A lot of people have been writing up their plans to save the financial system, and I've been criticizing those plans. It's unfair to attack those who are attempting to do something without offering an alternative. This strawman is here to encourage debate. I may revise it using your suggestions. Please feel free to write me at magwitch@gmail.com. Share and build on this all you want.
BackgroundThe international financial system is suffering its greatest crisis ever. This panic is occurring against the backdrop of a phenomenal amount of debt outstanding, immense leverage within the financial system, deflation, and serious international imbalances in flows and stocks. This has led to a big shortfall of demand, despite historically low savings rates.
It's my contention that this crisis has arisen because of excessive debt loads and abnormally low risk premia. These resulted from regulatory laxity, current account surplus recycling, and excessive, repeated use of policy to combat any recession.
Things feel pretty bad now, but they've only gotten started. Money in the system still hasn't even begun to decrease yet, and neither has observable leverage. We're sitting at 353% debt-to-GDP. Real interest rates are rising. People are beginning to trade on the solvency of the Treasury itself. These indicators continue to worsen, despite and due to our policy actions and natural forces. Debt burdens grow as deflation grows; ability to service that debt shrinks as does GDP. Clearly, we're in a debt-deflationary spiral.
We've tried myriad solutions, including cutting interest rates, rescuing bad banks, allowing other bad banks to fail, small fiscal stimulus via tax rebate, direct monetary injection into banks, quantitative easing and more. These have not been sufficient to slow the spiral, and some may have exacerbated the problem.
Our most common and familiar policy tools have proven ineffective thus far. So have some novel ones. We now have two major policy tools remaining: Keynesian stimulus, and quantitative easing.
Keynesian stimulus involves running outside fiscal deficits as a countercyclical policy in hopes that demand in the private sector will be resuscitated. This deficit can be provided through excess spending or dramatic tax cuts. When private savings are high and investment is low, when there's lots of slack in the economy, when employment is weak, and when nothing's moving, this makes a lot of sense. It supplies a shock to private demand at precisely the time it's waned.
That's not the world we live in right now, though. We have very low private savings, excessive consumer spending, lots of slack in the economy, and average employment. There is absolutely no shortage of demand for capital.
In this environment, Keynesian stimulus can crowd out private demand because the government has to borrow in order to fund its programs. While that seems like it's no big deal with interest rates so low, those are nominal rates. Real interest rates matter much more, and they'd go up through Keynesian stimulus. You can't watch those go up at this point because deflation's severity is masking the pricing of bonds. Instead, you'd witness it only through increasing severity of deflation. Our hope is that Keynesian stimulus is a net positive to demand, with a multiplier that's higher than any the private sector can offer right now, and it will trigger the private sector to recycle this spending. But it's not proven that it works in environments like this one. Japan has already experienced that it is counterproductive when government debt is high.
As Werner put it, "What all these formulations (classical, Keynesian and post-Keynesian) have in common is that the ineffectiveness of fiscal policy is the result of increased interest rates.... The main problem with these interest-rate based arguments for fiscal policy ineffectiveness is that there is no empirical evidence in their support.... we find that short-term real interest rates fell from 4.2% on average in 1991 to 0.11% on average in 2000, while long-term real interest rates fell from 3.0% on average in 1991 to 0.7% in 1998." However, Japan had a very large current account surplus during that time, and we have a very large current account deficit. We had low real yields initially, yet we have high real yields now. There are strong empirical and theoretical reasons to believe that fiscal deficits may actually drain economic vitality further.
Our foreign creditors could not fund this stimulus, even if they wanted to.
Quantitative easing, the alternative, is also no sure-fire winner, encountering only failure when tested in the wild. It's very difficult to define what quantitative easing is, but one certain aspect of it is the creation of excessive cash reserves in the system. By that measure, we're already using quantitative easing thanks to the Fed's program to pay interest on deposits. It isn't working, because risk-adjusted returns on investment are judged to be around or below 0%. That means the bank just deposits the extra cash with the Fed and walks away. To fix this, we'd have to reduce the risk involved or allow these investments to become so cheap that that return goes above zero. Allowing the investments to deteriorate that badly defeats the purpose of the program in the first place. Reducing the risk is extremely difficult and costly to do, and fraught with unintended consequences if it's even possible.
We don't have any other good tools, and even if we did, there is a much larger problem to consider: the solvency of the Fed. The Fed's balance sheet is arcane and rarely discussed. At one point, it was almost a technical aspect of how the system worked. However, the government has tried bailout after bailout. As a result, a lot of bad securities have been purchased or repoed. These won't be placed back to the banks in any reasonable timeframe because it would cause them to fail again.
The sheer magnitude of the bad stuff on the books of the Fed and Treasury, which should be seen as a consolidated entity at this point, is staggering. It would have to be vastly larger for the government to shoulder alone all readjustment necessary.
The Fed is a bank similar to any other, with liabilities and assets. There are special rules that apply to it, but those rules don't violate that fundamental truth. The Fed can't just "print" money as we throw the term around; it must purchase a security or perform a repo agreement to get the money into the system. Because its favorite food, short-dated treasuries, are already so strongly bid, it can't use those. It has to buy something else, which inevitably exposes the Fed to some risk. This might be credit risk; this might be term risk; this might just be a plain negative spread.
The key point is that governmental losses matter, because they hit the asset side of its balance sheet. This is by design. The Fed's liabilities, which are the deposits all banks have placed with it, are unchanged when an asset it owns defaults. If the Fed suffers significant loss, as it almost certainly will on the securities it's already bought, it must recapitalize itself through either:
I don't think it will be beneficial to require the government to recapitalize itself to an enormous degree. The damage it would cause to the rest of the economy would be far too great.
If we're only successful in reigniting inflation, the Fed's predicament is just as bad. It normally would curb an inflationary spiral by selling Treasuries into the market, but it doesn't have any of those left. It could stop rolling over repos, but then it blows up the banks on the receiving end. The assets it bought during the crisis go down in value as inflation increases. It falls deeper and deeper in the hole.
As lucifer points out, "gold based or strict credit economies cannot create the infrastructure and technological breakthroughs we are accustomed to." Fractional-reserve banking, for all its propensity to cause calamities and ruin fortunes, is collectively a great system. It spurs real innovation and development like none other in history.
We also have to be careful not to obscure market pricing too badly through excessive intervention. The entire point of our market economy is to allow people to move to where they are most useful. Price is the signal they follow. Deflation, securitization, and other issues already weakened this transmission. Buying everything out as the government severs the invisible hand completely and buries it somewhere on the Fed/Treasury balance sheet.
Current efforts to reinflate our debt structure may succeed. I view this success as undesirable at present due to the impairment of the Fed's balance sheet and the likelihood that we would emerge only with higher total debt loads and a propensity for the next collapse to be even worse.
I believe it's best to stop attempting to backstop all deposits and all banks, because we will be unable to do so without causing severe damage, outpacing the damage done through allowing some companies and banks to fail. Too big to fail has truly become too big to save. Instead, we will try to share losses amongst depositors, creditors, owners, and the government.
Solutions at this point will be unfair to somebody. They have to be. We've collectively promised too much to ourselves and that reality will be faced regardless. Our goal is to protect all individuals and the system itself as much as possible, and share the burden as we readjust to new expectations. For this to be politically palatable, a great deal of suffering will have to already have taken place. Nobody will agree to this unless it's eminently apparent that there is no better choice. Once they do, it's the government's thankless job, as it has been since time immemorial, to decide who gets screwed, and how. Communicate explicitly, clearly, honestly, and persistently.
Chris reminds us that bankruptcy courts have always been responsible for doing precisely this job. They decide who loses least for the best outcome for everybody. They're pretty good at this job. We should let them do it.
I still don't think this plan would work, because I believe current pressures and feedback loops are too strong. I prefer it to others I've read, though.
At all costs, we must protect the integrity of and trust in our government. If we lose that, we've lost something far greater than our economy and financial system. I love my country, and others should feel that way too.
Thanks for all your time. I really appreciate it during this crisis. Here's a black swan for your trouble. Photographed by me at the Sichuan Panda Reserve's Swan Lake.
