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Sentences to fear
Covered bonds issued by "too big to fail" banks are basically equivalent to mortgage backed securities guaranteed by Fannie and Freddie.
Here is much more, though I cannot see that the credit of the United States government is in danger. There is a) the printing press, and b) our location on the left side of the Laffer Curve. The point remains that additional debt for the major banks, while arguably necessary, weakens the off-balance sheet position of our government.
Posted by Tyler Cowen on July 30, 2008 at 08:11 AM in Economics | Permalink
Comments
I don't understand why this is different or more worrisome than mortgages funded by insured deposits. Why is everyone so upset about this?
Posted by: A at Jul 30, 2008 8:31:47 AM
So investors may get their principal back, but taxation and inflation may seriously dampen their returns. When the government balance sheet is out of whack, investors want more because taxation and inflation are going to demolish their returns.
Posted by: at Jul 30, 2008 8:39:57 AM
I would agree with A's first sentence, but the answer to sentence two is that everyone should be upset about both. You know exactly where those guarantees ultimately end.
It's nauseating what Paulson and team are doing. Why aren't you free-marketeer crusaders screaming your heads off?!
Posted by: meter at Jul 30, 2008 8:58:58 AM
Are you sure we are on the left side of the curve?
Posted by: Jim Lebeau at Jul 30, 2008 9:01:25 AM
I would have agreed with part B any time before about 1995. However, the whole Laffer Curve is slipping left as the world slips right, notwithstanding the best efforts of every government to prevent the latter.
Tax competition is increasing in the developed world. Even if we are still on the left side of Laffer, I seriously doubt we are in the rapidly, upwardly sloping portion of the curve. And relying on significant tax increases will only become more difficult in the future as tax competition increases.
And the printing press thing won't work either. As soon as we become dependent on borrowing to continue funding our government's basic needs, which is just a few decades away, we won't be able to afford to trigger a run on our bonds.
Frankly, I think we're screwed on both counts.
Posted by: M. Hodak at Jul 30, 2008 9:17:49 AM
These instruments have tremendous popularity in the EU (especially in Germany). As long as the level of funding available to one institution through these vehicles is limited to a small percentage (I feel like I heard a 4% threshold being kicked around somewhere) the potential downside is fairly limited. I'm speaking purely from a operational standpoint, not the overriding question of gov't intervention. That coupled with a minimum level of credit quality from the issuing institution could minimize the risk of moral hazard.....The horrifying part of all this is what data Paulson and Co. must be seeing if they're reacting so dynamically!
Posted by: Chicagoan at Jul 30, 2008 9:39:56 AM
short-term: how deep is this hole?
long-term: we seem to be hit by our national cognitive dissonance about "free markets" on many levels.
The consumer prides himself on a free market economy, but takes 12 national programs to expand home ownership as a birthright.
The banker prides himself on free markets, but has a (figurative) Rolodex full of contacts for government bailout.
... maybe I'm to focussed on consistency, but I think we should rethink a bit what should be free and what should be a socialized market. Starting from a clean sheet of paper I'd put medical care above houses.
Posted by: odograph at Jul 30, 2008 10:00:16 AM
This the way I see it, anybody please correct me if I am wrong:
The failures of large financial organizations could spread to banks and because banks work on fractional reserve system their failure can cause a rapid contraction in money supply and therefore could cause a depression. So would the bailouts just balance the contraction out, keeping the money supply constant?
The other problems that I see are:
1. Even as a very conservative cautious saver I do not look at my bank’s financial reports, I just check to see if the bank is FDIC insured.
2. As a human being I am comfortable with a certain level of risk. So if I work in a bank that is insured and regulated and will be bailed out, that means the risk of what I would normally is lower and so I will seek riskier investments and behavior.
3. Banks compete so even if I have the ability to create money and lend it and even if the Feds try to make is easy for me to make money so that I will not fail, I, in order to attract money and make investments, may have to spend lavishly to keep up with the competition thus even though one would think it very difficult to not make money in banking I will end up no more profitable than any other business in a competitive industry and thus just as prone to failure.
Therefore I think that as long as we have fractional reserve banking and insured account we have to these periodic bail outs.
I am wrong?
Posted by: floccina at Jul 30, 2008 10:04:35 AM
note: It's important to remember as well that "affordable housing" and "home appreciation" are contradictory goals.
Programs which prop prices make them less affordable. Programs which add (good) low cost housing curb appreciation.
And certainly it becomes a bit of a Ponzied goal to get everyone in an appreciating house at once!
Posted by: odograph at Jul 30, 2008 10:05:54 AM
floccina, I think you've describe why FDIC insurance has always been paired with bank oversight and regulation.
... but those became somewhat less paired in the last decade.
Posted by: odograph at Jul 30, 2008 10:08:47 AM
Meter asks a good question:
"Why aren't you free-marketeer crusaders screaming your heads off?!"
My answer is that I have been. Reporters have interviewed me about it and sometimes they report my "screams" and sometimes they don't. Re Tyler's blase response, I'm reluctantly coming to the conclusion, after having read his site almost daily for over a year, that Tyler is not a free-market crusader. He's a first-rate economist, but his passion seems to be almost solely about the analytics rather than the policies.
Am I wrong, Tyler?
Best,
David
Posted by: David R. Henderson at Jul 30, 2008 10:31:11 AM
@odograph I have always found it disturbing that politicians would look at deregulating banking and privatizing prisons before they have deregulated and privatized everything else. IMO these are the last things we should deregulate/privatize. In these areas one must be very careful how one goes about deregulating/privatizing. IHMO you cannot have deregulated banking as long as you have FDIC insurance and fractional reserve banking. Am I wrong?
You wrote:
floccina, I think you've describe why FDIC insurance has always been paired with bank oversight and regulation.:
@odograph Do you think that it is possible to regulate banking effectively? After all there must be a million ways to take increased risk and no way in good times that regulators can stop bankers. I look at the lobbies of banks and number of employees to customers and I think no way this efficient as say retailers and that increases risk. Notice that when this problem was occurring (2001 to 2006) few politicians (other than Ron Paul) were yelling stop this will not end well. Voters (more likely than non voters to be home owners) were happy that their home prices were rising.
Posted by: floccina at Jul 30, 2008 10:52:19 AM
I think the money supply thing is a bit overdone. It's an expectations thing. We've basically been in retrenchment or anemic growth so long now. We've been hearing about the "crisis" for almost a full year now. We have wealth destruction already. It happened. Everyone with wealth already took the wealth effect hit in 2000-2002. We've been worrying about gas prices since 2001. Globalizatin is already destabilizing and diversifying our economy in untold, unknowable, and unplannable ways. Monetary smoke and mirrors aren't going to have the same effect they may have before.
Sometimes the argument is that we don't know enough to allow things to run their course because the abyss is so deep. I don't think that argument applies now, if it ever did.
This is as close as I come to a scream .
Posted by: Andrew at Jul 30, 2008 11:58:22 AM
use of the printing press will destroy america's credit worthiness.
other currencies have gone from being the reserve currency to no longer being the reserve currency, including the Franc, the Pound, etc. The dollar is next on the block.
Once the dollar is no longer the reserve currency, look to see long term interest rates being dramatically higher than they are now.
Laffer-optimal tax rates will be needed just to service the debt. Too bad they've already been spent
-zanon
Posted by: zanon at Jul 30, 2008 12:16:03 PM
"There is a) the printing press, and b) our location on the left side of the Laffer Curve."
a) The printing press isn't a panacea. Seignorage has real costs. See Zimbabwe for an extreme example.
b) The Laffer Curve isn't quite so simple or uniform when you factor in tax competition (Switzerland, UAE, Cayman Islands, etc.). While higher tax rates may lead to an increase in total revenue, the wealthiest will manage to avoid higher taxes, resulting in a substantially greater burden on the middle class. Undesirable for any legislator with aspirations of re-election.
A comprehensive analysis of the government's credit-worthiness and ability to repay, should take into account its assets and not just its ability to raise taxes and/or print money. Uncle Sam still owns plenty of land, infrastructure assets, and service businesses (USPS, Amtrak, etc.), which could be privatized via auction.
However, on the other side of the balance sheet, the government's liabilities aren't pretty (or easily quantifiable). $10 trillion in public debt is only the tip of the iceberg. Social security and related entitlement programs (especially healthcare benefits) are rapidly growing liabilities of the government, but without any underlying value-generating assets. When you add in other unfunded obligations (government employee pensions) and poorly-funded insurance guarantees (PBGC, FDIC, etc.) the situation starts to look increasingly bleak.
Bottom line... I don't have any of my money invested in US treasuries.
Posted by: Russ R. at Jul 30, 2008 1:33:55 PM
The difference between the government backing Fannie Mae and other leveraged banking institutions and a highly leveraged hedge fund is that the government can take people's money at gunpoint. So the government won't go insolvent until it has brought the entire economy down. Great!
Meanwhile, regarding "free market supporters":
"Appearing on Glenn Beck last night, Ron Paul said that Fannie Mae and Freddie Mac should be allowed to fail."
http://www.independentpoliticalreport.com/2008/07/ron-paul-vs-bob-barr-on-fanniefreddie/
Posted by: Mr. Econotarian at Jul 30, 2008 1:34:47 PM
Being on the left-side of the Laffer Curve doesn't matter much if the political situation makes it impossible to raise taxes
Posted by: Robert Olson at Jul 30, 2008 1:36:30 PM
floccina asks "Do you think that it is possible to regulate banking effectively?"
I think that has to be an "on a scale of 1 to 10" question ;-). Never 10, but certainly more than 1.
As I understand it the pre-BushII rules, and the pre-BushII rule enforcement, were not so bad.
Posted by: odograph at Jul 30, 2008 1:47:02 PM
Most of what the government is covering was not lost in the real economy, but transfered to winners a zero sum transactions. We should figure out how to tax those who won to get the money to cover the losses. If this discourages future similar activity, it would be win win for the rest of us.
Posted by: joan at Jul 30, 2008 1:59:39 PM
Most of what the government is covering was not lost in the real economy, but transfered to winners a zero sum transactions. We should figure out how to tax those who won to get the money to cover the losses. If this discourages future similar activity, it would be win win for the rest of us.
Posted by: joan at Jul 30, 2008 2:00:33 PM
@ joan
"We should figure out how to tax those who won to get the money to cover the losses. If this discourages future similar activity, it would be win win for the rest of us."
Pleaes explain how penalizing prudent investors to reward imprudent investors discourages a repeat of the recent fiasco?
Exactly what part of moral hazard do you consider "win-win"?
Posted by: Russ R. at Jul 30, 2008 3:04:27 PM
http://en.wikipedia.org/wiki/Laffer_curve#The_Neo-Laffer_curve
What side of the Laffer curve are we on again? I didn't think many economists still took it seriously.
Posted by: Axis at Jul 30, 2008 4:03:30 PM
Besides the reasons already cited, those dreaded speculators help provide another reason inflation won't work so well this time. Any inflationary behavior, or even expected inflationary behavior, by the Fed is immediately reflected at the gas pump -- via futures speculators anticipating the behavior of the owners of oil reserves who expect greater inflation (and thus decide to pump later rather than now until the oil price rises to its new net present value reflecting the greater expected inflation). Oil prices, like gold prices, vary exponentially with long-term expected inflation. (Indeed since at least 2000 their movements have been highly correlated for this reason).
The "printing press" is thus no longer a covert means of default. Any excess money supply, actual or expected, is quickly and obviously visible at the corner gas station. And in constrast to gold, high gas prices are politically painful. More here. And look here for vivid illustrations of scenarios where the Fed attempts such a default-by-inflation. I also have a nice study in the works of the historical relationships betwen oil, gold, inflation expectations, and actual inflation.
Posted by: nick at Jul 30, 2008 5:26:09 PM
"our location on the left side of the Laffer Curve"
oh, you mean the seeming unlimited willingness of foreign central banks to keep on buying US debt?
Posted by: glory at Jul 30, 2008 6:32:17 PM
Speculators simply cannot keep an item above its intrinsic value for long. And why would they want to? Anyone who tried apparently just got killed. Were speculators responsible for the DROP? Of course they were. We are all speculators.
Let's not forget those who hyped up this witch hunt. Where other than the government or banks could people be so wrong and just move along? At least CEOs do get replaced. I'd make a donation for Bush/Cheney severance package. Drawback of Democracy #86: You have to wait for the election, you can't pay the scoundrels to get out of town.
Posted by: Andrew at Jul 31, 2008 8:11:18 AM
