(Notes for Remarks Made at a Joint Atlas/NCPA Breakfast on Friday, September 26, 2008)
I'm still under the influence of our "Cowboy Chic" night last night. I can relate to the cowboy part, but I'm not so sure about the chic. Given our preoccupation with the ongoing financial crisis, it reminded my of the way a cowboy doubles his money: "He folds it over and puts it back in his pocket."
My research has turned up only one cowboy poem about banking and collateral. To summarize, the cowboy went to the bank to borrow some money. The banker said he'd have to have some collateral and asked the cowboy: "How many cows you got?"
The cowboy was a little put off by that, but everything worked out all right, and the cowboy made a nice profit on this cattle. When he went to the bank to pay off his loan, the banker encouraged him to deposit his profits in the bank. The cowboy thought about it for a minute, then asked the banker, "How many cows you got?"
The financial crisis is over a year old now, and is getting worse despite the Fed's best efforts. The Fed has been playing whack-a- mole for a year now-it knocks one problem down and up pops another.
As a rock and roll fan, I'd cite Buddy Holly's song: Crying, Waiting, Hoping as capturing the mood of the past several months. As a country music fan, I'd probably choose "I can't kiss you good-bye darling cause you won't go away."
I don't have much time this morning, so I'll just summarize the origins of the sub-prime mess with a sophisticated Japanese Haiku:If good loans Don't earn enough to suit us Maybe bad loans will.
Of course, all this happened within the context of long-standing American culture of debt, which I've tried to capture in a less sophisticated rhyme:My house is under water, for sure My car is upside down, you bet But I'm getting me a consolidation loan And finally getting out of debt.
We have too much debt and not enough credit. This strikes me as odd since credit and debt are two sides of the same coin, and, by definition, are always equal.
What's been going on is a long, painful deleveraging process; so, I expect my next poem to be titled "The Deleveraging Blues."
But I'm blocked, like the credit markets, and I can't get anything to rhyme.
All I've got so far is"My capital is too thin to spread on a cracker What I need is a Middle Eastern backer Or maybe a Chinese sovereign wealth fund Would lend me back some of my mon-ny"
[I learned that little method of cheating for a rhyme from Arlo Guthrie's motorcycle song.
"I don't want to die; I just want to ride my motorcy-cle"]
By the way, what rhymes with toaster? I don't want to have the bank repossess my toaster.
The Real Economy
On the impact of the crisis on the economy:
A little-noticed GDP revision gave us a negative 4th quarter 2007-the first negative quarter since this expansion began in the 4th quarter of 2001.
The 1st and 2nd quarters 2008 were positive, largely because of the impact of the cheaper dollar on net exports-exports went up and imports went down. In the 2nd quarter, real GDP rose 3.3 percent, and increased exports and reduced imports together accounted for 3.1 percentage points of that. [The plus 3.1 percent increase was just revised down to plus 2.8 percent.]
I think renewed weakening in the economy is inevitable. Consumers, who now account for 70 percent of total spending, have been sustaining the economy by spending all their disposable income and saving none of it. They thought of their capital gains in the stock market and their homes as their savings, and would usually withdraw some of their equity when they refinanced.
Those two piggy banks for consumers are now long gone. Most consumers need to consume less and save more, but if too many of them become thrifty at the same time, we'll have-pardon me ladies and gentlemen-a "Paradox of Thrift," as described by Keynes.
The downdraft in labor markets is getting stronger. We've had a decline in payroll employment for the past 8 months, and the unemployment rate has finally moved above 6 percent.
We may not get two consecutive negative real GDP quarters, but I think the business cycle dating committee of the National Bureau of Economic Research is almost certain to declare a recession, beginning last December or January. The recession, or slowdown, is unlikely to be as short-lived as the last two, and probably not as mild.
The Credit Markets
The pipes of the credit markets have been clogging up, and it was still getting worse as of yesterday morning. Too bad my mother is no longer with us. She could have fixed this mess. No matter what was wrong with me, her cure was always a large dose of Syrup Pepsin, her laxative of choice. I'm pretty sure that most of you think of the present bail-out proposal as an appropriate target for a laxative.
What is vs. what ought to be.
There's a country song that says, "I tell it like it used to be when you were still in love with me," and, later, "I tell it like it ought to be ‘cause how it is killing me."
How things ought to be is that the moral hazard involved in the mortgage securitization process should have been recognized and dealt with years ago.
How it ought to be is that Freddie and Fannie should have been restrained years ago by eliminating their subsidized borrowing rate.
Investment banks ought to have had some limits on their debt relative to capital, to prevent excessive leverage. However, given where we were this past year and where we are now, I think government intervention along the lines of the Paulson plan is necessary to prevent a financial meltdown.
Bailouts and Moral Hazard
I know I can't make you feel good about any of this, but things aren't as bad as the conventional wisdom has it. I'll comment briefly on bailouts, moral hazard, potential inflation, and the budget impact of what's been going on.
The main reason to avoid moral hazard is to avoid rewarding overly risky behavior by decision makers so that future decision makers won't emulate their behavior.
The Fed facilitated the buyout of Bear Stearns by J.P. Morgan/Chase by lending $30 billion on collateral after a large haircut.
Bear was not bailed out because top management lost their jobs and stockholders were virtually wiped out. They were gobbled up, not bailed out.
For that reason I don't think the Fed's loan created significant moral hazard that would invite others to emulate the policies that brought Bear down. Bears creditors and counterparties were helped compared to the alternative outcome of bankruptcy. That might bias future creditors to favor larger institutions, but these secondary parties aren't as relevant to the moral hazard problem and the decisionmakers.
The situation is similar with the Fed's $85 billion, fully collateralized, bridge loan to AIG.
The CEO of AIG, on the job only a few months, was fired by the Secretary of the Treasury expressly to avoid moral hazard.
Also, the Treasury got an 80 percent equity stake in AIG, a company that arguably could have made it on their own after the bridge loan. This also is not an outcome future decision makers will want to emulate because AIG was treated so well.
The takeover of Fannie Mae and Freddie Mac was also similar-not a bailout, but a takeover. The CEOs lost their jobs and the stockholders were wiped out. I would argue that no moral hazard affecting decision makers was created by the Fed's offer of access to the discount window and the Treasury's potential injection of funds. After all, they were put into conservatorship by their regulator.
The two CEOs were let go even though most of the accounting irregularities occurred on their predecessors watch. Stockholders were either wiped out or virtually wiped out.
I would not define any of these cases as "bailouts" that would encourage copying of their sins, even though creditors and counterparties may have benefited.
After all, good economic policy that contributes to a good economy also creates a type of moral hazard by encouraging more entrepreneurial risk taking. I would call this benign moral hazard. [This argument was made persuasively in a WSJ opinion piece by the Research Director of the Dallas Fed.]
Was the Fed's role inflationary?
The Fed brought down its target Fed Funds rate from 5 ¼ to 2 percent and created new facilities for channeling reserves to those in the greatest need in addition to the loans mentioned above.
What many people have missed is that the Fed has been offsetting these injections of liquidity through the discount window with open market operations. There has NOT been a sharp or significant bulge in most measures of the money supply.
With respect to interest rates, the Fed's rate reductions on the short end of the curve have not brought down rates farther down the curve, especially mortgage rates. Only Treasury rates have declined, in a flight to safety.
Banks and other financial institutions are scared and are hoarding their liquidity. The velocity of money is no doubt declining and, right now, I think the net impact could be more deflationary than inflationary going forward given the massive destruction of paper wealth in the deleveraging process.
The Fiscal Impact of the $700 billion Plan
With respect to Treasury expenditures on the $700 billion bailout package, as the Secretary has emphasized and no-one seems to get, they don't plan to put the money down a rat hole, which is often the case with other government expenditures. Assets will be purchased initially, but ultimately they will be sold back into the market. They need President Clinton to help them explain that this particular government spending is an "investment"-not normal government spending.
If the package is approved as proposed by the Treasury Secretary, I think there is a reasonable chance that after a couple of years the operation may turn a profit. If not a profit, then the net loss will certainly be only a fraction of the up-front cost. However, all bets are off if the plan is loaded down with the disincentives to participate currently being discussed.
Now, don't you feel better?