Left Flank

Steven R. Weisman offers one of the more thoughtful and understandable essays on the global financial crisis I've read recently.

As the United States struggles to get past the turmoil, the challenge will be to understand its most basic causes. Did the trouble start with the Reagan agenda of deregulation? The Bush era's passive Securities and Exchange Commission and Alan Greenspan's Federal Reserve, with their loose rules governing off-the-books investments and the ratio of capital to lending by financial institutions? The flood of capital into the United States from China and the Persian Gulf? The Federal Reserve's easy money and the failure to regulate complex new derivatives? Or was it the liberal political pressure on Congress and the administration to keep interest rates low and expand homeownership recklessly through Fannie Mae and Freddie Mac? The truth probably includes some role for all these explanations. But the truth has also been radically unclear because of the difficulty in understanding the machinations and statements of the financial wizards handling our money.

Throughout its recent heyday, Wall Street sounded so smart. They developed computer models and complicated packages of assets that seemed to make the risky debt piled on homeowners and consumers look like safe debt. The sheer complexity of these assets masked the weakness in the system. The jargon employed to describe off-the-books «structured investment vehicles,» «collateralized debt obligations,» and computerized financial models--not to mention the exotic derivatives like «credit default swaps»--was a barrier to understanding how they worked. As Representative Barney Frank says, it has not been easy for even the most sophisticated investment banker to explain the workings of credit default, currency, or interest-rate swaps. Swaps--essentially contracts between two or more parties aimed at hedging against the loss on an underlying asset--are the instruments that Warren Buffett famously once described as «financial weapons of mass destruction.» The danger is aggravated by the difficulty in measuring what threat they posed for the institutions--commercial banks, investment banks, mutual funds, pensions, hedge funds, insurance companies--possessing them. There are now more than $500 trillion of such swaps and options notionally coursing through the global financial system, and, while we know that doesn't translate into $500 trillion in risk, no one is sure in the current environment what the actual risk is. Not since the height of the cold war has the fate of the world rested so profoundly in the hands of a priesthood of experts with a monopoly of understanding obscure concepts, if they understand them at all. The expertise of the cold warriors was in throw weights, MIRVS, and the concept of «mutual assured destruction,» which was supposed to make us secure. It is not a terribly comforting analogy.

(...)

Economic crises are never so easy to decipher when you are still in the midst of them. Even afterward, it can be difficult. We're still debating the causes of the Great Depression and which parts of the New Deal worked. The first priority for long-term reform must be to make the entire global financial system more transparent, comprehensible, and accountable without imposing too many new restrictions. We need stricter oversight by the Treasury and the Federal Reserve, both of which have been lax for years, and more public understanding of what that oversight is and is not doing. A nation or collection of nations that does not nurture a healthy regulatory system runs the risk that the people in charge lack a fundamental understanding of the system's weaknesses and have little incentive to look for clues to possible failures when times are good. While the best system might not have been enough to forestall catastrophe, it might have prevented us entering this crisis feeling so helpless.

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The South Korean won is down below 1400 to the dollar and over 1700 to the Euro even the yen is doing slightly better at 15), but, unfortunately for my won in South Korean banks, the greenback is getting stronger because of Multiple Economic Factors Driving Fears of Global Recession. Bizarrely, and perhaps because of Paulson's TARP and the rolling bank recapitalizations, there's no confidence in even the EU (where the dollar is worth about 75 cents). Obviously, this is not good for most of the world's economies.

JEFFREY BROWN: Well, explain that to us. The dollar -- this is after years of the dollar dropping. It suddenly -- and this has been creeping up over the last few days -- is quite strong. Now, why? What does that tell us?

SIMON JOHNSON: Well, it tells us that things are becoming even more turbulent. The dollar has been declining, roughly speaking, since 2002. All of a sudden, people are seeing it as the ultimate, perhaps the only safe haven, partly because the Eurozone, the European countries that share the euro, looks increasingly shaky.

So there's a flight into dollars. And that is really potentially destabilizing the situation further.

JEFFREY BROWN: Wait a minute. But it's a good sign in the sense that it shows confidence in the U.S. markets, but destabilizing for other countries.

SIMON JOHNSON: It shows confidence in the U.S. government. They're coming into U.S. treasuries. It doesn't prevent the U.S. stock market from falling, obviously.

And it absolutely shows a lack of confidence elsewhere in the world. No one believes in anything right now apart from U.S. treasuries. That's a big change; that's a big problem for everyone else in the world.

JEFFREY BROWN: And particularly for emerging markets.

SIMON JOHNSON: Emerging markets have a lot of debt denominated in dollars, particularly the private sectors. They borrow to do productive things with it, but they owe money in dollars.

Now their currencies are depreciating against the dollar, it gets harder and harder to pay that back. Their governments have reserves -- quite a lot of reserves -- but nowhere near enough to deal with the current situation.

Is the Paulson strategy turning into a beggar-thy-neighbor disaster?

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The good news is, LIBOR is down.

Karen Petrou, I mentioned LIBOR, that lending rate between ranks has dropped to its lowest level in over a month. That's a good thing, right?

KAREN SHAW PETROU, Federal Financial Analytics: That's right.

JEFFREY BROWN: Why?

KAREN SHAW PETROU: LIBOR means the rates that banks charge each other. And we can't get the money until the banks do. And we can't get it at a rate that we want or that the economy can benefit from until the banks are able to move the money at the lowest possible cost.

JEFFREY BROWN: And so now, what can they -- they lend to each other at a better cost?

KAREN SHAW PETROU: If this stays down -- the markets have been terrifically volatile. So while the news is very, very good, it's far too soon in these strange and strained market times to look too far ahead.

I'd say this is so far, so good. And the way the markets have been, that's the best we've seen in a really long time.

The bad news is, banks are taking Hank Paulson's bailout cash and hoarding it.

ANDREW ROSS SORKIN, New York Times: Well, I think that we are seeing the right steps being made. But at the end of the day, you know, they may become -- they're advertised as if they're a quick fix, a silver bullet, and they're not.

And I think that consumers and Main Street need to appreciate what we're really getting ourselves into. You know, the Treasury is giving $250 billion to the banks ostensibly to lend out, but it's not going to come to you or I anytime soon.

In fact, more often than I'd like to say, they're going to keep that money and hold onto it, in part because they are expecting to have losses, and so they need that capital.

JEFFREY BROWN: Explain that a bit, Andrew -- I'm sorry -- because you wrote today in your column that banks were actually hoarding the money, holding onto it.

ANDREW ROSS SORKIN: Well, that's exactly right. They're going to be getting this capital from the government, ostensibly, as I said, to lend it. However, they're not going to use it for that purpose, at least in the immediate term.

They're going to use it and hold onto it, in part because they're expecting losses at their own firms. And so they have capital requirements, which means they have to have a certain amount of money in the bank.

And if they know that they're going to be losing money in the future, they need to hold onto that money.

The other thing that some of them may do with that money is go out and make acquisitions and buy other banks. Now, that's not a bad thing, because it will make some of these banks stronger, but it means that you will not be getting this money into your pocket anytime soon.

It's like pouring water on sand!

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Oddly, instead of prepping myself for a dive off my roof, I'm taking cathartic relief from a consensus among smart talking heads and pundits, that humility is coursing through the media like a vaccination. No one knows if there is any precedent for this financial market crunch, and if so - or more likely, if not - what do we do? The big guy prayer - calling on the «leaders» to save us - took a swan dive now that consensus has it that allowing Lehman Brothers to tank was a bad plan.

That's because now - and blogging is a form of archiving - the plan is recapitalization.

American officials unveiled a three-part rescue programme on Tuesday October 14th. Under the first part, the Treasury will inject as much as $250 billion into American banks, with roughly half initially going to nine big institutions. The capital would come in the form of non-voting preferred stock. Under the second part, the Federal Deposit Insurance Corporation (FDIC) would guarantee unsecured borrowing by banks for maturities of up to three-and-a-half years, at a relatively modest cost of 75 basis points. That would include interbank loans. Under the third part, the FDIC would guarantee without limit small-business bank deposits that do not pay interest. Also on Tuesday the Federal Reserve gave more details of its previously-announced commercial paper backstop programme, which should ease borrowing for big nonbanks, such as GE Capital.

The plan is undoubtedly bold: it marks perhaps the largest foray by the American government into ownership of private enterprise since the second world war. But it would have looked much bolder a month ago. As it is, America has only caught up to where Germany, France and especially Britain (in that case, last week) had already reached. To a great extent, Hank Paulson, the treasury secretary and Ben Bernanke, the Federal Reserve chairman, are making up for what were, in retrospect, miscalculations in their earlier efforts.

The early evidence is reassuring. The historic stockmarket rally on Monday, though it petered out on Tuesday, will impress the retail audience of small investors and politicians. But the more important verdict is from the wholesale audience in the credit markets, which has been encouraging. Borrowing costs for big financial institutions plunged on Tuesday, as measured by credit-default swap spreads. Libor, the rate at which banks lend to each other, also dropped, although it remains stratospheric. «This is definitely the end as far as the systemic aspect to the credit system goes,» said Gregory Peters, head of fixed income at Morgan Stanley.

Even if true, that will not alleviate the downward pressure on the economy. Bank lending is still constrained by a lack of balance-sheet capacity: banks have been forced to boost loans to companies that are shut out of the commercial-paper market while setting aside more capital for future loan losses.

The new capital injections should help. In theory $250 billion of new capital leveraged by ten-to-one could support $2.5 trillion of assets in banking system, serious money when total loans to non-financial corporations, households and state and local governments in America stood at $27 trillion on June 30th. But it is unlikely to spur a big expansion in new loans. Much of the credit restraint comes from nonbanks such as the captive finance-arms of carmakers. Moreover, fewer householders can meet the stricter underwriting standards that now prevail because they have lost the equity in their home, or their jobs. «The combination of declining wealth and a sharp tightening of credit availability is likely to induce a substantial recession in consumer spending,» said Peter Hooper and Thomas Mayer of Deutsche Bank on Tuesday. They project zero growth for America in 2009 and outright contraction for every other G7 country apart from Canada.

The programme should overcome the errors that, with hindsight, hampered earlier efforts to tackle the crisis. The most prominent was the decision to let Lehman Brothers fail. That sparked a run on money-market funds which held Lehman paper, and forced deleveraging by customers and counterparties who had trading positions with Lehman. It dramatically raised in investors' minds the odds that other big banks could also fail, and those fears risked becoming self-fulfilling as their stock prices plunged, credit spreads exploded and lenders and depositors fled. The bank-loan guarantee and expanded deposit-insurance limits should eliminate that risk.

The authorities' second mistake was to treat the crisis as one principally of liquidity rather than solvency and thus to focus on solutions that did not directly rebuild capital in banks. The focus was understandable: in aggregate American banks are well capitalised and it is not clear how many would have voluntarily accepted public injections of equity. Fed officials had discussed ways the government could inject preferred equity into banks that also issued common stock as far back as June. But Mr Paulson worried that Congress would say no and in the process alarm markets more, according to some officials. A person close to the Treasury says that Mr Paulson and Mr Bernanke were in agreement on how to proceed. In any event, Mr Paulson made sure the bail-out law impliclity allowed such injections. But not until the law passed and panic ensued did he conclude it was necessary, and Britain's dramatic recapitalisation plan last week all but forced his hand.

Thirdly, the plan marks a move away from ad hoc interventions towards a comprehensive solution. In contrast to earlier rescues for AIG, Bear Stearns, Fannie Mae and Freddie Mac, the recapitalisations announced on Tuesday are designed to encourage new private capital infusions, rather than punish shareholders. Under the terms announced on Tuesday, the Treasury will receive preferred stock on the same terms as other preferred shareholders and warrants for common stock equal to 15% of the preferred stock, convertible at the trailing 20-day average stock price when the preferred stock is issued. The preferred stock will pay a 5% dividend for the first five years, and 9% thereafter. Those are hardly onerous: they are less than the 10% yield Morgan Stanley will pay Mitsubishi UFJ Financial Group and that Goldman Sachs will pay Warren Buffett for their preferred-stock investments. The banks can buy back the Treasury's stake after three years, sooner if they issue sufficient stock of their own.

Yet, even for all its customary optimism, The Economist is not immune to the bogeyman.

Aggressive as these actions are, they may not be the last. As the world falls into recession, loan losses will mount and banks may need yet more capital. Some emerging markets may be on the brink of another crisis on the scale of 1997-98. After 14 months, the defining characteristic of this financial crisis has been its tendency to change shape and return in ever more virulent form. But if the corner really has been turned, then attention in America will turn to the consequences of the bail-out, in particular: how will future administrations handle the responsibilities and temptations that come with being a big financial stakeholder?

Comparing the Japanese debacle in the 90s with the 2007-8 mutation, Joshua Kurlantzick rains further on the recapitalization prayer.

Koizumi's strategies were actually based on lessons learned after America's savings and loan crisis, when nearly half of the country's S&Ls went out of business and the rest were forced to adapt their business models. «A central lesson to remember from the U.S. [S&L] experience is that ... in the end, the principal use of public funds was to put institutions out of business,» notes economist Benjamin Friedman in a study comparing the S&L crisis to Japan in the '90s. Today, public funds are being used to do the opposite--to keep companies in business regardless of whether they change their practices, meaning that, as in Japan, the government might have to intervene again in a few years. Japan was able to afford repeated infusions of state cash in part because it was an export powerhouse. But, in the United States, which already boasts $10 trillion in public debt and regular trade deficits, another round of bailouts would be truly catastrophic. It could doom the entire U.S. economy throughout the next president's term. A «lost decade,» you might say.

Finally, Megan McArdle and Dan Drezner agree to remain skeptical and embrace their utter dearth of fortune-telling skills.

So, is there clear answer? Yes, according to Michael E. Lewitt, the dismal science is our savior.

...the stock market has the patience of a flea. The government's Herculean intervention into the markets will do what they are supposed to do--lead U.S. banks to start making loans again and reignite economic growth. But U.S. stock markets continue to be driven by «hot money»--failing to see money market rates plunge immediately, they conclude that these key lending rates won't drop at all. This is short-sighted and self-defeating. The government's actions will take some time to work, but they will work. The laws of economics were not repealed on the upside--that is why the markets crashed. But these laws were also not repealed on the downside, which is why these radical steps will work sooner rather than later.

Do less, but be firm and forceful when you do DO it? I'm very glad now I studied more political science than economics: it's axiomatic that the worst will happen, not, as the dismal science has it, that we can approach perfect equilibrium. At least I didn't waste my tuition money.

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What Eric Schoenberg and Gary Marcus are arguing, that psychology is a useful guide for economic policy, but that ultimately skepticism about ideal economic presuppositions are beneficial, dovetails nicely with Nassim Taleb's black swans and Arnold Kling's caution. It's also just another way of understanding how the stock market jitters and the congressional bailout drama relate to what laypeople are experiencing.

As an explanation of the first vote US House rejecting the Paulson bailout plan, it's reassuring to hear Schoenberg to discuss the experimental economics game, concept of the ultimatum game. And then, from that point, move forward armed with more than ideological talking points to solutions.

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Michael Merritt expressed his preference for divided government, and here's a cautionary tale against a President McCain and a Democratic-controlled Congress.

Far from confounding the parties, divided government has enabled them to adhere to dogma. Democrats have succeeded at increasing spending and Republicans at holding down revenue, with credit and con games making up the difference. The result: the state budget, signed 10 days back by Mr Schwarzenegger, may not last the month. On Thursday the governor wrote Hank Paulson with an urgent request for $7 billion, without which the state may not be able to pay its bills in the short-term.

Like Mr McCain, Mr Schwarzenegger campaigned as a centrist who could check the ambitions of a Democratic legislature with the strength of his personality and principles. A President McCain might do better with a Democratic legislature than Governor Schwarzenegger has, but a Republican identity and fearsomeness don't guarantee that he will.

And, I was just going to argue something about remaining principled during a financial crisis.

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On the bailout bill that just passed the US Senate, I know I'm in the minority: it's crap. But, watch, listen, or read this debate between Kenneth Rogoff, Scheherazade Rehman, and John Cochrane on the Online Newshour and tell me that these three experts don't agree the plan should just contain one provision, the FDIC insurance boost from $100K to $250K. And, tell me that these three can't properly state why the rest of this grotesque bill would do little more than allay fears irresponsibly stoked.

After that, rebut Daniel J. Mitchell.

The proposed bailout of the financial system is a misguided scheme that will hurt the U.S. economy in the short run and long run. The economy currently is stumbling as a consequence of a government-created housing bubble, but a bailout of companies, executives, and shareholders that made unwise decisions would, at best, extend the economy's adjustment process. More likely, the bailout would impose considerable additional economic damage because political factors would at least partially supplant market forces in determining the allocation of resources.

Finally, tell me with a straight face the bailout bill comes even close to addressing the reality in which The Economist swims.

Most of the time nobody notices the credit flowing through the lungs of the economy, any more than people notice the air they breathe. But everyone knows when credit stops circulating freely through markets to banks, businesses and consumers. For almost a year the markets had worried about banks' liquidity and solvency. After the bankruptcy of Lehman Brothers last month, amid confusion about whom the state would save and on what terms, they panicked. The markets for three-, six- and 12-month paper are shut, so banks must borrow even more money overnight than usual.

Banks used to borrow from each other at about 0.08 percentage points above official rates; on September 30th they paid more than four percentage points more. In one auction to get dollar funds overnight from the European Central Bank, banks were prepared to pay interest of 11%, five times the pre-crisis rate. Astonishingly, rates scaled these extremes even as the Federal Reserve promised $620 billion of extra funding.

Bankers have always earned their crust by committing money for long periods and financing that with short-term deposits and borrowing. Today, that model has warped into self-parody: many of the banks' assets are unsellable even as they have to return to the market each day to ask for lenders to vote on their survival. No wonder they are hoarding cash.

This is why those politicians who set the interests of Main Street against those of Wall Street are so wrong. Sooner or later the money markets affect every business. Companies face higher interest charges and the fear that they may one day lose access to bank loans altogether. So they, too, hoard cash, cancelling acquisitions and investments, in order to pay down debt. Managers delay new products, leave factories unbuilt, pull the plug on loss-making divisions, and cut costs and jobs. Carmakers and other manufacturers will no longer extend credit (see article) and loans will become elusive and expensive. Consumers will suffer. Unemployment will rise. Even if the credit markets work well, the rich economies will slow as the asset-price bubble pops. If credit is choked off, that slowdown could turn into a deep recession.

Financial markets need governments to set rules for them; and when markets fail, governments are often best placed to get them going again. That's pragmatism, not socialism. Helping bankers is not an end in itself. If the government could save the credit markets without bailing out the bankers, it should do so. But it cannot. Main Street needs Wall Street; and both need Washington. Politicians—and President George Bush is the most culpable among them—have failed to explain this.

Governments need not just to communicate, but also to co-ordinate. Past banking crises show that late, piecemeal rescues cost more and work less well. Ad hoc mergers work for a while, but demands for help tend to recur. Inconsistency sows uncertainty. Cross-border banking can make one country's policies awkward for the neighbours: the Irish government's guarantee of all deposits threatens to suck in money from poorly protected British banks. France's suggestion on October 1st that Europe's governments should work together was a good one; Germany's rejection of it was wrong.

Central banks have co-ordinated their liquidity operations. Now that oil prices have plunged and worries about inflation are receding, interest-rate cuts are possible. They would be more powerful if co-ordinated. But it is not only central banks that need to combine. Whatever America's Congress does, governments should work together on principles to stabilise and recapitalise banks—not just to stem panic but also to save money. Even if, as the Europeans claim, the crisis was made in America, it now belongs to everyone.

Please, some reader say something other than a form of «It's a good bill, because Hank Paulson says so», or «Do something, do anything, now!»

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