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Hypotheses which are too simple to be true as stated
We need a new banking system. A new banking system takes years to build. We will be in an economic downturn for years and because this crisis is global it will not be better than Japan in the 1990s. It is hard to build a new banking system through the current, old, nearly insolvent banking system. Maybe some smart person has a plan to build a new banking system through the old system, while avoiding toxic contamination through the problems of low-solvency institutions. That smart person remains silent. I have not given up hope. The Great Depression had bank failures, we have bank zombies.
Posted by Tyler Cowen on October 10, 2008 at 01:33 PM in Economics | Permalink
Comments
don't we have 2 banking systems? local, retail banking and casino banking, which is where the extremely smart and wealthy play notional betting games with house lines of credit?
Posted by: Bababooey at Oct 10, 2008 1:41:01 PM
Rather than build the new system _through_ the old system, is it possible to build the new system in parallel to the old system? Use regulation/oversight/whatever to keep the old system limping along while the new system is being built? Use proper incentives to gradually shift activity away from the old system and onto the new system.
It's somewhat interesting how replacing a banking system bears some resemblance to how production computer systems are replaced.
Posted by: Anon at Oct 10, 2008 1:52:50 PM
How about this. Each of the 5 Canadian big banks is assigned (i.e. given) one or more of the most struggling banks worldwide. They're also given a capital infusion from the G8 and others of a few trillion $$$ in order to absorb all the garbage on the books. Then they're forced at gunpoint (metaphorically of course) by the govt. of Canada to get global commercial credit flowing again. Canada does end up running all of world finance and Toronto becomes THE global financial center but that seems only fair since we apparently are the only ones who weren't stupid enough to get into this mess in the first place.
Posted by: ramster at Oct 10, 2008 1:54:43 PM
Explain zombie banks, and what's undesireable about them.
I don't understand how capital is freed up by their elimination, unless it only means that you can be sure about dealing with surviving banks owing to natural selection.
In which case the undesireable feature is only that they make trading unsafe.
Posted by: rhhardin at Oct 10, 2008 1:55:34 PM
Do we really need a whole new system? How about the current system with a revaluation of risk and less leverage?
Posted by: Brian at Oct 10, 2008 1:58:55 PM
A zombie bank behaves exactly like a bank, but it lacks subjective experiences.
Posted by: Eliezer Yudkowsky at Oct 10, 2008 2:08:48 PM
George Soros is pretty smart.
In today's WSJ he has a proposal for fundamentally rebuilding the part of our system that is most broken, the housing mortgage market. His idea is based on the proven model that Denmark has long used.
Here's a key part of his proposal:
"Finally, the asymmetric nature of American mortgages is replaced by what the Danes call the Principle of Balance. Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes. To state it more clearly, as home prices decline, the amount that a homeowner must spend to retire his mortgage decreases because he can buy the bonds at lower prices."
Soros believes there's a relatively straightforward path to get us from here to there.
What do you think?
Posted by: a student of economics at Oct 10, 2008 2:11:42 PM
so how many of the banks are really dead/insolvent? do we really believe everyone is? or is it just a couple, but no one knows which ones? As far as I can tell, the credit unions are fine; the money market funds and community banks will be fine with a little bit more deposit insurance; and some industrial and tech companies are sitting on big piles of cash.
Otherwise i'm reminded of the math puzzle about the village where all the women know everyone else's husband is unfaithful but not their own.
Posted by: DK at Oct 10, 2008 2:13:28 PM
It exists already:
http://en.wikipedia.org/wiki/Microcredit
Don't save big fat cats, save the entrepreneurs and the workers! Most of employment and taxes in the world comes from them, if you take out the few bubble years.
Posted by: Alecco at Oct 10, 2008 2:33:50 PM
Maybe some smart person has a plan to build a new banking system through the old system, while avoiding toxic contamination through the problems of low-solvency institutions.
=======
It's a LOT easier than you might think. See the Humpty-dumpty thread.
As for preventive medicine, it won't be any easier to re-regulate a "new" industry than to re-regulate the old, will it? I mean, they'll be staffed with the same characters, even if we change the chairs on the deck...
Soros believes there's a relatively straightforward path to get us from here to there. What do you think?
========
My 2-cents (and that's all it is, really):
An interesting idea.
It will not help with the existing problems, so ...
Prospectively, it will make it hard(er) to be a mortgage lender. It's bad enough that you risk pre-payment of your mortgage loan, when interest rates fall. If I understand it, Soros is talking about making the face value of your loan fall when ... mortgage spreads widen (because home prices are falling and the risks associated with not getting paid at all are rising).
I wouldn't want to be the first one to price that type of security, but if the Danes have done it, it's worth a look...
Posted by: Amicus at Oct 10, 2008 2:34:14 PM
People just need to calm down, I'll take a bad crises every 75 years and a recession once every 12 years. We don't need a new system, we just need a few more rules added to the old system (mostly in the swap system, more transparency). We could socialize all banks have stagnate growth, but I say let the free market take its course.
We need to stop playing with numbers like borrowing from ourselves and giving us back to ourselves by calling it a "stimulus package. The best long term thing we can do is chug along through this like sensible people. We have to take the good with the bad. I think most American's understand this, the bad thing is that our politician's and policy makers don't believe this
Posted by: torris187 at Oct 10, 2008 2:42:43 PM
There's too much corruption, and too much interest (and dollars) vested in corruption, for anything to be fixed. This is the fall of America. It will never be fixed. No republican, no democrat, nobody can fix it. It's over. I blame about 95% of it on Bush, but that's a moot issue at this point. America is doomed. 10 years from now all you'll see will be dirt, churches, and mosques.
Posted by: BruceM at Oct 10, 2008 2:43:31 PM
BruceM:
"The church will stand, I think. They'll need it."
I always love reading comments that make my gloomy take on the world look like that of Norman Vincent Peale....
Posted by: albatross at Oct 10, 2008 3:02:17 PM
BruceM: I understand you don't like Bush (or Republicans, per your website)...but blaming this on Bush is ridiculous.
Posted by: Alex at Oct 10, 2008 3:14:54 PM
Well at least now we now how much the Lehman CDS is worth: 8.625, down from the mid-market 9.75 and far less than the expected 13. The bidder list is interesting too.
Posted by: StreetWalker at Oct 10, 2008 3:32:03 PM
It seems to me that the only reforms or changes in regulation that need to be done are to make Freddie and Fannie subject to the same regulations as any other publicly traded company and to regulate the CDS part of AIG like an insurance company. It was these three institutions that were the epicenter of the whole mess.
Perhaps the bond rating agencies need to be replaced as well.
Posted by: kurt9 at Oct 10, 2008 3:39:16 PM
"I blame about 95% of it on Bush": you starry-eyed optimist, you.
Posted by: dearieme at Oct 10, 2008 3:39:17 PM
How did you get Eliezer_Yudkowsky to start coming out of the MR woodwork?
Posted by: Person (aka Silas) at Oct 10, 2008 3:48:13 PM
I get 5 credit card solicitations in the mail every day; there is money to be lent out there. Isn't the problem relatively localized within certain functions in the banks? Why don't we just let the sickest firms declare bankruptcy and sell their corporate credit depts and other non-cancerous parts whole to healthy banks? Put the proceeds into a fund for contingent liabilities, auction the remaining CDS' and move on. The downward shock in capacity will make lending very profitable for the next two years, and investors will provide funds. We've still got 7,000-8,000 healthy banks to go before Armageddon.
Posted by: pytheian at Oct 10, 2008 3:57:42 PM
1) Despite some similarities between the Japanese banking and financial crisis of the 1990s and ours and others' today ---along with the similar kind of price-decrease in real estate --- your conclusion, Tyler, that recovery will be dragged out as long seems doubtful. Way way doubtful.
..........
2) Why?
The Japanese real-estate and banking bubble burst in 1991, and the government didn't start playing an active role in recapitalizing the banking system there for a good 7 years. Instead, it tried to recover the economy by means of massive deficit spending --- public works stuff, aimed at the favorite constituencies of the Liberal Democratic Party politicians without any effective nation-wide program here --- and let deflation get under way . . . with, additionally, a likely liquidity-trap emerging once monetary policy reduced core short-term interest rates to practically zero.
The banks, according to the heads --- who also owned a large and usually majority share of the big corporation giants (and vice versa!) --- could take care of the problems themselves.
...........
3) Then, in 1998, when the Japanese economy was clearly sick --- no recovery of solid growth in sight --- the LDP-dominated governments began to sponsor some bailout programs.
The initial ones, dragged on for a couple of years or so, were woefully under-financed and did nothing to recapitalize the system. The economy continued to limp along with either sluggish growth or renewed recessionary plunges.
..............
4) Finally, earlier in this decade, the Japanese government managed to get about $450 billion spent on recapitalizing the banking system --- this, mind you, in a country with about 40% (120 million people) compared to ours. By 2004, the financial system was again sound.
And interestingly, as a NY Times article today showed --- something I hadn't known before --- the Japanese government eventually managed to sell off troubled assets that offset about 75% of the $450 billion spent.
..............................
.............................
5) By contrast, we are moving far swifter. Moreover, there hasn't been the cozy cross-ownership patterns between banks and big corporations here (the bankers and corporate heads would dominate each other's boards).
Right now, nobody actually knows what the toxic and half-toxic CDOs in the banks are actually worth. How long will this take? Nobody knows really. More likely, as the TARP allows, the Treasury will probably have to simply emulate the British and buy lots of equities in the more solvent banks and let the others go.
And there's no reason why this should take longer than a few weeks to get lots of the capital into the banking system that way, assuming that an Obama-transition team start working right away after the election in early November with the existing Treasury heads and those of other relevant federal financial agencies.
.............
6) So we will likely have a new banking system, you see. But, I wager, within at most months, not years as in Japan. And the entire financial system, not just banks, will be both rationalized --- as much as GM and Ford will be eventually --- and far, far better regulated, with regulators who take their jobs seriously.
.........
Michael Gordon, AKA, the buggy professor
Posted by: the buggy professor at Oct 10, 2008 3:58:01 PM
The answer is an old story: the devil is in the details.
1. Recapitalization plan
Needs to be carefully structured. Should the government stake be a form of callable super capital that takes precedence even over existing long-term senior debt holders? The balance between helping banks and not helping them too much is the hardest part of the plan.
Relies on an aggressive FDIC shutting down the worst and those that abuse the aid. FDICIA and the S&L crisis experience will probably help the FDIC make good decisions.
2. Anyone who thinks that government recapitalization will unfreeze interbank markets needs to explain why this would work. The problem in interbank markets is that the cashflow banks used to trade in these markets has flowed elsewhere. Unfreezing interbank markets will require redirecting the money that's gone into Treasury money market funds to financial commercial paper or bank deposits. Ideally this would be done through market incentives, like say, allowing Tbill rates to go negative. Maybe a guarantee on all deposits is a good idea -- if people want government paper they can access it via the banking system. (Of course, this too would require the FDIC to be hyper-aggressive.) The thought that government might try to intermediate these flows is downright scary.
Posted by: Anon at Oct 10, 2008 4:13:19 PM
just to be clear I think bush is 95% responsible for the destruction and fall of America, not the mortgage crisis.
Posted by: brucem at Oct 10, 2008 4:14:22 PM
One more thought: Policy makers need to remember that in order for a deposit insurance scheme to be effective in drawing funds to/keeping funds in the banking system, policy rates can not fall too low. Large depositors need to get a decent low return, or they may turn to risky (but potentially profitable) alternatives like commodities.
Posted by: Anon at Oct 10, 2008 4:20:20 PM
Student: I think that's a fine way for future mortgages to be funded, if both the creditor and the borower agree to those terms. Of course, creditors will demand higher rates to compensate for new downside risk. (Of course, they will demand higher rates than they had in the past anyway, because they will have revised their estimates of default risk upward.)
Involuntarily changing the terms of existing mortgages to these proposed terms is another story. Even setting aside the ethics of so radically changing the terms of a contract after the fact, even setting aside the utilitarian question of whether the benefit we gain now would be worth the price of scareing future lenders with the precedent of an ex-post-facto pro-debtor contract change, there is the legal question of wether courts would allow it.
From my point of view, the most important policy requirement for a future mortgage market is that the GSEs disappear. Creditors should face the full risk of borowwer default upfront; the government should not try to set up some system that pretends that risk doesn't exist.
Posted by: David Wright at Oct 10, 2008 4:28:32 PM
How many banks do you think are insolvent? And what are you basing it on?
Posted by: Ted Craig at Oct 10, 2008 4:28:57 PM
