How to fix the financial crisis

Just when you were wondering whether we’d ever come through at Pontification Central, over the fold we explain how to fix the financial crisis is explained in full.

Well not really.  I’m buggered if I know.  But this post from Thomas Palley seemed as ‘on the money’ as any I’ve seen lately.  

The Liquidation Trap

The U.S. financial system is caught in a destructive liquidation trap that has falling asset prices cause financial distress, in turn compelling further asset sales and price declines. If unaddressed, it risks sending the economy into deep recession or even depression.

Current conditions are the result of bursting of the house price bubble and the end of two decades of financial exuberance. That exuberance was fostered by a cocktail of forces.

First, economic policy replaced wages and productive investment as the engines of growth with debt and asset inflation. Second, greed and free market ideology combined to promote excessive risk-taking and restrain regulators. This was encouraged by audacious claims that mathematical economic models mapped reality and priced uncertainty, making old-fashioned precautions redundant.

Recognition of the scale of financial folly has created a rush for liquidity. This is causing huge losses, triggering margin calls and downgrades that cause more selling, damage confidence, and further squeeze credit. That is the paradox of deleveraging. One firm can, but the system as a whole cannot.

Having failed to prevent the bubble, regulatory policy is now amplifying its deflation. One reason is mark-to-market accounting rules that force companies to take losses as prices fall. A second reason is rigid capital standards.

Application of mark-to-market rules in an environment of asset price volatility can create a vicious cycle of accounting losses that drive further price declines and losses. Meanwhile, capital standards require firms to raise more capital when they suffer losses. That compels them to raise money in the midst of a liquidity squeeze, resulting in fresh equity sales that cause further asset price declines.

Bad debts will have to be written down, but it is better to write them down in orderly fashion rather than through panicked deleveraging that pulls down good assets too.

This suggests regulators should explore ways to relax capital standards and mark-to-market rules. One possibility is permitting temporary discretionary relaxations akin to stock market circuit breakers.

Later, regulators must tackle the underlying problem of price bubbles. Currently, central banks are only able to control bubbles by torpedoing the economy with higher interest rates. New flexible measures of control are needed. One proposal is asset based reserve requirements, which systematically applies adjustable margin requirements to the assets of financial firms.

The Fed must also lower interest rates, and not just for standard reasons of stimulating spending. Lower short term rates are needed to make longer term assets (including houses) relatively more attractive, thereby shifting demand to them and putting a bottom to asset price destruction.

Fears about a price wage inflation spiral remain misplaced. Instead, the threat is deep recession triggered by the liquidation trap. If inflation is a wild card, now is the time to use the credibility the Fed has earned. Emergency rate reductions can be reversed when the situation stabilizes.

The great irony is central banks can produce liquidity costlessly. Usually the problem is restraining over-production: today, it is over-coming political concerns about bail-outs. Those concerns are legitimate, but they also risk inappropriately restricting liquidity provision and unintentionally imposing huge costs of deep recession.

At the moment the Fed is protecting banks and the treasury dealer network but leaving the rest of the system in the cold. That is perverse given how the Fed went along with expansion of the non-bank financial system. Instead, the Fed should consider an auction facility that makes longer duration loans available to qualified insurance and finance companies too.

The facilitys guiding principle should be an expanded version of the Bagehot rule. Accordingly, the Fed would auction funds at punitive rates, with loans being fully collateralized. The goal should be to facilitate repair of distressed financial companies with minimum market disruption and at no taxpayer expense. By creating an up-front facility, the Fed can get ahead of the curve and reduce need for crisis interventions that are always more costly and disruptive.

Among financial conservatives there is a view that financial markets deserve punishment for their sins and only that will cleanse them. This view is often presented in terms of need to restore market discipline and stay moral hazard.

The view from the left is strangely similar, arguing Wall Street fat cats need to be punished. Asset prices should fall, banks must eat their losses, and all but the most essential financial firms should be allowed to fail.

Both views have a moralistic dimension, and both risk unnecessary economic suffering. The mistakes of the past cannot be undone. All that can be done is to minimize their costs and then truly reform the system so that they are not repeated.

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29 Responses to How to fix the financial crisis

  1. Bill Posters says:

    So in other words, now that the profits of the boom have been privatised, the losses of the bust should be socialised.

    Not a lot new in that thought.

  2. Fred Argy says:

    Is this another version of the Resolution Trust Corporation, which is designed to create a new temporary resolution mechanism for a short period? It would mean buying up at “fair market prices” and allow a more orderly liquidation of assets.

    But what is “fair”? And then there is the Bill Posters concern about profits being privatized and losses socialized. But here I am on the side of the angels: I believe there are wider economic externalities to consider here. Large investment companies should be allowed to fall but not at when we are in the midst of a financial crisis.

    It certainly is not the kind of thing Stevens suggested – which was to introduce higher interest rates in times of booming asset and credit markets even when inflation was contained.

  3. Chris Lloyd says:

    It is not a bail out if you lend money at a high spread with full collateral. Its a more like a government take over (of ownership but not governance).

    I think the moral hazard problem is more serious. If every large institution believes (with good reason) that that they are government guaranteed they will build that into their future behaviour. They would be silly not to. I sure would!

    The author hopes to “minimize the costs and then truly reform the system so that they are not repeated.” The US government will do the first because the costs are visible and present. I do not see much chance of the them reforming the system when things settle down, as the payoff will be vague and potential, not to mention the huge financial and political constituents hostile to any form of government intrusion.

  4. JC says:

    I’m not sure where the moral hazard is for the AIG managers and shareholders, Chris. Perhaps there may be for bondholders and sundry creditors and even then they rank behind the US government/Fed in terms of getting their money back. So moral hazard based on the AIG platform looks pretty horrible from any stand point.

  5. Bingo Bango Boingo says:

    Bill, only a person who is wilfully blind to what has been going on could come up with glibness like “privatise the profits, socialise the losses.”

    The shareholders in these institutions have been wiped out. And rightfully so! They’ve only got themselves to blame. So massive private losses there. And of course a decent slab of the profits were socialised along the way through corporate and income taxation.

    BBB

  6. JC says:

    BBB:
    It’s actually in reverse in the AIG deal.

    It’s socialize the profits and privatize the losses. LOL.

    The Fed is making out like a bandit.

  7. niall says:

    effective nationalisation, but no mention of more strigent regulation. Horse bolted, barn door now firmly shut.

  8. Michaeel Kalecki says:

    the Fed should have cut the Federal funds rate to 1% as soon as possible and make the yield curve out to three years as steep as possible.

    Until Banks get profitable as soon as possible they will simply limp along.

    As it is Rogoff and Reinhart are saying the US will have a number of sub-standard growth. This seems highly possible

  9. JC says:

    the Fed should have cut the Federal funds rate to 1% as soon as possible and make the yield curve out to three years as steep as possible.

    90 day T notes were at a few basis points. How are you going to steepening things with those sorts of rates, “Michael”

    Until Banks get profitable as soon as possible they will simply limp along.

    ummmm Who would have thought. Thanks

    As it is Rogoff and Reinhart are saying the US will have a number of sub-standard growth. This seems highly possible

    Yes it’s possible it will be highly possible, “Mick”

  10. Michaeel Kalecki says:

    you are confusing the federal funds rate with treasury notes.

    the Fed obviously didn’t think of it otherwise they would have done it.

  11. JC says:

    What am I confusing now Homes? What have I done now that makes you angry? I havent confused anything at all. Here:

    Heres last nights US yield strip for US government paper

    %
    3 mth .7
    6 mth .86
    12 mth 1.52
    2 year 1.90
    3 year 2.16
    5 year 3.6
    10 year 4.12

    To get a positive yield curve you would have to set the fed funds rate at zero? Dont be a dumphy, Homer.

    But yes they do have room to lower rates a smidgeon but they have to be really careful as they could fire up commodities again.

    Since the announcement of the RTC last night where the Treasury is going to create a toxic waste dump for those radioactive instruments they may not actually have to lower rates any more as this could stop the rout. Looking at Citigroups ongoing earnings from last quarter as an example they reported 6.5 billion in earnings before writeoffs so they are actually profitable from their ongoing operations.

    now homes as an aside and away from the topic. Do you still think latham’s Skank Ho comment was referring to the Taiwanese president’s mistress or do you think Skany Ho was an pejorative American Ghetto reference to a woman. Also can you tell us who in the NSW Labor right thinks that reference meant the Taiwanese leaders mistress? Honest question here Homes.

  12. JC says:

    the Fed obviously didnt think of it otherwise they would have done it.

    here’s my bet, homes. I think the Fed would have thought of it before you did. I know that’s a 100 to 1 shot but I would still take the bet. :-)

  13. JC says:

    sorry that 1 month should be .07%

  14. Tel says:

    Oh come on guys, here’s a suggestion… we have means, we live within those means. How complicated does this have to be? A bit of searching around comes up with this little tally:

    US Total Debt peaks
    1835 – 150pc of GDP
    1933 – 270pc of GDP
    2008 – 350pc of GDP and still rising at 20pc

    Wednesday, the US senate put through another “emergency” spending bill to dump another 70 gigadollars into their oil wars. These expensive acquisitions don’t return a profit, except for the Afghan poppy fields. The cost of which is paid mostly by Europe (the profit goes in an unknown direction).

    For Australia, the solution is simple: ease ourselves further away from the US economy and diversify our trade (and our loyalty) in as many directions worldwide as possible. Meanwhile make sure we have at least enough food, fuel and guns to be self-sufficient in the base essentials. The physical world always wins, the paperwork can say what it wants to.

  15. invig says:

    I know what to do.

  16. rog says:

    Its pointless comparing the GDP of 1835 to 2008 – unless we can find a way of exchanging currency through a time machine it remains a fallacy.

    In 1883 an FJ holden might well have been something that dreams are made of but without decent roads and a reliable fuel supply it would have been of no value at all.

    So what was the means that GDP was measured in 1883?

  17. Michaeel Kalecki says:

    JC,

    are you that ignorant you really do not understand the difference between the federal funds rate which influences other similar financial instruments and where banks get their funding from on ewholesale markets and treasury notes.

    Treasury notes went down in yield when market participants panicked and went for safety first.

    It had nothing to do with Fed policy

  18. JC says:

    are you that ignorant you really do not understand the difference between the federal funds rate which influences other similar financial instruments and where banks get their funding from on ewholesale markets and treasury notes.

    No Homes, i’m not ignorant, you are. I tabled the US interest rate out to 10 years.

    You argued that the Fed’s objective should be a positive yield curve. I simply presented the fact that the Fed would have to have the Fed funds rates at zero in order to act on your recommendation.

    Treasury notes went down in yield when market participants panicked and went for safety first.

    yes and?

    It had nothing to do with Fed policy

    I never said it did, scooter. I merely presented evidence that your recommendation of a normal yield curve would require zero as the short term rate. This isn’t another one of those Nazi economics defense screeds of yours, is it, Homes? they’re so boring now.

    Just accept that you latest recommendation is silly and apologize. I’m very forgiving of you. You know that.

  19. Tel says:

    Its pointless comparing the GDP of 1835 to 2008 – unless we can find a way of exchanging currency through a time machine it remains a fallacy.

    I was not comparing GDP across time. I was comparing the unitless ratio of total debt to GDP. In other words, an estimate of a nation’s ability to service their debt. Like taxation rate, it is a timeless concept.

  20. JC says:

    Tel:

    What if the world has changed since then. Why assume that the ” carrying ‘ capacity for debt was much more appropriate then than now? Do you have any evidence to show you’re right?

  21. Michaeel Kalecki says:

    JC,

    did you ever think of what would have happened if the FED had have cut the fed rate to 1% late last year.

    Imagine how that profitability would have helped the banks instead of being worried about inflation which was never going to impact core inflation.

    That is one of the reasons why treasury notes fell to absurd levels.

    you are the idiot arguing that there was no full employment on Germany

  22. JC says:

    did you ever think of what would have happened if the FED had have cut the fed rate to 1% late last year.

    No, but let’s go though it shall we.

    gold $2000 an ounce.
    Oil $200 buck a barrel
    BHP $65 bucks a share

    Euro/ US 1.75

    Aussie 1.1

    Yen 90

    Imagine how that profitability would have helped the banks instead of being worried about inflation which was never going to impact core inflation.

    umm okay. But look at what it also would have caused, dumphy.

    That is one of the reasons why treasury notes fell to absurd levels.

    Ummm Homes, you told us that the if the Fed had cut the Fed funds rate to 1% they would have engineered a positive yield curve. That wouldn’t have been possible according to the notes and bond strip i presented earlier. You’re wrong, so please apologize to the readers.

    you are the idiot arguing that there was no full employment on Germany

    Wtf. What’s germany got to do with the US yield curve, homester?

    Have you been hitting the turps?

  23. Michaeel Kalecki says:

    JC,

    only a genius could argue a yield curve the other day had any relevance to October or November last year.

    well no it didn’t cause that at all.

    If you had even had any idea of the yield curve back then you might have noted quite a steep yield curve.

    Never mind go and ask some-one who actually works in the financial markets.

  24. Tel says:

    Pascal’s Wager gives a reason to believe in God, surprisingly without providing any evidence of the existence of God. Sounds kind of clever at first. Sadly, Pascal’s Wager also provides a reason to become a Muslim, and a Jew, and a Necromancer and to believe in pink elephants and flying spaghetti as well.

    What if the world has changed? What if the old rules don’t apply anymore? Maybe everything we think we know is really wrong. Say paradigm three times and call me in the morning.

    I would argue that no country, nor empire in history has been able to escape a crisis by merely printing more money. Gamblers who regularly lose don’t suddenly start winning because they make bigger bets. A business that is unprofitable with a million dollar overdraft does not get profitable by clocking up a 10 or 100 million dollar overdraft… and so we go. Bad management does not turn into good management when handed a bigger budget.

    What amazes me is that we have all this infrastructure built around financial indicators, and a worldwide system of tracking economic activity and when all those indicators point to a problem, we decide that the answer must be to tinker with the measurement. Think about a steam engine driver who is watching the dial on the boiler pressure go up and up. So the dial gets into the red zone and he knows that it should never get into the red zone so he just cracks the faceplate on the meter and pushes the needle back down to a “safe” level. That’s the sort of behaviour we are dealing with here.

    Similarly, economic indicators are measurements (admittedly approximate measurements, but better than nothing) of a physical system. As mentioned above, the US is facing the problem that reducing interest to zero causes inflation to explode, while raising interest to even a few percent pushes it to recession (leaving them with almost no room to adjust). No one seems to believe that the approaching singularity is actually a needle on a dial that points to a problem in the physical world. Don’t look at what the economy is actually doing, just look at ways to tweak the indicators. It’s almost like the people who built the world economy secretly knew it was all a bit of a scam and they are now embarrassed to see that it is no longer possible to pick the answer that you desire and then make up a methodology to get to that answer.

    This does not fulfill my definition of wise leadership.

  25. JC says:

    Homer:

    Not for nothing, but this why people always end up getting angry with you.

    This is what you said at comment #8

    The Fed should have cut the Federal funds rate to 1% as soon as possible and make the yield curve out to three years as steep as possible.

    Theres no mention of this year, last year, 1850 or 1918.

    When I explained to you nicely (I might add) the 3 month US bill is about .07% therefore making zero the appropriate fed funds rate in order to create a positive yield curve you went off into a tangent with this incoherent comment:

    you are confusing the federal funds rate with treasury notes.

    the Fed obviously didnt think of it otherwise they would have done it.

    I then nicely explained to you that I wasnt confusing anything and that you should apologize to the readers for wasting their time. I didnt really expect an apology myself as I was just looking after everyone else. Do you notice how big hearted I am here, homes?

    Proving ignorance is bliss you then made this comment:

    are you that ignorant you really do not understand the difference between the federal funds rate which influences other similar financial instruments and where banks get their funding from on ewholesale markets and treasury notes.

    Treasury notes went down in yield when market participants panicked and went for safety first.

    It had nothing to do with Fed policy

    Sequentially this was even more incoherent than the previous comment, by the way..

    Suddenly without any warning whatsoever you introduce 2007 into the picture with this comment:

    JC,

    did you ever think of what would have happened if the FED had have cut the fed rate to 1% late last year

    .

    Again I was nice and calm with you as I politely explained what may have happened if the Fed had cut rates too far too soon.

    Now your idiotic idea of a zero funds rate (bcause that what it would have to be) in order to achieve a positive yield curve morphs into a cut in 2007 rather than in 2008

    See why everyone always gets cross and angry with you Homes? See why Im tired of always having to come out and patiently explain that youre smarter than what you normally appear. I feel like Im just always putting out fires for you Homes. No more Mr. Nice Guy from me now on.

  26. A NON FARMER says:

    Why not accept reality.
    At some level the finance sector has to realise that is dealing – or having to deal with reality.
    I read somewhere that there have been up to eleven layers of ‘scrip’ above actual transactions.

    Anyone might acknowledge that someone might want to take a risk by pledging money towards a damned good idea.
    Stretch that towards getting others sucked in to investing more towards a good idea.
    Take that one – or maybe eleven steps further – when the good idea is ditched, the money men have fleeced the turnout, departed the scene, and everyone in between is also left in the ditch – then we have compounded fraud.

    What has happened recently is that fraud has suddenly become recognised as existing. Hells Teeth – there it is!
    And it is endemic in the top three quarters of the money market.
    Amazing that. Even the jaded press has been trying to draw this little detail to public attention these last many months.
    It is time to recognise that the producers in society need a direct claim upon how finance is distributed.
    By producers I mean the primary and secondary industries that keep society functioning.
    Their asset is the modern equivalent of the Gold standard and should be recognised as worthhy of the same weight.

  27. JC says:

    It is time to recognise that the producers in society need a direct claim upon how finance is distributed.

    Wanna elaborate on that a little, NF as you seem to be getting awfully close to the One Nation’s/league of rights idea from decade ago wanting a zero interest policy.

  28. Michael Kalecki says:

    JC,

    One of your most endearing traits is to put a gigantic foot in your mouth when you try to be a smart alec.

    I do not have the time nor the interest to point out how many errors you have made but just find someone who works in the financial markets and they will point it out.

    By the way neither you nor anyone else would know the reaction of the market to a fed funds rats of 1%.

    It could scarcely be worse

  29. JC says:

    One of your most endearing traits is to put a gigantic foot in your mouth when you try to be a smart alec.

    Frankly Homer, “I don’t give a damn”. Dude I read and re-read everything I said and can’t quite see what i said was wrong. You’re not going into skanky ho defense mode, are you?

    I do not have the time nor the interest to point out how many errors you have made but just find someone who works in the financial markets and they will point it out.

    Homes, how about you? Lol

    By the way neither you nor anyone else would know the reaction of the market to a fed funds rats of 1%.

    Oh But you do, Homer Greenspan. You do , right?

    It could scarcely be worse

    Your comments? I know.

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