Rethinking subsidized finance

Regular readers know that I view proposals to fund bank asset purchases with high leverage, non-recourse government loans to be an objectionable form of hidden subsidy from taxpayers to private investors and bankers. Calculated Risk agrees.

But John Hempton points out that

all banking capital is non-recourse with the taxpayers — through the FDIC bearing the downside. As long as a fair bit of capital is required (as it should be required for banks) this is not dissimilar to new private money starting banks.

I doubt Calculated Risk would have an objection to that. The issue is not non-recourse — it is the ratio of private to public money because if only a slither of private money is required there is little real risk transfer to the private sector. If a lot of private money is required there is real risk transfer and this plan is the real-deal, but would reduce the chance that the private money could be found.

I gave ratios of 6.5 to one or 7 to 1 because those were about a third where banks were allowed to operate and these funds will hold what on average will be riskier assets. Numbers — not the concept — should be the realm of debate.

I won’t speak for CR, but some of us would disagree with JH’s presumption that status quo banking with new money would be unobjectionable. Nevertheless, it is wonderful to see put in writing that all banking capital is non-recourse with the taxpayers. Taxpayers write a put option to depositors (and implicitly to other bank creditors), in exchange for a premium in the form of a deposit insurance fee. JH’s plea that we should look at the numbers is characteristically on the mark: In option terms, both the value of the bankers’ put option and its “vega” — the degree to which its value is enhanced by bank asset volatility — are dependent upon the amount of non-recourse leverage provided.

These are precisely the terms in which we should view the banking industry’s quest for every greater leverage over the past decade, with all those SIVs and AIG regulatory capital products and whatnot. They were trading-up, from a modestly valuable, out-of-the-money option written by taxpayers to a near-the-money option whose value could be dramatically increased by taking big chances. It’s as if you sold a put option on a $100 asset with a strike price of $85 to someone, and somehow that fothermucker changed the terms of the contract so that the strike was $100 while you were stuck on the other end of it without being paid a dime more in premium. Any private investor would consider themselves cheated by this kind of switcheroo. Banks were robbing taxpayers ex ante, not just during the crisis, by endlessly maximizing their value on zero-sum option contracts with governments caught on the other side.

As even Paul McCulley, the PIMCO dude, acknowledges

it has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises. To be sure, they have private shareholders. And, yes, those shareholders get all the upside of the net interest margin intrinsic to the alchemy of maturity and risk transformation. But the whole enterprise itself depends on the governmental safety nets.

Banking-as-we-know-it is just a form of publicly subsidized private capital formation. I have no problem with subsidizing private capital formation, even with ceding much of the upside to entrepreneurial investors while taxpayers absorb much of the downside when things go wrong. But once we acknowledge the very large public subsidy in banking, it becomes possible to acknowledge other, perhaps less disaster-prone arrangements by which a nation might encourage private capital formation at lower social and financial cost. Rather than writing free options, what if we defined a category of public/private investment funds that would offer equity financing (common or preferred) to the sort of enterprises that currently depend upon bank loans? Every dollar of private money would be matched by a dollar of public money, doubling the availability of capital to businesses (compared to laissez-faire private investment), and eliminating the misaligned incentives and agency games played between taxpayers and financiers who would, in this arrangement, be pari passu. Also, by reducing firms’ reliance on brittle debt financing, equity-focused investment funds could dramatically enhance systemic stability.

Private-sector banking has not existed in the United States since first the Fed and then the FDIC undertook to insure bank risks. There is no use getting all ideological about keeping banks private, because they never have been. We want investment decisions to be driven by economic value rather than political diktat, but at the same time capital formation has positive spillovers so we’d like it to be publicly subsidized. How best to meet those objectives is a technocratic rather than ideological question.

In thinking this through, I don’t think we should give much deference to traditional banking, on the theory that we know it works. On the contrary, we know that it does not work. Banking crises are not aberrations. They are infrequent but regular occurrences almost everywhere there are banks. I challenge readers to make the case that banking, in its long centuries, has ever been a profitable industry, net of the costs it extracts from governments, counterparties, and investors during its low frequency, high amplitude breakdowns. Banking is lucrative for bankers, and during quiescent periods it has served a useful role in financial intermediation. But in aggregate, has banking has ever been a successful industry for capital providers? A “healthy” banking system is arguably just a bubble, worth investing in only if you’re smart enough or lucky enough to get out before the crash, or if you expect to be bailed out after the fall.

If banks were our only option, we might think of them like airlines — we’ve never figured out how to run the things profitably, but we do want commercial air travel, so we find ways to cover their losses. But at least with airlines, the costs are relatively modest, and we constantly experiment in hopes of hitting on a sustainable business model. Despite being catastrophically broken, the core structure of banking has been fixed in an amber of incumbency and regulation since the Pleistocene era. It’s long past time to try something else.

 
 

37 Responses to “Rethinking subsidized finance”

  1. Next-gen (narrow) banking can be understood in four steps:

    1) Read in Paul Romer’s entry on Economic Growth in the 2007 edition of The Concise Encyclopedia of Economics:


    “Perhaps the most important ideas of all are…ideas about how to support the production and transmission of other ideas…North Americans invented the modern research university…As national markets for talent and education merge into unified global markets, opportunities for important policy innovation will surely emerge…There are…safe predictions. First, the country that takes the lead in the twenty-first century will be the one that implements an innovation that more effectively supports the production of new ideas in the private sector.”

    2) Read in the April 20, 2008 edition of the New York Times:


    “In 2005, each year of college yielded an additional 12.9 percent. The rate of return from each year of graduate school has risen even more…to 14.2 percent.”

    3) Read in Disrupting Class: How Disruptive Innovation Will Change the Way the World Learns, a 2008 book co-authored by Clayton Christensen:


    “In the last three decades, increasing numbers of cognitive psychologists and neuroscientists…have produced a multitude of schemes to explain…that people learn differently from one another.

    …If we agree that we learn differently and that students need customized pathways and paces to learn…”

    “We state above that in the first phase of the disruption of the instructional system the software will likely be complicated and expensive to build. The reasons for this can be traced to the use of the existing commercial system when marketing the system, as noted previously, as well as to the relative immaturity of Web 2.0 software. Within a few more years, however, two factors that were absent in stage 1 that are critical to the emergence of stage 2 will have fallen into place. The first will be platforms that facilitate the creation of user-generated content. The second will be the emergence of a user network, whose analogues in other industries would be eBay [i.e., an online market is a type of user network]

    …the data suggest that by 2019, about 50 percent of high school courses will be delivered online.

    …80 percent of courses taken in 2024 will have been taught online.”

    4) Read at http://www.LandofOpportuniTV.com:


    We the undersigned urge President Obama and members of Congress to consider creating and funding a venture capital (VC) firm that invests in American companies that:

    i. introduce an online market that provides a new and improved way to customize education [1] (For details, click on the ‘1’. [1.4] contains excerpts from reviews of the business plan.)

    ii. introduce online markets that provide new and improved ways to showcase and earn money from expertise [2]

    iii. introduce a loan program for consumers of customized education ASAP [3]

    iv. make the popularity of the company’s markets and loan program mutually reinforcing, so a borrower who performs well in the markets — thereby demonstrating her ability to earn a high and/or fast-rising return on her expertise — is rewarded with a lower interest rate [4]

    v. take advantage of new government regulations to become a bank, as a means of increasing the amount of money the company can lend [5]

    vi. introduce other loan programs and financial services that complement the markets [6]

    The VC firm can be similar in form to In-Q-Tel [7], a VC firm that is funded solely by America’s Central Intelligence Agency.

    Summing up:

    Puts, calls, related exotica — all very fun to chat up (I’ve read Hull’s Options, Futures &Other Derivatives, Mishkin’s Economics of Money, Banking &Financial Markets, and on and on; and I enjoy complexifying/mathematizing my biz model), but understanding next-gen banking starts w/ mucking around in the real economy: what technology can do today, what people’s investment needs are today, what disruptive innovations are possible today, etc.

    So Steve et al., if you really want to expedite the advent of next-gen banking, you should sign the petition at http://www.LandofOpportuniTV.com, and encourage others to sign.

    Best,

  2. JKH writes:

    I can see where equity holders hold a put to debt and deposit holders, and where depositor holders cover their risk with an FDIC put to taxpayers, and where creditors of TBTF banks hold a general put to taxpayers. So taxpayers write the put that ends up being the ultimate backstop.

    But can you translate “all banking capital is non-recourse with the taxpayers”? Does it mean recourse to the other assets of the providers of equity capital? Does it mean recourse to the other assets of the managers of the firm? Can you give me an example of where any creditors or guarantors have any “recourse to capital” in any case, whatever that means?

    The very idea of option vega in this context is an iconic representation of the asset valuation bubble that created this mess in the first place.

  3. The problem is that the lessons of the Depression were tossed aside by the “true believers” in modern finance (financial tricksters) through deregulation and leverage, and investment banks and commercial banks and hedge funds and basically almost every variety of financial intermediary except credit unions blew it.

    The investment banks and rating agencies conspired to fleece the public with the mortgage securitizations that some of the banks were just stupid enough to hold (or dumb enough to make bad RE loans and portfolio them–or unethical enough to book bad loans to get rich quick).

    I am impressed with the Canadian model, a banking system run as a public utility under strict regulation. We’re much more likely to be able to get there in the short run than to yet another fast-buck market solution.

    Leave investment banking to the investment banks, and let them go bust when they screw up. Keep the balance sheets of the commercial banks clean and conservative, so that they don’t freeze up when risk premia rise.

    By their fruits shall ye know them–I don’t trust “modern finance” to solve this problem. Modern finance has hosed the banking system up with deregulation and CDSs and other derivative crap they’ve pushed so bad the government is going to have to take it over to sort out the mess sooner or later, and the longer they wait, the worse the problem gets.

    The AIG bailout is mostly to prevent triggers on CDSs from triggering, as I understand it, so we’re bailing out the derivative holders before we bail out the banks. This makes sense?

    I’d declare all CDS contracts null and void unless held as hedge against an owned asset, for starters. On net, that’s supposed to be a zero sum game, but it will impact the pigs like AIG who sold these things thinking it was free money–and they’re the ones who should be expropriated, not the taxpayers. The losses on the underlying securities aren’t going away–why recognize them twice?

    Summers and Geithner have got to go, or change their tune quickly to restore confidence.

  4. john haskell writes:

    One of the following statements is true. Please choose:

    A) Private-sector banking has not existed in the United States since first the Fed and then the FDIC undertook to insure bank risks.

    B) There is no use getting all ideological about keeping banks private, because they never have been.

  5. winterspeak writes:

    SRW: Great post–I think your characterization of bank actions as taking a “out-of-the-money option written by taxpayers to a near-the-money option” through covert leverage increase. While reserve requirements are not important, capital requirements are, and the whole spectrum of CDOs, CDS, SIVs, etc. etc. essentially circumvented capital requirements.

    This is a problem because of a political unwillingness to wipe out creditors. Why do Citi shareholders still have anything, given that they are now only pure moral hazard players? Why have creditors been kept whole? I don’t see how the public/private entity you envision quite mitigates this problem — it may make it worse. Weren’t Fannie/Freddie meant to be public/private entities?

    You wrote a great post a while ago about how, high leverage, actually makes it easier to recapitalize banks because there are so many liability holders who could be converted to equity. That has not changed.

  6. Zane Selvans writes:

    But there are profitable business models for airlines! My favorite being Southwest. Why we insist on bailing out the big ones is a mystery to me.

  7. babar writes:

    not to be a pedant, but leverage also increased the value of the put option by increasing the volatility of its underlying.

  8. mencius writes:

    SRW:

    We want investment decisions to be driven by economic value rather than political diktat, but at the same time capital formation has positive spillovers so we’d like it to be publicly subsidized.

    Do you agree with this statement, or are you just stating the present consensus?

    If you agree with it, can you justify it? You seem to be getting at the heart of the question which is concealed by the Rube Goldberg machine of insured maturity transformation: whether the government should create money and lend it to private citizens and enterprises, for “capital formation.”

    Is your answer to this question yes, or no? If “yes,” I refer you to my argument about the zero-sum nature of monetary creation. If you translate this policy into normalized accounting, what you see is the lending of confiscated savings. There may be arguments for this, but I am not sure they are the ones you are making.

    How best to meet those objectives is a technocratic rather than ideological question.

    What is the difference between “technocratic” and “ideological” questions? Do these involve a different decision process, for example? Does “technocratic” mean “inductive” and “ideological” “deductive?”

    In thinking this through, I don’t think we should give much deference to traditional banking, on the theory that we know it works. On the contrary, we know that it does not work. Banking crises are not aberrations. They are infrequent but regular occurrences almost everywhere there are banks.

    Indeed. But the problem, perhaps, is an excessively narrow historical view. I’ll bet dollars to donuts that when you say “almost everywhere there are banks,” you are referring to one historical tradition of finance: the Anglo-American system founded in 1694 with the Bank of England.

    So, for example, I know of no banking crises associated with the hard-money banks of Amsterdam and Hamburg. Of course, their golden ages were in the 17th and 18th century. But this is history, too, isn’t it? The 18th century happened, didn’t it? Can we just say it’s meaningless, because it was so long ago, and bankers did their banking in funny languages and wore weird clothes with ruffs and doublets?

    I mean: is it really surprising that, in 2009, we might find that something invented in 1694 was kind of broken?

    And yet these are the only two options that appear to be on the table: assume that the Anglo-American banking model is perfect due to its great antiquity, and all it needs is to have the duct tape pulled off it; or that the only thing wrong with it, or at least the New Deal edition of it, is that some of the duct tape has started to come off, and all we need to do is wrap it up with another roll. Or, of course, some combination of the above.

    Private-sector banking has not existed in the United States since first the Fed and then the FDIC undertook to insure bank risks.

    Private-sector banking has never existed in the United States, which has always been the paradise of monetary cranks and paper-hanging politicians. There has never been a bank in America which did not have a corrupt informal relationship with state and/or federal government.

    Why would we expect either the ancient past or the sclerotic present to give us a well-engineered monetary and financial system? Do we expect either to give us a well-engineered pickup truck, operating system or automatic cat-litter box? No – if we want these things, we go out and build them.

  9. mencius — do you remember our first long debate, way back when? we’re likely to agree on problems and crisis management more than solutions. i am no friend to savers, in the fiat Winterspeakian or even the moldbug-ian sense. indeed, i consider savers — people who take opting out of consumption today as granting a birthright to consumption tomorrow — as prime villains in the present dilemmas. i am a friend to investors, people who direct the goods and services they don’t consume to productive purposes that yield fruit they may consume later. and i also believe in the deep rationale for limited deposit insurance: relatively poor people should have the illusion of “saving”, without worrying about the mechanics, so long as we manage the broad economy well enough to deliver. but wealthy people expecting to be made whole on government bonds and FDIC guarantees? i got no sympathy. i am quite serious about subsidized capital formation, and yes that implies some form of confiscation from the accounting entries of “savers” in order to fund entrepreneurs, whether that be by taxation, inflation, or whatever. if you want to drive wealth forward into the future, you’ve got to do the work of ensuring there are actually goods and services there. not consuming today while requiring the state to ensure you get “your fair share” tomorrow is just free-riding.

    your history is much, much better than mine. i’m glad to concede no private-sector banking practically ever, it was just more than i could myself comfortably justify. re amsterdam and gibralter and whatnot, i think we have to take seriously some disagreeable things. however unjust in a wide variety of ways, that Bank of England model seems to have been remarkably conducive to the prosecution of empire. “hard money” banking experiments, while they may or may not have maintained a tolerable business clime (did they? how did they end?) seem not to have survived. if we devise a system of payment, accounts, and capital formation that would work nicely in isolation, but would get trounced in military or commercial competition with a manic, unstable, Bank of England clone, we’ve not done well enough. Publicly subsidized capital formation, with the implication of greater or lesser manipulation by the state of the direction in which capital is to be applied, is like nuclear weaponry. it may be disagreeable, but it cannot be uninvented. Since we’ll never rid the world of it, we’re forced into the Nash equilibrium at the “yuk, yuk” quadrant. We can’t do without the possibility of confiscation and nihilodestructive application of capital, much as we would like to avoid it.

    So, the best we can do is make confiscation more transparent and controlled, make it so that in ordinary times there is less insidious war financing (which is always by subterfuge or patriotism, as war is never a commercially viable venture for the capital providers) and more upfront public financing of useful projects, with a tinge of mercantilistic push from the state but hopefully private control over the choice of projects. again, maybe in a yeoman village it would be best to do without any of this. but we don’t live in that village. and at least we have the side benefit of screwing free-riders and prodding them to plan production or at least commit to specific consumption rather than letting them pout on about their “prudence” while demanding a share of a future they had no hand in creating.

    i agree with you very much on the last.

    Why would we expect either the ancient past or the sclerotic present to give us a well-engineered monetary and financial system? Do we expect either to give us a well-engineered pickup truck, operating system or automatic cat-litter box? No – if we want these things, we go out and build them.

    whatever we do, whatever characteristics and values we wish to embed in a financial system, institutions invented in 1694, or even the 18th century, are probably susceptible to dramatic improvement, given very dramatic changes in what is not practicable.

  10. d4winds writes:

    I like this analysis/post, esp. the vega reference. It is not the depostiors in the traditional commercial banking sector, however, which have been the largest beneficiary of the put, but the couterparties and other creditors of the investment banking subsidivizations. Until now, investment banking has not been subject to governmental guarantees against downside risk on its assets. Those guarantees were at best implicit, mild, and considered to be economy-wide rather than IBank specific (the Greespan/Bernanke put) but have become very explicit, outrageously costly, and firm specific with TARP &AIG.

  11. BSG writes:

    Steve – the available evidence would seem to indicate you are seeking the impossible, perhaps unnecessarily.

    As you very eloquently describe, governments the world over have consistently abused their “exorbitant privilege”, with terrible consequences. If you give them the authority to punish savers for their horrible crime, they will abuse it and cause the damage you observe. That damage is so great, that I wonder why you think it would be less than would-be savers in a sound money regime would allegedly cause.

    Even if the restraints you seek on currency issuers were realistic, they may very well be unnecessary. The US proved in WWII that a mobilized citizenry will do what it takes to defend their country (if not the world.) While there was plenty of subterfuge involved (including printing money, of course), there were so many direct and easily observed costs (rationing, taxes, wage and price controls) that it seems likely the subterfuge was unnecessary (of course, we can’t prove a counterfactual.)

    Where the subterfuge is necessary, is for unpopular and likely unnecessary wars (anyone remember Vietnam?) So the ultimate restraint may have important fringe benefits.

    Even in facing off against mercantilist powers without firing a shot, the historical evidence suggests that it’s pretty easy (maybe too easy) to whip up the population to support, say, protectionism if it comes to that. No need to cut off your nose to spite your face beyond that.

    Besides, sound money may very well bring such prosperity that the mercantilists would be left eating dust. Since this hasn’t been tried within well-documented memory, it is admittedly impossible to prove without trying, but we wouldn’t exactly be shooting in the dark either.

    Regarding your admirable goal of teaching would-be savers good citizenship, it may be moot. Honest institutions combined with a modicum of ambition, if not outright greed, would likely persuade most savers to take on varying degrees of productive risk. It’s not as though hoarding even sound money doesn’t carry its own set of risks (theft, damage, changing world.)

    Besides, look at when risk aversion skyrockets. It’s when large policy-induced bubbles burst. Eliminate those and you get your wider participation in production of future goods and services. No need to force anybody, or cheat them, with all of the costly Orwellian implications of these.

    I suggest that the weight of the evidence is that the only way to prevent the abuses we all seem to agree ought to be prevented is by removing from our government the lawful ability to (at least directly) manipulate the currency. Even in the unlikely event that there are associated costs, I submit these are outweighed by the benefits.

  12. joebhed writes:

    This is taken from Milton Friedman’s “Monetary and Fiscal Framework for Economic Stability”

    “”1. A reform of the monetary and banking system to eliminate both the private creation or destruction of money, and discretionary control of the quantity of money by central bank authority. The private creation of money can perhaps best be eliminated by adopting the 100 per cent reserve proposal, thereby separating the depositary from the lending function of the banking system.

    The adoption of 100 per cent reserves would also reduce the discretionary powers of the reserve system by eliminating rediscounting and existing powers over reserve requirements.

    To complete the elimination of the major weapons of discretionary authority, the existing powers to engage in open market operations and the existing direct controls over stock market and consumer credit should be abolished.

    These modifications would leave as the chief monetary functions of the banking system the provision of depositary facilities, the facilitation of check clearance, and the like; and as the chief function of the monetary authorities, the creation of money to meet government deficits or the retirement of money when the government has a surplus. “”

    ELIMINATE THE FED’s OPEN-MARKET OPERATIONS.

    Eliminate taxpayer risk from FDIC takeovers.

    100 percent-reserve banking.

  13. AnoninCA writes:

    I know of no banking crises associated with the hard-money banks of Amsterdam and Hamburg. Of course, their golden ages were in the 17th and 18th century.

    End of Seven Years War led to tight money in Germany. Don’t know what happened in Hamburg, but due to interconnectedness, Amsterdam financial system almost collapsed in 1763. It was bailed out by the Bank of England (see Adam Smith on the astounding amount of gold shipped to Amsterdam) because the British banks were at risk. In 1772 or 1773, there was a crisis in Amsterdam triggered by speculation. The Bank of England didn’t help out and this is more or less when the international money market moved from Amsterdam to London.

    Hard-money was a myth to exploit. As soon as the government of the Dutch Republic was in trouble it secretly borrowed massive amounts from the Bank of Amsterdam which ended up with about a 25% coverage ratio at the time of Napoleon’s invasion.

  14. Dave writes:

    What is with all the hate for savers?

    Capital formation comes from saving. Inflation doesn’t create capital, it merely bids up the price on existing capital. Real capital formation requires real sacrifice. Savers are foregoing consumption now so that another individual can borrow their savings and build capital with which they produce future goods for the saver to consume.

    Since our economy is so large and complex savers deposit their savings in a bank, which lends it out to an entrepreneur. The problem is that banks are not lending it out to entrepreneurs, but lending it out to consumers to consume rather then invest, or speculators to bid up the prices of existing capital without adding any new value. Part of the reason for this is that its easier to make money speculating then producing, and because accounting entries as to the value of debt register only whether the last minimum payment was made, not whether the borrower has any way of repaying the principle.

    Real capital accumulation therefore requires real savings and a financial system through which to channel that savings into capital formation. Inflation, confiscation, and institutional subsidies hinder these goals. First, inflation doesn’t create new capital. It merely bids up prices on existing capital. However, it can reduce the amount of real savings in the economy (who likes getting ripped off) and it can convince entrepreneurs that there is a greater amount of savings out there then there really is. So all inflation serves to do is reduce savings and channel it in inefficient ways, as inflation makes rational economic calculation increasingly difficult. Similarly providing guarantees and special protections to particular institutions only invites recklessness.

    If you provide savers confidence that their savings will be invested well rather then squandered away they will put their capital at risk. That will lead to more savings the more capital appreciation. If you tell savers their capital will be confiscated and wasted your going to get less saving and less capital accumulation.

  15. Dave — I have no beef with savers who make the consumption they forego available to an intermediary, who then invests it on their behalf in exchange for some portion of the proceeds. I would call such people investors. But note that those savers would take losses if they or their intermediaries invested poorly.

    I have a strong beef with savers who forego consumption in exchange for claims against the government, taking no responsibility for the direction of their capital, but demanding to be made whole plus interest in real terms even if the capital they have failed to steward is squandered.

    “You” can’t provide savers with confidence that their savings will be invested well rather than squandered. Who is “you”? The government? Regulators? Some nebulous financial system? All of those are hopelessly compromised decisionmakers. The only way savers can ensure that their foregone consumption will be used wisely is to supervise its use as capital, or find trustworthy delegates to do so and take a hit if they chose poorly.

    Nobody is telling savers their capital will be confiscated, not even inflationists (among whom I number, for the moment). Savers’ capital has already been squandered, because savers delegated the management of it to crooks and thieves, public and private. The question now is who should pay for that: the savers who enjoyed outsized “returns” for some time on production that has proved to be illusory, or the producers of current wealth, who would need produce mightily and then be taxed in order to make a previous generation of savers whole.

    Savers who are not investors want free insurance on the investments they make without acknowledging. I think we should provide, as a public good, some quantity of that insurance, so that not every welder has to be a stock picker. But people who wish to “save” millions of dollars are more should, frankly, devote all their time and energy to managing capital, or place their trust in agents they choose very carefully and whose losses they are willing to bear. The broad public cannot afford to subsidize the laziness of people who demand their opportunities today to magically be preserved or enhanced in the future, without any work or risk on their part in ensuring it is so.

  16. BSG writes:

    Steve – Now I’m confused. Using inflation to save the “system” amounts to saving creditors (investors or savers, who are really forced investors) who had no right to expect to be bailed out at the expense of those who did (insured depositors, or small savers). Or perhaps you advocate redirecting bailout money to industry which effectively means letting the financial system collapse.

    How do you propose to direct all of the newly issued money?

    FWIW, I am not aware of a single sound money advocate that also advocates free public insurance to savers, especially large ones. Quite the contrary.

  17. Dave writes:

    That’s a lot there, let’s go a few against at a time:


    I have a strong beef with savers who forego consumption in exchange for claims against the government, taking no responsibility for the direction of their capital, but demanding to be made whole plus interest in real terms even if the capital they have failed to steward is squandered.

    As do I. I’m no fan of the treasury bubble either, but keep in mind what people are buying. In the best of worlds they are giving their capital to the government to invest in society itself (schools, etc) so as to meet those obligations. In the worst of worlds they expect the government to squander it (wars, etc) but since the government has a monopoly on force it can extract taxes from its impoverished citizens. In effect its like loaning money to the mob. Here though we have to blame both the taxpayer who continues sending the check each year despite ever worse performance, and the government official that runs things like Uncle Tony’s protection racket. I think we can agree that inflation/default on those obligations will occur down the line in such a scenario, as you can only loot the people so much till nothing is left. However, if that’s how your government is run you’ve got bigger issues then just the financial system.


    The question now is who should pay for that: the savers who enjoyed outsized “returns” for some time on production that has proved to be illusory, or the producers of current wealth, who would need produce mightily and then be taxed in order to make a previous generation of savers whole.

    Obviously those that own the worthless securities should get nothing. The problem you mention is a problem of government guarantee. If you don’t have to guarantee AIG, then you don’t need to tax people to pay off AIG shareholders. Simple as that.

    What level of insurance should be provided, I would argue zero, but I assume you would at least argue less then today. If your worried about another Great Depression without the FDIC then structure things around a monetary system where banks aren’t constantly insolvent because of fractional reserve.

    That doesn’t mean every welder need be a stock picker. There would still be bank CDs and company bonds and checking accounts (where people would keep money they actually wanted to be money). In fact a world with sounder money would make such investments more attractive then speculating.


    The broad public cannot afford to subsidize the laziness of people who demand their opportunities today to magically be preserved or enhanced in the future, without any work or risk on their part in ensuring it is so.

    I agree, so stop dancing around the elephant in the room. Instead of coming up with a bunch of guarantees and then finding ways to meet them (inflation, taxation, etc) just stop granting institutions idiotic guarantees.


    “You” can’t provide savers with confidence that their savings will be invested well rather than squandered. Who is “you”? The government? Regulators? Some nebulous financial system? All of those are hopelessly compromised decisionmakers. The only way savers can ensure that their foregone consumption will be used wisely is to supervise its use as capital, or find trustworthy delegates to do so and take a hit if they chose poorly.

    And this is made all the more difficult by what your talking about. Economic calculation is difficult. If it weren’t we would all be Warren Buffet. Inflation and fractional reserve make it extremely difficult. When the Fed increases base or the private banking system uses its magic credit powers it causes the illusion of increased wealth. People start to think houses in Florida are worth twice what they really are because credit has expanded. They all rush to take out loans to start their own construction company. The act of increasing money and credit distorts economic decision making and damages the capital structure. Bubbles have always existed, but when you add expanding and contracting credit they become reflexive, increases in money and credit cause price increases that cause further increases in money and credit.

    People demand money (or its close substitutes like T-Bonds) when they don’t want to put themselves at risk. In order for them to put their money at risk they either need to do the work themselves, or more likely find an agent. For the agent to do his work well he needs the same thing everyone else needs in order to make sound economic calculations, a stable supply of money and a stable unit of value to measure wealth in. A stable money supply goes hand in hand with rational investing. If money and credit are increasing or decreasing wildly rational economic calculation becomes impossible and finance becomes and world of speculation.

  18. Spectator writes:

    This is a great blog that elegantly captures many of the key issues.

    I think a lot of this discussion muddies the waters, as the perfect is the enemy of the good. FDIC insurance works well enough. Even government theft via inflation is an evil we can live with if we punish the excesses and vote out the inflationists.

    The real culprit here is bailouts of speculative private investment capital. This includes private bank capital. Big risk takers need severe punishment and public humiliation that sends a message to the market, not unlike the message a mobster might send in handling a default. Instead we have the equivalent of children that have never been punished. Let’s not try to reinvent banking when allowing big market failures will do. Moral hazard is the whole ball game.

  19. Dave & BSG — I think we’re actually agreeing more than we’re disagreeing, with the caveat that we have to distinguish between looking forward and the present mess.

    The only form of savings I object to is government-insured savings, whether the insurance is de facto or de jure. This includes direct claims on government and claims on governmet-insured entities. Investment, whether direct or via investment companies like credibly uninsured “banks”, is wonderful, as far as I’m concerned. Investors willingly bear most costs if things go wrong, they gain (and usually there are positive spillovers) when things go well. As BSG sez, and Dave implies, these are all things “sound money” types totally agree with.

    However, it does not describe the world as it is. Much “savings” took the form of claims on government or claims on assets or institutions with de facto implicit guarantees by government. It is this form of savings that I object to.

    If, going forward, we can minimize savings-as-govt-liabilities, I agree with all Dave’s points about the desirability of stable metrics of value for rational economic calculation. “Sound money” covers a lot of ground — I think my ideal would be heterogenous competitive monies, but there are commodity monies and “bit gold” and who knows what else &mdash’ but in some form or another, in some enlightened future, I’m all for it.

    However, it is too late now to suggest that the money we had was in fact sound, and that investors in anything other than government securities were not guaranteed. If we’d let the incumbent banks fail and there creditors take losses, I might agree that we could salvage “sound money” from the money we have (although there would still be far too many direct claims on govt that ought not be made whole, given our economic performance). But we’ve already committed to make whole the least productive investors: those who invested in brands (Citi, or just AAA) without any interest in the projects they funded, or any evaluation of the skill of their delegates other than BIG, FAILURE UNTHINKABLE. Having already committed to making whole the worst, it would be idiotic and unjust to tax labor and investors in real projects to ensure that nominal-make-whole is real-make-whole. That is to say, we abandoned the US dollar as sound money when we started bailing out everybody, and to try to “harden” it now would be terribly unjust. BSG, we’ve already committed to bailing out large bank creditors, and our financial system is already collapsed, because or in spite of that. I’ll rant and rave against every transfer going forward, but that’s too much done already, even if we could make them stop. So, going forward, I’d rather we inflate then let the worst creditors get made whole by taxing everyone else.

    How to inflate is politically a tough question, though it’s not hard for me to give an answer in theory. We should inflate by supplying flat transfers to US citizens. Give everyone 20K per year over a few years, and watch the price level change and balance sheets “heal”.

    Looking forward, again, I’m with you both in some kind of sound money, if we could arrange things so that this kind of mess won’t again occur. That’s a very big if. I do think we’ll need a hard break, a credible regime change. I’m all for hitting moral-hazard creditors (lenders to banks begging for bailouts) as hard as our we are willing to stomach. The greater the degree to which we force “savers” who made poor choices to bear their own losses, the lesser the need to inflate away the injustice of the transfers. But making the idiot creditors of CDOs and Citibank whole while insisting on a strong dollar is just feudalism. One privileged groups steals or squanders money, another privileged group is made whole by the state, and the rest of us get worked and taxed to cover the party.

    We are where we are. By all means, propose “sound money” going forward, and depending on the details, I might be with you enthusiastically. But it’s too late to suddenly insist that today’s fiat currencies be made “sound”.

    Dave — a small point of disagreement.

    That doesn’t mean every welder need be a stock picker. There would still be bank CDs and company bonds and checking accounts (where people would keep money they actually wanted to be money). In fact a world with sounder money would make such investments more attractive then speculating.

    In a world without guarantees, bank CDs and company bonds would not be “safe”. Picking good ones might not be much easier than picking stocks. Unguaranteed banks often do go bust, though they always have a lot of marble in their lobby to emphasize their solidity. We really do need to think hard about how to offer “safe” vehicles for small savers whom we want to exempt from the work and risk of investing, without creating loopholes that allow those who ought to be contributing to economic calculation to free-ride and shirk. Low-limit (on a per-person, not per-institution) deposit insurance is one approach to that. There are others. The issue is real, though, and would be real under “sound money” as well.

  20. Dave writes:

    I guess we need to differentiate the world as it should be from the world that is.

    In the world that should be we really ought to let a lot of these institutions fail. I don’t buy the argument that it is necessary to keep them functioning to preserve the “real economy”. The fall of Lehman Brother’s for instance didn’t cause the global downturn. Decades of over consumption and over leverage caused the global downturn. If Lehman were on life support like AIG I don’t think that would change a thing. The “too big to fail” argument seems to me nothing more then a correlation = causation fallacy used to fleece the public. If we simply let the bondholders in these banks take the hit there is no need to inflate away the debt. You could set up a new non-zombie bank without those problems with a lot less capital.

    In the world that is these are powerful institutions with entrenched political and economic power. They have and will continue to get bailouts. Any nationalization that doesn’t wipe out bondholders and stockholders is totally without teeth. So once these people have been bailed out the only way the government can meet its obligations is inflation. This will happen eventually, but it will be a burden to all savers, rich and poor, rather then focused on those responsible. It’s what is going to happen, it’s what the scenario I base my investing on, but it certainly isn’t a desirable outcome. I think you’ll find that when the inflation train gets rolling its going to cause a lot more damage then you foresee. Inflation has a way of severely distorting economic calculation.

    Secondly, in the world that should be when a decision is made to inflate money would be given out equally to each citizen. In the world that is money is going to be given out to the well connected and powerful first, allowing them to secure even more scarce economic resources.

    Lastly, on the matter guaranteed banks going bust that’s as true as how some companies go bust. We hope it happens less often with banks which represent loans to many different types of companies. Nevertheless, depositors occasionally taking haircuts in some banks is not the end of the world. Systematic risk is what we worry about in banking, so its only a problem if it prompts others to withdraw their money in a fractional reserve system. If you get rid of fractional reserves you get rid of the bank run problem. We have a clear separation between money (demand deposits) and investments (CDs).

    We don’t have fractional reserves because its a great system, but because some powerful people came up with a way to live off maturity transformation and getting off it is so problematic nobody bothers unless there is a complete collapse. If we are about to have a collapse it would be good to think about how to set up a new system afterward.

  21. BSG writes:

    Steve – while it’s tempting to think that spreading around large amounts of newly created cash would solve the debt problem, I don’t think it’s so simple. A much larger proportion of today’s debt is variable interest or short term, so that approach may very well harm more people than it helps, and that’s before considering the additional collateral damage resulting from the misallocation of resources.

    If the Fed then suppresses interest rates with more “printing”, we end up in a hyperinflationary spiral, which even avowed inflationists do not advocate (at least directly.)

    That’s why I think there is no way around a managed unwinding that we’ve alluded to before here. It’s only a question of how much real wealth we’ll squander to, for example, those that gambled on derivatives (as but one particularly undeserving group of economic parasites benefiting from the current approach.)

    As for when to make beneficial changes, the sooner we start the better. Those that profit from the very broken system we have will be very happy if we keep handing them money because of their self serving warnings that now is not the time. It never seems to be. In the mean time, the costs continue to mount while the benefits remain ever elusive.

  22. Phillip Huggan writes:

    In Canada there is a mechanism where if the railway shipping becomes too profitable, a small wealth tax goes to fund grain R+D. Something like that should work for large banks. When profit thresholds are reached banks could be forced to invest in gold companies, or developing world banking (to give more alternatives when bubbles threaten), or save money for recession small business loans….the same way grain R+D ensures railways have a future customer.

  23. BSG — Obviously floating-rate debt is harder to inflate away than fixed, but it’s not impossible. Undoing the fixed debt overhang would go a long way, and of course the more deleveraging through bankruptcy the better from the perspective of managing inflation. Even hyperinflations are usually of limited duration, and by the time their done, people are unlevered, either bankrupted by interest rates that move faster than incomes, or exonerated by the reverse circumstance. There’ve been lots of hyperinflations (defined as a 50% or greater reduction in some conventional measure of the price level over a few years time) that have not gone exponential a la Weimar or Zimbabwe. I think that’s about the best we can hope for now.

    Mencius offered a good proposal, once a long time ago. I suspect we’ll come round to doing something like what he suggested, eventually. I don’t think it will be painless. On the contrary, I think it will be chaos. But at this point, I think its inevitable, and certainly preferable to forcing the rest if us to put value under the absurd quantities of scrip being committed to rescues and stimuli and bailouts. This currency regime is already toast. We’re just waiting it out, and hoping we manage to cobble something better together without things turning violent.

  24. BSG writes:

    Steve – we’re certainly screwed, or more precisely, we’re being screwed. My greatest objection is to implications that any of this is unavoidable or that “printing” is a good faith attempt to somehow optimize the response for the benefit of anyone other than the ones most responsible.

    I know people who have lived through massive inflation and while you do come out the other side, the result is mass impoverishment except of those most responsible for the abuses.

    What’s worse in our case is that we likely won’t have an external safety net or someone to hand us a rope (I mean to climb out with, of course :-).

  25. BSG — Conditional on having and continuing to make whole all creditors of the USG and major financial solutions, “printing” may be optimal. That’s an ugly, ugly condition though. Ideally, those institutions (including USG) wouldn’t have so many creditors, and ideally (except USG) they’d work out their debts or default on them privately. Given the choices we’ve made until now, I think printing is the only option, though I think we’ll wait ’til a social boiling point and claim we were forced to the deed.

    And yeah, there’s no use romanticizing an inflationary depression. It will impoverish people, and for as long as it lasts, as Dave says, it will hinder recovery and capital formation. The sharper and shorter the devaluation the better. After the storm, human capital and (ironically) maybe a primary residence are all you can really bank on. If we’re smart or lucky, it may not kill us. But this is not a “soft landing” or a “hard landing”. It’s a crash landing, and we’re losing altitude as we speak.

    But this too will pass. The best we can do, I think, is look past money and finance, and think about what kind of real economy we should try to build, and how it ought to be organized. A great deal is in flux. Issues that have seemed settled may soon not seem settled at all, for better and for worse.

  26. BSG writes:

    Steve – you are almost certainly right on the inevitability of inflating away the debt, it seems so easy, after all. As for this being optimal, I’m not so sure. Though selective default seems unthinkable, it may very well be easier to optimize. It’s so unlikely, though, that I don’t waste more than a trivial amount of time musing about it.

    I still occasionally kid myself that it may be possible to stop the Fed from continuing to bring much of the world’s bad assets on its balance sheet. From brief excerpts the other day it seemed that even Dodd told Kohn that the AIG bailout can’t continue like this and that he’s prepared to legislate a resolution regime. Even Corker said that some were “making out like bandits” by buying CDS at deep discounts in order to collect Fed money. I know it’s probably kabuki, but still…

    I agree about the rest, especially human capital. I’m also encouraged by the widespread can-do spirit in the U.S. – we _will_ pick up the pieces. It’s a crying shame about all of the otherwise avoidable suffering and it will be much more so if we end up retaining something resembling the abomination of a financial system we have now, even in its better-regulated form.

  27. mencius writes:

    indeed, i consider savers — people who take opting out of consumption today as granting a birthright to consumption tomorrow — as prime villains in the present dilemmas. i am a friend to investors, people who direct the goods and services they don’t consume to productive purposes that yield fruit they may consume later. and i also believe in the deep rationale for limited deposit insurance: relatively poor people should have the illusion of “saving”, without worrying about the mechanics, so long as we manage the broad economy well enough to deliver. but wealthy people expecting to be made whole on government bonds and FDIC guarantees? i got no sympathy. i am quite serious about subsidized capital formation, and yes that implies some form of confiscation from the accounting entries of “savers” in order to fund entrepreneurs, whether that be by taxation, inflation, or whatever. if you want to drive wealth forward into the future, you’ve got to do the work of ensuring there are actually goods and services there. not consuming today while requiring the state to ensure you get “your fair share” tomorrow is just free-riding.

    O Sensei: your wushu is great and ancient and strong. You go up stairs without stepping on the steps. The feathery tips of the high bamboo are no stranger to you. Your students are countless as the flies in the great market of Anyang. Your art has been praised by the Duke of Chou, the King of Wen, and the Prince of Krugman. Whereas I am but a poor wandering student with nothing but a bowl and some rags on my back.

    But tonight, O Sensei: I make you my bitch.

    The thought that here possesses you is, of course, the “paradox of thrift” beloved of 20th-century inflationists everywhere. I myself struggled long with this demon. Finally I calmed myself, drew a deep breath, and remembered that the Way has no exceptions, except the Way itself. From that moment I was at peace. It was not I that discovered the truth. It was the truth that discovered me, and through my fists it will discover you as well.

    First, let’s remember the tool of normalized accounting. (Actually, a friend who actually knows what this word means suggested “renormalized,” which I like better.) Under renormalized accounting, all balances of true money (M0) sum to a constant, such as 1, or 2^64.

    (I like 2^64 because it provides a standard denominator. Call each unit a “bit.” There are 18 quintillion bits. This would lead to slightly Zimbabwean terminology, but while we’re changing our monetary system, why not change our terminology? Bits fit nicely in binary logarithms – 5b30 is 5*2^30 bits.)

    The important fact is that a legacy financial system can be renormalized at any point without changing the pattern of supply and demand. For example, when Turkey recently chopped six zeroes off the lira, life in Turkey before and after the change was exactly the same, except that tourists no longer had to learn the word “milyon.”

    Therefore, we can don or remove our renormalization spectacles at any time. The purpose of accounting is to speak the truth about economic activity. My view is that renormalized accounting provides a more accurate truth, at least at the macroeconomic level. Certainly, as in They Live, a very different reality appears when you put the glasses on.

    In renormalized accounting, it is impossible to create money. But when renormalized accounting is used to illustrate a non-normalized economy, creation of money appears as a confiscation which affects all moneyholders equally – a salami attack, in the parlance of computer criminals.

    What’s neat about your argument for subsidized finance – as befits your deep wisdom in the Tao – is that you understand this perfectly. You are not arguing that there are no aliens. You are arguing that we should welcome our new alien overlords. This is unusual and refreshing honesty. It is still wrong, though.

    But so that we know we’re talking about the same thing, let me state your argument in my terms. You are arguing that economic actors who store money, rather than either (a) lending it or (b) spending it, are antisocial. Therefore, your ideal design for a (renormalized) monetary system would include a balance tax, which skims the accounts of these “prime villains” and spends or lends the proceeds.

    I should note that my argument against this is not a libertarian one. I have no moral problem with any kind of tax. When I think about the problem of administering a monetary system, I think of the administrator as either (a) an absolute monarch, or (b) the sysadmin of a virtual world. Neither party feels any moral compunction over involuntary balance transfers.

    A balance tax, however, is a profound violation of the great principle of wu wei. Libertarians are libertarians because some fraction of the Tao has slipped through the bars of their linear, Western way of thinking, and expresses itself in the American language of “rights.” There are no rights. There is only the Way. But thanks to wu wei, the two are easily confused.

    The basic problem with a balance tax is that it’s a terrible tax. A good tax is a tax that is simple and inescapable. The balance tax is simple all right, but it is very easy to escape: hold some commodity other than the standard money, ie, one which does not slowly evaporate. By taxing monetary balances, you at least stimulate all the loophole-finding instincts of your subjects, and at worst you destabilize and destroy the whole system. There are much better ways to squeeze the peasants. Notice, for example, how unusual in human history any kind of asset tax is – let alone a tax on money itself.

    But this alone cannot not refute your argument. Every tax creates some distortion. Possibly the distortion created by your balance tax is, as you assert, desirable. Your goal is to dissuade the “prime villains” from their villainous behavior. Indeed the method seems appropriate for the purpose.

    Let’s look more closely at these money-hoarding swine. Your objection is: if they were lending their money, they would be contributing to capital formation. If they were spending it, they would be contributing to economic activity. But, since they are doing neither, their actions are antisocial.

    Am I describing your thoughts correctly? If so, the demon’s words are on your tongue. Let me smash it now with my Drunken Fist, and free you of this obnoxious passenger.

    Assuming for contrapositive purposes that money-hoarding is antisocial, is there anything worse? Indeed there is. Our money-hoarder could destroy his money. Not only is destroyed money not lent or spent, even after the hoarder’s death it is not inherited by a lender or spender.

    But just as renormalized accounting provides an alternative interpretation of monetary creation, it provides an alternative interpretation of monetary destruction. With the sunglasses on, when you print a hundred-dollar bill, you are slicing bits out of everyone else’s balance and adding them to yours. Thus counterfeiting is theft, and seignorage is taxation.

    With the sunglasses on, when you burn a hundred-dollar bill, what happens? You are taking the bits in your balance, and spreading them evenly across the accounts of all others. Not only is this not an antisocial act, it is the precise opposite of an antisocial act. And since the glasses depict the same world, an act cannot be social with them on and antisocial with them off.

    Another way to see this is to compare the acts of burning a Benjamin, and lending a Benjamin. If you lend the money, the borrower uses it to compete in the market for the factors of production needed to produce a capital profit. If you burn the money, that borrower does not exist. And, you wou
    ld argue, less capital is produced.

    But recall Hazlitt’s lesson about what is seen and not seen. Here, what is not seen is that all the other borrowers in the economy find that their money goes farther, because demand for the factors of production is lower, and thus so are prices. Thus their enterprises are more profitable, and thus they produce more capital. And we again see the zero-sum nature of monetary destruction. By lending to no one, you are in a sense lending to everyone.

    So where does the “paradox of thrift” come from? How did anyone ever get the idea that storing money is antisocial?

    What the exercise of renormalization tells us is that the pattern of economic activity depends on the pattern – not the absolute quantity – in which money is distributed around an economy. Change the pattern of moneyholding, and the pattern of trade must change as well.

    For example, if you transfer money from drinkers to nondrinkers, you decrease the demand for whisky and increase the demand for Snapple. The beverage industry has no option but to adjust to the transition. If you transfer money from people who want to spend it now, to people who want to spend it a year from now, you enforce a similar adjustment.

    Therefore, it is easy to describe transfers which increase or decrease aggregate indicators, such as GDP. This is true even under renormalized accounting. Transfers from lenders or hoarders to spenders will increase renormalized consumer spending by definition, and GDP equals spending.

    The essential reading here is the first two chapters of Carlyle’s Chartism – “Condition-of-England Question” and “Statistics.” The Way may be strong in you, it may even be strong in me. But to Carlyle alone was the true vision granted.

    What Carlyle tells us is that when you define the goal of an economic planner as the maximization of GDP – yes, even renormalized GDP – you have departed entirely from the path of righteousness. Nor will any other statistical aggregate do. The quality of an economy, which is what the true sovereign seeks to maximize, cannot be measured numerically.

    What is the right amount of spending, of investment, and of hoarding in an economy? That amount that the actors wish to engage in. It cannot be known a priori. By definition, any attempt to shift these levels by force creates an opposite pressure in which actors attempt to evade this diktat, and return to their desired equilibrium.

    Thus all our analyses produce the same result. Hoarding money cannot be an antisocial act because burning money, which is even worse by the same criteria, is the very definition of a social act – it benefits all others, at the actor’s expense. Transferring money from hoarders to lenders does not increase capital production, just capital prices. Transferring money from hoarders (or lenders) to spenders can increase spending and hence production, but to assume axiomatically that this is a desirable outcome is incorrect.

    There is a very simple and banal reason that 20th-century economists focused so much on the problem of overproduction and underconsumption. The reason is a political one. Any technique for goosing production is also a technique for getting votes. The result is a political system addicted to unstable and eventually ineffective techniques for maximizing spending, which are constantly collapsing as economic actors find ways around them.

    Eg: any formula for convincing the population to take on unsustainable levels of debt is a formula for generating unsustainable levels of consumption. I think it’s pretty clear how that one has worked out.

    There is also an easy explanation of why the “inflation tax” is so popular with politicians. It is highly covert. A balance tax in a renormalized or hard-money economy is extremely visible and easily resented. A dilution tax in an open-ended fiat system is almost invisible. Thus there is an element of dishonesty behind the popularity of this mechanism – an element no true sage would countenance. The righteous ruler has nothing to hide.

    So this is how I translate economic designs intended to maximize spending: as rationalizations by an addict whose real goal is his next fix. The Tao, of course, is not at all averse to the feeling of becoming the butterfly. But it is the exceptional nature of the experience that produces its charm. When the stimulus becomes a normal part of your day, it is no longer a stimulus, but something more ancient and grim. We cannot say “don’t go there,” because we are there. But our task is to escape, not to accept.

    And note that I have not even invoked the Hayekian argument that central planners are likely to do a much worse job of allocating loans than private lenders. Who directs lending plans the economy. Private lending is planning, without a center. Government lending? Meet Darrel Dochow.

    I know you are not operating under this illusion, but when one speaks in the democratic “we,” it is all too easy to imagine ourselves subject to some perfect ruler, out of Galadriel by Herbert Croly. Au contraire. A perfect central planner might even be preferable to the distributed private planning of the lending market. But our apple is what it is: rotten to the core.

    Rethink subsidized finance, indeed! Rethink it back to the hell it came from. Begone, demon.

  28. Monsieur Mencius — I accede entirely to your characterization of my claims as demonic and generally villainous, but, alas, in the details I think that you misunderstand me.

    I am not at all concerned, as a general matter, with the “paradox of thrift”. I have no trouble whatsoever with anyone burning their money. Under the current fiat system, I view that neither as a prosocial nor antisocial act, since central bankers will just recreate and redistribute what was lost to awful bankers and awful politicians. But, in your hypothetical 2^64 world, I agree, it would amount to a generous gift to THE PEOPLE, albeit somewhat regressively distributed.

    I detest people who hoard monetary claims not because they do not spend enough, but because they do not invest enough. I’m not at all concerned, for the sake of the present discussion, with maximizing current GDP. (I’ll add a bit of a conventional, mealy-mouthed caveat to that later, but really, it is just not my thing. My feelings about “stimuli” are mixed at best.) My sole concern has to do with the future when savers unprodded by busy bodies will in fact wish to consume their savings. I am a bit of a hard-ass. It is not enough, I say, that you have foregone consumption in the past, to entitle you to consume today. If you were a baker, and you baked a thousand cakes and let them rot, your foregone consumption should avail you only ridicule. To earn a claim to consume in the future, you must both forego consumption, and see to it that the consumption you have foregone is employed with sufficient wisdom that it will generate your future consumption. This is really very libertarian. Your production 50 years ago is no claim on me today. The value and produce of your capital today provides your only claim on present goods and services. Unfortunately, there is no certain means of taking today’s foregone consumption and turning it into what you will want 50 years hence. Too bad. If you want 50-year future wealth, it is up to you to carry that wealth forward in time. We invent securities markets and financial institutions and whatnot to “help” you, but it’s up to you to make good choices, or endure the fate of not enjoying the future wealth for which you had hoped.

    If you want to, you can buy and hold gold, or 27 bits, or whatever. I don’t really have a problem with that as long as no one is guaranteeing the future purchasing power of your commodity of choice. Gold is a good store of value sometimes, claims on enterprise are better at other times, you take your pick. Fine.

    But savers want more than that. They want to hold risk-free claims on money, for a duration of their choosing, and have the purchasing power of those claims (at least once interest is paid) to be guaranteed. That implies the more than innocuous renormalizations by the state, but renormalizations that leave savers relatively better off than other parties whenever aggregate economic outcomes fail to produce goods and services at a rate that matches the expansion of money claims. It is that to which I object. If I produce real goods and services now, but the broad economy tanks, I should not be taxed to make whole “savers” whose absence from the informational project of running an economy helped produce the broad scarcity. In my view, investing is work, and money savers are shirkers.

    Note that none of this has anything to do with short-term stabilization. Savers aren’t bad because their not lending or spending reduces current income. They are bad because their failure to invest (i like equity better than debt) reduces aggregate income at the time they intend to redeem their money, and yet they expect their claims to be redeemed at full value. If the state got out of the business of stabilizing the purchasing power of its claims, then I wouldn’t care. Wanna hold green paper? Whatever. But the state is not getting out of that business, especially since savers largely run the show. This financial system bailout, it’s really about bailing out savers, who demand that the purchasing power of their pseudogovernment claims be made whole, or else. I do detest those people, even if it is every upper-middle-class pension fund.

    I will invoke the Hayekian argument. The reason to detest savers of guaranteed money claims is quite because they contribute no information to the collective allocation decision, but demand a non-negative real return regardless of how the decisions of people actually doing the work turn out. Investors offer information and bear risk, savers do neither.

    All of this, you’ll note is very libertarian. None of it meshes with “subsidized finance”. And yet I do support that, too, very cautiously and just a little. I think that “rational central planning”, while a shitty way to run a whole economy, provides a useful noisy signal that decentralized Hayekian agents might miss. There is a place for the scientific Soviet, just not a very large place. I do think that the US government, for example, ought to have interfered quite aggressively with the “market outcome” of obviously unsustainable current account deficits and attendant industrial changes over the past few years. I think a fair reading of actual outcomes demonstrates that Hayekian agents are short-sighted in a manner not conducive to the continued prosperity and stability of a state, and that central planners should push back on that a bit. I’m deeply sensitive to the fear that if you give a politician a taste of the “commanding heights”, that plate will soon be empty. But then I think that even the most laissez faire market economies are prone to self-destruction, if their excesses and deficiencies aren’t checked. So, I want a world where central planners don’t run the show or forbid things, but where they do get to play, and create biases that counter arguably poor market choices. Also, I think that Hayekian agents are particularly poor about taking into account the needs of strategically competitive states, and that we will live in a world of such states for the foreseeable future. So I want a pretty big loophole by which states might, for example, fund the raising of armies. How to balance all these desiderata and concerns ain’t easy. Much could go wrong, whichever way you tilt things. I think it’s possible to get a good mix with a lot less subterfuge than we currently have, and with institutions much less liable to massive malfunctions. Perhaps I am overoptimistic (though I am usually not accused of that).

    I did promise to offer a mealy-mouthed semi-defense of “stimulus”, and I’ll do so half-heartedly. I think a case can be made that a downspiralling economy can create self-fulfilling prophesies if left entirely in the hands of Hayekian decentralized actors. Individuals rationally perceive the coordination problem associated with moving from a bad to a better Nash equilibrium as impervious to spontaneous resolution, which leaves us in an unnecessarily poor state. This is the kind of circumstance where central planning might in fact be useful, if policymakers can create conditions for even a brief period where actors perceive more active economic interaction to be rational. Central planners in this story don’t have to “get it right” over the long term, a Hayekian impossibility. They just have to, if you’ll forgive me, provide some infrastructure that persuades decentralized agents en masse that there is opportunity. I would support this kind of stimulus.

    But I don’t have much use for talk of “multipliers” or discussions of whether GDP is “below potential”. All that strikes me as bullshit. I would support a stimulus devoted entirely to the best medium term public goods and infrastructure investment that central planners can come up with (without regard to shovelreadyhood). I like Obama best when he talks industrial policy, green energy and public transit and all that. It’s not that he can get it right. It’s that putting arguably idle resources to work on this kind of thing maximizes the chances that we’ll get a rationally optimistic moment,
    because some of that stuff will turn out to be good and worthwhile, despite the limitations of planners. Overall, I am not an enthusiast of the present stimulus program, and not qua Krugman because it is too small, but because too little of it is devoted to medium-term investment or projects that excite the imagination. I think we should pay attention to precisely what we are buying, and think less in terms of stimulus but in terms of countercyclic investing, that the government is capable of purchasing important public goods cheaply while no one else can afford anything. That countercyclic investment can get rational Hayekettes interested in opportunities they might otherwise rationally avoid is an important bonus, but thinking about things in those terms tempts policymakers to bullshit think-happy projects.

    (I also do like that stimulus is inflationary, as I am as I’ve said an inflationist for the moment. But in a better world, how we manage an inflation and public investment decisions would be pretty much separate, except that we might strategically defer the inflation, and prolong the private sector downturn, in order to get good deals on important public investment.)

    Anyway, I hope that I’ve not dissuaded you that my ideas are heretical and demonic. But, I hope it’s clear that my heresy is not quite the one that you attributed to me.

  29. RueTheDay writes:

    I think we now have the answer to the riddle of “why was risk vastly underpriced from 2003-2007″. I remember reading a number of academic and popular papers a few years back that marvelled at the incredibly shrinking spread between Treasuries and risky assets. All sorts of contortions were made in an attempt to explain the mystery. The real answer was simple – AIG basically insured away all default risk in almost all markets and no one ever bothered to ask what would happen if AIG tanked (perhaps because no one had a good picture of how much financial insurance AIG had written). Decades from now, when the history books are written on the cause of Great Depression II, I believe that AIG and the failure of financial insurance will be center stage and the subprime stuff will be long forgotten.

  30. RueTheDay writes:

    Mencius: “For example, if you transfer money from drinkers to nondrinkers, you decrease the demand for whisky and increase the demand for Snapple. The beverage industry has no option but to adjust to the transition. If you transfer money from people who want to spend it now, to people who want to spend it a year from now, you enforce a similar adjustment.”

    The problem with hoarding is that it doesn’t represent any sort of transfer at all. It represents holding money for the sake of holding money, as a precaution against future uncertainty. This is a rational response on the part of the individual agent. At the level of the overall economy, however, it represents lower employment and income for all.

    “What is the right amount of spending, of investment, and of hoarding in an economy? That amount that the actors wish to engage in. It cannot be known a priori.”

    There are some hidden assumptions here, in terms of information availability and externalities. Members of a primitive tribe may desire a good crop yield, but may not understand the factors involved or have an effective means of dealing with future uncertainty. What is the correct mix of irrigation, fertilizer application, and sacrificial virgins thrown into volcanoes? Austrians would say one can’t know a priori, and that if the subjective preferences of the actors involved lean towards more virgins in volcanoes and less water and fertilizer on the crops, so be it, any interference by the tribal chief to shift that mix will make things worse.

    “By definition, any attempt to shift these levels by force creates an opposite pressure in which actors attempt to evade this diktat, and return to their desired equilibrium.”

    What is “force” vs “non-force”? Can you define it WITHOUT skyhooking enforced property rights and enforced contracts into place? In other words, can you provide a non-arbitrary definition of force outside of a particular institutional construct? Hobhouse had a great discussion of this in his 1911 book, Liberalism.

  31. mencius writes:

    SRW,

    Your demon is working very hard, I see. After all, it must strain not only against the puny force of my mind – but also now against the titanic force of yours. Surely it cannot resist much longer. (A good exorcism feels like popping a zit in your brain. When it finally goes, you’ll know.)

    For now, though, the demon’s efforts are able, and we must oppose them. Clasped firmly in inflation’s succubus embrace, you write:

    I detest people who hoard monetary claims not because they do not spend enough, but because they do not invest enough.

    Right. Note: this is actually what I believed you believed when I wrote the response above. Though I wish I had stated it so clearly and succinctly. Since you have now done so and in your own words, I can oppose it much more effectively, I hope.

    (Let’s be clear, though, about what we mean by “monetary claims.” We mean direct property ownership of money, carrying zero counterparty risk – as opposed to ownership of promises of money, carrying nonzero counterparty risk. In a world in which a fiat issuer uses its printing press to play AIG, as it were, and magically eliminate counterparty risk for certain types of instruments – at least when said counterparties are their friends in the banking industry – it is easy to confuse the two. But as a matter of theory they are qualitatively distinct, no matter how corrupt your actual, present government may be.)

    In any case: the “paradox of thrift” has two forms. We can call them “form A” and “form B.” In “form A”, the thrift-hater detests money-hoarders because they do not spend enough. In “form B”, the hater detests hoarders because they do not lend enough.

    The demon normally presents as form A. But now that I think about it, there is also a lot of form B out there, as well. However, unless I am completely misinterpreting your words, which strike me as quite clear, you have an unusually strong and distinct case of form B, showing no sign of form A.

    Ie: your mental immune system has deftly defused the normal or Krugmanian “paradox of thrift,” only to fall prey to a corollary.

    It shouldn’t be hard to see why the two are identical. Lending is spending. In each case, the lender/spender is exchanging money for something other than money. This might be a snowmobile, or it might be a promise of future money.

    The connection between inflationism and the paradox of thrift is also clear. If you believe it is socially harmful to hoard, destroy or deface money, you must believe it is socially valuable to dishoard, mint or counterfeit money. An argument for the one is an argument for the other. I feel that most choose to argue against thrift and deflation, rather than for profligacy and inflation, because it is easier to mislead one’s intuition in the negative direction.

    We shall return to the unity of spending and lending later on, for it explains the epidemiology of the demon. But for now, let us merely note the similarity between form A and form B, and go on to refuting form B.

    This was indeed the point I intended to make when I wrote, above:

    Here, what is not seen is that all the other borrowers in the economy find that their money goes farther, because demand for the factors of production is lower, and thus so are prices. Thus their enterprises are more profitable, and thus they produce more capital. And we again see the zero-sum nature of monetary destruction. By lending to no one, you are in a sense lending to everyone.

    I still think this is a satisfactory explanation. But let me explain the same point again from a different angle, which may be more transparent to you.

    Basically, I think, you are applying your micro intuition in a macro context, in a way that causes the macro answer to come out wrong. The image that is in your head, when you think of the thrifter who is so miserly as to not buy a snowmobile loan, is of a evil rich old man sitting on a strongbox of gold coins, or possibly an Appalachian meth lord with packets of twenties tucked in the springs of his rank, seeping mattress. (Ah, paper money.)

    So, the thrift-hater reasons: if this money was not in the box, or under the mattress, or whatever – if it was lent, ie, exchanged for a loan – it would be working productively for society. It would be financing a bodega in Queens, or helping a young couple in Michoacan afford their first house, or sending another credit card to a meth-addicted welfare mother in West Virginia.

    In other words, the money is sitting idle, it is not being used, it is going to waste. This is the common language of the 20th-century inflationist – you will find it in Gesell, in Douglas, in Keynes. The virus in your mind has passed through some rough trade, so to speak.

    But it is a strong virus. So let us dispel it.

    What actually happens when the old man succumbs to the relentless flow of 20th-century propaganda and puts his Krugerrands “into the market,” ie, exchanges them for securities? He could buy debt or equity. But let’s say he buys debt.

    The correct macro perspective, which pulls your eyes away from the character of individual lenders or borrowers whether sordid or pure, is that the macro effect of the old man’s cave-in – and thus of each epsilon of lending – is to raise the price of loans. Ie, the marginal effect of increased lending is to decrease interest rates.

    I’m sure this does not come as any kind of news to you. However, it allows us to see the previously unseen antisocial consequence of dishoarding to spend on loans. Ie: lower interest rates, which means lower incomes to those on a fixed income. (Yes, it’s true: in a healthy society, people actually do make their own financial plans for their old age.)

    This unseen antisocial effect is, again, just a special case of the fallacy of the paradox of thrift. In the paradox of thrift, the people who are harmed by the dishoarding/minting are always the people whose existing money is forced to compete with the new money. In form A this is the existing spenders; in form B it is the existing lenders.

    Note that lower interest rates also mean (new) borrowers pay less. Ie, by dishoarding/minting you have accomplished the standard result of inflation: you have transferred purchasing power from some people, to other people. But since a sovereign government can do this openly, why do it covertly? There are answers to this question, but there are no good answers.

    The value and produce of your capital today provides your only claim on present goods and services. Unfortunately, there is no certain means of taking today’s foregone consumption and turning it into what you will want 50 years hence. Too bad. If you want 50-year future wealth, it is up to you to carry that wealth forward in time.

    This is a wonderful specimen of the inflationist antigen. Let us take advantage and craft a custom antibody for it.

    Why do people hold money? What motivates the old man with the strongbox? Why is there any such thing at all? Clearly, zero demand for monetary storage means no one has any desire for money, which means money has no value. Another paradox with which many have struggled long.

    If the old man has a longevity potion as well, and he demands money 50 years from now, it is against his interest to keep the coins in the box. Rather, he should spend them on a fine product of his friendly local financial industry.

    Even in a closed-loop monetary system, a properly run financial industry, by appropriate diversification and other financial engineering, can produce effectively risk-free 50-year returns far higher than that of a strongbox, with only one caveat.

    A financial industry cannot diversify against disasters that affect the entire pl
    anet, such as a cometary impact, global plague, etc, etc. If the old man wants 50-year returns even in the case of such disasters, he may want to keep a few Krugerrands in his box.

    Predictable disasters are actually very useful to the deductive economist. If astronomers predict that the world is going to end in 2029 when it is hit by a comet, the supply of loans maturing in 2030 will be: zero.

    To put it differently: if an economy cannot produce nonzero returns across any term T, it has no productive capacity across that term. This is true for T=epsilon (eg, a “demand deposit”) by definition. It is true in practice for most short T. If it has no productive capacity, obviously, an attempt to use financial engineering to make it produce is misguided.

    So, if the old miser actually wants 50-year money, it is in his interest to lend. That does not mean he will lend. But government has enough real problems to solve, without the need to use financial engineering to compel its subjects to act in ways that already match their interests. (And remember, as we’ve seen, if he does not lend but actually destroys the money, his action remains a social one. It is just social in a different way.)

    But nonetheless, many people (especially in societies without our modern concept of financial engineering) do keep boxes full of gold and silver coins. And they hold these, “idle,” for long periods of time. What could they possibly be thinking?

    There is an excellent reason for people to hold monetary reserves. Monetary reserves are assets held on the personal balance sheet against the inevitable contingent liabilities of life. Ie: random bad things happen, and you need to have money to deal with them. Often, you have to have a lot of money. And you need this money now, not 50 years from now.

    (If you live in Zimbabwe and bad things happen to you, on the other hand, you write a letter to the Zimbabwean Reserve Bank and ask for a loan. This is literally the case. It is the direction we’re heading in, too.)

    At the macro level, a society with a large quantity of hoarded present money is a resilient society. A society that can bend when it is pushed, that does not have to break. It is a society that rebuilds after disasters, that wins wars, that is strong, independent and can take care of itself.

    In my own personal opinion, this is a good description of the American society of 1909. It is not a good description of the American society of 2009. The difference? A century of systematic inflation. To debauch a people, debase their currency.

    Is it possible for an overly paranoid society to be too prudent in this regard? Of course it is. Is the general error of excessive fiscal prudence one which our society is likely to fall into? Is a bear Catholic? Does the Pope…

    Of course, the demon retains an unchallenged and unchallengeable claim. Dishoarding/minting, if spent on loans, lowers interest rates. And lower interest rates have another effect: to increase production.

    (At least, to the extent that the loan is used for productive purposes. In the last ten years of the Great Bubble, what percentage of lending was actually lending to industry, as opposed to lending for consumption? But never mind all that. We will assume that all debt is actually linked to some kind of productive process, because at least some debt is, and in a healthy society this percentage would be much higher.)

    We cannot deny this effect. What we must deny, however, is that it is desirable by definition.

    Note the way in which lower interest rates increase production. It is always on the margin. Lower interest rates make productive processes which were, before the inflation, marginally unprofitable, and make them marginally profitable.

    Ie: from the Carlylean “condition-of-England” position, the new production is more of the worst, whatever the worst may be. Before the inflation, “cheap and nasty” did not pay; now, it does. Is this an improvement? Well, it certainly represents an increase in GDP.

    It is not a secret or a mystery that inflation is a method for increasing production, and hence producing “growth.” The question is: is the condition of England improved by this change?

    The Carlylean answer is: this question demands an aesthetic and moral judgment. It is not amenable to either logic or mathematics. But you (or your demon) is as forbidden to claim that reason demands the answer of “yes,” as I would be to claim that it demands the answer of “no.”

    So why do so many so constantly insist that the answer is “yes?” Having put a couple more bullets in its head, we may examine the origin of the fallacy.

    Let us go back to the snowmobile analogy. With the lens pulled all the way b ack, buying a loan is just like buying a snowmobile. It is a purchase, and generally a major one at that.

    In both cases, the purchaser’s task – and his only task – is to make sure the exchange is not one he later regrets. If he’s buying a snowmobile, he should make sure that (a) he actually needs a snowmobile, and (b) that he is getting a good snowmobile at a good price. The same exact statements are true for a loan.

    This comparison helps us understand the memetic epidemiology of the paradox of thrift. Clearly, the idea that everyone needs a snowmobile, even if he lives in Florida, will be popular among the snowmobile industry, and in the minds of those who make a living by selling their labor to it. If the purchasers can be influenced even slightly in that direction – $$$.

    Moreover, while the proposition may be itself preposterous, while it may not be swallowable on its own and as a whole, it may be implied through a chain of bogus but opaque inferences. Another idea that may become popular among snowmobile makers is the prediction of a sudden, sharp global cooling, resulting in Ice Age conditions in the states now least prepared to handle them. Therefore, if you live in Tallahassee and you do not own a snowmobile, you are putting your children at risk.

    Etc. So, if USG in its infinite wisdom delegates all research into global cooling into the hands of the snowmobile industry, we can quickly see what will happen.

    Basically, the etiology of the demon is the three-way incestuous alien mating of academia, government, and the banking industry. This has caused the former two to be very friendly to perspectives, positions, models and regulations that favored the interests of the third.

    With what results, we now see. There has not been a shortage of lending. There has been way, way, way, way, too much lending. But the ATM is now broken, and the “tab,” as Cassandra puts it, has finally arrived.

    A healthy society, under normal conditions, with a closed-loop monetary system, has a neutral balance of trade with the future. Every year, lenders are repaid about as much as they lend. Needless to say, this structure does not characterize macroeconomic conditions in the 20th century.

    Note that if you consider the entire productive sector as a single balance sheet, the sight of that balance sheet constantly sucking in more than it spits out is not at all a pleasant one. A firm that continually increases its capitalization may be a firm that is growing. It may also be a firm that is chronically hemorrhaging money.

  32. mencius writes:

    Premature posting removed my last paragraph:

    Inasmuch as the distinction between capitalism and state socialism (ie, Brezhnevism) has any meaning anymore, the difference is that in capitalism, the productive sector is profitable. Have you flown on United lately? Isn’t it more and more like Aeroflot every year?

    This is the real secret of the FIRE economy. My wife is from Columbus, and over the last few years every time we’ve visited her family there I’ve found myself asking: what do all these people do? What, specifically, do they produce?

    The answer, to some extent, was: nothing. Rather, their labor was allocated toward unproductive purposes (such as erecting McMansions, insuring them, etc) by misguided government policies. Just like the White Sea canal, only with big-screen TVs.

    These unprofitable activities were the direct result of a financial system designed, through the miracle of inflation, to make losses look like profits. Unfortunately, because (unlike China, where they seem to actually just be able to order banks to lend), the US is not a real command economy, in a sense that the center has actual authority.

    No – the Rube Goldberg machine only works on the way up. You cannot leverage lending in an environment of declining asset prices. Thus we have to repay all the debts of the bubble, without any further infusions of funny money. Oops.

  33. BSG writes:

    Steve – while your objection to savers’ expectation of guaranteed deposits is a clearly a proper one, I wonder if you overlook the fact that it is the inflationists of various stripes that created that, so that they may entice would-be savers to trust their cash to those who had repeatedly been previously proven utterly untrustworthy, to say the least.

  34. mencius writes:

    RTD,

    I think we now have the answer to the riddle of “why was risk vastly underpriced from 2003-2007″. I remember reading a number of academic and popular papers a few years back that marvelled at the incredibly shrinking spread between Treasuries and risky assets. All sorts of contortions were made in an attempt to explain the mystery. The real answer was simple – AIG basically insured away all default risk in almost all markets and no one ever bothered to ask what would happen if AIG tanked (perhaps because no one had a good picture of how much financial insurance AIG had written). Decades from now, when the history books are written on the cause of Great Depression II, I believe that AIG and the failure of financial insurance will be center stage and the subprime stuff will be long forgotten.

    You made this comment on Naked Capitalism, too. I liked it there as well. Of course, you’re assuming that historians decades from now will not be an even worse pack of liars than the historians of today, an assumption the past would not teach you to be so optimistic about.

    But consider: what, exactly, is the difference between AIG and FDIC? Both mint put options for counterparties of politically favored financial institutions. It’s just that the origins of the former are so obviously sordid – whereas the latter is the product of the hallowed Roosevelt administration. But did you ever know any sordid institution that later became pure? Me, neither.

    There are some hidden assumptions here, in terms of information availability and externalities. Members of a primitive tribe may desire a good crop yield, but may not understand the factors involved or have an effective means of dealing with future uncertainty. What is the correct mix of irrigation, fertilizer application, and sacrificial virgins thrown into volcanoes?

    I don’t know. Perhaps we should ask Darrel Dochow?

    That’s one thing people forget when they compare the Obama administration to the New Deal. The New Deal guys were (a) about 20 IQ points smarter than their equivalents of the day, and (b) had real executive power. Regardless of the fact that he was almost certainly a Soviet informant, for example, I’d give USG back to the guy who really ran it in the later FDR era – Harry Hopkins – in a microsecond.

    When Harry Hopkins decided to do something, he would hire a hundred thousand people in a month, and dirt would be turning that same month. USG can no more muster that kind of energy today than David Rockefeller can screw like a Dartmouth fratboy – if you’ll excuse my crudeness.

    What is “force” vs “non-force”? Can you define it WITHOUT skyhooking enforced property rights and enforced contracts into place?

    Apparently kids these days have never heard of natural law.

    Believe it or not, no tribe of hominids has ever been found so debased that they did not know it was wrong to lie, cheat or steal. And despite all the efforts of the world’s most advanced progressives, I’m not sure one has even been created – although it’s only fair to note that most of the best work in this area is being done in other countries.

    Thus natural law: that system of rules corresponding to the innate moral instincts of Homo sapiens. For some reason, many of our 20th-century friends of humanity have a big problem with this.

  35. RueTheDay writes:

    Mencius said: “But consider: what, exactly, is the difference between AIG and FDIC?”

    Six months ago I would have said that the difference is the FDIC is backed by the full faith and credit…, today, with the USG owning 79.9% of AIG, not so much.

    The real difference should be one of scope. The FDIC should, under the present system, exist to protect the assets of small depositors, not the entire financial system (which they can’t guarantee even if they wanted). This is one of the reasons why we’re in very dangerous territory on the money market mutual fund issue and on the bank bond issue – both are well outside the capability of the FDIC and I fear disaster if this were ever tested.

    Mencius: “Apparently kids these days have never heard of natural law.”

    No, we’ve heard of it and agree with Bentham’s “nonsense upon stilts” comment.

    BTW, do you have “natural courts” and “natural lawyers” to adjudicate disputes under “natural law”?

    Mencius: “Thus natural law: that system of rules corresponding to the innate moral instincts of Homo sapiens.”

    Really? What exactly does natural law say about the private ownership of land and unproduced natural resources? What does it say about unequal bargaining power between parties to a contract (without which you cannot have a non-arbitrary definition of force) and asymmetric information between parties to a contract (without which you cannot have a non-arbitrary definition of fraud).

  36. MattJ writes:

    Steve- Given your last comment on savers wanting guaranteed returns, I wonder what you think about defined benefit pensions? I have been becoming more and more convinced that they are a really bad idea, likely to collapse, in both their private and public forms. Do you agree? Or is there some reason that guaranteed returns over time can work when desired by the government, and not when desired by individuals?

  37. slackful writes:

    RueTheDay:

    Agree re who will be best remembered, but AIG was just one of the players. Huge participants with access to financing had effectively nakedly shorted risk, or volatility. All of the major strategies were short volatility, in a leveraged way. The nearly unlimited short selling of risk (limited only by access to financing) caused the price of risk to decline dramatically, as measured by e.g. a benchmark like the VIX circa December, 2006. AIG’s insurance offerings are easier to understand, given their literal nature, but almost any major levered “investment”, or yield-generating strategy you can think of at that time involved the leveraged short-selling of volatility. Of course this changed the equilibrium price of risk. And now we’re in the short squeeze from hell.