and Ben Bernanke aren’t cut from the same cloth as heck-of-a-job Mike Brown (of the Federal Emergency Management Agency) and I’m-not-to-blame Homeland Director Michael Chertoff.

No disagreement. On who should pay, I think there are two components, first is the responsibility (punishment) aspect - those who caused this should be forced to pay a price. But there is also a second aspect I tried to highlight in the post below this one that those who received the majority of benefits as the bubble inflated should pay the majority of the costs now that it has popped, and the benefits were not limited to The Captains of Finance.

Who Should Pay for the Bailout?

Luigi Zingales' reaction to the financial market bailout plan, "Why Paulson is Wrong," has been getting a lot of attention and a Vox EU version of the argument appears below (my initial reactions are here). The main point is that taxpayers should not pay for the bailout.

Several points on this. First, if the government does do a bailout, the size of the bailout won't necessarily be $700 billion, and it is unlikely that it will be. The government is using the money to purchase assets. Some of those assets will appreciate, some will depreciate, and we don't know for sure what the net result will be. We could make money on the deal, we could lose money, we just don't know. But one thing is fairly certain, it's unlikely that the value of every security the government purchases will fall to zero, and that would be required for the government to lose all the money it spends (invests). See knzn on this point.

However let me be clear, even if the expected value of this deal is zero, that is, even if we expect losses and gains to cancel over time, taxpayers still need to be compensated for the risk they are taking. There is a risk that this bailout could lose hundreds of billions of dollars, and, just like in any financial transaction, the parties assuming that risk need to be compensated for it.

"Anatomy of a Crisis"

Barry Eichengreen says two key regulatory changes, one in the 1970's and one in the 1990's, are key factors in the crisis:

Anatomy of a Crisis, by Barry Eichengreen, Commentary, Project Syndicate: Getting out of our current financial mess requires understanding how we got into it in the first place. ...I would insist that the crisis has its roots in key policy decisions stretching back over decades.

links for 2008-09-21

• Bailouts for Fun and Profit - knzn
• Truth & Reconciliation - Interfluidity
• Did Fannie and Freddie cause the mortgage crisis? - Econbrowser
• What is the point of credit default insurance? - Angry Bear
• Alan Blinder and Harrison Hong on the Financial Crisis - YouTube
• Back to Square One - Bruce Bartlett
• The Mortgages of the Future - Robert Shiller
• Why Short Selling Matters - knzn
• Financial Frustration - Capital Gains and Games

"No Deal"

Paul Krugman reacts to the rescue plan:

No deal, by Paul Krugman: I hate to say this, but looking at the plan as leaked, I have to say no deal. Not unless Treasury explains, very clearly, why this is supposed to work, other than through having taxpayers pay premium prices for lousy assets.

As I posted earlier today, it seems all too likely that a “fair price” for mortgage-related assets will still leave much of the financial sector in trouble. And there’s nothing at all in the draft that says what happens next; although I do notice that there’s nothing in the plan requiring Treasury to pay a fair market price. So is the plan to pay premium prices to the most troubled institutions? Or is the hope that restoring liquidity will magically make the problem go away?

Here’s the thing: historically, financial system rescues have involved seizing the troubled institutions and guaranteeing their debts; only after that did the government try to repackage and sell their assets. The feds took over S&Ls first, protecting their depositors, then transferred their bad assets to the RTC. The Swedes took over troubled banks, again protecting their depositors, before transferring their assets to their equivalent institutions.

The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.

And there’s no quid pro quo here — nothing that gives taxpayers a stake in the upside, nothing that ensures that the money is used to stabilize the system rather than reward the undeserving.

I hope I’m wrong about this. But let me say it again: Treasury needs to explain why this is supposed to work — not try to panic Congress into giving it a blank check. Otherwise, no deal.

So, two points: First, taxpayers need a stake on the upside. Second, there needs to be a clear explanation of how the plan will work, including how assets will be valued and how it addresses solvency problems through recapitalization.

An Overview of the Crisis and What to Do about It

In 400 words or less:

The professor: Mark Thoma, Guest opinion [more]: Many people associate the onset of the Great Depression with the stock market crash in October 1929. But a more important cause was a series of banking panics in the years prior to the Great Depression, and the particularly severe banking collapse from 1930-1933.

The response to this crisis and the devastating economic disruption that came along with it was the Banking Acts of 1933 and 1935, also known as the Glass-Steagall Acts. The goal was to stabilize the banking system by enhancing the power of the Federal Reserve to regulate financial markets and to intervene when problems emerged.

And it worked. The changes resulted in a very long period, over 50 years, where financial markets remained calm.

That calm is now over, and we are experiencing our worst financial crisis since the Great Depression. What happened? What ended the tranquility? Very simply, financial innovation got ahead of regulation.

The problems we are having did not arise in the traditional banking sector; the problems come from what is called the shadow banking sector. This is comprised of firms such as hedge funds that do just what banks do -- they take deposits, they use the funds to purchase financial assets such as housing loans, and they only keep a fraction of those deposits on hand as cash reserves. But these firms are essentially unregulated and hence subject to the same problems that traditional banks faced prior to the 1930s .

What is the solution to our problems? First and foremost, We need to clean up the mess we are in and do all we can to stop things from getting any worse. Recreating the Resolution Trust Co., as we did in the aftermath of the savings and loan crisis, would be a useful step to take to remove the bad financial paper that is poisoning financial markets.

Over the longer run, it is essential that regulation be modernized. The most important task is to bring the shadow banking sector out into the sunlight, and to put it under the same regulatory structure and safeguards faced by traditional banks.

The last time we restructured our financial system from the ground up, the result was more than 50 years of stability. With a determined effort we can repeat that success and modernize our financial system so that it is substantially less likely to suffer a massive meltdown, but still innovative enough to meet our financial needs.

"Challenges that the Recent Financial Market Turmoil Places on our Macroeconomic Modeling Toolkit"

Many years ago I was at an NBER conference. A lot of the time is spent in sessions, but there's also quite a bit of time when it's more like a social event. However, I'm not the best mingler in the world, far from it, but one person who was there, Charles Evans, went out of his way to make me feel welcome and I haven't forgotten. So I don't expect me to ask him any really tough questions in this simulated interview on the usefulness of modern macroeconomic models in the present crisis:

links for 2008-09-20

• Guarantee All Bank Deposits - WSJ.com
• How Much is a Trillion? - Economists for Obama
• Problems Stall Action for Collider - NYTimes.com
• Challenges of Financial Turmoil for Macroeconomic Models - Charles Evans
• Lending's Blind Spot - Peter R. Fisher
• The pecuniary benefits of subsidizing education - Richard H. Serlin
• Bush Officials Urge Swift Action on Rescue Powers - NYTimes.com
• U.S. Bailout Plan Calms Markets, Struggle Looms Over Details - WSJ.com
• The impact of venture capital financing - Vox EU
• Bailout Proposal Costs Estimate - naked capitalism
• A TAD (Toxic Asset Dump) for the USSA - Willem Buiter
• A history lesson from the Great Depression - Salon.com
• On the Ongoing Crisis: Causes and Opportunity Cost Again - Econbrowser
• Rick Davis: Fannie and Freddie Reduce Systemic Risk - Economists for Obama
• Congestion pricing for security trades? - Interfluidity
• Why the world needs more subprime loans, now - Daniel Gross
• Vox EU article is misleading - Richard H. Serlin
• The government as shareholder - Free exchange
• Understanding the Three Ways of Dealing with Financial Crises - Brad DeLong
• Thoughts on the Big Buyout - Brad DeLong

Recapitalization

Paul Krugman:

Uneasy feelings, by Paul Krugman: Details are scarce on the big buyout; but as a few dribble out, I’m getting uneasy.

Here’s the source of my uneasiness: the underlying premise behind the buyout seems, still, to be that this is mainly a liquidity problem. So if the government stands ready to buy securities at “fair value”, all will be well.

But it’s by no means clear that this is right. On one side, the government could all too easily end up paying more than the securities are worth — and if there isn’t some kind of mechanism for capturing windfalls, this could turn into a bailout of the stockholders at taxpayer expense.

On the other side, what if large parts of the financial sector are still underwater even if the assets are sold at “fair value”? Is there a provision for recapitalizing firms so they can keep on functioning?

Maybe the plan will look fine once we see the details. But while Paulson and Bernanke are a lot better than the people we might have had in there (thank you, Harriet Meiers!), their track record to date does not lead to the automatic conclusion that they know what they’re doing.

Dean Baker:

Questions on the Bush Bailout Package, by Dean Baker: The NYT missed the obvious questions with the Bush bailout proposal. The most obvious question: is how will paying market price for near worthless assets prevent the collapse of zombie institutions like Bear Stearns, Lehman Brothers and AIG? These institutions needed money. They won't get it from selling mortgage backed securities, that are chock full of bad mortgages, at the market price. We already know this, because they already had the option to do so. ...

The other big question is: how will we get the banks to honestly describe the assets they throw into the auction? ...

Question II is directly related to question I, because a poorly designed auction system will be a fiasco, wasting taxpayers dollars and rewarding the most effective liars. If we have more time to design the auction system, then we can minimize this risk. There would be urgency if the auction system was the mechanism that would prevent the sort of freeze up of the financial system that we saw this week, however if the auction system will not accomplish this goal, then we can take the time necessary to get it right.

Here's a proposal. First, in return for taking toxic assets off of a firms books at a price that is higher than the market rate, the government would get a share of any future profits the firm makes for some time period, say 10% for ten years, something like that. Administratively, it could come as an increased tax rate on profits and, if it helps politically, it could be earmarked for a particular cause. The government pays the firm a fair value for the assets plus an additional amount to help with recapitalization, and in return gets a claim on future profits for a period of time (I would also tie executive compensation directly to profits to help prevent gaming).

For additional recapitalization, I would do something similar. Give the firms a zero or very low interest term loan and, in return, taxpayers get a share of future profits for a period of time, say another 25% (or whatever rate is appropriate, the rates could be set so that, even with expected defaults, taxpayers ought to make a profit). The firm pays back the zero interest loan in full and gives up a share of future profits.

The reason for doing it this way rather than through a private sector debt for equity swap is that we need to stop the crisis as soon as we can, sooner is better than later, and it may take too long if left to the usual procedures. Quoting Luigi Zingales with respect to debt for equity swaps (via a link at Marginal Revolution Marginal Revolution, and I should note that he is not in favor of the Paulson plan) :

So why is this well-established approach not used to solve the financial sectors current problems? The obvious answer is that we do not have time; Chapter 11 procedures are generally long and complex, and the crisis has reached a point where time is of the essence. If left to the negotiations of the parties involved this process will take months and we do not have this luxury.

One of his worries is:

If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay. Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price? The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses.

Government intervention can make this happen faster and help with his first concern, and wouldn't profit sharing help with his second worry, that inflated prices will cost taxpayers money?

Would you support something like that? Better ideas?

"The Bailout of All Bailouts is a Bad Idea"

Robert Reich:

The Bailout of All Bailouts is a Bad Idea, Robert Reich: ...On Capitol Hill, Senator Charles Schumer suggested that government inject funds into financial companies in exchange for equity stakes and pledges to rewrite mortgages and make them more affordable. At the other end of Pennsylvania Avenue, Hank Paulson reportedly is considering an agency like the Resolution Trust Corporation ... to take bad debts off the balance sheets of financial institutions.

Problems are: (1) It's not likely to do all that much good because no one knows how much bad debt there is out there. Even if the government bought a lot of it, investors and lenders still couldn't be sure how much remained. ... As the economy slows, bad debts will grow. Again, the problem isn't a liquidity or solvency crisis; it's a crisis of trust.

(2) However much bad debt there may be, that amount is surely far greater than the $394 billion of real estate, mortgages, and other assets that the old RTC bought from hundreds of failed savings-and-loans -- thereafter selling them off form whatever it could get for them. The Bailout of All Bailouts would therefore put taxpayers at far greater risk than they are even today, and require an unprecedented role for government in reselling assets. Another major step toward socialized capitalism.

A better idea would be for the Fed and Treasury to organize a giant workout of Wall Street -- essentially, a reorganization under bankruptcy, for whatever firms wanted to join in. Equity would be eliminated, along with most preferred stock, creditors would be paid off to the extent possible. And then the participants would start over with clean balance sheets that reflected new, agreed-upon rules for full disclosure, along with minimum capitalization. Everyone would know where they stood. Bad debts would be eliminated. Taxpayers wouldn't get left holding the bag. And there would be no "moral hazard"...

Congress, the Fed, and the Administration shouldn't be giving more help to Wall Street. Policymakers should focus instead on people who really need a safety net right now -- workers who have lost or are about to lose their jobs, who need extended unemployment insurance and health insurance for themselves and their families; homeowners who have lost or are likely to lose their homes, who need additional help meeting mortgage payments and reorganizing their debts; and people who have lost or are in danger of losing their savings or pensions, who need better insurance against possible loss.

The only way Wall Street's meltdown doesn't spill over to Main Street is if policymakers begin to pay adequate attention to the people whose wallets really keep the economy going, and who merit more help than the Wall Street tycoons whose carelessness and negligence have put it in such jeopardy.

I've been arguing we don't have to choose one or the other, the best approach is a portfolio of policies, so we should do both. We should help to eliminate the toxic financial paper as soon as possible, and we should help workers and others who have been (or will be) hurt by the crisis.

Why is McCain Playing Political Games in a Serious Crisis?

Can McCain show any more ignorance of economics than he has this week? And why is he playing political games - misleading people about the cause of the financial crisis so he can try to score points by (falsely) blaming Obama - during a serious crisis?

Let's start with McCain's comments from earlier today:

A Worker Bailout Fund?

In response to the financial crisis, as we help firms that are deemed too big and too interconnected to fail, hundreds of billions of dollars are being tossed around as though it is mere pennies.

Since it is widely expected that the crisis will get worse before it gets better, and since there is a non-trivial chance of a substantial uptick in unemployment, shouldn't we begin thinking about a worker bailout fund?

Or are workers too little to be helped?

I don't think so. So instead of waiting until unemployment goes way up, and then watching Congress fight over what to do about it while people struggle to make ends meet, let's get a plan in place now that dedicates some of the money being tossed around to helping workers. If unemployment goes up, what will we do? How will we help?

If we are going to bail out the big players - take toxic paper off their hands - there's no reason at all not to bail out workers too.

I want to think about this more, so help me out. How should such a proposal be structured? What should the worker bailout fund look like?

Paul Krugman: Crisis Endgame

"The big buyout is coming":

Crisis Endgame, by Paul Krugman, Commentary, NY Times: On Sunday, Henry Paulson, the Treasury secretary, tried to draw a line in the sand against further bailouts of failing financial institutions; four days later, faced with a crisis spinning out of control, much of Washington appears to have decided that government isn’t the problem, it’s the solution. The unthinkable — a government buyout of much of the private sector’s bad debt — has become the inevitable.

The story so far: the real shock after the feds failed to bail out Lehman Brothers wasn’t the plunge in the Dow, it was the reaction of the credit markets. Basically, lenders went on strike...

This flight to safety has cut off credit to many businesses, including major players in the financial industry — and that, in turn, is setting us up for more big failures and further panic. ...

And the Federal Reserve, which normally takes the lead in fighting recessions, can’t do much this time because the standard tools of monetary policy have lost their grip. ...[T]he interest rate on Treasuries is already zero, for all practical purposes; what more can the Fed do?

Well, it can lend money to the private sector — and it’s been doing that on an awesome scale. But this lending hasn’t kept the situation from deteriorating.

There’s only one bright spot...: interest rates on mortgages have come down sharply since the federal government took over Fannie Mae and Freddie Mac, and guaranteed their debt. And there’s a lesson there for those ready to hear it: government takeovers may be the only way to get the financial system working again.

Some people have been making that argument for some time. Most recently, Paul Volcker ... and two other veterans of past financial crises published an op-ed ... declaring that the only way to avoid “the mother of all credit contractions” is to create a new government agency to “buy up the troubled paper”... Coming from Mr. Volcker, that proposal has serious credibility.

Influential members of Congress ... have been making similar arguments. And on Thursday, Charles Schumer, the chairman of the Senate Finance Committee ... told reporters that “the Federal Reserve and the Treasury are realizing that we need a more comprehensive solution.” Sure enough, Thursday night Ben Bernanke and Mr. Paulson met with Congressional leaders to discuss a “comprehensive approach” to the problem.

We don’t know yet what that “comprehensive approach” will look like. There have been hopeful comparisons to the financial rescue the Swedish government carried out in the early 1990s ... that involved a temporary public takeover of a large part of the country’s financial system. It’s not clear, however, whether policy makers in Washington are prepared to exert a comparable degree of control. And if they aren’t, this could turn into the wrong kind of rescue — a bailout of stockholders as well as the market, in effect rescuing the financial industry from the consequences of its own greed.

Furthermore, even a well-designed rescue would cost a lot of money. The Swedish government laid out 4 percent of G.D.P., which in our case would be a cool $600 billion — although the final burden to Swedish taxpayers was much less, because the government was eventually able to sell off the assets it had acquired, in some cases at a handsome profit.

But it’s no use whining (sorry, Senator Gramm) about the prospect of a financial rescue plan. Today’s U.S. political system isn’t going to follow Andrew Mellon’s infamous advice to Herbert Hoover: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” The big buyout is coming; the only question is whether it will be done right.

Fed Watch: Friday Can’t Come Soon Enough

Tim Duy says policymakers need to be honest that a solution to the financial crisis will not be painless:

Friday Can’t Come Soon Enough, by Tim Duy: A wild week is coming to an end, with news that US policymakers are preparing a comprehensive approach the financial crisis – see the prophetic Mark Thoma below. Details are thin at this point, although the central feature is expected to be a mechanism that will extract the bad assets from Wall Street’s balance sheets. The devil, of course, is in the details. A critical element, as described by the Wall Street Journal:

A big question still to be answered is how the government will value the assets it takes onto its books. One possible avenue could be some sort of auction facility, so that the government would not have to be involved in negotiating asset values with companies. Financial companies would likely take big losses.

But Calculated Risk makes an important point about this approach – it appears to deal with only one side of the balance sheet:

Details of how this will work aren't available yet. But one of the key problems - in addition to the risk to the taxpayer - is that this program will actually reduce regulatory capital as losses are realized. The opposite of the goal!

So even after the bad assets are removed, the affected firms still need to be recapitalized, presumably via taxpayer infusions. What exactly will the taxpayer receive in return? Preferred stock? Since we are already moving toward an overarching solution, maybe we should just follow the example of Sweden. Via Yves Smith:

Fed Watch: What Was He Thinking?

Next, Tim thinks stress maybe taking its toll on Bernanke:

What Was He Thinking?, by Tim Duy: There are two stories about Federal Reserve Chairman Ben Bernanke that are rather disturbing. The first is reported via Yves Smith. Apparently, Bernanke told a private economist David Hale:

"We have lost control," said Hale, quoting Bernanke. "We cannot stabilize the dollar. We cannot control commodity prices."

To be sure, if Bernanke actually believed he had policy independence in an economy driven by the financing of foreign central banks, we should all be a bit concerned. And why would he tell anybody this? How do I get such a private meeting?

I am hoping the quote was taken out of context.

Did the Surge Work?

New evidence suggests that "ethnic cleansing by rival Shiites may have been largely responsible for the decrease in violence for which the U.S. military has claimed credit":

UCLA study of satellite imagery casts doubt on surge's success in Baghdad, EurekAlert: By tracking the amount of light emitted by Baghdad neighborhoods at night, a team of UCLA geographers has uncovered fresh evidence that last year's U.S. troop surge in Iraq may not have been as effective at improving security as some U.S. officials have maintained.

Night light in neighborhoods populated primarily by embattled Sunni residents declined dramatically just before the February 2007 surge and never returned, suggesting that ethnic cleansing by rival Shiites may have been largely responsible for the decrease in violence for which the U.S. military has claimed credit, the team reports in a new study based on publicly available satellite imagery.

"Essentially, our interpretation is that violence has declined in Baghdad because of intercommunal violence that reached a climax as the surge was beginning," said lead author John Agnew, a UCLA professor of geography and authority on ethnic conflict. "By the launch of the surge, many of the targets of conflict had either been killed or fled the country, and they turned off the lights when they left."

Risk Absorption as a Last Resort

Back in March I said:

I’m starting to think that the Fed should drop the term part of the TSLF and instead trade permanently for risky assets (with the haircut sufficient to provide some compensation for the risk), bonds for MBS, money for MBS, or whatever, and don’t limit trades to banks.

The Fed would act as “risk absorber of last resort.” Why should it do this? There has been an unexpected earthquake of risk, a financial disaster on the scale of a natural disaster like Katrina, and the government can step in and sop some of it up by trading non-risky assets (money, bonds, etc.) for risky assets at an attractive risk-adjusted price. To limit the amount, this could also be done through auction with a ceiling on how much will be traded, except unlike the current auction it wouldn’t be a repo and it wouldn’t be as limited in terms of who can trade and what can be traded.

What am I missing? Moral hazard and worries about the next time? I’d still fix this first, worry about moral hazard later, perhaps through regulatory changes down the road that (hopefully) limit the opportunities for such behavior.

Most of you thought I was nuts, and said so. If we were going to do something like this, doing it then would have been better, but it looks like we are about to do something like this now:

U.S. Plans to Clean Up Finance System, WSJ: The federal government, acknowledging the need to take a more comprehensive approach to the financial crisis, is working on a sweeping series of programs that would represent perhaps the biggest intervention in financial markets since the 1930s.

At the center of the potential plan is a mechanism that would take bad assets off the balance sheets of financial companies.... It's size could reach hundreds of billions of dollars...

Treasury Department officials have studied a structure to buy up distressed assets for weeks but have been reluctant to ask Congress for such authority unless they were certain it could get approved. The intensified market turmoil may have changed that political calculus, even with less than two months left until the November elections.

A Treasury spokeswoman said: "Treasury Secretary Paulson joined Federal Reserve Chairman Bernanke in a meeting with House and Senate Republicans and Democrats to discuss current market conditions. They began a discussion with them on a comprehensive approach to address the illiquid assets on bank balance sheets that are at the underlying source of the current stresses in our financial institutions and financial markets. They are exploring all options..."

[Under t]he possible plan..., a new entity might purchase assets at a steep discount from solvent financial institutions and eventually sell them back into the market. ...

Update: See also To whom and for what? by Steve Waldman, and The Bailout of All Bailouts is a Bad Idea by Robert Reich for different opinions.

links for 2008-09-19

• What’s a swap line? - macroblog
• The Bailout of All Bailouts is a Bad Idea - Robert Reich
• To whom and for what? - Interfluidity
• Diamond and Kashyap on the Recent Financial Upheavals - Freakonomics
• Fed and Treasury Offer to Work With Congress on Bailout Plan - NYTimes.com
• Why the 79.9% Equity Position for Bailouts? - Credit Slips
• Money Demand is Stable After All - Macro and Other Market Musings
• Blocking Care for Women - Op-Ed - NYTimes.com
• A new RTC? Not like the old RTC - Clive Crook
• Education does not produce pecuniary externalities - Vox EU
• A visual diagram of inter-connectedness - Rogue Economist Rants
• This greed was beyond irresponsible - John Gapper
• Not the time to worry about moral hazard - FT.com
• Why global capitalism needs global rules - FT.com
• The US has invented socialism for the rich - Nouriel Roubini
• What the Candidates Can Do - R. Glenn Hubbard
• Flunking Economics - Eugene Robinson
• Greenspan’s sins return to haunt us - FT
• Is It the Dawn of the Reregulation Era? - Michael Mandel

Connectedness

From a member of the Physics Department here at the UO:

Notional vs net: complexity is our enemy, Information Processing: The credit default swap (CDS) market, where AIG played, had notional outstanding value of about $45 trillion at the end of 2007. Of course many of these contracts are partially canceling, so the the net value of contracts in the market is much smaller than the notional value.

Unfortunately, the network diagram (network of contracts) probably looks something like this:

Imagine removing -- due to insolvency, lack of counterparty confidence, lack of shareholder confidence, etc. -- one of the nodes in the middle of the graph with lots of connections. What does that do to the detailed cancelations that reduce the notional value of $45 trillion to something more manageable? Suddenly, perfectly healthy nodes in the system have uncanceled liabilities or unhedged positions to deal with, and the net value of contracts skyrockets. This is why some entities are too connected to fail, as opposed to too BIG to fail. Systemic risk is all about complexity.

If bonds are issued to finance government spending, and if they are treated as new wealth by the private sector, they will stimulate new spending. However, if taxes are also increased at the same time, then the assets (bonds issued to finance the debt) and the liabilities (taxes) cancel each other out exactly and the bonds will be neutral, i.e. they will not stimulate any new spending since no net wealth is created.

Realizing this, people then asked, what if you give the bonds to the present generation as you run a deficit, and save the taxes for the next generation, wouldn't bonds be net wealth in that case? One group gets the benefits, the other the costs. Robert Barro answered the question in the paper "Are Bonds Net Wealth." He pointed out that if parents care about their children, then they will adjust their bequests to account for these kinds of changes in intergenerational distribution of assets and liabilities. Under the right conditions, e.g. perfect capital markets, the present value of all future liabilities will exactly match the present vale of all assets and no net wealth is created.

A key element here, though, is the connectedness of generations. Not everyone has children, for example, and Barro's mechanism works by putting the utility of children as an argument in the parents utility function. In the 1980s, in response to Barro's paper, I remember seeing a seminar given that attempted to estimate intergenerational connectedness. I can't remember exactly what the paper found after all these years, but the main point is that measures of connectedness exist. [In answer to the question, are bonds net wealth?, many people who have examined the empirical work take an intermediate position and use 50% as a rule of thumb, i.e. that 50% of bonds are net wealth, the other 50% is offset through anticipated tax liabilities).

Since measures of connectedness exist, and I presume physicists also have such measures (of complexity), I'm wondering if financial market regulators should start developing measures along these lines. Can we measure the connectedness of financial institutions econometrically? If so, can we also follow along the lines of the Hirfandahl index for monopoly power and develop guidelines for when a firm is too interconnected with other firms, so interconnected that it's failure threatens the overall system? Couldn't we then "break-up" the firms the way we do monopolies, "disconnect" the firm until it's failure wouldn't be so devastating?

As pointed out above, size alone isn't the key feature, the degree of connectedness (complexity) is also important, and regulators - as far as I know - don't have good empirical tools for assessing this aspect of financial markets.

"Unbelievable"

Steve Benen may not be an economic expert, but you don't have to be to recognize when McCain is talking nonsense about economics. If he's talking on the subject, it's a pretty safe bet he has it wrong:

Fire Christopher Cox?, Political Animal: John McCain has apparently decided he has to say something different and/or unique about the crisis on Wall Street, so he's come up with a new line: he wants to see Securities and Exchange Commission Chairman Christopher Cox fired.

"The chairman of the SEC serves at the appointment of the president and has betrayed the public's trust. If I were president today, I would fire him," McCain says...

"The primary regulator of Wall Street, the Securities and Exchange Commission (SEC) kept in place trading rules that let speculators and hedge funds turn our markets into a casino," McCain says."They allowed naked short selling -- which simply means that you can sell stock without ever owning it. They eliminated last year the uptick rule that has protected investors for 70 years. Speculators pounded the shares of even good companies into the ground."

...First, the president cannot fire an SEC chair. It's procedurally impossible. As ABC News reported, "[W]hile the president appoints and the Senate confirms the SEC chair, a commissioner of an independent regulatory commissions cannot be removed by the president." That seems like the kind of thing McCain ought to know before spouting off on the subject.

Second, the SEC did allow all kinds of short selling, but that's legal under the federal regulatory system that John McCain -- and his advisor, Phil Gramm -- helped put in place. After more than a quarter of a century in Congress, has McCain ever proposed changing these laws and imposing stricter regulations? No. Has he ever, before today, criticized Cox's oversight of existing trading rules? Not as far as I can tell.

Third, I'm not an expert, but I'm fairly certain short selling is not the underlying cause of the current crisis. The sub-prime mortgage fiasco and over-leveraged banks are. If McCain wants to make a case for firing Cox, he should at least get the cause right.

When did we start requiring the presidents to follow the law? Didn't that change eight years ago?

On the short-selling point, Barry Ritholtz is direct:

I don't have much of a problem with the uptick rule -- its pointless, and is easily worked around by hedge funds... And, I agree that rules against naked short-selling -- already illegal -- should be enforced.

But if you think the current economic, credit and financial problems are caused by shorting, you are simply a smoking too much dope.

Paul Kedrosky doesn't hold back either:

Fire the SEC's Chris Cox? Sure, Then Fire John McCain: Oh, now John McCain is suddenly swinging with both fists on capital markets? He just said he thinks SEC Chair Chris Cox should be fired because he allowed naked short-selling and that is driving the current crisis? Un-be-frickin-believable.

First, it is the height of irresponsibility for a politician to grandstand so clumsily when the market is as fragile as it is right now. It shows a remarkable lack of financial sophistication and market smarts on the part of John McCain, and I didn't have much confidence in either from him in the first place (and that does not make this an Obama endorsement, because he has done diddly to convince me he gets this either).

Second, this has nothing to do with naked short-selling. Repeat after me: The trouble is not with short-sellers. The trouble is not with short-sellers. The trouble is with an over-levered financial system built on a house of cards comprised of under-collateralized toxic paper that was applauded all the way up by "housing is the American dream" nutters who couldn't see that vast expansions in thinly-traded credit are a path to economic ruin. Focusing on the short-sellers will lead to completely wrong and counter-productive non-solutions to the current crisis.

Unbelievable. Truly.

And, continuing with Barry, there may be reasons to question SEC actions, but they are not the reasons McCain cites:

How SEC Regulatory Exemptions Helped Lead to Collapse, The Big Picture:

The losses incurred by Bear Stearns and other large broker-dealers were not caused by "rumors" or a "crisis of confidence," but rather by inadequate net capital and the lack of constraints on the incurring of debt.

--Lee Pickard, former director, SEC trading and markets division.

...As we learn this morning via Julie Satow of the NY Sun, special exemptions from the SEC are in large part responsible for the huge build up in financial sector leverage over the past 4 years -- as well as the massive current unwind

Satow interviews the above quoted former SEC director, and he spits out the blunt truth: The current excess leverage now unwinding was the result of a purposeful SEC exemption given to five firms.

You read that right -- the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.

Instead, the 2004 exemption -- given only to 5 firms -- allowed them to lever up 30 and even 40 to 1.

Who were the five that received this special exemption? You won't be surprised to learn that they were Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley. 

As Mr. Pickard points out that "The proof is in the pudding — three of the five broker-dealers have blown up."

So while the SEC runs around reinstating short selling rules, and clueless pension fund managers mindlessly point to the wrong issue, we learn that it was the SEC who was in large part responsible for the reckless leverage that led to the current crisis. 

You couldn't make this stuff up if you tried. ...

Chalk up another win for excess deregulation.

Of course, John McCain is no friend of deregulation, at least not today. Or is he? With so many flip-flops, and so much double-talk, I'm losing track.

Update:

Steve Benen ... erroneously claims that “the president cannot fire an SEC chair. It’s procedurally impossible.”

The question is not one of the Constitution, but rather one of statute. “The creation, composition, and powers of the SEC are found in the Securities Exchange Act of 1934. The commission consists of five members who are appointed by the President with the advice and consent of the Senate. The terms of the commissioners are staggered and the basic length of each term is five years. No more than three of the commissioners may be members of the same political party. The statute does not provide for a chairman. Until 1950, the Chairman was elected annually. Following Reorganization Plan No. 10 of 1950 (see, Reorganization Act of 1949, 5 U.S.C. §§ 901-913), the President designates the chairman. Pursuant to this Reorganization Plan, the chairman succeeded to most of the executive and administrative functions of the commission.” S.E.C. v. Blinder, Robinson & Co., Inc., 855 F.2d 677, 681 (10th Cir. 1988).

An email cautions that we should not accept Bainbridge's argument since one 10th Circuit case may be of questionable precedential value. I'll update as I find out more.

Okay, here's more - the McCain camp seems to believe it can only request that the SEC chair resign and hope the request is honored, the president cannot fire the SEC chair:

Wright asked McCain spokesman Tucker Bounds to explain how the Republican nominee would fire Cox if he were elected. "Not only is there historical precedent for SEC Chairs to be removed, the President of the United States always reserves the right to request the resignation of an appointee and maintain the customary expectation that it will be delivered," Bounds responded. Wright says the McCain camp pointed to the example of former SEC chairman Harvey Pitt, "who resigned in 2002 when it was made clear to him that he had lost the confidence of the Bush administration."

So either McCain was wrong earlier when he said that he could fire the chair, Bounds now says he doesn't have that power and can only request a resignation, or Bainbridge is correct and the McCain camp reversal - Bounds' attempt to clean up after McCain’s earlier statement - is wrong. But whichever way it turns out, the McCain reversal shows that they are confused about the president’s powers in this area. [It does appear that the use of the word "fire" was incorrect.]

Central Banks Take Coordinated Action

Central banks are attempting to increase liquidity in global financial markets. Banks have been reluctant to lend to each other recently, and this is an attempt to increase the flow of funds in these markets:

A consortium of the world's major central banks this morning pumped $180 billion into global financial markets, attempting to ensure banks have enough cash to operate and rebuild confidence in a system that had virtually ground to a halt.

The coordinated action, announced at 3 a.m. eastern time, saw the U.S. Federal Reserve free up additional dollars for financial centers around the world, including $110 billion for European banks, $60 billion for the Bank of Japan and $10 billion for the Bank of Canada. Those institutions, in turn, will make the money available in short term loans to banks and financial firms that have, given the turmoil of recent days, begun loathe to lend to each other.

Here's the late night press release from the Fed:

Press Release: September 18, 2008, 3:00 a.m. EDT

Today, the Bank of Canada, the Bank of England, the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank are announcing coordinated measures designed to address the continued elevated pressures in U.S. dollar short-term funding markets. These measures, together with other actions taken in the last few days by individual central banks, are designed to improve the liquidity conditions in global financial markets. The central banks continue to work together closely and will take appropriate steps to address the ongoing pressures.

Mishkin: Don't Worry about Inflation

I don't have any disagreement with this:

Don't Worry About Inflation, by Frederic S. Mishkin: ...The Consumer Price Index (CPI) last month rose more than 5% over a year earlier, way above a rate that is consistent with price stability. At the same time, the federal-funds rate is at 2%, so the real interest rate on federal funds -- the interest rate adjusted for inflation -- has turned very negative.

Will this low real interest rate lead to inflation spiraling out of control? Shouldn't the Fed react...? The answer is no.

It is certainly true that central banks should be worried about high headline inflation caused by high commodity prices. After all, households daily pay for energy and food items, and they are a big chunk of people's budgets. But central banks cannot control relative prices for food and energy. When a cold snap freezes the Florida orange crop or a tropical storm hits the gasoline refineries along the Gulf Coast, monetary policy cannot reverse the resulting spikes in prices...

Particularly volatile items like food and energy, which are included in headline ... inflation, are inherently noisy and often do not reflect changes in the underlying rate of inflation...

"The Liquidation Trap"

Thomas Palley:

The Liquidation Trap, by Thomas Palley: The U.S. financial system is caught in a destructive liquidation trap that has falling asset prices cause financial distress, in turn compelling further asset sales and price declines. If unaddressed, it risks sending the economy into deep recession – or even depression.

Current conditions are the result of bursting of the house price bubble and the end of two decades of financial exuberance. That exuberance was fostered by a cocktail of forces.

First, economic policy replaced wages and productive investment as the engines of growth with debt and asset inflation. Second, greed and free market ideology combined to promote excessive risk-taking and restrain regulators. This was encouraged by audacious claims that mathematical economic models mapped reality and priced uncertainty, making old-fashioned precautions redundant.

Recognition of the scale of financial folly has created a rush for liquidity. This is causing huge losses, triggering margin calls and downgrades that cause more selling, damage confidence, and further squeeze credit. That is the paradox of deleveraging. One firm can, but the system as a whole cannot.

Having failed to prevent the bubble, regulatory policy is now amplifying its deflation. One reason is mark-to-market accounting rules that force companies to take losses as prices fall. A second reason is rigid capital standards.

Application of mark-to-market rules in an environment of asset price volatility can create a vicious cycle of accounting losses that drive further price declines and losses. Meanwhile, capital standards require firms to raise more capital when they suffer losses. That compels them to raise money in the midst of a liquidity squeeze, resulting in fresh equity sales that cause further asset price declines.

Bad debts will have to be written down, but it is better to write them down in orderly fashion rather than through panicked deleveraging that pulls down good assets too.

This suggests regulators should explore ways to relax capital standards and mark-to-market rules. One possibility is permitting temporary discretionary relaxations akin to stock market circuit breakers.

Later, regulators must tackle the underlying problem of price bubbles. Currently, central banks are only able to control bubbles by torpedoing the economy with higher interest rates. New flexible measures of control are needed. One proposal is asset based reserve requirements, which systematically applies adjustable margin requirements to the assets of financial firms.

The Fed must also lower interest rates, and not just for standard reasons of stimulating spending. Lower short term rates are needed to make longer term assets (including houses) relatively more attractive, thereby shifting demand to them and putting a bottom to asset price destruction.

Fears about a price – wage inflation spiral remain misplaced. Instead, the threat is deep recession triggered by the liquidation trap. If inflation is a wild card, now is the time to use the credibility the Fed has earned. Emergency rate reductions can be reversed when the situation stabilizes.

The great irony is central banks can produce liquidity costlessly. Usually the problem is restraining over-production: today, it is over-coming political concerns about “bail-outs”. Those concerns are legitimate, but they also risk inappropriately restricting liquidity provision and unintentionally imposing huge costs of deep recession.

At the moment the Fed is protecting banks and the treasury dealer network but leaving the rest of the system in the cold. That is perverse given how the Fed went along with expansion of the non-bank financial system. Instead, the Fed should consider an auction facility that makes longer duration loans available to qualified insurance and finance companies too.

The facility’s guiding principle should be an expanded version of the Bagehot rule. Accordingly, the Fed would auction funds at punitive rates, with loans being fully collateralized. The goal should be to facilitate repair of distressed financial companies with minimum market disruption and at no taxpayer expense. By creating an up-front facility, the Fed can get ahead of the curve and reduce need for crisis interventions that are always more costly and disruptive.

Among financial conservatives there is a view that financial markets deserve punishment for their “sins” and only that will cleanse them. This view is often presented in terms of need to restore market discipline and stay moral hazard.

The view from the left is strangely similar, arguing Wall Street “fat cats” need to be punished. Asset prices should fall, banks must eat their losses, and all but the most essential financial firms should be allowed to fail.

Both views have a moralistic dimension, and both risk unnecessary economic suffering. The mistakes of the past cannot be undone. All that can be done is to minimize their costs and then truly reform the system so that they are not repeated.

"How Many People Have Lost their Jobs?"

knzn says some people might be misinterpreting what Obama is saying:

How many people have lost their jobs?, knzn: According to Barack Obama, 600 thousand Americans have lost their jobs since January. Actually, he's wrong: something like 20 million Americans have lost their jobs since January. It's just that most of them found new jobs. Probably the new jobs generally weren't as good as the ones they lost. And almost certainly, more than 600 thousand of them were unable to find new jobs...

Like almost everyone else..., Senator Obama is making the mistake of using a net job loss figure with language that, if taken in its plain sense, clearly implies he is talking about gross job loss. And it seems to me that gross job loss is the appropriate concept: losing your job is a pretty serious bummer...

There has been a lot of talk about Senator McCain and how he has been saying things that aren't true in order benefit himself politically. It turns out that Senator Obama is also (obviously unintentionally) saying things that aren't true, but in this case they benefit his opponent.

links for 2008-09-18

• How many people have lost their jobs? - knzn
• The Power of Oil Consumers - Henry A. Kissinger and Martin Feldstein
• A New Role for the Fed - Investor of Last Resort - NYTimes.com
• Hitler’s rise and stock prices - Vox EU
• There Are No Libertarians In Recessions - Shawn
• Morgan Stanley in talks with Chinese government - William J. Polley
• America's Ad Hoc Fiscal and Monetary Policy - Felix Salmon
• Banks Now Permitted to Count Goodwill as Capital - naked capitalism
• Relaxation of Regulatory Capital Rules - Credit Slips
• Liquidity trap - Paul Krugman Blog
• For Wall Street, Greed Wasn’t Good Enough - Op-Ed - NYTimes.com
• The Shadow Financial Regulatory Committee's opinion - William J. Polley
• McCain's gaffe about the economy's strength - Daniel Gross
• DOT Economist: “Keep Your Infrastructure Stimulus” - The Bellows
• Offensive - Free exchange
• About that efficient markets hypothesis - Free exchange

Speculation and Oil Prices

We’ve heard a lot about how speculation has caused volatility in oil and other commodity prices recently, and there are calls in Congress to put constraints on speculative activity in order to stabilize prices and markets, so let's go back to the issue of whether speculative activity has been the driving force behind commodity price movements, oil prices n particular.

To begin, it's important to recognize that not all speculative activity is the same, and not all of it is bad, and as we look into how to better regulate these markets, we need to keep the types of speculative activities separate so that we don’t stifle the good type of speculation as we try to eliminate the types that cause us troubles.

First, speculative activity can arise from attempts to profit from manipulating the price of a good, and some people believe this type of manipulative activity can explain much of the volatility in oil prices we have seen recently. This, obviously, is a bad type of speculation and we should prevent it to the extent possible.

Second, moral hazard combined with easy money can lead to an undesirable type of speculation. If market participants have ready access to funds, and if they believe losses will be covered, say, through a government bailout, then they may be willing to invest far more than is optimal in speculative ventures. If they hit it big, they win. If things go sour, the government covers their losses.

A third type of speculation we’d like to avoid is speculative bubbles, and this is probably what most people have in mind when they hear the term speculation. Speculative bubbles occur due to “bandwagon effects” where rumors or some other force causes prices to deviate from their underlying fundamental values in a self-feeding frenzy that drives prices upward in a bubble, or downward in a crash.

Fourth, speculation allows us to insure against expected future changes in supply or demand, that is, anticipated changes in the price. If we expect higher demand or lower supply of a good at some point in the future, that is, if we expect a higher future price, then speculators will take some of the good off the market today, store it for the future, and then sell it after the price rises. In this way, speculation provides insurance against the future fall in supply or increase in demand by having the good available to meet those changes.

Finally, there is stabilizing speculation, for example selling short near peaks in anticipation of price declines can dampen natural market volatility, and this is generally desirable. This type of speculation - short-selling - is under considerable scrutiny right now, but in general this dampens rather than enhancing market volatility and we ought to encourage the dampening variety.

So yes, by all means, limit the bad type of speculation through regulatory changes. But be sure to keep the types that help.

Moving next to commodity prices and speculation, I've taken the stance that there is little evidence of the first and third types of speculative activity, manipulation and bubbles divorced from fundamentals, and I don't think the second type - moral hazard - made a large contribution. I've argued fundamentals are the most likely source of most of the price variation, and by fundamentals I mean any new information that causes people to change their expectations of supply and/or demand, and I've taken a lot of criticism here over that stance, the stance on speculative bubbles in particular. So let me add this to the debate (see also See You Later, Speculator - WSJ.com):

Scott Irwin takes down Michael Masters, by Jim Hamilton: Econbrowser is pleased to host another contribution from Scott Irwin, who holds the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois. Today Scott offers a critique of a recent report by Michael Masters on the role of commodity speculation.

The Misadventures of Mr. Masters: Act II
by Scott Irwin

The impact of speculation, principally by long-only index funds, on commodity prices has been much debated in recent months. The main provocateur in this very public debate is Mr. Michael Masters, a hedge fund operator from the Virgin Islands. He has led the charge that speculative buying by index funds in commodity futures and over-the- counter (OTC) derivatives markets has created a "bubble," with the result that commodity prices, and crude oil prices, in particular, far exceed fundamental values. Act I of the Masters farce was his testimony to the Homeland Security Committee of the U.S. Senate in May of this year. Act II is now upon us in the form of a lengthy research report co-authored by his research assistant, Mr. Adam White, and his testimony this week to a subcommittee of the Energy and Resources Committee of the U.S. Senate.

My purpose in writing this post is to show that Mr. Masters' bubble argument does not withstand close scrutiny. He first makes the non-controversial observation that a very large pool of speculative money has been invested in different types of commodity derivatives over the last several years. The controversial part is that Mr. Masters concludes that money flows of this size must have resulted in significant upward pressure on commodity prices, which in turn drove up energy and food prices to consumers throughout the world. This argument is conceptually flawed and reflects a fundamental and basic misunderstanding of how commodity futures and related derivatives markets actually work. It is important to refute Mr. Masters' argument since a number of bills have been introduced in the U.S. Congress with the purpose of prohibiting or limiting index fund speculation in commodity futures and OTC derivative markets.

Rogoff: America will Need a $1,000bn Bail-Out

Kenneth Rogoff hopes the rest of the world retains its optimistic stance toward the ability of the US to overcome the problems it is facing. If that optimism fades, things could get much worse:

America will need a $1,000bn bail-out, by Kenneth Rogoff, Commentary, Financial Times: One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 64-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but ... it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

It is true that the US government has very deep pockets. ... It is also true that despite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account ... nationalising ... Freddie Mac and Fannie Mae, the costs of ... bail-out of ... Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet ..., and finally, yesterday’s $85bn bail-out of ... AIG.

Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending ... an amount closer to $1,000bn to $2,000bn. ...

Fed Watch: Quite a Day

Tim Duy assesses the day's events:

Quite a Day, by Tim Duy: I am in Portland tonight, taking a breath to assess the day’s events as I mentally prepared for a three hour presentation on the economy for a friend’s business group. A spectacular harvest moon was hanging over the Cascades as I approved the city; the deepest orange moon I have ever seen.

That can’t be a good omen.

To say the least, this was an interesting 24 hours. My son took his first swimming lessons. A forest fire is raging within spitting distance of the family cabin. I understand the local bar has burned to the ground; I can’t see how that is going to be good for property values. And the Fed bought an insurance company.

I seem to remember that the US owned at least one “gentlemen’s club” in the wake of the S&L crisis, so what’s the big deal with an insurance company?

But I get ahead of myself – consider first the Fed’s interest rate decision. It was the logical choice one would have expected at the end of last week. The Fed Funds rate was held steady at 2%, risks are equally balanced between inflation and growth, and it was acknowledged that commodity prices have moved significantly lower. That the Fed did not cut interest rates in the face of arguably the most treacherous period of the financial crisis says little about moral hazard concerns, in my opinion. Instead, it indicates the Fed sees little that lower interest rates can do to alleviate the crisis. Policy is directed to the real economy, and by virtually every measure, rates are already lower than one would expect given the flow of data. That is not to say that the state of the real economy is healthy. Anything but, to be sure. But, while one can say that the Fed has been behind the curve with respect to the financial market turmoil, we have seen in the past a considerably slower reaction to real economic data.

More interesting is the AIG loan/purchase/bailout. I have to imagine the employees of Bear Sterns and Lehman Brothers are currently thinking that they clearly did not take on enough risk over the past several years. Lehman employees, in particular, were fed into the moral hazard grinder that was operational for a scant two days. How unfortunate. Which leads me to my most significant concern about Fed policy over the past year – the inconsistency. Facilitate the liquidation of Bear Sterns by backstopping $29 billion of questionable assets. Then, recognizing the moral hazard created by that move, let Lehman collapse. Then, recognizing the consequences of vanquishing moral hazard, effectively purchasing AIG. At this point, the endgame should be clear to policymakers – a taxpayer bailout. The bad assets need to be consolidated and eliminated. Congress needs to be working on a mechanism to make this happen, a new RTC. Any Congressional action needs to include a reevaluation of the state of financial regulation. Perhaps, just a thought here, insurance agencies need to be separate from investment banks. And if, as is often threatened, the shadow banking industry just moves offshore, maybe we should just let it do so.

"Resurrect the Resolution Trust Corporation"

Following up on Tim Duy's statement that "bad assets need to be consolidated and eliminated," and that "Congress needs to be working on ... a new RTC," a group of former financial officials has the same recommendation. They want Congress to create something similar to the Resolution Trust Corporation or the Home Owners Loan Corporation, and use these institutions to remove "toxic paper" from financial markets:

Resurrect the Resolution Trust Corp., by Nicholas F. Brady, Eugene, A, Ludwig, and Paul A. Volcker: We are in the midst of the worst financial turmoil since the Great Depression. Absent bold action, matters could well get worse.

Neither the markets nor the ordinary diet of regulatory orders, bank examinations, rating downgrades and investigations can do the job. Extraordinary emergency actions by the Federal Reserve and the Treasury to date, while necessary, are also insufficient to resolve the crisis. ...

"Paradigms of Panic"

Before getting to the main point, "Paradigms of Panic," it will be helpful to start with some definitions. First, not all bank runs are alike:

Bank runs come in two kinds.

In some cases, the bank run is a pure self-fulfilling prophecy: the bank is “fundamentally sound,” but a panic by depositors forces a too-hasty liquidation of its assets, and it goes bust. It’s as if someone calls “fire!” in a crowded theater, provoking a stampede that kills many people, even though there wasn’t actually a fire.

In other cases, the bank is fundamentally unsound — but the bank run magnifies its losses. It’s as if someone calls “Fire!” in a crowded theater, and there really is a fire — but the stampede kills people who would have survived an orderly evacuation.

We also need to distinguish traditional bank runs from their modern counterparts. Traditional bank runs are fairly familiar and are described in more detail below, but what do modern bank runs look like? Here's an example involving hedge funds from something I wrote in the past. (It's slightly edited. The term "bank-like function" in the first sentence means financial intermediation. Most of the discussion of financial intermediation is about temporal intermediation, i.e. borrowing short and lending long, but intermediaries can also aggregate and smooth risk, aggregate small deposits into large loans, and lower transactions costs):

Entities outside the traditional banking sector have been engaged in bank-like functions and are hence subject to bank-like problems such as bank-runs.

For example, hedge funds can be hit with withdrawals even if they are not in trouble themselves, at least initially, due to uncertainties about the future state of the market, rumors, etc.

But like a bank who lends out most of the deposits it receives and only keeps a fraction of the deposits on hand as reserves, a hedge fund uses the deposits it receives to purchase securities and other assets for its portfolio maintaining some as a cash reserve. But unless it has substantial cash reserves on-hand, when investors make withdrawals the fund must begin to liquidate its portfolio to pay them off.

But if nobody will purchase mortgage-backed securities you are offering, who do you sell to? With nobody buying the assets the fund is trying to sell, they are forced to try to raise cash in other ways, and problems mount.

And it can feed on itself, just like a bank run. If investors hear that people are having trouble getting their money out of a particular fund, or from funds generally, they will rush to get their money out before the fund fails, and the problems spread as funds try to sell assets to raise the needed cash.

So it's sort of like a bank run, but without a standing lending facility (i.e. the equivalent of a discount window) available to meet the demand for liquidity, though such institutions could be created.

And they have been created.

Next, the "New World Order" and how to save the free world:

links for 2008-09-17

• Do-Nothing Economics - Eric Rauchway
• It's The Wages, Stupid. - Swampland
• How likely is it that polar bears will become extinct? - Arctic Economics
• The left and right of it all - macroblog
• Perhaps, Time for Someone to Play Offense - NYTimes.com
• Interesting times - Clive Crook
• Larry King not so live - Paul Krugman Blog
• The destruction that Lehman wrought - Bluematter
• Dilbert Survey of Economists - Scott Adams Blog
• How is McCain connected to the almost bankrupt AIG? - Andrew Leonard
• McCain doesn’t know what his own committee does - Think Progress
• Fed Silence on Energy Speaks Volumes - Real Time Economics
• A Commitment Pill? - Olivia Judson
• Dynamically Inconsistent Preferences and Money Demand - Angry Bear
• Den of Thieves - On Faith
• Capital inflows conundrums - Dani Rodrik
• Get Your Class War On - Thomas Frank
• Fed's AIG Deal: Here There Be Dragons - Real Time Economics
• A Failure Tax - Op-Ed - NYTimes.com
• No More Creampuffs - Kenneth Rogoff
• Greg Mankiw Is Funny! - A Tiny Revolution
• The end of American capitalism as we knew it - Willem Buiter
• Why the EU should auction carbon permits - Vox EU
• Farewell to the neo-classical revolution - Project Syndicate
• McCain, Social Security Privatization, and the Financial Crises - Ezra Klein
• The end of lightly regulated finance has come far closer - Martin Wolf
• Counterparty Risk Moves to the Fore - Felix Salmon
• Monetary policy and the models - Vox EU

Fed Gives AIG an $85 Billion Loan in Exchange for 80% Stake

As noted in an update to the post below this one, the Fed is going to give AIG an $85 billion loan in exchange for an 80% stake in the company:

Fed Readies A.I.G. Loan of $85 Billion for an 80% Stake, NYT: In an extraordinary turn, the Federal Reserve was close to a deal 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 briefed on the negotiations.

In return, the Fed will receive warrants, which give it an ownership stake. All of A.I.G.’s assets will be pledged to secure the loan, these people said. ...

So you as a taxpayer now have a large stake in AIG.

Update: Paul Kedrosky:

IG, Risk Homeostasis, Moral Non-Hazard and Apollo Landings: I wish people would shut up about "moral hazard". Yes, bridging AIG through its current crisis is not something you want to do; and yes, it would be better if the market solved its own problem. But even a cursory analysis of the serpentine connections between AIG and capital markets tells you that the latter just can't happen, so you have to hold your nose, be an adult, and live with the former.

Moral hazard, while real sometimes and in some places, is vastly overrated as an effect. Granted, it's seductive in the same way that risk homeostasis is -- the notion that, for example, people drive faster and take more risks because they have seatbelts -- but like risk homeostasis, moral hazard is vastly over-diagnosed. People at major financial services outfits don't project five years into the future and say, "Lever up, boys and girls. We'll either make a lot of money now, or be bailed out later." Real people in real markets don't think that way. Matter of fact, if anything, they're short-sighted in that regard to a fault.

Further, imagining that people load up with "end of the world" liabilities in an effort to be anointed with "too big to fail" status is muddled non-thinking from run-amok conspiracy theorists. They would be better off sticking to, you know, perhaps denying the Apollo moon landings. Because the idea that a GM can now credibly post-AIG make the case that capital markets will blow up if we don't assist it too is silly -- and suggesting that auto companies (just to pick an example) will now plaster themselves with leverage bombs to make their own "We're dangerous too!!" case stronger is sillier still.

More: Why Bail Out AIG's Bondholders? -Felix Salmon. Calculated Risk risk reports: Fed: AIG Deal Done.

Update: John Jansen isn't happy with the Fed:

Thoughts on A Loan to AIG, by John Jansen: Let me begin by noting that no details have been released on the alleged transaction between the Federal Reserve and AIG and so to comment is dangerous. But I will anyway!

If the Federal Reserve Bank of New York plans to write an $85 billion check to AIG , then Treasury market participants should duck for cover. They will likely raise the money by selling Treasury debt from the System Open Market Account. I have no idea how they would do that but it would be the largest such sale of securities since the dawn of human history.

At this point I run into a problem as I lack a detailed set of facts. I will offer some comment but I understand that I am on rough terrain. Why does the Federal Reserve not control 100 percent of the company? Capitalsim punishes bad risk. These jokers took bad risk in spades, They should be wiped out. The common shareholders should be left with nothing. If this was a good deal for the taxpayers, this would have been a private transaction. The very fact that the Fed is involved speaks loudly to us that no private company believes that this is a prudent loan.

Preferred shareholders? If the deal calls for making them whole, I ask why. There does not seem to be any reason to bail them out.

Bondholders? They should be forced to take a haircut. This is not FNMA or Freddie Mac issuing debt for 40 years with a wink from the Treasury Secretary and the implied backing of the Government. This was a completely private enterprise. AIG debt could have been purchased earlier today for cents on the dollar. To reward the holders of that debt truly creates a windfall profit.

The Federal Reserve is careening down a very slippery slope. The risks of that joyride are understandable and worthwhile if they exact a financial pound of flesh from those at AIG who so bungled their mission. On the surface that does not appear to be the case here.

Update: Was it legal?:

Fed Invokes ‘Unusual and Exigent’ Clause — Again, by David Wessel, RTE: In lending up to $85 billion at a hefty interest rate – LIBOR plus 8.5 percentage points – to insurer AIG, the Federal Reserve once again relied on its rarely used legal authority under Section 13(3) of the Federal Reserve Act to lend to “any individual, partnership or corporation” in “unusual and exigent circumstance” provided the borrower “is unable to secure adequate credit accommodations from other banking institutions.”

Until its loan to then-ailing investment bank Bear Stearns in March, the Fed hadn’t used that lending authority since the Great Depression, lending exclusively to commercial banks and other deposit-taking institutions. The relied on a different section of the Federal Reserve Act to offer loans – which weren’t actually made – to government-sponsored mortgage giants Fannie Mae and Freddie Mac. ...

In a Tuesday night statement, the Fed said, “The (Federal Reserve) Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance.” [Note: the term of the loan is 24 months, and "is collateralized by all the assets of AIG and its subsidiaries."]

Update: Tyler Cowen examines some of the Fed's new properties:

The Federal Reserve now has commercials: Really. View it here.  This one is even better. Here is the Fed on risk protection.  And here: "The Greatest Risk is Not Taking One."  Here is Fed Karaoke.

Replacing Financial Market Transparency with Trust

Over issues of little consequence, all the various flavors of economists can have fierce debates over issues such as the proper role of government. Libertarians might stake out one extreme position, someone will argue the other side, and there are always at least a few who will take the middle ground. But when it's a policy issue of critical importance, such as in the wake of a financial crisis, the differences among us are much less apparent.

Transparency - the availability of essential information about the market - is needed for markets to function optimally. A key point of this argument from Arnold Kling is that financial markets replace transparency with trust by necessity, and this makes financial markets inherently unstable. The problem is that trust is fragile, it can be broken easily, and thus some sort of insurance is needed to overcome lack of trust and keep these markets functioning smoothly. One way to do this is through government provided deposit insurance, and I fully agree that this is a critical element in maintaining trust in financial markets (and as noted below, not all events can be anticipated and this means that some interventions to provide the necessary insurance will necessarily be ad hoc). But the main point I want to emphasize is that government must step in when there is a danger that trust will be significantly eroded by the failure of financial markets:

What Should Government Guarantee?, by Arnold Kling: ...On financial markets, I am in the middle between the Progressive view that government can guarantee everything and the libertarian view that the government should guarantee nothing.

My view is that financial markets are inherently unstable, because financial intermediation inherently replaces transparency with trust. If my bank were perfectly transparent, then I would know everything about its loans, including the underlying risks of the real estate developers, small businesses, and individuals to whom it is lending money. But in that case, I would not need a bank--I could just make those loans myself. So if you assume perfect transparency, you assume away the need for financial intermediation.

In fact, you have to assume the opposite of perfect transparency. You have to assume highly imperfect transparency, with reputation and trust serving as substitutes.

In banking, deposit insurance helps facilitate trust. A private insurance pool might work, but people trust government-provided deposit insurance even more.

With deposit insurance, the consumer loses all motivation for worrying about the bank's risk management. By the same token, the insurer has to worry a lot. In the U.S., the FDIC has been getting better over the years, but you can never get complacent. Any system can be gamed eventually, so it's a challenge for the regulators to stay one step ahead of the banks.

What we see with Bear Stearns, Freddie and Fannie, Lehman, and AIG insurance are institutions that are not FDIC-insured banks where nonetheless a question arises about whether some of their creditors ought to be protected by the government. I think that just about everyone is unhappy that these decisions are being made ad hoc, after the firms got in trouble, rather than having rules set ahead of time. But maybe what the government is doing is actually pretty reasonable. ...

Overall, I think that having some regulated, insured institutions, like the banks, is good. I don't think we can or should try to regulate everyone. Regulators should try to anticipate crises and prevent them. But almost by definition, the crises that do occur will be ones that they did not anticipate, and the responses will have to be somewhat ad hoc.

My grandmother lived through the Great Depression. After she passed away, we found money hidden all over her house - I'm sure there was some we never found, maybe buried in the yard or something. Even with deposit insurance, after the experience of the Great Depression she never trusted banks again, and nothing could convince her otherwise. That lack of trust takes assets that could be used productively to finance investment projects and hides them in the house or yard.  And when you spread this behavior over millions and millions of people, the result is lower investment and lower growth.

In addition, when trust evaporates, the withdrawal of assets from the financial system is not limited to households with relatively modest savings worried about their bank deposits. People and businesses with large accumulations of assets do the equivalent of hiding their money in the cookie jar, and this can cause investment markets to dry up very fast. And as my grandmother's case shows in its own small way, once trust is gone it can take a long time to be reestablished, if ever.

The consequences of a big financial crash are not necessarily temporary, it is not simply a case of wiping out that which needs to be creatively destructed and moving on, the damage to trust can be permanent, and if it is, the consequence will be lower investment, lower growth, and fewer jobs than if the trust-busting crash had been prevented. The cost of, say, a quarter percent lower growth for 25 years is large, far larger than the cost of a typical bailout, and the costs do not fall solely on those who made the choices that caused the problems, the costs fall on all of us.

Update: Given the above, and this, it shouldn't be a surprise that I think this is a good idea:

Fed Readies A.I.G. Loan of $85 Billion for an 80% Stake, NYT: In an extraordinary turn, the Federal Reserve was close to a deal 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 briefed on the negotiations.

In return, the Fed will receive warrants, which give it an ownership stake. All of A.I.G.’s assets will be pledged to secure the loan, these people said. ...

"A Perception of 'Good faith' is Key to Economic Growth"

Robert Shiller explains the moral issues behind bailouts:

A perception of ‘good faith’ is key to economic growth, by Robert Shiller, Project Syndicate: The United States government’s takeover of mortgage giants Fannie Mae and Freddie Mac constitutes a huge bailout of these institutions’ creditors... With the government now fully guaranteeing Fannie’s and Freddie’s debts, ... taxpayers will have to pay for everything not covered by their creditors’ inadequate capital.

Why is this bailout happening in the world's most avowedly capitalist country? Don’t venerable capitalist principles imply that anyone who believed in the real estate bubble and who invested in Fannie and Freddie must accept their losses? Is it fair that innocent taxpayers must now pay for their mistakes?

The answers to such questions would be obvious if the moral issues in the current financial crisis were clear-cut. But they are not.

Most importantly, it is not clear that the bailout will actually impose any net costs on US taxpayers, since it may prevent further systemic effects that bring down the financial sector and, with it, the world economy. Just because systemic effects are difficult to quantify does not mean that they are not real. ...

There is no accurate science of confidence, no way of knowing how people will react to a failure to help when markets collapse. People’s reactions to these events depend on their emotions and their sense of justice.

The booms and busts have caused great redistributions of wealth. People who bought into the stock market or housing market did either well or poorly, depending on their timing. People will judge the fairness of these outcomes in terms of what they were told, and what kinds of implicit promises they inferred. ...

What were people ... told about the markets in which they invested? Was it all really truthful? Unfortunately, there is no way to find out. ...

To be sure, while there may have been much ‘cheap talk’ – general advice with disclaimers – most of the losers in this game are not starving. But we cannot blithely conclude that all the losses should be allowed to stand in full force.

The gnawing problem is one of ‘good faith’. Economies prosper only on the perception that ‘good faith’ exists. The current situation, in which speculative booms have driven the ... economy – and, having collapsed, are now driving it into recession – suggests that there may have been a lot of bad faith by people promoting certain investments.

Consider investors in Fannie and Freddie bonds. While the US government never officially promised to bail them out, it did create a special agency, the Office of Federal Housing Enterprise Oversight, which was to assess their strength in an annual report. But this agency never even acknowledged that there was a housing bubble. Government leaders gave no warnings.

So can we really say that investors must suffer the full consequences of any losses? How can this be fair?

The world is discovering capitalism and its power to transform economies. But capitalism relies on good faith. A perception of unfair treatment can be deadly to economic growth, because it means that people will lose trust in businesses, and hence be less willing to offer to them their precious capital and labor. Is that outcome morally superior to a bailout?

Fed Leaves Interest Rates Unchanged

Here's the press release:

Press Release

Release Date: September 16, 2008

For immediate release

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

"Moral Hazard for Corporations"

Yesterday, in his "Third Rant of the Day", knzn argued:

[W]hen the financial system is strained and interest rates on Treasury securities are already quite low, there is an increased risk that a weak economy will turn into a serious recession which the Fed will have little power to combat. If you depend on your job to earn a living, that’s a pretty serious risk.

So instead of putting “taxpayer money” on the line, Secretary Paulson is putting taxpayers on the line.

Today, he argues that moral hazard is misunderstood, and that "the financial system as a whole should be insured":

Moral Hazard for Corporations, by knzn: With all the talk about “moral hazard” lately, I have realized something: there is a basic flaw in the way the subject is typically discussed with respect to financial corporations. I’m not saying that the people discussing it are necessarily misunderstanding, but the terms in which it’s typically discussed will tend to lead the unwary into sloppy thinking or confusion.

"!*#\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...

Gut Instinct and Math Ability

In case you are tired of politics and financial crises, here's something a bit different:

Gut Instinct’s Surprising Role in Math, by Natalie Angier, NYT: You are shopping in a busy supermarket and you’re ready to pay up... You perform a quick visual sweep of the checkout options and immediately start ramming your cart through traffic toward an appealingly unpeopled line halfway across the store. As you wait in line and start reading nutrition labels, you can’t help but calculate that the 529 calories contained in a single slice of your Key lime cheesecake amounts to one-fourth of your recommended daily caloric allowance...

One shopping spree, two distinct number systems in play. Whenever we choose a shorter grocery line over a longer one, or a bustling restaurant over an unpopular one, we rally our approximate number system, an ancient and intuitive sense that we are born with and that we share with many other animals. Rats, pigeons, monkeys, babies — all can tell more from fewer, abundant from stingy. An approximate number sense is essential to brute survival: how else can a bird find the best patch of berries, or two baboons know better than to pick a fight with a gang of six?

When it comes to genuine computation, however, to seeing a self-important number like 529 and panicking when you divide it into 2,200, or realizing that, hey, it’s the square of 23! well, that calls for a very different number system, one that is specific, symbolic and highly abstract. By all evidence, scientists say, the capacity to do mathematics, to manipulate representations of numbers and explore the quantitative texture of our world is a uniquely human and very recent skill. People have been at it only for the last few millennia, it’s not universal to all cultures, and it takes years of education to master. Math-making seems the opposite of automatic, which is why scientists long thought it had nothing to do with our ancient, pre-verbal size-em-up ways.

Yet a host of new studies suggests that the two number systems, the bestial and celestial, may be profoundly related, an insight with potentially broad implications for math education. ...

Why Obama'a Health Care Plan is Better

David Cutler, Brad DeLong, and Ann Marie Marciarille have an op-ed in the WSJ comparing the health care plans of Obama and McCain:

Brad DeLong: Bingo!

Why Obama's Health Plan Is Better

...Harvard Professor and Obama Health Care Advisor David M. Cutler and his coauthors show that John McCain's health-care reform plan burdens America's high-value businesses with extra taxes. In America today, high-value and high-wage jobs are also high-benefit jobs. John McCain taxes them. And when you tax something, you get fewer of them: fewer of the high-value jobs that take advantage of the skills of the American worker and produce high wages and salaries for workers and high profits for managers and business owners.

By contrast, Barack Obama's health-care reform plan lifts the health-care cost burden from the backs of America's high-value businesses in five ways: Learning how to eliminate the one-third of costs for services at best ineffective and at worst harmful. Rewarding doctors and hospitals for providing health rather than performing procedures. Pooling individuals and small firms to give them bargaining power vis-a-vis health insurers. Preventing illness through making it profitable to provide regular screenings and healthy lifestyle information, the most cost-effective medical services around. Covering more people and removing the hidden shifted costs of the uninsured by lowering premiums by $2,500 for the typical family, allowing millions previously priced out of the market to afford insurance.

The lower cost of benefits will allow employers to hire some 90,000 low-wage workers currently without jobs because they are currently priced out of the market. It also would pull an estimated one and a half million more workers out of low-wage low-benefit and into high-wage high-benefit jobs. And more workers currently locked into jobs because they fear losing their health benefits would be able to move to entrepreneurial jobs, or simply work part time. [Talking Points][Why Obama's Health Plan Is Better][Update: More on the McCain plan: McCain’s Radical Agenda - Bob Herbert]

links for 2008-09-16

• Monetary policy and the models - Vox EU
  
• Fed Gets Ready to Gulp, Save Financial System - John M. Berry
• Trends In Economics: A Calculus of Risk - Scientific American
• How Fractals Can Explain What's Wrong with Wall Street: - Scientific American
• See You Later, Speculator - WSJ.com
• Epochal - The Bellows
• Another Two-Day Test for Bernanke's Fed - Real Time Economics
• Economic-Stimulus Plan Lacks Bipartisan Backing - WSJ.com
• No case for a cut in the Federal Funds Target - Willem Buiter
• Obama, McCain diverge on Wall Street cures - Ben Smith and Avi Zenilman
• Back to the Real Side of the Economy: Recession Watch - Econbrowser
• Palin Tells Debunked Teleprompter Tale - Washington Wire
• Obama vs. McCain on Gramm-Leach-Bliley - Economists for Obama
• In Candidates, 2 Approaches to Wall Street - NYTimes.com
• Late night musings on the financial situation - William J. Polley
• The rise of the commercial banks - Daniel Gross
• Spencer on Industrial Production Report - Angry Bear
• Whats Spanish for Lies? - New York Times Blog
• Third Rant of the Day - knzn
• Careless, Disingenuous, or Just Ignorant? - knzn
• Surveying the Carnage - Felix Salmon
• Value of insect pollination worldwide estimated at 153 billion euros - EurekAlert

"Why Wall Street is Melting Down, and What to Do About It"

Robert Reich says stop the bailouts, and start imposing regulations that will rebuild the trust that is needed for financial markets to function:

Why Wall Street is Melting Down, and What to Do About It, by Robert Reich: Hank Paulson didn't blink, so Lehman Brothers went down the tubes. The end of socialized capitalism? Don't bet on it. The Treasury and the Fed are scrambling to enlarge the government's authority to exchange securities of unknown value for guaranteed securities in an effort to stave off the biggest financial meltdown since the 1930s.

Ironically, a free-market-loving Republican administration is presiding over the most ambitious intrusion of government into the market in almost anyone's memory. But to what end? Bailouts, subsidies, and government insurance won't help Wall Street because the Street's fundamental problem isn't lack of capital. It's lack of trust.

The sub-prime mortgage mess triggered it, but the problem lies much deeper. Financial markets trade in promises -- that assets have a certain value, that numbers on a balance sheet are accurate, that a loan carries a limited risk. If investors stop trusting the promises, Wall Street can't function. ...

What to do? Not to socialize capitalism with bailouts and subsidies that put taxpayers at risk. If what's lacking is trust rather than capital, the most important steps policymakers can take are to rebuild trust. And the best way to rebuild trust is through regulations that require financial players to stand behind their promises and tell the truth, along with strict oversight to make sure they do. ...

Lacking adequate regulation or oversight, our financial markets have become a snare and a delusion. Government only has two choices now: Either continue to bail them out, or regulate them in order to keep them honest. I vote for the latter.

Stiglitz: The Fruit of Hypocrisy

Joseph Stiglitz:

The fruit of hypocrisy, by Joseph Stiglitz, Comment is Free: ...The new low in the financial crisis, which has prompted comparisons with the 1929 Wall Street crash, is the fruit of a pattern of dishonesty on the part of financial institutions, and incompetence on the part of policymakers.

We had become accustomed to the hypocrisy. The banks reject any suggestion they should face regulation, rebuff any move towards anti-trust measures - yet when trouble strikes, all of a sudden they demand state intervention: they must be bailed out; they are too big, too important to be allowed to fail.

Eventually, however, we were always going to learn how big the safety net was. And a sign of the limits of the US Federal Reserve and treasury's willingness to rescue comes with the collapse of ... Lehman Brothers, one of the most famous Wall Street names.

The big question always centres on systemic risk: to what extent does the collapse of an institution imperil the financial system as a whole? ... Last week ... Henry Paulson judged there was sufficient systemic risk to warrant a government rescue of ... Fannie Mae and Freddie Mac; but there was not sufficient systemic risk seen in Lehman.

The present financial crisis springs from a catastrophic collapse in confidence. ... Lehman's collapse marks at the very least a powerful symbol of a new low in confidence, and the reverberations will continue.

The crisis in trust extends beyond banks... How seriously, then, should we take comparisons with the crash of 1929? Most economists believe we have the monetary and fiscal instruments and understanding to avoid collapse on that scale. And yet the IMF and the US treasury, together with central banks and finance ministers from many other countries, are capable of supporting the sort of "rescue" policies that led Indonesia to economic disaster in 1998. Moreover, it is difficult to have faith in the policy wherewithal of a government that oversaw the utter mismanagement of the war in Iraq and the response to Hurricane Katrina. If any administration can turn this crisis into another depression, it is the Bush administration.

America's financial system failed ... and it must now face change in its regulatory structures. ...

It was all done in the name of innovation, and any regulatory initiative was fought away with claims that it would suppress that innovation. They were innovating, all right, but not in ways that made the economy stronger. Some of America's best and brightest were devoting their talents to getting around standards and regulations designed to ensure the efficiency of the economy and the safety of the banking system. Unfortunately, they were far too successful, and we are all - homeowners, workers, investors, taxpayers - paying the price.

Krugman on Countdown: The Fundamentals are Strong?

More daily links

The economy:

• Worse than it looks - Paul Krugman
•  Yes, It Is a Recession . . . in Goods Production too... - Brad DeLong
• Principals, Agents, and Bank Regulators - SCSU Scholars
• Moral Hazard and Protecting the Taxpayer - knzn
• Midday thoughts on the financial situation - William J. Polley
• Fun times at the Federal Reserve - Free exchange
• The Wall Street meltdown -- and you - Andrew Leonard
• NY Fed Meeting on AIG - Calculated Risk
• The Shadow Knows - Arnold Kling
• So why did this happen to Lehman and not somebody else? - Curious Capitalist
• After 73 years: the last gasp of the broker-dealer - John Gapper
• New York Fed Makes Unusual Intervention - Real Time Economics

Oil and commodities:

• New study says high grain prices are likely here to stay - EurekAlert
• Fuel inputs in the food system could be reduced by 50% - U.S. Food Policy
• Save the Environment - Drill, Baby, Drill - Op-Ed - NYTimes.com
• One if by Land, Billions if by Sea - Op-Ed - NYTimes.com
• Don't drill offshore, baby - The Register-Guard
• Drilling Everywhere Would Only Save a Few Cents a Gallon - Dean Baker
• When Will Year on Year Crude Oil Turn Negative? - Bonobo Land

Other:

• Coupon redeemers stigma is contagious (unless they're attractive) - EurekAlert
• McCain wants to cut social security and healthcare benefits - Dean Baker
• Sticky Prices vs. Sticky Information: A False Dichotomy? - Kids Prefer Cheese
• The Backfire Effect - Kevin Drum

"I am Still Not Sure Whether the Column was Meant as a Joke"

Others have noted that Donald Luskin, an "adviser to John McCain's campaign", published op-eds in both the Wall Street Journal and Washington Post arguing that the economy is doing just fine, and contesting the well-known result that the economy does best when Democrats are in power. Here's an example of the response to Luskin:

Dean Baker: Like most newspapers, the Washington Post likes to run opinion pieces that present a different take on the news. But most newspapers prefer that this different take is grounded in reality, not the Post.

Today the Post featured a piece by Donald Luskin, an advisor to John McCain, saying that the economy is just fine. ...

While Luskin argues that people were led to believe that the economy is bad because of the media’s negativism, it is also possible that they are responding to the weakest labor market since the early nineties. They may also be responding to the fact that wages fell behind inflation by close to 2 percentage points last year as people’s paychecks did not keep pace with the price of food and the price of gas.

In fact, the typical worker has seen no benefit for the last seven years of economic growth. Workers probably know that they are not getting ahead, even without the media pointing it out.

The rest of the piece is a range of confused and misleading statistics. ...

Luskin also doesn't see anything unusual in the pattern of failing financial institutions. Yeah, Fannie and Freddie go down every week, not to mention Bear Stearns, Lehman Brothers, Indymac. These are not neighborhood banks going down the tubes.

Even the "record" homeownership rate touted in the price is nonsense. The rate has fallen sharply in the last two years. In age-adjusted terms (people are more likely to own homes in their 40s than their 20s) we're not far above where we were a quarter of a century ago.

This column has no place in a serious newspaper (unless its intention was to embarrass McCain). ...

John McCain must be listening to Luskin and his other nothing but a bunch of whiners advisors, because today he proclaimed:

"The fundamentals of our economy are strong..."

Yep, just like Dean Baker just explained, the fundamentals are great. In fact, one of the most important fundamentals - income for the typical household as measured by median income - didn't grow at all during the recent expansion phase of the economy, though income growth was "strong" if you live in McCain's area of the income distribution.

So we should believe what McCain said last December:

McCain: "Economics is Something That I've Really Never Understood": ... "The issue of economics is something that I've really never understood as well as I should....,'' ... "...I would like to have someone I'm close to that really is a good strong economist. As long as Alan Greenspan is around I would certainly use him for advice and counsel." ...

"I've never been involved in Wall Street, I've never been involved in the financial stuff, the financial workings of the country, so I'd like to have somebody intimately familiar with it," he said of a potential vice president.

I don't think his vice-presidential choice has much to offer on "financial stuff".  So let's go back to McCain's advisor, Donald Luskin, and see what we can learn about the kind of advice and analysis the McCain camp is getting. Here's Jeff Frankel:

What Does It Take to Define Away the Statistics Showing Superior Economic Performance Under Democratic Presidents than Under Republicans?, by Jeff Frankel: A panel on Supply Side Economics in Washington, September 12, included statistics on the superior performance of the American economy under President Clinton compared to his Republican successor. ... Former Treasury Secretary Larry Summers gave some statistics that included Democratic versus Republican presidents throughout the postwar period. ...

By coincidence, in a column in that day’s Wall Street Journal, Donald Luskins sought to “get something settled once and for all. Have the stock markets and the economy historically done better under Democrats or Republicans?”

Here is what he wanted to straighten us out on: “Superficially at least, the Democratic claims are true: Since 1948, the Standard & Poor’s 500 total return (capital gains plus dividends) has averaged 15.6% when a Democrat was in the White House and only 11.1% when a Republican was in the White House. You get a similar result if you look at growth in real gross domestic product. Under Democratic presidents, the average since 1948 has been 4.2%. Under Republican presidents it has been only 2.8%.”  But then he goes on to argue that Kennedy should really be classified as a Republican (he cut taxes), Nixon as a Democrat (wage-price controls), George H.W. Bush as a Democrat (he raised taxes), and Bill Clinton as a Republican (free trade; and he might have added eliminating the budget deficit, supporting the Fed, reforming welfare, other policies that would normally be thought of as conservative). He argues that if you make these switches in party assignments, then the US stock market and economy has performed better under “Republican” presidents (which, remember, now includes Kennedy and Clinton) than under “Democrats” (which now includes Nixon and the first Bush).

I am still not sure whether the column was meant as a joke.  At the risk of finding out that I have been taken in by a prank, I will assume that the author is serious. Brad DeLong  picked this one up right away, and thinks the author is serious. ... But Brad didn’t offer any sort of detailed rebuttal.  I suppose one could argue “live by ad hominem, die by ad hominem.”   But I think blogosphere courtesy, such as it is, calls for a substantive reply. 

My first response is to point out that the Nixon, Bush and Clinton policies he cites are not isolated cases, but appear on a longer list of examples I like to give showing how for the last 40 years, rhetoric notwithstanding, Republican presidents have pursued policies that are surprisingly farther removed from the ideal of good neoclassical economics than have Democratic presidents.   This is especially true if one defines neoclassical economics as the textbook version, which allows government intervention for externalities, monopolies, etc..  But I would argue that it applies even to the “conservative economics” version that puts priority simply on small government.

The criteria underlying this generalization about Republican presidents are:
(1) Growth in the size of the government, as measured by employment and spending.
(2) Lack of fiscal discipline, as measured by budget deficits.
(3) Lack of commitment to price stability, as measured by pressure on the Fed for easier monetary policy when politically advantageous.
(4) Departures from free trade.
(5) Use of government powers to protect and subsidize favored special interests (such as agriculture and the oil and gas sector, among others).   

I have documented in writings listed elsewhere that Republican presidents have since 1971 indulged in these five departures from “conservatism” to a greater extent than Democratic presidents. The name I would give to this set of departures, as well as to the parallel abuses of executive power in the areas of foreign policy (intervening in Iraq) and domestic policy (intervening in people’s bedrooms), is neither “liberal” nor “conservative” but, rather, “illiberal.”

My second response is to point out that the author is re-defining “Republican” and “Democrat” tautologically to be “good” or “bad.” A definition that departs so far from actual party affiliation does unacceptable linguistic violence.    And of course it is circular logic to then find that the economy does better under “Republican” presidents than “Democratic.”

An analogy.   Marx and Engels of course professed to have the welfare of the common man as their goal. The Soviet Constitution asserted that the USSR expressed “… the will and interests of the workers, peasants, and intelligentsia.”  It claimed to embody democracy, the rights of freedom of speech, freedom of the press, freedom of assembly, freedom of religion, inviolability of the person and home, and the right to privacy.    Needless to say, this was all pure rhetoric, which was continuously and comprehensively violated by the actual operations of the Soviet state.   But by Luskins’ logic, the western democratic system, which did put these ideals into practice should be re-classified as communist, and the superior performance of the western system should be chalked up as going to the credit of communism!   It makes no more sense to credit the achievements of Bill Clinton to the Republicans than it would to credit the achievements of western democracy to the Communists.

Paul Krugman: Financial Russian Roulette

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

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

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

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

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

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

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

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

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

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

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

Fed Watch: End Game:

Tim Duy assesses the financial crisis, and what the Fed is likely to do at its next rate-setting meeting:

Endgame?, by Tim Duy: News is flowing in faster than the ability to process the implications.  When I went to bed Saturday night, the only sure thing looked like the liquidation of Lehman Monday morning.  A scant 24 hours later, to that liquidation is added the sale of Merrill Lynch to Bank of America and, later the possibility of a collapse of AIG by midweek.  The Fed and Treasury suddenly play hardball, and the floodgates break open.

Mark Thoma is working overtime to keep readers informed. 

Fed officials likely now understand the can of worms they opened with the Bear Sterns bailout.  At that point, Wall Street realized that attempting to solve their own problems was a sucker’s bet – better to string things along with the expectation that the Fed would ultimately solve the problem of bad assets by bringing them into the public domain.  Arguably, this is one reason the Lehman issue was allowed to fester for another six months.  Moral hazard.  With policymakers now drawing a line in the sand, market participants can no longer cling to the hope that the Fed will absorb additional bad debt (notice how quickly Merrill moved when policymakers claimed they will serve only as matchmakers, rather than put additional public money explicitly at risk).  It is looking like the endgame is finally here.

To give the Fed the benefit of the doubt, earlier this year they likely saw the financial crisis as primarily a liquidity event.  Thus, they could make the analogy that market participants just needed a “slap in the face,” and some rapid rate cuts and fresh sources of liquidity would give confidence that much needed boost.  By now, however, officials probably realize this is a solvency crisis.  Too many debt instruments hinge on the state of the US housing market, and too many homeowners took on loans that are simply unaffordable. 

A solvency crisis can only be addressed by eliminating the bad assets (since analogies to Japan are all the rage, note that the unwillingness to eliminate nonperforming assets helped prolong that banking crisis).  Moving the assets onto the Fed’s balance sheet via temporary repo operations does not eliminate the problem, it just moves it around.  Instead, the questionable assets need to be eliminated, and some agent needs to accept the loss.  Who will that agent be?  Wall Street obviously prefers that the taxpayer ultimately absorbs that loss; the Bear Sterns bailout provides the precedence for such an outcome via the Fed’s financial backstop. 

Repeated Bear Sterns type bailouts would eventually force taxpayers to absorb the losses of the entire crisis and, more importantly, do so without legislative approval.  We can cordially debate the appropriateness of taxpayer support, but we should all be clear that that decision needs to be made in a democratic fashion.  It is too big an issue for an “ends justify the means argument,” a justification that Bernanke & Co. need to do whatever is necessary to make the trains run on time.  Bernanke & Co. likely understand this now, encouraging their hesitation to continue down that road.  Of course, if Lehman is forced to liquidate assets, that too has obvious consequences, such as setting prices for those assets that further destabilizes the investment banking community, pushing financial markets to an end game in the crisis.  Still, even with that crisis in the making, the Fed has already pushed their legal boundaries; some would argue they have stepped well beyond those boundaries.  And it hasn’t stopped – the Fed expanded the collateral it will accept in repo operations, putting taxpayer dollars at risk in a less explicit manner (I see no legal justification to open a credit line to AIG – if them, why not Ford or GM?).  Still, despite the Fed’s creative efforts to date, the crisis is moving to a stage that is simply too big for the Fed; Congress needs to step up and define the parameters of any mass bailout of the financial sector.  Some version of the Resolution Trust Corporation is the most likely outcome.  I suspect that taxpayers will ultimately absorb significant losses, but it will be a crime if such a bailout does not entail a radical reevaluation of financial regulation.  But to what extend will Congress be willing to perform a hard look as an industry that has brought the illusion of wealth that hides gaping and undeniable equity flaws in the US?

The FOMC is gathering this week for a decision on interest rates.  I imagine all bets are off regarding the outcome; indeed, we may get an emergency rate cut by the time I get to the office.   As of Friday, policymakers were widely expected to keep rates steady; only the language of the statement is in doubt.  Specifically, market participants will be looking to validate growing expectations of a rate cut later this year.  At issue is the use of the term “significant” to qualify the inflation threat.  Given the collapse of commodity prices, there appears to be room to remove that qualifier.  I suspected they would be wary, however, of giving hints that a rate cut is in the making – they are probably just now breathing signs of relief that Dollar/commodity dynamic is no longer working against them.  They do not need to trigger a fresh run on the Dollar; moreover, Chinese policymakers likely are happy that they foreign currency value of their Dollar assets is on the rise, and do not want a reversal of that situation.  After last week’s nationalization of Freddie and Fannie, we can no longer hew to the illusion that policy is based only on domestic considerations. 

Cutting interest rates, I suspect, will make little if any difference at this juncture.  That said, the Fed has delivered a rate cut at each critical juncture of the past year.  I am at a loss to convincingly explain why this week is any different.

links for 2008-09-15

• Blame the Short-Sellers - Paul Kedrosky
• How ethnic fragmentation undermines good governance - Vox EU
• Response to my Mother - Alex Tabarrok
• The Tragedy of 'The Tragedy of the Commons' - Discourse.net
• Bears Watching - Economic Principals
• Ben Stein Watch - Felix Salmon
• Comic Relief Courtesy Don Luskin - naked capitalism
• How we measure poverty - Los Angeles Times