What’s Wrong with the World

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September flashbacks.

I’m starting to have flashbacks to last September. It’s not a pleasant feeling. The banking sector is clearly still in dire straights. Financial stocks have plotted an almost unbroken decline since the first of the year. Citigroup announced this week a rather desperate plan to dismember itself. It is expected to report a staggering $10 billion loss for the 4th quarter of 2008.

Meanwhile, Bank of America has been pleading for a second bailout, and according to The Wall Street Journal, likely to get it — which would earn it the distinction of being third company in the last four months bailed out by the government twice. At stake is BofA’s commitment to purchase the distressed securities firm Merrill Lynch, which deal, if it failed, could be another Lehman-like detonation.

The excellent website Baseline Scenario reproduced a Bloomberg chart showing that credit default swaps on the banks are creeping back toward September levels. And one thing (maybe the only thing) that CDS is good for is this: predicting a company’s approaching agony.

Federal Reserve Chairman Bernanke bluntly told us Tuesday that more capital injections will probably be necessary; and even the President-elect hinted that it would be “irresponsible” not to have that second TARP tranche ready for new emergencies, so he asked President Bush to request it. The latter duly obliged.

Elsewhere, hedge fund redemptions are still accelerating. “Cry me a river,” you say? Fair enough. But I think it is also fair to conjecture that the one prominent feature of the early Great Depression which we have mercifully avoided (if the extraordinary Fed and Treasury activity did nothing else, at least it accomplished this) is massive bank runs. Our economy today is much more sophisticated than that of the 1930s — instead of bank runs we get hedge fund runs.

In a word, we’re not out of the woods yet. Not by a long shot.

UPDATE: Don’t miss Francis Cianfrocca’s post on the resurgence of the banking crisis. His succinct and mournful summary: “You just accept that the biggest moral-hazard-creating event in world history is preferable to not having a banking system at all.” He recommends revisiting the original TARP plan, specifically in the form of a “First National Bad Bank of the United States,” which would be chartered to

issue debt on a full-faith-and-credit guarantee, possibly with an agency-like imprimatur that would generate a few extra basis points of yield. It would be used to buy up maybe half a trillion dollars’ worth of asset-backed paper from banks, and simply hold to maturity. [. . .]

As with a hedge fund, the point would be to capture the risk-adjusted yield from the asset portfolio and repay the investors. Risk is simply the credit risk of the portfolio, because the purchases would be non-leveraged. (The low cost of capital makes this possible.)

Downsides? Well, there’s the moral hazard of course. The banking system will never return to full-normal because everyone will know how rigged and nationalized it is. This effect will last for at least a generation. More than a generation, if the textbooks start getting rewritten to reflect a new dogma that private enterprise doesn’t really work in banking.

That’s were we are, folks: up a creek, and our only paddle is a bizarre sort of thing that slaps you in the face every time you row.

Comments (56)

From Baseline Scenario:

A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions’ balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. . . .
Well, yeah, duh.

A lot of folks are still catching up on understanding the nature of the problem, and why the original TARP proposal was such a smart way to address it. We may all know at this point that it was the overeating and smoking that caused the heart attack, but that doesn't turn us all into heart surgeons.

It is often reported that it is the "hard-to-value" nature of the toxic paper that deterred Paulson from the original TARP plan. But this is still baffling to me. "Hard" is not the same as "impossible." These firms have been taking huge writedowns on a mark-to-market basis for months. Why not use even the distressed market of today to gauge value? Surely even the most ridiculous pile of bad mortgages, sprinkled with a few good ones and presented as an investment-grade instrument would not be valued at zero, right? Unless we are to imagine that there are CDOs out there composed, literally, of mortgages on houses, all of which are, or soon will be in foreclosure, it can't actually be impossible to value the assets.

Bernanke suggested in London the other day that revisiting the original TARP plan might be a good idea. Hopefully someone was listening.

Paul, as I noted in Zippy's earlier post and as others have likewise said, the value of those assets are not exactly zero, but are demonstrated to be low enough to bankrupt some of the "too big to fail" owning institutions-that's what matters. The people in power can't accept this and erroneously believe economic losses can be significantly avoided with "the right kind of bailout." But those financial institutions screwed up massively, the damage has been done and cannot be *spent away*, and the only decision is whether to eat the damage now or have younger folks eat the worse damage in the future by giving them a bigger bubble and more debt.

But my arguments have already been made, the people in power continue to not recognize what's going on, and I do not believe they will come to recognize how events continue to point to their error because the public wants to minimize their own (generation's) suffering at all costs and will, misgivings notwithstanding, support the politicians as long as the media paints the picture as "bailout or ARMAGEDDON". And there's enough confusion to make their hope "plausible," at least to themselves.

So we're faced with the fact that these bailouts aren't working--as the critics predicted would be the case--and we apparently need bigger and better ones handled by the exact same people. And despite hundreds of billions borrowed, we're back to MBSs once again. And the housing market is still tanking.

Hope is only good depending on in what the hope is placed. Hope in God is the best. Hope in our government, at this point, is bordering on delusional.

...the value of those assets are not exactly zero, but are demonstrated to be low enough to bankrupt some of the "too big to fail" owning institutions-...
Where "demonstrated" means "some analyst with who knows what axes to grind has proposed a theory." And by the way, hasn't valued the actual securities but rather has calculated the value of his own assumptions as produced by his own model.

His point (I think I said this the last time Albert brought it up) that mortgages include an implicit put option is a good one, of course, but that hardly converts predicting the future cash flows into a straightforward equation. As I am sure Albert knows, the present value of a put is irrelevant unless I plan to trade it. If I hold it to expiration it either has value or it does not. In one of my own personal option transactions recently the puts I had sold turned out to be worth pretty much exactly what the buyer paid for them on expiration day. In others they have been worthless, or worth more than the person paid for them. The intransigent refusal on the part of some people to face the fact that today's market price does not accurately reflect actual future cash flows from a security, especially as those securities become more complex, does not help maintain the objectivity of the discussion. What a trader just paid for something similar to X is one measure of value; the cash flows X actually produces over its lifetime is a different measure of value; and those things are not as tightly coupled as free market zealots would like everyone to believe. I know, because I've personally made money on them not being as tightly coupled as free market zealots would like everyone to believe.

I realize that concluding that mortgage backed securities are definitely worthlessness would be helpful to certain polemical positions. That doesn't make it true.

Oh, and by the way, if the TARP had paid five times $700B for securities that had turned out in the long run to be completely worthless, that still would have been a bargain compared to the alternatives, and not just for the current generation but for future generations as well. The whole "let the entire first world economy die in order to heal it" approach to this is just nuts. "Putting off" what was happening is like "putting off" a nuclear war. It is worth doing for the sake of current and future generations, period. "Let him die to heal him" is Christian Science applied to economics. It is crazy talk.

Look, couldn't Zippy say some things to us about how bad the welfare "recovery" plans are that Obama seems to have in mind with a trillion dollars or however much it is? Because a lot of people are gonna see these as just more bailout, the exact same arguments are going to be used to support them (the whole economy will fail without them, etc.), and I have reason to think that Zippy at least believes there is a distinction to be made here. From the headline I saw lately (something like "Bernanke Says Obama Plan Would Stimulate Economy"), I'm not sure Bernanke is making that distinction. I mean, we could move on, already. We've got a president who seems to be all revved up to come in here as FDR II, and I'd like to think I have Zippy on my side in opposing his plans.

I have reason to think that Zippy at least believes there is a distinction to be made here.
Oh yes, a very large distinction. It is like the difference between rescuing a man from death by heart attack and rescuing him from having to work in a menial job for a while after making a bunch of willfully awful decisions.

FWIW, when I was listening to Bernanke's comments on the radio he did distinguish between rescuing the financial system and rescuing the economy, saying outright that the proposed stimulus package does not address the former. Not that he is against the latter, mind you, but the distinction is there.

I'm not a Bernanke defender - heck, I'm not even a Paulson defender, just an "original Paulson plan" defender - but it isn't true that Bernanke is unaware of the difference between systemic risk to the financial system and economic downside in the core economy. The fact is that we can live with the latter, and it is almost certainly healthy to do so; but the former will kill us.

So would it be fair to say that you're on record as opposing the type of stimulus package that we seem to be in for with Obama, Zippy?

So would it be fair to say that you're on record as opposing the type of stimulus package that we seem to be in for with Obama, Zippy?
Yes, I don't think "core economy" fiscal stimulus packages are a good idea either politically or economically, but especially the former, and especially in our current conditions: even if I could be convinced that they were economically beneficial (I am squishy on the point, not being an economic idealist at the best of times), there are a whole host of very strong political reasons not to do it. (Very similar reasons stood against doing the TARP, for that matter: it is just that the consequences of inaction were in fact of an entirely different order).

Right now IIRC there is easily enough private cash on the sidelines to buy up 3/4 of the stock market at today's prices. Maybe more. That is just a ludicrous amount to have tied up in cash; a healthy and functioning financial system will ultimately free up that mattress-stuffed cash to be used for productive purposes.

I also opposed a non-chapter-11 auto rescue. And the Paulson plan was only a "good idea" in the sense that a defibrillator is a good idea; far, far better is to avoid the circumstances for its use in the first place.

"...predicting a company’s approaching agony."

To add to the harrowing prognosis, Moody’s predicted that the speculative-grade default rate among U.S. companies will jump to 15.3% at the end of 2009, compared to 4.4% at the end of 2008. Just a month ago they were predicting a default rate of 10%. Roughly 70% of US companies issuing debt are speculative-grade or lower. Let's hope their projections are wrong, though we are now seeing corporate America experience the same kind of trauma homeowners faced when they couldn't carry their debt.

Millions of Americans who never heard of a Collaterized Debt Obligation or a Credit Default Swap, but contributed to their comapny's growth and 401ks, are going to get badly hurt. Those dependent on the social safety net and private charity will, as always bear the worst of it. On the other hand, the small bureaucratic and moneyed elite who govern our nation will mostly escape the worst consequences left by their speculative binge. The challenge down the road will be to build a decentralized economic and political order hostile to monopolies and gross social stratification.

In the meantime, the injunction to Love Thy Neighbor will take on a special meaning for those who lived as if they didn't have any. Community life is about to make a welcome comeback, if only by default.

Albert: establishing that the toxic assets are sufficiently large to bankrupt most of the banking sector does not seem to be a very useful thing at this late date. Most of us (even total laymen like me) realized that by about October 1st, especially when you throw in the multiplier effects of massive leveraging and the detonations of the derivatives contracts. Hell, one AIG office held toxic assets sufficient to bankrupt the state of Georgia. So you don't have to convince me.

But I'm with Zippy: the liquidationist position is untenable, and, had it been adopted in the autumn, would have been ruinous. Like it or not, the modern American economy cannot function without a high finance banking sector. It just can't. I'm wholly open to the idea of revisiting how we got there, and whether it was really such a great deal after all. I'm wholly open to the idea of working to get back to a traditional community banking model, of retreating from the system of abstraction and globalized mathematical engineering.

But autumn 2008 was just not the time to be arguing for that view of things.

And now we have the old "paradox of thrift" back to haunt us: what is healthy on a small-scale (shifting from a negative savings rate to a positive 3 or 4%, reining in spending, paying down debt, converting risky equities into bonds, etc.) is damaging on the large-scale. It is damaging because its effect is deflation. Score another one against bigness. No doubt Chesterton could have a field day with an economic system that turns health activities on the family and community level into destruction activities on the national level.

Zippy: The intransigent refusal on the part of some people to face the fact that today's market price does not accurately reflect actual future cash flows from a security, especially as those securities become more complex, does not help maintain the objectivity of the discussion. What a trader just paid for something similar to X is one measure of value; the cash flows X actually produces over its lifetime is a different measure of value

And the intransigent refusal of some people to face the fact that the actual future cash flows from a security are not guaranteed (apart from the US govt throwing more cash at the bad investments) is worrisome. That refusal to recognize the risk inherent in the securities is precisely why the financial institutions are in trouble now. The risk involved lowers the value of a security regardless of what the cash flows are stipulated to be. Sure, you could hold on to those securities and hope that the value will eventually rise, but if it doesn't due to unforeseen circumstances, then you're screwed even though the securities were supposed to provide a cash flow and that possibility is the reason for lower value than face value. Risk valuation. That was precisely the point of the essay to which I linked and which you miss.

Paul, what makes you think that delaying "ruin" now (not that anyone's shown Armageddon would occur) by more deficit spending is not simply going to worsen and push the financial problems onto the next generation? Do you really have any confidence that our government, who continue to use the same people who were overseeing the financial industry as it set itself up for disaster, will do anything but push the problems onto the next generation and then congratulate themselves on "averting" disaster in the present?

The annoying thing is that, of course, the longer we wait to cut our losses and the more debt we pile on, the closer we come to actual financial Armageddon, which will happen when no foreign entity is willing to lend us money anymore due to our ever-increasing levels of spending. We're "fine" until then, but if the US can't borrow any more (and there are reasons to think that countries will consider the US itself "too big to fail" but the consequences of that event will be no better, just different) then we'll really see financial Armageddon that will make anything that could happen now look delightful.

some analyst with who knows what axes to grind has proposed a theory.

Yes... which happens to accurately represent reality. The nerve!

I'm not a Bernanke defender - heck, I'm not even a Paulson defender, just an "original Paulson plan" defender

I thought your position was that we ought to just support whatever Paulson said we should do. "Shut up and row" and all that.

Merrill Lynch demonstrated the value of CDOs when it agreed to sell $30.6 billion for $6.7 billion or 22¢ on the dollar. Then when the details of the deal came out they financed 75% of the deal, so they only got $1.68 billion or 5.5¢ on the dollar with a chance to get more if things work out.

I wouldn’t even pretend to know what they are ultimately worth but after that sale “hard to value” became part of the general lexicon.

It seems so far that government has spent or pledged $8.5 trillion to buy four months, and that doesn’t even count Obama’s stimulus plan. If this keeps up it’s not our kids problem- the future is here. It seems to be a question of deflationary depression or inflationary depression.

N.b. Chart does not include $300 billion in guarantees to Citigroup nor the last 800 billion unfreeze lending nor 200 billion on TALF

Albert:

And the intransigent refusal of some people to face the fact that the actual future cash flows from a security are not guaranteed (apart from the US govt throwing more cash at the bad investments) is worrisome.
The actual future cash flows are not guaranteed for those securities. (In fact, the actual future cash flows are not guaranteed for anything at all). Feel better?

BA:

I thought your position was that we ought to just support whatever Paulson said we should do. "Shut up and row" and all that.
In September, yeah, pretty much. (Though obviously not "whatever": if he had proposed that we invade China or something, then no).

People who opposed the TARP at that time were either ignorant or evil. That exhausts the possibilities.

From Paul's update:

“You just accept that the biggest moral-hazard-creating event in world history is preferable to not having a banking system at all.”
Exactly.

When thinkers august (and diverse) as Zippy and Paul agree on a matter that runs counter to my intuition (and investment dollars), I am forced to take great pause... but would someone remind me once again: Why is "deflation" so bad (apocalyptic in Zippy's September posts)? Doesn't that make things (broccoli, gas, and shares of XYZ) cheaper? And wouldn't that be a net gain for most of us (the ones who stay employed and not up to their necks in debt)? Given a fixed or only slowly growing supply of money (as it has been through most of money's history), isn't deflation a perfectly ordinary and survivable event? A mere punishment for past, and prophylactic against future bad investment? And wouldn't that be a, more or less, good thing?

This is posted not as endorsement of the individualist ethos and panicked psychology underwriting the escape plans of "prudent" financiers staring at corporate default rates last seen during the Great Depression. Rather it reflects the kind of conversations one can now find on Wall Street, and most notably expressed in a book written by the former Chief Strategist at Morgan Stanley, Barton Briggs entitled War Wealth and Wisdom. The article below should temper those who think a "let the markets sort it out" approach is plausible, or that social stratification is a contrived obsession of "Marxists".

Preparations, in Lange’s case, include a storeroom in his basement in New Jersey stacked high with enough food, water, diapers, and other necessities to last his family six months; a biometric safe to hold his guns; and a 1985 ex-military Chevy K5 Blazer that runs on diesel and is currently being retrofitted for off-road travel. He has also entertained the idea of putting an inflatable speedboat in a storage unit on the West Side, so he could get off the island quickly, and is currently considering purchasing a remote farm where he could hunker down.
http://nymag.com/news/features/all-new/53372/

To the extent that "deflation" represents the reverse of inflation, it may well be good and healthy. But generally the word is used to refer to a deeper cycle of collapse. (Sometimes the more healthy version will be described as "disinflation.") The more technical term for really destructive deflation, like what happened in the Great Depression, is "deflationary cycle."

I still have some trouble getting my mind wrapped around it, but one thing to keep in mind is that during sustained deflation, debts are gaining in value as assets are losing value. Think about how ruinous that is. Your house is a declining asset while your mortgage is an expanding liability. (I think I have that right.)

There is also the psychological aspect: a general retreat from risk-bearing assets of any kind. Capital investment declines, production declines, wages decline, everyone parks what wealth they have left in cash. How to get people back to a situation where they are willing to take on any risk again is a huge problem.

Steve:

My concern in September was not deflation, and while it is definitely a concern now it is not an apocalyptic concern of mine. My concern in September was the more or less complete and sudden disappearance of the banking system, taking all of everyone's money, and the confidence people have in money as a medium of exchange, with it.

Some might argue that the government would step in at that point, that is, after we allowed the banking system to disappear, especially in the form of the FDIC; but (1) that wouldn't do a thing for corporations, all of which would have imaginary cash on their balance sheets that they could not get to, because it was held in banks which had disappeared, and (2) in any case would cost orders of magnitude more than the TARP.

Corporations across the board had plenty of cash "on hand" going into the fall. As I mentioned above, there are very high levels of cash in private hands right now. The consumer's savings is jack squat; but corporations have been frugal and saved, on average, which is why before the financial crisis - the specific problem with the banks - many reasonable people expected a mild recession rather than a deep one.

The problem is that "on hand" means "in the bank".

I still have some trouble getting my mind wrapped around it,

I have to say, Paul, that that may be a sign that you are being sold a load of goods. And as for the point about the mortgage and the house, well, all the more reason to have as little debt as possible and to pay it off lickety split. That's how it strikes me, anyway. It seems to me that a major part of the problem is the assumption that a healthy economy should be built substantially upon debt.

Think about how ruinous that is. Your house is a declining asset while your mortgage is an expanding liability.

That doesn't sound very ruinous assuming I keep my job (I know, big assumption, but a large majority even in the worst of times, manage to keep their jobs or find new ones). My house would have to fall an additional 50% in value for it to be worth less than I paid for it... and 60-70% to be under the mortgage amount.

I certainly understand the psychological aspect of deflation, but hoarding of money (i.e., capital) should be the engine of capitalism, not the death of it. Inevitably, people will eventually feel safe enough to start investing all that cash again, growth will start back up again, people will inevitably look at XYZ Corp's stock price and bet that it's a steal, and they might have learned a few lessons in frugality and self-sufficiency along the way. Again, win-win.

On the banking aspect, Zippy, I'll bow to your expertise and/or inside information. I still like to know how the hell we got to such a place, and am still inclined to think that the problem is likely too much gov't intervention (e.g., the existence of the Federal Reserve) rather than too little. If TARP was the right response (expensive gov't involvement) to an emergency situation, that doesn't mean that expensive gov't involvement (aka politically motivated manipulation) in the economy didn't bring us to that place to begin with.

If TARP was the right response (expensive gov't involvement) to an emergency situation, that doesn't mean that expensive gov't involvement (aka politically motivated manipulation) in the economy didn't bring us to that place to begin with.
I agree.

Lydia: I had trouble wrapping my mind around deflation even back when I was studying it in college, a decade ago when it all seemed so reassuringly abstract. And I certainly agree that building an economy on debt is a proposition growing more dubious by the minute. As I said above, I'm wholly open to examinations of how we got here, and how we avoid just "rebooting."

Steve: Yes, absolutely, employment is obviously an enormous factor. But I hope you see that the debt problem may be even larger for companies than it is for households. And that means that they stagnate and fail. So certainly unemployment is a big part of the fears of deflation.

Paul said:

I'm wholly open to the idea of revisiting how we got there, and whether it was really such a great deal after all. I'm wholly open to the idea of working to get back to a traditional community banking model, of retreating from the system of abstraction and globalized mathematical engineering.

But autumn 2008 was just not the time to be arguing for that view of things.

This is the unfolding tragedy of it all: That in trying to hold back a financial apocalypse, our only option is to reconstitute the systems that left us so vulnerable. Really, Paul, is anyone going to want to discuss a new banking model or a humbler financial system once we're back in the saddle of a growing economy, things are getting good again (financially speaking), and the next apocalypse is a decade away? I'm afraid not. (You and me, and others at WWWTW, maybe, but politicians? Treasury secretaries??)

Your paradox of thrift is clarifying. I'm with E.F. Schumacher: Small is beautiful. Something needs to shake up our confidence in the Big. And bailing it all out until it's back on its feet is not going to help. That's not to say I favor freefall into financial oblivion. By all means, let's go for a soft landing. But let's recognize that we're heading down and, more importantly, let's make ourselves comfortable with the idea of staying there.

Well said, Chris. I'm generally with you. So long as we avoid a depression, some really healthy things could come of this. In my observation, we're already past the point where we could really go back to business as usual. Investment banking is basically gone as an independent sector. Massive leveraging as a model of investment is gone, probably never to return. Last week the WSJ ran front-page piece on the mess the recession has made of 401(k)s. When the WSJ is openly skeptical of the 401(k), I think it's fair to say we've seen a real change in attitudes about wealth.

I am going to dissent from the idea that building an economy on debt is bad. Debt is just a form of financing which is senior to equity: we could get rid of it completely and have only equity, of course, but what would be the point? Debt on one side of an investment transaction is savings; on the other side, it funds the interest on that savings by using the principal in productive activities, the residual profits from which, above the interest on the debt, go to holders of equity. I don't see the advantage to criticizing debt financing per se: it is just a way of getting investors with different risk tolerances together in order to put their money to productive use.

What is bad to the point of insanity is building an economy on debt-fueled consumption, or these non-productive debt-fueled speculative price bubbles. Belloc's distinction between debt as investment in productive activities and debt as consumption or speculation is critical here, the latter being usury.

And getting rid of debt completely (that is, not permitting that kind of contract) would not eliminate bubbles; it would just change how bubbles are financed. At the end of the day substantive judgments independent of accounting statement numbers make all the difference between usury and investment; and we are not set up as a society at all to make those kinds of substantive, value-laden discriminations. Usury is so far off the radar that we have forgotten what it means; but there are consequences to ignoring the natural law, and the present crisis is one of them. This is the Great Usury Crisis of 2008-20??.

That's a great comment, Zippy. Probably worth expanding into a full post so you can unpack the debt/usury distinction. The Great Usury Crisis does have a certain ring to it.

I'll admit that it took me a good five minutes to sort this sentence out, at which point I realized how awesome an explanation it is:

"Debt on one side of an investment transaction is savings; on the other side, it funds the interest on that savings by using the principal in productive activities, the residual profits from which, above the interest on the debt, go to holders of equity."

Zippy: Feel better?

It's like pulling teeth, Zippy.

I've always enjoyed Mr. Cianfrocca's posts for their clarity, if not prescriptive merit. It's fascinating that after all the government interventionist flailing about and throwing creative variations of money (capital, for equity, etc.) at the finance industry in the past three months, with only "Well we're still standing!" as *definitive* proof that it worked exactly as planned, they're gradually coming to recognize that the problem never was "irrational crises of confidence" or anything that "no one could have seen coming."

It was the losses in the housing market (which, including devaluations due to risk, makes those MBSs almost worthless, contrary to the wishful thinking of some interventionists) de-leveraging throughout the finance sector. The losses are real, and no amount of government intervention can eliminate them; they can only "mitigate" the losses by pushing them onto the next generation by borrowing trillions that the next generations will have to pay back with sweat and blood. That is all the government can do.

I sound like a broken record by now, but it's unnerving that on a website whose frequenters are supposed to be aware of the flaws of modernity, no one's discussing the immorality of making the next generations suffer for this one's foolishness and greed as if we moderns are truly independent of history, family and generational responsibility. If interventionists really believe the notion that somehow this is all better for the next generation, then I think they ought to make the argument instead of ignoring the issue and hiding behind the apparently absolute need to prevent economic suffering in the next few years.

"Usury does not mean high interest. It means any interest, however low, demanded for an unproductive loan. It is not only immoral [on which account it has been condemned by every moral code-----Pagan-----Mohammedan-----or Catholic] but it is ultimately destructive of society." - Hilaire Belloc

Albert:

...no one's discussing the immorality of making the next generations suffer for this one's foolishness and greed...
The reason I am not discussing that is because I do not believe that that is happening, at least specifically w.r.t. the TARP.
If interventionists really believe the notion that somehow this is all better for the next generation, then I think they ought to make the argument ...
I've already made that argument, a bunch of times. The sudden disappearance of the banking system would be apocalyptically bad for everyone now, and their children, and their childrens' children, and on into the future as far as it is reasonable for us to have the hubris to project.

Probably worth expanding into a full post so you can unpack the debt/usury distinction. The Great Usury Crisis does have a certain ring to it.
Yeah, I probably will at some point. I really, really didn't want to talk about the economic crisis again at all, but addressing it from a fundamental moral/natural law perspective (as I see it) may be W4-worthy.

Zippy: I am going to dissent from the idea that building an economy on debt is bad. Debt is just a form of financing which is senior to equity: we could get rid of it completely and have only equity, of course, but what would be the point? Debt on one side of an investment transaction is savings; on the other side, it funds the interest on that savings by using the principal in productive activities, the residual profits from which, above the interest on the debt, go to holders of equity. I don't see the advantage to criticizing debt financing per se: it is just a way of getting investors with different risk tolerances together in order to put their money to productive use. [boldface mine]

Paul: It is a common modern error to assume that the technical characteristics of a thing amount to the whole. But this is obviously wrong.

Does anyone recall the marvelous post Paul wrote on Technicals and the Modern Error? It seems to be what is going on here with respect to debt. Lydia questions the wisdom, if not virtue, of building an economy on debt (I'd concur with her sentiment). Zippy responds that debt is merely a technical instrument for transferring and building wealth and proceeds to detail the technical processes of how that works itself out: "I don't see the advantage to criticizing debt financing per se: it is just a way of getting investors with different risk tolerances together in order to put their money to productive use." Ahh. ...

I don't think debt financing is merely a technical alternative to equity. We are not supposed to be in debt because of the burden we place on our neighbors: "Owe no one anything, except to love each other, for the one who loves another has fulfilled the law." This does not change even though we are in a modern society which thinks that just because it's a familiar practice or because everyone in the contractual agreement understands what is going on and consents, that going into debt is somehow neutral. Sure it may happen, but is not something that's simply okay.

We should not build an economy on debt financing, but on savings in which we give and build out of what we have. The "downside" is that this way of doing things isn't as profitable or as materially productive as financing and leveraging debt (in which it makes sense to go into (supposedly neutral) debt to invest in securities with a positive interest rate spread). But maybe that's a good thing in a society that idolizing material productivity over responsibility to neighbors and past/future generations.

Zippy: I've already made that argument, a bunch of times. The sudden disappearance of the banking system would be apocalyptically bad for everyone now, and their children, and their childrens' children, and on into the future as far as it is reasonable for us to have the hubris to project.

Well, no you haven't. You've made the assertion a bunch of times. Just like now.

I actually agree with Zippy that there can be such a thing as rational debt in some given set of circumstances. But we'd almost certainly not pick out all the same circumstances, and I'm inclined to think that it would be preferable if one could avoid it. It was rational for me to get a mortgage to buy my house, but if I could have bought it for cash, I would have, and that would have been even better. It was also rational to get a very conservative, non-risky mortgage and to make paying it off a major priority.

Lydia, sorry, I didn't intend to put words in your mouth (type words on your keyboard?). I was merely concurring in the sentiment to question what's at stake in the role of debt in the economy. No doubt we'd all agree and disagree on specifics.

I, too, don't believe "owe no one anything" is a blanket statement of the overriding good of not being in debt. Some goods outweigh that good; others don't. But "not being in debt" is a good and not merely a neutral instrument. And such decisions involve personal and communal relationships that "merely technical" understandings of debt have and continue to ignore. That is troubling to me. There ought to be personal and social bonds between the loaner and the loanee such that the loanee is personally grateful to an actual person (or persons) and does not desire to be a burden to the loaner(s). And that's another good that is ignored in these "high finance" understanding of debt.

A Bellocian analysis of the current financial crisis would certainly be interesting. It should be noted, though, that Belloc's views on usury where pretty much original to him. Neither the arguments he offers nor the distinctions he makes were ever the position of the Catholic Church on the subject.

We should not build an economy on debt financing, but on savings in which we give and build out of what we have.

Okay, but (serious question) where would those savings go and what would they do while you were waiting for the opportunity to build?

I actually agree with Zippy that there can be such a thing as rational debt in some given set of circumstances.

Kindly pay no mind to the ever surmounting debt into the greater trillions of rather dubious and hastily conceived stimulus packages which would, after all, not in the least be apocalyptically bad for everyone now, and their children, and their childrens' children, and on into the future.

These amusing continued exploits into the arcana of Economics are as amazingly dubitable (let alone, futile) as current and past attempts at remedy.

That is not to say, I am not thankful in the least for opinions proffered by their supposed initiates.

"Kindly pay no mind to the ever surmounting debt into the greater trillions of rather dubious and hastily conceived stimulus packages"

I'm about as rabidly opposed to that stuff as it's possible to be.

But "not being in debt" is a good and not merely a neutral instrument.

Albert, amen, exactly. The person who takes the loan of capital to start his business should feel burdened by it and relieved when he pays off the loan. He should prefer to start the business with his own money, and he should not ask people to take high risks on his behalf. And so forth. I'm troubled by the sense that debt is just this normal thing. It's not intrinsically evil, but it should _bother_ people, like (hard to think of a good analogy here) an as-yet-undischarged promise, or a cast on your leg or something. Something you'll be glad to be rid of and don't just consider ho-hum, much less healthy.

We should not build an economy on debt financing, but on savings ...
That is self-contradictory. A savings account is when you loan your money to the bank, and the bank pays you interest on that debt. Savings and debt are not an either/or proposition: they are two sides of precisely the same coin.
Me:
I've already made that argument, a bunch of times. The sudden disappearance of the banking system would be apocalyptically bad for everyone now, and their children, and their childrens' children, and on into the future as far as it is reasonable for us to have the hubris to project.
Albert:
Well, no you haven't. You've made the assertion a bunch of times. Just like now.
If I accept your characterization of it as a mere assertion, it is a mere assertion which is so self-evidently true that it is pointless to argue with a person ridiculous enough to deny it.

Zippy and Albert,

As to your respective comments concerning savings, I draw your attention to the following to acquaint the both of you gentlemen with what has been precisely phrased as the "Paradox of Thrift":

Usually, frugality is good for individuals and for the economy. Savings serve as a reservoir of capital that can be used to finance investment, which helps raise a nation's standard of living. But in a recession, increased saving -- or its flip side, decreased spending -- can exacerbate the economy's woes. It's what economists call the "paradox of thrift."

SOURCE: http://online.wsj.com/article/SB123120525879656021.html

Ari:

I am quite aware of the term.

If we want to refer to buried talents as "savings", that is one thing. But savings in the ordinary everyday sense means money in the bank. Money in the bank is substantively a loan issued by individuals or institutions to the bank: debt and savings are in that case literally, identically the same thing. From the bank's perspective, it is a debt owed to the depositor. From the depositor's perspective, it is savings held at the bank. But the "it" is not a different thing in shifting from one perspective to the other: it is precisely and literally the same thing.

Savings. Is. Debt.

It is all well and good to trash debt, treating it as somehow tainted and undesirable in itself; but that is (literally) the same as trashing savings, unless the "savings" one is advocating is paper bills in a mattress or talents buried in a field.

Aristocles,

So far as I can tell, the "paradox of thrift" is based on a muddle. When people save, the money doesn't just disappear. It is either invested directly, or is put into the banking system, where it is loaned out to other people. Once one takes account of this fact, the paradox disappears.

And to amplify Zippy's last point: back in the Depression, when the FDIC was being debated, some people did actually argue against it on moral hazard grounds. Viz., if the banks have government insurance for savings deposits, depositors will gradually lose the awareness that even a savings account is a (low) risk-bearing activity. In other words, without government intervention, we would all be much more aware of the relationship between savings and debt.

I think the people who said that about the FDIC had a point. And of course Zippy is completely right that a savings account in the bank that earns interest is a type of loan to the bank. I would never deny it. They don't just keep it sitting there in a box, or they couldn't pay you any interest on it. And we do need to keep a strong awareness of the risks we are taking even in those relatively low-risk situations. I continue to maintain, however, that the person who _owes_ the debt should feel it as a burden. There's just an obvious sense in which the person on one side should feel differently from the person on the other side. Not, mind you, that the person making the loan should not feel some concern. But his concern is with the risk he's taking that he'll lose his money because someone else turns out to be unable to discharge an obligation, not with the possibility that he himself won't be able to discharge an obligation to pay back money. These are simply not symmetrical concerns.

In other words, without government intervention, we would all be much more aware of the relationship between savings and debt.

Right.

But does that necessarily mean engaging in seemingly excessive intervention which might very well be counter-productive to the entire endeavour of correcting the whole problem -- even worse, manufacturing an entirely new one that, in all likelihood, might result in circumstances more dire than the current one, that subsequent generations will have to pay for or, even worse, might not be able to remedy at all.

I'm not too sold on the idea that, even at this very moment, expediency continues to be the best policy.

...the person who _owes_ the debt should feel it as a burden. ... with the possibility that he himself won't be able to discharge an obligation to pay back money.
I don't think debt is a burden at all beyond the bare fact that it entails an obligation to pay back the loan with interest, or, if that is not possible within the terms under which the debt was issued, to give first claim to assets to the debt holders over equity holders. That is what everyone agrees to going into the contract: it is just a capital structure, with the upside scenarios and downside scenarios specified and agreed by the parties ahead of time. In that sense equity is also a burden, because shareholders also have expectations of returns and claims to residual assets. Debt is not fundamentally different from equity: it just gets first claim to the company's/individual's assets, in front of equity holders in the line, in the case of losses leading to bankruptcy. (Preferred stock is kind of a mix of debt and equity: it usually gets a guaranteed dividend, which is like interest on a loan, and in some cases is convertible to common stock so it shares in the full upside of the common, while maintaining a claim on the original principal amount invested; but it gives way to debt's claims on principal).

Furthermore, in context, in many cases debt can mean the reduction of the net burden on the creditor, not an increase.

Suppose carrying the burden of a particular loan is quantified as X. Borrower Bob buys piece of equipment E with the loan. E increases Bob's capacity to carry burdens by X + Y. Bob's net burden is now lower, by Y, than it was before he took on the loan.

Taking on debt, done intelligently, does not increase the burden on a savvy borrower. It decreases his net burden; though it does increase the risk exposure, in addition to the reward exposure, of equity holders. The problem is not debt financing per se, which done right is a win-win for both the creditor and the debtor; it is misunderstanding or misapplication of debt financing.

Maybe what people want to object to is the burden of taking on third-party financing at all, even for productive activities, independent of the agreed-upon capital structure. That is, maybe folks are objecting to both debt and equity investments, including preferred equity. But if so that is a very radical perspective that we might want to explore a bit more fully before committing to it. There are good reasons to take on third-party investments in a venture even when I have enough cash to finance the whole thing myself.

Steve: Okay, but (serious question) where would those savings go and what would they do while you were waiting for the opportunity to build?

Sorry for my confusion, but who is the "you" in this situation, the one who is saving, the one who is waiting to build, or are they the same person?

Zippy: That is self-contradictory. A savings account is when you loan your money to the bank

I said savings, not a savings account. Are you so intellectually wedded to the current finance system that you can't see a difference? If I store my money in a holding institution for safe-keeping, am I "lending it?" If I store my car in my friend's garage, am I lending it to him? No. If you want to talk about a philosophy of banking and what good functions a bank might have, maybe we should start another thread...

But savings is not necessarily debt. It just is in our debt-financed economy.

If I accept your characterization of it as a mere assertion, it is a mere assertion which is so self-evidently true that it is pointless to argue with a person ridiculous enough to deny it.

Well, by all means. Count most of the people who correctly predicted the current crisis and their prescriptions "ridiculous," and the ones running the finance system into the ground with eyes wide open "self-evidently" right. Because of course we should trust those geniuses on Wall St and DC and their "self-evident" proclamations without argument, right?

aristocles, I'm aware of the possible phenomenon, which, as Blackadder notes, will only happen if banks do not invest savings. But the general problem is the assumption that a short-term hard crash (which happens to be just deserts) is worse than a longer-term and deeper spiral (which happens to push the burden onto the next generation) and is worse in the long-term. Are we willing to eat the consequences of our actions or not? If not, do we think a "free lunch" exists such that we can mitigate our losses without placing greater burdens on the next generation who bear no responsibility for causing the current situation?

Zippy and others, I'm heading out for the weekend without access to the internet. Thank you again for some of the best discussion on the web. I'm sorry for bailing out on a really great and enjoyable discussion on questions that need to be asked. Sorry Steve about not getting a substantive answer to your question.

I do believe we need to do re-think some of our basic assumptions with respect to finance/banking and make sure we're not trying to retroactively justify practices/institutions that admittedly are effective in a sense, but have costs we perhaps do not fully appreciate.

Cheers!

Albert:

Well, by all means. Count most of the people who correctly predicted the current crisis and their prescriptions "ridiculous," and the ones running the finance system into the ground with eyes wide open "self-evidently" right. Because of course we should trust those geniuses on Wall St and DC and their "self-evident" proclamations without argument, right?
When I make a very specific claim, and you pretend that I said something else entirely, you are just telling me in yet another way that it isn't worth the effort to try to talk to you on the subject.

Ah, have a good weekend, Albert.

Sorry Steve about not getting a substantive answer to your question.

That's okay. Zippy pointed to the question in a more substantive way. Yes, where are you going to "save" your money? If in a bank, then, yes, you are simply lending it to them at a very low risk and return, so that they can loan it out with a slightly higher risk and return and (hopefully for them) make some money, or in the case of a credit union, just pay the employees. I suppose you can make the argument that a Checking account (being M1) doesn't really work that way (like M2 savings and CDs), but that really is a pretty thin hair to split for most of us. Banks aren't required (AFAIK) to even be able to support all their checkable deposits with cash, much less the real savings. But I'm constantly moving money between them. To me, it's all "checkable", I just don't plan to check all of it except in case of some emergency.

Of course you *can* save money in a mattress... or indirectly by purchasing (and storing and protecting) physical commodities (e.g., gold, silver, Black Velvet Elvis Paintings, etc.), but other than that, there really is no way to do it without "lending" it in the current economy. I doubt that even taking away the Fed and going back to a gold (or gold + silver) standard, would change this aspect of the economy; although it might tend towards a reduction in the amount of lending taking place for unproductive investments (such as Jet Skis, iPods, Slim Jims & Licorice Ropes).

Have a great weekend, everyone!

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