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Do not doubt that this is a real crisis: more on Fed’s balance sheet

by Brad Setser
September 30, 2008

My colleague at the Council on Foreign Relations, Paul Swartz, has graphed the shift in the composition of the Fed’s balance sheet. The Fed has extended a lot of credit to the financial system — and supplied even more liquidity by letting the investment banks borrow some of its Treasuries.

fed-balance-sheet.PNG

Note: I updated the graph in response to the comments below. The CFR’s web technology does not currently allow the graphs to be expanded. More of Paul Swartz’s graphs — including a new graph on the impact of the house vote on various financial markets — can be found on the CGS website.

The amazing thing about this graph is that it doesn’t capture all the credit central banks extended to the financial system last week (Paul used the weekly average numbers, not the data for the end of the week) or the new credit that will be provided by the programs that were expanded today. Those programs should allow the Fed to increase its lending even further.

This graph also does not capture the $500 billion the Fed has lent to other central banks through various swap lines — dollars that other central banks have lent to their own troubled institutions.

Right now, the world’s central banks are truly providing the short-term financing to host of troubled banks that are having trouble raising funds in the market. Laurence H Meyers of Macroeconomic Advisers notes:

“The liquidity measures are a stopgap … You’re funding the banks’ balance sheets, but nobody wants to lend money to them because they’re all afraid of insolvency.”

That sounds right to me. Right now, the US is relying a bit too heavily on the Fed to keep this crisis from spiraling truly out of control. That avoids hard political choices –notably hard choices about how best to recapitalize the financial system — but it also creates some long-term risks for the Fed.

I fully recognize the risk that the US government eventually could flood the market with unwanted Treasuries, driving interest rates up — and thus there are limits on how much support the US government can supply the financial system. But as of now, there isn’t much evidence that there is a shortage of demand for Treasuries — indeed, recent market moves suggests a shortage of Treasury bills in the market rather than a surplus. And that certainly is not because the US government has been scaling back its bill issuance.

By my calculations, the supply of marketable Treasury bills not held by the Fed –i.e. the bills actually in the market — increased from $738.4 to $1200.2b between August 2007 and August 2008. That is a net increase in supply of around $462b. The Treasury was issuing more bills, and the Fed was reducing its holdings to “sterilize” or offset the credit it extended to private financial institutions. The US data on foreign holdings only runs through July, but it suggests that foreign central banks only snapped up $50b or so of this increase: central bank holdings of bills rose from around $180b to $232b. There was a huge surge in private holdings of Treasury bills, with the stock in private hands nearly doubling in 12 months.

And that was before the big surge in bill issuance in September.

Yet judging from market yields, there is no shortage of demand for T-bills despite the huge increase in supply — an increase in supply that is primarily in private not central bank hands. The New York Times reports:

Yields on three-month Treasury bills shrank to just 0.29 percent on Monday, a sign that investors were fleeing from any kind of risk, even if it meant earning a return far lower than the inflation rate.

The outstanding stock of notes (coupon paying bonds with a maturity of between one and ten years) not held by the Fed rose by $280b from August 2007 to August 2008, so there wasn’t just an increase in bill supply. And again, there doesn’t seem to be a shortage of demand. Here though central banks have been big buyers.

One other interesting side note: I would estimate that foreign central banks now hold well around 70% of the outstanding $2265b stock of marketable Treasury notes not held by the Fed. To get that estimate I have to assume that central banks account for most of the $260b or so of private purchases of Treasury bonds over the past year bringing their , and that central banks hold few bonds over ten years and few TIPs — so total central bank holdings of notes are in $1650-$1700b range. Central bank holdings are actually fairly concentrated in certain market segments.

84 Comments

  • Posted by Richard Kline

    This is, indeed, what a panic looks like. But the core problem is fear over the potential insolvency of major banking institutions. Throwing colossal liquidity at panicked wealth holders does nothing to solve the root problem; it’s like giving opium to the audience when the lead tenor in an opera has slumped in the arms of the cast with a heart attack. Get the corpse offstage, and sent in the understudy, puhleeeze. In short, we have the Fed throwing bonds at wealth holders by the billion weight _in order to avoid those hard political choices_. Excactly. Yes, we have a panic: it is a political panic at least as much as it is an actual financial panic. Nothing will be done to solve the latter problem until the former is acknowledged as a problem. But I do know that the wealth holders got a message today from the Other Ranks: “We aren’t fighting your war on reality.”

  • Posted by KnotRP

    T bills are just the rest stop after a drive away from MM mutual funds that were breaking the buck. My spouse (who never talks about such boring things) tells me Oprah had Suzie Orman on her show last week, and she told everyone to bail out into Treasuries and FDIC insured CDs. The herd is just waking up, and still moving slowly.

  • Posted by julieng

    we’re in a liquidity trap no worries for the T-bill/bond market in the near term.

    I think we should now focus now on the debt itself considering a recessionary environment.
    Revenues are already falling and deficits are headed to grow rapidly,
    here is a example about on how fast it could go.

    http://www.connpost.com/localnews/ci_1053823

  • Posted by julieng

    sorry the link is broken

    Connecticut budget deficit doubles to more $300 mln
    http://www.reuters.com/article/domesticNews/idUSN2234129620080922?feedType=RSS&feedName=domesticNews

  • Posted by mrskeptical

    hi brad,
    i find myself asking the same basic question abt the USdollar swap lines :
    http://www.federalreserve.gov/newsevents/press/monetary/20080929a.htm
    - where has all the USdollars gone to?
    - why is USD needed at the first place (as opposed to local euros)?
    - don’t the foreign central banks carry a pile of reserves?
    - and can they just pump in their own currency (ie euros)?

    also, i recall roubini and yourself wrote a paper in 2005 saying that asian economies learnt all the wrong lessons from the 97 asian crisis and more importantly, another asian crisis is on the cards.. whats your take now?..

    your insights are much appreciated..

  • Posted by adiemuso

    Hi Brad,

    Been quite a while since i last posted anything. Though I have been following your excellent posts. Market has been a havoc.

    Now, if the majority of the recent demand in short dated bills and notes are private, and that the 700b “bailout” will be passed sooner or later, will there be a massive selloff in the near zero yielders, once the market stabilises?

    On the other hand, should the current negativities persist, will these short term interests move up the yield curve which could possibly translate into more macroeconomic issues for the US?

  • Posted by Ethan

    Brad, what’s this going to do to your old hobby-horse, NIIP net income?

    I note, with curiosity, that net income for Q1 and Q2 of 2008 were each about $30b. Q3 will reflect both a crash in the dollar value of foreign-owned US equity, and an insatiable demand by foreign investors for T-bills at negative real rates!

    After $6-7T in free loans over the last 20 years, it looks like the US might come out ahead again!

  • Posted by t

    Brad, you would do better to publish your graphs in .png format rather than .jpg – they will look much clearer.
    Thanks for the blog btw.

  • Posted by London Banker

    With respect to the Fed balance sheet, “Yup. I told you so.”

    Brad, I was looking back a couple years on your blog at RGE trying to find an exchange we had during the set up to the current crisis. I said I thought then that the Fed was exporting inflation abroad through its massive (hidden) M3 growth, as credit was created and drawn to the States on the back of foreign asset bubbles in dollar pegged economies. I projected that the Fed would also eventually export deflation abroad, making sure that when everything crashed it would crash disproportionately outside US borders leaving the US “flight to safety” status in tact with a survivor bias favoring US markets.

    I can’t find the exchange, but maybe you recall it too.

    Events of this week lead me to think I wasn’t too far off the mark in my conspiracy theorising.

    What has changed is that so many are now alert to the plan, that the outcome is no longer predictable. China, Russia and the Gulf are independently and collectively now pursuing their own strategies to protect investments, gain marketshare and secure survivor bias to their own economies.

    Very interesting time to be a spectator on the sidelines.

  • Posted by Dave C.

    “China, Russia and the Gulf are independently and collectively now pursuing their own strategies to protect investments, gain marketshare and secure survivor bias to their own economies.”

    Exactly. China’s State Council has given approval to the Chinese PLA Navy for building global military force projection capabilities to defend natural resource trade routes from Africa and the Middle East.

    http://www.telegraph.co.uk/news/worldnews/asia/china/3096464/China-aims-for-military-might.html

    China is rapidly developing a highly modern military that will be the equal of Western armies with the ability to operate anywhere in the world. The rapid growth of China’s navy is matched by its desire to expand into the Indian Ocean and South China Sea to feed resources into its voracious economy.

    The analysts, from Jane’s Information Group, believe that the Chinese Communist Party can only continue to rule the country if it maintains economic growth at more than 10 per cent. It is already investing heavily in Africa for food and natural resources.

    Within the next year the first navy pilots will begin training for aircraft carrier operations that are expected to be operational early in the next decade. A London conference attended by defence business leaders was told that new air-to-air refuelling planes are being delivered that will double the range of the Chinese air force’s increasingly modernised fighters.

    “China is developing a modern highly manoeuvrable force able to operate anywhere as good if not better than Western armies,” said Christopher Foss, editor of Jane’s Armour and Artillery.

  • Posted by Dave C.

    Quotes of the Day from former Republican House Speaker Newt Gingrich:

    “This bill is not the best proposal for solving the housing crisis. It is not even a good proposal for solving the crisis.”

    “having a former chairman of Goldman Sachs preside over disbursing hundreds of billions of dollars to Wall Street is a terrible concept and inevitably will lead to crony capitalism and the appearance of — if not the actual existence of — corruption.”

    http://online.wsj.com/article/SB122273395169288417.html

  • Posted by London Banker

    @ Dave C
    You’ll like this.

    Reuters US bailout, better regulation both needed – Xinhua

    “Rescuing Wall Street is urgent in order to protect the American economy, but at the same time as rescuing it, regulation of Wall Street needs to be strengthened,” China’s Xinhua news agency said. It did not elaborate on what should be done.

    While the comments do not officially represent those of the government, they are the most clear signal of thinking in Beijing to appear since the failure of the bill, since China is currently in the middle of a week-long holiday.

    Premier Wen Jiabao said in an interview last week that Beijing was worried about the impact on its investments of the financial turmoil and that now was time to cooperate to calm markets.

  • Posted by obey

    Brad says “Right now, the US is relying a bit too heavily on the Fed to keep this crisis from spiraling truly out of control. That avoids hard political choices –notably hard choices about how best to recapitalize the financial system — but it also creates some long-term risks for the Fed.”

    A couple of questions: what are the long-term risks for the Fed? Could you spell these out?

    Is there some time-limit as to how long the fed can keep funding the banks in this manner? Despite the generalised panic, it seems that the breathing room it has provided for the banks to shore up their balance sheets has been beneficial – 40 bn in recapitalization in the last week only.

    Maybe I’m being too sanguine about this, but it seems that the healthier banks are perfectly able to recapitalize without government intervention, and that all that is required to unclog the markets is some transparency regarding CDS exposure – i.e. setting up some kind of clearing-house for CDS transactions.

  • Posted by Twofish

    Kline: Throwing colossal liquidity at panicked wealth holders does nothing to solve the root problem.

    It’s not designed to. No one is looking at the root problem, because everyone is focused on preventing a massive collapse. To use your analogy, people are trying to pump adrenallin into the system to keep things from falliing apart and stabilize the patient so *then* we can talk about the root causes. It’s impossible to have a rational discussion of root causes, while people are in crisis mode, and what everyone is trying to do is to get ourselves out of crisis mode, so that people can get some sleep without worrying about the next bank failure.

  • Posted by Twofish

    obey: Is there some time-limit as to how long the fed can keep funding the banks in this manner?

    I give it about a month at the most. It really don’t care what passes Congress because arguing about the details of the plan is like arguing about the color of the fire truck.

    If it will help people get things out of their system, I propose that we have a national “tar and feathering” party of all Wall Street executives in which they are put in stockades and the public can throw garbage at them. If it will help get something passes, it’s a very small price to pay.

    obey: Maybe I’m being too sanguine about this, but it seems that the healthier banks are perfectly able to recapitalize without government intervention, and that all that is required to unclog the markets is some transparency regarding CDS exposure – i.e. setting up some kind of clearing-house for CDS transactions.

    We’ve already reached the limits of what private banks can do. For Citigroup to buy Wachovia, FDIC had to guarantee all losses above $4 billion. There are two or three regional banks that are teetering on the brink right now, and dozens perhaps hundreds about to follow. Europe is just beginning to deal with their problems.

    Also the WaMu and Wachovia purchases were made with the assumption that Congress would do something. Without assurance, no sane bank is going to lift a finger since it is irrational to try to save a drowning man if he will pull you under and kill you both.

  • Posted by tl

    London Banker: Its called “dollar hegemony.”

    What is happening with the creditor’s consortium that you discussed previously ? Dollar hegemony will be broken when other countries get together and agree to settle in some other currency besides USD (and Iran’s oil bourse settling in EUR comes through).

  • Posted by Dave C..

    China Central Bank Chief Zhou Xiaochuan criticizes US Neo-liberalism Economic model for Wall Street banking fiasco. Zhou Xiaochuan believes in a “sound money monetary policy”. I would much rather have Zhou Xiaochuan as the US Federal Reserve Chief than “Helicopter money” Ben Bernanke.

    http://www.bloomberg.com/apps/news?pid=20601089&sid=a_vogPNymGZs&refer=china

    China PBoC Chief Zhou Xiaochuan says, “Unlike other government departments, the central bank’s main concern was inflation, which cooled to 4.9 percent in August, the slowest pace since June 2007. There is a risk that inflation may rebound.”

    According to Fan Gang, an adviser at People’s Bank of China, the fallout from loose lending practices in the U.S. will prompt China to curb some of its market changes and seek trade accords within Asia rather than support any global pact, Fan said earlier yesterday at a conference in Toronto.

    “The American model should be modified in a significant way, and we expect the American model to be modified in a significant way,” Fan said in a panel discussion sponsored by the Financial Times. “We will turn more to the European model; more on financial discipline and less with the securitized instruments.”

  • Posted by Twofish

    I normally dislike Ayn Rand, but I’m starting to think about “Atlas Shrugged” and perhaps it would be a good thing if all of the supposed “evil Wall Street banksters” just went on strike for a week, so that people can see the wonderful utopia that would result without financial markets.

  • Posted by Twofish

    DC: Zhou Xiaochuan believes in a “sound money monetary policy”. I would much rather have Zhou Xiaochuan as the US Federal Reserve Chief than “Helicopter money” Ben Bernanke.

    Except that Zhou Xiaochuan is usually fighting with local government officials that want soft money with the State Council acting as referee. Sometimes Zhou wins. Sometimes the local officials win.
    The system in China actually works will because you get this balance.

    Right now I suspect that the local officials are winning since now is not the time to pull liquidity and the fact that the PRC government is buying shares in the Shanghai market is the Chinese version of dropping money from helicopters.

  • Posted by Twofish

    To have a government work, you really need two types of people working with each other. You need a “populist” that people can relate to and trust, and you need a “technocrat” someone who has specific and deep knowledge of a particular issue. The trouble is that the more “technocratic” you are, the less of a “populist” you are. If you are a “technnocrat” then chances are that you’ve spent years and years in some university somewhere, and that doesn’t make you “plain folk.”

    What happens in most economic crisis is that you have a technocrat that comes up with specific policies and then you have the populist true to relate those policies to the common man. Where the system broke down is that the people driving the bailout where both “technocrats” and that person that is supposed to be the “populist” doesn’t have a huge amount of trust and credibility.

  • Posted by Dave C..

    Twofish,

    China PBoC Chief Zhou Xiaochuan deserves kudos for largely insulating the Chinese economy from the Wall Street banking fiasco. Even foreign banks operating in China are required by the China PBoC to incorporate and operate as fully independent stand-alone Chinese corporations. For instance, AIG-China balance sheets were unaffected by the parent corporation’s de facto bankruptcy. The direct, net financial cost to the Chinese banking sector was the $9.7 billion recorded loss on AAA-rated subprime bonds securities for the Bank of China.

  • Posted by Dave C..

    “For Citigroup to buy Wachovia, FDIC had to guarantee all losses above $4 billion.”

    Correction:

    “Citigroup also cut a deal with the Federal Deposit Insurance Corp. in which it will pay the federal bank regulator $12 billion in preferred stock, in exchange for the FDIC’s promise to absorb any Wachovia losses that Citi incurs above $42 billion.”

    http://money.cnn.com/news/newsfeeds/articles/djf500/200809291252DOWJONESDJONLINE000552_FORTUNE5.htm

  • Posted by Hal

    You need a site where clicking on a graph will EXPAND it so it is more readable. Clicking on your graph does NOT expand it or make it more readable.

  • Posted by Doctor Science

    Thanks for your insight. As a non-economist I am faint but pursuing on these issues.

    Technical comment re the graph:

    As t said, it would be better in png. More importantly, you need a better choice of colors — I can barely tell the difference between “Bonds” and “Bills”, and my color-blind husband cannot use the graph at all.

  • Posted by RealThink

    Brad: “it also creates some long-term risks for the Fed.”

    In a fiat money environment, Central Banks face no risks whatsoever as long as their little printed papers are accepted. They can create as many as they want out of thin air and give them in exchange for any of a number of meaningless promises (Treasuries, MBS, etc.) that they will be returned. They are never effectively returned in the long run, as history shows that M0 always keeps rising.

    The only news last week was that the rate of rise of USD M0 shot up. As long as foreign holders of USDs and promises to pay USDs in the future do not flinch, Ben can just go ahead.

    A financial crisis means that Mx (x=1,2,3) and M0 tend to converge. During 1929-1932, the gold standard prevented the Fed from avoiding the natural convergence of Mx down to M0. Now Ben is showing his resolve to make M0 converge UP to Mx.

  • Posted by RealThink

    Richard Kline: “Throwing colossal liquidity at panicked wealth holders does nothing to solve the root problem”

    Yes, it does. Basically that “wealth” you refer to is actually “financial wealth”, implying future purchasing power of “real” things. From a Hubbert’s Peak perspective, it is inevitable that future purchasing power be destroyed because there will be less real things to be purchased in the future. Now, that “wealth” destruction can be accomplished in two ways:

    a. the currency retains its value, and the financial instruments lose theirs (“asset” deflation)

    b. the currency is debased, and the financial instruments retain their nominal value

    There should be no doubt by now about which path has been chosen.

  • Posted by RealThink

    Sure enough, path b. above relieves the “wealth holders” of their panic only to the extent that they do not realize that their “wealth” remains constant only because the yardstick in which it is measured (aka currency) is getting smaller and smaller.

  • Posted by Jeff Benson

    Brad,
    Would a coordinated rate cut by the world’s central banks cause a global international run on the US money markets. I’ve read concerns from Roubini and Greg Mankwaw that the Chinese authorities are starting to eliminate their exposure to the US liquidity crisis by pulling their interbank short term dollar denominated funding. Is this a real threat?

  • Posted by David Collum

    Anybody who concocted the first bailout plan shouldn’t be allowed to get near whatever passes (gag) and probably shouldn’t be allowed to handle sharp objects or heavy machinery.

  • Posted by Twofish

    One interesting thing about what is going on is that when the United States government does something that markets see as silly, the first reaction that the markets have is to buy US Treasuries giving the US government more money to do silly things.

  • Posted by Tom Riedel

    I’m with David Collum. Something must be done, but nothing as stupid and misdirected as the Paulson plan should ever be done!

    The problem with the bailout is that it addresses the wrong problem, liquidity. I think the central issue here is solvency which is not addressed in any of the solutions I’ve seen proffered. If confidence in the banking system (i.e. believing their fellow banks are actually insolvent) is the central issue here, how come we are not from learning the last great banking crisis of confidence, the Great Depression? How did they restore confidence? It certainly wasn’t by papering over the issues with obscene amounts of money. It was through the Banking Relief Act of 1933. This act shut down the banks (Bank Holidays) for 4 days and had them open up the books to government inspectors in order to determine who was solvent and who wasn’t. Those that were solvent were reopened with the Gov’s seal of approval and those that weren’t were addressed and disposed of. This is a comprehensive solution that directly addresses the root cause of the credit woes that involves minimal taxpayer dollars and has been historically vetted. All of these are aspects that the current plan cannot even come close to claiming.

    I have yet to hear why this idea, which on its face, seems far superior to the current one, will not work or is not preferable. That is unless you are one of the insolvent institutions hoping that you can paper over your losses with taxpayer money.

  • Posted by bsetser

    If Chinese banks pull out of the dollar interbank market, they will have to put the dollars somewhere — and treasuries are the most likely option. that just forces the US government to act as the intermediary of last resort. I have a hard time seeing how china can cut its dollar exposure in a global context where it has stregthened its de facto dollar peg.

    as for “how do I know that interbank lending has stopped” — well, i read the FT, and various of its sources say it has stopped. as does the NYT. and the fact that the fed and ecb have had to lend out so much suggests it has stopped. And i look at market indicators — like the TED spread. The kind of distress I see in these kinds of markets reminds me a bit of the kind of distress emerging markets experience during serious crisis.

    as for the risks to the fed — they include:

    a) credit risk, as it is exchanging supersafe treasuries for less good assets. big losses would force the treasury to recap the fed (or reduce the fed’s profits). that is manageable. perhaps more importantly it would damage the fed’s credibility.
    b) running out of money —
    c) dependence on the treasury, in part because the treasury can issue tbills to provide the fed with more funds to lend out. generally tho central banks like to stand on their own two feet; it increases their independence.
    d) pushing on a string — monetary policy is less effective when the banks aren’t lending, as monetary policy works primarily through various credit channels.

  • Posted by Dave C..

    As P.T. Barnum once said, “there’s a sucker born every minute”. With the way the credit markets are panicking and snapping up anything issued by the US Treasury for practically zero interest, perhaps now’s a good time for the China PBoC to sell it’s US Treasury securities? Invest the proceeds into a strategic oil reserve to mitigate the declared Pentagon Neo-conservative military strategy of blockading energy supplies to cripple the Chinese economy.

  • Posted by Twofish

    Riedel: Those that were solvent were reopened with the Gov’s seal of approval and those that weren’t were addressed and disposed of.

    The problem is that in 1933 things moved much slower than they do now. I doubt that you could close the banks for four hours without causing mass panic. In particular, a lot of non-bank companies rely in just in time financing and turning off the banks for four days is like turning off the power in the US for four days, and you can’t just turn off the system in the US. You have to literally turn off the whole system everywhere in the entire world.

    Also, the part about what to do once you find that a bank is insolvent runs into problems. If you determine that a bank is insolvent then what? OK shut it down, but then what do you do about all of the creditors. OK, pay the depositors from insurance and wipe out everyone else, but

    1) FDIC is likely going to need recapitalization and if you have banks failing without FDIC having access to immediate funds things fall apart, and

    2) Once you zero the bonds, then you start having a domino effect in which one bank causes another bank to be insolvent. Also it’s not just banks. One problem with the system is that it is likely that we are going to find some bad stuff in pension funds, non-bank corporations, insurance companies, etc. etc.

    Riedel: That is unless you are one of the insolvent institutions hoping that you can paper over your losses with taxpayer money.

    It’s actually the opposite. If you paper over the losses then you end up like Japan where everything goes dead for a decade.

    The trouble is that if you realize the losses and try to flush them out of the system, you are going to find big giant holes in the financial system where you didn’t expect. If you don’t have ready cash to fill those holes, then you are going to have major, major problems.

    The problem here is time. Papering over the holes in system is not an option at this point, and over the next month we are going to find all sorts of places were the cancer has spread, and if you have holes in the financial system and no cash to fill them, then the ship is going to sink.

  • Posted by Dave C..

    Economist Marc Faber Says U.S. Taxpayer Bailout Won’t Work
    http://www.bloomberg.com/apps/news?pid=20601080&sid=alvjAlfEBU1s&refer=asia

    Sept. 30 (Bloomberg) — Investor Marc Faber said any proposal to rescue the U.S. financial system will fail to avert a recession in the world’s largest economy.

    A stock rally in the event that a package is approved will be temporary and should be used as “an opportunity” to sell, said Faber, who predicted the so-called Black Monday crash in 1987. U.S. lawmakers voted yesterday to reject a $700 billion plan worked out by congressional leaders and the administration of President George W. Bush.

    “The rejection of the package is good because it shows that some people in the U.S. are still sane,” Faber said in a phone interview. “A bailout will not buy the U.S. a way out. The government is less powerful than markets in fixing this mess.”

  • Posted by Twofish

    Benson: Would a coordinated rate cut by the world’s central banks cause a global international run on the US money markets.

    The problem with rate cuts is that right now rates on treasuries are basically zero. Also never mind causing a global international run on the US money markets, there *is* a global international run on US money markets.

    People are frantic to stop the bank run that’s going on right now.

    Benson: I’ve read concerns from Roubini and Greg Mankwaw that the Chinese authorities are starting to eliminate their exposure to the US liquidity crisis by pulling their interbank short term dollar denominated funding. Is this a real threat?

    The Chinese **are** eliminating their exposure to the US liquidity crisis by pulling their interbank short term dollar denominated funding. So is everyone else in the world. Everyone is pulling out of the credit market and the only people supplying money are the central banks.

    In some ways this is the logical conclusion of the last several years in which the central banks were the only ones providing long term funding. Now the central banks are the only people providing short term funding, but that is going only work for maybe another few weeks before the money runs out and the system shuts down.

    The thing that has to be emphasized is that we are not trying to prevent a crisis, we *are* in the middle of a credit crisis. The world financial system is on fire, and what we are seeing now is as bad as anything that happened in October 1929. Perhaps it’s unfortunate that everything is computerized now because you don’t see pictures of people lining up at the bank window demanding their money, but it’s happening now.

    As far as the details of Paulson’s plan, I’d rather wait until the fire is put out before I start screaming at the firemen.

  • Posted by Joe Rotger

    Tom,

    Sounds fine, trouble is…

    In a CDS transaction you have three parties involved: the CDS seller bank, the CDS buyer company and the bank that is lending the money which is being covered with the CDS.

    If you allow CDS seller bank to go under, you would also have to let a significant number of lending banks to go under too, because they lent more than they would’ve normally –their (greedy) thoughts led them to believe they were covered.

    Or, how many banks are involved in the $62 trillion CDS?

    Or more likely, it would be necessary to do the revision of all the loans involved to see if they are good loans, which was neglected at the origination, and seems to be at the root of the problem –as with the subprime loans, no one cared.

    Not forgetting that a lot of companies with uncovered debts would also go under, carrying with them other companies and banks…

    That the economy will dive is without doubt. The question is: will there be enough water in the pool for the plunge?

  • Posted by obey

    Twofish, you said: “We’ve already reached the limits of what private banks can do. For Citigroup to buy Wachovia, FDIC had to guarantee all losses above $4 billion. There are two or three regional banks that are teetering on the brink right now, and dozens perhaps hundreds about to follow. Europe is just beginning to deal with their problems. Also the WaMu and Wachovia purchases were made with the assumption that Congress would do something. Without assurance, no sane bank is going to lift a finger since it is irrational to try to save a drowning man if he will pull you under and kill you both.”

    Well, I don’t think those deals depended on the Paulson Plan passing. They were done to ensure status as too-big-to-fail, and were sweetened by FDIC guarantees limiting risks.

    Which makes me wonder: who needs the Paulson plan? the Fed, Treasury, and the FDIC demonstrably have broad discretion to flood the markets with liquidity by massively expanding the Fed balance sheet, effectuate huge de facto nationalizations and establish extensive credit lines (AIG), and take on toxic asset-related risks in order to sweeten private sector deals. Who needs any further legislation? The three musketeers can simply muddle through on their own authority, nationalizing when necessary, cleaning up balance sheets at the margin to sweeten recapitalization/merger deals, and maintaining liquidity through the discount window. The limits to their discretion under current law seem pretty flexible…

    We’ll be fine until January when either
    1. Phil Gramm sells the US financial sector to UBS for a dime, or
    2. Obama pushes through authorisation for a full Swedish Plan.

  • Posted by bsetser

    Fro what it is worth, I would favor a plan that focuses more on recapitalization to assure solvency.

    And for the little it is worth, I wonder –given his views on the powerlessness of governments — if Marc Faber would like to see what would happen if the Fed and the ECB withdrew the nearly $1 trillion in liquidity support they have no provided to the US and European financial markets. At a point in time when the only borrower that is trusted to pay back what it borrowed is the government, it strikes me that government is the solution not the problem … the question is how to organize the rescue, not the need for one.

  • Posted by Twofish

    obey: Well, I don’t think those deals depended on the Paulson Plan passing. They were done to ensure status as too-big-to-fail, and were sweetened by FDIC guarantees limiting risks.

    Strongly disagree. It may not be Paulson’s plan, but if nothing passes, there is no way that any sane bank would have agreed to merge with WaMu or Wachovia.

    obey: The three musketeers can simply muddle through on their own authority, nationalizing when necessary, cleaning up balance sheets at the margin to sweeten recapitalization/merger deals, and maintaining liquidity through the discount window. The limits to their discretion under current law seem pretty flexible…

    The have lots of discretion but they only spend the money that Congress authorizes them to spend and they are going to run out of money within the next month. Once the money runs out then neither the Fed or Treasury can do anything. If you look the amount of money that the Fed is pumping into the financial system, it is truly astounding.

    We’ll be fine until January….:

    No we won’t. If you look at how much money the Fed and Treasury are spending to prop up the system and how much money is available to them, it’s going to run out very soon.

    If it were possible to deal all of this until after the November elections and resolve it in a lame duck session, people would, but if you look at how much the Fed is pumping into the system and how much money is available, we aren’t going to get past the election.

  • Posted by TM

    “Payments show bailouts start to shift cash to mortgage trading firms”

    http://www.business-standard.com/india/storypage.php?autono=335924

    “Borrowing from Fed: The next day, AIG began borrowing money — $14 billion — from the Fed and continued borrowing for three more days, receiving loans totalling $37 billion, it disclosed in a financial filing on September 26. AIG then met its collateral calls to its Wall Street trading partners, S&P analyst Rodney Clark said in an interview.

    The payments show how bailouts engineered by Paulson and Federal Reserve Chairman Ben Bernanke are beginning to shift money to Wall Street firms involved in sub-prime mortgage trading.”

    I gotta ask-how are AIG(and others) going to pay back the Fed????

  • Posted by obey

    Twofish said: “The [fed, treasury, fdic] have lots of discretion but they only spend the money that Congress authorizes them to spend and they are going to run out of money within the next month. Once the money runs out then neither the Fed or Treasury can do anything.”

    I’m willing to take your word for it. But does someone (Twofish? …Bueller?) have some numbers on this?
    - how much can the Fed expand their balance sheet further?
    - what are the current statutory limits on Treasury’s discretion in setting up credit lines-for-warrants à la AIG?
    - How much more toxic-asset-liabilities can the Fed/Treasury/FDIC take on before Congress has to get involved?

    It had seemed that they were doing these things willy-nilly up until now.

  • Posted by Dave C..

    From Mish Shedlock,
    Why we should trash Paulson’s taxpayer boondoggle. Adopt Ireland’s solution that solves the economic credit problem:

    http://globaleconomicanalysis.blogspot.com/

    Why Ireland’s Plan Works

    What Ireland is fighting is the same thing that the Fed is trying to fight here (outflows from banks and money market funds into short term government debt.)

    The problem is NOT mom and pop puling bank deposits, it is corporate treasurers and state treasurers whose jobs are on the line pulling deposits from weak banks and putting them into stronger ones.

    The fastest way for the US and other governments to solve this is to raise deposit insurance ceilings. This is a far better option than ballooning the Fed’s balance sheet more.

    Furthermore, I would highlight that fully guaranteed deposits would put the US government even more at the top of the capital structure of banks. Existing senior debt is all of a sudden now fully subordinated to a potentially unlimited amount of insured deposit debt.

    Why the Paulson Plan Fails

    The Paulson plan fails because it does not stop mistrust between banks or mistrust by depositors. All it does is throw $700 billion in taxpayer money down a black hole.

    The Paulson plan is also unconstitutional. There is no constitutional authority for the US Government or the Federal Reserve to use public (taxpayer) money for what is definitely a private purpose (bailing out Wall Street).

    Finally, the Paulson plan takes time to implement fairly, and there are many holes in the oversight process.

  • Posted by Karl Dennigner

    The Paulson plan cannot work.

    But there are alternatives. Good alternatives.

    One is at the above web site, called “The Genesis Plan”.

    There are many others, and they deserve consideration.

  • Posted by Dave C..

    http://www.globalresearch.ca/index.php?context=va&aid=10393

    Paulson’s bill is designed to avoid a system-wide crash by clearing the banks’ balance sheets so they can resume extending credit to consumers and businesses. The hope is that massive infusion of capital will “turn back the clock” to the happy days of low interest speculation and bubble economics. Paulson is a “one trick pony” who firmly adheres to the belief that wealth creation depends on maximum leverage and an ever-weakening currency. But that world view is no longer applicable after reaching Peak Credit, where consumers are no longer able to make the interest payments on their loans and businesses and financial institutions are forced to curb their spending and dump their toxic assets at firesale prices. The system is deleveraging and nothing can stop it. Paulson has yet to accept the new reality.

    Besides, there’s no guarantee that the banks will use the money in the way that Paulson imagines. As one Wall Street veteran explained to me, “I don’t see one penny of that $700 billion ending up helping the broader economy. I see it being used to prop up share prices so the insiders can salvage as much as possible when dumping their shares”.

    Indeed, the $700 billion is just part of a massive “pump and dump” scheme engineered with the tacit approval of the US Treasury and the Federal Reserve. Once the banksters have offloaded their fraudulent securities and crappy paper on Uncle Sam, they will do whatever they need to do pad the bottom line and drive their stocks up. That means they will shovel capital into hard assets, foreign currencies, gold, interest rate swaps, carry trade swindles, and Swiss bank accounts. The notion that they will recapitalize so they can provide loans to US consumers and businesses in a slumping economy is a pipedream. The US is headed into its worst recession in 60 years. The housing market is crashing, securitzation is kaput, and the broader economy is drifting towards the reef. The banks are not going to waste their time trying to revive a moribund US market where consumers and businesses are already tapped out.

    No way; it’s on to greener pastures. They’ll move their capital wherever they think they can maximize their profits. In fact, a sizable portion of the $700 billion will likely be invested in commodities, which means that we’ll see another round of hyperbolic speculation in food and energy futures pushing food and fuel prices back into the stratosphere. Ironically, the taxpayers largess will be used against him, making a bad situation even worse.

  • Posted by Jehu

    By Twofish:

    “people are trying to pump adrenalin into the system to keep things from falling apart and stabilize the patient so *then* we can talk about the root causes. It’s impossible to have a rational discussion of root causes, while people are in crisis mode, and what everyone is trying to do is to get ourselves out of crisis mode, so that people can get some sleep without worrying about the next bank failure.”

    I cannot believe this is true. I am more than sure most here are aware that this entire crisis rests on the inability of the consuymer sector to absorb any more new debt.

    No matter how much credit is available to be lent, the rescue will fail with new debtors. It is a classic case of pushing the string.

    Tell me why this reasoning is wrong please, Twofish.

    There may be some other reason for this rescue, but the official explanation doesn’t make sense.

  • Posted by Jehu

    From Dave C.

    “Besides, there’s no guarantee that the banks will use the money in the way that Paulson imagines. As one Wall Street veteran explained to me, “I don’t see one penny of that $700 billion ending up helping the broader economy. I see it being used to prop up share prices so the insiders can salvage as much as possible when dumping their shares”.”

    Why not put the money directly in the hands of the consumer/taxpayer with a permanent tax cut for working families.

    We certainly know what they will do with it.

  • Posted by RebelEconomist

    It seems to me that we are being presented with a false dichotomy today, in an attempt to bounce us into supporting the Paulson plan. Either pass what is on offer, which just happens to involve a free gift to the bank shareholders and junior creditors, or face economic collapse. I don’t buy it.

    Just nationalise banks as they fail, and then work out later how to dispose of them. The shareholders, and probably junior creditors, should face the first losses before any call on the government. That way minimises both public expenditure and moral hazard.

    In the time that the Paulson plan has been debated, several banks in Europe have got into difficulty, been nationalised, remained open for business, with no panic. It must be possible to approve such a scheme for the US as quickly as passing the existing bill.

    And the wider the spreads between private and government credit, the stronger the case for nationalisation.

  • Posted by James Kroeger

    It is my understanding that the Fed obtains securities on its balance sheet by simply paying for them with money that is created out of thin air with a keystroke.

    I’ve spoken to two Fed economists who assured me that no account of limited size is debited when the Fed buys securities during Open Market Transactions. It is ‘new money’ that did not exist prior to the moment when it was keystroked into existence.

    If this is true—I have NEVER been able to find an economist who would deny that it is—then why is it that anyone is suggesting that the Fed could ‘run out of money?’

    Is it not true that if the Chinese were to try to sell all of their dollar assets for Renminbi, interest rates would be relatively unaffected if the Fed were to simply buy them all up?

    Can anyone direct me to some factual information that will either confirm or refute the above assumptions?

  • Posted by KnotRP

    Twofish says: I normally dislike Ayn Rand, but I’m starting to think about “Atlas Shrugged” and perhaps it would be a good thing if all of the supposed “evil Wall Street banksters” just went on strike for a week, so that people can see the wonderful utopia that would result without financial markets.

    —–

    A well run bank is a blessing.
    A looting operation disguised as
    a bank is a curse.
    Main Street (where original wealth is created) can suvive without Wall Street, particularly when
    it’s looting more than banking.

    It’s ironic that Main Street is shrugging at Wall Street right now, yet you invoke the metaphore in reverse, as if that’s a credible threat. Small regional banks would spring up in the sunshine left after the removal of diseased growth….life will go on, people will adjust.

    First, sort out the good from the bad.
    Then, throw capital at the good.

    Ready, Aim, Fire….not Ready, Fire, Aim.

  • Posted by Michael

    The very fact that the 62% increase in Treasuries put into the markets in one 12 month period was performed in a panic-driven process and the purchases were made in a panic-driven process is perhaps the best indicator that the purchases don’t reflect any long-term commitment to Treasuries.

    Once the panic subsides the selling will begin, and unless the sense of panic can be successfully re-created at regular intervals, will turn into a rout from this new form of toxic debt.

  • Posted by Dave C..

    http://www.newsweek.com/id/161649/page/2

    So are China’s banks at risk of contagion? China’s banking sector is “one of the healthiest in the world,” says Jing Ulrich, Chairman of China Equities at JP Morgan. Chinese banks are awash with liquidity, sitting on bank deposits from thrifty savers totaling $7 trillion. Banking analysts were not alarmed that China’s two biggest retail banks had $280 million worth of exposure to bankrupt Lehman Brothers. Nor is there much sign of the domestic mortgage market triggering an identical, system-wide collapse. Although home ownership levels are as high as 80 percent in some cities—a sign of China’s passion for property—many homebuyers pay cash. Ulrich says mortgage-holders seldom buy beyond their means, so a wave of defaults is unlikely, even in a slowing economy.

  • Posted by Twofish

    Jehu: I cannot believe this is true. I am more than sure most here are aware that this entire crisis rests on the inability of the consumer sector to absorb any more new debt.

    I hate to use too many analogies, but you have a patient that has a really horrible lifestyle. Eats fatty food, smokes, doesn’t exercise, etc. etc. One day that person has a massive heart attack.

    At that point the picture changes, and we are in a situation where people are frantically shocking the patient, doing CPR, and just basically keeping things alive. The global economy is literally on life support right now.

    That’s basically the situation we are in. Paulson’s plan is not intended to solve any of the root problems of the economy, any more than putting someone in ICU is intended to make someone give up smoking.

    It’s intended to prevent a massive economic meltdown. Now maybe the heart attack patient will leave the hospital and change their ways or maybe they won’t. Right now, I don’t care, because if the credit markets seizes up, you are going to have massive bankruptcies throughout the entire economy.

    Kroger: I’ve spoken to two Fed economists who assured me that no account of limited size is debited when the Fed buys securities during Open Market Transactions.

    This is true, but right now the Fed is massively *selling* Treasury bonds and then using the cash raised to buy short term commercial paper. Once the Fed and Treasury depletes its stock of bonds then it has no more cash to do anything. The only people that can provide the Fed with more Treasury Bonds is Congress which is where is where to get back to Paulson’s proposal.

    Once the Fed runs out of Treasury Bonds and if Congress doesn’t authorize the issuance of new bonds, then *GAME OVER*. The Fed at that point has no ability to prevent a general economic collapse.

  • Posted by obey

    Dave C., thanks, that’s interesting. They then seem to have a strong funding base. But at some level the Chinese banks are directly or indirectly sitting on dollar denominated assets- principally treasuries – which will tank if interest rates rise or the dollar falls. Or am I wrong?

  • Posted by Twofish

    KnotRP: Small regional banks would spring up in the sunshine left after the removal of diseased growth….life will go on, people will adjust.

    I find that people who are most optimistic about what life is like after an economic meltdown have never really lived through one. Yes, people will adjust. After all, people did live through the Great Depression and World War II, and even worse things. I find it amazing the hell that people have been able to go through. But I’d rather not take the journey.

    KnotRP: First, sort out the good from the bad.

    If you are in a burning building you do not have time to do the sorting, because if you wait, everything will burn to the ground. Once you start having bankruptcies, then previously good loans will turn bad, and you will have a cycle that won’t stop until everything is leveled.

    Michael: The very fact that the 62% increase in Treasuries put into the markets in one 12 month period was performed in a panic-driven process and the purchases were made in a panic-driven process is perhaps the best indicator that the purchases don’t reflect any long-term commitment to Treasuries.

    They don’t. No one cares if the US defaults in 2030. Right now people are just rushing into Treasuries so that they don’t get soaked if the economy falls apart next month, because people are facing the very real possibility that there will be no economy next month.

  • Posted by KnotRP

    Twofish says: find that people who are most optimistic about what life is like after an economic meltdown have never really lived through one.

    You are hopelessly confused if you think I’m optimistic. I just think you cannot unbreak an egg.
    You seem to think you can, if you hurry.

  • Posted by KnotRP

    Twofish – your burning building analogy presumes the arsonist hasn’t already carted off anything and everything worth saving…..that’s where we differ.
    The water now has more value than what you would apply it to…

  • Posted by CG

    Twofish: Once the Fed runs out of Treasury Bonds and if Congress doesn’t authorize the issuance of new bonds, then *GAME OVER*. The Fed at that point has no ability to prevent a general economic collapse.

    What if Fed prints dollars, uses said dollars to buy Treasury Bonds from China, China converts dollars into RMB – ie debase the dollar, revalue RMB, begin rectifying global imbalances, etc

    Would require quite the coordination, but I believe a debasing of the dollar played a role in bringing an end to the Great Depression, no? I dont think this scenario would cause a “general economic collapse”, but no doubt there’d be significant temporary pain in the adjustment…

    (Long-time reader, first-time poster)

  • Posted by flow5

    It would seem that somewhere, somehow, if total net debt (not just Federal Debt) keeps rising faster than production (Real-GDP), the burden of interest charges at some point now indefinite and unknown, but nevertheless real, will become too great to carry.

  • Posted by flow5

    Any deficit, by definition, creates a demand for loan-funds. The larger the deficit, the higher interest rates will be, or the less they will fall.

    Any given deficit should be evaluated in terms of: (1) the size of the deficit in the context of the size of future deficits, and the accumulated debt relative to the means and costs of financing the whole: (2) how the deficit is financed: (a) from savings or (b) commercial bank credit, i.e., newly created money; and (3) the purpose for which the deficits are incurred.

    Prorating the federal deficits over the entire spectrum of federal expenditures, it can be said that virtually all of the current deficits are attributable to defense spending, military and civil service pensions, interest on the debt, and welfare and unemployment benefits. Social security for now is not include in the above list since only a very small proportion of social security benefits are financed from non-social security taxes.

    From an economic standpoint, only interest is “untouchable”.

    If current projections of Federal Deficits materialize in this, and the next few years, interest rates (both long and short-term) will be driven up sharply by the increased demand for loan funds. I.e., any recovery in the economy will present a “Catch 22” situation. An upturn in the economy will add increased private demand for loan funds to the insatiable demands of the Federal Government.

    The consequent rise in interest rates will effectively abort any recovery.
    Raising taxes to accomplish a reduction in the deficit would be counter-productive.

    Most of this debt is short-term. Combine this with the factor with the constant roll-over of some of the long-term debt and it becomes obvious that the burden of higher interest rates will be compounded. The burden becomes a function of the major portion of the debt, not just the current deficits.

    The burden, in fact, becomes exponential. In other words, if the trend is not stopped, the debt inevitably has to be repudiated.

  • Posted by flow5

    Those who are wont to minimize the ill effects of the deficit are prone to compare the size of the deficit with nominal GDP, as if the volume of nominal GDP were independent of the size of the deficit. Unprecedentedly large deficits “absorb” a disproportionately large share of nominal GDP

    Present deficits are unprecedented no matter how measured, and the past gives us no reliable guide to the future effects of deficit financing, beneficial or otherwise.

    To appraise the effect of the federal budget deficit on interest rates, it is necessary to compare the deficit, not to GDP, but to the volume of CURRENT SAVINGS made available to the credit markets. The current deficit is absorbing about 24% of gross savings.

    The more alarming aspect of the deficits is not the effect on interest rates but the effect of high interest rates on the level of taxable income and the volume of taxes required to serve a cumulative debt now exceeding $9.7 trillion.

    Both high interest rates and high taxes induce stagflation, thus eroding the tax base and increasing the volume of futures deficits

  • Posted by flow5

    It should be recalled that the charges on debt are related to a cumulative figure; and since the multiplier effects of debt expansion on income, the ingredient from which the charges must inevitably be paid, is a non-cumulative figure, it would seem that the time will inevitably arrive when further debt expansion is no longer a practical or possible expedient, either to provide full employment or to keep debt charges with tolerable limits.

  • Posted by flow5

    The significant economic purposes for which a debt was contracted, or the manner in which it was financed, is of inestimatable value in evaluating it’s impact.

    For example if the debt was acquired to finance the acquisition of a (new-security), the proceeds of which are used to finance plant and equipment expansion, rather than the purchase of an (existing-security) to finance the construction of a new house, rather than to finance the purchase of an existing one (as will Paulson’s planned $700 bill bailout), or
    to finance (inventory-expansion), rather than refinance (existing-inventories).

    The former types of investment are designated as “real” as contrasted to the latter, which constitute “financial” investment (existing homes). Financial investment provides a relatively insignificant demand for labor and materials and in some instances the over-all effects may actually be retarding to the economy. Compared to real investment,it is rather inconsequential as a contributor to employment and production. Only debt growing out of real investment or consumption makes an actual direct demand for labor and materials.

  • Posted by Michael

    Twofish- “It’s intended to prevent a massive economic meltdown. Now maybe the heart attack patient will leave the hospital and change their ways or maybe they won’t. Right now, I don’t care, because if the credit markets seizes up, you are going to have massive bankruptcies throughout the entire economy.”

    You’re absolutely right, and any discussion not accounting for this fact is wasteful.

    The problem is not the past case history showing how the finance industry got sick, nor even the current necessity of immediate radical medical treatment.

    The problem is just how different life is going to be from here on, since it is now apparent that the patient cannot survive going forward (after stabilization of the immediate crisis with open-heart surgery) without a permanent pacemaker of government subsidy for excess credit creation. Any return to an income/savings-based equilibrium economy are henceforth financially and politically unacceptable, as that would require the elimination of 70% of the finance industry and a drastic drop in our GDP level.

    Thus, the emergency medical intervention morphs into a permanent medical life-support process for the finance industry. You are correct that the American and World economies as we know them have become dependent upon the finance industry for excessive credit to conduct the level of business to which we have become accustomed. We are – not as an intentional conspiracy, but as the outcome of ordinary capitalist evolution – now hostage to the excesses of the finance industry, and if we don’t subsidize them immediately and permanently they will drag us straight to Hell with them. You got that right.

    But, do you understand why now is precisely the time that most of us would like to at least think the forbidden thought that maybe there will be no end to this kind of kidnapping unless we consider saying no?

  • Posted by Roland

    If nothing else, a protracted crisis would help put the “political” back into political economy.

    Besides, it’s sort of fun to watch Twofish’s complacency openly give way to panic.

    As for crisis, a lot of “plain folk” actually do have the vivid experience of unemployment, being broke, not being able to do what one wants, reduced expectations, etc.

    That’s why we’re not as worried as some of Twofish’s beloved shrugging tekkiecrats.

  • Posted by Twofish

    Roland: Besides, it’s sort of fun to watch Twofish’s complacency openly give way to panic.

    It’s actually rather curious since I do think that the plane will miss the mountain, but it’s heading in a direction that has me very worried.

    Roland: As for crisis, a lot of “plain folk” actually do have the vivid experience of unemployment, being broke, not being able to do what one wants, reduced expectations, etc.

    Unless you are from Argentina, Russia, or Mexico or are over 70 and lived through the 1930′s, you probably haven’t had experience with the type of calamity that we are looking at.

  • Posted by Twofish

    CG: What if Fed prints dollars, uses said dollars to buy Treasury Bonds from China.

    The trouble is that to buy something you have to have a seller, and right now very few people are willing to sell Treasury bonds, and it’s not going to stop the current panic, and probably would make it worse.

    In the long run, the government could assume the bad debt and then inflate the debt away. It is a bad option, but it’s an option.

    KnotRP: You are hopelessly confused if you think I’m optimistic. I just think you cannot unbreak an egg. You seem to think you can, if you hurry.

    The curious thing about all of this is in some ways I think that McCain is right. The US economy *is* fundamentally sound. That’s why it would be a stupid/tragic thing if this crisis gets out of hand and causes some real economic damage (which interestingly enough, it hasn’t.) One thing that is painful about reading the history of economic crises is what a senseless waste it is when things blow up for no good reason.

    So the fact that I’m panicky is actually a flip side to my normal complacency. There’s no point in getting excited if you think you are doomed and there is nothing that can be done about it. But I think that there is. The decisions that get made in the next month will determine the course of history for the next generation.

  • Posted by James Kroeger

    “Now maybe the heart attack patient will leave the hospital and change their ways or maybe they won’t. Right now, I don’t care, because if the credit markets seizes up, you are going to have massive bankruptcies throughout the entire economy.””

    So why are no economists proposing bypass surgery? Congress could allocate $1-$2 trillion dollars to (A) finance a huge increase in federal spending, and (B) capitalize a Taxpayers’ Bank to address all liquidity concerns re: Main St.

    This Taxpayers’ Bank could provide abundant loanable reserves to small businesses and non-financial firms and even households, e.g., mortgage re-financing. This would effectively insulate Main St. from the chaos of Wall St. The patient’s heart could then be repaired through creative destruction.

    Think about it. If a trillion dollars of govt. spending were injected into the economy, Main Street would likely experience an economic boom at the same time that the financial sector is collapsing utterly.

    Trillions of dollars of paper wealth would be written off. Then, after the wave of bankruptcies finally subsides, the survivors would be in a position to start lending again. After the crisis has passed, Congress could then re-privatize the Taxpayers’ Bank, if that was considered desirable.

    Benefits: (1) Main Street largely protected from the Wall St. carnage, (2) moral hazard returns to the private banking sector, (3) the problem of ‘toxic paper’ is cleansed from the system, and (4) the whole thing gets resolved in a year or so.

    Ready to sign on, Brad?

  • Posted by Michael

    Twofish – “Unless you are from Argentina, Russia, or Mexico or are over 70 and lived through the 1930’s, you probably haven’t had experience with the type of calamity that we are looking at.”

    Nope, I missed the Depression, having been born in the middle of WWII. Or did I?

    One of the effects of the Depression was the elimination (through the “calamity” that you propose we fear) of insolvent banks, over-leveraged stockholders, and creditors with zero judgement everywhere. Businesses and worker/comsumers stopped using cheap credit to speculate and “buy on the installment plan” as they had prior to the Crash.

    Definitely hard times for the 20% unemployed (but good times for the 80% who were employed and saw their real wages rise faster and higher than ever before or since). Also hard times for those who had taken on more debt than they could afford.

    But the aftermath of the Depression-level credit crash was not the “calamity” you claim it must be – the whole country did burn to the ground and the economic body did not die.

    Rather, a whole generation learned a critical lesson and returned to the income/savings model they had been using to create wealth (slowly) before they went crazy and used leveraged debt instead to try to create wealth (quickly). By the time WWII came along, we were at the lower but stable equilibrium economy that we would have been at if the 1920 credit excesses had never occurred in the first place.

    During the war, consumption and borrowing were constrained both by the rediscovered habit of THRIFT as well as by government rationing and other economic controls.

    After the war, there was the highest level of household savings per capita EVER in the U.S. I grew up in the period from 1945-1966 when all that accumulated saving was spent without excess credit creation and I can tell you the result was the most stable and consistent non-inflationary growth I have ever seen. Thus, I am a direct beneficiary of the “calamity” of the Great Depression.

    However, when Americans had spent their 20-years worth of accumulated savings, and a new generation (mine) that hadn’t experienced the Depression took over, a new cycle of excessive credit growth began, leading to the debt-fueled trade imbalances, permanent fiscal deficits, and inflation of the period from 1967-1979. The “Golden Era” turned into “Stagflation.”

    I DID live through the crash of the 1982-1983 recession (which, if you didn’t, I can tell you felt like a Depression to the 10% unemployed and all the closed businesses). Thanks to the Fed taking a counter-cyclical stance under Volcker, a crash was permitted, and once again the speculators and leveraged debtors (and many banks) were cleaned out. Were you there for that one?

    The result? The so-called “Great Moderation” from 1984-2006 when, even with growing excesses of leveraged debt and speculation again running wild (to the point of $62 trillion in speculative gambling with other people’s money) and with a pro-cyclical Fed feeding the fires, we managed low unemployment with little inflation and few recessions until the inevitable reckoning. We only got to live out that fantasy as long as we did because of the cleanout from Crash of ’82.

    Why the history lesson? Because, if you don’t accept the necessary healing role of credit contractions (even the more abrupt and severe ones, which are the result of greater excesses and denial) as one of the healthy parts of the business cycle, I don’t believe you understand the business cycle.

  • Posted by Twofish

    Michael: I DID live through the crash of the 1982-1983 recession (which, if you didn’t, I can tell you felt like a Depression to the 10% unemployed and all the closed businesses). Thanks to the Fed taking a counter-cyclical stance under Volcker, a crash was permitted, and once again the speculators and leveraged debtors (and many banks) were cleaned out. Were you there for that one?

    Yes, and one part of the that effort was the establishment of the Resolution Trust Corporation which cleaned everything out.

    Michael: Why the history lesson? Because, if you don’t accept the necessary healing role of credit contractions (even the more abrupt and severe ones, which are the result of greater excesses and denial) as one of the healthy parts of the business cycle, I don’t believe you understand the business cycle.

    Precisely, but the danger is that things can go off the rails, and you end up with the type of massive contraction that you see in October 1929 or the type of bloodshed that you see in Latin America. The type of thing that doesn’t just last a year or two, but destroys an entire generation.

  • Posted by KnotRP

    Twofish says: The curious thing about all of this is in some ways I think that McCain is right. The US economy *is* fundamentally sound.

    So eight plus years of flat real wages combined with record personal debt, record low housing equity, record low personal savings, poor job creation, and offshoring of many job functions, and you think the economy is fundamentally sound?

    I guess we’ll have to agree to disagree.

  • Posted by DAve

    FDIC insures depositors against bank failures. It provides in its present state insurance for up to $100K each depositor.

    The latest brilliant idea is to up the limits from $100K to $250K each depositor.

    FDIC DOES NOT HAVE ENOUGH MONEY TO COVER THE DEPOSITS IT ALREADY HAS AND NOW THE PLAN IS TO INCREASE ITS (WHICH MEANS OUR) OBLIGATIONS AND EXPOSURE ALMOST THREEFOLD.

    Check out the amount of money FDIC actually has versus how much it will have to pay if only a few more banks fail. It doesn’t even have 1/10th of what it could need. And many more banks WILL fail guaranteed.

    This seems like just another back door way to trick us into bailing out big money players.

    Our representatives are not supposed to be our enemies

  • Posted by KnotRP

    DAve…the way it works, see, is ya have this $250K bazooka in your pocket, see….so having a bazooka means you won’t have to use it…
    oh, I used that one already? Hold on a sec, while I check my notes…

  • Posted by Twofish

    KnotRP: So eight plus years of flat real wages combined with record personal debt, record low housing equity, record low personal savings, poor job creation, and offshoring of many job functions, and you think the economy is fundamentally sound?

    Yes. Because corporate profits are huge and while median wages are flat, wages and salaries for the people in high incomes have skyrocketed. Over the last eight years, the US economy has generated a ton of wealth, it’s just been concentrated at the top 1% of the population.

  • Posted by Jehu

    Twofish: I hate to use too many analogies, but you have a patient that has a really horrible lifestyle. Eats fatty food, smokes, doesn’t exercise, etc. etc. One day that person has a massive heart attack.

    Two fish, I think the problem is a lot less complicated than appears in this forum. All this analogy about mucking around in the E.R. trying to save the patient is fine.

    But financial system crisis is not the patient, it is part of the disease process – is it not?

    The object is prevent the disease from doing more damage to the real patient: ordinary Americans, aka, Main Street.

    If the plan were to contain the disease, and then eliminate it, how would your ideas change?

  • Posted by Jehu

    Which brings us to the real issue: the disease is not being contained and eliminated.

    It is being treated as if it were the patient.

    Meanwhile, the real patient has no idea what is about to happen.

  • Posted by adiemuso

    test

  • Posted by a

    Excuse me if this has already been commented on, but is this the dynamic we are seeing now that the Fed has used up its balance sheet?

    The banks need dollars. The Fed gives them dollars. To get those dollars, the Fed sells Treasuries. To buy those Treasuries people are selling dollar assets, such as hedge funds and money-market funds. Money-market funds then have less money to invest in commercial paper. Banks are able to raise less money via cp. Companies are able to raise less money via cp, and thus turn to their credit lines at banks. So banks need even more dollars. Am I missing something?

    Maybe this is called “pushing on a string” or “liquidity trap” – I don’t know. But if the Fed has really used up its balance sheet, having the Fed lend money to banks with its right hand while its borrowing money via Treasuries with its left, will not help over-all dollar liquidity at all.

  • Posted by RebelEconomist

    a,

    What you are missing is that someone has to buy non-treasury dollar assets. That is the Fed. The Fed is buying loans – aka lending money – which are collateralised with the banks’ dodgy assets (which, pending the TARP, remain on their books).

    Pushing on a string is something different. That occurs when, because the demand for money, being a relatively risk-free asset, is so huge that increasing the money supply does not increase spending. Instead the additional money is readily held. I do not think we have reached the point yet where the Fed are expanding the base money supply (ie lending without selling treasuries), but with all the schemes going on, it gets a bit hard to tell!

  • Posted by Twofish

    Jehu: If the plan were to contain the disease, and then eliminate it, how would your ideas change?

    I honestly have no idea what long term changes the US has to make in its economic structure, and what happens next will involve a lot of debate and heated discussion.

    However, in order to have that discussion we have to get the economy into some shape where we can put it on autopilot for a few months and think and discuss what to do next. The problem with the current situation is that if you “do nothing” then you going down exactly the same path that “do nothing” did in early-1930.

  • Posted by Jehu

    “The problem with the current situation is that if you “do nothing” then you going down exactly the same path that “do nothing” did in early-1930.”

    Exactly. The US had to direction to take in the 30s:

    1. Inflation
    2. Reduce the work week

    Washington chose inflation – which worked for six decades, but now has foundered on the rocks of consumer debt.

    Perhaps this time we could try the other, and let the creidt market unwind in a way which doesn’t hurt ordinary people.

  • Posted by Twofish

    a: The banks need dollars. The Fed gives them dollars. To get those dollars, the Fed sells Treasuries.

    What happens is that to get those dollars, the Fed takes as collateral securities or loans that the banks have and then issues cash to the banks. This is where the Fed prints money (literally). You give the Fed something of value as collateral, the Fed shows up with an armored truck full of green paper.

    For this to work, the banks have to give the Fed something of value. Some security or loan or treasuries. If the banks have nothing of value to give to the Fed or anyone else, they can’t get dollars to loan out, and so they start cutting back on the dollars that they have.

  • Posted by flow5

    “Great Modernization”

    Hardly, the DIDMCA created the legal framework for the addition of 38,000 more commercial banks to the 14,000 we already had, and in the process, the abolition of 38,000 intermediary financial institutions.

    The intermediary financial institutions effected were the nation’s savings and loan associations, mutual savings banks, and credit unions. Trust companies and stock savings banks were commercial banks for many years.

    The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves.

    Legal reserves increased by a factor of 3.5 from 1981 until 2006. And during this same time period, the commercial banking system’s expansion coefficient doubled.

    “There is general agreement that, for almost all banks throughout the world, statutory reserve requirements are NOT BINDING. Banks need central bank deposits for clearing checks and making other interbank payments, which gives the central bank leverage over money and bond markets”

    Richard G Anderson
    Federal Reserve Bank of St Louis

    THE MONEY SUPPLY CAN NEVER BE MANAGED BY ANY ATTEMPT TO CONTROL THE COST OF CREDIT.

  • Posted by s

    One thing the people keep glossing over is how Paulson and Bernanke sat in front of Congress last year and said to everyone that they were imploring Banks to raise capital. The banks opted not to. Why? They clearly calculated that they could lie and obfuscate and in the worst case designate themselves TBTF. Thus they went on paying healthy dividends with yields in excess of 7%.

    Banks and their shareholders played chicken with the US taxpayer and they won a pyrrhic victory in the Senate. This plan is a about one thing, not diluting into oblivion JPM, BAC, C, WFC etc. And yet we see JPM hit 52 week highs. This must be what it was like on the Russian Stock Exchange in 1986.

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