Anna Schwartz on the crisis

by on October 20, 2008 at 9:49 am in Economics | Permalink

She offers a clear statement of the previous default point of view:

…this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he’s shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

This is almost certainly true if the number of "problem banks" is sufficiently small.  It works less well if the number of problem banks is very large.  And why might you believe the number of problem banks is large?:

1. The very actions of Bernanke and Paulson — both smart and competent people and in the case of Bernanke with libertarian sympathies — are signaling that the number of problem banks is large.

2. The credit freeze signals that the number of problem banks is large.

3. We cannot afford to take the chance that the number of problem banks is large.

4. Direct knowledge that the number of problem banks is large.

#1-3 seemed increasingly persuasive to me as the crisis went on, but it would be nice to shore up #4, which to this day remains weak.  Of course since #4 is not independent of what government is doing at any point in time, the signal extraction problem is significant.  If we see banks doing poorly, it could simply be that markets do not like the chosen remedy.  Furthermore share prices reflect what the market thinks banks are worth, but only conditional on what policies the market expects.

Bunbury October 20, 2008 at 10:07 am

That all makes sense but the current US proposal makes no sense from either persepective. Forcing money on good banks and not imposing a penalty on the weak ones is just odd.Why should Wells Fargo face dilution while the investment banks get cheap finance? Won’t someone think of the taxpayers?

David S October 20, 2008 at 10:15 am

It is impossible to know how large the problem is when you can’t look at a balance sheet to tell if a bank is solvent or not. And that problem is wide spread.

“…. The root cause of the current lack of trust in our financial
markets is threefold:
1. Nobody can trust a balance sheet. This is due to off-balance-sheet
vehicles (which were supposed to be banned after ENRON) and “Level 3″ assets, which nobody can analyze the true valuation of, as identification of the claimed assets and their valuation models are undisclosed.

2. Credit Default Swaps (CDS) are “over the counter” (OTC) transactions
with no margin or capital supervision. As a consequence nobody knows if their “counterparty” can pay. In fact huge percentages of these people can’t pay – but nobody knows who they are.

3. Leverage. The SEC removed broker/dealer 12:1 leverage limits in 2004.
Every firm that has failed – all five (Fannie, Freddie, Bear Stearns, Lehman and AIG) had leverage far in excess of 12:1. The bailout bill is even more dangerous as it accelerates a provision intended to go into effect in 2011 that allows Ben Bernanke to increase financial firm leverage by dropping reserve requirements on banks to zero should he so choose. It is excessive leverage that got us here in the first place, and this bill actually makes it worse.

The solution to the trust issues in our financial system is elegant and
it will work.

1. Force all off-balance sheet “assets” back onto the balance sheet, and
force the valuation models and identification of individual assets out of Level 3 and into 10Qs and 10Ks. Enact this requirement beginning with the 3Q 2008 reporting period which begins next month. Total taxpayer cost: $0.00

2. Force all OTC derivatives onto a regulated exchange similar to that
used by listed options in the equity markets. This permanently defuses the derivatives time bomb. Give market participants 90 days to get this done; any that are not listed in 90 days are declared void; let the participants sue each other if they can’t prove capital adequacy. Total taxpayer cost: $0.00

3. Force leverage by all institutions to no more than 12:1. The SEC
intentionally dropped broker/dealer leverage limits in 2004; prior to that date 12:1 was the limit. Every firm that has failed had double or more the leverage of that former 12:1 limit. Enact this with a six month time limit and require 1/6th of the excess taken down monthly. Total taxpayer cost: $0.00″

For more information about the plan, read
http://www.denninger.net/letters/genesis.pdf

Also read Karl Denninger blog, http://market-ticker.denninger.net

mw October 20, 2008 at 10:27 am

I’m also somewhat skeptical of what Anna says. She seems to be saying a limited number of banks and thus a limited number of creditors would fail if the government took a principled nothing’s-too-big-to-fail approach going all the way back to Bear Stearns, with new creditors seizing higher yields. But there are only so many people with money out there and many, such as foreign governments, sour on any possible downside risk. They over-invested their piles of cash in housing markets worldwide as risk-free investments with slightly better yields than T-bills. A sudden pull-out by them into only T-bills and commodities would be nothing sort of financial apocalypse.

meter October 20, 2008 at 10:39 am

“1. The very actions of Bernanke and Paulson — both smart and competent people and in the case of Bernanke with libertarian sympathies — are signaling that the number of problem banks is large.”

Again, I say unto thee that I keep reading and hearing that smaller, regional banks are doing fine.

Capitalize them and let the BoAs, Wachovias and Citis fail (if they must).

Anonymous October 20, 2008 at 10:41 am

Hmm. Tyler describes Bernanke as having “libertarian sympathies.”

I guess that’s why he said this morning, “With the economy likely to be weak for several quarters, and with some risk of a protracted slowdown, consideration of a fiscal package by the Congress at this juncture seems appropriate.”

You can read the full article here: “Bernanke gives nod to more government stimulus,” http://news.yahoo.com/s/ap/20081020/ap_on_bi_ge/bernanke

Sounds like a good libertarian to me. Ergh. I guess it’s just more establishment apologies from Tyler in the name of “pragmatism.”

Steve Sailer October 20, 2008 at 10:45 am

The basic problem is that we aren’t as rich as we thought we were two years ago. The question is merely the precise mechanism by which the savers and or taxpayers will be shaken down to pay for debts run up by people who lived high on the hog.

gabe October 20, 2008 at 10:49 am

Paulson is smart but his goals are not to help the people they are to help himself and his freinds.

Bernanke is smart but he is not libertarian he is a servant of the people who wish to increase the power of the fed and the treasury.

What is the evidence that Paulson and Bernanke want to help the people more than Goldman Sachs and JP morgan? there isn’t any. They have engaged in direct robbery from the people to the benefit of the establishment who has been destroying our free markets for 90 years.

Don the libertarian Democrat October 20, 2008 at 11:14 am

Aren’t there thousands of small banks still around? I agree with her in this case. We should save only the best banks for now,and let them get going, and then deal with increasing the number of banks later.

kurt October 20, 2008 at 11:25 am

2. The ________ signals that the number of WMDs is large.

# of imported aluminum tubes.

George October 20, 2008 at 11:44 am

From above:

1. The very actions of Bernanke and Paulson — both smart and competent people and in the case of Bernanke with libertarian sympathies — are signaling that the number of problem banks is large.

2. The credit freeze signals that the number of problem banks is large.

3. We cannot afford to take the chance that the number of problem banks is large.

4. Direct knowledge that the number of problem banks is large.

I’m starting to wonder how closely Tyler read the cited article. Since the discussion centers around point 1, we cannot use point 1 as an argument against the article. Doing so assumes the article is wrong, which is obviously what we are discussing.

Point 2 is covered in the article. The argument there is that the credit freeze results from uncertainty, not a clear knowledge of a large number of problem banks. Again, we cannot use point 2 as an argument against the article without first proving the point. I see no efforts to do so in Tyler’s post.

Point 3 is just fearmongering. We can “afford” anything we want. We just don’t want to afford it. It would make our lives less comfortable for years to come. We’d much rather throw money at the problem and hope it goes away.

By Tyler’s own admission, point 4 is going to be very hard to prove.

Gee, we’re out of points to consider…

David October 20, 2008 at 12:03 pm

The FDIC is “signaling” that about 107 banks are a problem. I think we can live without 107 banks.

Andrew October 20, 2008 at 12:36 pm

The banking system: All banks are insolvent if depositors start lining up at the door.

Individual banks: Some banks are more insolvent than others.

Back to the banking system: When you see people lining up at the bank around the corner do you get in line at your bank?

Adam October 20, 2008 at 12:54 pm

We cannot afford to take the chance that the number of problem banks is large.

By what criteria?

As for number 1, that’s never a good argument to make. The “very smart people believe this” argument is always a flimsy substitute for looking at the case for something on its merits. It could be that “very smart people” such as Bernanke and Paulson benefit personally from what they advocate. Or it could be that being “very smart” doesn’t necessarily always mean “very accurate”.

kurt9 October 20, 2008 at 1:27 pm

“The SEC removed broker/dealer 12:1 leverage limits in 2004.”

Why did the SEC do this? Anyone here know?

Barkley Rosser October 20, 2008 at 2:48 pm

It is widely known that Alan Greenspan was a big fan of Ayn Rand,
and reportedly still has “libertarian sympathies.” I have never
heard this said of Bernanke prior to this posting, although it
may be true.

Alan Brown October 20, 2008 at 7:39 pm

Competant? Libertarian? Doubtful.

Most competant libertarians would not be printing money like its going out style and only wonder if they should stop when the CPI tells them to.

John V October 20, 2008 at 10:54 pm

Bernanke…libertarian sympathies?? I did a triple take on that one.

I come to think of Bernanke as being many things…A New Keynesian, a moderate conservative politically, a mainstream economist, a fearless usurper of Fed hubris and a slave of macro….but a libertarian or having libertarian sympathies???

Sure. Maybe he’s for some social libertarianism on gay marriage and privacy and whatnot.But insofar as it concerns economics and his job at the Fed in particular??

He’s about as libertarian Paul Krugman or Alan Greenspan. Yeah: Greenspan too. I don’t care how “libertarian” Greenspan is or was in private life. He was anything but libertarian when he was in charge….all the more shameful considering his stances on monetary policy before he had the power.

Dan October 21, 2008 at 12:54 am

The Ingenesist Project; Putting an End to Debt Economics

The U.S. National Debt is over 10 trillion dollars. Assuming deficit spending stops today, every man, woman, and child in the US is responsible for $33,500.00.

This means that $33,500.00 of every person’s productivity has already been spent. Obviously, the only way to pay the debt is to increase every person’s productivity by exactly $33,500.00.

The only sustainably way to increase human productivity is innovation. The Ingenesist Project is an open source economic development program that will meet this challenge head-on by inducing an Innovation Economy.

The Innovation Economy:

The Ingenesist Project has identified three relatively simple web applications which, when applied to Social Networks, will allow human intellect, social capital, and creativity to become tangible outside the construct of Wall Street, Corporations, and Government.

The Ingenesist Project will build a mirror economy trading rallods (‘dollar’ spelled backwards) in an innovation economy. Rallods will be backed by “innovation† whereas dollars are backed by “debt†, hence, a mirror economy.

The Ingenesist Project has a Patent Pending for an Innovation Banking System and will release all rights to the public domain. By definition, The Ingenesist Project holds 10 Trillion rallods – and counting – to spend on development.

The Ingenesist Project will generously award rallods on a reputation scale for posts to The Ingenesist Project public forum toward the design, development, and improvement of the three web application (did I mention TIP has 10 million million rallods to blow?).

The New ‘Stock’ Market

Countless “new-to-the-world† business plans and patentable methods, systems, and devices will result from the The Ingenesist Project.

Entrepreneurs are encouraged to patent, protect, or contain all intellectual property that they develop and become as wealthy as they possibly can under the condition that they pay royalties, equity, or options to their knowledge inventory.

The entrepreneur’s “Secret-Sauce†, however, must be shared with The Ingenesist Project in order to improve the Percentile Search Engine Algorithm for the benefit of the public domain.

Participants eventually be able to trade services among each other in Rallods.

Objective:

Deficit spending is unsustainable. The existing financial system has exceeded its ability to pay back the debt and is being consumed by the interest on this debt.

As the dollar crashes, society will need an alternate economy to trade upon – one whose currency is backed by something tangible – our own productivity!

The dollar may eventually peg at some exchange rate to the Rallod.

Dan October 21, 2008 at 12:54 am

The Ingenesist Project; Putting an End to Debt Economics

The U.S. National Debt is over 10 trillion dollars. Assuming deficit spending stops today, every man, woman, and child in the US is responsible for $33,500.00.

This means that $33,500.00 of every person’s productivity has already been spent. Obviously, the only way to pay the debt is to increase every person’s productivity by exactly $33,500.00.

The only sustainably way to increase human productivity is innovation. The Ingenesist Project is an open source economic development program that will meet this challenge head-on by inducing an Innovation Economy.

The Innovation Economy:

The Ingenesist Project has identified three relatively simple web applications which, when applied to Social Networks, will allow human intellect, social capital, and creativity to become tangible outside the construct of Wall Street, Corporations, and Government.

The Ingenesist Project will build a mirror economy trading rallods (‘dollar’ spelled backwards) in an innovation economy. Rallods will be backed by “innovation† whereas dollars are backed by “debt†, hence, a mirror economy.

The Ingenesist Project has a Patent Pending for an Innovation Banking System and will release all rights to the public domain. By definition, The Ingenesist Project holds 10 Trillion rallods – and counting – to spend on development.

The Ingenesist Project will generously award rallods on a reputation scale for posts to The Ingenesist Project public forum toward the design, development, and improvement of the three web application (did I mention TIP has 10 million million rallods to blow?).

The New ‘Stock’ Market

Countless “new-to-the-world† business plans and patentable methods, systems, and devices will result from the The Ingenesist Project.

Entrepreneurs are encouraged to patent, protect, or contain all intellectual property that they develop and become as wealthy as they possibly can under the condition that they pay royalties, equity, or options to their knowledge inventory.

The entrepreneur’s “Secret-Sauce†, however, must be shared with The Ingenesist Project in order to improve the Percentile Search Engine Algorithm for the benefit of the public domain.

Participants eventually be able to trade services among each other in Rallods.

Objective:

Deficit spending is unsustainable. The existing financial system has exceeded its ability to pay back the debt and is being consumed by the interest on this debt.

As the dollar crashes, society will need an alternate economy to trade upon – one whose currency is backed by something tangible – our own productivity!

The dollar may eventually peg at some exchange rate to the Rallod.

Lawrence H. White October 21, 2008 at 7:02 pm

Tyler, you are right that shutting down insolvent banks “works less well if the number of problem banks is very large.” But you should consider that the zombie alternative, leaving insolvent banks open, also works less well if the number of problem banks is very large. Shutting them down seems to me more prudent than the zombie alternative in both the small- and large-problem-number states of the world.

You might also consider Pedro H.’s (of the blog Incentives Matter) add-on to Anna Schwartz’s perspective: “The government is artificially creating a lemons market when it does not allow discrimination between healthy and unhealthy banks to occur via bank failures.”

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