Monday, October 13, 2008

Send in the FBI!

On Monday the markets all over the world rallied on an almost unprecedented scale as a result of a new cash injection plan, based on a Swedish crisis management model, dusted off by Gordon Brown in England. What will almost inevitably happen, is that we can forget all about the bailout plan that was approved a couple of weeks ago, where U.S. taxpayers would buy “bad assets” from Wall Street firms. Instead, U.S. taxpayers will soon own large parts of a few U.S. banks; the few that will be left standing after a coming wave of bank mergers. I think it’s a great plan, and have said from the beginning that this is the only thing that has any potential of working. It remains to be seen whether the U.S. government will try to guarantee all transactions between banks, like the EU has said it will, but I doubt that this could be done in reality. The risk of default is too big.

The fact that the stock market has plummeted lately is not the biggest of our concerns right now. The biggest risk to the financial system is the fact that banks are not lending to each other. Banks are not lending to each other because they don’t know how many bad assets the other banks have. They don’t know this because all the banks are trying to hide their assets, and are able to do so because of a lack of regulation. It is for certain that there are many Wall Street firms and banks that will not make it through this crisis, but we don’t yet know which ones they are. It makes perfect sense for banks to be suspicious and pull the plug on lending when the potential borrower might be in such bad shape that it will go under only the next day. There are still around 100 trillion dollars worth of bad assets out there, and nobody knows where they are.
I propose radical steps in order to deal with this problem, steps that involve forensic accountants from the FBI.

The very basis of a capitalist system is information that guides buying, selling, lending, and other decisions. If we are to ever get out of this crisis, we must find all the information that is hidden from the view of investors, the government and the public. The bad assets in the banks and other financial institutions that are hidden from view can only be found by means of coercion, because it would not be in the banks’ interest to have them exposed. I believe that the best way to expose the bad assets would be to make a law that would enable the FBI to raid Wall Street banks and financial institutions and comb through their books meticulously in search of bad assets. The findings would then be published continuously for everyone to see. This would eventually smoke out all the bad assets and cleanse the economy to some extent. Obviously, having such bad assets exposed would not be good news for the banks’ stock prices or near-term future prospects. However, the alternative is to have them hidden for longer, which will drag the economy down for years to come. That is exactly what happened to Japan during the 90s, a decade that has come to be called “Japan’s lost decade”.

I believe we need to take such drastic steps because we need to make up for decades of de-regulation. The financial regulation has failed, and is wholly inadequate at this point, so something drastic must be done before we can start over and re-make our regulatory system. A lot of people are feeling vengeful towards Wall Street these days, but that is not why I am proposing FBI raids. I am proposing this because I believe this is the only way to truly deal with the problem. It is somewhat bizarre to hear about “greed on Wall Street” as a reason behind the crisis. A Wall Street worker or executive would not be doing his job if he were not greedy…


Anonymous said...

What do you think of roubini's contention that continuing to bail out the banks or even buy their shares, will not resolve this crisis.

The key (he says) to resolving this crisis is for the government to prevent these foreclosures from taking place - he argues that they literally need to change the terms of the loans in order to make it possible for people to be able to remain in them.

What's the point of bailing out the banks when the consumers (the banks customers) will still not be able to borrow because of their pre-existing personal debt.

Jacob said...

I think that contention is erroneous, simply because this crisis is definitely not just about housing anymore. In addition, the issue of housing and housing prices is much more complex to be solved by the Roubini plan, or McCain's or Obama's recently announced plans. The issue also involves integration, fuel costs, but above all the future of securitization. The U.S. will have to adopt the system of covered bonds, which will make mortgages more expensive, and houses cheaper.

The banks must be bailed out so as to not cause unemployment. The days of borrowing to consume or invest are over...

Anonymous said...

I am now totally confused as to why paulson is telling these banks to spend the money he is giving them!

So, the banks are going to loan money to each other in order to do what exactly???

I read this article in the NYT comments section and tend to agree with it.

Boosting liquidity is a short-term solution. The fundamental problem is that recent economic gains have gone only to a relative few. The switch to double income households, the assumption of debt, and the vanished proceeds of the asset bubble were used by the majority of consumers to sustain their purchasing power relative to inflation.

Without stronger wage growth across the entire working population, demand cannot be sustained. And without demand, there is no market, no growth – only a slow spiral down into the abyss.

Are these banks forgetting that most americans are in debt and are stuck with stagnant wages?

Jacob said...

You are exactly right about wage growth and the connection to spending. Since only a small portion of the population is unionized in this country, the combination of increased inflation and lower employment in the years to come will probably mean lower real wages for most Americans.

In reality, the new Paulson plan is only a crisis management plan designed to make it so that businesses who depend on loans for investments and payroll will not go under or have to lay people off. Just like a factory which may not have enough cash to buy a new assembly robot for a surge in production, banks may not have enough cash at all times to finance a new big deal, such as a huge loan. For that reason, they must borrow from other banks.

In addition, politicians will probably try to make the case for continued effects of "voodoo economics", meaning that somehow the wheels will start spinning again and before we know it things will go back to the way they used to be. That is not so.

Anonymous said...

Why on earth would a business depend on loans for payroll? To be honest, this is the first time I have heard this concept.

If you can't even afford to pay your employee's without loans, aren't you better off laying them off until you have the cash on hand to pay them?

The entire american business model makes no sense. Do they do this in other advanced economies? i.e. pay employee's with loans?

Jacob said...

Yes, that is, unfortunately, the reality. When cheap credit is made available, that tends to happen. In an eposide of Seinfeld, Jerry tells Kramer when Kramer has offered Elaine a loan from Jerry (curiously): "People don’t turn down money, that’s what separates us from the animals".

I believe that payroll is usually not paid by loans in other advanced economies, where credit is not generally as easily available. The exceptions have been countries that have, up until recently, also gorged themselves on credit such as Spain, England and Russia. In many parts of Europe, taking loans is still a shameful act.