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It looks like the United States’ no bailout policy lasted all of two days

by Brad Setser
September 16, 2008

AIG’s bondholders got a huge break. That is an observation, not a criticism. The credit markets were not reacting well to Lehman’s bankruptcy filing.

$85 billion is a lot of money. The terms of the loan are onerous. 850 bp over LIBOR (a penalty rate) plus equity warrants. The US government now effectively owns a significant chunk of the US financial system, and provides liquidity to an even bigger chunk of it. To state the obvious, the crisis has entered a new phase.

Rogoff and Reinhart’s paper on the cost of systemic banking crisis looked good when it first came out. It looks even better now.

An anonymous Federal reserve official was quoted recently in the Wall Street Journal saying:

“We’ve re-established ‘moral hazard,’” said a person involved in the talks, referring to the notion that the government should eschew bailouts, since financial firms might take more risks if they’re insulated from the consequences. “Is that a good thing or a bad thing? We’re about to find out.”

Felix is right; the person involved in the talks didn’t quite get the concept of moral hazard. The US government removed ‘moral hazard” — the availability of insurance that protects investors from losses on risky assets — from a portion of the credit market. I am still not sure if it was a good or a bad thing. But it sure seems to have revealed that a significant portion of the US financial system wasn’t strong enough to stand on its own, without a government backstop.

81 Comments

  • Posted by SS

    There’s a long list of banks waiting for the same treatment — onerous or not. I don’t think anyone really knows if the Fed will make a full recovery on this one or just took a multi-billion dollar bullet for “the global financial system.”

    Simplistically speaking, how much would the dollar depreciate if the US had to absorb $1T in losses when all was said and done?

  • Posted by manch

    Brad, will you be doing a tally of Fed’s balance sheet any time soon? The Fed is looking more and more like a hedge fund now. Wonder when it will reach for the printing press….

  • Posted by Twofish

    It’s not so much AIG bondholders that got the benefit but rather the bondholders of Lehman and other banks that will close. What got AIG in trouble was taht it was in the credit insurance business, so when Lehmann fails, AIG had to pay up. The I think really worried people was if AIG fails, then who is the next domino?

  • Posted by bsetser

    manch — i’ll be most interested in the fed balance sheet data released on thursday, and the data released next thursday. if only other central banks were as transparent

  • Posted by moldbug

    Note that this is exactly Bagehot’s cure: lend freely at very high rates. Well, lend freely to solvent institutions at very high rates. But…

    (I suspect a lot of people tonight could derive real comfort, and possibly even a bit of inspiration, from resting their heads on a copy of good old Lombard Street.)

  • Posted by Cedric Regula

    Mama Mia, I go play tennis for a couple hours and the feds spend another $85 billion? Now I a scared to play golf tomorrow.

    The goons is gonna add this to my insurance policy when I hava to buy protection. What gives goombas????

  • Posted by Andrew

    I dunno.

    Could we possibly have some kind of a cheat sheet? The Sheep, over here, are Too Big To Fail.

    Bear Stearns, Countrywide, Fannie/Freddie, Merrill Lynch, AIG, Citigroup, Bank of America, JP Morgan, Goldman Sachs…

    The Goats, on my right, can be Thrown To The Wolves, with a bit of creative financing to assure that they have an orderly demise off camera:

    Lehman Brothers, Washington Mutual, Wachovia Bank, Morgan Stanley…

    Is there rhyme or reason to who gets to be a Sheep and who gets to be a Goat?

  • Posted by Cedric Regula

    I call my uncle eddie, he just burn a these houses down then a we not have this problem anymore.

    Capice??

  • Posted by Rosenberger

    Andrew’s right, the selectivity of the bailout/no-bailout decisions is worthy of nothing less than ridicule. It’s also the very worst kind of corruption, and encourages the kind of incestuous cronyism that we most identify with banana republics.

    Whatever the blunders of Richard Fuld at Lehman, I see absolutely nothing that makes Lehman worse off (or more deserving of bankruptcy) than JPMorganChase, Morgan Stanley, BoA, Wells Fargo, Citi and Goldman-Sachs. If Lehman goes, so should they.

    In fact, if anything JPMorganChase, GS, Morgan Stanley and the others are even more beset with toxic junk than Lehman is. They’re just a little better at the Enron cooking-the-books practices than LEH was.

    If anything, Fuld will likely make sure that all the ugliness about not only Lehman, but the entire industry comes out now in full detail, to bring down the other banks with his own. That’s probably his only protection from becoming the scapegoat– if his rivals are taken down as well, then everybody’s swimming around for the life rafts.

    In fact if anything, I’d

  • Posted by Cedric Regula

    This is so hilarious I had to post it, tho who knows what it has to do with anything.

    I went to my usual Forex website and looked at the home page and each of the paragraphs listed below is a headline for a research note from one of the analysts. These people all work at the same place. Note the confusion.

    Wonder when Soros, Rogers and whoever else will try a speculative currency attack on the Fed? That would clarify things.

    ======================================

    US Dollar Could Falter As Federal Reserve Leaves Rates at 2.00%, Signals Neutral Stance
    Tuesday, 16 September 2008 23:16:43 GMT

    US Dollar Forecast: Fed Rate Expectations Bolster Dollar vs. Euro, British Pound, Australian Dollar

    Tuesday, 16 September 2008 20:12:55 GMT
    Senior Currency Strategist
    Jamie Saettele
    Forex Technicals: The Day Ahead, September 17

    The technical evidence suggests that the US dollar will retrace a portion of its gains since July. The biggest winner may be the British Pound.

    Technical Analysis
    Euro Could Fall Against Commodity Currencies
    Tuesday, 16 September 2008 23:23:17 GMT

    Buy Pound, Kiwi Financed by Yen, Dollar, Says Automated Signals
    Wednesday, 17 September 2008 00:50:08 GMT

    Analyst Picks
    Short Euros And Long Pounds A Consistency Across DailyFX Analyst Picks

  • Posted by Rahul Deodhar

    I was pained that Lehman went bankrupt – it was as good a company, a little better on the insides perhaps, than any other.

    But I was even more pained at bailout of AIG.

    I believe a more regulatory approach may have had better effect. In crazy times it is better to slow down and get bearings right. FED should have peeked under the hood of all banks and FIs in US and then used some regulatory enforced structured unwinding over set time-table. That might have been a better bailout without tax-payer money than otherwise.

    By doing selective bailouts – FED is inviting more trouble. And I think now someone will need to bailout the FED.

    I think current crises needs global regulatory response and coordination. I hope the politicos hurry up and get their acts together. Else contagion will be erratic – widespread and like self-sustaining wave.

    Rahul

  • Posted by Dave C.

    Next on the US Taxpayer bailout list is:

    Washington Mutual
    Wachovia
    Citicorp

    Everyone is “too big to suffer a loss”.

  • Posted by Twofish

    Andrew: Is there rhyme or reason to who gets to be a Sheep and who gets to be a Goat?

    If you can argue that Chapter 11 will destroy the world financial system, then you can get an intervention. Also, I think the question is not so much whether you fail but how you go about failing. The board of directors and CEO’s of all of the companies have been removed and replaced. The problem is that Chapter 11 may be too blunt an instrument for dealing with a failed financial company.

  • Posted by Twofish

    DC: Next on the US Taxpayer bailout list is Washington Mutual/Wachovia/Citicorp

    The money is already gone and someone will have to pay. If you create a normal Chapter 11, the people that end up paying are depositors, and discouraging savings and investment is probably something that you don’t want to do.

    I should point out that how the US is handling the banks is very much like how China ended up handling it’s banking problem in the 1990′s, and part of what China did was to tell all of the people that kept screaming about moral hazard to shut up because there are worse things in the world than moral hazard. Judging how well Chinese banking reform worked out in the end, I really think that the US should start taking some notes.

  • Posted by les

    Now that BofA bought out countrywide and Merril, I guess they can be reclassified as “too big”. At first, I thought these purchases were reckless, especially Countrywide. In retrospect, it’s brilliant. BofA will have its own trouble in a year or two, but they have a govt that loves to save companies that are “too big” to fail.

  • Posted by anon

    bsetser – I’m not sure I understand your point on moral hazard – seems like the Fed’s action in this case snuffed out the idea for equity investors, but reinforced it for creditors, similar to Fannie and Freddie.

  • Posted by Blissex

    «My question to the business world is, will the state have to become a more effective watchdog in order to prevent market collapses like this.»

    That’s s stupid question! because the only effective watchdog is voters. All the enormously risky profits cashed in by the financial industry executives and the losses being covered now can be explained very simply: those executives purchased protection from Congress with generous campaign donations, and voters did not care, or cared more about lapel pins or lipstick. In a democracy the price of liberty is eternal vigilance as someone said.

    «Its as though the financial elite in London/New York/Japan visions didnt penetrate beneath the middle class who are comfortable but they are not primary creators of wealth like the workers.»

    But the elite (top 1%) and the middle class (top 20%) tend to believe that they are the only creators of wealth, and the “workers” in the bottom-of-the-barrels 80% are exploitative parasites who create no wealth and steal a large chunk of the wealth created by their betters via the tax system.

  • Posted by Blissex

    «The Fed is looking more and more like a hedge fund now. Wonder when it will reach for the printing press.»

    If you look at the details they have been setup to pretend no public money has been involved, and that Congress does not need
    to appropriate any money or setup an agency.

    In both GSE and AIG the Fed became a 79.99% shareholder *at no cost*, purely by providing a loan, which formally will be
    repaid. The Fed is effectively becoming the off-balance-sheet SIV of last resort of the USA government, even more than the
    hedge fund.

    Even the 79.99% is significant, as IIRC there is some rule about liability consolidation and listed companies that gets triggered at the 80% level. It means that that Fed in its role as the mother of all SIV is technically just the majority shareholder.

    This is Enronesque accounting to a colossal degree.

  • Posted by kafka

    Is the US of A defaulting on the world through the default of its coorporations and their defacto nationalization? I dont get why is the USD so strong?

  • Posted by Blissex

    «This is Enronesque accounting to a colossal degree.»

    To add to this, the NYT writes that the purpose of the game was to game accounting rules:

    http://www.nytimes.com/2008/09/17/business/17insure.html?_r=1&oref=slogin

    «If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, which in turn would have reduced their own capital and the value of their own debt.»

  • Posted by charlie

    Moral Hazard has been long gone. Paulson and Bernanke’s job at the moment is to get McCain elected. All decisions are political at this point. The republicans felt that the gov’t bailing out everyone rap could cost them votes, so they let Lehman go under so now they can claim the gov’t didn’t bail everyone out. Lehman going under doesn’t directly effect many voters. They don’t have much public facing business.

    AIG is an insurance company. They can’t let annuitants and policy holders not get paid. It might cost too many votes.

    Banks have to be saved because they are public facing. If my bank goes under and I lose money, I’ll be mad and not vote for the incumbents.

  • Posted by Dave C.

    Quotes of the Week:

    Warren Buffett writes, “the subprime mortgage was a glass of poisonous wine concocted by the US financial industry. They not only drank it themselves but also offered it to others”.

    Former US ambassador to China Jim Sasser states, “the US subprime disaster could actually prove to be a good thing for China because it will make Americans realize that the cause of their country’s economic woes was of their own making rather than the renminbi exchange rate. This has reduced the political pressure on China”.

  • Posted by bsetser

    blissex — good points about 79.9 to avoid consolidation of liabilities; tis obvious once you state it. I also think there is a strong case that more bailouts should be done through an AMC and fewer via the fed — but in a crisis, you tend to use the tools available to you. But it is a bit ironic that the fed now runs an insurance company and the treasury now runs two enormous financial intermediaries.

    anon — that was what I meant. I agree that the fed has consistently acted in ways that limit moral hazard for the equity investors, but not for debt investors (setting leh bondholders aside) in the financial sector. and that is my point, more or less. right now, the (unregulated) financial sector seems to needs a bit of moral hazard — namely the sense that those holding the debt of financial institutions will be protected by the actions of the USG — in order to rollover their debt. and since their assets are at best illiquid and at worst not worth anything close to their formal marks, the financial sector absolutely needs to be able to rollover its debts (or meet collateral calls for big derivative players).

    finally, the big regulated banks have long been too big to fail in the sense of too big to fail a la lehman and have all their unsecured creditors take a huge hit. they are regulated banks with FDIC insured deposits. that means deposits are protected. good thing too.

    they are also probably too systematically important to be allowed to fail to honor their large unsecured capital market debts as well. that undoubtedly is a source of moral hazard — we have effectively learned that big capital market intermediaries need to be regulated to limit moral hazard as they are now too systematically important to fail.

    on the other hand, they are not too big to fail in the sense of having their equity wiped out and being taken over by the USG. as long as they can rollover their debts, whether or not that happens will be a function of the quality of their assets — and how tough the regulators/ acccountants are when it comes to the valuation of hard to value assets.

    query: should the USG be tough if this means the effective USG takeover of many large banks? or should the USG try to give the banks time to work their way through, and use the favorable yield curve to recap themselves out of their income?

  • Posted by anon

    bsetser – or somebody – can you explain why the bankruptcy of Lehman was so feasible, while that of AIG was unthinkable? The balance sheets were $ 800 billion and $ 1 trillion respectively, so that’s no indication.

    Was the size of AIGs credit default swap (or credit insurance) book that much larger than Lehman’s?

    Was it the international exposure that was the trigger (similar to FF)?

    I haven’t yet heard a clear explanation of the difference between the two for systemic risk, other than CNBC hyperventilation about the $ 1 trillion number.

  • Posted by Dave C.

    “I should point out that how the US is handling the banks is very much like how China ended up handling it’s banking problem in the 1990’s” – Twofish

    Excuse me, the Chinese government bailed out 100% state-owned banks in the 1990′s, so essentially the state was just transferring credits from one government agency to another. In the US kleptocracy bailout, private sector capital misallocation is receiving an US taxpayer bailout. Wall Street privatizes the profits and socializes the losses to the US federal taxpayer. PIMCO’s Bill Gross was quoted on the London Financial Times that he made a “cool $1.5 billion profit” from the taxpayer bailout of Fannie Mae and Freddie Mac.

  • Posted by Dave C.

    What a bunch of jerks! PIMCO CEO says “$85 Billion isn’t enough”. Wall Street demands more US taxpayer bailouts and corporate welfare.

    ——

    “Pimco’s El-Erian: AIG Deal “Not a Huge Help”

    http://www.cnbc.com/id/26753460

    “Pimco’s Co-CEO Mohamed El-Erian say the government bailout of American International Group “may help a little bit because it reduces uncertainty, but it’s not going to be a huge help.”

    “The Fed’s balance sheet is starting to get encumbered by too many things,” he said.

  • Posted by otto

    Brad, I’d really like to ask a basic question here, unafraid of my ignorance.

    When a gov’t cuts an $85Bn cheque, where do the funds come from?

    I’ve been thinking about it since last night and although I suspect this and that method, I’ve come to the conclusion that i don’t have a clue. Any takers?

  • Posted by Blissex

    «When a gov’t cuts an $85Bn cheque, where do the funds come from?»

    That’s the $85b question… In the particular case it is a loan from the Fed, which means it comes out of their balance sheet, which is mostly USA securities.

    Ultimately the USA treasury is on the hook, because profits or losses from/to the Fed go to the USA treasury.

  • Posted by JKH


    “Query: should the USG be tough if this means the effective USG takeover of many large banks? Or should the USG try to give the banks time to work their way through, and use the favourable yield curve to recap themselves out of their income?”

    I note your use of the word “time”, which is important, as I emphasized in a comment several posts ago. Observations:

    a) The design of the financial system is in the very early stage of a great transition – from a broken one to a better one hopefully. But work toward this objective is highly suppressed by necessity right now, because of the priority of dealing with the very crisis that makes the need for such redesign so obvious.

    b) The current system is broken to the degree that it is driving toward catastrophe without government intervention. This is moral hazard for libertarianism. But a floor on systemic risk is required in order to prevent catastrophe.

    c) The depth of the system breakdown is such that there is no template for dealing with it. The Fed and the Treasury must make the kinds of systemic risk judgments that their private sector CEO counterparts were incapable of making in dealing with specific risk judgements within the existing system. This is moral hazard for CEOs.

    d) The Fed and the Treasury have made a sequence of decisions with a different mix of moral hazard effects – each different mostly with respect to their effect on debt and equity capital components of the affected institutions. These are case specific decisions required to contain systemic risk. Lehman was allowed to fail outright while Bear, FF, and AIG weren’t – due to different configurations for systemic risk. But these ex post moral hazard decisions won’t necessarily be relevant in a redesigned system that can better compartmentalize systemic risk dangers.

    e) The point on the yield curve recapitalization is very interesting, because it is part of a family of considerations that have to do with the difference between mark to market asset risk and income risk. The primary difference is time. The yield curve is one source of franchise income recapitalization for the banking system. There are other sources. But the franchises require time in order to stabilize their asset losses with income gains. And over time, some of those asset losses will even reverse or even better in the case of debt securities – mature.

  • Posted by JBW

    If AIG was a truly “international” company, would 13(3) of the Fed charter still allow it to act as it did here?

    What if, say, UBS runs into similar trouble? Who will act as a backstop?

  • Posted by Dave C..

    So, AIG, which couldn’t pay its debts, “borrows” another $85 billion from the Fed at more than 11%. How’s AIG going to pay that money back? It’s not.

    The US taxpayer gets taken to the cleaners!!!!!

  • Posted by Dave C..

    From Reuters, Chinese government says the World requires a new financial regime that is no longer dependent on US Dollar hegemony – DC

    http://www.reuters.com/article/ousiv/idUSPEK4365020080917?sp=true

    BEIJING (Reuters) – Threatened by a “financial tsunami,” the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said on Wednesday.

    The commentary in the overseas edition of the People’s Daily said the collapse of Lehman Brothers Holdings Inc (LEH.P: Quote, Profile, Research, Stock Buzz) “may augur an even larger impending global ‘financial tsunami’.”

    The People’s Daily is the official newspaper of China’s ruling Communist Party, and the overseas edition is a smaller circulation offshoot of the main paper.

  • Posted by Blissex

    «So, AIG, which couldn’t pay its debts, “borrows” another $85 billion from the Fed at more than 11%. How’s AIG going to pay that money back? It’s not. The US taxpayer gets taken to the cleaners!!!!!»

    Oh please, it is obvious that’s just smoke and mirrors — the $85B at 11% are being “lent” by the Fed to a company owned by the Fed, not to some random guy with a mortgage. It is the Fed owing itself money, just a fiction.

  • Posted by Dave C..

    From Bloomberg, US government debt soon to also be downgraded by foreign investors.

    http://www.bloomberg.com/apps/news?pid=20601103&sid=a7qdBFTyKnU4&refer=us

    Sept. 17 (Bloomberg) — The cost to hedge against losses on U.S. government debt rose to a record after the Federal Reserve rescued American International Group Inc. to avert the worst financial collapse in history.

    Benchmark 10-year credit-default swaps on Treasuries increased 4 basis points to 30, according to BNP Paribas SA prices at 6:45 a.m. in New York. The contracts have risen from below 2 basis points at the start of the credit crisis in July 2007 and are more than double those on government bonds sold by Austria, Finland or Sweden.

    The U.S. Treasury pledged an $85 billion loan for AIG just 10 days after committing as much as $200 billion to prevent a collapse of mortgage companies Fannie Mae and Freddie Mac. The U.S. budget deficit will grow next year to $438 billion, the Congressional Budget Office said Sept. 9, making it harder for President George W. Bush’s successor to either cut taxes or increase spending.

    “The latest bailout comes at the expense of the U.S. taxpayer,” Tim Brunne, a Munich-based credit strategist at UniCredit SpA, wrote in a research note today. “It cannot be expected that AIG will survive in its present form.”

  • Posted by Blissex

    «The depth of the system breakdown is such that there is no template for dealing with it.»

    Maybe, but this has been a very slow motion disaster, and one that has been pretty much obvious to external observers since at the very least a year ago (people like Baker and Roubini have predicted it several years ago). The Fed and Treasury obviously have *much* better advance visibility than external observers, so they must have much more advance notice.

    What is amazing is that these guys had such a long time to prepare and discuss a plan including drafting some legislation to introduce at the right moment etc., and they seemingly are shooting from the hip instead.

    This seems a classic example of “groupthink” or collective kool-aid drinking, where it was inconceivable even to prepare for the case that the boss’ “everything will be fine” line might some day be proven wrong.

  • Posted by Jian Feng

    When I commented about government inventions yesterday, I actually mean “protecting the cheaters”. Fundamentally, a lot of Wall Street’s profits come from cheating people, much more so recently. Buying a piece of bread at one cent and selling it at two cents is not cheating; it is just business provided that the bread is good and someone is hungry. Buying a million pieces of good bread, mixing them with a million pieces of bad bread and selling the two million pieces in one thousand packages of “AAA-rated” bread for whatever amount of money each is absolutely cheating in any moral system. In an efficient market with proper laws and enforcement through governmental interventions, these cheaters would have been weeded out quickly. The system that US has now is perhaps worse than that in the robber baron era. The robbers essentially hijacked the government to pay whatever necessary to keep the party going. Why should the robbers stop when others are paying the ransoms to keep the society “harmonious”? If the robbers won’t stop, the harmonious society will soon get a very, very rude awakening because the Titanic is getting too much water, way too fast.

    Brad, you were saying that the water was nowhere near saturation. I just wonder how much water can the Titanic hold in theory. How much greenbacks can US print before its total assets are so diluted that nobody is willing to buy more US fiat? Is there any theoretical study of this sort in the economics field? It’s sort of like estimating the impact of global warming. Difficult and unreliable, but must be done. The actual number, if good, would greatly ease the concerns of many people, including the foreigners who are stilling paying the ransom. In the absence of a good number, people will follow their gut feelings and may try to jump ship even though the Titanic might not sink.

  • Posted by JKH

    “What is amazing is that these guys had such a long time to prepare and discuss a plan’

    Fair enough, to a degree.

    But remember that “these guys” each have a formal but normally partial role in a very fragmented regulatory system, involving the Fed, Treasury, Congress, various insurance regulators, the states, Basel, etc., etc. Neither Bernanke nor Paulson personally created this system, and neither had full control over its total operation. Bernanke in particular had little direct say over the independent dealers or AIG operations as going concerns. What’s he to do? Conduct a full regulatory coup prior to the crisis? It took a crisis for the Fed and Treasury to act on emergency powers. And just consider the changes to the system architecture that are now being considered.

  • Posted by Cedric Regula

    Dave C.. Says:

    “From Reuters, Chinese government says the World requires a new financial regime that is no longer dependent on US Dollar hegemony – DC”

    Mama Mia, whadaya mean “hegemony”? That college boy talk for we gotta no renimbis here for buying toasters and shoes?

    You on our turf. You take real money.

    We go’en to the mattress anyway. Feds snooping around the banks too much. Makes us nervous.

    You wanna piece of this? You pay !

  • Posted by bsetser

    the Swiss government has thought about the “UBS” and “Credit Suisse” question (small country v big global bank), and it is a hard one. I suspect that the answer would require that a host of foreign central banks lending a ton of fx to the SNB for swiss gov bond collateral. either that or the big central banks would have to lend to a banking group that they don’t supervise.

    My sense is that the nyt story got the reason for the AIG bailout right — i.e. it had insured a lot of bonds and if the insurance went bad a lot more banks would have to take losses and deplete already depleted capital. my there also does seem to be an element of randomness — Was LEH was treated more harshly (especially the debt) than Bear b/c it had a worse balance sheet or b/c of concerns that bear had introduced too much moral hazard? I am not sure. I don’t have the skills needed to evaluate the comparative health of different bank and broker dealer balance sheets.

    Jian — the Fed actually hasn’t been printing money. The fed has effectively financed its lending by selling assets (i.e. Treasuriues). The US treasury has been issuing debt to fund its deficit, but that is a bit different. and now the treasury is issuing treasuries to raise funds that it deposit with the fed that the fed can lend out. That is intermediation using the government’s balance sheet, not money creation.

  • Posted by gaius marius

    “The Fed’s balance sheet is starting to get encumbered by too many things,” [El-Arian] said.

    what to make of this?

    http://www.newyorkfed.org/markets/statement_091708.html

    up to now, it seems to me that the governmetn steps have been to prevent a deflationary credit unwind. this looks to be the first monetary inflationary step in the crisis.

  • Posted by JBW

    Thanks for your thoughts regarding the UBS hypo.

  • Posted by RealThink

    (Comment splitted after unsuccessful attempt)

    Viewing this bailouts from Hubbert’s Peak (i.e. from the perspective of the physical limits to growth), one salient feature comes out clearly: the US Governmint (no typo) is bailing out precisely those parts of the economy that are doomed by Peak Oil. Like Easter Island’s Council trying to hold up moai construction activity and its related finance.

    First, Fannie and Freddie. Two entities whose purpose is to perpetuate the growth of “a living arrangement that has no future” (J. H. Kunstler’s trademark for suburban development).

    Now, AIG. A company doomed by two facts: first, by having ensured the unensurable: credit defaults. Second, by having invested a large part of its capital (from sound and unsound policies) in financial assets that are doomed in terms of real value (in the sense that they can keep their nominal value only if the currencies they are denominated in are massively debased).

  • Posted by RealThink

    (second part)

    To see the basis for the above statements about AIG, one must understand the essence of fractional reserve banking, whereby banks lend money in excess of what they have on deposit, effectively creating money out of thin air. That system worked so far because tomorrow’s economic expansion, enabled by increasing energy inputs mainly from fossil fuels, provided adequate collateral for today’s debt. But the oncoming plateau and subsequent decline of the global extraction rate of fossil fuels, the principal drivers of economic growth (google Ayres and Warr), undermines the validity of that collateral which in turn erodes the real value of most financial assets. (Sure enough, the Solow model in which economic growth depends on the exogenous A(t) aka TFP and loosely defined as “technological progress” is the main conceptual obstacle in understanding this.) This means that financial “wealth” destruction will proceed in either way: by assets dropping in nominal value (some to zero which is the case with defaults) while the currency retains its value in real things, or by assets holding up their nominal value due to massive currency printing (which seems to be the adopted path).

    If this pattern of bailing out activities doomed by Peak Oil continues, the logical next stop are Detroit’s Big Three and the airlines.

  • Posted by Twofish

    Jian Feng: Buying a million pieces of good bread, mixing them with a million pieces of bad bread and selling the two million pieces in one thousand packages of “AAA-rated” bread for whatever amount of money each is absolutely cheating in any moral system.

    Actually the theory behind CDO’s was the opposite in that you take a set of good and bad bread and the separate out the good bread from the bad, sell the good bread to people that want good bread, and bad bread to people that want bad bread.

    Trouble with that is that it doesn’t work if all of the bread turns out to be bad.

  • Posted by Blissex

    «But remember that “these guys” each have a formal but normally partial role in a very fragmented regulatory system, involving the Fed, Treasury, Congress, various insurance regulators, the states, Basel, etc., etc. Neither Bernanke nor Paulson personally created this system, and neither had full control over its total operation.»

    But don’t forget that all these guys while placed at different bits and pieces of the structure, they are all friends and colleagues, because they are all delegates from the same organisation, the Republican Party.

    It is not like Bush, Paulson, Bernanke, Greenspan, Snow are perfect strangers to each other, they are all where they are because they know each other as they all work for the same master, the same party, and have the positions that they have solely because they were appointed to them to carry out party policy.

    The policy of a party that is well organized, cohesive; just consider the Tuesday meetings between congressmen, party activists, and so on, especially to discuss appointments and careers.

    Especially as all these people are part of an administration that is famously focused, on-message, integrated, loyal.

    Astonishing that these guys had no contingency plan.

    Now a plan is emerging, but it is being made up on the spot, even if of course it is being made to the server the interests of the sponsors of the party.

  • Posted by Cedric Regula

    Woulda all yous looka this? Elliot Ness couldn’ta put it better. Hank the Knife printed up treasureals, “sold them”, put the “proceeds” widda the Fed, and thisa not only like nadda print’en money, but it’s like shink’en the money supply, make’en greenbacks worth more.

    So I don’t know what yous is all worried about when we got talent like this backing us up.

    ==
    Statement Regarding Supplementary Financing Program
    September 17, 2008

    Today, the Treasury Department announced the initiation of a temporary Supplementary Financing Program. The program will consist of a series of Treasury bill auctions, separate from Treasury’s current borrowing program, with the proceeds from these auctions to be maintained in an account at the Federal Reserve Bank of New York. Funds in this account serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.

  • Posted by Twofish

    DC: Excuse me, the Chinese government bailed out 100% state-owned banks in the 1990’s, so essentially the state was just transferring credits from one government agency to another.

    No. The banks owed money to depositors and didn’t have assets to pay the depositors. So the government took tax revenues and made the depositors whole.

    DC: Wall Street privatizes the profits and socializes the losses to the US federal taxpayer.

    No. Most of the bailout goes to depositors and homeowners.

  • Posted by Fullcarry

    It looks like the selling in the financial stock is systemic. Its happens as people need to hedge against counterparty risk. And it tends to feed on itself. The treasury and FED are not helping matters by constantly wiping out the equity holder.

  • Posted by Twofish

    Bilssex: Because they are all delegates from the same organisation, the Republican Party.

    Actually most Wall Street people vote Democratic. Campaign donations to Obama from Wall Street are far outstripping donations to McCain. New York is a pretty solid blue state. New York City has some of the highest tax rates in the United States, and personally I think this is a good thing.

    Most Wall Street people that I know find Republican economic policy to be horribly naive at times. Personally, I’m voting for Obama since McCain seems to be pretty clueless about what is needed to fix the financial system, and I think that it is really important to work on things like health care and the incomes gap.

    Bilssex: The policy of a party that is well organized, cohesive; just consider the Tuesday meetings between congressmen, party activists, and so on, especially to discuss appointments and careers.

    And those meetings included Barney Frank and Christopher Dodd. There is just no way you can do what Bernake and Paulson did without getting the support of both Democrats and Republicans, since Democrats can effective veto anything that the Fed or Treasury does.

  • Posted by Dave C..

    Twofish,

    So essentially the Chinese state recapitalized the state-owned Chinese banks using state tax revenue. That’s alot different than taxpayers bailing out PIMCO losses on Fannie Mae and Freddie Mac bonds. Very little of the taxpayer bailout goes to depositors and homeowners. America’s Joe6pack is losing his shirt. In fact, AIG raided $20 billion from the New York state employee pension and annuity accounts to cover financial derivative losses. It’s really an absolute travesty of justice that the US taxpayer is picking up the tap for private-sector casino gambling in the derivatives market.

  • Posted by glory

    “how the US is handling the banks is very much like how China ended up handling it’s banking problem”

    state capitalism…

  • Posted by Dave C..

    Fed out of money?

    By John Brinsley and Rebecca Christie

    Sept. 17 (Bloomberg) — The U.S. Treasury said it will sell bills to allow the Federal Reserve to expand its balance sheet, a day after the government agreed to take over American International Group Inc.

    “The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve,” the department said in a statement today. “The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program.”

    Yesterday the Fed announced an $85 billion loan to AIG, in exchange for a 79.9 percent government stake in the largest U.S. insurer. The Fed also has set up several other emergency lending programs to provide Wall Street firms with ready access to funding.

    The new bill program “will provide cash for use in the Federal Reserve initiatives,” the Treasury said.

    The Treasury said it will sell the new bills using its existing auction procedures, giving “as much advance notification as possible.” The bills will not have a uniform fixed term, giving the Treasury the same duration flexibility that it has with cash-management bills.

    To contact the reporter on this story: Rebecca Christie in Washington at rchristie4

  • Posted by bsetser

    full carry –

    after the salaries the street paid themselves (including record 07 bonuses, lest we forget) the us gov cannot bailout the equity holders. tis something some folks should have thought about in advance ….

  • Posted by Jian Feng

    Brad, you know that I am a lay person in economics. Since anyone holding US treasury can sell it for US dollars, how different really is issuing more treasuries from printing more money? I know that printing more money is a very dirty world; only failed states do that. Right now, the total US debts, including the 5 trillion sunk in F&F well excede 100% of US GDP. Is there some kind of warning line (like the highest water line for a levy to be safe) for a regular country (e.g. Switzerland), expressed in % of GDP?

  • Posted by moldbug

    bsetser: “That is intermediation using the government’s balance sheet, not money creation.”

    Given that dollars are (as most would say) Fed liabilities, or (as I prefer) Fed equity – and given that Fed and USG are clearly one entity – this distinction seems a little fragile!

  • Posted by JKH

    Moldbug,

    They won’t be creating money of 0 maturity, which is a non-trivial distinction.

  • Posted by Twofish

    DC: That’s alot different than taxpayers bailing out PIMCO losses on Fannie Mae and Freddie Mac bonds.

    PIMCO made a huge amount of money betting on the Freddie and Fannie. Someone else lost a lot of money making the opposite bet. The money to shore up Fannie and Freddie by and large didn’t end up in hedge funds.

    DC: Very little of the taxpayer bailout goes to depositors and homeowners. America’s Joe6pack is losing his shirt.

    He has a job, still has his bank account and can sell his house. Neither would be true if the economic system fell apart.

    DC: In fact, AIG raided $20 billion from the New York state employee pension and annuity accounts to cover financial derivative losses.

    Because otherwise those losses would have been borne by the banks and then by depositors.

    DC: It’s really an absolute travesty of justice that the US taxpayer is picking up the tap for private-sector casino gambling in the derivatives market.

    In casinos, when someone wins money, someone else loses money, and we would not have the problem that we have if it was a casino issue.

    What happened was that people wrote checks assuming that some money existed. When it didn’t you have to figure out who bears the loss. If the Fed didn’t do want it did, then you might have had a domino chain of collapsing banks in which people start losing their jobs, their bank accounts, and are stuck with a house that cannot be sold.

  • Posted by Fullcarry

    Brad,
    I appreciate what you are saying. I just don’t know how we get out of this vicious cycle where counterparty risk needs to be hedged. And the only vehicle available for doing that is a financial firm’s equity which gets driven down to bankruptcy or bailout levels.

  • Posted by InquiringMind

    The $5 trillion of Fannie & Freddie debt are actually *assets* for Fannie/Freddie (& now, I guess, the US gov).

    The problem is that they may not be worth the full $5 trillion face value…there is risk there…

    …but they do not represent a new $5 trillion liability to the US gov, so saying that the US Gov is now +$5 trillion in debt is a hyperbolic misunderstanding of the situation.

    IM

  • Posted by Blissex

    «but they do not represent a new $5 trillion liability to the US gov»

    Ahhh, and where did the GSEs find the money to lend $5 trillion? Their business is to borrow money cheaply with their implicit gov backing and with the borrowed money purchase and securitize mortgages.

    Since they have/had a minuscule amount of capital, less than 1% of their assets, they must have borrowed 99% of the money used to purchase those assets.

    So they have $5 trillion on both sides of the balance sheet (not quite, because part of that of that is debt guarantees, and part
    of that outright loans).

    Now formally/technically that is not part of the USA balance sheet, because of accounting shysterism played by the USA Treasury, but whom are they kidding?

    «The problem is that they may not be worth the full $5 trillion face value…there is risk there…»

    The *net* debt is not 5 trillions; it is pretty sure that there is a net debt, or else the pretend-capital of the Gses would not have been wiped out. Estimate heard so far is that the assets are worth about $300b-600b less than the liabilities, and this is the amount that the USA treasury is looking at having to finance.

    http://www.ft.com/cms/s/0/e30472a6-7e79-11dd-b1af-000077b07658.html

    «The operations of mortgage finance companies Fannie Mae and Freddie Mac, which were placed into a federal conservatorship, should now be treated as part of the federal budget, the head of the Congressional Budget Office said on Tuesday. — That means that revenue earned would be reflected as a receipt, and spending would be reflected as an outlay, — CBO Director Peter Orszag said
    at a briefing.»

    Note that here he is careful to say “operations”, not “assets”, because thanks to technicalities neither the asset nor the liability side of the GSE balance sheet need to be consolidated with that of the USA.

  • Posted by pseudorandom

    Twofish: No. Most of the bailout goes to depositors and homeowners.

    You mentioned this in another thread yesterday and to repeat what I said there: this is nonsense.

    Depositors were already insured through the FDIC they don’t need any bailouts by definition. Bailout money is for those who were not insured and had no right to expect the government to make them whole i.e. unsecured creditors and derivative counter-parties.

  • Posted by Twofish

    pseudo: Depositors were already insured through the FDIC they don’t need any bailouts by definition.

    And FDIC only has enough cash on hand to cover 1.5% of total deposits. In case of a total bank meltdown, they would have gone under. FDIC has about $50 billion in reserves. AIG needed $85 billion in cash. If it had gone under each domino would have been larger and larger.

    Part of the problem is that people thought they were more insured than they really are.

    pseudo: Bailout money is for those who were not insured and had no right to expect the government to make them whole i.e. unsecured creditors and derivative counter-parties.

    Yes. With most of those counter-parties European banks who were relying on credit insurance issued by AIG. If those had gone under and been forced to liquidate, the dominoes would have kept falling. By the time the wave hit the FDIC insured banks it would have overwhelmed FDIC.

    Really scary stuff.

  • Posted by Twofish

    You get into a lot of “who watches the watchmen” issues in finance. It’s not enough to say “we are insured” you have to worry about who insures the insurers. Just because there is an FDIC sign out in front doesn’t mean that you are completely safe.

  • Posted by Twofish

    blissx: Ahhh, and where did the GSEs find the money to lend $5 trillion?

    You gave it to them.

  • Posted by pseudorandom

    Twofish: You get into a lot of “who watches the watchmen” issues in finance. It’s not enough to say “we are insured” you have to worry about who insures the insurers. Just because there is an FDIC sign out in front doesn’t mean that you are completely safe.

    That’s all true enough but there is no issue of fairness or moral hazard in paying back depositors of FDIC insured institutions. Depositors have an explicit US government guarantee (upto $100k etc).

    There are huge fairness issues involved in bailing out unsecured creditors and counter-parties. It may sometimes be necessary to do so for the sake of systemic risk, but taxpayers should rightly be outraged and demand corrective steps and if necessary criminal prosecution of anyone guilty of wilful negligence or fraud.

  • Posted by Twofish

    pseudo: That’s all true enough but there is no issue of fairness or moral hazard in paying back depositors of FDIC insured institutions. Depositors have an explicit US government guarantee (upto $100k etc).

    There’s actually a lot of moral hazard. Suppose you two banks that are FDIC insured. One pays 1.5% interest, one pays 3.5% interest. Which one do you choose? Most people will choose the 3.5% interest one.

    Suppose you have two insurance companies. One charges $1000/year for auto insurance. The other charges $500/year for auto insurance. Which one to you choose? You choose the $500/year one.

    The trouble with those choices is you aren’t asking too much *why* a bank is paying more interest or charging less money for insurance. The trouble is that if *no one* is looking at why banks pay more interest or why insurance companies charge less, then its likely that the money where you put your money in aren’t the ones you should be putting your money in.

    But you don’t care, you just see the FDIC rating or the Moody’s AAA rating and assume everything is alright.

    pseudo: There are huge fairness issues involved in bailing out unsecured creditors and counter-parties. It may sometimes be necessary to do so for the sake of systemic risk, but taxpayers should rightly be outraged and demand corrective steps and if necessary criminal prosecution of anyone guilty of wilful negligence or fraud.

    Scapegoats are convenient, but usually if you look at these messes they often are caused by lots of people making the sorts of decisions that involve choosing a 3.0% FDIC insured CD over a 1.5% FDIC insured CD.

  • Posted by pseudorandom

    Twofish: There’s actually a lot of moral hazard. Suppose you two banks that are FDIC insured. One pays 1.5% interest, one pays 3.5% interest. Which one do you choose? Most people will choose the 3.5% interest one.

    This is theoretically possible, but in practice I have not noticed much of a difference in interest on insured deposit accounts. No one that I know of chooses their band based on interest. Similarly no one that I know of picks their auto-insurance co based only on rate – other things matter too. Bank deposits are meant for convenient access. If you want returns on long-term savings, bank deposits are a poor choice in any event.

    Also huge interest rate differentials would be a failure of regulation. The prudent regulator would limit the interest rates on insured deposits.

    Summary: with prudent regulation any moral hazard associated with deposit insurance can be reduced to negligible levels.

    Compare this with the blatant hazard/unfairness involved in bailouts of unsecured creditors of investment banks.

  • Posted by pseudorandom

    Twofish: Scapegoats are convenient, but usually if you look at these messes they often are caused by lots of people making the sorts of decisions that involve choosing a 3.0% FDIC insured CD over a 1.5% FDIC insured CD.

    Sure. Every criminal who gets caught says that he is a scapegoat being unfairly punished. Losses of this magnitude imposed on the tax payer is a serious matter and a tough stance would not only serve the interests of justice but would also deter this sort of behavior in future.

  • Posted by thor

    Brad: “the Fed actually hasn’t been printing money.”
    well, what would happen if Fed starts printing money in this kind of environment? i suppose it’s not the same thing as printing same amount in normal conditions. if u buy assets that were worth $500 billion and now are worth practically $0 for printed 500 billion dollars it wouldn’t have same inflationary pressures as ussualy. amount of money didn’t change.

  • Posted by Rien Huizer

    Brad,

    Excellent post and commentary. What the Fed and the US gvt are doing is just replacing private credit by gvt credit. Not printing money at all. I guess people worry about the morality of this (and there is a lot of morality in this tale) but not really about the implications of this rapid nationalization of the financial system. What will drive allocation, who will allocate using the gvt debit card, when will the system reprivatize, etc. There are instances of countries doing a decent job by using a nationalized (or almost) banking system for rapid development, but even a diehard developmentalist economists like Chang (whose argument is pretty sophisticated) would not believe that the US is at a stage of development where gvt can allocate efficiently. It may try to do so (but, this administration does not have much time left) but then it may degenerate into something that could be inflationary, “soft budget constraints”, the common disease of socialist economies. Democracies are even less well equipped to manage nationalized finance than dictatorships…

  • Posted by moldbug

    JKH,

    It is a nontrivial distinction, but given the ease of borrowing money of 0 maturity against Treasuries… all dollar assets without liquidity or solvency risk look pretty similar right about now.

    One way to think of a Treasury strip is as a restricted dollar, like a dollar bill with a “not valid until” date. MT makes that date a lot less meaningful than it would otherwise be. It’s an interesting question to ask what people would pay right now for a dollar that was not valid until 2038, could not be used as collateral, but was nonetheless risk-free.

  • Posted by Twofish

    pseudo: Also huge interest rate differentials would be a failure of regulation. The prudent regulator would limit the interest rates on insured deposits.

    In which case what people end up doing is to move their money from regulated insured deposits to unregulated deposits with pseudo-insurance. When the pseudo-insurance falls apart, we end up in the current situation.

    The other problem is that you get regulatory arbitrage. You take money that is from low-yield regulated products and then you figure out ways of buying unregulated high-yield products. You end up making a lot of money until everything falls apart.

    pseudo: Summary: with prudent regulation any moral hazard associated with deposit insurance can be reduced to negligible levels.

    I think you are going to find it a lot harder to do this than you think. Especially in 10 years when everyone forgets about this little episode and are complaining about how little they are making in boom times.

    It’s easy to say more and more regulation now. Just wait five to ten years. People have short memories.

    pseudo: Compare this with the blatant hazard/unfairness involved in bailouts of unsecured creditors of investment banks.

    You are an unsecured creditor of an investment bank. You don’t know that you are, but you are. A owes B. B owes C. C owes D. D owes E. When A goes under, you have a chain of dominos falling and you are in that chain.

  • Posted by Twofish

    pseudo: Losses of this magnitude imposed on the tax payer is a serious matter and a tough stance would not only serve the interests of justice but would also deter this sort of behavior in future.

    I really don’t think so, since people have short memories and incredible ability to rationalize behavior, and next time people will come up with fifty reasons why this time is different.

    I think that the focus needs to be less on finding scapegoats and more on increasing regulations to make sure that when you have a downturn the next time, it doesn’t turn into a crisis.

  • Posted by JKH

    Moldbug,

    You really lost me on this one. I’d need a rewording somehow in order to understand it.

    But Brad’s point is quite correct technically. It would be overlooked by 99 per cent of people with an opinion on the subject, but is important to conventional interpretation. I understand your consolidated perspective on the government/treasury/Fed balance sheet and tend to think in those terms myself. You’re probably aware that the Fed has been controlling the monetary base as defined, first with substitution activity on the asset side (bills for “crap” (but “crap” fairly marked down at an inflection point for the substitution decision)), and now with intermediation activity sourced on the liability side that similarly doesn’t affect the monetary base. That’s all in terms of monetary tiers as conventionally defined, prior to your kind of conceptual transformation, of course, but Brad’s point still deserves some credit.

  • Posted by moldbug

    JKH,

    I don’t think we disagree on anything substantive here, but let me explain anyway.

    Basically, while I share the consolidated perspective, I see both FRNs and Treasury obligations as equity, not debt.

    Certainly the dollar, being nonredeemable, is not a promise to pay anything. When it was redeemable for metal it was zero-maturity debt. The transition from debt to equity is the normal result of defaulting on obligations.

    Moreover, “risk-free” debt is an oxymoron. But a T-bill *is* risk-free – the people selling CDS on them are pretty much charlatans. (I’ll sell you as many Treasury CDS as you want to buy. Cheap, too.)

    In the equity space, however, there is an analogous instrument: restricted stock. Google, for instance, compensates its employees with restricted shares which vest over time.

    Therefore it’s very easy to imagine restricted dollars. On the face of the dollar is printed a date, after which it is a valid dollar that you can use to buy a hamburger. Until that date, it has to be priced by a financial market. Try to spend it, and the cashier will get all huffy with you.

    If we accept the premise that Treasury obligations are risk-free – implicit in the consolidated perspective – for any Treasury note, you can construct a precisely equivalent structure of restricted dollars.

    In a non-MT financial market, these restrictions would be extremely significant. I’m very curious as to what 2038 dollars would go for. But under the rules of MT finance, banks can lend 2008 dollars which are backed by 2038 dollars. Naturally this has a considerable positive effect on the price of 2038 dollars.

    Capisce? (I, too, am a huge Cedric fan.)

  • Posted by pseudorandom

    Twofish: The other problem is that you get regulatory arbitrage. You take money that is from low-yield regulated products and then you figure out ways of buying unregulated high-yield products.

    The people who do this “regulatory arbitrage” are mostly the financiers. Ordinary depositors don’t normally bother partly because without leverage the small arbitrage gains are simply not worth it. Do you do your banking (I mean checking/savings accounts not long-term investments) at institutions based on how much interest they offer instead of convenience, location etc? This is purely a theoretical problem that does not exist in reality.

    We can sit here all day and invent theoretical problems with any regulatory regime. In the real world well-designed regulatory policies work extremely well.

    Twofish: It’s easy to say more and more regulation now. Just wait five to ten years. People have short memories.

    Sure the financiers will whine and moan about any regulations that limit their windfall profits. They are a hypocritical bunch. The job of the regulator is to stay firm and say no.

    This thing about short memories etc is just a cliche. People who lived through the 1930′s still remember lessons from that period. Normal people outside of Wall St are just not that short-term oriented.

    Twofish: You are an unsecured creditor of an investment bank. You don’t know that you are, but you are. A owes B. B owes C. C owes D. D owes E. When A goes under, you have a chain of dominos falling and you are in that chain.

    It’d be wonderful if creditors are forced to do their due diligence before lending to LEH or Citi in future. I see it as entirely a good thing.

  • Posted by Blissex

    «The other problem is that you get regulatory arbitrage. You take money that is from low-yield regulated products and then you figure out ways of buying unregulated high-yield products.»

    Such an innocent statement! With BoA/ML merger and the suspension of 23A, that’s no longer regulatory arbitrage, that’s regulatory policy — in effect the Fed is *requiring* banks to do that. Isn’t it funny?

  • Posted by Blissex

    «But a T-bill *is* risk-free»

    Again, only for people who do their accounting in dollars. For those who do their accounting in other currencies, there is a huge currency risk, because they are only denominated in dollars, so the currency risk cannot be separated.

  • Posted by JKH

    Moldbug,

    Your view of government liabilities as equity is intriguing. Is that an Austrian slant or your own?

    Government and CB liabilities are uniquely strange. I’ve always thought of the consolidated balance sheet as having a hole that is plugged with the present value of taxation – which technically is a component of human capital rather than physical or financial capital.

  • Posted by moldbug

    JKH,

    My own, I’m afraid. The thing about Mises, IMHO, is that while he was basically right, he was basically right in the context of Austro-Hungarian finance. (Mises actually had more or less Bernanke’s job in 1920s Austria, not exactly a placid lake of financial stability – he was no armchair theorist.)

    There is not really anything new in the Austrian canon after Mises. If fact, if you only read one book by Mises, I favor his _Theory of Money and Credit_ – 1912. Rothbard was a titan, but he was also an orthodox Misesian, and his ideology tends to interfere with his economics. Everyone else, including Hayek, is just not in the same class. And worse, the modern Austrians are mostly focused on defending, rather than upgrading, the legacy. Quite understandably! But still…

    Basically what I mean by “Austro-Hungarian finance” is that the Misesians took the gold standard for granted and considered fiat currency an abomination. Well, it is an abomination – in retrospect, it’s pretty hard to call it a good idea. But that doesn’t mean you can’t use the basic Misesian methodology to think about a fiat system.

    So take this Ron Paul speech from 2002, on the GSEs. Prescient? Sure. The speech was probably written by Lew Rockwell (don’t even start me on Lew Rockwell), who was a student of Mises and Rothbard. But note that the only solution offered for the problem is to liquidate, liquidate, liquidate.

    Well – in Austria in the ’20s, liquidating back to gold was an option. Almost, sort of. And theoretically now it is an option. I really think you might be able to get the gold price back to $20, or at least $33, if you liquidated to M0. But is this a *good* option?

    As for government liabilities, I think of USG as a sovereign corporation – basically, it owns America. The only difference is that this ownership is enforced by its own guns and bombs, not some higher (temporal) power. And this is not a financial difference.

    So you would expect USG’s paper, whatever we call it, to be pretty valuable. As indeed it is. Whether the source of the future payment streams USG can generate is taxation, real estate sales, or natural resources, it’s – as Cedric would say – money.

  • Posted by JKH

    I’ll let Cedric’s classification prevail for now. Thx #2.