Fabius Maximus

3 October 2008

The last opportunity for effective action before disaster strikes

Filed under: Post-WWII era over? — Tags: , , , , — Fabius Maximus @ 12:01 am

Summary:  The Paulson Plan is already irrelevant.  New and larger measures are needed immediately.  This is the second post in a series describing their size and scope.  We are only weeks away from disaster.  Fortunately, I am certain that Secretary Paulson and Chairman Bernanke know this.  Bernanke, as an expert on the Great Depression, certainly understands the need for fast and effective action.

Situation report

The end of the post-WWII debt supercycle started with the collapse of the mortgage brokers in December 2006.  Since then the government has made aprox 15 initiatives to stop the deterioration of our financial system.  The super SIV, 3.25% in cuts to the federal funds rate, FHA Secure, Hope Now, a $120 billion tax rebate, massive expansion of access to the Fed’s discount “window”, TAF auction, TSLF, PDCF, the Bear Stearns bailout, the nationalization of the GSE’s and AIG … and now the TARP (aka the Paulson Plan).  Don’t bother looking up the acronyms, they will all soon be forgotten.

All too small, too late.  Incremental and reactive, responding to critical problems of last month — irrelevant to the current situation.  This is a recipe for disaster.  Like in the US 1929-1933 and Japan 1989-1996 — delaying the necessary large-scale response until the problem was no longer manageable.

Now the US financial system is seizing up.  The machinery remains, but the gears no longer turn.  Most of you have no idea to what I am referring, but you will learn over the next few weeks.  To use a bad medical analogy, the financial system has had a cardiac arrest.  Rather than describe the problem, this post describes solutions.

What must be done now

Recommendations from A solution to our financial crisis, 25 September 2008:

  1. Stabilize the financial system.
  2. Stabilize the economy.
  3. Arrange long-term financing for steps #1 and #2 with our foreign creditors.

 This post discusses step #1 — how to stabilize the financial system.

Restarting the necessary flows through the business credit system must be done immediately, and will require drastic measures. The following indicate the broad scope and scale of the necessary action, not the specifics.

(A)  Broad guarantees of the securities for the financial sector.  Not just banks and brokers, but also leasing companies and lenders of every flavor.  Confidence in these securities must be restored now.

The Paulson Plan is only a small first step in this direction.  More is needed, fast.  The Fed is pumping vast sums into the financial system (“Wall Street”), but the money is not reaching “Main Street.”  Disintermediation is necessary.

(B)  Direct lending to business.  For example,

(1)  Direct loans to corporations by the Fed (e.g., Fed purchases of commercial paper from companies).   Update:  the Fed has begun doing this, per this announcement.

(2)  Fast loans from the Small Business Administration on simple security (personal guarantees and net assets of the business).  As were made to families after Katrina.

The full effects of the recession will hit in the next few quarters, and the current financial crisis has exacerbated it.  We should prepare for something longer and deeper than 1973-75 or 1980-82 (the worst since the 1930’s).  Let’s not wait to begin mitigation efforts.  Anyone asking “Dude, where’s my recession” should be banned from the Internet for life.

(C)  Massive fiscal stimulus.  Government spending on valuable infrastructure.  Expanded education programs.  Fast cash disbursements to local social service agencies.  Avoid the usual chaotic rush — begin setting them up now, as their lead times are long.  The alternative is dropping money from helicopters later.  This is essential, but logically part of recommendation #2:  stabilize the economy.

Details

This is triage.  Immediate aid to those who can survive.  Fairness and equity are now irrelevant luxuries.  Punishment of the innocent and rewards to the guilty can wait until the immediate crisis has passed.

This is just first aid.  The recession is coming.  None of these measure will speed its end or lay a foundation for an economic expansion afterwards.  Such measures must wait for the new Administration.  The timing of the crisis, in the midst of a critical national election, could not be worse.  Let’s hope our leaders can put aside their partisan differences to take the necessary steps.  Let’s promise electoral death to those who cannot manage to do so.

I doubt we can take these measures without prior agreement of our creditors.  The additional — and larger — measures necessary next year will certainly require their money, so let’s consult them now — rather than arouse anger by assuming their cooperation.  For years they have provided vendor financing — loaning us the money to buy their goods.  Now we ask them for much larger loans to mitigate the results of our past imprudence.  Without their aid we cannot simultaneously obtain the necessary funds, keep interest rates low, and avoid a collapse of the US dollar.

This is one of the major inflection points of American history.  The outcome will be shaped to a large degree by the skill and values of the new Administration.  Please do all you can to help America make that decision.  Donate your time and money.  Get involved in discussions.  Write and talk about it with everybody you know.

What should we do next, after applying First Aid?

That is a complex question.  For a simple answer see the following (you will not like the answers):

  1. A solution to our financial crisis.
  2. America has changed. Why do so many foreigners see this, but so few Americans?

Other sources saying similar, if milder, things

  1. “From central bank to central planning?“, Prof Delong (Economic, Berkeley), BusinessDay, 29 September 2008
  2. “UC Berkeley economists think through the crisis“, San Francisco Chronicle, 2 October 2008
  3. “Edge of the Abyss“, Paul Krugman, op-ed in the New York Times, 2 October 2008
  4. “Transcript of Charlie Rose’s interview of Warren Buffett“, Bloomberg, 2 October 2008
  5. “Financial and Corporate System is in Cardiac Arrest: The Risk of the Mother of All Bank Runs“, by Nouriel Roubini, RGE Monitor, 3 October 2008

Krugman and Roubini are among America’s top economists; Buffett is one of our top businessmen.  Their warnings deserve close attention.  Esp note Buffett’s comments:

We have a terrific economy. It’s like a great athlete that’s had a cardiac arrest. And it’s flat on the floor, and paramedics have arrived. And they shouldn’t argue about whether they put the resuscitation equipment a quarter of an inch this way or a quarter of an inch that way. Or they shouldn’t start criticizing the patient because he didn’t have blood pressure tests or something like that.

They should do what’s needed right now and I think they will. I think the Congress will do the right thing. I think that they’ve gotten into certain arguments and then they start worry about assessing blame and there’s a little demagoguery. But in the end, something this important, they’ll do the right thing. This is really an economic Pearl Harbor. That sounds melodramatic, but I’ve never used that phrase before, and this really is one.

Esp note this:  “Libor Rises, Commercial Paper Slumps as Credit Freeze Deepens“, Bloomberg, 2 October 2008 — Except:

The crisis deepened after the worst month for corporate credit on record. Leveraged loan prices plunged to all-time lows, short-term debt markets seized up and even the safest company bonds suffered the worst losses in at least two decades as investors flocked to Treasuries. Credit markets have frozen and money-market rates keep rising even after central banks pumped an unprecedented $1 trillion into the financial system.

“The credit window is closed,” Jim Press, president of Chrysler LLC, the third-largest U.S. automaker, said today at the Paris Motor Show. … “It’s going to get much, much worse,” said Gregory Peters, head of credit strategy at Morgan Stanley in New York. “The credit markets are effectively shut, the CP market, which there’s not enough focus on, is under complete duress. That can’t be sustained, as that’s the lifeblood of corporations funding themselves.”

Commercial banks and bond dealers borrowed $348.2 billion from the Fed as of yesterday, an increase of 60 percent from the prior week amid the worsening credit freeze.

The market for commercial paper plummeted $94.9 billion to $1.6 trillion for the week ended Oct. 1 as banks and insurers were unable to find buyers for the short-term debt amid the worst U.S. financial crisis since the Great Depression. Financial paper accounted for most of the decline, plunging $64.9 billion, or 8.7 percent, to a two-year low.

…”The purge is broad and is impacting issuers with far more predictable cash flows — regular run-of-the-mill companies in need of working capital,” Crescenzi wrote today in a note to clients.  “The declines add to the urgency for fixes to the credit crisis and bolster the case for a Fed rate cut.”

The U.S. market for short-term debt backed by assets including mortgages and car loans fell $29.1 billion, or 3.9 percent, this week to a seasonally adjusted $724.7 billion, according to the Fed.

Afterword

If you are new to this site, please glance at the archives below.  You may find answers to your questions in these, such as the causes of the present crisis.  I have been writing about these events for several years; since November 2007 on this site.  As you will see explained in these posts, the magnitude of the events now happening is beyond what most Americans have — or can — imagine.

Please share your comments by posting below.  Please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling). 

Some FM posts about the current crisis

For a full listing see the FM reference page about the Financial crisis – what’s happening? how will this end?.

A few of the most important posts warning about this crisis

This crisis has long been forecast by many, including in articles on this site.  Even now that we are in the whirlwind, these provide valuable background material on its causes — and speculation about the results.  To see the all posts on this subject, go to the FM reference page about The End of the Post-WWII Geopolitical Regime.  Here are some of those posts.

  1. A brief note on the US Dollar. Is this like August 1914?, 8 November 2007 — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
  2. The post-WWII geopolitical regime is dying. Chapter One, 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
  3. We have been warned. Death of the post-WWII geopolitical regime, 28 November 2007 — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
  4. Death of the post-WWII geopolitical regime, III – death by debt, 8 January 2008 – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
  5. Geopolitical implications of the current economic downturn, 24 January 2008, – How will this recession end?  With re-balancing of the global economy, so that the US goods and services are again competitive.  No more trade deficit, and we can pay out debts.
  6. A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
  7. What will America look like after this recession?, 18 March 208  — The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
  8. The most important story in this week’s newspapers , 22 May 2008 — How solvent is the US government? They report the facts to us every year.
  10. The World’s biggest mess, 22 August 2008 — A brillant ex pat looks at America from across the ocean.

78 Comments »

  1. B. S. The Wall Street “crooks” win. Wall Streeter Paulson’s bailout is nothing but a TREMENDOUS cash transfer from thrifty taxpayers to greedy, risk-taking so-called “bankers.”

    Let capitalism work. The MARKET will bankrupt the stupid, greedy, bast**ds as it should. Then the MARKET will brush itself off and continue to function. It’s just a momentary disruption. No big deal!
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    Fabius Maximus replies: This is a familar recommendation. Robert Taft, and Andrew Mellon will have their modern equivalents, advocating the hard path that leads to long-term prosperity. President Hoover wrote in his Memoirs that Mellon, as Secretary of the Treasury, had

    … only one formula: liquidate labor, liquidate stocks, liquidate the farmers, and liquidate real estate…. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.

    Yep, current events are “no big deal.” Just like the 1929 – 1932 crash was “no big deal.” Unfortunately by the time the people with such views are proved wrong, the damage will be severe. Don’t look for them to admit their mistakes or apologize.

    Comment by Big Boy — 3 October 2008 @ 3:43 am

  2. It is also looking as if the European countries and banks are in even deeper trouble than the US Banks, if that is possible.

    “Financial Crisis: So much for tirades against American greed“, Ambrose Evans-Pritchard, The Telegraph, 2 October 2008

    Japan and China maybe the only ones who are in a position to help and do they have enough to help out the west in general. For China this is a rare opportunity to defeat not just the US but the west without fireing a shot. We are in a very precarious position. This is where greed, leverage, debt, dependence, and partisanship has brought us. Everyone who is an incumbent from city and counties all the way up are guilty of gross negligence but will they be fired at the next election? No! It may be time for a third party put that won’t happen for 2 more years.

    Despair is a sin. Hopefully someone is listening.
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    Fabius Maximus replies: Add the Gulf states, esp the Saudi Princes, to the list.

    The Telegraph op-ed is a fun read. Underlying this is a more serious issue: can the European Monetary System survive a recession? Milton Freidman said “no.” Papers have been written on both sides of the debate. Here is the latest, a typical economists who nicely describes the problem and concludes “perhaps yes, perhaps no.”

    “Is the Euro Sustainable?”, By C.A.E. Goodhart (London School of Economics)

    BTW — I too have heard despair is a sin, but have never found the exact basis for this belief in Christian theology. Does anyone have a reference, to either Scriptural or doctrine?

    Comment by FxConde — 3 October 2008 @ 3:46 am

  3. Dude, where is my financial disaster?

    Comment by ian — 3 October 2008 @ 3:55 am

  4. Shipping is beginning to come to a stand still. I need to verify this but sounds about right.

    “Playing games“, David Warren, at his blog, 1 October 2008 — Excerpt:

    “The various credit crises we face are real, notwithstanding the facetiousness with which I began this column. Anyone who doubts this should look into shipping news. All over the world, ships carrying vital commodities are failing to load and sail because banks are currently too shy to extend modest, conventional credit instruments. The cumulative effect of that, and much else like that, will soon bring home the reality of failing banks even to those who keep their money in pillows.”

    We live in very interesting times.
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    Fabius Maximus replies: The Baltic Freight Index is signaling something bad, as it has crashed hard. For an article explaining its significance see “The Shipping News – The best economic indicator you’ve never heard of.“, Daniel Gross, Slate, 23 October 2003.

    Comment by FxConde — 3 October 2008 @ 3:56 am

  5. If nobody in the Administration, campaigns, or house/senate leadership will stand up and lay the root cause of this melt down where it belongs – at the feet of the congress, in the persons of Carter, Clinton, Frank, Dodd, and the curse of income redistribution, then there’s no sense in pursuing a government solution.

    No good money after bad. If you won’t identify the problem, name the enemy, you aren’t serious about fixing it.

    Let the market be a market. And I hope that we’ve got enough lamp posts in D.C. to do the pay proper respect to our outgoing legislators.
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    Fabius Maximus replies: Ah, the old song. Robert Taft, and Andrew Mellon will have their modern equivalents, advocating the hard path that leads to long-term prosperity. President Hoover wrote in his Memoirs that Mellon, as Secretary of the Treasury, had

    … only one formula: liquidate labor, liquidate stocks, liquidate the farmers, and liquidate real estate…. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.

    Current events are “no big deal”, just as 1929-1932 was. By the time these folks are proven wrong the damage will be beyond anything they imagine possible. If history is a reliable guide, we should expect no apologies.

    Comment by TmjUtah — 3 October 2008 @ 3:57 am

  6. This is a fine piece of work, by the way.

    Comment by Mister Snitch! — 3 October 2008 @ 4:02 am

  7. Since the ‘bailouts’ are all about protecting the 535 jobs in the Capitol building, I’m already disinclined to believe the ’sky is falling.’ The credit crisis right now is as much as banks *expecting* the hand out and ceasing business because they expect to get inflated value for their merchandise.

    This whole thing is cause by a lack of market freedom. Restricting it further will just create a larger problem down the road.
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    Fabius Maximus replies: There is no need to rely on Washington or Wall Street to see the seriousness of our situation. Main Street is already feeling the effect, as normal channels of credit have dried up. Another week and the effects will be immense. Another month and they will be beyond your worst nightmares.

    As for the reliance on market freedom, I suggest you read the history of 1929-1932.

    Comment by Chad — 3 October 2008 @ 4:04 am

  8. “I doubt we can take these measures without prior agreement of our creditors. The additional — and larger — measures necessary next year will certainly require their money, so let’s consult them now — rather than arouse anger by assuming their cooperation.”

    And if we fail to secure their cooperation? Europe is now facing a bank solvency crisis of its own. Our Asian and Arab creditors may decide that Europe is the better credit risk. They may even decide that slowing growth and rising inflation at home deserve more attention than U.S. insolvency.
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    Fabius Maximus replies: And your point is? We can only try. I doubt that they will allow their largest customer and the core of the world’s financial system to crash. They will, however, ask for concessions in return.

    Comment by Anthony J. Alfidi — 3 October 2008 @ 4:07 am

  9. Looking over some of those links I’m impressed how biased or out-dated they are. Anthony is quite right that European banks and insurers are in worse shape than American institutions. And China’s must be an absolute disaster of jury-rigged plans.

    If our choices truly are an either-or between surrendering the last bastion of liberty to the evil of socialism and letting the world economy collapse, I say let it burn. Then we pick ourselves off and carry on like we have before.
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    Fabius Maximus replies: I suggest that you do not so quickly draw conclusions.

    * Europe has been affected, but it is not clear how badly. To say their “banks and insurers are in worse shape than America’s” is not supported by the available data.

    * To say “China’s must be an absolute disaster of jury-rigged plans.” is just a wild guess. Many western observers (e.g., Stratfor) have been predicting China’s collapse since Dinosauers walked the Earth. (OK, not quite that long – but it seems like it).

    “I say let it burn. Then we pick ourselves off and carry on like we have before.”

    That is one of the more irresponsible statements I have heard in a long time. I suggest reading some history to learn of the consequences of such events. Not just in the human suffering they cause, but the often terrible changes they make in societies. I suggest starting with these:

    “Before the Deluge – A portrait of Berlin in the 1920’s”, by Otto Friedrich
    “The World of Yesterday”, Stefan Zweig

    Comment by Chad — 3 October 2008 @ 4:15 am

  10. How about if we drop dollar bills out of airplanes. Will that help?

    Dude, recessions are when you get dragged back to reality. You’re $9.7T overspent in the US and a similar amount in France, Germany and the UK. Those credit card companies are calling you, Fabius. You need to pick up the phone and let them know when you’re going to pay them the money you owe. Credit is siezing up? I should say so. That’s what happens when you spend, spend, spend.
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    Fabius Maximus replies: How nice that you have such a fun attitude to this crisis. I assume you have some basis for confidence that it will not spin out of control into something causing immense suffering. Like 1973-75 or 1980-82. Or worse (which I consider likely).

    On another level, I find your indifference to the suffering of your fellow Americans quite astonishing. I assume you would act differently if your neighbor’s house was burning, or you found someone injured in the Street. To say “its the circle of life” sounds good in a Disney movie (esp when set to song), but that is meant for children.

    Comment by K T Cat — 3 October 2008 @ 4:17 am

  11. While they’re at it, I hope they hasten the demise of the large banks by encouraging direct internet match making between lender and borrower. There is no longer as much need for the historical banking function of qualifying worthiness of borrowers. Private investors are already supplying liquidity through direct lending. This is a continuation and logical extension of other developments which have already badly damaged conventional banks. Why do you suppose banks have been breaking their usual lending rules? Partly pressure from Barney Frank, but also a variation of “Desperate men do desperate things”. Our credit system is ossifying because the cream of the business is going to internet “bankers”, while the boring dross remains in the old banking entities.
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    Fabius Maximus replies: Do you have any evidence for this?

    Comment by bc — 3 October 2008 @ 4:35 am

  12. I’d worry about the government. Why do you think so many revolutions come at the end of supposed eras of prosperity? Because of the greed and disgust with the political elite.

    President Bush, Congress have zero clout with the American people. The only thing they have is to promise anyone, anything, at any price. For now.
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    Fabius Maximus replies: Do many revolutions come “at the end of supposed eras of prosperity?” The American revolution did, but that was exceptional in many ways. The French revolution resulted from the bankruptcy of the monarchy. The Russian revolution resulted from defeat in WWI.

    Comment by Paul from Florida — 3 October 2008 @ 4:37 am

  13. I agree with Paul from Florida, but not to the point of revolution. The whole bailout bill screams of desperation – a desperation to avoid the reality that 40 years of Keynesian economics has led us to a culture where paying for what you buy is for the chumps.

    I’ll say it again. Fabius, we all owe $9.7 TRILLION dollars. This spasm of spending $700B or $900B or $1.1T or whatever isn’t going to hide the fact that we’ve borrowed our way into a massive financial hole. As anyone who’s hear Dave Ramsey knows, spending still more isn’t going to get you out.
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    Fabius Maximus replies: The US government owes $5.8 trillion dollars in net debt (the result of past expenditures). The other $4.2 trillion is debt the government owes to itself (part of the gross debt). Write yourself an IOU for a million dollars. Has anything changed?

    Either way, this is on the low end of the range as government debt goes, and not a problem for a $14 trillion dollar economy.

    Perhaps you are thinking of our total liabilities, which includes both the debt (resulting from past expenditures) and the discounted value of promises to make future payments). It is stated on page 32 of the Fiscal Year 2007 Financial Report of the United States Government.

    “Considering this projected gap in social insurance, in addition to reported liabilities (e.g., debt held by the public and federal employee and veterans benefits payable) and other implicit commitments and contingencies that the federal government has pledged to support, the federal government’s fiscal exposures totaled approximately $53 trillion as of September 30, 2007, up more than $2 trillion from September 30, 2006, and an increase of more than $32 trillion from about $20 trillion as of September 30, 2000.7 This translates into a current burden of about $175,000 per American or approximately $455,000 per American household.”

    That is a big problem, but one for the future. The current problem is our household debt, as easily seen by the graphs in “A picture of the post-WWII debt supercycle“.

    Comment by K T Cat — 3 October 2008 @ 4:41 am

  14. “your indifference to the suffering of your fellow Americans quite astonishing. I assume you would act differently if your neighbor’s house was burning, or you found someone injured in the Street. To say “its the circle of life” sounds good in a Disney movie (esp when set to song), but that is meant for children.”

    How old are you Fabius? I spent the last three years getting out of a deep financial hole. Indifference? Hardly. I walked through Costco the other day and could recall a time just a little while ago when I couldn’t afford a broom. A freaking broom was too much for my budget.

    I got myself out of debt and I’m doing fine because I sucked it up and paid off my loans. A cruel person would have advised me to keep borrowing. I’m not the one who is indifferent to suffering, my friend. We owe something like $27,700 each on the debt. That’s $110,800 for a family of four. Pay up.
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    Fabius Maximus replies: Probably older than you, but that is irrelevant. I was not referring to your awareness of your personal suffering, but your sensitivity to that of others.

    The core of modern economics is that recessions and depression are good neither for our soul nor for the economy. They usually result from policy errors. Just like most traffic accidents. Failing to take corrective action to avoid a recession is as morally just as failing to steer around the tree when driving a busload of kids.

    Comment by K T Cat — 3 October 2008 @ 4:47 am

  15. Well, the investment banks used to make a pretty penny trading bonds by exclusively knowing the real time spreads in the bond market through their front row seat status. Bloomburg ruined that franchise and became a billionaire in the process. Today, everyone knows the spreads in real time due to Bloomburg. I’ll send you a link for a gal in Oakland Ca. who does direct internet matchmaking for home mortgages. She’s doing very well.
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    Fabius Maximus replies: Bond trading is a tiny tiny dot in the overall financial sector — and not relevant to what you described in your previous comment.

    Comment by bc — 3 October 2008 @ 4:47 am

  16. “As for the reliance on market freedom, I suggest you read the history of 1929-1932.”

    Fabius, what a load. Hoover was “The Great Engineer” and he too tried to inflate the money supply after a long boom and it didn’t work. He also had in place all sorts of public works projects to jump start the economy. There was noe “market freedom” back then. Just like there hasn’t been market freedom for the past twenty years. It’s been all about government interventing. In this case a price ceiling on interest rates, and GSEs.

    The bailout will not avert the correction. It will only posepone it.
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    Fabius Maximus replies: OK, I do not understand what you are attempting to say.

    (1) If you are defining market freedom as a theoretical condition never tried on Earth, perhaps you are correct. I don’t see the point of mentioning it, unless you are telling us about the wonders of Heaven. Down here we try to avoid recessions and depressions, or at least mitigate their effects. If you disagree, that’s fine — but I doubt you will get many people to agree with you. Certainly nobody familar with history.

    (2) As I have explained at some length — see the links in my post — the bailout (I assume you mean the Paulson Plan, now in Congress) is irrelevant to our current problems. It will not postpone anything.

    Comment by Brian Macker — 3 October 2008 @ 5:04 am

  17. The general price pressure comes from a “race to the bottom” effect, induced by Rockefeller’s “Ruinous competition”, internet style. Banks used to extract profit from borrowers inability to determine the current fair market price of loans, but today borrowers have pretty much Zen like awareness of what constitutes a fair deal. How can I prove this? I can’t, but it seems pretty likely that banks have been sustaining profitability by assuming ever more risk. The ever more risk part is becoming evident. Bank profitability as a reward for taking this risk on has not soared for any banks I know of. You would expect higher volatility in bank profits combined with higher mean profits industry wide given the added risk they took, but I don’t think that has happened even looking back. I guess I’ll cop out and say that higher risk without higher reward is the market response to banks losing their old status as low risk moderate profit endeavors.
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    Fabius Maximus replies: You have describe part of the reason for declining bank margins. Some others are…

    * Disintermediation (corporations can directly tap security markets for money).
    * Collapse of profit margins on many products due to technology.
    * Increased competition due to growth in number of financial instutions.

    As a result financial institutions sought to maintain profits by measure such as…

    * Increased leverage on their balance sheet.
    * Provide credit to more-risky customers, both business and households.
    * New products (derrivatives, such as interest-rate and credit-default swaps)

    Better regulation could have kept these trends under control. But “regulatory capture” is a dynamic identified in the early 1970’s, as regulators repond to the needs of their “clients” more strongly than their assigned mission. In any case, that is all water over the dam. The financial system will be unrecognizably different when all this is over, so no point in pointing fingers — or discussing how to stop horses that have long since left the barn.

    Comment by bc — 3 October 2008 @ 5:19 am

  18. Since the government is, as always, the problem, I find myself saddened but unsurprised by the readiness of individuals who should know better to turn to the government for a supposed solution. It matters little how bad the current crises is – and I tend to agree with you that the looming market correction will be a bad one – no bill that our congress passes, bailout or otherwise, is going to be more than a temporary stop gap that will do nothing except postpone the fall (and make it, ultimately, worse).

    Further, since any such bill will also (as all such previous instances in our history have done) lead to the aggregation of yet more power unto Washington and the further erosion of our freedoms, I find that the only sentiment I can bring myself to is to hope that these incompetents we’ve chosen to represent us doing nothing at all.

    I’ve seen you repeat, many times, that those advocates of letting the market do its job should read up on history circa 1929-1933. I would riposte that you would be wise to look at history circa 1933-1941, wherein government interventionism in the guise of recovery served only to prolong the pain.
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    Fabius Maximus replies: As I have explained at length — and mentioned in this post and others — the Paulson Plan will probably do little. Which is why larger measures are necessary, or the system damage will spread through the economy. The belief expressed in so many of these comments, that the “free market” fairy will save us, has no support that I am aware of in history or theory.

    As I have also shown, any measures we are likely to take will concentrate power — both in the government and (more broadly) among our governing elites. On the other hand, the consequences of doing nothing could be very bad. It is evident that many of the folks commenting here have no idea what that means.

    As for the 1930’s… It is clear that the policies of the US and UK made the depression needlessly long and deep. Only WWII blasted us into recovery, after 1938. Of course, Lord Keynes published “The General Theory of Employment, Interest and Money” in 1936, so our mistakes were not clear at that time. But how can you support this:

    “wherein government interventionism in the guise of recovery served only to prolong the pain”

    The nations that did well in the depression — esp the Scandinavians and Germany — had more intervention in the economy than us, not less.

    Comment by Jason — 3 October 2008 @ 5:39 am

  19. Since banks and other institutions were coerced by government to make loans that would never be paid off and then were ENCOURAGED to create vehicles and practices to morph the trash into assets and THEN were successful in seeing government become the last player in the musical chairs, where should the pain rightfully be felt?

    There’s not enough numbers in both houses of Congress to make more than a splatter on the pavement. But we are still truly, if woefully ineptly, a government of, by, and (ha)FOR the people.

    So, the responsible parties are about to pay. That’s us. You , me, the neighbor.

    I take no comfort in the knowledge that if our economy is this screwed up, the nannystates across the water must be three times’ worse off than us. The debt that we shouldered as world policemen was never felt by the old countries; they started buying their balloons and cake decades before we started seriously slouching toward serfdom.

    It’s going to be bloody. But if you stick your hand in a wood chipper, can you really be surprised? Didn’t think so.

    Don’t worry! O! is going to save the day! Ha. That right there is going to be good for a thousand points down on the Dow on Monday, isn’t it? I wouldn’t want to be Barney Frank this time next week.

    Oh, and don’t try that “better” regulation schtick. If you can’t start with “ethical”, “better” isn’t even a possibility.
    .
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    Fabius Maximus replies: The myth that the Community Reinvestment Act (passed in 1977) had any significant role in the US debt supercycle was thoroughly debunked in this thread. A dozen studies were cited in rebuttal; the proponents cited nothing but assertions in support of it.

    The causes of this crisis are described in these three posts:

    * “A picture of the post-WWII debt supercycle” — Four graphs tell the story.

    * “Death of the post-WWII geopolitical regime – death by debt” — The dynamics of our fall.

    * “We have been warned. Death of the post-WWII geopolitical regime” — Some of the many many warnings we received along the way from major institutions and major experts.

    Comment by TmjUtah — 3 October 2008 @ 5:45 am

  20. “As I have also shown, any measures we are likely to take will concentrate power — both in the government and (more broadly) among our governing elites. On the other hand, the consequences of doing nothing could be very bad. It is evident that many of the folks commenting here have no idea what that means.”

    The whole problem with the idea that “the consequences of doing nothing will be bad” is that it presupposes that there is some course of action that yields an outcome that could be characterized as “not bad.” No such course of action exists. The current US economy is unsustainable; it will correct itself, one way or another. You are likely correct that an ideal course of action will mitigate the pain to some extent – my quibble is not so much the course of action you propose as it is the actors chosen for implementation.

    It is all well and good to assume fiat – to claim that “this needs to be done, or that.” However, the second you bring this argument before our body politic and present it as a course of action, that assumption falls flat. I will claim categorically (and I have seen zero evidence in our recent history to challenge this assumption) that /no/ measure likely to pass this congress will be to the benefit of our nation.

    “The nations that did well in the depression — esp the Scandinavians and Germany — had more intervention in the economy than us, not less.”

    I am not sufficiently familiar with the economic history of the Scandinavian nations to provide comment, but I will say that I am highly surprised you chose Germany as an example. First off, the Weimar Republic was hit especially hard by the crash, and thus an equivalent climb from its minimum appears proportionally much greater. Secondly, Germany rose out of the depression by completely throwing of the shackles of said republic, favoring a Fascist tyranny instead – and, if there is one thing that dictators have proven themselves good at, it’s making the trains run on time. The short term result was favorable – the first bloom of tyranny – but the end result can hardly be called an improvement. By 1940, the German economy was falling down around Hitler’s ears.

    Lastly, regarding my comment that “government interventionism prolonged the pain,” I would consider this to be self-evident. It’s commonly accepted that the New Deal prolonged the recovery, and we are even now feeling the after-effects of its policy. In fact, as a direct result of the New Deal, we are facing a near-term crisis in the form of the coming Social Security insolvency issue that will make even our current financial woes look small.
    .
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    Fabius Maximus replies: That’s a pretty exteme position, too extreme to debate in this small forum.

    Much of this seems to rest on counterfactuals — such as “how the US would have done without the New Deal.” Or “what would a modern economy look like with minimal regulation.” These are outside my pay grade to discuss. All I can say is that you will find few experts in economics or finance who agree with you.

    “the Weimar Republic was hit especially hard by the crash, and thus an equivalent climb from its minimum appears proportionally much greater.”

    What crash? This is not correct, to the best of my knowledge, as Weimar was not hit hard (certainly not more than the US) by the 1929 stock market crash.

    “Germany rose out of the depression by completely throwing of the shackles of said republic, favoring a Fascist tyranny instead”

    German’s economic performance in the 1930’s was largely a function of what we would now call Keynesian fiscal stimulus. Massive government spending, far more than FDR’s. It worked, as easily seen by comparing pictures of German and British enlisted men in WWII. The Brits tended to be smaller than the Germans, and bowlegged. Poor diet in childhood, mostly. Now if only Hitler had ambitions other than war…

    “if there is one thing that dictators have proven themselves good at, it’s making the trains run on time.”

    This is a myth, originally said of Mussolini. See Snopes (or any biography of Italy in that era) for a debunking.

    Comment by Jason — 3 October 2008 @ 6:42 am

  21. the fed needs to stop conducting auctions for term funds. they need to set the rate and supply whatever is needed. they need to target not only the overnight rate (pay interest on reserves instead of the current add/drain to hit the funds target), but target 1 month to 3 month rates.

    we should not worry about a fiscal deficit of 10% of gdp as the federal government will be the only entity able to affect agregate demand until private sector balance sheets are restored.
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    Fabius Maximus replies: I am not an expert in money market operations, so I assume the Fed’s procedures in these things are the best ways to conduct this monetary policy (they are good at this stuff).

    The question is not if we — the debtor — worry about a 10% fiscal deficit. Debtors never worry about such things.

    The US will probably not have a sufficient savings rate to fund such a large fiscal deficit. We are almost totally reliant on foreign central bank lending, which they have done to finance our purchases of their goods. But this borrowing will be different, for internal consumption not trade finance. Will they share your complacency about funding a large piece of $2 trillion dollars in 2009 borrowing (10% of $14,000 b plus $500 b in maturing debt)?

    Comment by sg — 3 October 2008 @ 6:47 am

  22. “The core of modern economics is that recessions and depression are good neither for our soul nor for the economy. They usually result from policy errors. Just like most traffic accidents. Failing to take corrective action to avoid a recession is as morally just as failing to steer around the tree when driving a busload of kids.”

    Poppycock. Modern economics is built around an entitlement mentality that says we can have endless expansions and our government can drive the economy to accomplish this. Both are false and both have made this situation worse than it had to be.

    If you are spending more than you earn, you are building up debt. You will need to first reduce consumption to the point where income = expenses and then reduce consumption further to the point where you can pay down debt. That’s a recession. It’s an involuntary reduction in consumption to make up for past excesses. We have massive government debt and now, massive, unpayable mortgage debts. That’s a pretty good mix of past excesses.

    As for the government driving the economy, Barney Frank can’t even run a gay brothel in his home without screwing it up. Now we’re ask him to help “run” the banking system through the control systems of the government. Good luck with that.

    It’s not that the market is superior, it’s that it has an inexorable mathematical quality to it. It cannot be denied. Lots of people took out loans they couldn’t pay back. The loans still have to be paid. The government gives us all $400B more worth of treats and toys than we pay for. Those have to be paid for. The money has been borrowed so we could all pretend we were rich when we weren’t. It has to be paid back.

    You may be right that the bailout is necessary to stave off a worldwide depression. If we stave it off and keep living beyond our means, we are still screwed in the end.
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    Fabius Maximus replies: Lots of extreme views in the comments on this post. Interesting that nobody so far seems able to cite actual evidence, in theory or history, for their views.

    “Modern economics is built around an entitlement mentality that says we can have endless expansions and our government can drive the economy to accomplish this.”

    Can you support this statement in any way? I am aware of no school that believes that the business cycle can be prevented. Of the three major schools of economics, two discuss how to manage the cycle (Monetarism and Keynesian) and the third says we must mnage mostly the upcycles (Austrians). These are caricatures, of course.

    Comment by K T Cat — 3 October 2008 @ 6:49 am

  23. “What crash? This is not correct, to the best of my knowledge, as Weimar was not hit hard (certainly not more than the US) by the 1929 stock market crash.”

    Oh, the perils of hyperbole. I didn’t mean the stock market crash in specific; I meant, rather, the ultimate economic minimum before the recovery began.

    I’ll leave the rest as a simple “agree to disagree,” with one additional comment: I am by no means an expert in economics (although, to the extent I have studied it, my preferred flavor is Austrian), but I know enough history to know that, however bad our economic problems may be, the long term issues created by our efforts to solve it will be worse. There is simply no way around the law of unintended consequences, and any long term aggregation of government power in exchange for short term benefit is no bargain at all.
    .
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    Fabius Maximus replies: I don’t believe your characterization of Weimer’s experience in the great depression is correct on any level, not even as hyperbole. Their hyperinflation during 1921-23 removed many of the economic imbalances, such as high debt levels, that made our depression so severe. So they had a less severe crash.

    As for the rest, it is an extreme position but beyond the scope of discussion on this site.

    Comment by Jason — 3 October 2008 @ 7:20 am

  24. That a company like GE feels the need to issue new shares in the present market conditions shows the tightness of liquidity in the banking sector. GE having trouble borrowing money!! Scary. I wonder when you will begin to see solvent companies defaulting on debt & wages etc., etc., because they are hit with a lack of liquidity….

    Are there any US banks with surplus liquidity anymore?
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    Fabius Maximus replies: Lots. They are just not lending. The Fed is pouring liquidity into the financial system, but little of that is reaching the business sector.

    Comment by Rune Kramer — 3 October 2008 @ 7:55 am

  25. I find it hard to believe that “credit has frozen”. Banks are in the business of lending money, if they don’t lend then they have no reason to exist. What I think more likely is that “credit has frozen at the current prices (rates)”. If you want to restart the credit markets then the institutions with money (asian, middle east) must be promised a payoff (rate) that matches perceived risk. However a rise in rates would crush those who are already in heavy debt OR whose balance sheets are so nontransparent that they are considered very risky borrowers.
    If the number of indebted corporations/individuals is high enough (not just in absolute numbers but also in relative significance/influence) then it may be politically impossible to allow their failure. Other than bankruptcy the only way to get rid of existing too-large-to-pay-off debt is to inflate it away.
    So it is a choice: whether to prop up indebted USA corporations/individuals or to preserve the dollars’ status as global reserve currency.

    Comment by esd29a — 3 October 2008 @ 10:15 am

  26. “Modern economics is built around an entitlement mentality that says we can have endless expansions and our government can drive the economy to accomplish this.”

    Can you support this statement in any way? Well here’s you supporting it.

    “Failing to take corrective action to avoid a recession is as morally just as failing to steer around the tree when driving a busload of kids.”

    You are presuming it can be known what the correct direction and magnitude of corrective action should be. You have no evidence for that.

    You have also merely asserted and not shown that the just price of unintelligent sustained excess is not pain. I assert that it is, and point you to the Gods of the Copybook Headings. If the only way the pain which is coming can be shared to those who most individually contributed to it is to not bail out Wall Street, then that is an excellent idea.

    BTW, in saying “recession is coming”, you admit those asking “Dude, Where’s my recession?” were perfectly correct when they were saying it.

    And yes, the CRA and two other things are at the root of this crisis, the other two being the implicit federal backing of FM-FM and the willingness of the mortgage underwriters to make temporary profits by writing loans which the CRA* but not history justified.

    *I do not assert the CRA demanded such loans in any but a few cases, but the fact any such loans existed meant many hundreds of thousands of loans which were not blatant quota loans were made which were not justifed by traditional criteria. Borrowers were saying, “If they–bad risk minorities–can get a loan, why can’t I?” and lender’s were saying, “If they have to get a loan–bad risk minorities–and it’s federally backed, why shouldn’t I loan to this better risk?”

    Also, you keep on saying we should read up on the Great Depression, which started in 1929. I think you should read up on the The Law, which came out in 1850.

    Yours, Tom Perkins, ml, msl, & pfpp
    .
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    Fabius Maximus replies: By the numbers…

    “Well here’s you supporting it.”

    I disagree. The quote you open with (from comment #14) is an expression of my belief– a statement of applied morality; there was nothing in that comment about economics. Modern economics theory since Keynes provides a theoretical basis for acting on this, which of course you can agree of disagree with. None of this is relevant to the question I asked, asking for some evidence to support your statement that “Modern economics is built around an entitlement mentality.”

    “recession is coming”,

    Thanks for catching that sloppy writing. As has been evident in these posts, the recession started in Q1 (since we do not have accurate monthly data; if we did it would probably be Dec 2007). I meant the full and severe effects of the recession are coming; we have seen only mild early phases. (I have edited that to make this clearer)

    “the CRA and two other things are at the root of this crisis, the other two being the implicit federal backing of FM-FM”

    I agree with the latter, although “at the root” may be too strong. The myth that the Community Reinvestment Act (passed in 1977) had any significant role in the US debt supercycle was thoroughly debunked in this thread. A dozen studies were cited in rebuttal; the proponents cited nothing but assertions in support of it. Also, what are you quoting from (no source is given for that paragraph near the end)?

    Comment by Tom Perkins — 3 October 2008 @ 10:50 am

  27. Yes we must do something – call your representative and tell him to vote against the bailout. Doesn’t anyone see what’s happening here?
    Monday – bailout vote and market tanks.
    Tuesday – previous day bailout vote fails – market starts to recover. DJIA came close to having the largest one day rally ever.
    Wednesday – market nervous about bailout vote – down slightly.
    Thursday – previous day bailout vote passes – market tanks – Reid scares insurance co. investors.
    Friday – bailout vote – market nervous – will be close to even – might be up slightly on insurance co investers.
    Monday – if bailout passes and Bush signs, the market will have the largest down day ever – losing 2K points.

    Problems in the market? “It’s the bailout, stupid.”

    Paulson is an ex Wall-Street CEO, with a 3/4 billion dollar trust fund that’s sinking fast. Of COURSE it’s a crisis and a bailout needs to be passed – or he’ll lose nearly 1/2 billion dollars. Oh, sorry George, were you thinking I meant it was a crisis for the country? My bad…

    Comment by JinnyB — 3 October 2008 @ 10:53 am

  28. The pipe isn’t blocked, it’s got a hole in it.

    Comment by AntiCitizenOne — 3 October 2008 @ 10:59 am

  29. Reminder: It’s easy to exaggerate a crisis in moments of crisis. It happens all the time.

    About the €: The fundamental problems of the Euro are the large differences between the participating countries and the lack of exchange rate balancing of asymmetries. I don’t see how the Euro zone could be split by a crisis that affects all.
    .
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    Fabius Maximus replies: Yes, but that is not happening now, on the basis of clear and objective data.

    As for your 2nd point: see “Can the European Monetary Union survive the next recession?” for a discussion of this.

    Comment by Sven Ortmann — 3 October 2008 @ 11:32 am

  30. Unfortunatly, I think Fabius is right, and its probably exacerbated by something I just realized: There is so much reliance on very short term financing.

    So many companies, and all banks, get a huge fraction of their liquidity on the commercial paper, overnight loans, and similar markets. As witnessed by the TED spread, still continued withdraws from money-market funds dispite the treasury backstop [1], complaints from AT&T, McDonalds, etc.

    This means that things, without an explicit government backstop, things can unwind VERY quickly when companies can’t roll over their loans. So a company can go from “fine” to “no cash at all” in a month or even overnight.

    My GF just got fired from a little company, that, I bet, will not be able to make payroll in a month: They have some very nice assets (which are probably already collateral against loans) but no liquidity. With no liquidity, you can’t make payroll. You can’t make payroll, you cease to exist as a company.

    Lord only knows how many companies don’t have the liquidity to survive a real credit crunch.

    This IS bad. Very bad.

    [1] There are two problems: The backstop is ONLY against existing money, and as short term rates go to 0, there is so little margin for error. Its one thing to try to beat an index, its another to try to beat 0 when treasuries are yielding 0%.

    Comment by Nicholas Weaver — 3 October 2008 @ 12:10 pm

  31. Despair is the absence of hope. As Christians, we are to have faith in the Lord, hope in our salvation, and to be content in our daily life.

    I believe the scriptural basis for despair being a sin is Matthew 6:25-34.

    “Therefore I tell you , do not worry about your life, what you will eat or drink; or about your body, what you will wear. Is not life more important than food, and the body more important than clothes? Look at the birds of the air; they do not sow or reap or store away in barns, and yet your heavenly Father feeds them. Are you not much more valuable than they? Why of you by worrying can add a single hour to his life?”

    See also Philippians 4:12-13.

    I know what it is to be in need, and I know what it is to have plenty. I have learned the secret to being content in any and every situation, whether well fed or hungry, whether living in plenty or want. I can do everything through him who gives me strength.
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    Fabius Maximus replies: Thanks for this info!

    Comment by Jeff — 3 October 2008 @ 12:35 pm

  32. The system can change within weeks.

    Companies that “depend” on short-term loans for paying salaries can in a very short time change their liquidity management to keep some M3 money – the additional cost is marginal, a little bit of interest rate, that’s all. Banks don’t give away money as before, but they receive more than before from the Fed – now guess what – there’s a lot of money in the system, just not where it used to be. There’s even more money than before.

    A reduction in loans is actually a good thing – about USD 700 billion consumption less would delete the trade balance deficit. The USA has lived beyond its means as a nation 8trade balance deficit), as a state (budget deficit) and even many as individuals (mortgage and credit card debt). THIS NEEDS TO STOP. A full stop of this insanity is nothing that needs to be averted, but something that should have happened years ago.

    The U.S.Americans lived beyond their means and enjoyed it, were often arrogant to others based on illusions of (borrowed) power and wealth. Now is the time for payback, and the change will be brutal, but IT WILL BE A CHANGE BACK TO WHAT’S DESERVED.

    Forget about trying to keep the consumption levels – both state and private – of the past years. It was not deserved, but loaned. Chinese and other foreigners were basically working for promises only – now it’s time to keep the promises and pay them.

    https://www.cia.gov/library/publications/the-world-factbook/rankorder/2187rank.html
    http://www.bea.gov/newsreleases/international/trade/trad_time_series.xls

    The present financial markets crisis is only a symptom, something that could not have happened without the mentality that allowed the mismatch of consumption and income. (And don’t forget that the U.S. economy will not improve without huge investments, too).
    .
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    Fabius Maximus replies: This is like an emergency room team receiving a patient in cardiac arrest, and recommending a better diet and exercise. In a situation like today’s the causes are irrelevant. Those consideration will be important later, but not now.

    “Companies that “depend” on short-term loans for paying salaries can in a very short time change their liquidity management to keep some M3 money”

    Not possible for any reasonable time horizon. Companies that have short or long term debt maturing this month are in big trouble, unless they existing lines of credit sufficient to provide the cash. Few businesses have sufficient cash flow to payoff debt in any short to medium time; that is why they borrow.

    Comment by Sven Ortmann — 3 October 2008 @ 12:50 pm

  33. I guess in your eyes, I’m just an uneducated American, but perhaps you could explain to me and the rest of us unwashed masses why business credit line rates haven’t changed and banks have not begun paying higher interest rates?

    Again, I’m just a simpleton, but I would think that a bank staring a OMGWTFCREDITCRISIS in the face would begin adjusting these before throwing in the towel and calling for a taxpayer funded bailout…
    .
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    Fabius Maximus replies: There is no reason to say such things. Economics is not the highest nor more important branch on the tree of knowledge.

    When people worry about a systemic crisis — normally credit-worthy customers paying them back — they just don’t loan. If you worried that I might not pay you back, what rate of interest would you charge? Nothing that a bank could offer without getting into big legal and PR trouble.

    Comment by Some Taxpayer — 3 October 2008 @ 1:19 pm

  34. Oh, and by the way, not to point out that the Maximus has no idea what he’s talking about, but the U.S. Small Business Administration does not give direct loans to businesses. Never has (other than in disasters).

    And the SBA lenders are still giving loans at the same rates as before the OMGWTFCREDITCRUNCH. Because they’re still Federally-guaranteed, and the banks have the same risk. Heck, I wouldn’t be surprised if they didn’t push to bump up the guarantee levels in the bailout bill and start moving 7(a) lending into mainstream loans.

    Not to pile on to a over-educated gentleman who has no idea what he’s talking about.

    Seriously, as a taxpayer, I’m getting tired of the BS predictions from investment bankers and brokers claiming the sky is falling. Maybe in Manhattan, pal, but for the rest of us, it’s just a regular old recession, and we’re not going to make it worse by handing you geniuses what hard-earned money we have left, courtesy of Mr. Paulson.
    .
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    Fabius Maximus replies: I suggest not making such snide remarks without actually reading the post.

    “Small Business Administration does not give direct loans to businesses. Never has (other than in disasters).”

    The title and text describes this as a disaster. And I specifically said “As were made to families after Katrina.” These recommendation are things that have never been done before (Fed loaning money to non-financial corporations, SBA loans directly to businesses), but are needed now.

    “Maybe in Manhattan, pal, but for the rest of us, it’s just a regular old recession,”

    This is a common reaction to extraordinary circumstances, like people on the beach hearing the tsunami warnings and dismissing them — “never happened, don’t bother running.” It sounds good, but often has unpleasant consequences. Like folks who believed the foolish “Dude, where’s my recession” articles — and failed to prepare for the current downturn.

    Comment by Some Taxpayer — 3 October 2008 @ 1:28 pm

  35. The key is that the discussion and problem symptoms are about liquidity. Well, what happens when banks don’t loan money away? It certainly doesn’t lie all in their safes. No, the money is still in the economy, but business in the financial sector is not as usual, the money flows are changing. That’s why the bankers scream.

    The banks did a terrible job in their primary task; efficient allocation of resources. They mis-allocated resources into building construction and snowball systems that were built around the housing market – and into consumption. Meanwhile, there was not enough money directed into real investments – or even only good real investments.

    The financial system sucked at allocating resources and it sucks now, just for another reason – a reason that’s not pleasant, but painful for the financial branch.

    The real economy problems happen not only because of some stupid problems in the banking sector – that’s just part of the trouble. No, the real economy is in trouble because of fundamental problems. It’s sick.
    .
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    Fabius Maximus replies: This displays a large-scale misunderstanding of how banks work.

    When banks slow their rate of lending, they are reducing their leverage. Perhaps from 10:1 to 8:1. They do not work by taking a dollar out of their safe and lending it. They take it out and lend it 9-fold. So a reduction of lending is a reduction of “oxygen” to the economy.

    Comment by Sven Ortmann — 3 October 2008 @ 1:29 pm

  36. Update: “Edge of the Abyss“, Paul Krugman, op-ed in the New York Times, 2 October 2008 — Excerpt:

    “As recently as three weeks ago it was still possible to argue that the state of the U.S. economy, while clearly not good, wasn’t disastrous — that the financial system, while under stress, wasn’t in full meltdown and that Wall Street’s troubles weren’t having that much impact on Main Street.

    “But that was then. The financial and economic news since the middle of last month has been really, really bad.

    … “There’s growing evidence that the financial crunch is spreading to Main Street, with small businesses having trouble raising money and seeing their credit lines cut. And leading indicators for both employment and industrial production have turned sharply worse, suggesting that even before Lehman’s fall, the economy, which has been sagging since last year, was falling off a cliff.

    “How bad is it? Normally sober people are sounding apocalyptic.”

    Comment by Fabius Maximus — 3 October 2008 @ 1:30 pm

  37. Tiny typo alert in the 11 July post on the EURO: Its other flaws from this this.

    I don’t believe it’s the last chance — when GE has to borrow short term money by issuing new shares, it’s a clear sign of a huge problem, but it’s not yet the last step before disaster.

    Why couldn’t they, or another company, ask 100 different small banks for small, $10 million short term loans? I bet they didn’t try — because they’re waiting for a BIG bailout, and the BIG solution. Banks waiting for a Big Solution from Big Government is becoming a significant contributing factor to the crisis.

    Too many houses — house price values drop — too much financial paper on top of house values — too many bankers. So far the real crisis is 1) housing industry (few new residential units) (with evidence somewhere), and 2) financial houses, especially those with big MBS leveraged balance sheets.

    But the near-recession we’ve been in does seem about to become a bigger slowdown, as the weakest (or slowest to use alternatives to Big Banks) firms can’t get short term money.

    Funny, the arguments about weak companies unable to get short term money parallel the needs for weaker economies in the Eurozone (like Italy or Spain) to get short term money — so the Euro may indeed break up. Just as Slovakia is about to join in Jan.

    Comment by Tom Grey — 3 October 2008 @ 2:06 pm

  38. Look at the TED spread. 3.6%+ over treasuries. This implies that each bank is basically stating “EVERY other bank has at 3% chance of imploding in the next 2 months AND NOT PAYING A DIME, DESPITE ANY GOVERNMENT BACKSTOP”. That is, assuming they will lend at all.

    This really is unprecidented.

    Comment by Nicholas Weaver — 3 October 2008 @ 2:09 pm

  39. Strong recommendation to read

    “Financial and Corporate System is in Cardiac Arrest: The Risk of the Mother of All Bank Runs“, by Nouriel Roubini, RGE Monitor, 3 October 2008 — Excerpt:

    “It is now clear that the US financial system – and now even the system of financing of the corporate sector – is now in cardiac arrest and at a risk of a systemic financial meltdown. I don’t use these words lightly but at this point we have reached the final 12th step of my February paper on “The Risk of a Systemic Financial Meltdown: 12 Steps to a Financial Disaster” (Step 9 or the collapse of the major broker dealers has already widely occurred).”

    Roubini is a professor of economics at NYU, noted expert in international finance, and founder of RGE Monitor (a aggregator of economics and finance articles, invaluable for anyone in those fields).

    Comment by Fabius Maximus — 3 October 2008 @ 2:26 pm

  40. When GE, in order to get $3B in LONG TERM liquidity, has to pay 10%/year on it PLUS a 10% premium for complete payoff PLUS options with a strike price at current price for $3B worth of shares to Warren Buffet, you have a big problem.

    This is terms that would make a loan-shark embarrased.

    Comment by Nicholas Weaver — 3 October 2008 @ 2:31 pm

  41. I never figured you for a flaming Leftist. The most extreme views posted in this thread have been YOURS. The problem is that we have too much debt–too much Government debt, too much corporate debt, and too much personal debt. The last thing we need in the United States is more debt, yet that is exactly what you are proposing in order to stave off a recession. More debt is only going to add fuel to the fire and prolong the inevitable. You’re pretty good at asking others to provide evidence for their positions. It is now my turn. I demand to see proof that YOUR solutions will not make things worse.
    .
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    Fabius Maximus replies: I was speaking of extreme views vs. conventional economic theory. With respect to recommendations you are correct. But the news flow suggests I may not be an extreme view for long, as seen in the articles I list by Warren Buffet and Professors Krugman and Roubini. As others recognize the danger, they give similar advice.

    I obviously agree with you about the debt problem, as seen in the five dozen articles I have written about this over the past year (for a list see “End of the post-WWII geopolitical regime“).

    But the flow of money through our economy is stopping, as in the “cardiac arrest” so often mentioned. This must be restarted fast or the consequences will be horrific.

    Comment by Hard Right — 3 October 2008 @ 2:41 pm

  42. It is heartening to see 40 comments (so far) on this thread; that translates to some much higher number of readers. I don’t understand all that F.M. writes and do not agree with all of that which I do ken. But he has done an excellent job of identifying broad questions and challenges, and placing them in a historical context.

    To the skeptics who followed a link here (from where?), I offer one example of an important question that F.M. has posed, but that the mainsteam media and the blogosphere have yet to address:

    “America is in the process of contacting its foreign creditors, asking them to fund the Paulson Plan with the first installment of some trillions of dollars in additional loans. Most of these powers are unfriendly to us, to varying degrees. What makes this exchange attractive from their point of view? What concessions must we be prepared to offer?“

    Comment by AMac — 3 October 2008 @ 2:56 pm

  43. Fabius:

    This is an amazing thread and my crystal ball is as cloudy as anyone else’s. But realistically, the steps you call for – or something substantially similar – just aren’t going to happen at least between now and next January.

    I used to snark that discussions of how future historians would judge the Bush administration were fanciful because they over-optimistically assumed that the future would have historians.

    Now I grit my teeth.
    .
    .
    Fabius Maximus replies: That is also my fear. But we do have not that much time. Let’s hope that the sight of the gallows focuses the minds of our leaders, and impels them to action. Chairman Bernanke certainly understands these things, and the need for fast powerful action.

    Comment by Duncan Kinder — 3 October 2008 @ 3:00 pm

  44. Update: Transcript of Charlie Rose’s interview of Warren Buffett, Bloomberg, 2 October 2008 — Excerpt:

    “We have a terrific economy. It’s like a great athlete that’s had a cardiac arrest. And it’s flat on the floor, and paramedics have arrived. And they shouldn’t argue about whether they put the resuscitation equipment a quarter of an inch this way or a quarter of an inch that way. Or they shouldn’t start criticizing the patient because he didn’t have blood pressure tests or something like that.

    “They should do what’s needed right now and I think they will. I think the Congress will do the right thing. I think that they’ve gotten into certain arguments and then they start worry about assessing blame and there’s a little demagoguery. But in the end, something this important, they’ll do the right thing. This is really an economic Pearl Harbor. That sounds melodramatic, but I’ve never used that phrase before, and this really is one.”

    Comment by Fabius Maximus — 3 October 2008 @ 3:28 pm

  45. WSJ on Paul Ryan, a fierce anti-Fannie critic for years. Supporting the bailout.

    They call it leadership. I have to agree, leading me to flop around some more. Against big gov’t, big bailouts — but especially against BIG recession. Other European Central Banks are rescuing their own overexposed banks (German guy to eat some crow?) — Euro over-regulation wasn’t enough, either.

    Whatever I learned in 8 years of investment banking is already obsolete. I still think faster purchasing/ offering to buy all foreclosed houses at 50% of prior mortgage would be a huge help.

    Other speculation: The Fed is loaning money — why not Factoring, too? Let the Fed buy short term GE receivables at 90% of nominal value, so GE gets cash?

    Time for the Fed to help real companies directly, and NOT use the now-clogged imploding financial institutions. Prior Tax rebate loans — for all companies that paid tax last year, they can directly borrow from the Fed an equal amount of the prior year’s tax (at the high AIG bailout interest rate).
    .
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    Fabius Maximus replies: This is largely what I recommended in my post (It would have been polite of your to acknowledge that in your comment).

    “Time for the Fed to help real companies directly”
    That is almost exactly what I said.

    “Let the Fed buy short term GE receivables at 90% of nominal value”
    Fed buying of commercial paper from companies is fast and easy direct unsecured lending, faster and easier then secured lending (such as buying receivables).

    Comment by Tom Grey — 3 October 2008 @ 3:36 pm

  46. Warren Buffet is investing new money in GE. Wells Fargo, one of the best run banks in the world that avoided toxic debt, is in a bidding war with Citicorp over insolvent Watchovia. So you think those two purchasers feel that there will soon be a financial meltdown and total liquidity starvation? You can;t buy cheep assets with other cheep assets, cash is king when there is no liquidity. Both of these entities are betting on assets (with their own money) being more valuable in the future than now.
    .
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    Fabius Maximus replies: People with cash go shopping during panics. To see this at work watch the early scenes of “It’s a wonderful life.” Mr. Potter has cash to buy up Bedford Falls, while everyone else suffers. That’s a natural element of a crash, but does not make the crash less real to the 95% who cannot so benefit from it.

    Trivia note: Buffett did not “invest” in GE. He loaned money to them, with an option to invest in the future. They are two different things.

    Comment by Doug_S — 3 October 2008 @ 3:37 pm

  47. What Leadership Looks Like

    Comment by Tom Grey — 3 October 2008 @ 3:58 pm

  48. Buffet also invested in Goldman Sachs, which will heavily benefit from the bailout. He, like Soros, has been touting the bailout. There is a kind of vulture capitalist play going on here, too tricky for me to unravel.

    I have nothing but admiration for Fabius, a free market advocate and a believer in the Roman as well as American founders’ ideal of citizenship, who, in this serious national crisis, is clear-minded and non-ideological enough to see that massive state intervention is needed and unavoidable.

    Comment by seneca — 3 October 2008 @ 4:04 pm

  49. If the US Government cannot get enough foreign credit on suitable terms then I presume it would only be able to support essential industries directly. The remainder would fail and then we’d be left with a command economy.

    The pattern repeats world-wide. Perhaps I’m depressing myself unduly, but this recession could last decades, because where would be the mechanism and leadership to restore international trade?
    .
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    Fabius Maximus replies: The US economy borrows aprox 5% of its income. In a recession the borrowing goes to near zero. So a decrease in new loans would hurt, but not to the extent implied by this comment.

    The pattern does not repeat world-wide because the world is not a net debtor.

    Recessions are cyclical events. They are part of the normal economic cycle. To use a bad metaphor, the economy must both inhale and exhale. The natural vitality of a normal economy restores itself in a downturn as the imbalances that produced the downturn are corrected.

    The situation is bad, but can be managed with cooperation and calm thinking. Let’s not be like the fictional savages that worry each winter that the days will grow ever shorter, until we have 24 hours of night. Eventually the solstice comes, and the days grow longer.

    Comment by alan143 — 3 October 2008 @ 4:37 pm

  50. One is amazed at the dogmatism of some people who simply do not understand how the economy actually works. There is a very good and utterly factual article at the NYT today that very explicitly pinpoints part of the regulatory failure that got us here: “Agency’s ’04 Rule Let Banks Pile Up New Debt“, NY Times, 2 October 2008.

    The notion that some sort of economic Darwinism would produce perfection is folly. Civilization by definition means moving beyond tooth and claw. The uninformed should be silent, or become informed. And how naive is it to even imagine that there won’t be those who benefit from the attempt to solve the crisis? ‘Twas ever thus. That is no reason not to act.

    Comment by Greg Panfile — 3 October 2008 @ 5:00 pm

  51. Thank you for everything you’ve done so far, Fabius. Get some decent food and some rest because it looks like you’re in for a busy weekend.

    This far exceeds my worst-case predictions of what would happen. I was strongly against the bail-out because I didn’t understand how quickly things could go to heck in a handbasket (I figured it would take at least a month for things to deteriorate this far). Now I guess I’ll have to be a flip-flopper and support the damned thing.

    Comment by pluto — 3 October 2008 @ 5:30 pm

  52. Actually, technically, Buffett invested in capitol (stock), not a loan, for both Goldman and GE. But only technically.

    Its super-duper preferred stock, that guarentees a 10% dividend and can be rebought for 10% over the issue price/current price (whichever is higher), plus a boatload of options that can be exercised later.

    Which means he’s in the least senior position in case of bankrupcy (below unsecured creditors). There are no requirements for principle payments, just a dividend payment (potentially forever).

    But at the same time, the terms are really REALLY rapacious. If the credit market hadn’t frozen up and there was no alternative, and also a need for a “buffett stamp of approval”, there is no way a sane company would take those terms.

    Comment by Nicholas Weaver — 3 October 2008 @ 5:37 pm

  53. I’m just surprised Fabius is for Paulson’s plan of thowing money at the Ivy League educated geniuses that put us this mess to begin with.

    And as for Sage of Nebraska, he’s full of fecal matter when he states ““We have a terrific economy. It’s like a great athlete that’s had a cardiac arrest. And it’s flat on the floor…” Its a terrific economy for players like him who can game the system because of
    their vast wealth. And of course he’d be for the bailout because he’s well situated to exploit it.

    For working and middle-class people OTOH the economy hasn’t been “terrific” or even good for to for a long time. Save for the easy credit, it stinks.

    This is why among other reasons they are aginst Paulson’s bailout.
    .
    .
    Fabius Maximus replies: Perhaps you should read the post more carefully before commenting. The very first line of this post is “The Paulson Plan is already irrelevant.”

    At the end you would see the titles of the two posts discussing the Paulson Plan. Even without reading them, the titles might suggest you have incorrectly characterized my view of the Plan.

    * “Slowly more voices are raised about the pending theft of taxpayer money”

    * “America appoints a Magister Populi to deal with the financial crisis“

    Comment by Rodger — 3 October 2008 @ 5:47 pm

  54. For an excellent treatment of a despair from a Christian perspective, see Kierkegaard’s “The Sickness Unto Death.”

    For Kierkegaard the consummate dialectician (and also the Father of Modern Existentialism), despair can take at least three forms.

    Comment by Jimbo — 3 October 2008 @ 6:20 pm

  55. Short comment on GE: On top of the Buffet deal they will issue $12 billion of common stock to the public.

    That GE have not been able to raise $15 billion somewhere on planet Earth is bad. GE is not limited to just the US financial market. They are a global company.

    Comment by Rune Kramer — 3 October 2008 @ 6:27 pm

  56. Rodger: “BERKSHIRE HATHAWAY INC.”

    Berkshire/Hathaway owns a fair amount of stock. The market price, as of 1/08, is $75 billion. Out of a total market capitalization of $220 billion. But these are, for the most part, big blue-chip stodgy companies, which are ones you interact with every day. Wells Fargo. Coca Cola. American Express. Kraft Foods. Etc.

    But thats only part of it, the rest of the value, some $145 billion worth, is the company’s core businesses, which are insurance (with particular care to prevent counterparty risk and systemic risk), manufacturing, and services.

    THis is his real wealth: If the US economy grows strong fundamentally, Berkshire/Hathaway is strong. If it collapses, B/H collapses. How much money do you think Dairy Queen, Acme Brick, Geico Insurance, Clayton Homes, or See’s Candy will make if the economy is in the toilet?

    And he’s actually poised to make nothing on the direct bailout: Berkshire/Hathaway is one of the few companies considered a good risk, doesn’t have toxic crap to unload, avoided counterparty risk, and the ability to make rapacious investments (like the GE and Goldmam investments) actually goes away if the bailout is succesful.

    Comment by Nicholas Weaver — 3 October 2008 @ 6:28 pm

  57. Another BIG danger sign: The State of California!?! is having liquidity problems: “Calif. leaders hope bailout loosens credit market“, AP, 3 October 2008.
    .
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    Fabius Maximus replies: Most people have no idea about the terrible condition of State and local budgets. They have become dependent on highly cyclical sources of income — e.g., income taxes instead of property taxes — while their expenditures have become more cyclical (e.g., social services grow faster than basic services). The result will not be pretty during the next recession.

    I suspect that many States will run large deficits, which they will not be able to meet by cutting services. Federal aid will be needed. Few will care about the Consitutional requirements for a balanced budget.

    Comment by Nicholas Weaver — 3 October 2008 @ 8:00 pm

  58. Would a guy like Tonto of tv fame go out and get drunk at a time like this or cross the stream back to his teepee and tell Mrs. Tonto, “our god’s are really looking out for us. Whiteman will now have to live in a teepee same as us”.

    Several bankers in Mainland China will be toasting each other with ” Three Giant Leaps for China in one year. First the Olympics, then the astronauts walk in space and now holding America by the short hairs”.

    And Dudes in Arizona will form a posse and wear tee shirts with “Shit happens” on them while drinking green beer while herding goats.

    In Hollywood old Frank Capra scripts will undergo re-writes and voila angesl will fly down and do what angels do best. Sprout wings.

    Welcome to the Brave New World.

    Comment by omop — 3 October 2008 @ 8:14 pm

  59. Forget Wall Street! Forget DC! What about pensioners? The wife and I live on SS. When Russia and Argentina went thru their seizures, pension payments ceased. I am trying to figure out how we are going to heat the house and stock the frig. Fortunately, we have no mortgage, but what about those who do? The 700bn has to come from somewhere. Note how quick the defense budget has passed. That leaves the only other available pool of cash in the SS trust fund. I can see myself fighting with my neighbor for a cardboard box to sleep in, and a dumpster to dive in.
    .
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    Fabius Maximus replies: The bankruptcy of the Federal pension and medicare systems lies in the future. Even then the problem can be managed by means-testing and taxing benefits, with reasonable restrictions on benefits (such as “unneccessary” medical care). It is not as dire as some project. This will involve breaking the “promises.” But anyone who believes such promises is bound to be disappointed in life, one way or another.

    Comment by dumbpolack1 — 3 October 2008 @ 8:40 pm

  60. you write “The US will probably not have a sufficient savings rate to fund such a large fiscal deficit. We are almost totally reliant on foreign central bank lending, which they have done to finance our purchases of their goods. But this borrowing will be different, for internal consumption not trade finance. Will they share your complacency about funding a large piece of $2 trillion dollars in 2009 borrowing (10% of $14,000 b plus $500 b in maturing debt)?”

    the federal governemnt is not reliant on foreign central banks or domestic savings to “fund” itself. when the federal government spends it debits the treasuries account at the federal reserve and credits a member bank’s account. bond sales and taxes are reserve drains. the federal government does not collect taxes or sell bonds before spending. the money used to pay taxes and buy bonds comes from govenment spending.

    foreign central banks have accumulated dollar reserves as a result of their foreign exchange policy. should they no longer which to accumulate dollar assets they will have made a decision to alter their fx policy – not alter our ability to run a deficit.

    the pubilc sector deficit is exactly equal to private sector (including foreign private sector) savings.
    deficit spending can be inflationary but the federal government is not revenue constrained.

    http://www.epicoalition.org/docs/FebruaryWorkshop.htm
    http://www.epicoalition.org/docs/cambridge05paper.pdf
    .
    .
    Fabius Maximus replies: This is totally incorrect, but too complex to discuss on this site. Much as if you decided to question gravity.

    Comment by sg — 3 October 2008 @ 9:36 pm

  61. Extermle choices are always bad , for example extermely unregulated markets or planned economies both proved to be non sustainable

    just one thing

    “Fairness and equity are now irrelevant luxuries” ?? In the US you have a weird culture that considers the disadvantaged as unproductive, and it is clear that Fairness , improved public schooling ,and better social services are Eternal Luxuries , while a 600 Billion Dollars Defence expenditure is a neccessity.
    .
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    Fabius Maximus replies: That was meant in a narrow sense, as to which capitalists to bail out. It was not a broad discussion of allocating funds to provide basic social services, not even remotely mentioned in the post.

    Comment by Samer — 3 October 2008 @ 10:06 pm

  62. btw, the largest systemic risk in the world now is europe, who as trichet noted, do not have a federal budget to deal with the same issues the us is facing. they have mandated budegt deficit limits that prevent counter cyclical government spending. spain and italy are in terrible shape and can add nothing to a pan europen bail out type plan. will the french and the germans be willing to bail out the rest of the union? the eu may very well not survive this – certainly not in their current form.
    .
    .
    Fabius Maximus replies: I very much doubt that is true. With one exception: the risk of the EMU itself fragmenting, as discussed in “Can the European Monetary Union survive the next recession?.” That level of systemic risk the US does not have, fortunately.

    Comment by sg — 4 October 2008 @ 12:44 am

  63. nice read: “The Real Great Depression“, SCOTT REYNOLDS NELSON, The Chronicle of Higher Education, 17 October 2008 — “The depression of 1929 is the wrong model for the current economic crisis”

    In the end, the Panic of 1873 demonstrated that the center of gravity for the world’s credit had shifted west — from Central Europe toward the United States. The current panic suggests a further shift — from the United States to China and India. Beyond that I would not hazard a guess. I still have microfilm to read.

    I guess it is time to stock up on canned goods.
    .
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    Fabius Maximus replies: I cannot see how you arrive at your exteme conclusion from anything in this article (which is clever, but that’s about all IMO).

    Comment by drake — 4 October 2008 @ 1:30 am

  64. To take up Buffett’s analogy to Pearl Harbor: If we were being threatened by a foreign power, Fabius would advocate peacefully surrendering to their tyranny – because fighting to protect our freedom would result in massive human suffering.

    So much for the argument for surrendering (what’s left of) our economic freedom to government intervention.
    .
    .
    Fabius Maximus replies: Please share with us how you arrive at this bizarre conclusion.

    Comment by Steve — 4 October 2008 @ 1:37 am

  65. Update: it is not only business that suffer when the credit tap is shut off

    “California may seek Treasury financing“, Reuters, 3 October 2008 — Excerpt:

    California Gov. Arnold Schwarzenegger has told U.S. Treasury Secretary Henry Paulson that the most populous U.S. state may need the federal government to buy $7 billion of debt the state is unable to sell due to weak credit markets- and that California may not be alone.

    The $7 billion issue of revenue anticipation notes would raise cash to tide California over the near term until it gets expected revenues, but the plan to sell the debt is in peril because the municipal debt market is frozen, State Treasurer Bill Lockyer said earlier this week.

    “This is not a normal year,” said Lockyer spokesman Tom Dresslar on Friday, adding that the state was preparing the issue but that markets were in turmoil: “The paralysis lingers.”

    The municipal bond market, where California hopes to sell its short-term notes, has all but frozen up over the past three weeks as buyers have been scarce and tax-exempt yields have skyrocketed. Few deals have been priced, while scores of issuers such as states, hospitals, school districts and others, have postponed their bond sales awaiting a market turn around.

    … If the state could not sell the notes, it would have to adopt measures to cut spending, such as delaying salaries of teachers and other state employees.

    Comment by Fabius Maximus — 4 October 2008 @ 1:50 am

  66. “California may seek Treasury financing“ – substitute italy or spain or belgium for california and they don’t have a europen treasury to go to and you get an idea of what is facing the eu. add to that the banks are all short usd and have no way to obtain them apart from via the ecb who get them from swap lines with the fed.

    my view is the euro will soon break 100.

    Comment by sg — 4 October 2008 @ 2:24 am

  67. “Fabius Maximus replies: Please share with us how you arrive at this bizarre conclusion.”

    Please share with me what’s bizarre about it.
    .
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    Fabius Maximus replies: Why? You made the statement, and should have some basis for it.

    However, to spell it out, it bears no visible relationship to anything I have posted on this site.

    Comment by Steve — 4 October 2008 @ 2:55 am

  68. “Fabius Maximus replies: Why? You made the statement, and should have some basis for it.”
    You said it was bizarre. You should have some basis for that.

    “However, to spell it out, it bears no visible relationship to anything I have posted on this site.”
    You haven’t advocated government intervention in the economy?
    .
    .
    Fabius Maximus replies: So you believe that everyone who advocates government intervention in the economy (a mainstream belief in economics since WWI) would “if we were being threatened by a foreign power, advocate peacefully surrendering to their tyranny – because fighting to protect our freedom would result in massive human suffering.”

    WWII is a counter-example to your theory, since millions of men and women who voted for Hoover and FDR went off to fight, not surrendering to tyranny. (Hoover initiated many of the programs expanded by FDR).

    Also, many veterans and current members of the US armed forces are, for example, members of the Democratic Party — and “advocates of government intervention in the economy.” Please be polite when throwing this accusation at them face-to-face.

    Comment by Steve — 4 October 2008 @ 4:00 am

  69. Fabius Maximus replies: This is totally incorrect, but too complex to discuss on this site. Much as if you decided to question gravity

    please tell me what is totally incorrect. it is factualy correct in terms of treasury fed operations and represents an accounting identity in terms of public sector debt vs private sector savings.
    the notion that we borrow from foreign central banks to fund the federal deficit is naieve at best.

    from a greenspan interview re. solvency of social security

    GREENSPAN: “Well, I wouldn’t say that the pay-as-you-go benefits are insecure, in the sense that there’s nothing to prevent the federal government from creating as much money as it wants and paying it to somebody. The question is, how do you set up a system which assures that the real assets are created which those benefits are employed to purchase.”

    notice nothing about the federal gov’t being dependant on taxes or foreign central banks or any other foreign or domestic private entity to fund itself. we have a fiat currency and spend at the federal level by debiting the treasuries account at the fed and crediting a member bank account. that is indeputable fact. if you pay your taxes in cash the traesury will burn the cash, they wont say great now we can pay some social security benefits ….. bond sales are an offset to the newly created cash and represent a reserve drain as do taxes.
    .
    .
    Fabius Maximus replies: Yes, both Greenspan and Bernanke have talked about printing money as the last resort of the government. “Helicopter Ben” they call him after his famous “the U.S. government has a technology, called a printing press, that allows it to produce as many U.S. dollars as it wishes at essentially no cost” speech.

    The limiting factor to currency creation is inflation. Remember Weimer, the extreme case? Hyperinflation? It never recovered, and in less than a decade Germany was being run Hitler.

    Please, this is basic economics, hence off-topic for this site — which discusses geopolitics. You can choose to agree or disagree as you choose, but debate it elsewhere. There are other places on the web for this.

    Comment by sg — 4 October 2008 @ 6:38 am

  70. “The limiting factor to currency creation is inflation”

    exactly , not china’s or anyone elses willingness to lend. its an enormously important distiction for economic and geopolitical reasons. we need to be clear that we are not beholdant to china or the middle east. we are entering a defaltionary period and the inflattionary impact of a larger deficit should not be viewed as a constraint.

    thank you for your resonses.

    Comment by sg — 4 October 2008 @ 8:20 pm

  71. Important Update:

    Today the Fed announced that is it doing 1 above, making direct unsecured loans to non-financial companies (e.g., buying their commercial paper). I see no alternatives at this time. This is good news, but will require massive funding to have the necessary effect.

    See this press release from the Fed for details.

    Comment by Fabius Maximus — 7 October 2008 @ 2:51 pm

  72. Fabius, are you some kind of hyperintelligent AI supercomputer with unlimited resources and patience? I am surprised and impressed by your cool equanimity in the face of these aggresive, wilfully ignorant comments.

    Onto your actual post, I agree that urgent action is required and the scope will be unprecedented. Most commentors so far seem to have no idea as to the scale of the problem.

    Your comment above mentions the need for “massive funding” for the “stage 1″ treatment to have the necessary effect. I think we can all take it as read that the US’s creditors are now taking a very serious interest in the situation and I would be very surprised if there was not a lot of talk going on behind the scenes. Would be very interesting to be a fly on the wall at that meeting.

    One wonders what the credit line necessary for the stage 1 action is. One also wonders what the appropriate next step for the US Govt could possibly be. Given the extent of the cancer and the lateness of the day I am beginning to think that nothing less than granting basically unlimited emergency powers to the treasury to take whatever actions they see fit will do the trick. Pointing fingers and assigning blame can come later; nothing now is more important than getting the system back on its feet.

    If only the people posting their simplisitc, ideologically-motivated comments here would realise that if the system is not fixed, NOW, that we could see martial law in the USA by the end of the year. Now, the implementation of Fabius’s step 1 makes that a lot less likely, of course. But the nightmare scenario of millions of businesses suddenly folding, leaving even more millions suddenly unemployed and needing food, is real and plausible. That situation must be avoided by any means necessary.

    —

    Since this is nominally a geopolitical blog, I wonder if you have any speculation on “concessions” which have already been agreed in condition to further lending. Your posts discuss such conditions as if they’re far-future hypotheticals; given the astonishing speed at which this situation is unfolding I cannot help but suspect the “concessions” are already on the table. Rumours are flying around, I would love to hear your take. The recent semi-official murmurs that the yuan is about to appreciate are perhaps revealing in their timing.

    Another thing I’d love to hear your view on is the astounding development that default risk is now seemingly being priced into 10yr T-bills.

    Thanks for all your work.
    .
    .
    Fabius Maximus replies: I doubt if international coordination is that advanced yet. More likely they are discussing more technical matters, focused on restarting global commercial capital flows.

    “that we could see martial law in the USA by the end of the year.”

    A more reasonable worst case outcome — and worst case outcomes by definition almost NEVER happen (I cannot repeat that too often) — would be nationalization and direct government control of the financial system. This is a finanical problem only. The nation’s human and physical resources remain untouched, so no massive social disorder need result. No martial law, riots, and such. We did not see that even in the 1930’s, a far greater event in most ways.

    “the astounding development that default risk is now seemingly being priced into 10yr T-bills.”

    The credit market mechanisms have gone bonkers under the stress. This is seen by some private companies having credit default swap rates better than that of the US Treasury, which can print money (source). It’s a malfunction.

    Comment by Sho — 8 October 2008 @ 9:35 am

  73. Update: advice similar to item (A) in my post: ”

    “Getting the interbank market going again: the central bank as counterparty of last resort“, Willem Buiter, blog of the Financial Times, 5 October 2008 — Excerpt:

    “The interbank markets, secured and unsecured are, respectively, moribund and dead. The reason banks don’t lend to each other in the interbank market is counterparty risk – fear of default of the party they are lending to. Unsecured interbank lending (for which Libor or Euribor are common price measures) has effectively vanished, even at the overnight maturity.

    “… When banks don’t lend to each other, they are also unlikely to lend to economic agents that matter intrinsically: households and non-financial corporations. This has been a problem for a while in the US and the UK as regards bank lending to households, to developers and to firms in the construction sector. It is now spreading rapidly, in the US, the UK and in the rest of Europe, to the non-financial sector as a whole, starting with SMEs, but not stopping there.

    “To get interbank lending going again, banks must have confidence in each other’s solvency and liquidity. How can we restore trust in these interbank relationships? There are a number of options.

    “(1) Nationalise the banks. When they have a common majority owner (the state), the state can simply instruct the banks to lend to each other. Problem solved. It may come to that in any case, but for those who are not ready for such measures, here are a couple more.

    “(2) Guarantee interbank lending. Here the Treasury guarantees interbank transactions, both secured and unsecured. This should be done against fees that ensure the Treasury an acceptable risk-adjusted rate of return on this activity.

    “(3) Have the central bank interpose itself as the universal counterparty for interbank transactions. This is effectively already the case in the overnight market in the UK and the euro area. When the Fed starts paying interest on reserves (commercial bank deposits with the Federal Reserve System), we will see the same phenomenon there.”

    About Prof Willem Buiter:

    Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

    Comment by Fabius Maximus — 8 October 2008 @ 1:05 pm

  74. Fabius: obviously I meant the worst case scenario, which would involve not only business failures en masse but also a massive collapse in the dollar. Nationalisation wouldn’t help in that nightmare scenario. And 1930 is not directly comparable, because the US was not a net debtor nation at that time – it would be more like the financial situation in 1930 plus the oil shock in the 70s.

    Anyway obviously that is a highly unlikely scenario that no-one wants to precipitate, least of all the creditors! I simply wanted the previous commentors to realise that the situation was a lot more serious than they seemed to assume, and government action was not an arbitrary gift to their financial buddies, but urgent and absolutely necessary emergency first aid to the very basics of the nation’s economy.

    Oh and by the way, it seems international coordination got a lot more advanced in the mere hours between replies here…
    .
    .
    Fabius Maximus replies: I understood that you meant a worst case scenario. I replied that a social collapse is not realistic even in the most extreme scenarios, IMO.

    Why do you say that “international coordination got more advanced in the past few hours.” I wrote my reply after the news about the 6 nation rate cut. As I noted in this post, this is small step towards coordination, nothing compared to what is required.

    Comment by Sho — 8 October 2008 @ 6:44 pm

  75. Update: “to inject capital into financial institutions” was the first item that Hank Paulson listed as his priority in his press conference yesterday, thus suggesting that now the US, like the UK, will undertake a partial nationalization of its distressed banks.

    For an explanation of this major development, see Nouriel Roubini’s new article at RGE Monitor — Excerpt:

    “The reality is that the TARP legislation passed by Congress (formally the Emergency Economic Stabilization Act) does not in any explicit way allow for such recapitalization of banks via injection of public capital. The US Treasury has initially resisted including explicitly such authority in the Act for several reasons: the banking industry that helped drafting the legislation was against it; there was ideological resistance to the idea of the government taking equity – however preferred – in financial institutions; there was concern that being explicit about public recap of banks would lead to banks’ resistance to participate in the toxic asset purchase program. That is why the Treasury formally resisted putting any explicit wording of public recapitalization of banks into the legislation.

    “So how come Treasury now says that its first priority is to inject public capital in banks? And where is Paulson getting such authority since there is nothing formally explicit in the Act to allow such recapitalization?

    “This is a fascinating story that is worth telling in full detail. Here are below those details…”

    Comment by Fabius Maximus — 9 October 2008 @ 2:55 pm

  76. Came across this post in the WSJ forum: “The Government Is Contributing to the Panic“, 11 Oct 2008 —

    “THE CORRECT WAY TO HANDLE CDS SYSTEMIC RISK, from a former bankruptcy attorney as well as former General Counsel to a Mortgage-Backed Securities Issuer:”

    “Markets will not resume rational behavior until the nuclear threat of credit default swaps has been rendered harmless. There are $55 Trillion of these private, non-regulated insurance agreements outstanding involving every major money center bank, investment house and major insurer worldwide. There are two ways to take away counterparty risk. One is to guaranty their performance. The other is to render them unenforceable or of only limited enforceability. …”
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    Fabius Maximus replies: We are living out the 4 blind men and the elephant fable. One feels the leg and says “It’s a tree!” …

    Most of the folks wisely comment on the technical aspects of the crisis were unaware of these things a year ago. Now they have the simple plan to save the world. It’s a normal defense mechanism to boil a large, complex event into one easily understood marble — and prescribe the cure. Tom Grey says it is ALL ABOUT home prices. This guy says it is ALL ABOUT CDS. Others say it is ALL ABOUT the interbank lending mechanisms (fix LIBOR and you fix the world!). All share undeserved confidence in their prescriptions.

    This is absurd. We are experiencing a systemic failure due to the accumulated imbalances of 50+ years, most esp the buildup of more debt than the system can handle. To use a metaphor, this induces “torque” on the finanical system, under which many components are failing. Each failure increases the stress on the system.

    There are no magic bullets, no simple cures. Many things need to be done. Some are quickly effective. Some have long lags, but must be done now because we will need their action ASAP — even it it is 2009.

    Comment by bc — 12 October 2008 @ 3:03 am

  77. The above is a variation on the theme of hyper corporations spanning a hyperspace of hyper functionality. GE is a perfect example. GE makes jet engines and locomotives, while GE capital functions as a bank, currency trader, and for all we know has dabbled in CDS’s. Like AIG, even though only one segment gets into trouble, the whole entity is too big to fail. The above post rings true in the sense that world governments need to disentangle this hyper structure with hyper laws which can selectively bankrupt targeted activities without bankrupting the hyper entity. One nice thing about being “the government” is you can change the law as well as run the printing press.

    Comment by bc — 12 October 2008 @ 3:30 am

  78. FM note: At 1486 words this post was far over the comment policy’s limit of 250 words. I have edited it down to a still-too-long 423 words. You can see the full comment here.

    Max, you write that the “cause” of this debacle doesn’t matter. All that matters is effective action.

    I can’t disagree strongly enough. If your home has water in the basement and you start throwing fixes at the problem without accurately diagnosing the cause, how can you imagine that your fixes will work? A successful “fix” only comes from knowing from where the water comes.

    … The cause of the current crisis is widespread and continuous violation of Say’s Law. The central bank creates credit out of thin air, credit that is (in optimistic times) borrowed and multiplied through fractional reserve banking to become marketplace demand. … If this theory is correct, the government and Federal Reserve are, when they propose to throw ever more of their “money” (it’s credit backed by NOTHING, no capital creation at all) at bad loans and bailouts, in actuality revealing more and more of the fraud that held together the “House Of Cards” (as President Bush referred to the U.S. economic system recently).

    There are two conclusions (perhaps there are others) one can draw from markets selling off in response to each new proposal and each new bailout. One is yours, that their proposals are simply too small, and that a much more massive amount of intervention is needed to get lenders to lend and borrowers to be solvent and borrow again. The other, mine, is that the confidence that used to greet government fiat credit creation is gone.

    … Everything you propose for politicians and bureaucrats to do will not have any benefifical effect. … Sadly, since misdiagnosis of this disease is nearly universal the “cures” will continue until the patient is nearly dead. … Then will be revealed the truth: That we were always on our own and that those who trusted their rulers to “take care of them” were the worst kinds of fools for their awe of men and women whose primary qualification for power was naked ambition.

    All the prescriptions for fixing this and fixing that, even if they recognize that this crisis was 50 (or more) years in construction, are based on what is fundamentally an incorrect grasp of cause and effect in the affairs of men.

    … Let’s get back together in a decade and see which of us is alive and relatively wealthy, and which of us lost everything we had and suffered mightily. I’ll follow my own path, and you go with the herd.
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    Fabius Maximus replies: All sites discussing any of the social or physical sciences get comments like these, in effect saying that the foundations of this field are wrong. Sometimes they are correct, but the odds are fairly solidly on the other side. A rebuttal to this is beyond my abilities and outside the scope of this site.

    Comment by David C. — 13 October 2008 @ 1:29 am


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