The public is terrified that banks are going to fail, which is why the demand for safe havens is exploding: gold is up over $100/oz. in the past few days, and the interest rate on 3-mo. T-bills has dropped to zero (actually, 0.1% according to Bloomberg as I write this). And of course stocks are down to new lows, and credit spreads are sharply wider. This now approaches a classic crisis of confidence in the banking system.
A problem like this can't be solved by lowering the Federal funds rate (but you can't rule out the possibility that the Fed would be compelled to do just that if things get worse). For now, the government is going to have to take some action which shores up confidence directly. And they are probably going to have to socialize a good portion of the real estate-related losses that have not already been written off. Raising the FDIC deposit insurance limit would help, as would establishing another RTC, as suggested by Brady, Ludwig and Volcker in today's WSJ. And the Fed will have to "lend freely" as recommended long ago by Walter Bagehot.
More disturbing is the increasing (though still relatively small) likelihood that some of these losses will be absorbed via the printing press. Higher inflation is a back-door way of dealing with too much debt. That's the Argentine recipe for getting out of a debt mess: run the printing presses and use the money to pay off debt holders. Higher inflation not only reduces the burden of the debt but in this case it might also slow or stop the decline in housing prices, and that would short-circuit this crisis directly. The risk of higher inflation would help explain the sudden rush to gold (though I think it's mainly a bank panic for now). No one has proposed an Argentine-style solution yet, and even if they did it would most likely be disguised amidst a blizzard of other measures, loans, and/or bailouts.
So, the solution to this problem will probably involve 1) the socialization of remaining real estate losses, and 2) more inflation than most people expect. On this latter point, I would note that the TIPS market is assuming that inflation is set to plunge from its current 5% level, averaging a mere 1.5% over the next five years. If you think inflation could be higher than that (which seems likely to me), then TIPS should be your investment of choice if you're looking for a safe haven.
A few quotes regarding banking from a champion of free enterpirse:
ReplyDeleteImprudent granting of credit is bound to prove just as ruinous to a bank as to any other merchant. Ludwig von Mises
There was no reason whatever to abandon the principle of free enterprise in the field of banking. Ludwig von Mises
It is extremely difficult for our contemporaries to conceive of the conditions of free banking because they take government interference with banking for granted and as necessary. Ludwig von Mises
What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract. Ludwig von Mises
CDLIC
Most appropriate quotes, cdlic.
ReplyDeleteAnd why is the socialization of real-estate losses a confidence inspiring action? The failure of GSEs proves they are misallocating capital to uneconomic activities --this process should be stopped immediately if we want the economy to recover and better meet all of our needs.
I'm not saying it's the best solution. But if the government decides to pick up the tab for further losses, then that removes the risk of bank and/or financial market failure. It takes the losses out of the hands of a small number of institutions and distributes them across the whole population. It buys everyone time to work this problem out. It's quite unfortunate, to be sure, and it's the price we pay for all the mistakes which led up to this crisis. Let's hope we can rebuild things in a more intelligent fashion.
ReplyDeleteI just learned that 3/4 of all the debt of AGI is held by FOREIGN BANKS. Thus, the American tax-payer, via the Federal Reserve actions today (9-17-08), just bailed out the likes of Chinese and Russian banks holding the debt. No doubt Chinese and Russian bankers and politicians are celebrating by dancing in the ‘streets’ this evening while drinking moutai and vodka.
ReplyDeleteCDLIC
The GSEs have been directly responsible (in part) for the misallocation of scarce resources to uneconomic activities. The Fed/Treasury action ensures that these harmful behaviors will continue in a context that prevents market discipline from stopping them.
ReplyDeleteThis is not even a solution, let alone the best solution. It is the problem.
The only people benefitting are other banks and debt holders, many of them foreign, as cdlic mentions.
And, as you well know, the Federal Government can't ever pick up the tab -- it is us, the people who have already been harmed by the misallocation of resources.
This bailout is a bigger crime than the original creation of the GSEs, because now their insolvencies prove they harm the economy. When founded, it is arguable that government officials didn't understand the GSEs would cause so much damage.
We never should have had the GSEs. They weren't necessary. Then the politicians got involved, and that made a bad problem worse. Just like social security, a tax masquerading as an annuity program, with the benefit payouts determined by politicians instead of by actuaries.
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