Brad Setser

Brad Setser: Follow the Money

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The quiet bailout continues …

by Brad Setser
July 7, 2008

The roughly $30 billion sovereign wealth funds provided to troubled US financial institutions (Citi, Merrill, Morgan Stanley) attracted a lot of attention.*

The (almost) $30 billion of Bear Stearns’ assets that the Fed took onto its balance sheet (as explained here) to facilitate JP Morgan’s takeover also has attracted a great deal of attention. Understandably so. The Fed’s decision to orchestrate JP Morgan’s takeover of Bear and its subsequent decision to make liquidity available to the broker-dealers are, as of now, the defining moments of the crisis.

The $283.5 billion increase in central banks’ holdings of Treasuries and Agencies in the custodial accounts of the New York Fed during the first half of 2008 hasn’t attracted nearly as much attention.

But $283.5b — $567b annualized — is a big number. A 10% fall in the dollar against the currencies of those countries adding to their accounts at the New York Fed would generate paper losses equal to the total (known) exposure of the world’s sovereign funds to US financial institutions, or the Fed’s total exposure to Bear’s own debt portfolio. A bigger fall in the dollar would produce bigger paper losses. And given that many of the countries adding to their reserves most rapidly are doing so precisely because their currencies are facing strong pressure to appreciate, such a slide in the dollar isn’t hard to envision. It might even be probable …

Between June 4 and July 2, central banks added $45.2b to the custodial accounts at the New York Fed; between May 28 and July 2 (a five week period) central banks added $54.6b to their accounts. That wasn’t as much as April — but it was a lot more than May. It brought the total for Q2 up to $132.7 billion (nearly equally split between Treasuries and Agencies) — only a bit below the $150.8b increase in q1.

Not all central banks make use of the New York Fed, though someone big clearly is. The growth in the the Fed’s custodial holdings consequently is a minimum, not a maximum. Total official purchases of US debt are far higher than the increase in the custodial accounts at the Fed. Nonetheless, it is worth noting that the increase in the Fed’s custodial accounts so far this year, annualized, is well in excess of total recorded official purchases in 2007.

This matters. The US had a large external deficit going into the subprime crisis. That means it has a constant need for external financing. Foreigners need to more than just hold their existing claims on the US, they need to add to them. The US responded to the subprime crisis with policies — a fiscal stimulus, monetary easing — designed to support domestic US demand, not to assure ongoing demand for US financial assets. And for a complex set of reasons – ongoing growth in China, energy-intensive growth in the Gulf, limited expansion of supply and perhaps monetary easing in the US — the price of oil has shot up even as the US has slowed. Higher oil prices are likely to push the US trade deficit and the US need for financing up — not down – at least in nominal terms.

So far that hasn’t been a serious problem. Central bank reserve growth has been very strong, most because a couple of big countries are adding to their reserves at an incredible rate. The New York Fed data tells us that a lot of that growth has been channeled into safe US assets. But there are also growing signs that rapid reserve growth is causing some countries — including some big countries — trouble.

Yves Smith is worried. With reason. I started to worry about a year ago, when it became clear that the slowdown in US growth relative to global growth had prompted a fall in private demand for US assets, a surge in demand for Chinese assets and a strong acceleration in global reserve growth. Since then central banks have consistently made up for any shortfall in demand for US assets, allowing the US to conduct its monetary and fiscal policy without worrying too much about how its external deficit would be financed. If I had to bet, I would bet that this won’t change in the near future. As Nouriel Roubini hints, a sustained period of high inflation in the emerging world now looks to be the most likely way Bretton Woods 2 ends.

I have continually been surprised by the willingness of the world’s central banks to buy dollars, or perhaps by the reluctance of the leadership of many key countries to shift away from managing their currencies against the dollar. But the strains on the current system — high inflation in a host of countries adding to their reserves rapidly, and unwanted capital inflows into China — have become rather visible.

*Sovereign funds also provided additional capital to European institutions (notably UBS and now Barclays) to help cover their subprime related losses. Adding in those funds would bring the total sovereign wealth fund financed recapitalization of the US and European financial system to around $50 billion. Sovereign funds also participate in private equity funds that have injected capital into US financial institutions.

35 Comments

  • Posted by Dave Chiang

    The Far Eastern Central Banks are doing a great job managing the US Economic decline. President Bush is even travelling to the Beijing Olympics on vacation during two Middle East wars to celebrate Asia’s economic ascendancy in the 21st century. Eh? :-)

    Nevertheless, given the global reserve currency status of the dollar otherwise known as US Dollar hegemony, the United States has demonstrated that it doesn’t have to raise taxes to overspend money. As VP Dick Cheney has repeatedly stated, “trade and budget deficits don’t matter”. The Treasury and Federal Reserve created $1 trillion in bailout credit for the bankrupt financial sector in April alone.

    These days, America’s post-industrial service economy consists of the ability to create leverage and credit that fuels economic growth in finance capitalism. But instead of creating credit to fund industrial capital formation, the Federal Reserve banking system is lending to bail out corrupt financial pyramiding (EDITED HERE).

    SLIGHTLY EDITED BY THE BLOG MODERATOR TO REMOVE PERSONAL REFERENCES

  • Posted by bsetser

    DC — did you bother looking at the link to the data i used for this post? it shows the fed’s balance sheet. the fed hasn’t created a trillion dollars of credit. it has changed the composition of its existing balance sheet — i.e. it basically sold treasuries to finance its purchase of other assets (or swapped treasuries for other assets, though the swap was done in a way such that the bank or broker dealer was on the line for any fall in the value of the collateral). but it hasn’t expanded its balance sheet. not unless you think the data is inaccurate.

    the central banks that have been expanding their balance sheets rapidly are mostly in the emerging world. and while China may be doing a great job managing the United States’ fall (or at least braking it), China doesn’t seem to be doing such a great job of domestic monetary management. And here China isn’t unique — inflation is WAY up throughout the emerging world.

  • Posted by Dave Chiang

    On CBS “60 Minutes”, Alan Greenspan admitted that he supported the invasion of Iraq. That’s hardly surprising, since it is difficult to imagine that a nation can trudge off to war without the full financial support of the Federal Reserve. In his memoirs, Alan Greenspan admitted that the Iraq war was de facto for the exploitation of that nation’s energy reserves. Given Robert Rubin’s close financial/political association to Alan Greenspan and Ben Bernanke, an open discussion in a democratic blog forum about the Federal Reserve’s role in US government is both required and necessary.

    EDITS BY THE MODERATOR

  • Posted by Dave Chiang

    Brad, to answer your question about the Federal not printing a trillion dollars in credit, the bailout exchange of AAA US Treasury bonds for subprime garbage in the US banking system, recapitalizes US banks permitting them to continue to create money/credit in the US Economy. According to John Williams at Shadowstats.com , estimated broad M-3 money supply is exploding at a 16% annualized rate.
    http://www.shadowstats.com/alternate_data

    Of course, the Federal Reserve has little control over where this money creation goes in a fractional banking system. Unfortunately, I suspect alot of the newly created US Dollars is speculated in oil, the primary resource of industrial economies.

  • Posted by Missed Info

    I am sure this has been discussed before, but could one of the resident macro-thinkers summarize the likely consequences of foreign CBs stopping to buy US debt?

    Mish described it as a deflationary event (i.e. US rates rise rapidly and nobody can get any money) but that seems strange to me because the other side of the coin is that dollar must fall sharply and trigger price increases in everything that is priced internationally (and what isn’t except for local services?).

    So to me it would look like an inflationary event but accompanied by many people becoming poor quickly. But I am not an economist so I’m probably missing something.

  • Posted by Twofish

    Missed: other side of the coin is that dollar must fall sharply and trigger price increases in everything that is priced internationally (and what isn’t except for local services?).

    What happens next depends on US monetary policy. If demand for US debt decreases, the Fed can respond by raising interest rates which would be deflationary, or by keep interest rates low which would be inflationary.

  • Posted by Nick

    Well, I’m not claiming to be a well-known macro thinker, but I’d be surprised if the US Fed raised rates in any circumstances while the economy is slow. There’s a lot of political pressure to keep consumption (ie: our economy) going, and the only way to do that when Americans have no real wealth left is to have easy deficit money/credit. Nobody in politics today has the will to take a long term approach at the expense of short term fixes; just look at all the explicit and implicit bailout plans.

    The Fed can keep the money flowing without increasing its balance sheet, as they have already figured out, by doing the same thing the investment banks did to create the financial disaster we’re now dealing with: leverage their portfolio. They can loan back securities with a Fed guarantee, and use the exchanged treasuries to buy more bad debt. I’m not sure at what point the Fed will fail doing this strategy, but when it does, you probably don’t want to be living in the US or holding dollar-denominated assets, cause it’ll make the current market correction seem like a non-event.

  • Posted by DR

    Did you read the latest from Pimco?

    http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+July+2008.htm

    He anticipates a trillion dollar federal deficit around 2011. Just how is the US going to fund a trade and federal deficit both hovering over a trillion…

  • Posted by pappy

    Brad do you discount that this increase in holding is due to foreign central bank’s rapid increase in demand for dollars in order to service higher oil bills.

    seems to me like the pressure for opec shieks to move to the euro pricing was minimized by perhaps ( a silent agreement) which proved very difficult for them to pass up) i.e stick with the dollar thru depreciation and we will see to it that you shieks (as well as some hedge fund’s and investment banks) make a killing as the CFTC ensures this.

  • Posted by Twofish

    Nick: I’d be surprised if the US Fed raised rates in any circumstances while the economy is slow.

    If foreign demand for US securities evaporates then long term interest rates will rise and it will take massive cuts in short term rates to keep rates where they are.

    Nick: Nobody in politics today has the will to take a long term approach at the expense of short term fixes; just look at all the explicit and implicit bailout plans.

    Another factor is that you have to get past the short term to worry about the long term. If you don’t apply a short term fix, then things might blow up to the point that the long term doesn’t matter.

    Nick: I’m not sure at what point the Fed will fail doing this strategy….

    It all depends on the default rate for the securities that are being used as collateral. If most of the loans turn out to be good, then everything will work out in the end. If you start seeing massive defaults on the securities that are being lent to the fed, then you will have big problems.

    Personally, I’m on the optimistic side that everything will work out in the end.

    Nick: You probably don’t want to be living in the US or holding dollar-denominated assets, cause it’ll make the current market correction seem like a non-event

    The trouble with this approach is that if the US economy falls apart the entire global economy will go with it. There is really nowhere to hide, and moving to another country or holding something other than guns or gold isn’t going to help you very much.

  • Posted by pappy

    me thinks (given my hypthetical above)

    that the biggest threat to petro dollar support would be to regulate speculation because that would = lower oil prices w/0 boosting the dollar much.

    This would cut the central bank added $ demand to pay higher oil bills as well as increase opec’s pressure to shift to euro pricing.

    The second threat i see is a rapidly weakening euro. however with u.s banking sector getting spanked the fed’s next move will be to CUT rates (and thus would negate) and rapid weakening of the euro should the ECB decide to cut rates late this year.

  • Posted by Nick

    Twofish: It all depends on the default rate for the securities that are being used as collateral. If most of the loans turn out to be good, then everything will work out in the end. If you start seeing massive defaults on the securities that are being lent to the fed, then you will have big problems.

    I’m not sure you could find many people inside or outside the government who would contend that the securities held by the Fed as collateral are backed by “good” loans. Even the “AAA” collateral from Bear Sterns just got written down by ~4%, and that’s only with the current defaults, which are just the tip of the iceberg with alt-a coming up fast. The Fed doesn’t care: they are focused on the sort-term problem of trying to keep the credit-spending party going, fighting the natural market forces trying to correct the imbalance. And that doesn’t even begin to include all the “97%” FHA loans which are the majority of the current market, explicitly backed by the government, and nearly all going to default.

    It’s true that you need to survive the short term to get to the long term, but current policies are not about trying to survive, they are about trying to prevent pressure release and keep the credit party going. Responsible long term policy would be refusing to bail out people, let the financial industry take their losses, let the housing market correct itself, and deal with the economic slowdown until we can re-establish actual industries, and not an economy based on spending money we don’t have. Unfortunately, all the rhetoric from the current politicians and candidates is of the “spend more”, short term bailout, long term destructive, keep the consumer credit economy going variety, which doesn’t inspire hope for long term welfare.

    On the upside, America is not the foundation of the global economy any more; and although other countries will miss our unsubstantiated and unbounded spending, they have real, productive industries, and will survive if we collapse. That’s my theory, at least, and unfortunately we may live long enough to test it.

  • Posted by don

    “I am sure this has been discussed before, but could one of the resident macro-thinkers summarize the likely consequences of foreign CBs stopping to buy US debt?”
    Well, for one thing, aggregate U.S. demand for U.S. production would gain tremendously, as both demand for U.S. exports and import-competing production would grow.

  • Posted by flow5

    The importance of the Fed’s balance sheet is overdone. The only figure that is of importance is the sum total of the legal reserves figure:

    Flawed as the AMBLR figure is (Adjusted Member Bank Legal Reserves), it is still far superior to the Domestic Adjusted Monetary Base (DAMB) figure, which is generally cited. The DAMB figure includes AMBLR plus the volume of currency held by the nonblank public (Milton Friedman’s “high powered money”).

    Since the public determines its holdings of currency an expansion or contraction of DAMB is neither proof that the Fed intends to follow an expansive, nor a contractive monetary policy. Furthermore any expansion of the nonblank public’s holdings of currency merely changes the composition (but not the total volume) of the money supply. There is a shift out of demand deposits, NOW, or ATS accounts, etc. into currency. But this shift does reduce Member Bank Legal Reserves by an equal or approximately equal amount.

    Since the member commercial banks operate with no excess legal reserves of consequence since 1942, any expansion of the publics holdings of currency will cause a multiple contraction of bank credit and checking accounts (relative to the increase in currency outflows from the banks) ceteris paribus. To avoid such a contraction the Fed offsets currency withdrawals by open market operations of the buying type. The reverse is true if there is a return flow of currency to the banks.

    Since the trend of the non-bank public’s holdings of currency is up (ever since the 1920’s), return flows are purely seasonal and cannot therefore provide a permanent basis for bank credit and money expansion.

    In our Federal Reserve System, 90 percent of MO (domestic adjusted monetary base) is currency. There is no expansion coefficient attached to the currency componet of the monetary base. And the currency component of MO is so prominent, and the proportion of legal reserves so insignificant (and declining); that to measure the rate of change in “base money” (currency held by the non-bank public, plus vault cash, plus legal reserves) — to the rate of change in the M1 money stock figure (where 56% is currency), is effectively, to measure rates-of-change in currency unto itself (cum hoc ergo propter hoc); in probability theory and statistics, not a cause and effect relationship.

    Complicating the measurement of the monetary base is the fluctuation in the percentage of foreign currency in circulation to the percentage of domestic currency in circulation (estimated at ½ to 2/3 of all U.S. currency). I.e., the domestic monetary source base equals the monetary source base minus the estimated amount of foreign-held U.S. currency. Inflows and outflows of foreign-held U.S. currency (seldom repatriated) are related to political and price instability, as well as seasonal flows; and all are immeasurable in the short run…(quarterly).

    The “shipments proxy” estimate of foreign-held U.S. currency uses data on the receipts and shipments of currency, by denomination, at the Federal Reserve’s 37 cash offices nationwide (note: > 80 percent of foreign-held U.S. currency are $100.00 bills). Because of its influence on the DAMB, quarterly estimates of foreign-held U.S. currency are reported in the Feds “Flow of Funds Accounts of the United States” & in the BEAs estimates of the net international investment position of the United States.

    The volatility of the K-ratio (publics desired ratio of currency to transactions deposits), and the volatility in the ratio of foreign-held to domestic U.S. currency, both influence the forecast of the (1) cash drain factor, and (2) the movement of the domestic currency component of the DAMB. This causes unpredictable shifts in the M1 money multiplier (MULT – St. Louis), [sic], for M1 and thus for M2 as well.

    The Federal Reserve Bank of Chicago in its “Modern Money Mechanics” workbook, explains, using (“t”-accounts), factors that effect legal reserves. It is described as a booklet on bank reserves and deposit expansion. The stated purpose of the booklet is to “describe the basic process of money creation in a “fractional reserve” banking system” The monetary base plays no such role in its illustrations.

    It is therefore both inaccurate in practice, and incorrect in theory, to refer the DAMB figure as a monetary base [sic]. The only base for an expansion of total bank credit and the money supply is the volume of legal reserves supplied to the member banks by the Fed in excess of the volume necessary to offset currency outflows from the banking system. The adjusted member bank legal reserve figure is that base.

  • Posted by bsetser

    Missed info –

    I think your intuition is close to right. The impulse from a fall in demand for US debt (and corresponding rise in interest rates) would be contractionary. The fall in the $ would tend to stimulate domestic production of tradables (i.e. it would be expansionary), but there are lags in the process, so if the fall in demand for assets came suddenly, contraction in demand from the rise in rates would dominate — and the overall process would be contractionary. Resources do not shift across sectors quickly or painlessly in the real world (tho they sometimes do in economists’ models).

    A weaker $ would tend to push up import prices (and stronger demand abroad would push up export prices), so the price of tradables would tend to rise. This is inflationary, though the magnitude of the overall effect isn’t clear — US imports from China are under 3% of US GDP, so they aren’t huge in the overall price basket (the same argument works for imports from all the non-oil exporters now managing their currency) and some firms might try to keep market share by accepting lower profits rather than raising prices, so the “pass through” from a falling dollar to higher prices of imported goods isn’t one to one.

    For a real world example of this, German cars are now cheaper in the US than in Germany, apparently …

    Oil is a bit different b/c energy is an input into the production and transport of a host of other goods, so it can feed through more broadly … but the overall impact of an end of intervention on oil prices isn’t clear. if the contractionary aspect dominates, demand for oil should fall — and a fall in demand could take a lot of pressure off the market and bring prices down even if the dollar is falling.

  • Posted by Twofish

    Nick: I’m not sure you could find many people inside or outside the government who would contend that the securities held by the Fed as collateral are backed by “good” loans.

    I think the situation is much less dire than that. The derivative securities they burned the investment banks tended to concentrate defaults. Once you get out of sub-primes the ability of the borrower to repay the loan depends largely on the ability of the borrower to keep their incomes.

    Nick: The Fed doesn’t care: they are focused on the sort-term problem of trying to keep the credit-spending party going, fighting the natural market forces trying to correct the imbalance.

    The trouble is that if Bernake’s analysis of the Great Depression is correct then letting things fall apart will create a nasty cycle which will tear everything apart.

    There really is not much downside in what the Fed is doing. If they are wrong and things are going to fall apart, then things are going to fall apart, and easy credit is not going to make things much worse than they already are.

    Nick: Responsible long term policy would be refusing to bail out people, let the financial industry take their losses, let the housing market correct itself, and deal with the economic slowdown until we can re-establish actual industries, and not an economy based on spending money we don’t have.

    And Bernanke believes that this will lead to a domino effect of bank failures which will cause a repeat of the Great Depression. The trouble with refusing to bailout people is that people are quick to say no-bailouts when it is someone else’s money, but when your bank account disappears then suddenly no-bailouts doesn’t sound so nice.

    What would you do if you went to the ATM and nothing came out? You’d probably default on your mortgage, at which point you have a vicious cycle.

    Nick: On the upside, America is not the foundation of the global economy any more; and although other countries will miss our unsubstantiated and unbounded spending

    The United States is a big enough part of the world economy so that if the US goes, it will take along everyone with it. One of the things about finance is that you quickly realize that we are all interconnected, and you just can’t say to someone “go ahead jump off the bridge” since you are handcuffed to them, whether you realize it or not.

  • Posted by Twofish

    Also, establishing “real industries” is going to be very hard to do without credit or banks.

  • Posted by jkh

    Although a bit oblique to the topic, flow5 makes quite an important point about monetary system mechanics. Of those who like to quote and use monetary base statistics (not in this post), few would appreciate or understand it.

  • Posted by Nick

    Twofish: What would you do if you went to the ATM and nothing came out? You’d probably default on your mortgage, at which point you have a vicious cycle.

    I’m not suggesting the US not honor FDIC insurance; I think it’s appropriate and responsible to have a mechanism to ensure people’s bank deposits are safe. However, that’s a far cry from giving billions to lenders, taking hundreds of billions of MBS’s onto the Fed’s books in exchange for treasuries, leveraging the Fed’s balance sheet to keep IB’s afloat, etc. Nobody’s bank account balance would disappear if the Fed stopped bailing out IB’s, but a lot of large, extremely over-leveraged financial institutions would crumble (as they need to, for the market to work).

    Twofish: Once you get out of sub-primes the ability of the borrower to repay the loan depends largely on the ability of the borrower to keep their incomes.

    If you think that’s the case, you (and the Fed) might be in for a harsh wake-up call. There are many, many bad loans beyond sub-prime, most of which the borrower cannot repay without asset appreciation (which is unlikely to occur in a free housing market until well after the borrower would default). The alt-a portfolio alone is roughly double the size of the sub-prime amount, and substantially all of them will likely be underwater in 2-3 years. You really think people will keep paying underwater loans with 95%+ LTV when the payments double going to full amortization? Really? And that doesn’t even consider the prime loans which will be underwater…

    The thinking which indicates bailouts are necessary is inherently flawed: it’s not like there won’t be banks left if some big ones fail like Bear Sterns, or there won’t be financing for business if it’s not from BofA, or every financial institution is 30x leveraged and insolvent like Lehman. Financial institutions which make horrible business decisions chasing short-term profits should, and must (for long term market health), be allowed to fail. Unfortunately, it takes someone not afraid to make politically difficult decisions to ensure their collapse doesn’t endanger the US in general, and right now those people are in short supply in our government.

    It may be that other countries are buying US debt precisely because they agree that if the US falls, they will fall with us. Let’s hope that impetus is stronger than chasing positive equity return as we devalue the dollar trying to deficit spend our way out of our deficit spending created mess.

  • Posted by Twofish

    Nick: Nobody’s bank account balance would disappear if the Fed stopped bailing out IB’s

    Tell me…. When you deposit money into your checking account. Where do you suppose that money goes? Who do you think buys mortgage backed securities, and whose money do you suppose they use?

    Take a look in the mirror, since it is your money that the IB’s have been putting into mortgages.

    Nick: A lot of large, extremely over-leveraged financial institutions would crumble (as they need to, for the market to work).

    And somehow when all of these financial institutions collapse, your bank account and the payroll accounts of your employer are magically immune? Markets work when people who make bad decisions suffer for it, but once you get past a certain point, you end up harming people who had no input in the decisions that led up to that mess, and aren’t even aware how deeply tied they are into the system (i.e. you).

    Nick: There are many, many bad loans beyond sub-prime, most of which the borrower cannot repay without asset appreciation

    And loans in which are based on the borrowers income and credit are likely to remain good. People with good jobs and credit tend to keep paying their loans, unless they lose their jobs, which can happen if the bank that their employer has their payroll accounts in goes under.

    Nick: It’s not like there won’t be banks left if some big ones fail like Bear Sterns, or there won’t be financing for business if it’s not from BofA, or every financial institution is 30x leveraged and insolvent like Lehman.

    You really think so? All the banks are interconnected and lend to each other. If one goes poof then the likely result is a massive domino effect in which both the good banks and the bad banks fall off the cliff together. That’s what happened in 1929.

    Nick: Financial institutions which make horrible business decisions chasing short-term profits should, and must (for long term market health), be allowed to fail.

    And they are. The mess has wiped out most mortgage brokers and a whole web of institutions. The trouble is that once you go past a certain point, the process feeds on itself. Once you burn through equity, then the people that lose money are the people that the banks owe money to. In other words, you…..

    Nick: Unfortunately, it takes someone not afraid to make politically difficult decisions to ensure their collapse doesn’t endanger the US in general, and right now those people are in short supply in our government.

    And it’s easy to condemn the politicians when you don’t realise that *you* will be the person that gets hurt in a general banking collapse. Politicians are afraid of having to face a lynch mob of people that are angry as hell that they have lost their jobs and their life savings.

    This is not a bad thing.

  • Posted by don

    Brad: “I think your intuition is close to right. The impulse from a fall in demand for US debt (and corresponding rise in interest rates) would be contractionary.”
    I wonder. The assumption implicit in your analysis seems to be that the domestic rate of interest is determined by the global market, rather than by the fed.

  • Posted by Nick

    Well, speaking only for myself:

    When I deposit money into my NCUA-backed checking account, it goes to my credit union, which then loans it out to other members. If they go belly up, the NCUA (which is explicitly backed by the government, like the FDIC) pays out my account balance (to the limits of the insurance). This works for any FDIC or NCUA insured account, and the government has never failed to pay out, promptly (and most likely never will). Payroll accounts may take some hit, but since we’re only talking revolving payroll amounts over the FDIC insurance limit, it’s not likely over six figures for most companies, and recoverable. Sorry, gotta call BS on the “losing your checking account money” argument.

    I’d guess the overwhelming majority of money used to purchase MBS’s comes from hedge funds and money market accounts which are invested in “investment-grade” real estate backed securities, but you’d probably have to have someone follow the money to check that (such as the blog author, for example).

    Twofish: All the banks are interconnected and lend to each other.

    Not true. You’re probably thinking purely of large investment banks, which dominate the headlines these days. Think of all the small independent banks and credit unions around the country which didn’t get into the whole massive leveraging interdependent derivatives schemes; most of those will be fine (in fact, will thrive). Doing the right thing for the long term means seeing the big picture; in this case, it requires the largest purveyors of systemic risk to be collectively flushed, the FDIC to pay out what it needs to (to prevent unrelated people from losing money), the Fed to be disemboweled for shirking their oversight duty to prevent systemic risk, and new banks to step into the void and ensure credit for businesses is still available.

    Twofish: Politicians are afraid of having to face a lynch mob of people that are angry as hell that they have lost their jobs and their life savings.

    It would be a good thing, except their angry for the wrong reasons. They should be angry that politicians are trying to spend their way out of their spending problem, and in doing so are destroying people’s savings through currency devaluation. They should be angry that our government continues to promote deficit consumption as an “economy” through statistics and actions, and they are losing their jobs as a result. If they were trying to lynch the politicians for the right reasons, we might have some positive change. As it is, they are just angry that their government isn’t giving them enough handouts to compensate for ruining their livelihood, and the politicians are capitulating by giving more short term handouts at the expense of long term national viability. Hence, they get my condemnation.

  • Posted by Twofish

    Nick: When I deposit money into my NCUA-backed checking account, it goes to my credit union, which then loans it out to other members.

    Have you ever looked at the balance sheet of your credit union? About 60% of it consists of loans. The trouble with loans is that they have a long term payout which means that the bank can’t convert them to cash right now.

    About 20% of it consists of securitized loans (mortgage backed securities) which can be quickly converted into cash assuming that markets are functioning. If you have a massive banking crisis then they can’t liquidate those securities, meaning that you are sitting in front of the counter without cash.

    In order for the banking system to work, there has to be a mechanism for rapidly converting loans to cash and back again, and investment banks sit right in the middle of that system.

    Nick: If they go belly up, the NCUA (which is explicitly backed by the government, like the FDIC) pays out my account balance (to the limits of the insurance).

    So where does that money come from? Under normal conditions this money comes from insurance premiums. However, if the banking system were to totally collapse, that would get burned through. This happened in 1980 with savings and loans, and the government stepped in, and did a bailout of depositors.

    Two other problems:

    1) your bank deposits might be insured. Your employers payroll accounts are almost certainly well above the limits of the insurance.

    2) when do you get the money? If it takes a week to process the claims, then you are sitting with a bunch of IOU’s.

    The basic problem is that you want your money *now* whereas the bank has these loans that they need to collect over 15-30 years.

    Wouldn’t it be nice if there were a Federal agency that when people got nervous was willing to trade those loans and securities for cash to the banks. We can call it the Federal Reserve.

    Nick: I’d guess the overwhelming majority of money used to purchase MBS’s comes from hedge funds and money market accounts which are invested in “investment-grade” real estate backed securities

    Nope. Guess again….. You really do need to look at the balance sheet of your credit union. Also do you have a pension? Insurance? Where do you suppose they put their money?

    Nick: Think of all the small independent banks and credit unions around the country which didn’t get into the whole massive leveraging interdependent derivatives schemes; most of those will be fine (in fact, will thrive).

    Nope. The small independent banks and credit unions need the big investment banks to convert their loans into cash. Without big investment banks, the small independent banks and credit unions can sell their loans quickly to get the cash to give to the people who want their money ***now***.

    It gets worse because once people figure out that they might or might not get their money, they start getting in line to withdraw everything, and if you have everyone trying to withdraw at the same time, any bank is going to collapse.

    Nick: The Fed to be disemboweled for shirking their oversight duty to prevent systemic risk, and new banks to step into the void and ensure credit for businesses is still available.

    While you are waiting for those new banks to get set up, you are out of a job because your employer can’t pay your pay check, and you’ve lost your house because your bank has gone under and you are waiting for Congress to figure out how to finance the bailout for your credit union.

    Nick: As it is, they are just angry that their government isn’t giving them enough handouts to compensate for ruining their livelihood, and the politicians are capitulating by giving more short term handouts at the expense of long term national viability. Hence, they get my condemnation.

    Who is they? If my life savings went up in smoke, I’d be mad as hell. It’s easy to complain about “them,” but if you go through the balance sheets of the places they you put your money and read a little more about how the banking system operates, then you’ll find that “they” aren’t getting the bailout.

    “You” are.

    The trouble with all this is it happens after the fact, when you can’t buy groceries because your money is stuck. Wouldn’t it be nice if the government did something proactive? Like for example, maybe let the banks know that they would be willing to convert loans to cash so that people can make withdrawals so you don’t have people lining up in panic……

    Ohhh…. But wait…. They did that…..

  • Posted by Matt

    Brad and co

    You folks are looking intensively at a rather narrow risk window, in my humble opinion. There are problems, sure, but there is a global economy to be considered, and the transmission mechanisms are unclear. We could spend all afternoon tracking the death spiral of the next US bank to go, and the are some superb candidates, but more broadly, how about think of the inter-state market, spillover effects, and degrees of coupling or decoupling? That’s where I’d like to hear the fabulous resources of blog commentary to start to address.

    Anyhow, my post to Mark Thoma was:

    Matt says…
    People, please; so much macro, so little history. It’s as if the present was created today.

    It wasn’t, isn’t and never will be. Let’s look back a short ten years and think about the situation that Indonesia found itself in; Joe should be able to comment a bit, as it was a key battleground in his disagreements then and final exit from the World Bank. Ok, from memory in 1998 15 million people plunged below the poverty line because Indo went with IMF advice to cut micro subsidies in oils and foodstuffs, which led to rioting and crisis, which gave the world the unedifying spectacle of Camdessus wagging his finger at Suharto (one dictator to another), which led to the catastrophic loss of confidence from Asia in the IMF, the creation of the Chiang Mai Initiative and the accumulation of colossal reserves to save for the next rainy day, which is now: an autarkic response to multilateral failure. Frankly astonishing. And relegates the IMF to a bystander, unable to support the next wave-need from Asia. No wonder Kuroda is still plugging hedged versions of the ASian Monetary Fund while at the ADB.

    I don’t want to engage with the labels, neo this or that, since at this time to me they frankly carry too little explanatory power, and don’t offer sound and immediate remedies. What I can see is business failure of many kinds in many sectors, fostered by policy and oversight failure, and governmental responses which are perhaps not up to the task, in several jurisdictions. Maybe this makes me Classic Liberal, as I think the Growth Commission came out on recently, having basically re-promulgated Adam Smith. Well done. One could add the “yes, buts” but not productively. And we could have gone to the library about 50 thousand times to borrow the Wealth of Nations rather than pay the Growth Commission to reiterate the main message of the interface between states and markets.

    I’ll largely end this here, but welcome posters’ responses, esp those who remember the Asian crisis. I think we should be reflecting on the good, the bad, and the ugly, of the last war, since this one might benefit from principles-based considerations.

    On the specifics, it might be sui generis, in which case we’ve got a whole problem-solving to do. Like U household balance sheets and prospects…

    Matt

  • Posted by Matt

    Second bite: my last sentence should read “US household balance sheets”, secondly considering the impending bust of auto loans, credit card debt, primes following subprimes downwards and the role and function of universal default. Simple, really.

  • Posted by Twofish

    Also, it’s not just the investment banks that are highly leveraged. All banks are highly leveraged, it’s the nature of the business. If you look at the balance sheet of your credit union, you’ll probably find a 10-1 leverage ratio, which means that if you do see the types of default rates you think are plausible (and which I think are implausible) then the equity is going to get wiped out, and you’ll need a federal bailout to keep from losing money on your deposits.

    Historically, small independent banks and credit unions have often had problems because they can end up with all of the loans in one area and if that area gets hard hit, then they get burned first.

  • Posted by Howard Richman

    Missed Info asked: “I am sure this has been discussed before, but could one of the resident macro-thinkers summarize the likely consequences of foreign CBs stopping to buy US debt?”

    Don was correct when he responded: “Well, for one thing, aggregate U.S. demand for U.S. production would gain tremendously, as both demand for U.S. exports and import-competing production would grow.”

    But there are three other macroeconomic effects: (1) U.S. interest rates would increase, (2) fixed investment opportunities in U.S. production would increase, and (3) the dollar would fall in currency markets causing the cost of imports to increase. Let me discuss each in turn:

    1. Interest Rates Up. The increase in interest rates would cause an inflow of private foreign money and an increase in domestic US savings, but it would also cause several US financial institutions to go bankrupt.

    2. The increase in investment opportunities would cause US corporations to stop buying back their shares and instead they would invest their profits in US production. It would also cause foreign companies to build many new factories in the United States. These fixed investments would cause unemployment in the United States to fall to miniscule levels causing US wage rates to rise.

    3. The dollar would fall much further in world currency markets. This would cause the prices of things we import to rise. Americans would have more income that they could spend, but it would also cost them more whenever they were buying imported products, such as gasoline.

    All of these adjustments would be much less severe if they were to occur gradually. It would be much better for both the U.S. and for the world economies if foreign governments were to gradually reduce their reserve accumulations over five years instead of stopping cold turkey.

    Howard Richman
    co-author Trading Away Our Future
    http://www.trade-wars.blogspot.com

  • Posted by bsetser

    Don — I should have been more precise, and said “interest rate on long-term bonds.” The policy rate is one variable that impacts the int. rate on the ten year, but not the only one. and yes, i do think the current central bank buying spree has an impact on long-term yields. remember when the short rate rose and long-term rates didn’t.

    matt — I remember asia well, tho i watched it from the point of view of junior staff economist at the treasury. I also remember indonesia well. I think the IMF made enormous mistakes. But I don’t think it all hinges on the IMF’s advice to cut cooking oil subsidies. A couple of other things also mattered:

    – there were a host of insiders who benefited enormously from suharto’s rule. the first family. the plywood monopoly. etc. it was a political requirement for the uS and the IMF that suharto demonstrate that this system was changing, and the status quo was being bailed out.

    this i would note is separate from the question of whether or not all of the imf’s specific advice was right — when a well connected bank was allowed to fail w/o creating a system of deposit insurance, there was a rather damaging bank run that caused a lot of trouble. and some of the recommendations seemed to me to go too far — i.e. cooking oil.

    – there was an assumption in the imf and at the US that reform would be rewarded with capital inflows. in retrospect that was naive. a lot of banks had lent money to well connected business men and reform meant they were less good credits.

    – the $ exposure of the corporate sector was an important factor. firms with $ debts had to hedge as the rupiah fell, and that fueled a very destructive cycle.

    the lesson that many took from this was don’t ever put yourself in a position where you have to turn to the imf, especially if you are an insider in a regime that rewards insiders. that tho cannot explain all of asia’s current reserve accumulation. I can see why china wants limited short-term external debt and reserves of 10 to 20% of GDP (that implies, at 20%, may be $800b … ). but that doesn’t explain why china is adding $800b to its current $2 trillion stock (counting the banks fx and the CIC) this year …

    read bailouts and bail-ins, my book with dr. roubini on emerging market crises. there is a lengthy discussion of indonesia. you may disagree with our conclusions, but it would provide a decent basis for a serious discussion of the imf’s response.

  • Posted by Rien Huizer

    Matt etc,

    Remember the Indonesian case vividly (professionally). There was IMO a confluence of factors: (1)large volume of capital ready to flee in case of unrest in the wake of Suharto’s exit (dead or alive), based on gradual breakdown of the military-civilian-business regime (partilally due to selfish and immature behaviour os some 2nd generation Suhartos) (2) psychology among FX traders, speculators, especially in the region (3) FX option positions priced to unrealistic volatilities , all FX positions faclitated by weak system of exchange control (4) extremely poor quality of banking supervision with apparently massive irregularities in both state banks and private banks with no prospect of surviving that kind of a crisis (5) drought (an often underestimated factor reducing the absorption capacity of the informal economy.

    All in all, Indonesia was due for a little clean up. Both within the state/army sector and in the the ethnic Chinese informal hierarchy. A few people enriched themselves enormously,the wealthy generally did not suffer much more than a temporary period of hardship (or leave in Spore/US). many poor did not get much poorer, Indonesia got a slightly more modern government, etc. Among all these factors, the most important factor was loss of credibility on the part of the government (i.e. Soeharto) in the presence of well organized contingency plans of cronies and a large part of the upper strata. IMF acted predictably.

    I do not think that he US can learn much from the Indonesian case. It was completely different. If one wants to look for paralel cases, perhaps the UK in the late 1920s or, indeed, BW 1 .

    As to remedies: it is nice to dram about a cathartic collapse of the financial system, followed by dramatic resurrection (there we have an Asian paralel that is useful: the banking systems in Asia did not get better, the states (except Korea, where the banking system continues to be stressed) extracted so much money from their private sectors that they would never ever have to ask foreigners for assistance. The leson rom the Asian crisis is, IMO, that thre is no such thing s a therapeutic crisis. So the chllenge is to muddle through and deal with possibly angry creditors (the Chinese perhaps in a few years) coperatively. That will take a pretty special kind of US administration. I wish the winner of this year’s election all the luck in the world. Especially domestically. Only one term..

  • Posted by RebelEconomist

    Nick,

    I do agree with you. The Fed has been crying wolf for years, using the depression example to justify easing monetary policy in response to financial market stress (I am thinking of the 1987 crash, LTCM, Y2K, dotcom bust, 9/11 etc). The trouble is that each bailout increases the moral hazard and breaking the cycle becomes even more difficult. For some evidence of how this policy seems to have affected US financial market behaviour, see my blog posting at:
    http://reservedplace.blogspot.com/2008/06/greenspan-put.html

    As Twofish knows from previous discussions, I reject his argument that letting the present bust take its course could be fatal – economies do not die, they just decline, like Argentina. While I do agree with him that even staid institutions are affected this time (viz Norweigian local authorities), I think that there is a certain amount of relief is provided by (a) bank capital (b) deposit insurance funds and (c) I would levy a windfall tax on many of the management that have done well out of the party (eg Grasso, O’Neal, Prince etc) to help pay for the cleanup.

    As in the case of other (arguably related) US economic problems such as the trade, current account and government deficits, I think that the best approach is to spend resources facilitating and compensating for the adjustment, not forestalling it.

  • Posted by Paul

    I also agree with Nick.

    Money print is simply unsustainable. To most of politicians, the option looks great as it makes all the people apprently happy, especially under these mired financial markets. However, printing out money creates nothing. It just manipulates number. Whether it takes a form of accepting broader range of collateral or intervening overnight interbank rates, it’s all about printing dollar in the bottom line.

    As Ponzi-scheme fails in the end, all the number manipulations are doomed to collapse in the end. I’m really worried about Fed’s extremely short-sighted measures to face such destiny soon.

  • Posted by Matt

    Brad – thanks for the post in response, I was running an aid program in Indo at the time, and it collapsed, and needed a rescue phase, in part due to what in the absence of wide consultation would have to be viewed as an additional exogenous shock as the big players moved. Some was endogenous. But there are no tears due for programs which don’t do scenario analysis, preparation, recalibration, and action. I have to say I was there for the endgame, not the inception.

    I will read your book suggested and hopefully overcome the insinuation that despite travails in country I am not qualified to have a “serious discussion” about Indonesia and the IMF without having read it. I trust it deals with West Papua.

    Lastly, I agree with you and Rien Huizer that there were other things going on – banking issues, expatriation of assets, misc crookedness, and so on, but I still consider that they didn’t provide the sharp end of domestic and social conflict risk. These, I’m advocating in my current job, are especially germane as we look across the developing world to consider security effects of macro positions, food and oil price issue and so on; and they look potentially significant.

    M

  • Posted by Rien Huizer

    Matt,

    Do not know if this post is closed. You must have met Dennis LeTray there, a Canadian who headed the WB in Indonesia at the start of the crisis. He was badly treated later, but I think he would have had similar problems with the IMF approch, especilly following on inexplicble EXIM largess re Indonesian IPPs (all very well connected).

  • Posted by Matt

    Rien – seems the post is open.

    Yes, I know (of) Dennis and his occasional prophet in the wilderness pronouncements from the cosy environs of Mass Ave. Poverty has been good to DdeT. I wasn’t aware of the EXIM angle, however, so v much thanks for that. I was more focussed at the time on (perversely) grass roots and the banking workout.

    Ok, Dennis did himself no favors arguing against increased governance and anti-corruption efforts in the World Bank after the Volcker panel report last October. He ran a line that better anti-corruption efforts from the World Bank are a bit like putting a burglar alarm in your own home, while recognizing theft of, around, and amongst, the neighbors. (This @ http://www.cgdev.org) . Sorry, does not compute. There’s a fiduciary duty from the top down to see that the money goes where it’s supposed to. This is irreducible. But there are mistakes and failures, so one has to question, why, how, with what impact and is it instance or pattern? At least people should be pushing the bank on that front.

    Allied to that point, anyone care to assess why the WB put in Mark Baird fairly swiftly after the Stiglitz/EAP Regional/de Traay fight to straighten things out? .

    Matt

  • Posted by Sameer Chishty

    brad, so you’d continue shorting the dollar and us financials? what would you buy now?

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