Ceci n'est pas un post.

I don't have time to post right now, and besides, I promised myself that the next post would be a disquisition on regulation, in response to Dani Rodrik. (My two neurons are working real hard on that.)

But, today I am white-hot mad over AIG, and I need to vent. Yves Smith has done a beautiful job of describing the ridiculous awfulness of today's "restructuring". More importantly, she uses words with the appropriate intensity and valence: "banana republic", "looting", "Mussolini-Style Corporatism".

For so many years, Milton Friedman passionately argued that there is a relationship between economics and political life. In particular, he believed capitalism to be uniquely compatible with a free society.

What kind of society is compatible with an economy managed by a cadre of large, politically connected firms whose operations and those of the state are intimately connected, and which cannot be permitted to fail since that would bring "chaos"? Friedman would have remembered. "Mussolini-style corporatism" can't be quarantined at the corner of Liberty Street and Maiden Lane. Trillion dollar bail-outs represent claims on scarce resources. If times get hard, the idea of scarcity will become a lot less abstract. The state will be called upon to enforce "property rights", including rights to the property that the state is right now giving away (and which in turn are being given away to the truly deserving). First there are economic emergency measures. Later there may be emergency measures of a different sort. Mixing my libertarians, there is more than one road to serfdom.

It is so odd, how we are becoming inured to these sums, $150 billion for AIG, $140B in tax breaks to encourage consolidation into bigger and more dangerous banks, the hundreds of billions in equity infusions under the modified TARP plan, etc. The Fed's balance sheet has expanded by more than a trillion dollars over the course of several weeks, almost all of which is used to offer one form or another of covert subsidy to financial firms. A bit hyperbolically, I thought, I once compared the scale of the Fed's interventions to the direct cost of the Iraq War. Now that seems quaint. The scale of the government's response to the financial crisis now completely dwarfs the direct costs of that war, as well as any plausible estimates of the indirect (financial) costs. (Obviously, the real costs of war are not financial, and run much deeper than our economic problems. I hope the comparison doesn't seem flip.)

Of course, we are constantly told, all of this is an "investment", no money has been spent, the taxpayer may even turn a profit.

That's an argument that sounds reasonable only until you give it a moment's thought. Nearly all "government spending" (outside of entitlement transfers) is investment. When we build schools, run head start programs, buy fighter jets, and fund our court system, that is not "consumption". We don't do those things because we enjoy them, but because they create ongoing payoffs that we believe outweigh the opportunity cost of our funds.

When a firm purchases inventory, when it installs new machinery or operates a research lab, we don't claim that it has "consumed" its wealth. Investment is something we do in the real world. Financial claims are only faint, imperfect echoes of real investment. There is a bitter irony in the fact that, precisely when bankers have profoundly debauched the value of paper claims, taxpayers are being told that they are not spending, they are investing, when they buy unmarketable securities. Of course it would be "spending" to build a power grid or an airport.

Now, perhaps the government is a very poor investor. But do we have reason to believe that it is more skilled or less corrupt when it invests in financial claims rather than real projects? I find the case for a 16% real return on early childhood education far more compelling than the case for 5% nominal coupon on Goldman preferred stock.

It is likely that taxpayers will turn a paper profit on their paper claims against financial institutions. But that's not because they are good "investments". It's making these investments good is now a constraint on government action. The Fed cannot behave in ways that would compromise the value of the trash on its balance sheet. Once AIG was too big to fail, it cannot fail, no matter how big the black hole grows. Once GM enters the penumbra, very soon now, it also must not fail. Of course, we will not count this terrible loss of policy freedom as a cost.

That cost may be quite large. A commonly held view is that yes, the Fed's interventions are extraordinarily expansionary, and yes that could lead to inflation sometime far in the future. But for now we have D-leveraging, D-flation, D-pression to worry about. The Fed retains its traditional tools to fight inflation with, when the time comes. It will be able to sell Treasury bonds for cash and "mop up" all this "liquidity" it has "injected" into "the system".

But wait. The Fed doesn't hold very many Treasury securities any more (see Kady Liang). It would have to sell off some of the other stuff. Maybe we get lucky, and by the time we need to fight inflation, all those "money good" CDOs turn marketable again. Maybe not, though, and then the Fed will have little choice but to tolerate a great inflation or watch its own balance sheet implode. When the inflation comes, bright investment bankers will have already converted the bonuses we paid them into real property. It will be ordinary savers, and especially workers without bargaining power, who will be stiffed with the bill.

I think either a great inflation or a catastrophic deflation are pretty much unavoidable. It's the distributional effects that have me white hot with rage. We are sowing the seeds of inflation by making those most deserving of catastrophe whole, while doing nothing for those whose wages may soon achieve purchasing power parity with the emerging world. I'm actually cool with inflation — hey, all my money's in gold. A sharp inflation would be a kind of large-scale Chapter 11, a systemic debt-to-equity cramdown, debtholders get their claims devalued but the firm's nation's economic life goes on. However, inflation is a wealth transfer, and we should be conscious of from whom and to whom. For every dollar of Federal largesse that goes into the Wall Street bonus pool, three dollars should go into extremely generous unemployment benefits, paid sabbaticals for workers to return to school and retool, anything and everything to give people bargaining power to negotiate higher wages without all the hassle a union. Let's pass the "Take this job and shove it act of 2009".

Because the only thing worse than a great inflation with a wage/price spiral is a great inflation without one.

Steve Randy Waldman — Monday November 10, 2008 at 8:37pm permalink
Alex Thompson (mail) (www):
Wonderful post.
11.10.2008 9:57pm
The Fed doesn't need to sell the assets on its balance sheet to mop up liquidity any more. Now that it pays interest on reserves, it can get the banking system to sell asset instead.
11.10.2008 10:03pm
RueTheDay (mail):
And in other news, American Express is now a bank holding company......
11.10.2008 10:04pm
Steve Randy Waldman (mail) (www):
Marc — It can get the banking system to lend it back. (Selling assets only mops up liquidity if the seller hoards the cash proceeds, which typically only the Fed will do.)

Anyway, maybe.

I do a lot of thinking about the implications of a "floor" system -- printing too much money, but paying interest to sterilize (ht Aaron Krowne). It's clearly something in between traditional unsterilized cash and reserves removed via asset sales. On the one-hand, with a sufficiently high interest rate, banks have an incentive to leave the liquidity with the Fed. On the other hand, it's still zero maturity money, so the dynamics are complicated. In a stochastic sense, more dollars will still come and go than would be the case with no longer extant cash, so even if the interest rate is sufficiently high, it won't be as effective as traditional open market ops. But what gets interesting is how quickly the Fed might have to track the market -- suppose lots of cash is "sterilized" by being on-deposit with the Fed at a paid rate. Suppose market conditions change, and good projects / higher rates are on offer elsewhere. Then the quantity of reserves suddenly spikes, until either the deposited reserves are depleted or the interest rate of marginal projects is consistent with holding reserves. The Fed can always raise interest rates to prevent withdrawals, but they'd have to be fast, and of course that limits their interest-rate policy independence. Or they could buy assets to return to the previous interest rate target, but again, the "quantity" of base money will have spiked. (They can also lend via a stigma-free discount window, if one exists, but same issue.)

A lot depends on the question of what is more important for price stability, the price of short-term money (i.e. short-term interest rates) or the quantity of zero-maturity base money in circulation. I don't think we really know that. The recent consensus has been that controlling an interest rate is enough, but the recent consensus on a lot of things is a bit wobbly lately.

The Fed's ability to at least partially sterilize its own asset purchases definitely gives them a lot more freedom and policy flexibility. But if they overuse it, if they really "print" a lot of money expecting to be able to control the price level by paying interest, I expect they'll find themselves in a bind where either they have to tolerate higher interest rates or higher quantities of reserves.

A symmetric "channel" monetary policy is one thing, with central bank interest payments as a fail-safe. But a "floor" monetary policy is something else entirely, a brave new world of central banking. I expect we'll see how well or poorly it works, pretty soon.
11.10.2008 10:45pm
Independent Accountant (mail) (www):
Hyperinflation, or at least much higher inflation rates are coming. At this point, with the Fed's balance sheet exploding, it's too late to be avoided.
11.10.2008 11:21pm
Benign Brodwicz (mail):
[In the absence of a fair social and economic structure...] The most direct state-sponsored remedy for distributional atrocities at the personal level (the only level that matters) are more progressive personal taxes.

We'll see how much teeth President Obama's tax reforms wind up having, when most of his financial advisors work for or have made their fortunes with hedge funds.

Money = credit = power for the well-connected in the fascist model... but can the Internet truly give power to the people? It got Barack elected, I am convinced. The people who say he was "chosen" by the elite ignore the truly Davidic victory he won over the Clintons *and* the Bushes... over the entire Establishment.

Follow the money. Most of Barack's money came in <$500 dollops, and he took only a grand of PAC money. It just so happens that a lot of educated financial people still have egalitarian impulses, it would seem.

And aren't all these troubled financial firms supposed to pay this bail-out money back with interest? I cling to hope....

See Global Guerillas' link to Dmitry Orlov's stages of collapse for a bleak view of the future from one who lived through the collapse of the Soviet Union. I give us much better chances—a recession milder than the 'Seventies' or the 'Eighties', and 5%-10% inflation. I will post model results to support this that have performed well in forecasting the last two recessions in real time, if I get around to it.

All this assumes tht there is an optimal level of inequality that pretty much everyone on this blog agrees we've exceeded.
11.10.2008 11:55pm
Excess reserves are for the most part now an alternative funding mechanism for the Fed's asset expansion initiatives. The only substantive difference between that and issuing treasury bills is that the funding gets monetized via banking system intermediation. (Note that the Fed doesn't have to sell its own bills as the alternative. The government can issues new ones and park the money indefinitely in its Fed account as a source of sterilized funding.)

Paying interest on reserves is the quid pro quo mechanism now required to control the lower bound for the funds rate. (They're definitely having problems with rate control in the short term. I expect these operational problems will be temporary – there are too many crosscurrents now in the confusion of the current transition. And I'm not convinced by the explanations on Econbrowser on this subject.)

Excess reserves won't be a future problem. If things get to the point where we can be worried again about Fed induced credit expansion because of excess reserves, that will also be the point where the Fed can start unwinding its extraordinary asset accumulation (domestic and swaps). That will probably coincide with a tightening cycle for the fed funds target rate. The Fed should be taking its cue from developments in the broad credit aggregates in order to judge when such asset unwinding/tightening may be appropriate. It could be several years or more, depending on how bad things get.

That said, if one really is worried about base money all of a sudden, it can always be extracted very quickly by funding the Fed with more treasury bills instead.

I interpret the Fed's extraordinary balance sheet initiatives in this environment as anti-deflationary rather than deflationary. I have no particularly strong view on the ‘big inflation' problem. That said, the reappearance of inflation at some point may simply be an inversion of Keyne's ‘long run' warning. But I don't see the Fed's ‘tool kit', including its current balance sheet operations, as being an impediment to fighting inflation if and when it arises. There is certainly no monetary architectural reason why they won't be able to increase interest rates as much as Volcker did, if necessary. The issue then will be political will.
11.11.2008 1:29am
Previous should read "I interpret the Fed's extraordinary balance sheet initiatives in this environment as anti-deflationary rather than inflationary."
11.11.2008 1:32am
Steve Randy Waldman (mail) (www):
JKH — Fundamentally the issue is the maturity structure of the consolidated Fed / USG balance sheet. Right now, USG borrows very, very cheaply throughout the curve. Ideally, if I were Mr. Treasury (or Mr. Fed), I'd be borrowing as long as the market would bear without moving too deeply against me. SPF borrowing tends to be short (two months to a year-ish), but funding via reserves is very short -- it is funding by overnight loans basically.

The question is what happens if there is pressure for USD interest rates rise across the curve. The Fed is never powerless on the short end: it can always issue enough cash (through purchases or lending schemes) so that the marginal dollar is lent back at its deposit interest rate. But what's not known are the inflationary consequences of forcing a low interest rate target in the face of hot money capital flight. My intuition is that even for the world's reserve currency, that would be inflationary. I could be wrong. A "floor" monetary policy has never been tried by a major economy, and even if it had, experience during the "great moderation" may well not translate to current and future periods.

In a sense, though, what's old is new again. If we consider the consolidated Fed/USG balance sheet, what's going on is simply government borrowing on an enormous scale at short maturities. That's risky. You are right that the Fed/USG always has the power to fight inflation with sufficient political will. But that might well mean accepting high interest rates, large defaults, balance sheet insolvency of the Fed, tight fiscal policy, large losses to taxpayers, and a severe deflation. Alternatively, as James Hamilton has been arguing, the Fed always has the power to fight deflation, or to create inflation. The core question, the answer to which I think precisely nobody knows, is whether there is an achievable middle ground, some stable or gently oscillating facsimile of price stability. I'm a pessimist: I think that money has become too "post-modern" given the scale of the bail-outs, and am cynical that it can maintain its role as a stable store of value unless very draconian (and anti-Keynesian) policies are adopted, which I consider very unlikely. (I think the costs would be far worse than in the Eighties, because we are collectively much more levered.) But I'll be the first to admit that this is an intuitive position, and it could be quite wrong. I am chewing on my popcorn, and hanging to the edge of my seat.

(By the way, I'm not really opposed to the continuing heroism of the Fed/Fisc duo -- I just want it redirected from the people Paulson favors to the people I favor. It's yucky to put it that way, but that's where we are, isn't it? We'll all make normative arguments "systemic stability" vs "equity, moral hazard, and a middle-class society". Choose your poison.)

I think you are a bit oversanguine, "if one really is worried about base money all of a sudden, it can always be extracted very quickly by funding the Fed with more treasury bills instead." The point is to worry about a funding crisis while the economy remains overleveraged and fragile. That would affect both Fed deposits and Treasury borrowing costs.

But I do agree with you (I think we've agreed on this before) that so far, "the Fed's extraordinary balance sheet initiatives in this environment [have been...] anti-deflationary rather than inflationary." Looking backwards and at the world today, that's precisely right. The question is looking forward, have we painted ourselves into a corner? Do we have the tools to manage the risks we have effectively shifted from private sector to public sector balance sheets?

Let's both enjoy the popcorn, wait, and see.
11.11.2008 2:44am
Massimo GIANNINI (mail) (www):
You are right. I think that we should start to do some math on all "investments" already made and their returns. AIG is a blackhole at present. When somebody is suggesting a bold fiscal stimulus, I would like to see some prioritization and again financial math of further government spending...
11.11.2008 3:09am
Boy, nothing like impending doom to get the juices flowing!

It seems to me that there is a big elephant in the room in the form of some combination of lack of foresight, incompetence, malfeasance, etc.

Some of the hypothesizing on future actions to clean up the mess currently being created, while very interesting and instructive, comes across to me as rationalization. I have seen nothing in the actions of the authorities since the inception of the current crisis to indicate that they are thinking ahead or thinking constructively. I dare say it's a safe bet that they'll continue to do what they're doing until their proverbial Minsky moment arrives. When it does it will more than likely be too late.

Steve, since you brought up "emergency measures", I recall once again the famous Lord Acton quote I mentioned a while back. I have been truly scratching my head as to what it would take to open enough people's eyes to make a difference and get rid of this wretched Fed-based financial system. Some of the historical crises seem to have been so devastating and yet the system survives. Obviously nobody knows, but I would welcome your insight as to whether there is anything to indicate that "this time it's different." After all, repeated widespread suffering has not been a sufficient condition, even if it may be necessary, as we're witnessing.

Sorry for getting a bit emotional.
Maybe I'll go buy some gold so I'll feel better. :-)

Thanks for another great (non) post.
11.11.2008 4:56am
RueTheDay (mail):
Re: the Fed paying interest on reserves - If you remember, the Fed was pushing this earlier in the year when it believed that the financial crisis could be contained to the financial markets without impacting the real economy. The Fed wanted to be able to turn on the liquidity firehose while keeping the Fed Funds rate moderately high so as not to provide too much of a monetary stimulus to the economy. Those days are over, the crisis has spilled over, and the Fed is now in full-on easing mode, so the whole channel/corridor model is less relevant right now, but will likely represent a sea change in how monetary policy is implemented in the future during more normal times.
11.11.2008 6:07am
That's an interesting point on the maturity structure of consolidated USG/Fed borrowing. It would be prudent liquidity management now to extend term on this stuff where possible, taking advantage of the flight away from private sector risk and current curve pricing. And you're right that with reserve balances now at $ .5 trillion, the effect on consolidated maturity structure is non-trivial (although the eventual retirement of excess reserve funding, if and when it happens, would in itself extend the average consolidated maturity).
11.11.2008 8:22am
Not Yves (mail):
FYI, it's likely that Yves Smith is a "he," not at "she."
11.11.2008 1:54pm
Not Yves:

Here's fairly sound proof that Yves is a "she":

11.11.2008 2:07pm
11.11.2008 2:11pm
Lasse Enersen (www):
Very good post. Especially loved the fact that investing in early childhood education is a lot better investment than any ole Sachs paper :)
11.11.2008 2:50pm
Benign Brodwicz (mail):
11.11.2008 4:23pm
Andrew Neilson (mail):
Great post. By some eerie timing, I am currently reading Atlas Shrugged for the first time...many parallels between the Washington/Corporatist axis in the book and today. Lots of 'James Taggert'-like looters and value-destroying insiders around today. Who is John Galt in 2008?
11.11.2008 9:33pm
reason (www):
Steve I'm becoming a great fan of yours. This post is brilliant. The looting of the treasury by wall street should provoke much more anger than it has. I noticed that the Germans find it bemusing:

Are you aware of Steve Keen? What do you think of his ideas?
11.12.2008 6:56am
Justin Rietz (www):
Frankly, I think the Fed and USG are as baffled as we are. Their policy recommendations and implementations are all over the place, and it is clear that they don't know what to do.

It is for this reason that that I don't think the Fed will be able to avoid the inflationary pressures that likely result from the current monetary and fiscal policy. No one has the omiscience to know what to do and when to do it. This is the exact reason why we have free markets - central planning does not work.


P.S. - I didn't realize that the email address I entered when writing my comment would appear in the comment (most blogs don't publish the email address publicly).

Any way to remove this? I'm a bit of an anti-spam fanatic..
11.12.2008 10:10pm
say it ain't so joe:
Nov. 13 (Bloomberg) -- The great and the good of capitalism and free markets held a requiem dinner for the global financial system at a secret hideaway this week. As the waiter decanted a fresh bottle of 1985 Chateau Margaux, the blame game began.

``I blame the central banks,'' growled the bond trader, stabbing the air with a forkful of raw steak. ``If Alan Greenspan hadn't kept interest rates so low at the start of this decade, we wouldn't be in this mess. Talk about refilling the punch bowl when the party guests are already as drunk as skunks!''

``We told you we were not in the business of identifying bubbles, let alone trying to puncture them,'' replied the central banker, nibbling at a lettuce leaf. ``We warned you that credit spreads, emerging-market yields and volatility in stocks and bonds were all too low, and that you were under-pricing risk.''

The central banker took a sip from his refilled wine glass. ``Can you imagine the outcry if we had tried to halt the explosion in home ownership? I think you'll find that the true villains are the mortgage lenders; if they hadn't trashed their standards with self-certified and liar loans, the crisis in the housing market would have remained self-contained.''

``That's not fair,'' said the mortgage originator. ``We weren't on a level playing field. Fannie Mae and Freddie Mac were using their implicit government guarantee to distort competition in home loans. We were forced to take on more subprime borrowers just to stay in the game; if it hadn't been for all those clever derivatives products, we would never have been able to recycle all that toxic waste and keep the pyramid scheme afloat.''

Above Board

``Ah, the derivatives bogeyman,'' chuckled the structured- finance specialist. ``Listen, derivatives don't kill markets. Markets kill markets. Everything we did was designed to promote efficiency by allowing investors to disaggregate their risks. I can show you the bills from my lawyers to prove that every product we invented was legitimate.''

``All we did was offer advice on the best method of structuring securitization transactions,'' the capital-markets lawyer said. ``There would never have been a market for the racier collateralized-debt obligations if the rating companies had done proper due diligence, instead of slapping AAA ratings on anything and everything that offered to pay them a fee.''

``You can hardly expect the finest minds in finance to come and work for us when they can earn gazillion-dollar bonuses doing the same work for an investment bank,'' said the credit-rating assessor. ``We relied on the computer models that the banks helped us build, and those models turned out to be, shall we say, less than perfect. Besides, everything was fine until the money- markets froze. The problem wasn't over-optimistic ratings, it was an over-reliance on wholesale markets to fund leverage.''

On the Hook

The waiter cleared away the dinner plates. The diners all declined dessert -- ``Humble pie? No, thanks.'' -- agreeing instead that a couple of bottles of 1982 Chateau d'Yquem would round off the evening nicely.

``I'd never even heard of Structured Investment Vehicles until they started to blow up,'' said the central banker. ``We believed the banks when they said their business model was based on originate-to-distribute; how were we to know that once the music stopped, they were still on the hook for trillions of dollars of liabilities they'd slipped off the balance sheets?''

``Look, domestic savings rates just weren't high enough to provide the kind of leverage we needed to juice our returns to match those of our peers,'' said the commercial banker. ``We had to rely on money-market funds, rather than our deposit base. And the money markets wouldn't have frozen if it hadn't been for those ridiculous mark-to-market rules forcing all of us to prematurely disclose that we owned huge piles of securities that were rotting, before prices had any chance to recover.''

Capital Inadequacy

``We gave you plenty of leeway to play fast and loose with the truth so that you could stay solvent,'' said the regulator. ``Besides, you were just doing your job of maximizing returns to shareholders. If those greedy investors hadn't forced you to take on more risk, our rules on capital would have been more than adequate to keep the banking system solvent.''

``How on Earth was I supposed to fund the retirements of thousands of ex-employees when returns were collapsing simultaneously in every market?'' asked the pension-fund manager. ``Of course we wanted the banks to work their capital harder. We were in the same boat, trying to move money into new arenas to make a buck or three. We bought derivatives, commodities, we even held our noses and gave money to the hedge funds. That didn't turn out to be such a good idea.''

``Hey, we warned you there would be times like this,'' said the hedge-fund manager. ``If you want years when we deliver 50 percent, 60 percent returns, you have to expect periods when we will lose 20 or 25 percent of your money. You won't see us lining up with our begging bowls at the government bailout window.''

The waiter coughed, proffering a slim leather folder containing the reckoning for the evening's entertainment.

``You are a taxpayer, I take it?'' asked the investment banker. The waiter nodded. ``In which case, we were rather hoping you would foot the bill.''

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)
11.13.2008 7:30pm
Umoo Dot Com (mail) (www):
As this article so accurately describes, the Fed is increasingly favorable of large corporations and providing bailouts for their shortfalls. While it is in some cases necessary to the security of the general public, the "absorption of wealth" by companies such as AIG puts President-Elect Barack Obama in a precarious position. The inherited debt increases daily due to the failures of these companies, but "spending" in the form of investment in our nation's infrastructure and job market is vital. It will surely be interesting to track how fiscally disciplined Obama can be during his first 100 days while protecting against a total collapse.
11.24.2008 12:24pm
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