More on the "Bailout"

Greg Mankiw's friend provides a nice follow up to my previous posting that the bailout is not about Wall Street Fat Cats. This friend was responding to the letter signed by many academic economists that expressed concern about the $700 billion bailout package. The friend writes,

A LOT of payrolls get paid at the end of the month. The next for many companies is September 30. Three different people with hugely relevant knowledge said to me today words to the effect of: "Why don't your economist buddies want [insert fortune 100 company/companies here] to be able to pay their employees on Tuesday. If Washington doesn't do something now, they won't be able to". That just scared the hell out of me. I can go into more details if you like, but all of them involve the four horsemen of the apocalypse.

Greg Mankiw responds to this friend that he too has reservation about the details of the plan. However, given the urgency of the situation, he believes we should ultimately follow Bernanke's lead:

I know Ben Bernanke well. Ben is at least as smart as any of the economists who signed that letter or are complaining on blogs or editorial pages about the proposed policy. Moreover, Ben is far better informed than the critics. The Fed staff includes some of the best policy economists around. In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could.

If I were a member of Congress, I would sit down with Ben, privately, to get his candid view. If he thinks this is the right thing to do, I would put my qualms aside and follow his advice.

Greg is correct here in terms of acting soon. However, I am on board with Paul Krugman and other economists who see the original Paulson plan failing to address the capital shortage problem. In case you missed this part of the debate, Sebastian Mallaby sums it up nicely:

How can the Treasury encourage private players to back up its purchases? The short answer is: Buy cheaply. If the government pays, say, 30 percent of what the loans were originally worth, any hedge fund that thinks they are really worth 40 percent will dive into the market. If the government pays 50 percent of what the loans were originally worth, that same hedge fund will stay on the sidelines -- or may even figure out a way of betting against the government.

[...]

[However,]Paulson and Bernanke... shrink from buying loans cheaply because doing so would force banks that currently value loans at high prices to recognize big losses, leaving them with too little capital. Buying loans cheaply would solve the liquidity problem in the loan market, but it would also reveal banks' capital shortage.

The way around this problem is for the Treasury to buy equity in the distressed institutions directly. Lucian Bebchuk explains it like this:

[Treasury buying troubled assets at fair market value--buying cheaply--] may leave us with concerns about the stability of some financial firms. Because falling housing prices depressed the value of troubled assets, some financial firms might still be seriously undercapitalized even after selling these assets at today's fair market value. That is, of course, why the Treasury wants the power to overpay. It wants to be able to improve the capital position of firms with troubled assets, restore stability and prevent creditor runs.

But the best way to infuse additional capital where needed is not by giving gifts to the firms' shareholders and bondholders. Rather, the provision of such additional capital should be done directly, aboveboard. While the draft legislation permits only the purchase of pre-existing assets, the final legislation should permit the Treasury to purchase new securities issued by financial firms needing additional capital. With the Treasury required to purchase securities at fair market value, taxpayers will not lose money also on these purchases.

Furthermore, this direct approach would do a better job in providing capital where it is most useful. Why? Because simply buying existing distressed assets won't necessarily channel the capital where it needs to go. Allowing the infusion of capital directly for consideration in new securities can do so.

Note that this approach makes existing shareholders "bail in" some of the losses--since their existing equity shares will be diluted in value--as opposed to having taxpayers completely bail them out. I find this approach to be a more equitable one for the taxpayers.

How We Got Here

Since many people are now asking what caused this financial crisis, I think it is worth reposting Charles Morris' 8 Steps to a Trillion-Dollar Meltdown:

1. The Fed spikes the punch bowl. In the wake of the dot-com bust and 9/11, the Fed lowers interest rates to 1 percent, the lowest since 1958. For more than 2½ years, long after the economy has resumed growing, the Fed funds rate remains lower than the rate of inflation. For banks, in effect, money is free.

2. Leverage soars. Financial sector debt, household debt, and home prices all double. Big banks shift their business models away from executing transactions for customers to “principal trading”—or gambling from their own accounts with borrowed money. In 2007, the principal-trading accounts at Citigroup, JPMorgan Chase, Goldman Sachs, and Merrill Lynch balloon to $1.3 trillion.

3. Consumers throw a toga party. Soaring home prices convert houses into ATMs. In the 2000s, consumers extract more than $4 trillion from their homes in net free cash (excluding financing costs and housing investment). From 2004 through 2006, such extractions exceed 7 percent of disposable personal income. Personal consumption surges from its traditional 66 to 67 percent of GDP to 72 percent by 2007, the highest rate on record.

4. A dollar tsunami. The United States’ current-account deficits exceed $4.9 trillion from 2000 through 2007, almost all for oil or consumer goods. (The current account is the most complete measure of U.S. trade, as it encompasses goods, services, and capital and financial flows.) Economists, including one Ben S. Bernanke, argue that a “global savings glut” will force the world to absorb dollars for another 10 or 20 years. They’re wrong.

5. Yields plummet. The cash flood sweeps across all risky assets. With so many people taking advantage of cheap loans, the most risky mortgage-backed securities carry only slightly higher interest rates than ultra-safe government bonds. The leverage, or level of borrowing, on private-equity company buyout deals jumps by 50 percent. Takeover funds load even more debt onto their portfolio companies to finance big cash dividends for themselves.

6. Hedge funds peddle crystal meth. Aggressive investors pour money into hedge funds generating artificially high returns by betting with borrowed money. To maximize yields, hedge funds also gravitate to the riskiest mortgages, like subprime, and to the riskiest bonds, which absorb losses on complex pools of lower-quality mortgages known as collateralized debt obligations or CDOs. The profits from selling bonds based on very risky underlying securities override bankers’ traditional risk aversion. By 2006, high-risk lending becomes the norm in the home-mortgage industry.

7. A ratings antigravity machine. Pension funds cannot generally invest in very risky paper as a mainstream asset class. So, banks and investment banks, with the acquiescence of the ratings agencies, create “structured” bonds with an illusion of safety. Eighty million dollars of “senior” CDO bonds backed by a $100 million pool of subprime mortgages will not incur losses until the defaults in the pool exceed 20 percent. The ratings agencies confer triple-A ratings on such bonds; investors assume they are equivalent to default-proof U.S. Treasury bonds or blue-chip corporates. To their shock, investors around the world discover that as pool defaults start rising, their senior CDO bonds rapidly lose trading value long before they suffer actual defaults.

8. The Wile E. Coyote moment arrives. Suddenly last summer, all the pretenses start to come undone, and the market is caught frantically spinning its legs in vacant space. The federal government responds with more than $1 trillion in new mortgage lending and lending authorizations in multiple guises from Fannie Mae, Freddie Mac, the Federal Housing Finance Board, and the Federal Reserve. Home prices still drop relentlessly; signs of recession proliferate; risky assets plummet.

How to Understand the $700 Billion Number

Justin Wolfers points us to this entertaining take on the $700 billion number:

Mabye the Other Shoe is About to Drop

Yves Smith has me worried that the other shoe is about to drop:

It has been conventional wisdom that China, Japan, and other countries that run trade surpluses with the US, which means they fund our overconsumption by buying assets like US Treauries, would never restrict the flow of credit to us because it would lower their exports and hurt their growth. We've long been leery of the idea that unsustainable trends will have a life eternal, and Brad Setser has a simple reason why this process is self-limiting. Our foreign funding sources aren't just lending us money to buy their goods; they are also providing the funding for interest on the loans extended for past imports. At a certain point, the interest payments become so large relative to the value of the exports that the deal no longer makes sense.

The day of reckoning may be approaching well before Setser's tipping point. And the trigger is much simpler. We look like a lousy risk. The Freddie/Fannie conservatorship, the Lehman bankrutpcy, and the rescue of fallen Asian powerhouse AIG has, not surprisingly, lead to a reassessment of the US's creditworthiness.

Yu Yongding, who has advised China's central bank, urges Japan, China, and Korea to forge an agreement not to dump US bonds. Yu says in no uncertain terms that the Chinese are worried about their US holdings and see a US default as a real possibility.

We've said before that the US is in the same position as Indonesia and Thailand circa 1996, except we have the reserve currency and nukes. The precariousness of our position is now evident to all, save perhaps the average American citizen.

From Bloomberg (hat tip reader a):

Japan, China and other holders of U.S. government debt must quickly reach an agreement to prevent panic sales leading to a global financial collapse, said Yu Yongding....

[...]

An agreement is needed so that no nation rushes to sell, ``causing a collapse,'' Yu said. Japan is the biggest owner of U.S. Treasury bills, holding $593 billion, and China is second with $519 billion. Asian countries together hold half of the $2.67 trillion total held by foreign nations....

[...]

China's huge holdings of U.S. debt means it must bear a large proportion of the ``burden of sorting things out'' in the U.S., Yu said. China is not in a hurry to dump its U.S. holdings and communication between the two nations every ``couple of days'' is keeping Chinese leaders informed and helping to avoid a potential panic, he added.

``China is very worried about the safety of its assets,'' he said. ``If you want China to keep calm, you must ensure China that its assets are safe.''

Yu said China is helping the U.S. ``in a very big way'' and added that it should get something in return. The U.S. should avoid labeling it an unfair trader and a currency manipulator and not politicize other issues, he said.

So there you have it: not only might the other shoe drop, but just the threat of it happening gives political leverage to the Asian authorities. Of course, we have no one to blame but ourselves.

The Bailout is Not About Fat Cats on Wall Street

I recently tried to explain the importance of the financial crisis to a bailout-skeptical friend, who is a medical doctor, with these words:

Let me put it this way: how would you feel if you woke up tomorrow and found you couldn't use your credit or debit card and couldn't access the funds in your bank account in any way? Or consider how long your hospital could function if it could not tap into its lines of credit or access its funds. Just go and ask your hospital CFO. More generally, the real side of the economy--the side where goods and service get produced--would come to a grinding halt if credit stopped flowing. This has become a real concern lately.

I think this is a point that many people miss. Our economy is so incredibly dependent on a smooth functioning financial system that its absence would devastate our day-to-day lives. Yet many people fail to appreciate this dependency and thus find it hard see the importance of stabilizing the financial system. What they see instead is the bailing out of Wall Street Fat Cats.

Now one can question the details of the proposed bailout, but that is a different issue. One can also raise questions about moral hazard, but at this juncture any moral hazard concerns are dwarfed by the threat of financial system meltdown. This intervention is all about maintaining our financial system. Bloomberg's John Berry argues this very point:

In the days since Treasury Secretary Henry Paulson released his $700 billion plan to restore stability to financial markets, the essential point has been lost in all the complaints about bailing out banks and greedy executives.

Why should such institutions be helped when ordinary American taxpayers -- who have managed their own finances prudently and are being battered by a loss of wealth and jobs -- have to pick up the tab?

Because there's no choice.

The fuss about the purpose of the plan and the sense that it was really just intended to help a bunch of fat cats had reached a point that Federal Reserve Chairman Ben S. Bernanke, testifying yesterday before the Senate Banking Committee, stressed that he was a college professor, had never worked on Wall Street and had no connection to it. His only concern, he said, was the future of the economy.

The credit markets are in a ``fragile condition'' and not functioning properly, Bernanke said. If no action is taken, more jobs will be lost, more houses foreclosed and the economy will contract because credit won't be available.

``There will be significant adverse consequences for the average person in the United States,'' Bernanke said.

Now with all that said, the prospect of a $1 trillion dollar deficit next year and its potential impact on the dollar and future financing costs also is troubling. One can only hope that Bill Gross and others are correct in their assessment that Main Street may actually profit from the bailout.

Money Demand is Stable After All...

if you use MZM (money zero maturity) as your measure of money. That is what Pedro Teles and Ruilin Zhou show in their paper, A Stable Money Demand: Looking for the Right Monetary Aggregate.

The [money demand] relationship... holds very well until the mid-1980s but not well at all after that. This could be because the demand for money is not a stable relationship after all... Another conclusion, which is our view, is that the measure of money is not a stable measure. In particular, we argue that technological innovation and changes in regulatory practices in the past two decades have made other monetary aggregates as liquid as M1, so that the measure of money should be adjusted accordingly. We show that once a more appropriate measure of money is taken into consideration, the stability of money demand is recovered.

As noted above, the authors find MZM to be the appropriate measure of money. MZM is defined as M2 minus small denomination time deposits plus institutional money market mutual funds. The main idea behind MZM is that it is an aggregate measure of money that includes all forms of money that can be immediately turned into purchasing power--there are no time restrictions on the money balances. In making the case for MZM the authors go through the list of reasons for the instability of demand for M1 and M2:

...[A] series of sweeping regulatory reforms and technological developments [since the early 1980s]in the banking sector have significantly changed the way banks operate and the way people use banking services and conduct transactions. First, the Depository Institutions Deregulation and Monetary Control Act of 1980 abolished most of the interest rate ceilings that had been imposed on deposit accounts since the Banking Act of 1933 and authorized nationwide negotiable orders of withdrawal accounts (NOWs), which are interest-bearing checking accounts classified in M1. Furthermore, the Garn–St Germain Depository Institutions Act of 1982 authorized money market deposit accounts (MMDAs), interest-bearing savings accounts that can be used for transactions with some restrictions. MMDAs are classified in M2. These two major banking reforms blurred the traditional distinction between the monetary aggregates M1 and M2 in their transactions and savings roles. Second, the rapid development of electronic payments technology and, in particular, the growing use of credit cards and the automated clearinghouse (ACH) as means of payment, reinforced the effect of the banking reforms in slowing down the growth of M1. Both credit cards and ACH transactions can be settled with MMDAs and, therefore, with M2 rather than M1. Third, the widespread adoption of retail sweep programs (discussed in detail later) by depository institutions since 1994, which reclassify checking account deposits as saving deposits overnight, reduced the balances that were classified in M1 by almost half.

These fundamental changes in the regulatory environment and the transactions technology justify the use of a different measure of money after 1980... We show that changing the monetary aggregate measure from M1 to MZM from 1980 onward preserves the long-run relationship between real money, the opportunity cost of money, and economic activity up to a constant factor.

The authors then go on to empirically estimate a stable money demand function with MZM and show that there is no "case of the missing money" with this monetary aggregate. One interesting series of graphs they report plots the ratio of a monetary aggregate to GDP against the nominal interest rate. Some interesting inverse relationships emerge from these figures. I have reproduced the graphs below, but here have flipped the monetary aggregate to GDP ratio. See if you note any striking differences in this relationship based on the monetary aggregate used (click on graphs to enlarge):

I find it striking that GDP/MZM tracks the nominal interest rate series so much more closely than the other monetary aggregates beginning in the late 1970s. Let's say these results hold up going forward. A key implication would be that U.S. monetary policy could once again look at a monetary aggregate.

Update: John Carlson and Benjamin Keehn come to a similar conclusion here.

Waiting for the Other Shoe to Drop

As bad as it has been in U.S. financial markets, Ken Rogoff reminds us that it could be, and may yet become, worse:

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America’s flagship financial sector, the public and private sector’s massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

In other words, in spite of the financial meltdown going on in the United States foreigners continue to fund the United States living beyond its means as evidenced by the strength of the dollar. (Click on graph to enlarge.)


As Brad Sester notes, though, this foreign financing as of late is (1) coming only from the public sector in foreign countries and (2) even they are running from assets other than safe U.S. treasuries. On this latter point Brad points to a disturbing development reported in the Treasury's TIC data:

[The TIC data] tells a simple story: demand for risky US assets disappeared in the month of July. That continues a long-standing trend. But that trend intensified significantly. And I suspect its intensity increased even more in August.

Among other things, the TIC data challenges the common argument that sovereign investors have been a stabilizing presence in the market. Best I can tell, sovereign investors joined private investors in retreating from all risky US assets in July, and thus added to the underlying distress in the market. I don’t fault sovereigns for limiting their risk. It has proved to be a sound financial choice. But I also find it hard to square their (inferred) actions in the market with many claims about their behavior.

The TIC for July pains a very clear picture: Treasuries were the only US asset foreign investors were willing to buy. Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.

So even though foreign monetary authorities continue to support the dollar through purchases of U.S. securities they are doing so in a increasingly selective manner. As bad as the markets are now, it could get dramatically worse should this source of foreign financing dry up. It does not take a very imaginative mind to wonder how long before this other shoe drops too.