Due Diligence, Damn It
Rauchway's book is an exceptionally valuable pocket summary of the major actions of the New Deal. It solves a big problem for those with small pockets: how to keep enough facts at close hand to answer, with authority, all the anti-Roosevelt nonsense and disinformation in circulation these days.
But Rauchway is also very good on Hoover. He is especially good on the illusions and self-delusions of the Depression's first years. Chief among these was the optimism, the ritual statements that things would soon get better, that prosperity is "just around the corner." This false optimism we don't hear expressed so much today; President Obama knows to avoid it.
But false optimism is, nevertheless, still present. It has become a mental habit. It is institutionalized and embedded in the professional economic forecasts, notably the official baselines of the Congressional Budget Office. These cannot admit the possibility that we are at the start of a new Depression, because there is no similar experience in the statistical record on which they draw. It will take time, grim experience, and determined argument, before the President and Congress come to grips with this.
A second feature of the Hoover years was his desire to revive credit, lending and the operations of the banks. There was a touching faith in the institutions that had brought so much prosperity in the 1920s. And the people who had enabled the boom were in no position, mentally or politically, to admit their errors and change their views.
So it is today, obviously. The new Treasury, like the old one, remains in a Hoover mind-set, fixed on the chance of a top-down solution that would, in a phrase we hear constantly, "get credit flowing again." The idea is to stuff the banks with money, in the hope that they will burst and the manna will rain down.
But banks are not moneylenders! They do not need money, in order to lend! Banks create money. And they do it, when they want to. They lend, in other words, when there is a reason to lend. And not otherwise. The testimony of the bank chiefs yesterday made this very clear.
Or to put it another way, credit is not a flow. It is a contract. It requires a borrower as well as a lender. And the borrower must be both optimistic and solvent. These are the conditions that are not met today, and that cannot be met by stuffing money into the banks.
FDR realized two things. First, that the banks were bust. They had to be closed, reorganized and rebuilt. And second, that credit would revive only if the balance sheets and business prospects of the borrowers -- that is to say, of the American population -- were restored. The first he accomplished immediately. The second took through World War II, which (through victory bonds) massively recapitalized the American family. Meanwhile, for nine years New Deal spending kept Americans fed and economic activity alive.
What Secretary Geithner needs to do is, is assign teams to examine the banks. He must do this, before taking the fatal step of guaranteeing their assets. Examination, as in, look at the loan tapes underlying the mortgage-backed securities. Look at them. This is called "due diligence." Or, not buying a pig in a poke.
It will become clear that the banks either (a) do not have the loan tapes, and hence can say nothing about the quality of the underlying mortgages, or (b) where they do have the loan tapes, that sub-prime securities are deeply infected by fraud and misrepresentation.
We know this, because of the losses already incurred, and some evidence from inspections that have actually occurred.
When this becomes plain, it will be clear that there is no upside to these assets. They cannot recover. They are, essentially and for the most part, doomed to default. Therefore it is wrong to speak of the taxpayer "assuming the risk." The Treasury is proposing to take on a sure loss, thus to make a massive transfer to bank stockholders and incumbent management. With no effect on the balance sheets of the American public - and therefore no chance that credit and credit-fueled economic activity will revive.
That, so far as I understand it, is the economics of the Geithner plan.
Perhaps the Treasury has a clear and persuasive answer to this argument. But if they do, they have not made it. And their constant use of a bad metaphor - "credit flow" - raises grave doubts. Does the Treasury team really understand, in a way that clearly separates the public interest from that of the bankers, the situation we are in?
These FDR comparisons are getting kind of silly. First of all, FDR didn't realize the banks were bust; the banks were, in fact, bust. By the time of the Bank Holiday declaration, the country had experienced FOUR separate panics over three years, and 1/3 of all banks had been literally destroyed. Moreover, as economic historians now recognize, FDR only declared the holiday after STATE GOVERNORS forced his hand, by declaring their own holidays, thereby setting off a chain reaction that forced FDR's hand. Finally, a year of Pecora's congressional investigations gave FDR the legitimacy to act - a legitimacy that Obama, even despite the current banker mini-scandals, still lacks.
But perhaps most importantly, the actual economic problems that FDR faced were totally different than what we face now. In 1933, it was a nationwide depositor panic that threatened to bring down the financial system - in other words, it really was a problem of confidence, not insolvency. Thus, all FDR had to do is declare the holiday and insure the deposits. That stopped the run and solved the problem. Today, the problem is INSOLVENCY, not CONFIDENCE. So the analogy is simply fallacious.
I appreciate the desire of progressives to see every problem and ask "What would FDR do?", but in this case, the question obscures more than it clarifies.
February 13, 2009 7:15 PM | Reply | Permalink
. . . that credit would revive only if the balance sheets and business prospects of the borrowers -- that is to say, of the American population -- were restored. James K. Galbraith
Jamie goes on to point out that the balance sheets were fixed by massive deficit spending in WWII which was transferred to Americans who were "forced" to save it (rationing, price controls, and nothing to buy).
Today, Americans want to repair their balance sheets; until they've done so, it's unlikely they'll begin spending again.
So ---
Give them a trillion in cash, today; give them another trillion or two next year. Let the banks go their own way. Enough with these piddling "stimulus" plans that sound like more of Hoover's and Roosevelt's foolishness.
February 13, 2009 8:00 PM | Reply | Permalink
When the entire private sector is bent on shortening its balance sheet and paying down debt, the public sector’s balance sheet must move in the opposite, offsetting direction. When the entire private sector is striving to save, the government must dis-save. Axel Leijonhufvud via naked capitalism
February 14, 2009 11:57 AM | Reply | Permalink
And . . . "deficit spending will be absorbed into the financial sinkholes in private sector balance sheets and will not become effective until those holes have been filled." Axel Leijonhufvud
February 14, 2009 12:04 PM | Reply | Permalink
And some more ---
We are suffering a collapse in demand in consumer goods and services, in capital investment, and in exports -- all threatening to replicate the collapse in demand of the 1930s.
But unlike the 1930s our leaders enjoy the benefit of a consumer centered economy of huge proportions -- something that Roosevelt didn't have going for him. He was compelled to deploy deficit spending in public works (okay, the American ideology played a part in constraining his policies, also). Deficit spending trickled down to the consumer in the form of wages but even so, 1930s consumers couldn't carry the economy. Now, they can.
Again, the Great Depression wasn't resolved until the end of WWII by which time private balance sheets had been repaired and a consumer boom (Levittowns, cars, refrigerators, Sealy Posturepedics, etc.) could take off.
We can do it again but this time faster, because the intermediation of public works is unnecessary. Just give the people the money!
February 14, 2009 8:00 PM | Reply | Permalink
But banks are not moneylenders! They do not need money, in order to lend! Banks create money. And they do it, when they want to. James K. Galbraith
I suspect that this observation (which too many of us seems obvious) is "heretical," and I'd be interested to see whether others agree.
Textbook economics says the Fed creates money, transfers it to the banks which then, lend it and relend it based upon whatever reserve ratio the Fed has imposed -- the old give a bank a $1000 at a 10% reserve ratio and $9000 will be created.
But in fact what actually happens is that banks make loans which creates money and only then, do they bother to go out and find some cash from somewhere to maintain their reserve ratio (or convince the Fed to lower the ratio).
Thus, stuffing the banks with money and expecting them to loan it as a matter of course bespeaks little understanding of our credit based financial system -- and is doomed to failure.
February 13, 2009 8:17 PM | Reply | Permalink
"the old give a bank a $1000 at a 10% reserve ratio and $9000 will be created"
Why is this old saw passed around as fact?
Lend/give a bank $1000 and it can lend out $900.
If an efficient bank has $1000 in reserves/capital, it's a reasonable inference that there is $9000 on loan (and $10,000 on deposit or in capital). But just plunking down another $1000 deposit doesn't create any money at all. It only adds $1K to the $10K, and it only allows $900 more to be lent out for total assets of $9900.
See my other comment below for more on "banks create money".
February 13, 2009 10:04 PM | Reply | Permalink
"Thus, stuffing the banks with money and expecting them to loan it as a matter of course bespeaks little understanding of our credit based financial system -- and is doomed to failure."
Right, This is "supply-side" economics: Provide cheap credit and borrowers will appear. But the public is spent out on SUV's and McMansions. The day has ended when consumerism provided 70% of GDP. Demand for "stuff" is collapsing. It will have to be replaced by investment in public wealth, things such as education, infrastructure, alternative energy, health care.
We can, and will, accomplish this with increased taxes and spending on things that increase the public wealth, our wealth as a nation. Public wealth includes rapid transit, alternative energy, education, health care -- everything the Republicans are fighting.
How about ending the depletion allowance of the oil and mining companies? They are a subsidy for cheap oil and commodities. Encourages waste. End agricultural subsidies; payments to corporate farms. Private insurance companies for health care, etc.
February 15, 2009 3:41 AM | Reply | Permalink
This seems apt today:
I think we need Geithner to explicitly acknowledge this concern and explicitly repudiate it or make a strong case about it.
Banks extend credit, they do not create money. They borrow money or use capital, to make money work (harder or not so hard) and choose the risks it will work with. Maybe what the author is trying to say is that banks can borrow more or less at will from the Fed, "when they want to". Therefore if the Fed creates money on demand from banks and feeds it to them, they in effect create money.
But money creation is theft, counterfeiting in fact if not in law.
February 13, 2009 9:52 PM | Reply | Permalink
No.
The "author" is saying that banks create money -- not as you would have it, the Fed.
Are you sure you understand fractional banking? A chart displaying money creation -- "$1,000 becomes $10,000" -- under the standard doctrine is here.
February 13, 2009 10:31 PM | Reply | Permalink
Keep up the good fight Ellen!
February 13, 2009 10:59 PM | Reply | Permalink
Calling a column entry "Money" doesn't make it represent real money. It's also ludicrous to think that people borrow money to put it back in the bank earning less interest than they are paying the bank in the first place. Money in checking accounts is not money in deposit accounts, generally.
You're mistaking money creation for money working. The bank puts the $1000 (money) to work (as $9000 of distributed credit in the silly example). As said before, "money=credit" is a false equation which some folks like to pretend is true. FRB ties credit limits to money.
Lots of abstract macroeconomic notions don't translate into concrete reality at all well. When the first depositor asks for his money back, all the other loans get called in, and there's $1000 plus a bunch of angry debtors.
February 13, 2009 11:47 PM | Reply | Permalink
Eds, you normally have some thought provoking points, so you made me do some research here to make sure that my memory hasn't failed me completely. So I went to Helicopter Ben’s homepage and found this doc. The Fed Today which says:
"For the economy and banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to “create”money"
This is what Galbrieth says, so what do you mean by money working?
February 14, 2009 1:24 AM | Reply | Permalink
First thing I see is the scare quotes on 'create' money. That means the author is lying or speaking unduly metaphorically. So that's my point right there.
I'm simply calling for us to "call a spade a spade". We all know there is a huge difference between credit and cash. Cash, whether currency or not, is fungible, credit seldom is (though I can borrow on my credit to get money to lend to you, I can't just hand over my line of credit to you like I could hand over cash to you). Credit comes and goes even in a stable financial system, money is real unless you burn it up. If you get mugged and lose cash, you don't get it back unless you bought exotic insurance. If you get mugged and lose your credit cards, you might have zero losses. Stable money doesn't cost anything (except for inflation) but actual credit (when you have borrowed against a line of credit) generally costs more than current inflation.
One of the problems of modern finance is what I call the "monetization of money", treating money (and credit) as if it were just another commodity. Objectifying money is highly problematic even if it's a convenient mathematical trick in macroeconomics. And treating credit as if it were money is part, in my view, of what fostered this current mess. People just took MBS and wrote CDS and then even wrote CDO on the CDS, if I get the story right. People treated credit (and insurance) as if it were a sure thing.
In my view, a view which has not yet been challenged except by fallacious argument from authority, the "Money" column at Ellen's cite is a misnomer, a trick. At best it's a didactic tool to teach a concept, but like all crutches it should not be leaned on forever.
The Federal Reserve Board is the only authorized money creation facility in the US that I know of. They use bookkeeping entries to effectively create additional money. Banks aren't allowed to do that.
In some cases we can say that credit is an imaginary complement to real money, but that strikes me as clumsy. Just call credit what it is, credit.
Without FRB, money in the bank cannot work, it's like having it in a safety deposit box or under your mattress. With FRB, the bank can lend out some of the money, and thus can pay you interest on your deposit which is virtual work, it generates rent. The money loaned out does work for the bank, too, provided the borrower doesn't default.
Enough?
February 14, 2009 2:11 AM | Reply | Permalink
Hmmm, the scare quotes were in the document I think because it was an educational document, not an academic "take this" doc. but I am not the author ask Ben about that.
You have some intriguing points but to paraphase, a lot of abstract microeconomic notions don't translate into concrete reality very well.
What credit means to your daily interactions isn't the issue. Its what it means to the Money supply that matters. Money is created because of credit. In fact over 94% of money in the world is in the form of credit, not cash.
Yes cash and credit are the functionally the same thing. The only difference is ease of use (and that is reflected in the pricing). Credit is indeed fungible, when a mortgage is securitized that's credit being sold. When a shareholder buys partial ownership of an institution that is credit, if the institution has an LOC, then they have partial ownership and can use that credit.
These examples take a little longer to liquify but you can still do it. That is why in your example "stable money" costs less, it is a little more fungible, therefore you don't need to add a point or two for the trouble or the risk. That does not make it not credit, just worth a little more, or much more in times of great uncertainty. But they still function the same, but that is why their are different measurements of money supply (m1, m2, m3, etc.) And yes the FRD is key to the system... thats how it is here in the states.
So what do you advocate as Money? It sounds to me like you want a return to the gold standard. That is a good safeguard for current wealth by eliminating the risk of loss through government actions and consequential inflation. But it also limits our rate of economic growth to the gold supply which seems arbitrary and suicidal to me. Do you have a different suggestion?
P.S. I am sad that you didn't look at the links I was so proud I html tagged them. First time I have managed that.
February 14, 2009 3:06 AM | Reply | Permalink
I did look at the Fed Today link, and searched to find the quote!
I'll try to reply on topic later.
February 14, 2009 3:35 AM | Reply | Permalink
I feel like we're getting way off topic here, thread-wise. My point was that money=credit is part of the problem we have today. You buy into the fiction, I don't, here. I'm doing due diligence, so to speak, on the loose talk being thrown around by Ellen and now you.
Where have I argued against fiat money?? We're talking FRB here.
No, buying an RMBS is not buying credit, it's "buying" revenue streams, the rent, the work being done by the money which was loaned. And, collateral=credit is another error; mortgages are backed by collateral.
That people do or say stupid things should not legitimize them generally. I cannot give you my credit because my credit depends on my rating, I'm a different risk than you are. If we both have the same credit rating then for macro purposes we might be indistinguishable but in general the reason mortgages aren't just transferable to the new owner is because credit doesn't work that way. You have to get "appraised" like the property might get appraised when you go to refinance.
??
February 14, 2009 3:48 AM | Reply | Permalink
Yes we are off topic/ Money supply is cash and credit. I didn't say you argued against fiat money, just stated a distaste towards inflation and preference for a safe (gold) standard. I asked if that was what you meant.
Valuing an revenue stream is based upon ability to pay- credit. Mortgages are sold based on credit rating, not colletral, but fair point, it does play into it. However, they are still sold, and valued by credit- hence are fungible.
94% of money supply is credit. I agree that the disconnect between cash and many forms of credit is at the heart of our problems. However that has nothing to do with the original topic.
The point that Galbraith made that Ellen defended, and I have taken up is that money is created by banks. The Fed states it clearly that this is so. It is our current system.
February 14, 2009 4:53 AM | Reply | Permalink
No, "create" is not create. Until you can dispute this, you're just handwaving in support of dogma.
But yes, valuing revenue streams and selling credit are key components of the current situation. The involve a disconnect from reality based on the problematic notion that money=credit. Surely you've seen it said by others that the problem with mortgages involved a disconnect between the homebuyer and the ultimate investors (who objectified the homebuyer into a mere statistic). It's a failure of globalization, so to speak.
Whether you invoke Taleb's Black Swan or the Reflexivity of Soros, it doesn't look good.
February 14, 2009 3:03 PM | Reply | Permalink
Sorry, hit Submit too soon... the top is due diligence. The disconnect is a failure of due diligence. The MBS buyer can say "I don't care about the individuals and the details of their lives/credit situations" but my point is that that is not due diligence, if from a different perspective that perhaps Galbraith meant it.
Also, I did not disagree with Galbraith in general, but on this very general point:
"But banks are not moneylenders! They do not need money, in order to lend! Banks create money. And they do it, when they want to. They lend, in other words, when there is a reason to lend."
Banks are money lenders, or should be. They do need money, in order to lend. Banks don't create money, they pass money from one party to another. When banks fail to do due diligence, there is a problem. When banks foist off their fallacies on to 4th party investors, that allows problems to amplify. I don't see Galbraith joking there, so it was something to correct.
February 14, 2009 3:11 PM | Reply | Permalink
Look I dont' disagree with your due dillegnece points, or the disconnect is at the heart of our problems.
But forgive me for harping, but the Fed itself says that Banks create money. This is how fractional banking works. Its not dogma, but reality.
Other than that we agree a lot more than we disagree, please carry on.
February 14, 2009 4:14 PM | Reply | Permalink
No. The resource you presented was a teaching document not official policy. I've pointed out how Ellen's cite is a fraud.
And your cite did not say "banks create money" it said "banks 'create' money", as I've pointed out three times now.
There is a difference between As Is, and As If. It's often the difference between Fact and Fiction. Fiction is used in teaching, but should not be confused or conflated with Fact. Hypothesis is a mixed state, we might say it's What If, while dogma assumes What Is.
I'm glad we mostly agree! Sometimes I think we don't even communicate well. :-)
February 14, 2009 5:00 PM | Reply | Permalink
If I write you a check from my line of credit and you cash it. What is that? Money or credit?
February 14, 2009 9:16 PM | Reply | Permalink
It's a distraction. Money and credit are obviously related, my only point was, way back when, that there synonymy is context dependent, so that the global equation is false.
Your check is an IOU. It's not fungible, generally (unless made out to Cash, and even then it's not quite money and subject to restrictions). I don't quite know how you write a check from a line of credit, unless you mean the consumer credit card "checks" with their huge fees and gross interest rates. A line of credit might be used to back up a checking account, to cover overdrafts, for instance.
But when I cash the check, I get cash, the bank gets your personal IOU which it then processes until the IOU meets up with your checking account balance or appears on your credit card statement. At that point the IOU is nominally history and your line of credit drops a notch (assuming it's not unlimited).
Distraction.
February 14, 2009 10:05 PM | Reply | Permalink
Yes you get cold hard fungible cash. Money has appeared, some(the federal reserve for example) might even say it has been 'created'.
White flag.
On this issue I agree we do not see eye to eye. I have an understanding of money creation that I share with the Fed- but I have been wrong before and who trusts them anyway. I do not understand how you think money is 'created'.
Of course its all distraction. There is no intrinsic value to money. It is just cotton paper that we have faith will be honored. The value is the faith.
Currencies are honored based upon the credit of the institution behind it (gov or otherwise) and their fungiblity. A few points of risk are ascessed one way or the other. Same way we do it with credit.
February 14, 2009 11:33 PM | Reply | Permalink
Just repeating your mantra over and over again makes for poor discussion.
"I do not understand how you think money is 'created'. "
You're just wasting time with word games here.
February 15, 2009 2:10 AM | Reply | Permalink
BTW, maybe you'd be interested in discussing the idea of negative interest rates?
February 14, 2009 3:06 AM | Reply | Permalink
Yes, I will be. Talk soon
February 14, 2009 4:53 AM | Reply | Permalink
I don't know how. I won't be following these comments or that thread closely at this point.
February 15, 2009 7:59 PM | Reply | Permalink
Mr. Galbraith,
Please get these points out there. Write some editorials, go on cable, challenge that intellectual fraud Amity Shales to a fight in the schoolyard. We need to stop wasting money and get the public consensus around plans that will actually accomplish something (even though it will take a lot of time).
February 13, 2009 10:10 PM | Reply | Permalink
Jamie: very nice summary of our current position and of comparisons to Hoover. Ellen: right. We do not want to (indeed should oppose any attempt to) revive credit. We need jobs and income. We are on the wrong side of the leverage that Obama and Timmy talk about. Wall street is leveraged at least 30 to one against any assets that have any value. Trying to bail out the economy by saving Wall street will take perhaps $90 trillion (assuming "real" losses of $3 trillion). We need to get leverage the right way around: spend $3 trillion on jobs and income, and that will go a long way toward getting the leveraged money back in the black. Politicians and the public have no stomach for a $90 trillion bailout of the world's money managers. It will not happen.
February 13, 2009 10:40 PM | Reply | Permalink
"Trying to bail out the economy by saving Wall street will take perhaps $90 trillion (assuming "real" losses of $3 trillion). "
Can you explain that? I think you're playing fast and loose with 30:1 leverage in an unreal fashion. My understanding is that most derivatives are highly offset so any net exposure is much less than the notional value, if you're talking derivatives.
February 14, 2009 2:29 AM | Reply | Permalink
There are three ways to repair a balance sheet:
1. attract outside capital;
2. reduce debt;
3. save.
We're going to be reducing debt by way of liquidation -- Roubini estimates $3 trillion -- but that's not enough to repair private balance sheets economy-wide (Note: you can't reduce the liability side by paying down debt; because you're reducing the asset side at the same time).
We could all save -- and 10-15 years from now we'll be out of the recession.
The answer is "attract outside capital" -- transfers from future taxpayers to current taxpayers via deficit spending. And not via public works -- too slow. Via direct payments as in the 2008 Economic Stimulus Act -- but make them big enough to fill the holes in the private balance sheets.
It's all a matter of where we want to spend the money and how we get that money spent.
February 14, 2009 12:44 PM | Reply | Permalink
"(Note: you can't reduce the [balance sheet problem] by paying down debt; because you're reducing the asset side at the same time)."
But you can reduce future debt service loads by paying down debt, which allows future income to go to capital/savings.
All the talk about toxic assets ignores the liabilities side of the balance sheet. Maybe we should discuss "vampire liabilities" too.
February 14, 2009 3:56 PM | Reply | Permalink
I wish the president and congress were as quick to rewrite the regulations that govern the financial industry as they were to pass a stimulus package. I can see reviving some of the "too big to fail" banks, but without the regulations needed to control their excesses, they will still fail. Can our government do two things simultaneously?
Yes, it can. It was able to take us to war and eviscerate our freedom from searches and seizures at the same time. Let us see equal fervor for doing some good things that way.
February 14, 2009 12:11 AM | Reply | Permalink
It occurs to me I probably need to retract that post. It is certainly more important for Congress to get to the bottom of whether or not Barry Bonds used steroids, than to re-regulate the financial industry. I can wait.
February 14, 2009 12:13 AM | Reply | Permalink
Obama was elected for his multitasking image. Maybe it wouldn't be too much to hold him to that!
Simon Johnson had a point about big banks - don't revive them, divide them up.
February 14, 2009 2:35 AM | Reply | Permalink
I know that banks could create money under the gold standard. A $25,000 gold brick meant the Federal Reserve could issue $71,000 in credit to its member banks, and they could then issue $550,000 worth of loans. Of course, if everyone who bought money just tried to gold with it, this wouldn't work, but most people have other uses for money. I mean, what would you do with the gold, open a bank?
My guess is that it isn't that different with modern banks, except you don't have to dig holes in the ground and make a mess with cyanide to grow the money supply.
Also, people forget that our consumer society was born in the 1920s. That's when the nation went 50% urban, and consumer spending soared. Houses changed dramatically with indoor plumbing, central heat, sleeping porches and a garage for the car. Yeah, everyone bought a car, and they bought clothes, kitchen appliances, radios and so on, frequently on credit.
The problem is that consumers are tapped out. They've done their bit for the lamps of China, but now they've hit their limit. If we are going to revive the economy we need jobs. Giving everyone enough cash for a new TV isn't going to do it. Rather than compete with the private sector, we should create jobs that produce public goods, so everyone gets a share. That includes new businesses. Government infrastructure makes for good business.
February 16, 2009 12:13 AM | Reply | Permalink