Friday, March 20, 2009

Inability to Focus

"Members of the Senate, in a date which will live in infamy, our great nation was viciously attacked by Japan.  I call on you now to declare war against our aggressor."
"Hold on, President Roosevelt.  How can we be sure that military expenditures are spent without waste!"
"It's not just that.  The NYT has just broken a story that the Soviet Union is using our military aid in order to build prisons for top leadership.  This represents an insane level of compensation!"
"This is a scandal!  I demand that all military spending be stopped immediately until we can elimate all waste and fraud in the government and private contractors."  

Brooks is absolutely right when he says that there we have a crisis of leadership in handing the banking crisis.  Remember all those times when you were confused about why historical figures completely wiffed on important events?  Yeah.  

It's not as if what we're experiencing represents something unprecedented that changes the entire logic of economics.  Asset booms, followed by banking crises, happen with some frequency--most recently hitting Japan and then other Asian countries in 1998.  These countries floundered around a bit, then decided to fix the banking system, after which things got better.  Japan decided to willfully ignore the problem, built a lot of useless infrastructure, but actually saw some growth (considerable enough for a country facing demographic suicide) when they decided to fix the banking system.  So all this stuff about earmarks, stimulus plans, "reworking the economy on a sound grounding", green energy, bonuses, etc. are all diversions from the real problem of fixing the banking system.  Apparently, people are perfectly happy to see an economic collapse as long as no one unfairly games the system in the process.  

Well, now the Treasury has sketched out their plans a bit more.  No outright nationalism, but no bad bank/good bank model either.  Instead, you get this complicated public partnership structure in which private investors join the government in buying up assets from banks judged to be in trouble.  This partially reflects the political consensus that is quickly emerging in DC that no further funds should be appropriated for these unjustifiable bail outs, requiring the contributions of private money (cranky partisan point: this only happened because Obama spent his political capital elsewhere.  If he went on the Today Show and told us we would all die unless he got what he wanted on the banks, I suspect he could do virtually whatever he wanted.).  

Will private investors help the government properly price toxic assets?  That's really the big question now which will determine the stability of the financial system, and I don't think anyone has any clue.  This debate--depressingly, like so many previous ones--looks set to be divided almost entirely on ideological lines in the economics profession.  

We already have plenty of private investors buying up toxic debt, setting the markets prices you see today.  What's different when they go in with the government?  Government guarantees, presumably.  So this doesn't solve either of the two pricing problems here: 1) You don't want the government to overpay for the stuff, but private investors with guarantees are more willing to overpay 2) You don't want banks to undersell, triggering a new wave of losses, but they still are desperate for liquidity, so this price discovery will still devastate banks.  On top of that, how willing will private investors be to invest given the fact that Congress has just shown that it can single out any group of people and tax them nearly everything?

Still, if this is a part of a general plan of the government to commit to a plan, that's great, because uncertainty about government intervention is keeping a lot of private money on the sidelines as it is.  This also reflects a massive step forward for government thinking here, which has so far consisted of audacious attempts to waste as much taxpayer money as possible.  It gives me hope that one day Republicans will start saying things that make sense.

But none of this gets into the currency issues involved here--which have been serious for the Asian countries mentioned above.  Remember that Roubini was first bearish not because of the housing boom, but because he figured that our high current accounts deficit would be fixed by capital outflows, which would accelerate as our banking system collapsed.  Somehow that hasn't happened yet.  But with the government going trillions in debt in this current budget, pursuing monetary policy with great vigor, planning enormous deficits as far as the eye can see, and now printing money like crazy, I can say with virtual certainty that we're going to see a lot more inflation and a fall in the value of the dollar.  Taking on billions in additional liabilities through this new bank rescue only decreases the faith in the American dollar and hastens its collapse.  

Remember, fears exactly along these lines were why the IMF first recommended that countries in crisis cut their budgets, a tactic which was viciously criticized by Stigliz.  But if you're an emerging country whose debt is mistrusted by investors, turns out you can't start selling them in a crisis and expect them to sell like hotcakes.  This is increasingly less of a concern for developing countries with deeper financial markets, and increasingly more of a concern for America.

China is pretty much screwed here, since the US is doing everything in its power to destroy the value of its debt.  Any reasonable fund manager with that much dollar exposure, living in a non-dollar denominated currency zone, should be thinking very hard about how to reduce that exposure while keeping those treasury assets.  Rumor has it they keep secret reserves hedging exactly in this manner.  

The ideal bank rescue plan would not destroy the future income of the taxpayer while avoiding the complex task of deciding which of America's 8,000 banks to nationalize and which ones to not.  I'll write up my own plan at some point, but this looks about the best we're going to get.  

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