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September 30, 2008
On rescues and bailouts
I’ve been thinking a lot about this topic lately, and though it seems there are a good many folk who approach the issue with great certainty, I do not share their confidence. I have, however, found it helpful to think through the following (not entirely original) scenario:
I am sitting on my back deck one fine afternoon and notice smoke coming from the kitchen window of my neighbor Joe. The color and volume of the smoke—and the fact that I know that Joe is not home—leave no doubt that the kitchen is on fire.
I begin to calculate my possible responses. I think Joe has a sprinkler system installed, so it is possible that safeguards already in place will soon put the fire out. Of course, I’m not entirely sure the system is up to the task—or even if it exists—so I consider a limited intervention in the form of running inside my own house and calling the fire department. They are a pretty efficient unit, but in the best of circumstances it will take them some time to arrive. So I also contemplate the most extreme measure available to me: grabbing my garden house, breaking down Joe’s back door, and addressing the fire directly.
It’s a hard choice, so I begin to think about the costs and benefits of each option. If I rely on the uncertain quality (or existence!) of the sprinkler system, or wait for the fire department to arrive, the fire could spread rapidly and possibly threaten my property. On the other hand, if I rush in with my hose, I could get hurt—the direct intervention could be costly, too. What’s more, my intervention might not do the trick—the fire could be too big, my garden hose too inadequate a firefighting tool.
I decide to throw caution to the wind, grab the hose, and burst into Joe’s house. I am able to successfully quell the flames, escaping with only a few minor burns and watery eyes. I feel pretty good about the whole business, but the truth is I discovered that the sprinkler system was indeed operating and may have put out the fire on its own (though it hadn’t yet). And just as the last flicker expires, I hear the fire engines in the distance. They may have arrived in time to spare my house (though it is clear that the fire was spreading quickly). So, I wonder. Did I do the right thing?
Actually, my dilemma deepens. When the fire marshal arrives, he discovers that the cause of the fire was a cigarette, foolishly left to burn near a stack of old papers. I knew all along that old Joe was the reckless sort, and now I fear that by stepping in and containing the damage that Joe had brought upon himself I may just be encouraging more such carelessness in the future.
Then again, the kitchen is a total loss, and the smoke has permeated Joe’s house and ruined more than a few pieces of furniture. Though it is obvious that Joe has been spared total ruin, will he really feel that his actions have gone without consequence? Will he feel that the fates have bailed him out?
I wonder.
UPDATE: I'm getting some ribbing over the similarity between my scenario and the analogy offered today by a certain well-known candidate for high political office. Though I did note that my story is not entirely original, I assure you that the present coincidence is, well, entirely coincidental.
September 30, 2008 in Banking, Financial System, Money Markets | Permalink
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Comments
Posted by:
Matt Dubuque |
September 30, 2008 at 03:43 PM
Sorry, I don't feel *at all* like Joe's neighbor. I feel much more like the unwilling neighbor of a problem gambler.
Also on the face of it, it appears that Joe has a wealthy aunt (let's call her Sen. Auntie Em) he has ingratiated himself with. This is an aunt that he can intermittently tap for funds when he can't make his boat payment or those infrequent (but readily predictable) times when he burns his house down.
Makes the case for helping Joe a little less compelling, yes?
Posted by:
IdahoSpud |
September 30, 2008 at 03:43 PM
I suppose the question of whether Joe is careless again depends on whether he will be ever again be offered tens of millions of dollars in bonus to do so.
The real problem is that the incentives are skewed even without intervention.
Posted by:
Anurag |
September 30, 2008 at 03:54 PM
On the other hand, your other neighbors suffered no loss and will feel free to behave recklessly in the future, confident that you will save them.
Posted by:
Erik |
September 30, 2008 at 03:58 PM
The comparison isn't adequate. The risk/reward ratio in the case above should'nt motivate you to rescue joe's house at the risk of losing your own life.
To be brutal: that's why banks can't recapitalize at the moment unless at the cost of massive shareholders dilution.
To come back to your story: the owner would have called joe and asked 'if I go in now, do I get half the ownership of your house??'
Posted by:
Marc |
September 30, 2008 at 04:44 PM
The primary problem with this analogy is that it assumes an unlimited supply of water. But this type of fire, the more water you use, the less effective it becomes. Indeed, it won't be long before the water is actually fueling the fire.
The secondary problem is that it assumes Joe has morals. Forget it! He never had any and never will. The idea that the Joes of the world are affected by morality is something dreamed up by the government.
Posted by:
Anonymous |
September 30, 2008 at 06:10 PM
But Joe has only been occupying this house which actually is owned and guaranteed by his wealthy uncle and if it burns, it doesn't matter - he has partied there for a long time, all the while profiting considerably from the saved rent. Further, since as a neighbor he has been so ostentatious and selfish, and because we have a buffer zone in between our houses, I am willing to bet that my damages will be relatively minor in the hope that this pest of a neighbor will be effectively smothered by his benefactor.
Posted by:
BR |
September 30, 2008 at 08:16 PM
Just a mark of your obvious thoughtfulness Dave ... Don't disown the post!!
Posted by:
Guhan |
September 30, 2008 at 09:03 PM
Matt Dubuque
The interbank lending market remains in a coma threatening us all, irrespective of what the Dow Jones Industrial Average may be doing on a short-term basis.
As Senior Economist Gordon Sellon of the Kansas City Federal Reserve discussed in his seminal paper "Monetary Policy and the Zero Bound: Policy Options When Short-Term Rates Reach Zero" published in the Fourth Quarter 2003 edition of the Kansas City Federal Reserve's "Economic Review", the Federal Reserve should now consider under taking "twist" operations in the open market.
That paper is available here at the bottom of the link:
A "twist" operation by the Federal Reserve in the current context would consist of the Fed SELLING 3-month Treasury Bills while simultaneously PURCHASING 5-year Treasury Notes. Such operations, applied judiciously, would affect the term structure of various markets in a positive way.
Such "twist" operations are not without precedent. It was performed during the Kennedy Administration:
I urge people to STUDY Sellon's critical paper at the link provided above to grasp some of the subtleties involved here before engaging in uninformed knee-jerk criticism.
This is not a cure-all, but it is clear that it should be on the short list of our policy options.
Matt Dubuque
mdubuque@yahoo.com
Posted by:
Matt Dubuque |
October 01, 2008 at 09:30 AM
I like your metaphor - the only thing I think you missed is that the water hose used to put out the fire may bankrupt me and my children due to future taxes to pay for it. Makes me think more about taking some fire damage vs bankruptcy
Posted by:
GR |
October 01, 2008 at 09:53 AM
The best way to approach the liquidity & then part of the insolvency in the non-banks is to get the commercial banks out of the savings business (REG Q in reverse but excluding the non-banks).
What would this do? The CBs would be more profitable, there would be an immediate increase in the supply of loan-funds (non-inflationary liquidity), both long-term & short-term interest rates would be considerably lower, and the economy would crawl out of this depression.
Posted by:
flow5 |
October 01, 2008 at 05:57 PM
Just like“Banks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements – Testimony of Treasury
“These measures should help the banking sector attract liquid funds in competition with non-bank institutions and direct market investments by businesses” Testimony of Treasury
A commercial bank becomse a financial intermediary only when there is a 100% reserve ratio applied to its deposits.
Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.
From a systems viewpoint, commercial banks as contrasted to financial intermediaries: , never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity or any liability item.
When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) and every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs).
The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free gratis legal reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (transaction accounts), as fixed by the Board of Governors of the Federal Reserve System.
Since 1942, money creation is a system process. No bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand. If the member banks hold 80 percent of all bank assets, an expansion of credit by the nonmember banks and no expansion by member banks will result, on the average, of a loss in clearing balances equal to 80 percent of the amount being checked out of the nonmember banks.
From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its free/gratis legal reserves, not a tax [sic] – and thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other commercial banks (outflow of cash and due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.
That is, CB time/savings deposits, unlike savings accounts in the “thrifts”, bear a direct, one-to-one, unvarying relationship, to transactions accounts. As TDs grow, TRs shrink pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.
Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.
Consequently, the effect of allowing CBs to “compete” with financial intermediaries (non-banks) has been, and will be, to reduce the size of the intermediaries (as deregulation did in the 80’s) – reduce the supply of loan-funds (available savings), increase the proportion, and the total costs of CB TDs.
Contrary to the DIDMCA underpinnings, member commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its "open market power", to prevent any outflow of currency from the banking system.
However, disintermediation for financial intermediaries- (non-banks), is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets with historically lower fixed rate and longer term structures.
In other words, competition among commercial banks for TDs has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the "thrifts" with devastating effects on housing and other areas of the economy; and 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds.
Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to TRs within the CBs and the transfer of the ownership of these TRs to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs or the volume of their earnings assets.
In the context of their lending operations it is only possible to reduce bank assets and TRs by retiring bank-held loans, e.g., the only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.
The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits and the opportunity is present) which amount to server times the initial excess reserves held.
Financial intermediaries (non-banks) lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings; they always, as noted, create new money in the lending process. Saved TRs that are transferred to the S&Ls, etc., are not transferred out of the CBs; only their ownership is transferred. The reverse process, which is called “disintermediation”, has the opposite effect: the intermediaries shrink in size, but the size of the CBs remains the same.
Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.
From a System standpoint, time deposits represent savings have a velocity of zero. As long as savings are held in the commercial banking system, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.
From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.
Lending by intermediaries is not accompanied by an increase in the volume, but is associated with an increase in the velocity or turnover of existing money. Here investment equals savings (and velocity is evidence of the investment process), whereas in the case of the CB credit, investment does not equal savings but is associated with an enlargement and turnover of new money (money supply).
The difference is the volume of savings held in the commercial banking system is idle, and lost to investment as long as it is held within the commercial banking system. Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have recessionary effects in our highly interdependent pecuniary economy. Thus, the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment.
It began with the General Theory, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”
In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. Perhaps this is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Reg Q, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, etc.
How does the FED follow a "tight" money policy and still advance economic growth.? What should be done? The commercial banks should get out of the savings business (REG Q in reverse-but leave the non-banks unrestricted-compensated for transition). What would this do? The commercial banks would be more profitable - if that is desirable. Why? Because the source of all time deposits within the commercial banking system, is demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts. Money flowing "to" the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.
Dr. Leland James Pritchard (MS, statistics - Syracuse, Ph.D, Economics - Chicago, 1933) described stagflation 1958 Money & Banking Houghton Mifflin,
“The Economics of the Commercial Bank Savings-Investment Process in the United States” -- “Estratto dalla Rivista Internazionale di Scienze Econbomiche & Commerciali “ Anno XVI – 1969 – n. 7
“Profit or Loss from Time Deposit Banking” -- Banking and Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.
Posted by:
flow5 |
October 01, 2008 at 06:00 PM
I never liked this blog much, and now I like it even less.
Posted by:
whaaa? |
October 01, 2008 at 07:51 PM
Can I just say thank-you for publishing this blog. Could we make it mandatory reading for members of Congress?
Posted by:
Mr. ToughMoneyLove |
October 01, 2008 at 09:57 PM
Question: Will the water from your water hose corrupt the DNA on the cigarette remains and wipe any remaining finger prints from the paper ashes, door handle, etc? If so, the fundamental incentive for putting out the fire before the investigators arrive may become clear.
Posted by:
Ken |
October 01, 2008 at 10:01 PM
Yes, what a fine analogy.
The problem is the water table is running real low in the county.
For years Joe and his friends in the McMansion subdivisions have been watering their lawns knowing full well that the water table is low.
You have to decide if putting out the fire in Joe's house is the best idea.
Putting it out might be it. The water might run out for the whole county. If so everyone will have to move out and go somewhere else.
You also know that Joe has insurance and an insurance agency standing behind him. While losing his property because the lack of water will probably raise everyones insurance payments, at least no one would have to abandon the county and the county will be able to continue looking for a new source of water and live to fight another day.
So you really must choose between putting out the fire at the risk of loosing everything and perhaps even being unable to stop the fire from spreading if the well runs dry before it's out or creating a backfire that might help save everyone from facing the fire coming from Joes' house.
Posted by:
Chris |
October 02, 2008 at 11:57 AM
Whatever happened to 'individual responsibility and accountability?' I believe you've entered a highly contentious area of individual risk vs. the perceived common good.
When did you become big brother? When did you become his keeper? Where's your name on his deed/mortgage? When were you hired as security for his property? Are you his insurance company? Is he required to ask permission from you before he smokes his cigarettes, buys a newspaper, turns on the stove, yearly furnance checks, plugs in electrical appliances? Do you check his house for smoke and carbon monoxide detectors? Do you come over and replace the batteries yearly? Is he allowed to walk, talk, and chew gum at the same time....hahahahaha
And BTW, I'm your next door neighbor. I've noticed that you leave your lights on all nite. I'm concerned. What are you doing? Do you remember to turn off the stove after cooking and that woodburning fireplace is used way to often and is a fire hazard. When did you last get your electrical wiring replaced? Hmmmmmmm
Point; I will not demand that you comply to my standards. Therefore, as an adult I shall take precautions with my own home and wish my neighbor good luck as he does me.
"They that can give up essential liberty to obtain a little temporary safety deserve neither liberty nor safety." B. Franklin
Posted by:
rps |
October 02, 2008 at 01:44 PM
It's a good analogy. I have traded in the credit market for 20 years. This has been a market unlike I have seen. In 1987, we had a heart attack. But the market worked its way out of the mess. The Fed provided the correct action.
This has been with us for over a year, and has been brewing for longer than that. Kind of like a cancer.
I am against a bail out of gigantic proportions. However, it is mission critical that we get the credit interbank market operating again. It is the lifeblood of our economy. The government must do something targeted toward that.
What is the critical problem? Counter party risk. No one trusts the other's balance sheet. Do you blame them?
There is only one way I know of to alleviate counterparty risk. It's a clearing house, similar to the ones used by futures exchanges. If you go to www.cme.com, you can get a good description of how a clearing house works.
So going forward we don't necessarily need more regulation, but we do need a different market structure with a clearing house being an integral part of it.
Looking backward, it's really tough to figure out what to do. I am not in favor of suspending mark to market-because they didn't mark the stuff to market for years on their books. But we do need to get this stuff off their books. If this is through a RTC type vehicle so be it. As long as the government buys the stuff for pennies on the dollar, then we should be okay long term.
The other thing that concerns me is the politics around the issue. In the next administration, they really should not raise taxes-and they should do everything that they can to lower trade barriers. My worry is that they will do the opposite-replaying 1932.
Posted by:
Jeff |
October 02, 2008 at 11:20 PM
Aside from the fact that making up a ridiculous analogy proves nothing, the real situation involved giving $700 billion to an administration which has proven that not only *could* it f*ck up a two-car parade, but has repeatedly done so, while stealing vast sums.
And it's made by somebody who won't suffer when the administration does steal the money and laughs, handing the problem over to the Obama administration for Bailout II.
Posted by:
Barry |
October 03, 2008 at 01:03 PM
The analogy is stupid, as it leaves out several features of what is really going on, like the obscene paychecks on Wall Street, the fraudulent CDS sold by AIG to European banks to enable them to get around inconvenient capital requirements, and the big lie that the troubles of Wall Street are having such a terrible effect on Main Street that we must give them hundreds of billions of dollars. It is truly disgusting.
The Fed publishes a daily commercial paper report, as well as the weekly H.8 release that lists banking assets and liabilities. The CP report shows that nonfinancial companies are NOT having any trouble getting funded, while the H.8 shows that the expansion in bank credit continues unabated. Banks will not lend to each other because they know the balance sheets of other banks, like their own, are largely fictitious. But they are making loans to nonfinancial companies, and that's all that matters for the larger economy.
Posted by:
NotTheSameJeff |
October 04, 2008 at 03:33 PM
I think we need to add the part where Joe is standing in front of his house afraid to go in and put out the fire himself, but will be just happy enough to let his neighbors do it.
Posted by:
Jim |
October 04, 2008 at 11:12 PM

Well what Joe learns is partially up to him.
But Joe IS your neighbor. His property values affect your property values. And the fire threatened the house of your cousin, who lives next door to him.
Let's imagine that the cause was not merely a careless act of a misplaced cigarette, but was rather induced by Joe's son Charley, a Gothic type, who had been experimenting with homemade explosives in the basement.
Charley was in over his head and thought that past experience with harmful chemicals proved that they could never combust spontaneously in his absence.
Furthermore, some of the chemicals in Charley's possession required the consent of an adult to purchase, a "technicality" Charley had never complied with. Should Charley's father be punished?
However, the whole analogy of a neighbor's house on fire is completely unacceptable because it does not convey the possible consequences of the offending conduct.
This catastrophe in the interbank market that is beginning to amplify through the "real" economy is not merely a "house fire".
There is a small but quantifiable chance it could cause millions of premature deaths worldwide over the next ten years.
A far more apt analogy would be if the glorious Government researchers at Fort Detrick Maryland had been searching for a "defensive" response to an al Qaeda biological attack and had inadvertently released a highly virulent strain of smallpox into the population that threatened to kill 30% of the people worldwide.
But they never intended to do such a harmful thing.
Should the Secretary of Defense lose his job over such an occurrence?
Matt Dubuque