Plan B: Last chance to avoid financial system failure

www.itulip.com ^ | October 13, 2008 | Luigi Zingales

[Freedom_Is_Not_Free]

After pointing a gun to the head of Congress, threatening a financial meltdown in case his plan was not approved, Treasury Secretary Hank Paulson has finally arrived at the only logical conclusion: his plan will not work.

Desperate for a Plan B, Paulson is slowly warming to the suggestion of many economists: inject some equity into the banking system. Unfortunately, it is too little and too late. The confidence crisis currently affecting the financial system is so severe that only a massive infusion of equity capital can reassure the market that the major banks will not fail, recreating the confidence for banks to lend to each other. The piecemeal approach of 100 billion today, 100 billion tomorrow used with AIG will not work. It will only eat up the money, without achieving the desired effect—without reassuring the market that the worst is over. Simply stated, nothing short of a 5% increase in the equity capital of the banking system will do the trick. We are talking about 600 billion. Unfortunately, even if the government is willing to spend this kind of money, there are three problems.

[B4Ranch]

>The problem, as usual, is credit bubbles (in this case Greenspan’s bubble).<

I think you are wrong here. Nothing says that you have to make use of credit that is offered to you.

[palmer]

The currency is in no danger of being destroyed by extensions in the quantity of money to meet its panic, safety demand. Panics aka deflations are scrambles to get into money, destructions of currencies aka hyperinflations are scrambles to get out of it.

And what caused the current "panic to get into money"?

[AndyJackson]

I'd like to see mainstreet try to live for 6 months without financiers directing their activities.

Actually, the financiers would not like to see this because folks would discover that they offer nothing useful for all those fees and frauds.

[JasonC]

This is an evasion and deliberately misleading. If men are free to engage in credit transactions they will not meet the Paulean demands. The only way to ensure those demands are met is to regulate credit in a draconian manner with an all powerful state. Henry Simon faced this fact, libertarians try to finesse it with glib reassurances that are about as convincing as Marx promising the state will wither away.

Many investors don't want 100% commodity reserve credit. Many investors are entirely happy to instead engage in speculative and gratuitous credit. And for obvious reasons - it is actually much better for them if they turn out to be correct in their estimates of future values. The safety being sought by 100% reserves of commodities are *not* the safety nor the profit of the receivors of credit, nor of its extenders. It is externalities to third parties, and to passive lenders who aren't paying much attention, that drive the recommendation.

Pauleans and before them Mises alleged all sorts of malfeasance and fraud in gratuitous forms of credit, but those were smears. They are even more clearly just smears under present banking arrangements, where no bank promises anything it can't perform, if supported by the central bank in a smash. And no liberty of anyone is being harmed at any point in the process. All the smear claims of counterfeiting and taxation and the rest of it, are lies.

No, depositers are not being fooled at all, they do have access to their money. Their money is just the debt of the central bank. If they choose not to use it, that is their affair. There isn't anything in the slightest bit dishonest about any of it, it is a pure unmitigated smear to pretend otherwise. No one ever promised you that they'd never make a loan to anyone else, if you lent to them. You are free to go find someone who will make such a promise if you like, nothing is stopping you.

But it isn't what you do or what is done to you, that is bothering you. It is the use other men are making of their own freedom. At bottom, you pretend you are wronged by the mere falliable economic actions of other men. And if that were believed and acted upon, not one particle of meaningful economic freedom would remain to anyone. There isn't anything you can possible do, of which I can't say, "hey, that changed the exchange value of something I own, no fair!", and demand that the government make you stop.

[palmer]

Nothing says that you have to make use of credit that is offered to you.

Unfortunately a lot of people did make use of the cheap credit that was offered. Some of them, which I called "jerks" in a post above, used excessive amounts of that cheap credit to destroy our financial system.

[B4Ranch]

Those are the people that should be at the top of the list to be punished, not bailed out by “I’m Yer Buddy Pualsen”

[palmer]

The only way to ensure those demands are met is to regulate credit in a draconian manner with an all powerful state

So the only choices are Greenspan's credit bubble or authoritarianism?

[palmer]

Those are the people that should be at the top of the list to be punished

True, but that's not going to happen, in fact they are injecting money (not just credit) into parts of the financial systems (stupid insolvent banks) who enabled (loaned to) the jerks. The sadly predictable result is that the jerks will get rewarded in one last massive credit inflation or the credit bubble reflation fails and we all go down together (well except for some of the jerks).

[JasonC]

People believe that misallocation of capital has left less value in existence than was expected at the time loans were made, and they believe that holding long dated future claims will expose them to reduction in exchange values of such claims. They then try to hold immediate claims instead. While a few may do so, all cannot, and not because of any financial arrangement of any kind. 98% of all the real value we will ever provide to each other has no present existence, and will only be created at some future point in time. When too many people want to realize now, everything they own, it merely drives the real rate of time discount to infinity, temporarily threatening to destroy all future values. Since men's actual cooperation with one another depends on their long dated and ongoing projects, the destruction of those future values entails the dissolution of all their material incentives to cooperate with each other.

Many Pauleans suffer from the delusion that only money (and immediately consumable inventories, on the real side) is "truly" valuable, an error as old as the mercantilists, and regard all other forms of value as "fake". This is itself a gross error. You can't force all our wealth into the present, full stop. Financial arrangements have nothing to do with the truth of that statement. At a sufficiently panic time preference, there isn't any capital, and social cooperation halts.

The proper economic recipe to meet such a panic demand, therefore, is to let the quantity of money expand to accomodate it, while simultaneously directing demand toward future rather than present values. That is exactly what a lender of last resort does, and has done in every actual financial panic in the history of capitalism. Which does not abolish the cycle, it is merely part of that cycle, and a perfectly functional piece of it.

[B4Ranch]

I see the bailout as strechting the recession out much longer than if we allowed the mismanaged companies to fail. Worse yet IMO, if “I’m Yer Buddy Pualsen” keeps throwing money at it, he’ll put us into a lockdown depression.

[JasonC]

There isn't any authoritarian choice. The Pauleans are utopian ideologues as out of touch with economic reality as Marxian socialists. They have no workable alternate policy, only invective directed against the reality of the world and of economics.

We certainly have choices as to our monetary policy. But abolition of cycles is not among those choices, any more than abolishing death is among our health care policy choices, or abolishing war is among our defense policy choices.

Every rational and pragmatic conservative is capable of seeing this, or of instructing himself well enough to learn that it is true. There is nothing conservative about utopian ideologies demanding the destruction of the very economic freedoms that constitute capitalism and created the modern world.

[JasonC]

There is such a thing as the science of economics. It has a history. Look it up.

[JasonC]

Your statement is ignorant, and mine is entirely true. Demand for dollars has been higher over the past month than at any time in history. That is the flat opposite of people trying to get rid of every dollar as fast as it comes into their possession. That you can't tell the difference proves to a demonstration you have literally no idea what you are talking about.

[palmer]

When too many people want to realize now, everything they own, it merely drives the real rate of time discount to infinity, temporarily threatening to destroy all future values. Since men's actual cooperation with one another depends on their long dated and ongoing projects, the destruction of those future values entails the dissolution of all their material incentives to cooperate with each other.

Let me give a specific example: a bank loans a hedge fund $900k so they can buy $1m in speculative assets with 10:1 leverage. So, using your logic, the panic starts when the bank wants to realize now? What causes them to want to do that?

[JasonC]

That is demanding its return. "Do what you will, capital is at hazard". You demand that this cease, and that is a demand that other men's freedoms cease. And yes, those events are the result of free men acting economically, as they have always acted whenever free to act economically, and the effects are what they always are. Sure the government was also involved, but the same or the like would happen even if they weren't, and it did, for centuries.

[palmer]

Demand for dollars has been higher over the past month than at any time in history.

So that's why the price of gold went to zero!

[palmer]

There is nothing conservative about utopian ideologies demanding the destruction of the very economic freedoms that constitute capitalism and created the modern world.

Why didn't you demand Greenspan stop lowering rates because those low rates led directly to the destruction of your treasured credit-based "capitalism"? What did you do about this in 2002/3 when it really mattered?

[JasonC]

No. A panic demand for money is not caused directly by speculation, successful or failed, nor by banks calling loans. A panic demand for money means everyone, all investors as a class, all savers, all depositers, seeking to reduce their holdings of long dated claims and to increase their holdings of the safest forms of short dated ones.

All cannot in the aggregate do so, assuming the money supply remains fix. No trade any of them engage in can reduce the number or type of outstanding long dated claims one iota, nor increase those of the safest short dated ones (which are controlled by their issuers, the Fed and the treasury). Instead they can only change the terms of exchange between them.

[palmer]

Sure the government was also involved, but the same or the like would happen even if they weren't, and it did, for centuries

Ok, we are getting somewhere. How were they involved, specifically, in the creation of the credit bubble and subsequent deflation?

[JasonC]

First, it didn't led directly to the destruction of capitalism, which is alive and fine thank you very much, just going through the usual downphase of its cycle. Second, in 2003 I said the Fed was leaving rates too low for too long, and told anyone who cared to listen that asset backed securities at tiny spreads were an easy short, and told anyone who cared that New Century was an unsound bubble company that would not survive the cycle, and lots of other things. But it doesn't matter. We have a cycle because more people act in a pro cyclical than in a countercyclical manner, in terms of the aggregate weight of their bets. And I can no more change that than repeal gravity. Neither can you.