Thursday, October 02, 2008

On Bailing Oceans

I had a great teacher who used to say, "Maybe the way to the answer is to ask a good question." Here's a good question: If you were the CEO of a failed bank and the government gave you, let's think small, $50 billion in exchange for the worst trash on your balance sheet, what would you do with the money?

You're probably more altruistic than me. But as that CEO, I would haul ass to buy gold, ships full of grain, things that come in 55-gallon drums, Swiss francs, platinum, memberships in a Dubai golf course, toilet paper futures, a couple of chocolate plantations, copper wire, Filipino pot farms, and maybe some stock in Campbell's Soup (the only publicly traded stock which went up on Monday). I would not, not, not lend it to US consumers who don't have rock-solid credit.

First, in my CEO hat, I see Toyota's sales just fell by 30%, that venerable domestic carmakers were awarded huge government loans to avoid bankruptcy, and my own credit card portfolio looks like it'll need a rescue of its own. Second, I'd guess the country's going to be tapped out for a while and experience something between the 1987 stock market crash and Hooverville. Third, and most importantly, every other banker thinks like me. I know there will be a frenzied stampede to quality--the safe, boring investments which hold value will be snapped up, and if I move faster than my competitors do, I'll make a lot of money in the next asset bubble. If it means buying bordellos in Bangkok rather than making car loans to marginal US workers so they can show up at their jobs, too bad. I'll list the bordellos as resorts on the balance sheet and my investors will be happy.

Hey, there's no law yet against answering your own question, especially when it describes what's going to happen. The Senate just voted 74-25 to approve a bailout plan that's not going to work, and the House is expected to approve 450 pages of "Do Something." The plan pays face value, face value, for completely unregulated, illiquid, esoteric derivative instruments with leprosy. This is pure largesse, and bankers will take most of the bailout capital straight out of the country on amazingly nimble little sheep-legs, moving so fast that they blur. We can skip over the financial panics which took down Rome, France during the South Sea Bubble, Weimar Germany as a global domino in 1931, and the failure of Japan's long bail-out from 1987 until now. But some contextual blame-storming is in order.

So...who or what is to blame, and why won't the bill work? More than any single person, Milton Friedman is to blame, and his popular ideas are responsible for the confusions most impeding a solution. Friedman was (he's dead) the most respected worldly philosopher of US economics, and his Chicago School ideas formed current perceptions of how markets work. 25 years ago, his views on deregulation, markets, and shock therapy had become orthodoxy at the IMF, the World Bank, Wall Street, and in the halls of government. Few people are aware of how tolerant he was of monetary expansion, and fewer still are conversant with the trails of hyperinflation and crisis he left across the world (masterfully chronicled in Naomi Klein's magnum opus, "The Shock Doctrine").

Things resembling this same bill have been passed before in other countries over the barrel of crisis, and despite ample forensic evidence left at the crime scenes, hardly any people in the halls of power question Friedman's dogmas, let alone realize how dangerously, dunder-headedly wrong his doodle-bops have proven in both theory and practice. Even during these opening stages of our intestinal disturbance, the language used to describe it remains almost entirely his. We're agonizing on the toilet, alternating between vomit and dysentery, and his prescription is Ex-Lax. Simply put, Friedmania is a contorted, neo-colonial, cleverly self-rationalized excuse for looting governments and ridding societies of safety nets, pledging trusts in large organizations and moral hazards so atrocious Adam Smith would have pissed out a thousand posthumous pages on them. But for us, these precepts mark our policy compass.

Ben Bernanke, current Federal Reserve Chairman, is a prominent Friedman acolyte lauded for expertise on the history and causes of the Great Depression. In short, they don't think the Fed intervened aggressively enough in the financial crisis following the Crash of '29. At Milton Friedman's 90th birthday celebration in 2002, Bernanke remarked:
"Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve System. I would like to say to Milton and Anna: regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."
What he meant was that massive monetary expansion was the balm, and the Fed could have inflated its way back into macroeconomic prosperity. Shockingly, however, Friedman and Bernanke are completely wrong about the Fed's intervention efforts and the Depression. Their position is difficult to reconcile with facts (of which they surely can't be ignorant) and anyone with a passing interest will find that the Fed printed scads of money and repeatedly beseeched banks to start loaning it out in order to reverse the accelerating deflation trend. Yet despite access to capital, credit tightened and lenders kept foreclosing on mortgages and businesses, preferring to retreat into safe havens, abetted by government stimulus. I call this phenomenon the "What Bankers Do When They're Scared Shitless" theory of economics.

Approximately 40% of US banks failed back then, and small depositors were the first to lose their money. Now, the depositors are insured, but the world is plunging into financial vapor-lock. The Chicago School sees it as an opportunity. Back in the 1930s, after various stimulation packages, government work schemes, and something called the New Deal, the US unemployment rate was still over 25% in 1938. If you wanted a loan during the Depression, banks demanded proof of asset ownership 150%-200% over their loan amount. The architects of this bailout should recall what Friedrich Hayek, founder of the fairly sane Austrian School of economics, had to say about Hoover's panicked bailout efforts by 1932:

“Instead of furthering the inevitable liquidation of the mal-adjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion. ... To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about ...”

People ask me, "What's going to happen?" I don't know exactly, but Friedman and Bernanke believe the cure for deflation is inflation, and they believe the cure for inflation is higher inflation. History says massive credit expansion alone will not work, and if it succeeds, the good news is that we'll get hyperinflation. You only need to look at recent applications of these theories in Chile, Colombia, Argentina, Brazil, Thailand and Africa to view some possible futures. It's very hard to change human nature; getting bankers to recapitalize by lending easy money to troubled consumers goes against it, and is of highly dubious wisdom anyway.

There are success stories in ameliorating the cycles of boom and bust. Morality aside, if regulators take equity stakes in banks, give them access to capital and directly control their foreclosure and loan decisions, it has worked. In fact, this was exactly the intended role and purpose of the FDIC. Sweden took this course in 1993, it worked, and made handsome profits re-privatizing the Svenska Rikbank's equity later. Here, the right questions are not being asked. Questions like these:

1) how do we make sure banks make loans and extend relief to deserving consumers?

2) how can we curb hyperinflation while providing stimulus?

3) what would entice ordinary people to re-invest in banks?

George Soros, who probably understands global markets better than anyone, has a proposal that would work and answers those last three questions. In a system hamstrung by ideology, it probably won't happen, but on a personal level there's a bright side: you can out-hustle the bank CEOs to those asset havens.


Anonymous said...

Hey, why do you criticize my alma matter (sic)? The University of Chicago is a place where very unhappy people study why and how other people try to be happy. They make up for it by being short.

That said, what I like best about the bailout is the elimination of mark to market. Mark to market is critical for current assets -- that is assets that can be used to fund current operations within the next year. These are assets that are or could reasonably be convreted to cash. Mortgage-backed securities, because they could be traded, met that criteria. Now, congress is telling businesses that they can list those assets at some other value because they can't be traded.

Alice, help me! The white rabbit has fangs......

Okay, I am back. If the assets are not liquid, they are a long term investment and should be booked under "other" assets. Result, the bank is still illiquid. If they book them as "current" assets at market value, the bank is illiquid and can't fund current operations. Now if they get to hire a valuer to determine what the bonds would be worth, assuming they could be sold, all of the financial ratios used by investors to determine whether a business is being properly capitalized and operated efficiently and profitably -- all of those market signals become worthless. Net result, ASSUME THE BANK IS ILLIQUID!

Put charitably, we are so fucked. The banks will fail anyway -- either there will be national corporate socialist banks that set prices (soviet style only with stock) OR we devolve into anarchy. At least one option preserves liberty and freedom. Now I know where the slogan "Live free or die" comes from.

Anonymous said...

I would also recommend that anyone interested in this subjecct check out George Soros' proposal. At least it provides for an orderly decay of society...