Not understanding a systemic financial collapse
I have a lot of empathy with the conservatives in Congress who are skeptical of and opposed to the Paulson plan, the government's "bailout" or "rescue" bill (depending on how you want to spin it) intended to help stabilize the economy and the financial markets on an emergency basis. I share most of the outrage expressed by conservative commentators who decry the Freddie Mac and Fannie Mae mess, the sub-prime mortgage lender racket, the creeping nationalization of the U.S. free market, and the terrible precedents set by leaving so much finance in the hands of politicians, bureaucrats, and appointed regulators. In fact, I see John Maynard Keynes, FDR, and the New Deal written all over the path to how we got here, and written worse than ever over the path into the future. And I share the general lack of confidence in politicians' ability to understand or deal honestly and effectively with anything this complicated.
However, my anonymous economic advisor claims we would have gotten to this current mess even if there had not been any Freddie Mac or Fannie Mae at all. He keeps trying to help me understand that the current financial markets problem is much, much bigger than just that scandal of two government-backed bureaucracies (GSE's) taking advantage of their privileged position and turned into cash cows for their CEO's, shareholders, and friends in Washington.
The innovation of pooled and sliced mortgages and extremely complicated mortgage-backed securities, accepted by, and now permeated throughout, all the markets around the globe, made possible only by computer technology, has fundamentally changed the global markets in just the last few years. This is what has now brought global financial markets to a virtual standstill as, since the housing bubble has collapsed, no one really knows or can tell what those securities are objectively worth. Since no one can evaluate these assets, not even the people who hold them, no one wants to lose more money by lending to or investing in anybody else whose assets can't be valued and who may be suddenly out of business tomorrow.
It is all about risk and expectations. There was a lot of money to be made--legally and legitimately--by trading innovative mortgage-backed securities and derivatives back when they could still evidently be valued and while the expectation was that housing prices would continue to rise. Standard & Poor's, Fitch, and Moodys rating agencies share some of the blame by having rated many mortgage-backed securities as AAA. As my advisor says, the AAA rating on the mortgage-backed securities containing sub-prime mortgage elements did not mean the same thing as a AAA rating on other kinds of securities in earlier times--but few paid attention to that fact. It was not important while housing prices continued to rise. Expectations played into perceived worth (and still do) in a way that has not been widely appreciated. Now that the housing bubble has burst, all kinds of regulatory triggers written into financial contracts everywhere have kicked in, as AAA ratings are lost. And with them goes wealth, vanishing overnight.
If you want to blame somebody for the current financial crisis, you have to point the finger at anyone who accepted the risks of investing in mortgage-backed securities in return for the payouts, and this includes just about everyone in the world, from Main Street to your own backyard (and your own pension fund). You don't even have to use the loaded word "greed" to describe this--how about just "rational expectations of a decent return on investment"?
Freddie and Fannie's implicit governmental backing of some mortgages and mortgage-backed securities distorted the market, but contrary to a lot of feelings among conservatives, they are not solely responsible for the present paralysis. In the present global paralysis, suddenly no one can accurately value their own or other's holdings, and so no one is willing to purchase anything or lend money to anyone for more than a day or two.
In other words, the financial markets are not functioning. You do not yet see the full extent of this reflected on the Wall Street stock market exchanges, but it is alarming economists everywhere who look at credit-default spreads, swaps, LIBOR, and such arcania that few ordinary people, politicians, journalists, or commentators understand.
I do not understand it all, but my advisor's message is clear:
Yes, incompetent firms should be allowed to go bankrupt, and the government has no business in propping up individual businesses or firms per se. But the government does have, and has had for generations, a vital interest in trying to prevent a systemic collapse that would destroy the entire financial marketplace. We are too large now for any individual to step in and do it as J. P. Morgan himself did in 1895 and 1907.
There will be hundreds of U.S. banks failing in the coming period, and they will be allowed to go out of business and be taken over by other banks, and they will be (one hopes) taken apart in an orderly transition (as Washington Mutual just was), their deposits insured by FDIC. While the public retains its confidence in the marketplace to handle this process, assisted by government oversight and backing, there is no run on the bank. (And note that nobody is complaining about government intrusion in the marketplace when it comes to FDIC insuring deposits.) But what the government is trying to do now, with the Paulson plan, is to ensure that the entire financial system doesn't collapse like a house of cards to the point where there are no remaining banks or other buyers left to take over the worst ones. We are that interconnected now.
Time pressure? My anonymous economic advisor says that consumers are still able to get mortgages, car loans, credit cards, and ATM disbursements, and are still able to see the stock market going up and down every day, so they are not yet alarmed. But since banks will no longer lend to each other for much longer than overnight, there will soon be companies that can't get loans or credit to make payroll or to buy necessary time (think of energy companies, farmers who need loans to tide them over till harvest, colleges, or businesses who need credit to cover income fluctuations). When the cascading effect of layoffs and firms going out of business begins, when unemployment rises, the public will finally realize the threat.
Then outraged and desperate voters will be calling their Congressional representatives and demanding government action in the marketplace.
But how do you re-start an economy once it collapses? And at what cost? And with what philosophy?
Some say let the market take care of the current crunch for now. But without credit available, where do entrepreneurs and innovators go to get started? Where do people who lost their jobs go to get a paycheck? Who is willing to take over market niches and fund a risky venture when wealth is evaporating, assets are unvaluable, and credit does not exist to tide anyone over until commercial success (in a downmarket) is gained?
The question before us today is not one of bailing out a few failing firms, banks, or Wall Street fat cats at the expense of the taxpayers. The question is how do we get the U.S. and the world it is inextricably tied to to regain the confidence to start trading again when almost everyone's assets cannot be objectively or realistically valued? Uncertainty and risk are at play. The government is attempting to inject more certainty that only it is big enough to provide. And it is not even clear if this will work.
This is a problem no one has ever faced before.
One thing's for sure: like going to war, the outlook is gloomy and all the alternatives suck. And we are already so far along the Road to Serfdom now that it's almost laughable to be quibbling about whether a government-backed insurance program or just giving money to the Treasury Secretary to spread around is going to turn the tide.
The debates will continue indefinitely, no matter what is done or not done soon. But Paulson and many other economists see the urgent need to stem a systemic global financial collapse. I would like to see more authoritative information on this scenario being widely disseminated to politicians and the public making these decisions before it's too late.
Helpful? "What Would Milton Friedman Say to Ben Bernanke?" I wish Friedman were still here to ask about all this.
Another view: "Milton Friedman Would Have Welcomed the Fed's Intervention in Bear Stearns." Really?
Everybody has a different angle on Friedman. I would like to hear what Anna J. Schwartz, Friedman's co-author and an economic historian, has to say.
Powerline argues against the Paulson plan, and for incrementalism and more debate, citing the stock market not having totally tanked this week.
Nobody knows how close to the brink we can afford to go before it's too late to backpedal.
UPDATE: Estimating the chances of "contagion" ("a cascading series of defaults resulting in a loss of confidence in financial institutions, and therefore in a severe economic contraction that hurts just about everybody, whether they were responsible or irresponsible about debt"). "You've got to ask yourself one question: 'Do I feel lucky?'"
Labels: financial crisis