Reader Bruce Hall inquires why Econbrowser has not weighed in on the rescue debate. First, I’ll observe there has been plenty of commentary on the web. But if compelled, then speaking only for myself, I think the members of Congress who voted against the plan the first time should, this time around, ask themselves this single question: “Do I Feel Lucky?” Those who are familiar with this quote will understand my meaning.
Caveats: First, of course, the plan is not perfect; but as they say, don’t let the perfect be the enemy of the good. Second, the metaphor is inexact; in this case, collateral damage would encompass everybody — innocent and guilty alike — as well as the entire global macroeconomy.
Post by Menzie Chinn
.Update 10/3 3:40am Pacific: Martin Wolf has a more comprehensive discussion.
Update 10/5 3:40pm Pacific: In the comments, Stefan Karlsson misapprehends my meaning by fixing on the wrong segment. The correct segment is here.
To what extent has the Swedish model of injecting capital via equity purchases been discussed on the hill?
Otherwise, it seems that most members of the ‘elite’ agree that an imperfect plan, ideally quickly implemented, is better than no plan. That consensus view appears to stretch across conservatives and liberals and leftists without exception. I guess I’m leaving Michael Moore out of this ‘elite’.
C’mon, Professor; the Fed’s and Treasury’s track record with its various programs over these last 12 months is not impressive. None have worked, and even a dummy like me knew that would be the case, a priori.
They are throwing out liquidity aids when this is a solvency issue.
Until they address the underlying cause of the financial stress — that U.S. households will not be good for their $14 trillion in debt — they will be just postponing and exacerbating the implosion.
The bailout bill will not work, and will further freeze markets: why sell on the open market low when you can sell to the Treasury high? Why buy from a bank with whom you may not have recourse (risk of BK) when you can buy from the Treasury with whom you may have recourse?
The good news is that this effort will not last long. The economy is in a death spiral, and tax revenues are plummeting. When the bill passes tomorrow, foreigners will really get skittish about holding U.S. government debt, ’cause they see a whole lot more is going to be issued and they see the tanking U.S. economy.
When those foreigners get skittish and stop buying our t-paper, the game is over. The bailout bill will accelerate this, is my guess.
We’ll see.
Have you seen the Federal Reserve’s balance sheet lately?
Well, have you? Today’s for instance?
I think the better question would be, “Suppose this doesn’t work. Where will we get the next $700B?”
The markets might accommodate one dip of the ladle. Not two. And that means that the plan should be guaranteed to work.
A failed President & a failed Democratic Congress are going to buy failed mortgages. Sure to be a success.
Menzie,
Thank you for responding forthrightly.
The amount of confusion about the proposed funding legislation for the mortgage bailout is only exceeded by the ancillary and irrelevant spending tacked on to the bills.
I do believe that the credit bottleneck needs to be addressed quickly, but the parasitic nature of the bill that came out of the Senate is almost beyond belief.
http://banking.senate.gov/public/_files/latestversionAYO08C32_xml.pdf
451 pages; everything after 113 seems focused on everything except to…
to
5 restore liquidity and stability to the financial system
6 of the United States
That’s a big part of why I asked an economist’s opinion. The bill may address the financial liquidity problems, but does it open Pandora’s box of future problems by pandering to so many special interests?
http://mises.org/story/3127
Throw a trillion dollars down a rathole with no debate and no alternatives considered.
Brilliant.
Yeah, it seems like there is groupthink coverage here… Just like Iraq. It is about CYA, not what is the best policy.
EVERYONE thought Iraq had WMD and EVERYONE thought we had to do something.
Still, the plan seem very weak and more debate could come up with something cheaper, better, faster and fairer.
Many policymakers fail to understand that current financial crisis has a lot in common with the crisis in the early 1930s: what is happening to commercial paper, tender offer bonds, money market mutual funds, and investment banks is classical “bank runs” — but outside the traditional commercial banks. Just as then the nation didn’t have effective tools to deal with bank runs, we don’t have effective tools to stop the runs to non-banks right now, which makes the current crisis particularly dangerous. As non-bank financial institutions are responsible for about half of the financial intermediations in the US, it is imperative that the Congress take decisive actions to stop the crisis of confidence before it is getting out of hand.
That said, I am deeply disturbed by the lack of proper guidelines in the current Bill on how the Treasury Secretary should spend the funds. I think the Congress should insist congressional involvement and oversight in establishing such guidelines.
In particular, I think the Congress should instruct the Treasury Secretary to buy mortgages and MBS only (not other problem assets) and HOLD these assets to their natural ends (paid off, refinanced, or defaulted), instead of reselling/liquidating them in some uncertain future dates as it seems to be implied in the current bill. The main advantages of HOLDING them to the ends rather than liquidating them are the followings:
* Holding the mortgages to their natural ends is more effective in calming the market and freeing up funds for financial institutions. Instead, the plan to liquidate the purchased mortgages will keep the threat of depressed prices due to such liquidation alive and discourage investors (and fresh funds) to come into the MBS market, making the relief effort less effective.
* Holding the mortgages to their natural ends also allows the Secretary to buy the mortgages at ABOVE current market prices and still breakeven. The Secretary doesn’t need to make different assumptions about future cashflow (ie, the default rates and recovery ratios) from the private sector’s, but still pay HIGHER prices for these assset. This is because the government will use a LOWER RATE to discount future cashflow (due to its lower borrowing cost than the private sector).
* Holding the mortgages to their natural ends also makes it much more transparent to the public that this emergency bill will benefit homeowners/buyers, rather than just Wall Street’s fat cats. Further, holding them to maturity is operationally much easier than having an equity stake — it can be outsourced to some mortgage servicers and no high tech/high power finance talents are needed.
* Of course, at certain stage, it may seems unnecessary for the government to continue to hold these assets. I guess the Congress can specify that the government should auction off the remainder of the portfolio no early than, say, 5 years but no later than 10 year (the portfolio should be pretty small by then as most mortgages reach their ends within 7 years or so).
Thanks JeffreyKnoll for providing the rather long-winded but accurate link diagnosing the cause of the present banking and credit crisis. I do however take exception to Murray Rothbard’s assertion (in your link) that economic boom and busts are a product of fractional reserve banking. My readings indicate that the busts are a product of excessive rent on economies, whether from taxes or debt. That’s why “Jubilee Years” were common in ancient times during ascension of a ruler, when public and private debts by fiat were forgiven.
Thanks Menzie for noticing that this most important economic event in the last 80 years finally deserves a discussion on the Econobrowser.
My viewpoint is that it is UNCONSCIONABLE that the US government will securitize as national debt, derivative instruments originated by the US investment and banking industry. We are paying off the same people who participated in the fraud.
The government, through the FDIC, Comptroller of the Currency, and the FRBs, has all the power it needs to close down insolvent banks. The government can then take equity stakes in the survivors as it recapitalizes the system via banking institutions that have proved they are well managed… The TARP legislation does little more than enable end-game bank looting before checkmate.
See this NY Times article by Gretchen Morgenson on how AIG got suckered into owing $20 billion in Credit Default Swap settlements on Goldman Sachs securities.
http://www.nytimes.com/2008/09/28/business/28melt.html?pagewanted=3&pagewanted=all&em&_r=2&oref=slogin
Bookies in the U.K. are now taking bets on the first major city to experience a government acknowledged ECONOMICALLY INDUCED RIOT:
http://www.paddypower.com/bet$action=go_type&category=SPECIALS&ev_class_id=45&ev_type_id=10467&promo=nov_WePredictaRiot&crea=top
“It is better to keep your mouth shut and appear stupid than to open it and remove all doubt.” Mark Twain
“My viewpoint is that it is UNCONSCIONABLE that the US government will securitize as national debt, derivative instruments originated by the US investment and banking industry. We are paying off the same people who participated in the fraud.”
I’ll second that, and raise you a ‘DESPICABLE’.
I think that it is quite clear that Menzie has no idea what motivates Republicans.
May I suggest “Moral Politics”, by George Lakoff? Yes, that George Lakoff, darling of Democrats everywhere this election cycle.
His latest book on “framing” is not nearly as brilliant as “Moral Politics”, which perfectly explains the “Blue-State/ Red-State” divide.
Cliff notes version: Republicans subscribe to a “Strict Father” model of the universe, and Democrats subscribe to a “nurturing mother” one.
If you think that people need discipline in order to prosper, and those that fail do so by their own incompetance, you can see why a House Republican would vote against the bailout. By the very term “bailout”, how could a House Republican, strict father that he is, vote for the thing?
What we know:
Fannie and Freddie were out of control and had to be nationalized (as if they weren’t already government).
Because of government intervention via Fannie and Freddie and other minor involvements, financial asset prices disappeared (impossibility of economic calculation under socialism). No one knows what anything is worth.
Government, meaning congressional mandates facilitated (and in some cases even forced) mortgage companies to lend at lower standards as the government took the risk (again Fannie and Freddie) overtly encouraging moral hazard.
But the foundation of all of this, whether through Fannie and Freddie or other paths, was the government providing the money to fund an over expansion of credit and an over production of housing that is now sitting idle.
Since we know this, why add more of the same as the bailout is very clearly intended to do? Isnt insanity doing the same thing over and over expecting a different result?
Additionally, most understand that Federal Reserve inflation fed the housing market helping congress create the current housing/credit crisis. A bubble cannot exist without assistance from the monetary authorities (ref. John Law, the Mississippi Bubble and the South Seas Bubble).
Current statistics from the Federal Reserve show that they are repeating the error that got us into this mess as they expand the monetary base in a Keynesian attempt to stimulate consumption to “eat” our way out of the problem.
We cannot consume ourselves out of the problem. If there is no food on the grocery shelves (no real savings in the grocery) no amount of additional money will feed your family. If there is no more real savings in the housing sector no amount of additional money will solve the housing problem.
All we need to have a repeat of the 1930s is for the president to either call on business to voluntarily prevent wages and prices from declining, on threat of government harassment, (Hoover) or freeze wages and prices by law (Roosevelt).
Keynesian ideas did it once and they can do it again. Please consider how miserably the macro-economic theories failed in the 20th Century (the Great Depression and the Great Inflation) and search to find the alternative.
I read if they dont pass this plan the government could freeze all banking activities. I saw this at http://www.gotoguy.com/?p=367. Is this possible? Can they do this?
This is an assessment sent to me by a friend that says what I was trying to say in different words.
You, must understand that from my point of view, you cannot solve a debt, de-leveraging problem, with new debt; only income can ever resolve a debt problem.
Rolling debt can only buy you some time, but even then the time is constrained by a credit crisis which is a phenomenon that accelerates…so buying time in the context of an accelerating problem is a doomed strategy.
So, I cannot get excited about this purported bailout program because it is an obvious strategy to apply new debt to allow old debt to roll over. In the context of an accelerating problem, it will be overwhelmed much faster than any on TV now realize.
What is missing, and what was discarded from the house republican opposition, was any reference to a growth strategy. A big part of the accelerating decline is the absence of any way to recover through growth once the de-leveraging is complete. Without a growth strategy there will be no demand for credit even if the de-leveraging would free up some credit. In that context your de-leveraged financial institutions will be challenged to increase earnings (other than through yield curve steepness) which can only fuel consolidation in the financial industry and continued malaise and contraction in the other sectors of our economy.
DickF – I appreciate your comment that government complicity to form another investment bubble will no longer solve the problem.
Your comment “Without a growth strategy there will be no demand for credit even if the de-leveraging would free up some credit.” is not correct. There is broad political consensus that infrastructure reconstruction, alternative energy supply, and re-industrialization are necessary in the US. It is, in my opinion, inappropriate to tack-on an investment wish-list (re-investment strategy), on a bill designed to speedily provide liquidity to the banking system. The horse-trading necessary to achieve agreement on the prioritization and strategies to achieve these goals.
Last, it is precisely because there was no government regulation, that the banking crisis has occurred. Its the proliferation of un-capitalized or under-capitalized financial contracts (derivatives), and liberalized reserve requirements (Basil II), were the accelerants to the current conflagration.
I think we should try our luck. I think the rest of the world should be asking themselves if they feel lucky.
I can think of another good scenario, that surely won’t happpen.
The bill passes, barely, and the president does a turn-around and doesn’t sign or vetos it. The president says something to the effect: “Congess has shown that they can work together and we will guarentee interbank lending. The current plan will take time to implement, I call upon congress to use this time to create a simplified plan better suited to the american people, without earmarks. And, to address the problem of default risk, the root cause of this problem, caused by the lack of growth in energy supply. While we can not increase supplies to address this particular crisis, we can help ensure it won’t happen again in the future. This cannot be done by America alone, but America must lead the way, as it has been most reticent in developing production capacity…”
The house vote is now largely symbolic. The truth is that no one knows where we are heading on this massive unwinding of our leveraged financial system.It is too bad that we are here but we are. Years of faith and confidence building in the financial system have , in the main , served us well.We did not appreciate fragility of the underpinnings of system. The abuse to the system over the last few years has now resulted in a broken banking process. The element of trust has evaporated . I cannot see how this so called bailout is going to fix anything.
Menzie, can I ask a couple of questions?
First, it seems to me that the US’s basic problem is a chronic trade deficit, which has lately been financed by mortgage borrowing by US households from other countries.
2nd, the bailout is intended to transfer excessive household mortgage debt to the Treasury.
3rd, the only longterm solution is to fix the chronic trade deficit. Such a fix would greatly improve the US’s creditworthiness in the eyes of foreign lenders, and simultaneously reduce the need for such borrowing.
4th, the primary source of the chronic trade deficit is oil imports, and has been since the 70’s.
Conclusion: the US urgently, and as it’s first national priority, needs an aggressive plan to reduce oil imports, through an aggressive increase in CAFE requirements, fuel taxes, fuel substitution (CNG, ethanol, CTL with sequestration) and domestic drilling.
Does this make sense?
oops – I should have included PHEV/ErEV/EV’s as part of fuel substitution (the most important in the long run).
Nick G: My views on the trade deficit are contained here in the Council on Foreign Relations report.
“Deflation is going to happen – globally. Either we can use the course of deflation to shape healthy economies that will provide growth and employment and productive returns on investment in future, or we can allow deflation to further enrich those miscreants whose irresponsible policies led to the violent financial collapse we are about to experience.”
Gentlemen- Please see the attached essay that succinctly describes the likely strategy behind the TARP plan. I found the link in Calculated Risk’s Comments
http://londonbanker.blogspot.com/2008/10/financial-eugenics-paulson-plan-for.html
MarkS,
Your comment “Without a growth strategy there will be no demand for credit even if the de-leveraging would free up some credit.” is not correct. There is broad political consensus that infrastructure reconstruction, alternative energy supply, and re-industrialization are necessary in the US.
Mark,
I did not make this comment, it was by a friend, but I totally agree with it. All it says is that if you can’t pay your credit card bill with your current wage you will not be able to pay the bill tomorrow if all you do is compound your debt by borrowing from another source to pay the monthly payment.
This is one of the most serious problem in our personal finances today. A few years ago John Stossel did a piece on 20/20 about people who have taken just this approach to paying off credit cards. One man had six cards with a balance over $20k on each. Over time he had secured a new credit card to pay off the old card balance. He made $30K per year.
The only way you can pay off a debt is to make more money than the payment. If you do not make more than the payment your debt will simply continue to grow and you cannot borrow. It may take some time such as with the man in Stossel’s report but the time does come.
While you may be right that “there is broad political consensus that infrastructure reconstruction, alternative energy supply, and re-industrialization are necessary in the US” but that can only come from growth.
Once again let me use a personal example. Assume my house needs repair but I can’t pay my monthly mortgage payment. Making the repairs by taking out a second mortgage is not going to help me pay my mortgage payment. My house may be in better repair when it is foreclosed but not paying the bill will still lead to foreclosure.
Without economic growth and the associated increase in tax revenue the government will simply fall deeper and deeper into the abyss of the credit crisis. Taking more tax from the productive economy will only reduce tax revenue and compound the problem.
Bottom line is that this “bailout” will at best only postpone the day of reckoning.
MarkS,
While the London Banker does not understand deflation (inflation) equating it with price decreases, his sentiment is well taken. I agree with him that this bailout is actually a bankrobbery of massive proportions that will allow those who created the problem enrich themselves at the expense of the less fortunate. But don’t forget that the money is going to be spent by those in congress and those who created the problem are in congress or at least the political class (Franklin Raines for example) and they are the ones who will be enriched by this plan just as they were from Fannie and Freddie. With the nationalization of Fannie and Freddie legislators like Barnie Frank have to find another pools of funds to suck up.
Lets use some accounting concepts to see how far off “the plan is not perfect”. Toxic mortgages sit on the asset side of the balance sheet. Selling them to the Treasury moves that sum from Term Assets up to Cash, still on the asset side. Nothing has changed in Capital on the liability side of the balance sheet. Unfortunately, Capital is where the problem is. Banks don’t have enough of it. When it gets too low, a run on the bank occurs, ala Lehman, WaMu, Wachovia, etc. Ok, Bernanke has hinted that Treasury will “overpay” the value of toxic mortgages. The “overpay” portion does add to Capital, but this is a very inefficient way to solve the solvency problem. An economist should know this, but some forget.
Then there are many problems with lack of strong oversight, lack of using markets, increasing the national debt when debt is our problem, etc. But the nub of it, is Paulson’s bail-out does very little to fix the problem – the solvency problem. Another crisis will come. Count on it – like you count on the sun rising in the morning.
I like the way John H. Cochrane put it,
Yeah, great plan there. Do I feel lucky? No I think we are going to get f*cked by this plan. And it wasn’t letting the perfect be the enemy of the good, it was the better being the enemy of the stupid.
Any explanation why the market went down after the bill passed?
What are the next steps? I can not predict, have never lived through one of these.
Looks like:
1) Bought time (unpredictable market fluctuations)
2) Recession (Market down, unemployment)
3) Inflation? (Market up nominally, really flat)
4) ?Recovery (market realy up, reemployment)
Can somebody throw out a future scenario? How long does it take and what are the milestones?
If politics is important assume Obama wins. I personally don’t care which one wins, I recently parted ways with my long-time affiliation.
DickF – I implied that the Growth Strategy you noted is absent from the TARP bill might involve infrastructure, alternative energy, and re-industrialization. Industrialization will supply the trade credits, alternative energy will reduce the trade imbalance and inflation, and infrastructure the means to conduct trade.
I totally agree with your comments regarding personal finance, and by extension our national finances. Revolving credit is only delaying the inevitable. I do however strongly believe, that the accumulated household debt in America can no longer be serviced. Consequently credit losses will have to be absorbed. Right now, we’re seeing it in real estate and brokerage debt, and will soon see it in consumer credit, small businesses, and recent LBO privatizations. When sufficient debt has been liquidated, the capacity for credit expansion will re-emerge, allowing significant re-investment.
Steve Verdon – I think the market went down after the TARP bill passed, because some investors were disappointed that the House did not vote it down, so that it could be re-written in a more morally and economically palatable manner. Others cashed out, thinking the market will slide further since general consensus and the TARP bill confirms that we are sliding into a protracted and nasty global recession.
KevinM – My guess is the following scenario:
KevinM,
I agree with your first point, that this package buys us some time. But I believe that in the past 14 months we have been going through classical “bank runs” on non-bank financial institutions. What we learned in the 30s is that widespread bank runs are difficult to stop. So I think it is too early to assume that the financial/credit/confidence crises will be over with the package. I think the prudent approach is to use the bought time to set up some institutions to deal with possible future runs on institutions such as banks, money market mutual funds, commercial paer, etc.
Menzie, you’re forgetting that Dirty Harry was actually bluffing in that scene and that using this analogy means that the politicians behind the plan are bluffing too.
Stefan,
What makes you think Menzie was forgetting this? They probably are bluffing. This whole thing will probably turn out to be a ruse and I imagine that most of those who voted for the bailout either have no idea what they voted for or they understand that it doesn’t work so they are just “bluffing” until after the next election.
MarkS,
Thanks for clearing up your comment.
I think that you and I still have a difference of opinion. You see for the government to do as you suggest means they have to take even more from the productive economy.
If the investment in infrastructure, alternative energy, and re-industrialization is driven by the market, the consumer, the desires of people, then it could lead to growth, but if it is driven by government it will lead to more indebtedness. If the consumer places a higher value on other investments, then using government force to impose them on the market will simply lead to more economic dislocations and be counter-productive to your intent.
Well, the bailout passed, the TED spread is still blown out, and the stock market still tanked.
How do you like your trillion dollars down a rathole now?
Stefan Karlsson: That statement makes it into the movie twice. Think about the second time…
—
Richard Bove, an analyst at Punk Ziegel & Co claims in an interview with Fast Money, CNBC
that the large banks are in good shape and a good investment at this point. He claims that the large commercial banks are doing well and lending money to each other. In contrast the non-banking financial sector is suffering (along with States looking to raise money through bond issues).
Dick Bove is talking his book; he’s been bullish on big banks for quite some time now. He might be right for a short-term trade; this credit crisis will nevertheless take down the real economy and reduce big bank earnings going forward. The trailing multiples are still high and history suggests that these big bank share prices will gradually trade much, much lower.
————–
With respect to “feeling luck” and self-inflicted wounds that the mangled metaphor implies, I’m trying to think of a one-sided prisonner dilemma game that would capture this situation. Still thinking. Confirmatory bias, envy, and an ideological disposition to illusory self-sufficiency seem like more promsing explanations without the encumberance of non co-operative game theoretical framework.
Cannot help but think that Scandanavians are simply better managers of markets and natural resources than North Americans.
Talking this over with a friend, dean of B school, we came to agreement that this bailout is a mistake for reasons mostly stated above.
1. The problem is understated by 10 to 100 times, and nobody really knows what it really is.
2. New income is what is needed, and that requires investment in revenue production. Not meaning to be tautalogical here, just that we should be evaluating every cent we spend for how high its ROI is for the GDP. If we do that, we can get out of this mess. If we don’t we will probably crash.
3. Having blown so much on Afghanistan and Iraq, we no longer have much leeway fiscally. In 2000, we were in great shape. Now it looks like we are going to crack or go moribund for a good long time. (Modern wars are terrible investments. They are the national equivalent of buying a yacht – a hole in the ocean into which you throw money.)
4. The demographics of the baby boomers are against us in the US.
The saving grace of the “bailout” is that it isn’t $700 billion. It is $150 billion, and another $150 billion of pork. The pork, interestingly, ois probably the best part of it, if it is positive ROI on the investment.
We are in serious trouble. Very.
The bailout plan is good in the sense that it will turn stock market up, which is essential as wall street is critical in capital formation. We we explain below, the market will be up this week.
For those of you who are being influenced (implicitely at least) by market reaction to bailout plan passage, with all due respect I think you need to understand market prices better. The market follows technicals, and the point at which it was when the deal was signed was in the area of sellers. That is why it went down. I had to go search for buyers who were down in the low level.
It has been doing this since the monday bottom. We have been using this observation to time this market since Monday end of day, and we have been right in timing each and every daily top and bottom.
For instance we issued a call to buy the bottom of Thursday, and to sell the top of today (Friday).
Last call is to buy the bottom of today (Friday) at close.
http://marketwarnings.blogspot.com/2008/10/stock-market-trading-call-profit-taking.html
Follow the Warren Buffet model – – –
There are trillions of dollars on the sidelines ready to come into the market and begin taking equity positions in troubled FI’s. The asset side of FI’s balance sheets have shrunk while the liability side has remained relatively unchanged. FI’s will have no other option but to dilute ownership and sell equity stakes to raise cash. Look for private equity, sovereign wealth funds, etc to provide the cash infusions.
The intermediate step to get us to the point at which cash will flow in? — –The Treasury swap will replace bad assets with cash. The asset side of FI’s balance sheets may not increase in value but FI’s will have replaced a risky asset with cash. At this point private funds will flow into the FI’s in exchange for equity stakes.
One by one, FI’s will receive infusions from the private sector and become solvent. Counterparty risk will be reduced and the newly solvent FI’s will resume lending to one another.
The biggest obstacle at this point is getting Bernanke and Paulson to reveal the details of their plan to the market, and for the market to believe the plan will work.