The Right Side Of The Leverage
The book, and post, by Liaquat Ahamed, The Lessons of the Great Depression, provide a nice antidote to much nonsense promulgated by the right wing. The Great Depression was not caused by stupid Fed tricks, nor was it extended by stupid New Deal programs. It was - rather - the predicted result of the normal operation of a small government, Laissez-faire economy constrained by a gold standard. And, yes, it was predicted - by the greatest social scientist produced by America (and the greatest economist who ever spent time at the University of Chicago), Thorstein Veblen, in (among other trenchant analyses) "Sabotage" in 1919, the story of the coming great depression manufactured by oligopoly capital. Liaquat rightly notes the constraints placed on US policy-makers when they attempted to deal with the crisis. The references to blood-letting are apt, a practice that continued long after abandonment of the gold standard and Bretton Woods, which rendered such medieval medicine wholly anachronistic. The World Bank, IMF, and Washington continued to prescribe blood-sucking remedies until the US and developed world plunged back into another Great Depression last year, at which time they (re)discovered the benefits of Keynesian "big government" policy. Last weekend, I participated in a conference at the University of Chicago on the current financial crisis, where I found the last remaining blood-sucking Neanderthals pushing for "free" market solutions to this disaster.
Liaquat wonders about the size of the attack currently mounted by US policy-makers, as well as the implications for US current accounts and relations with the rest of the world. Here I would caution that the US fiscal stimulus package is far too small to provide much comfort, while the combined Fed-Treasury bail-out of Wall Street is both far too big and at the same time far too small to serve any useful purpose. Let me explain. Geithner and Summers insist on taking the wrong end of the leverage. We know that Wall Street was leveraged at least 30 to one-that means there is $30 of toxic junk assets for every $1 of "real" stuff (student loans, residential real estate, autos). So the Treasury plan is to spend $30 bailing out Wall street CEOs and shareholders on the hope that a dollar will trickle down to indebted US workers, homeowners, and student debtors. This is the "Democrat" version of Laffer-curve, Reaganomics, supply-side economics. Americans are insisting that we have got to get on the right side of the leverage: far better to spend a dollar to provide a job to households and then, perhaps, as much as $30 of Wall Street garbage might be made good. If Obama does not pay attention and immediately fire Larry and Timmy, his presidency will fail. This is not because we cannot "afford" the 5 to 10 trillion more dollars that will be needed to continue to bail-out Timmy's friends. It is because Americans will not tolerate continued suckling of such pigs at the Treasury's trough.
Finally, we need to understand that abandonment of gold and Bretton Woods freed American policy from current account constraints. More than that, it completely reversed causation. While it is commonplace to refer to Chinese "finance" of America's "profligate borrowing", the causation is exactly the opposite. It is America's willingness to forego medieval blood-letting, hence, our propensity to consume that provides the markets needed by the rest of the world's producers who still follow the Washington Consensus. While they work hard and skimp and save, we enjoy their output. Now, if I were elected Premier, I would advise the Chinese to consume rather than to accumulate US Treasuries. But so long as they like saving in the form of US dollar-denominated wealth, we have little choice but to provide the dollar wherewithal to finance their savings by consuming their output. And this is sustainable so long as they like to save and we like to consume. Should preferences ever change, our roles can reverse. True, it is more holy to consume than to save, but no disaster lurks if we become the savers.
It is true that it's no skin off our noses if the Chinese are willing to give us consumption goods in exchange for pieces of paper the production of which costs us nothing, but ---
The problem arises when we try to decide who the us is. Because, you see, we didn't all consume; only some of us consumed at the cost of signing obligations of debt in favor of, not the Chinese but the FIRE industry.
Should the we who didn't bail out the us that did?
April 14, 2009 12:30 PM | Reply | Permalink
You raise some interesting points but I want to inquire about
"We know that Wall Street was leveraged at least 30 to one"
That implies that Wall St. was overall at 30:1, but is that true? Maybe only small segments were.
Also, let's be clear on the "reality" of the $1 vs. the $30. The leverage would be $1 of equity plus $29 of debt. Now, that is all nominally real money from real investors. So how do you get
"that means there is $30 of toxic junk assets for every $1 of "real" stuff (student loans, residential real estate, autos)"
It's not that Wall St. printed money (tho' it may have printed debt and then treated it as if it were money). I mean, there may well be frauds, but in principle the junk assets represent principal and interest on debts plus collateral of dubious current value. Yes, it seems some slicing and dicing wiped out lower tranches when cash flows were reduced or mortgage defaults occured with underwater foreclosure values.
What I see is that besides debt chasing debt within the financial sector (possibly a huge problem), debt was grounded by real borrowers who gave nominally real borrowed money to sellers of real property. So that $30 flowed via MBS and ABS and with the help of nominal CDO and CDS to real people or real corporations (property sellers and corporate paper issuers). But the end borrowers are defaulting in droves.
The financial sector debt problem is partly that the likes of hedge funds took on debt in order to speculate in the stock markets. To the extent that the debt involved real money loaned to a hedge fund, that money was fed by the fund into playing the markets, and went to people who sold stock, options, indexes, etc. to hedge funds and made out like bandits in the process. The real money has been laundered back into the general economy, and the funds are left owing interest and principal to the real investors who are holding gambling IOUs.
One problem here is that leveraged buying of stock tends to inflate the market price of the stock out of reality. And just like with mortgages, when the underlying "asset" is found to be way overpriced, all that assetization collapses.
Getting back to politics, the big problem is government money being fed to gamblers and crooks (those overlap but are largely distinct). When John Paulson bets Lehman will fail, he puts a nominally real $22M up as a bet. And that bet pays off at $1B (per Portfolio). Whatever bookie took that bet is probably a big bank or an AIG type. If the government is paying off the Paulson's of the world via "bailouts", that's wrong. And further, that $1B is imaginary. It's not like Paulson made a value investment of $1B and needs to be made whole somehow. It's that he made a contract with a bookie. Such contracts should be declared null and void, and any money paid on them clawed back.
I don't see the government making this important distinction. That's very troubling.
April 14, 2009 2:48 PM | Reply | Permalink
According to Tyler Durden, the U.S. Banking and Thrift System* is leveraged (equity/liabilities) at 10:1 (1.375T/13.511T).
The issue -- Wray's hyperbole notwithstanding -- is whether the "system" is insolvent. The banks have written down $1T, thus far, against anticipated total losses of $2.2T(IMF) or $3.4T(Roubini). If the former's correct, they're solvent (barely); if Roubini's right, they aren't.
So, whatever their leverage may be, should we continue to pour taxpayer money into them?
* The five megabanks account for approximately 80% of the system.
April 14, 2009 4:09 PM | Reply | Permalink
10:1 is just standard FRB, right?
Roubini doesn't think $3.4T applies, he thinks $1.8T applies, from what I've seen.
I'm not clear on how writing down assets adds in there. It seems you think you can add up the writedowns plus the equity, 1+1.4=2.4 to barely cover the 2.2. I don't see how that works. Taking assets off the books leaves the liabilities and thus should shift the balance sheet negatively, thus reducing shareholder equity. Did the $1T writedown occur before the date of the $1.4T equity assessment?
If the losses will come to $1.8T, and there is currently $1.4T, then the future scenario is negative $400B. But it's not clear how that is distributed. It could be that the -400B is localized, with many other banks being adequately capitalized, or more accurately, much of the rest of the capital remaining in solvent banks regardless of the number of banks involved.
Again, fact deficiency. But this might be one rationale for PPIP, inflate assets while injecting cash into banks and putting the assets on someone else's balance sheet so the macro picture is complicated but not so scary. I just think PPIP stinks as formulated in the press.
April 14, 2009 4:54 PM | Reply | Permalink
10:1 is just standard FRB, right?
I don't think the FRB has anything to do with capital ratios. That would be the FDIC, presumably.
The FRB does have regulations stipulating what reserve ratios banks must hold -- for example, 10% for checkables but 0% for other deposits. And as of now, the banks are hugely over reserved (the FRB is paying them interest to do so -- who knows why).
April 14, 2009 7:43 PM | Reply | Permalink
Fractional Reserve Banking, not Federal Reserve Board. Sorry, I thought context was enough...
I don't understand the reserve ratios. I'm trying to work with simple ideas, the idea that banks can lend out up to 10x of deposits+capital. That FRB notion.
Is that overly simplistic or even wrong?
I really don't understand the Fed paying interest on reserves, unless that's equivalent to negative interest rates on funds actually loaned out.
April 14, 2009 9:47 PM | Reply | Permalink
. . . this might be one rationale for PPIP . . . .
It seems to me it's the only rationale.
Banks are being invited to trade a $30 asset for $90 cash. The balance sheet as reported may not be affected, because the the bank was carrying/valuing the asset at $90 before the transaction -- thus, no change. But realistically, an asset listed as a dollar of cash is a dollar of cash; an asset listed as a dollar of CDO^2 is ho-ho-ho.
And of course, once the CDO^2 is on the taxpayer's balance sheet, it's the taxpayer who'll be writing it down, not the bank.
April 14, 2009 8:01 PM | Reply | Permalink
Well, I think it stinks.
April 14, 2009 9:49 PM | Reply | Permalink
"If the losses will come to $1.8T, and there is currently $1.4T, then the future scenario is negative $400B."
- you should factor in future earnings as well. if the big banks can make 150B per year in pre-writedown profits, then you could just try to let them earn their way out of the mess. But I think the equity figures you're working with are inflated and losses in Roubini may be understated (the IMF now outglooms him). And letting them try to earn their way out of insolvency also may tend towards a vicious circle - a la Japan zombie scenario...
April 14, 2009 8:16 PM | Reply | Permalink
Help me out on my latest blog, if you would!
:-)
A nice feature for TPM would be the ability to leave a note for someone directly on their dashboard or similar location.
April 14, 2009 9:52 PM | Reply | Permalink
Like this?
"
Roubini ...
Conclusion: Actual macro data for 2009 are already worse than the more adverse scenario in the stress tests. These are not stress tests but rather fudge tests"
http://www.calculatedriskblog.com/2009/04/roubini-and-stress-test-scenarios.html
April 14, 2009 10:46 PM | Reply | Permalink
Finally, we need to understand that abandonment of gold and Bretton Woods freed American policy from current account constraints.
Translation: it allowed the government to inflate massively, sealing money from savers to give to borrowers.
While it is commonplace to refer to Chinese "finance" of America's "profligate borrowing", the causation is exactly the opposite. It is America's willingness to forego medieval blood-letting, hence, our propensity to consume that provides the markets needed by the rest of the world's producers who still follow the Washington Consensus.
Nonsense. Do you honestly believe that without our profligate consumption, China would not be able to turn its production inward? Production allwos consumption. Consumption does not create production, or else no one would be worried about "peak oil."
Now, if I were elected Premier, I would advise the Chinese to consume rather than to accumulate US Treasuries. But so long as they like saving in the form of US dollar-denominated wealth, we have little choice but to provide the dollar wherewithal to finance their savings by consuming their output.
Yes, we do. We could cut our consumption and they would save their money elsewhere.
And this is sustainable so long as they like to save and we like to consume.
Of course, what happens when they want to use some of that savings and find out that we have inflated it to worthlessness?
True, it is more holy to consume than to save
How can anyone take someone who says that seriously? I suppose you believe that we need to cut back on fossil fuel use to save the environment. Why, if consumption is so holy? We need savings, because we need a pool of unconsumed goods to fund future investments.
Let's be very honest here. Randall Wray is suggesting that we take those poor suckers the Chinese for everything we can by inflating our currency and by doing so, destroying all of the savings that China has in the U.S. He wants us to parasitically swindle the Chinese out of all of their U.S.-based savings.
April 14, 2009 7:10 PM | Reply | Permalink
Wow.
"Nonsense. Do you honestly believe that without our profligate consumption, China would not be able to turn its production inward? Production allwos consumption. Consumption does not create production, or else no one would be worried about "peak oil." "
It was our consumption which helped drive China's growth as a producer. No system can instantly turn its output inward, the demand just isn't there in general. Demand created by consumers "creates" production as supply in a responsive economy. Oil is a scarce resource, not applicable there.
But yes, China has been consuming internally and that consumption has been growing, making exports less important to first order. But exports at a profit generate incoming wealth flows. Why would China not want that?
April 14, 2009 10:16 PM | Reply | Permalink
It was - rather - the predicted result of the normal operation of a small government, Laissez-faire economy constrained by a gold standard.
B.S. It was caused by the governments of Europe and later the U.S. fighting the stupidest war in history and getting into debt to do so, and then not wanting to accept the consequences of their actions: deflation, deleveraging, falling wages to go with falling prices of consumer goods.
None of the destructive things that the various governments did in the 1920s to keep themselves on the gold standard would have been necessary had the countries not wanted to avoid the sacrifices that were necessary for having a gold standard. Instead, we used accounting tricks to support the pound so that Britain would not have deflation after World War I.
Moreover, all of this blaming of laissez faire ignores the fact that the U.S. had high tariffs on foreign goods at the time, and prevented the importation of foreign goods that was required in order for foreign countries to actually pay off their debts. It is one thing to advocate a tariff when you have a trade deficit. But when you have a trade surplus, you wind up making certain that your debtors can never pay you back.
April 14, 2009 7:16 PM | Reply | Permalink