One of my thoughts on the financial crisis is that the cause of disagreement among experts on how to prevent a disaster from the mortgage correction is rooted chiefly in theories of the causes of the Great Depression and the cause of the business cycle in general.
Fed Chairman, Ben Bernanke, and certain monetarists view the depression as rooted in a liquidity crisis. If that crisis could have been avoided, then a cascading series of confidence failures could also have been avoided. The theory is that the central bankers of the 1930s pursued an austerity policy at the wrong time, leading to runs on banks, hoarding of hard assets like gold, leading in turn to the inability of functional businesses to get capital in what should have been a prime, deflationary environment with which to attract labor and purchase capital assets.
The Austrians and I view the depression and the business cycle in general as a phenomenon of inflationary monetary policy and the distorted economic cycles caused by central banking and fiat currency. Central bank artificial inflation allows artificially long and non-correcting cycles of inflation. In the older regime of private banks, hard currency, and the “bank run,” any one bank’s over-extension would represent an arbitrage opportunity for other banks, so the cycle was often self-correcting, just as in private markets of other kinds, such as international currency exchanges. It was unlikely and unusual for too many players to make the same kind of error at the same time, but such “errors” are built into the system of central banking monetary policy because, at least in the short run, betting on speculative bubbles makes sense in today’s environment.
Further, central banks make these errors repeatedly not only because they are big, but because they are subject to various political pressures, such as the current pressure to avoid a recession at all costs. This relatively unregulated (in the short term) central bank inflationary policy leads to incorrect signals and speculative bubbles. When the market’s investors realize that they have diverted real savings into bad investments, the price of these investments drop, assets must be liquidated, and businesses fail.
Efforts to “prime the pump” and get the economy moving again lead to additional inflation and frantic activity, until rising interest rates are imposed out of the absolute necessity to cover rising prices from inflation and to attract foreign investors who have stronger currencies to invest in bank debt.
The Austrians note that the “supply shock” crises of the 19th Century–before the era of central banking or fiat currency–were over very quickly in contrast to the frequent, repeated, inflationary, and drawn out recessions of the 20th.
The third view, the Keynesian view, is that demand-side fluctuations call for government austerity (in times of inflation) and increased spending (during a slow down). These maneuvers are supposed to counterbalance inflation or increase demand respectively. These proposals rely a great deal on the multiplier effects of spending, but the Keynesian theory does not take adequate account of the “crowding out effect” of government debt spending and the historical unlikelihood of the government practicing austerity during boom times. The money comes from somewhere, and it would otherwise go to private bonds, private equities, and other productive uses.
Neither Bernanke, nor his Austrian critics, really endorses this view. But Bush does implicitly in his stupid stimulus package. It should be obvious why the Keynesian big government theory has been popular with government officials since its origination in the 1930s. It lets them spend money they don’t have, as if this were some courageous and far-sighted measure, rather than a demagogue’s natural instinct. Needless to say, the 1937 downturn should put to bed the Keynesians’ hoary view that the CCC and other public works projects of the New Deal pulled us out of the Great Depression. In fact, they made it worse.
But here we are again. We have the benefit of what should be the clear inflationary lessons from the 1920s, but Greenspan inflated the money supply like crazy after 2000, and Bernanke is undertaking another doomed effort to inflate our way out of an inflationary-speculative bubble.
A downturn of any kind is like pulling off a band-aid. The quicker we liquidate the bad investments, homes, nonperforming commercial paper, and upside-down businesses, the better off we’ll all be, and the quicker we’ll move onto the next cycle of growth. As Secretary of Treasury Andrew Mellon infamously said, “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” Indeed.
It’s not like anyone is going to debtor’s prison. Moreover, the more people “hurt” by seeking bankruptcy protection, the less stigma there will be to folks who are otherwise good risks. Protecting speculators, improvident banks, overly leveraged hedge funds, and over-extended mortgage holders from the consequences of their actions will only drag out the pain and delay a recovery.
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Don’t forget the classical and neo-classical view that the business cycle is just a natural economic phenomenon with no more “cause” than the weather patterns that cycle between seasons with an alphabet-plus of named storms and seasons where meteorologists are stretching definitions of tropical disturbances to get up to “G”.
I dunno about all of these pinheaded ideas about schools of economic thought, but there are clear signs of your claimed non-existent liquidity crisis, in the real world.
- commercial paper market, even from the highest quality issuers with no link to troubled asset classes, vastly diminished
- asset-backed market gone, again, regardless of the underlying collateral and whether that collateral has any linkage to troubled asset classes
- auction rate market failing for lack of a bid from institutional investors, high net worth individuals, and corporate treasuries despite the fact that the issuers are often highly rated municipal entities and the offered yields are at an all-time high vs. treasuries, esp. odd given the superior tax attributes of municipal bond interest
- extreme and irrational demand for treasuries because of the “flight to quality”, despite the fact that they are returning a negative real return at this point
- forced unwinding of funds like Carlyle Capital, where the underlying leveraged collateral was basically GSE-backed quasi sovereign instruments
- the implosion of Bear Stearns, which started the week with $17B in cash, and ended up with its cash depleted by Friday (i.e., classic run on the bank)
- leveraged loan market completely locked up despite the senior secured status of much of this paper, because the entire bid from the CLO/CDO market disappeared
- implied default rates on much US corporate debt wider than the default rate on stuff like Iraqi sovereign debt
I could go on and on. This is not to say that I’m a fan of Greenspan-esque monetary policy, but you talk like Bernake is doing a terrible job and that we should switch back to a gold standard. You can’t save the patient until you stop the bleeding.
Why don’t you stop the bleeding yourself? If everything you say is true, this should be an opportunity to buy low and sell high, no?
Everything I say is true.
The liquidity crisis happened for a few reasons. First, much of the bid simply disappeared after the CLO and CDO funds stopped buying. Some of this bid should never have been there in the first place, because it was for structured subprime mortgage paper, but other parts of the bid were for legitimate assets; but CDO/CLO funds have just stopped buying entirely.
Second, because of higher volatility, particularly downside volatility, the hedge funds have been taking down leverage. (Leverage can kill you in a high volatility market.) This has created relentless selling pressure that is not necessarily correlated with asset quality. This in turn has disrupted historical relationships, and forced some hedge funds, like the quantitative statistical arbitrage funds to sell because the historical correlations have been breaking down (i.e., the Treasury vs. municipal bond relationship) and they’re meeting margin calls.
Third, the market for a variety of reasons is viewed as being non-transparent. Some of this relates to the lack of credibility surrounding ratings agency opinions, which has kept “dumb money” like pension, insurance, and foreign funds on the sidelines. Some of it is because the value of monoline insurance guarantees is highly suspect. Some of it is because, as you noted, the risk that was distributed out into the financial system through stuff like structured products, is totally opaque and impossible to assess. Thus, people stay on the sidelines, or they irrationally make a flight to quality (i.e., Treasuries).
Fourth, banks and other financial institutions have been reluctant to lend money, both because they perceive that risk has increased, and because they face internal capital constraints. As writedowns have forced banks to reduce their capital base, the amount left over for lending has decreased. Moreover, there is capital, and then there is Capital. Some of the “capital” is mark-to-model/myth Level 3 capital that is illiquid and hard to value; the good stuff, the Tier 1 capital, is in short supply. Banks/brokers just dont lend that freely. You see both of these factors expressing themselves in things like a historically wide LIBOR spread to Treasuries (banks lending to other banks), and a steepening interest rate curve that drives up retail borrowing costs on stuff like prime conforming mortgages (despite the GSE guaranty).
I wasn’t being sarcastic. Isn’t this an investment opportunity; from what your saying, it sounds like it just takes time to assess the value of one species of paper versus another, and it also takes a little more time for people to scrape together money?
I wasn’t denying a liquidity crisis either in my original post; I was saying that the liquidity crisis is an epiphenomenon of a mass market liquidation of bad investments and five years (at least) of massive overinflation. Overly leveraged entitites should be failing, and their noteholders should get pennies on the dollar as required. Too much leverage is obviously risky and shouldn’t be bailed out or recognized as anything other than what it is: highly risky for the creditors who get a huge downside and a minimal upside.
Under the subprime crisis, there should be a liquidity crisis, a flight to quality, and a destruction of weak investments. In this milieu, things will eventually right themselves, and if undervalued paper is not being sold, it soon will. Sure, there will be a vig in the short run, but everything has a clearing price. Also, frankly, the massive panic aspects of this suggest these brainy hedge fund guys are not as brainy as we thought based on what you’re saying. There’s a world of difference of AAA commercial bonds from Toyota and municipal bonds from New York Port Authoriy versus a big bag of subrpime shit dressed up to look like a 10% annual performer. Why are they getting rid of good paper?
Also, please don’t use undefined jargon; it makes your points, which I basically understand, less persuasive and informative to other readers.
A lot of the sellers of “good stuff” are doing so to meet margin calls. This drives down the value of the “good stuff,” which in turn drives more margin calls. As Keynes said, “the market can stay irrational longer than you can stay solvent.”
The Long Term Capital situation is a good example; LTCM blew up in 1998, after the ruble default; investors sold certain bonds, and bought Treasuries (which drove up the price of Treasuries, and drove down the price of the other bonds). LTCM had a leveraged bet in place betting the exact opposite would happen–that the spread between Treasuries and the other bonds was at historically wide levels, and that the asset prices should converge and the spread should narrow. Instead, the spread blew out. The Fed intervened and put together a group of lenders. LTCM’s positions were liquidated in an orderly fashion, rather than in a distressed sale. Ironically, it ultimately happened that LTCM’s investment thesis was right, and the lenders actually made money on their bailout.
I dont deny that a lot of mortgage-related paper needs to deflate, and the home ownership percentage in the country needs to decline. People who bet on this need to be de-equitized. (The Bear “bailout” at $2 was actually a good thing in my mind, and I like the $10 price much less.) But I think the key is for the unwind to be orderly, and to take place over the course of 1-2 years. If you try to do the unwind in 6 months, it’s just going to create a financial panic, and cause widespread financial institution collapse, regardless of credit exposure.
Finally, as you know, our family has in fact taken about 20% of our net worth and bought auction rate securities to take advantage of the credit dislocation. We’re receiving an average tax-free return of around 6% on our money, holding only top-quality issuers, with is north of a 9% return. We fully expect that the issuers will eventually refinance this paper, since they are paying short term rates in excess of the long-term cost. (Tax exempt money market funds are paying around 2.4% after tax these days, and long-bond muni funds are yielding 4.5%.) It is a big opportunity, but it is not for the faint of heart.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aZvLQY_CwB_s&refer=home
To my point about banks hoarding cash
“It’s not like anyone is going to debtor’s prison.”
No, but people are becoming homeless, etc. And some people can’t even afford to hire a bankruptcy attorney as a result in the downturn of the economy.
Now, I can’t speak the economic lingo, but I don’t understand why it seems that the greatest measure of the American economy is spending? I would think that a more stable economy would be in saving money and building real wealth—not over-extending oneself by spending other people’s money through risky credit. Something is terribly, terribly wrong.
If I was the conspiracy theorist-type, I’d say the banks don’t seem to mind foreclosures. They do little to help people make payments and keep their homes. Can’t pay 20% interest? Too bad. Pleasure doing business with you…
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current financial crisis is not child’s pazzle to solve, however a great deep rooted concern.I think we should give a little breathing time to the elected government to come up with most appropriate and stable solution.
Breathing room? They’re sucking the air from our lungs with this big spending, and they don’t deserve deference but watchful eyes when it comes to that sort of redistributionist claptrap.