Economic Dreams - Economic Nightmares

Financial "Rock, Paper, Scissors"

Let the rock be gold, the paper be money, and the scissors, a shredder. We have a stage set for "financial rock, paper, scissors". From a historical perspective, we can easily trace the most recent path from gold to paper money (or fiat currency) as it has played out on the world stage—officially beginning in 1971 when President Richard Nixon officially declared the US to be off the gold standard. Numerous books have been written on the matter. Here is a very short history that begins in 1913 titled "Privatize the Gains, Socialize the Losses", by Peter Treadway. Paper covers rock! {Note: Treadway's paper isn't the best short history around, and may replace it with something else, but I do like the title.}

What is just now playing out is the predicted credit bust that predates the shredding of the paper money when market cycles turn ugly. Or maybe it doesn't precede shredding (partial shredding via inflation really), but someone will have to explain to me just how we get out of this mess otherwise. Oh, I almost forgot Mosler's Law: "There is no financial crisis so deep that a sufficiently large increase in public spending cannot deal with it." I'll post more on the "Chartalist fix" soon.

Numerous blogs are now tracking the debt bubble that is still building (and shifting from "private" to "public") in the wake of the credit bubble. Few are offering acceptable resolutions to the debt problem. At least I'm not finding them—or accepting them. Here are a few places that track the problem: Doug Noland's Credit Bubble Bulletin, Steve Keen's Oz Debtwatch, Edward Harrison's Credit Writedowns.

Paul Krugman, among other Keynesian economists, advocates higher inflation to create more space for interest rate cuts in times of stress. Of course "higher inflation" for awhile would help the government out from under some of the debt burden too. But at the expense of those on fixed incomes, unless tax policy or other means were used to make "fixed incomes" types whole again.

Many on the "right" seem to want to blast Krugman for advocating that we inflate our way out of the crisis, as if that were (1) true, and (2) the only tool Krugman advocates for. Yet the Feb 12 IMF paper, "Rethinking Macroeconomic Policy" (pdf) Krugman points to in a recent post, talks through various tools to try to find a path forward, including

• Raising the Inflation Target
• Combining Monetary and Regulatory Policy
• Higher Inflation Targeting and Foreign Exchange Intervention
• Providing Liquidity More Broadly
• Creating More Fiscal Space in Good Times
• Designing Better Automatic Fiscal Stabilizers

Neo-chartalists, at least some of them, advocate what I'll call an "modern-day alchemy fix" to the debt problem, remember: "There is no financial crisis so deep that a sufficiently large increase in public spending cannot deal with it."

In any supposed "fix" there will be winners and losers, with the government in the middle of the mess. Scary times ahead! Both the Keynesian and the Chartalist approach suggests inflation. But how much? Scissors cut paper! Out come the shredders, figuratively, to cut up the paper. Inflation to counter deflation? Or runaway inflation? What other ideas are worth looking at? Maybe it is as simple as re-regulation — as if that were simple — but I doubt it.

If the "scissor act" is too flagrant, as it may well be given the size of the debt we are dealing with, we will see a substantial loss of faith in US currency. Such could trigger wide-spread panic and subsequent worldwide Depression. At minimum we would see at least some countries try to mimic the US move, which might set a stage for hyperinflation. What China and the Arab states might do in response is an open question, particularly if we repudiate the debt outright apply Mosler's Law as some Neo-Chartalists advocate.

The point of this little note is to suggest that in the wake of inflationary actions to deal with the debt bubble, we will likely see — already are seeing, e.g."We are All Austrians Now" — calls for a return to what might be called 21^st century gold standard. If that were to become a political necessity, we will have come full circle: Rock crushes scissors!

I hope that we can stay with fiat currency and find means to deal with the mess at hand. But I am outclassed by most of the economists and finance experts I follow. So I watch and read, and occasionally comment. The "mess" is once-again center stage as the PIIGS threaten default. And California and other messes closer to home will prove interesting to watch as this year unfolds. This is a Wicked Problem of global proportions. But that is a story for another day.

Minsky Wake-up Call

For several years I've been using this blog to bring attention to the work of American economist Hyman Minsky — and watching to see who might be warming up to the work he began and others continue at the Levy Economics Institute at Bard College. In brief, the work is Post Keynesian and tracks money and credit flows with an eye toward instability — stability breeds instability and fragility trumps resilience at times. Bubbles need to be dealt with as they emerge, not by papering over them in the aftermath. Now Financial Times' Martin Wolf, building on a paper from Carmen Reinhart and Kenneth Rogoff deliveris a wake-up call to American bankers: Pay Attention to Minsky!

I will be watching around the blogosphere to see who else, particularly among American economists seems to be warming up to the real causes of great contractions, and who begins to show signs of learning lessons not-yet-learned. I will update this post and add others as I see evidence of economists waking up. Economists have lead the decent to the edge of the Abyss, and are rightfully blamed for their part in the mess. To Wolf:

Asia's revenge, Martin Wolf, October 8, Financial Times: What confronts the world can be seen as the latest in a succession of financial crises that have struck periodically over the last 30 years. The current financial turmoil in the US and Europe affects economies that account for at least half of world output, making this upheaval more significant than all the others. Yet it is also depressingly similar, both in its origins and its results, to earlier shocks. …

Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University identify the similarities in a paper published earlier this year.* They focus on previous crises in high-income countries. But they also note characteristics that are shared with financial crises that have occurred in emerging economies.

This time, most emerging economies have been running huge current account surpluses. So a "large chunk of money has effectively been recycled to a developing economy that exists within the United States' own borders", they point out. "Over a trillion dollars was channelled into the subprime mortgage market, which is comprised of the poorest and least creditworthy borrowers within the US. The final claimaint is different, but in many ways the mechanism is the same." …

[L]inks between the financial fragility in the US and previous emerging market crises mean that the current banking and economic traumas should not be seen as just the product of risky monetary policy, lax regulation and irresponsible finance, important though these were. They have roots in the way the global economy has worked in the era of financial deregulation. Any country that receives a huge and sustained inflow of foreign lending runs the risk of a subsequent financial crisis, because external and domestic financial fragility will grow. Precisely such a crisis is now happening to the US and a number of other high-income countries including the UK.

These latest crises are also related to those that preceded them – particularly the Asian crisis of 1997-98. …

The big global macroeconomic story of this decade was, then, the offsetting emergence of the US and a number of other high-income countries as spenders and borrowers of last resort. Debt-fuelled US households went on an unparalleled spending binge – by dipping into their housing "piggy banks".

In explaining what had happened, Ben Bernanke, when still a governor of the Federal Reserve rather than chairman, referred to the emergence of a "savings glut". The description was accurate. After the turn of the millennium, one of the striking features became the low level of long-term nominal and real interest rates at a time of rapid global economic growth. Cheap money encouraged an orgy of financial innovation, borrowing and spending.

That was also one of the initial causes of the surge in house prices across a large part of the high-income world, particularly in the US, the UK and Spain. …

The savings glut had another dimension, related to a second financial shock – the bursting of the dotcom bubble in 2000. One consequence was the move of the corporate sectors of most high-income countries into financial surplus. In other words, their retained earnings came to exceed their investments. Instead of borrowing from banks and other suppliers of capital, non-financial corporations became providers of finance.

In this world of massive savings surpluses in a range of important countries and weak demand for capital from non-financial corporations, central banks ran easy monetary policies. They did so because they feared the possibility of a shift into deflation. The Fed, in particular, found itself having to offset the contractionary effects of the vast flow of private and, above all, public capital into the US.

A simple way of thinking about what has happened to the global economy in the 2000s is that high-income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked. …

[L]inked dangers between external and internal imbalances, domestic debt accumulations and financial fragility were foretold by a number of analysts. Foremost among them was Wynne Godley of Cambridge university in his prescient work for the Levy Economics Institute of Bard College, which has laid particular stress on the work of the late Hyman Minsky.**

So what might – and should – happen now? The big danger, evidently, is of a financial collapse. The principal offset, in the short run, to the inevitable cuts in spending in the private sector of the crisis-afflicted economies will also be vastly bigger fiscal deficits.

Fortunately, the US and the other afflicted high-income countries have one advantage over the emerging economies: they borrow in their own currencies and have creditworthy governments. Unlike emerging economies, they can therefore slash interest rates and increase fiscal deficits.

Yet the huge fiscal boosts and associated government recapitalisation of shattered financial systems are only a temporary solution. There can be no return to business as usual. It is, above all, neither desirable nor sustainable for global macroeconomic balance to be achieved by recycling huge savings surpluses into the excess consumption of the world’s richest consumers. The former point is self-evident, while the latter has been demonstrated by the recent financial collapse.

So among the most important tasks ahead is to create a system of global finance that allows a more balanced world economy, with excess savings being turned into either high-return investment or consumption by the world’s poor, including in capital- exporting countries such as China. A part of the answer will be the development of local-currency finance in emerging economies, which would make it easier for them to run current account deficits than proved to be the case in the past three decades.

It is essential in any case for countries in a position to do so to expand domestic demand vigorously. Only in this way can the recessionary impulse coming from the corrections in the debt-laden countries be offset.

Yet there is a still bigger challenge ahead. The crisis demonstrates that the world has been unable to combine liberalised capital markets with a reasonable degree of financial stability. A particular problem has been the tendency for large net capital flows and associated current account and domestic financial balances to generate huge crises. This is the biggest of them all.

Lessons must be learnt. But those should not just be about the regulation of the financial sector. Nor should they be only about monetary policy. They must be about how liberalised finance can be made to support the global economy rather than destabilise it.

This is no little local difficulty. It raises the deepest questions about the way forward for our integrated world economy. The learning must start now.

*Is the 2007 US subprime financial crisis so different? An international historical comparison. Working paper 13761, www.nber.org

**The US economy: Is there a way out of the woods? November 2008, www.levy.org [concluding hyperlinks empowered by Iverson]

For more from the Levy Economics Institute see, e.g., Macroeconomics Meets Hyman P. Minsky: The Financial Theory of Investment, L. Randall Wray and Éric Tymoigne, September, 2008:

Expanding on an approach developed by financial economist Hyman Minsky, the authors present an alternative to the standard "efficient markets hypothesis—the relevance of which Minsky vehemently denied. Minsky recognized that, in a modern capitalist economy with complex, expensive, and long-lived assets, the method used to finance asset positions is of critical importance, both for theory and for real-world outcomes—one reason his alternate approach has been embraced by Post Keynesian economists and Wall Street practitioners alike.

[Wray and Tymoigne] argue that the current financial crisis, which began with the collapse of the U.S. subprime mortgage market in 2007, provides a compelling reason to show how Minsky’s approach offers us a solid grounding in the workings of financial capitalism. They examine Minsky’s extension to Keynes’s investment theory of the business cycle, which allowed Minsky to analyze the evolution, over time, of the modern capitalist economy toward fragility—what is well known as his financial instability hypothesis. They then update Minsky's approach to finance with a more detailed examination of asset pricing and the evolution of the banking sector, and conclude with a brief review of the insights that such an approach can provide for analysis of the current global financial crisis

Another Frightening Show About the Economy: NPR Edition

If you want to get really scared/mad about our current financial mess, take an hour and listen to last Friday's version of Chicago Public Radio's This American Experience, titled Another Frightening Show About the Economy.

Act One: The Day the Market Died
Act Two: Out of the Hedges and into the Woods
Act Three: Swap Cops
Act Four: What's Next

A few quick notes:

Act One helps us better understand how the very boring arena of Commercial Paper recently caught the attention of high government officials when the arena suddenly dried up, threatening businesses small and large, state governments, and more.

Act two delves deep into Credit Default Swaps and might be subtitled: How 'Insurance' morphed into 'Speculation' on a massive, unprecendented scale. If you want to get a good feel for these arcane instruments, listen closely. A Snip: "If bad mortgages got the financial system sick, [Credit Default Swaps] helped spread the sickness into an epidemic."

Act Three helps us better understand Regulation (or the lack of it). For example, Why were CDSs not regulated, say, way back in 1998 when Michael Greenberger, then with the U.S. Commodities Futures Trading Division, and others tried to get such regulation? Many in the Clinton Administration and Congress argued, according to Greenburger, "These products are entered into by very sophisticated financial institutions … you and I couldn't buy them … and these people are very, very smart and it is a mistake to let government get in the way." In Dec. 2000, Congress passed a law — as a little-discussed 262 page rider to an Omnibus Appropriations Bill — that credit default swaps and things like them could not be regulated. So it went! So it goes… Nobody was even trying to restrain the investors, turned 'speculators.'

Greenburger concludes, "… The idea that you can have $60 Trillion in a financial market which is more than all the stock sold anywhere in the world and not have any oversight whatsoever is self-evidently absurd, and we are seeing the end result of that today."

Act Four give us some insight into the Bailout Bill as it was, and as it transformed into Law.

And if that whets your appetite, listen/read to Michael Greenberger's Sept. 17 Was Adult Supervision Needed on Wall Street?, also from NPR.

HT: Calculated Risk

60 Minutes Does the Shadow Financial System

Last Night 60 Minutes aired an enlightening 12 min. spot on the Shadow Financial System — in which James Grant blames Wall Street investment houses, in the main, for the mess that not only bought the investment banks to the brink of ruin, but also all but wrecked (so far!) the worlds financial systems. It reminds me of an old line from Sci Fi author Robert Heinlein, paraphrasing, "People don't learn from the mistakes of others. They seldom learn from their own mistakes. Never underestimate the power of human stupidity."

As for mistakes, I agree with some of the 60 minutes interviewees that what happened at the top of the investment banks, and among some of their top traders, was likely more the stuff of outright graft and corruption than the stuff of mistakes. The big mistakes were made by the Fed, by the SEC, the so-called rating agencies, and others — in Congress and several Administrations who failed to see not only the bubbles they were blowing (Nasdaq, the housing bubble, and others around the world), but failed to regulate — were indeed actively deregulating — the financial markets. And not all the government players should be left out of the graft and corruption charges. Blame too a distracted American public more interested in watching "Reality" TV, sports and other amusements, than in watching what was happening to their government, to thier retirement funds, and so on.

Watch it:

Watch CBS Videos Online

Speculative Orgy Gone Bust: Bogle and Noland

This morning on NPR, John Bogle, founder of The Vanguard Group, said that we have a "Speculative orgy like nothing we've ever seen before in the history of the United States. … We've become a market dominated by speculators not by investors.

"I don't know if [the bailout] can succeed. I mean Goldman Sachs collecting deposits from investors, putting an ATM on every corner. I can't imagine it. … I worry about mixing banking — commercial banking — and investment banking, just like they worried about when they put in the Glass Steagall Act back in1933 or 1934."

Meanwhile, Prudent Bear's Doug Noland weighs in, particularly on the over-leveraged nature or our system:

The Wall Street Bust, 10/02: … It is today impossible to comprehend the full ramifications from The Bust in Wall Street Finance. Yet we can be rather certain that for the foreseeable future much less Credit and liquidity will be directed to the asset markets. And, at the same time, there will be significantly less Credit Availability for riskier loans of all varieties — for the household, business, financial and the government sectors. Few appreciate that these dynamics are extremely problematic for the U.S. Bubble Economy — an economic system that had come to a large extent to be governed by asset-based and high-risk lending. These dynamics are at the heart of today's Acute Financial and Economic Fragility and the resulting imploding markets.

The leveraged speculating community played such an integral role in the overall Credit Bubble and, more specifically, to the Bubble in Wall Street Finance. They were instrumental in both spurring financial sector Credit creation/leveraging, while directing this Flood of Finance to the asset markets. And the more the leverage and the greater the Flow to inflating markets, the higher the returns generated by this expanding pool of speculative finance. And the greater the returns, the more robust the "investment" flows into the hedge fund community — spurring more leverage and more potent fuel for additional self-reinforcing asset inflation. Well, this historic speculative Bubble is now in the process of blowing up. One of the greatest manias ever — surely The World's Greatest Episode of "Ponzi Finance" — is absolutely coming apart. And the wreckage is accumulating in all markets — everywhere.


Here at home, our maladjusted economic system will only be sustained by somewhere in the neighborhood of $2.0 TN of new Credit. It's simply not going to happen. The $700bn from Washington would seem like an enormous amount of support. In reality, it's nowhere even close to the amount necessary for systemic stabilization. To the $2.0 TN or so of new Credit required this year (and next) add perhaps as much as several Trillion more necessary to accommodate speculative de-leveraging (liquidations forced by huge losses). Importantly, the Bust in Wall Street Finance has ensured that insufficient liquidity will be forthcoming to maintain inflated asset prices and sustain the Bubble economy — creating catastrophe for the leveraged speculating community.

The "Freidmanites" thought they understood the (post-crash) policy mistakes that led to The Great Depression. They believed the "Roaring Twenties" was the "Golden Age of Capitalism." The great bust could have been avoided with a simple ($5bn or so) banking system recapitalization. As we are witnessing today, the issue is not some manageable amount of new "capital" to replenish banking system losses. Instead, the predicament is the massive and unmanageable amount of new Credit necessary to, on the one hand, sustain a mal-adjusted Bubble Economy and, on the other, the Trillions more required to accommodate a gigantic speculative de-leveraging. I have a very difficult time seeing a way out of this terrible mess.

I too have a difficult time seeing a way forward. It looks like we will have to do what Sweden did, but on a far larger scale — nationalize our financial system for a time — that either will bring hedge funds under the regulatory umbrella along with commercial banks, kill hedge funds outright, else ensure that hedge funds individually or collectively can't themselves be the next too-big-to-fail excuse for yet another government bailout. And let's hope that we get rid of the idea of Government Sponsored Enterprises (GSEs) and either keep Fannie Mae and Freddie Mac as government entities, else (not my preference) privatize them.

Kicking the Can Down the Road

The US House of Representatives Just passed what is best know as 'The $700 Billion Bailout Bill', now "larded up" sunstantially. Yves Smith, in an hour-long videoblog interview with Megan McArdle (Oct 1), argues that all that they have done is to kick the can done the road — problems will return again as early as November/December. Watch the hour-long interchange to gain a better pespective as to how we got into this mess over the last 40 years, what it means now and going forward.

Paul Krugman seems to agree that all this Bill will do, at best, is to buy time saying in The Edge of the Abyss (NY Times Oct 2)

… [A]t best, the plan will buy some time to seek a real solution to the crisis.

And that raises the question: Do we have that time?

A solution to our economic woes will have to start with a much better-conceived rescue of the financial system — one that will almost surely involve the U.S. government taking partial, temporary ownership of that system, the way Sweden’s government did in the early 1990s. Yet it’s hard to imagine the Bush administration taking that step.

We also desperately need an economic stimulus plan to push back against the slump in spending and employment. And this time it had better be a serious plan that doesn’t rely on the magic of tax cuts, but instead spends money where it’s needed. (Aid to cash-strapped state and local governments, which are slashing spending at precisely the worst moment, is also a priority.) Yet it’s hard to imagine the Bush administration, in its final months, overseeing the creation of a new Works Progress Administration.

So we probably have to wait for the next administration, which should be much more inclined to do the right thing — although even that’s by no means a sure thing, given the uncertainty of the election outcome. (I’m not a fan of Mr. Paulson’s, but I’d rather have him at the Treasury than, say, Phil "nation of whiners" Gramm.)

Nobody I read likes the "Plan" much, but many seem to think it will buy time. Some like Dean Baker don't think it was needed at all. See Baker's Sept. 29 Wall Street Held a Gun to our Heads. We'll never know whether those who wanted us to let-it-ride were correct. But we can wait and see whether this does little long-term to solve the big problems of tightly-coupled, structured-finance markets that were badly designed to cope with the mechanisms by which Wall Street insiders, big Hedge Fund managers, and others stole so much from too many of us.

A Trillion Here, A Trillion There

Rumor has it that former US Congressman Everett Dirksen once quipped "… a billion here, a billion there, and pretty soon you are talking about some real money." In the last few years we've upped the ante. Now it's a trillion here, a trillion there — on the Wall Street Bailout, on the Iraq War, for instance. It looks like the NeoCons have at least insured that the government will be squeezed in times to come. Their dark dream of Starving the Beast, however, is not a short-term outcome though. Looks like the US government is getting ever-more-powerful by the day and by the year, in both military and financial arenas. Or maybe that was their real dream after all. Sad but likely true: Too few NeoCons will go to jail. Too many of the rest of us will suffer.

Here is Gretchen Morgenson's take on the latest phase of the mess in today's NY Times, subtitled Fixing Others' Mistakes:

…Treasury Secretary Henry M. Paulson Jr. [Paulson] has called the fund the "troubled asset relief program." I'll just call it TARP for short (you know, the kind of thing they spread over muddy fields so you don’t soil your Guccis). [Iverson note: Yesterday, Willem Buiter called it a TAD: Toxic Asset Dump ].

And depending on how TARP is operated, and how the assets are valued before taxpayers are forced to buy them, it could bloat our final bill for this mess while benefiting the very institutions that got us into it.
Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running. But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren't visited upon TARP.

Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let’s assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar.

So what's a fair price that we TARPistas should pay for the assets?

If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents.

Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again.

Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very
minute to ensure that the TARP valuations are rigged in their favor?

You know the answer to that.

And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage, that drove us into this ditch.

Such is our lot today: They break it. We own it. …

For background, here is yesterday's NY Times look at Hank Paulson and Ben Bernanke's recent takeover of the US financial system: A Professor and a Banker Bury Old Dogma on Markets .

Today Paul Krugman tells us that he isn't sure that the TARP isn't instead just the perverbial 'wool pulled over our eyes':

Thinking the Bailout Through: … Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that's the real plan, Congress has every right to balk.

So what should be done? Well, let's think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn't the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let's not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.

Yves Smith hates the Paulson/Bernanke plan too, and tries to help us better understand why:

Why You Should Hate the Treasury Bailout Proposal …First, let's focus on the aspect that should get the proposal dinged (or renegotiated) regardless of any possible merit, namely, that it gives the Treasury imperial power with respect to a simply huge amount of funds. $700 billion is comparable to the hard cost of the Iraq war, bigger than the annual Pentagon budget. And mind you, $700 billion is not the maximum that the Treasury may spend, it's the ceiling on the outstandings at any one time. It's a balance sheet number, not an expenditure limit.

But here is the truly offensive section of an overreaching piece of legislation:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

This puts the Treasury's actions beyond the rule of law. This is a financial coup d'etat, with the only limitation the $700 billion balance sheet figure. The measure already gives the Treasury the authority not simply to buy dud mortgage paper but other assets as it deems fit. There is no accountability beyond a report (contents undefined) to Congress three months into the program and semiannually thereafter. The Treasury could via incompetence or venality grossly overpay for assets and advisory services, and fail to exclude consultants with conflicts of interest, and there would be no recourse. Given the truly appalling track record of this Administration in its outsourcing, this is not an idle worry.

But far worse is the precedent it sets. This Administration has worked hard to escape any constraints on its actions, not to pursue noble causes, but to curtail civil liberties: Guantanamo, rendition, torture, warrantless wiretaps. It has used the threat of unseen terrorists and a seemingly perpetual war on radical Muslim to justify gutting the Constitution. The Supreme Court, which has been supine on many fronts, has finally started to push back, but would it challenge a bill that sweeps aside judicial review? …

And Robert Reich said on Thursday that The Bailout of All Bailouts leaves too much room for future Wall Street shenanigans, for future "moral hazard."

… 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" incentive for future financial wizards to take giant risks with other taxpayers' money.

Today Reich lays out five conditions that ought to be placed on any Bailout:

What Wall Street Should Be Required to Do, to Get A Blank Check From Taxpayers … 1. The government (i.e. taxpayers) gets an equity stake in every Wall Street financial company proportional to the amount of bad debt that company shoves onto the public. So when and if Wall Street shares rise, taxpayers are rewarded for accepting so much risk.

2. Wall Street executives and directors of Wall Street firms relinquish their current stock options and this year’s other forms of compensation, and agree to future compensation linked to a rolling five-year average of firm profitability. Why should taxpayers feather their already amply-feathered nests?

3. All Wall Street executives immediately cease making campaign contributions to any candidate for public office in this election cycle or next, all Wall Street PACs be closed, and Wall Street lobbyists curtail their activities unless specifically asked for information by policymakers. Why should taxpayers finance Wall Street’s outsized political power – especially when that power is being exercised to get favorable terms from taxpayers?

4. Wall Street firms agree to comply with new regulations over disclosure, capital requirements, conflicts of interest, and market manipulation. The regulations will emerge in ninety days from a bi-partisan working group, to be convened immediately. After all, inadequate regulation and lack of oversight got us into this mess.

5. Wall Street agrees to give bankruptcy judges the authority to modify the terms of primary mortgages, so homeowners have a fighting chance to keep their homes. …

I can't wait to see what the next few weeks/months bring. "Interesting Times" indeed! Looks like a good time for me to resume this blog…

Willem Buiter: Reigning in ‘Leverage’ to Restrain Asset and Credit Boom-busts

In a very good Financial Times post, Willem Buiter weighs in on "leverage", "asymmetry", and the very important need to create institutional means to disallow financial entities from capitalizing via leverage on the upside of credit booms while running for the protective cover of the government on the often sudden downsides.

Buiter has three recommendations, highlighted below, that ought to be vetted carefully as we work our way from the 'wilds' of our current deregulated escaped-from-regulation system into a relatively tamer future-world of once-again, reasonably 'structured finance'. In short, Butier recommends (shortening his commentary a wee bit): (1) common risk-adjusted Basel II-type capital adequacy requirements and reporting requirements imposed on all large institutions whose leverage exceeds a given value, (2) minimal funding liquidity and market liquidity requirements be imposed on, respectively, the liability side and the asset side of the balance sheets of all large leveraged financial institutions, and (3) all large leveraged institutions deemed too large, too interconnected, or simply too well-connected to fail, be made subject to a Special Resolution Regime along the lines that exists today for deposit-taking institutions through the FDIC. To Butier:

Restraining asset and credit booms, Willem Buiter, ft.com, May 25, 2008: … [There is] a major asymmetry in the macroeconomic policy and financial stability framework. This asymmetry is not that interest rates respond more sharply to asset market price declines than to asset market price increases. Even if there were no 'Greenspan-Bernanke put', such asymmetry should be expected because asset price booms and busts are not symmetric. Asset price busts are sudden and involve sharp, very rapid asset price falls. Even the most extravagant asset price boom tends to be gradual in comparison. So an asymmetric response to an asymmetric phenomenon is justified. This does not mean that there has been no evidence of a 'Greenspan-Bernanke' put, of course. In fact I believe that phenomenon - excess sensitivity of the Federal Funds target rate to sudden declines in asset prices, and especially US stock prices - to be real, unfortunately.

Fundamentally, the key asymmetry is that the authorities are unable or unwilling, whether for good or bad reasons does not matter here, to let large leveraged financial institutions collapse. There is no matching inclination to expropriate or otherwise financially punish or restrain highly profitable financial institutions. This asymmetry has to be corrected. Therefore, any large leveraged financial institution, commercial bank, investment bank, hedge fund, private equity fund, SIV, Conduit or whatever it calls itself, whatever it does and whatever its legal form, will have to be regulated according to the same principles.

Operationally, the asymmetry is that there exists a panoply of liquidity-and credit-enhancing measures that can be activated during an asset market bust and during a credit crunch, to enhance the availability of credit and to lower its cost, but no corresponding liquidity- and credit-restraining instrumentarium during a boom. When financial markets are disorderly, illiquid or have seized up completely, the lender of last resort and market maker of last resort can spring into action. …

Leverage is the key
These asymmetries have to be corrected through regulatory measures, effectively by across-the board credit controls. Every asset and credit boom in history has been characterised by rising leverage. The one we are now suffering the consequences of is no exception. Leverage is a simple concept which may be very difficult to measure, as those struggling to quantify the concept of embedded leverage will know. …

Traditional sources of leverage include borrowing, initial margin (some money up front - used in futures contracts) and no initial margin (no money up front - when exposure is achieved through derivatives).

I propose using simple measures of leverage, say a measure of gross exposure to book equity, as a metric for constraining capital insolvency risk (liabilities exceeding assets) of all large, highly leveraged institutions. Common risk-adjusted Basel II-type capital adequacy requirements and reporting requirements would be imposed on all large institutions whose leverage, according to this simple metric, exceeds a given value. These capital adequacy requirements would be varied by the monetary authority in countercyclical fashion.

To address the second way financial entities can fail, what the CRMB calls liquidity insolvency, meaning they run out of cash and are unable to raise new funds, I propose that minimal funding liquidity and market liquidity requirements be imposed on, respectively, the liability side and the asset side of the balance sheets of all large leveraged financial institutions. These liquidity requirements would also be tightened and loosened by the monetary authority in countercyclical fashion.

Finally, I would propose that all large leveraged institutions that are deemed too large, too interconnected, or simply too well-connected to fail, be made subject to a Special Resolution Regime along the lines that exists today for deposit-taking institutions through the FDIC. … [emphasis mine]

NPR Does Subprime

If you want a very good lay person's edition of the Credit Bubble mess, listen to NPR's Global Pool of Money Got Too Hungry (audio, 13 min., All Things Considered, May 9): "Adam Davidson and This American Life's Alex Blumberg jointly report on how rising defaults on subprime mortgages in the U.S. have became a global financial crisis. This American Life host Ira Glass talks with Michele Noris".

NPR demystifies SEVs, CDOs, MBSs, "Liar Loans," and more. The narrative concludes: "… Nobody really questioned things. And why should they? Everybody was making money — right up to the day the bottom fell out."

An hour-long version — The Giant Pool of Money — airs this weekend on This American Life.

James Galbraith on the 'Collapse of Monetarism'

Hyman Minsky, John Kenneth Galbraith and John Maynard Keynes take center stage as James Galbraith throws down the gauntlet to contemporary mainstream economists. Speaking at the 25th Annual Milton Friedman Distinguished Lecture at Marietta College, Marietta, Ohio, Jamie Galbraith asks Fed Chair Ben Bernanke and a host of others to embrace the " intellectual victory of John Maynard Keynes, of John Kenneth Galbraith, of Hyman Minsky." — else to explain "why not". We will search and update on any "why nots" if and when they surface. To Galbraith:

The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus [PDF], by James K. Galbraith, March 31, 2008 : … I come to bury Milton [Friedman], not to praise him. But I would like to do so on the terrain that he favored, where he was strong, and over which he ruled for many decades. This is monetary policy, monetarism, the natural rate of unemployment and the priority of fighting inflation over fighting unemployment. It is here that Friedman had his largest practical impact and also his greatest intellectual success. It was on this battleground that he beat out the entire Keynesian establishment of the 1960s, stuck as they were on a stable Phillips Curve. It was here that he set the stage for the counter-revolution that has dominated academic macroeconomics for a generation, and that – far more important — also dominated and continues to influence the way in which most people think about monetary policy and the fight against inflation.

What was monetarism? Friedman famously defined it as the proposition that "inflation is everywhere and always a monetary phenomenon." This meant that money and prices were tied together. But more than that, Friedman believed that money was a policy variable — a quantity that the Central Bank could create or destroy at will. Create too much, there would be inflation. Create too little, and the economy might collapse. There followed from this that the right amount would generate the right result: stable prices at what Friedman came to call the natural rate of unemployment.

The intent and effect of this line of reasoning was to defend a core proposition about capitalism: that free and unfettered markets are intrinsically stable. In Friedman's gospels government is the lone serpent in Eden, while the task of policy is to stay out of the way. Just as this was the vulgar lesson of "Free to Choose" so it turns out it was also the deep lesson of the larger structure of Friedman's thought. Friedman and Schwartz's Monetary History for all its facts and statistics carried a simple message: the market did not fail; the government did.

Friedman succeeded because his work was complex enough to lend an aspect of scientific achievement to his ideas, and because the ideas played to the preconceptions of a particular circle. As Keynes wrote of Ricardo:"The completeness of [his] victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely…to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority."

Friedman's success was similar to Ricardo's but not in all respects. Yes he also explained away injustice and supported authority. But the logical superstructure was not vast and consistent. Rather Friedman's argument was maddeningly simple, yet slippery. He would appeal to short run for some effects and to the long run for others, shifting between them as it suited him. … His money growth rules promised stable employment without inflation. Their promise was not austere, but happy. Ricardo was Scrooge. Friedman was more like the Pied Piper.