Sunday, September 28, 2008

The Liquidity Crisis

I realized after discussing the liquidity crisis today that I really hadn't read an explanation of the banking crisis that I thought was particularly good. Doesn't mean it isn't out there, but I hadn't seen it.

So, long story short, I gave it a crack. I'm no expert, but I have a basic undergrad background in economics and I think I basically get it. There are probably some details that I've screwed up so I welcome constructive/destructive criticism. If someone points out something substantive I can fix in the analysis, I will try to clean it up.

First, read this.

This page gives a good discussion of a liquidity crisis in corporate finance. A macroeconomic "high finance" liquidity crisis is essentially the same thing, only happening with large banks. As in everything in high finance, high-finance liquidity crises are more complex.

One key reason high-finance liquidity crises are much more complex and potentially disastrous than regular corporate liquidity crises is the meshed nature of the problem. When one big bank experiences a liquidity crisis, the bank seeks relief from its creditors in the same way a regular company would. But if the bank's creditors are close to a liquidity crunch themselves, they aren't really capable of making the calculation described in the linked example. The cost of forcing the illiquid firm into bankruptcy and allowing the illiquid firm to borrow additional money while you wait for them to shape up is the same - your own bank enters a liquidity crisis because you needed the cash from the illiquid firm to make your own debt payments.

Once this happens, the banking system has become a bag in search of a bagholder.

That bagholder in this case is the traditional banks, which are theoretically capable of absorbing the problem due to their tightly regulated debt-asset ratios that are much, much more favorable than those of the investment banks that are failing.

What Paulson and Bernanke are saying, and maybe they are right and maybe they are wrong, is that the traditional banking system may not actually be strong enough to absorb the fallout from a liquidity crisis that destroys the investment banking system.

If they ARE right, then it's correct for the government to step in, because the alternative is that they are on the hook as the bagholder for the ENTIRE banking system, unless they want to allow a whole hell of a lot of money to just disappear into thin air.

So that's the impetus for trying to bail out the entire investment banking system - because it's cheaper than bailing out the entire traditional banking system. Once again, of course Bernanke and Paulson could be wrong. But that's their argument, and at least in Bernanke's case he has no real personal stake in the call other than wanting to be right.

Now, that doesn't speak to HOW to step in. In fact, it doesn't even prove you SHOULD step in. There are other questions in that regard. One that's very important is "Is what we are doing going to work?"

On that I think there's great cause for skepticism. Even if Bernanke and Paulson think that there's very little reason to believe their plan will work, if they are worried that the banking system may fail they will obviously feel a strong subjective responsibility to try SOMETHING.

The Paulson plan does, on its face, make sense. If the investment banking system is failing, the problem is large but finite. All you have to do is provide enough liquidity to allow the failing firms to make it to the point where they've successfully taken enough of their "problem debtors" through the process described in the linked example that they've made it out clean on the other side.

The problem is, the original Paulson plan is not a particularly good deal for Treasury, because they are taking on a lot of risk and they aren't really on the hook to reap any windfall for that risk if the plan works and the banks recover. All they get in that case is the interest on the money they loaned out (which isn't nothing, but it's not commensurate with the amount of risk that's being taken on.)

The compromise the House Democrats cobbled together was a pretty good one in that regard – they are essentially buying a mix of toxic mortgage securities (which may be perfectly decent at the price they are paying, or they could be worth much less than the price they are paying) and stock options (which theoretically could wind up being worth a great deal of money, giving the government at least some upside in exchange for the big risk they are taking.)

The main problems remaining are tied up in the question of the actual solvency of the investment banks. If there are a significant number of INSOLVENT investment banks, meaning that they actually have more debts than assets, then there's not a heck of a lot that can be done.

The big problem for the next president is going to be what to do when the 700 billion allows the banking system to, say, limp along for a year before slipping into another liquidity crisis. If that happens, we'll be at a real crossroads because no one will want to accept that we wasted all that money, but you also have to draw the line somewhere.

Now that a deal has been reached, we'll never really know, at least anytime too soon, whether this deal was necessary. We'll know fairly soon whether it was sufficient.

APS

19 comments:

Herr Gokmop said...

I think your analysis is conflating several ideas, (liquidity crisis, insolvency, and whether or not a business can be saved) and it's also mis-characterizing Paulson's position. The link you've provided talks about a liquidity crisis as being the situation when an institution "lacks sufficient cash to expand inventory and production or violates some term of an agreement by letting some of its financial ratios exceed limits".

This is not really the same thing as what's going on with a lot of firms right now. The issue isn't that most of them can't make their payments (although that's probably true), it's an issue of trust. These banks need money on a day-to-day basis to run their operations, and can't borrow it because the prospective lenders don't know if their client's toxic debt will make them insolvent.

This brings me to the mis-characterization of Paulson's perspective. He isn't saying that the banking system can't shoulder the bad debt of the investment banks. Here's some of his congressional testimony, where he says "(...) We must do so in order to avoid a continuing series of financial institution failures and frozen credit markets (...)". Frozen credit markets here means that there's money to be lent, but nobody will lend it because they're scared they won't get it back. (Because the toxic debt on their customer's balance sheet means they're actually insolvent, but we can't tell). Along the same lines: "These bad loans have created a chain reaction and last week our credit markets froze up – even some Main Street non-financial companies had trouble financing their normal business operations. If that situation were to persist, it would threaten all parts of our economy." Finally, he says "We have also taken a number of powerful tactical steps to increase confidence in the system" -- from Paulson's perspective, the issue is confidence, not the shape of a company's balance sheet.

This isn't about whether banks can absorb the fallout. It's that we'll never find out because they won't lend the money in such uncertain circumstances.

Another point in your analysis - having a "liquidity crisis" does not mean that an organization will automatically be insolvent and isn't worth saving. Say I'm a bank, and invest every cent of my money in a high-yield investment that will pay off only after 6 months. As a result, I can't make my interest payments next month, so I'm facing a "liquidity crisis". Almost the same concept, I am "insolvent", i.e. by definition "unable to pay debts as they fall due". But if investors were to provide a bridge loan, after 6 months I would easily repay it and still turn a profit.

To provide a smaller example which still scales to investment banks, consider the "payroll bridging loan" industry. Companies routinely don't have enough money to make payroll, because those dollars are invested in product which will turn a profit later in the month. So they get a bridging loan by promising the lender that the profit on their goods will more than cover the loan. This is a routine, month-to-month process for thousands of businesses. In other words, the only thing that prevents them from facing a liquidity crisis *every single month* is the ready access to loans. But if I go to the payroll bridging lender and tell them, "well, I might actually lose $40 billion next month, I don't know yet". They will refuse to lend me anything, and my business will go under, *irrespective of whether I could have survived the $40B hit on my own*.

So if a business is insolvent, that does not mean that they will ultimately fail no matter how much capital you give them. The determination of whether they will still be insolvent after (time period X) depends on many different factors. (Their investments, market position, behavior of other investors)

So back to your point about whether or not the traditional banks could absorb the fallout -- if the "toxic debt" were properly valued (which it cannot be in its current state) then some businesses would be insolvent, and some would not be. As it stands, we can't tell which is which. Of those insolvent businesses, some would get bridge loans from banks, because the banks would know that they could cross the rough times and return to insolvency. Some would have fundamentals so weak that they would die. In the latter case, the traditional banking system isn't absorbing anything, they're just opting not to throw their money down a rat hole.

Raul Groom said...

Good points; I think a lot of clarification is needed on liquidity crisis vs. cash-flow insolvent, but I'm going to do an entire follow-up post on that. But I wanted to make one quick point here.

On Paulson's congressional testimony, you're absolutely right that I'm reading between the lines. In part that's because Paulson said very little beyond "Something bad!! Or my great plan!" But it's also because part of his story (the part where the high-finance liquidity crisis sparks a business liquidity crisis) sounds ultra-fishy to me.

During a different part of his testimony Paulson said "These bad loans have created a chain reaction and last week our credit markets froze up – even some Main Street non-financial companies had trouble financing their normal business operations."

Well, that's pretty bad I guess, but there's some unanswered questions here to put it mildly. By what mechanism did faltering investment banks lead to this freezeup whereby IBM or Microsoft or whoever (he doesn't say what companies) couldn't raise cash to do things they needed to do? And if it is the case, where are the CEO's of those companies, jumping up and down in favor of this plan? I haven't seen a big push for this plan from Main Street, and I think if it were as simple a mechanism as Paulson is implying, they would be front and center demanding action. That hasn't happened.

Now, it's possible that Paulson is just operating in bad faith and in fact there isn't a lot of real danger beyond investment bankers losing their shirts.

If that's the case - I'm with you. Treasury shouldn't do anything. But this is a weird moment, politically, for Paulson to be orchestrating a giveaway to Wall Street for no reason at all.

I'm essentially giving Paulson the benefit of the doubt and assuming that the mechanism he has in mind is that traditional banks would begin to face liquidity crises of their own and become cash-flow insolvent. At that point you proceed very quickly to a "Main Street" liquidity crisis, obviously, because the lubrication provided by investment banks is small potatoes compared to the lubrication provided by traditional banks.

So I'm in an unfortunate position, as are most people, once we get to this point. If Paulson and Bernanke believe that traditional banks are in danger in the short term, I have no real way of deciding whether that analysis is correct or not. I also understand that it's not OK for the Treasury Secretary and the Fed Chair to actually say out loud, in public "we think the banking system is headed for insolvency."

There's a lot about this situation that stinks to high heaven, including the fact that Paulson prefaced his breathless trip to Capitol Hill with three months of happy talk about how everything was basically fine.

But at some point you have to accept the fact that the country hires the Fed Chair and the Treasury Secretary to make these sorts of calls, and absent clear evidence that they are wrong, if they say something needs to be done to avert catastrophe, we ought to give them the benefit of the doubt. The stuff they are saying could happen, after all, COULD happen. It's not crazy talk.

APS

Herr Gokmop said...

First, the "Wall Street"/"Main Street" dichotomy is often bunk in disguise. Either 'street' is replete with businesses that go both ways, such as Merrill Lynch which is ostensibly "Wall Street", but take deposits from average customers who aren't buying securities.

Assuming that they are completely distinct things (which I wouldn't assume) how would the liquidity crisis spill over? One presumes that the "traditional" banks would lend money to the investment banks, and would then lose their shirts because the investment banks are long-term insolvent. I just don't see how that would happen, since if the investment banks' status was either unknown or long-term insolvent, in either case the traditional banks wouldn't lend in the first place.

Banks don't just lend to lend. If they can accurately assess the risk, then one wouldn't expect insolvency crises to spill over, because the banks will take on manageable risk (at least, one would hope given the recent unpleasantness). If they can't accurately assess the risk, they never lend in the first place and insolvency crises still don't spill over.

Again we get back to the situation where the issue is trust -- namely that the traditional banks can't assess the risk associated with making a loan.

I agree with your final point that at some point you have to give the Fed Chair the benefit of the doubt. But I don't have to do that for your assertion that they believe traditional banks are going to bust, because he didn't say that. That's your in between the lines reading of what he said, and I don't see any support for that reading other than the unrelated observation about the lack of main street support.

I don't think Paulson is operating in bad faith. But let's propose just for arguments' sake that the traditional banks would remain unscathed because they simply wouldn't lend. That would still be a pretty dire situation warranting action, since not only would the investment banks fail, but a bunch of other businesses with short-term liquidity problems that would have otherwise been fixed by a small, regular, timely loan (the kind they used to be able to depend upon). It need not be the case that the failures will spill over to traditional banks, and that's the only real reason he would have to put forward this plan while at the same time operating in good faith. For that reason, it seems like you're pulling your reading of his words out of a hat.

Raul Groom said...

But here's the problem with Paulson's plan in that case - if the problem is balance-sheet insolvency, as opposed to cash-flow insolvency, buying bad debts doesn't fix the problem.

The only way buying up bad debts fixes the problem is if the main problem facing the failing institutions is a lack of liquidity leading to a cash-flow insolvency.

Yves Smith explains why here:

http://www.hussmanfunds.com/wmc/wmc080929.htm

If you don't recapitalize the banks, you're only fixing the liquidity issue. You're not addressing balance-sheet insolvency at all.

That's why I still don't get the point of Paulson's plan unless he believes that the liquidity crisis itself threatens to spill over into the traditional banking system. In the short-term, it's certainly possible that some businesses will fail because they are short of cash. But it doesn't constitute, in any way that I can tell, an emergency justifying $700bn in emergency loans.

The emergency is if there's going to be a significant rightward shift in the money supply. The only way I can imagine that could happen is if the traditional banking system begins to fail; otherwise, once the failing investment banks have all failed, the economy will be in a lot of pain for sure, but the TED spread will recover, the Fed will regain its power to regulate the money supply, and all will be well.

Raul Groom said...

To finish that thought, that's the big reason I think the Paulson plan is bad, even though I believe Paulson when he says something needs to be done (again, I'm not so much saying I agree since I really don't know).

If we're going to act, let's act in a way that can help firms that are balance-sheet insolvent in addition to firms that are merely cash-flow insolvent by injecting equity into the firms instead of just buying bad debt from them.

That plan has the power both to have more impact (and more potential for heading off disaster) AND if it works, it's cheaper/more profitable since Treasury would reap a windfall from the once-again-profitable firms that it saved.

Uncle Kevin said...

You two mention the issue of trust. It seems that one big issue here is knowledge. No one, not the government, not the banks, not the investment banks, no one really knows how much bad debt is out there and who has it. A large portion of the bad debt is related to loans that now exceed the value of assets which supposedly "back" them. This is at the core of the problem of banks withholding loans. Supposedly the problem at WaMu was predominately finally triggered by the Lehman failure and JP Morgans severe reports on the falling value of the holdings. No one knows who has how much. Throw in the whole "mark to market" issue and everyone is afraid. There are very few entities that feel they have the capacity to dip into this market because they don't know how much they'll need to get back out. The fed is talking 0.7 to 1.4 trillion.

Paulson's theory seems to be he can buy the uncertainty out of the market. It isn't clear to me he can. And there is nothing in any of the bailout plans which will require that loans get easier to obtain.

Herr Gokmop said...

Uncle Kevin -- you're making I think essentially the same point that I am.

Nobody knows how much bad debt is out there, because thousands of bad mortgages have been intermingled with good ones in these securities, and nobody knows which ones will pay. It is this lack of knowledge that causes the lack of trust I was referring to. If people knew what the actual risk of these securities was, they would trust enough to lend to one another. Because they would know enough to accurately assess risk.

Taking Paulson only at his word, buying bad debt would have a positive impact on the problem. Bank A won't lend institution B money, because B is laden with unassessable (potentially toxic) debt. If the government buys the bad debt, the only thing left on B's balance sheet will be things whose risk is actually assessable. That will make bank A comfortable enough to loan institution B the money.

Now, if B is completely in the gutter irrespective of their subprime investments, you're right that A won't lend B the money, and the bailout won't help. But a big part of the premise of the bailout is that the system is otherwise sound, and that it's only certain investment classes that are causing the uncertainty and instability. As the theory goes, if you remove those asset classes from institution's assets, banks will be able to build sufficient knowledge of their customers' risk to lend.

Raul Groom said...

I think we're all basically in agreement about the trust/knowledge/uncertainty point.

It seems to me the obvious solution, assuming that's the ONLY problem, is for Treasury and the Fed to force firms to disclose how much of Big Shitpile they own. Then, balance-sheet insolvent institutions can be allowed to fail in an orderly fashion, while cash-flow insolvencies can be bailed out on a case-by-case basis.

Again, I just don't see the need for this giant mega-bailout unless the problem has already gotten too big for that to work, and threatens the traditional banking system. There could be something I'm missing. But if the problem is purely that big shitpile is scaring people, then let's limp along until January, let a bunch of banks go bust, and start over with a better regulatory structure.

What makes me skeptical about actually advocating that position is that I don't really see why Bernanke and Paulson would be lighting their hair on fire over this if that were really an option.

Raul Groom said...

One thing I see a few people bringing up around the blogosphere is the Iraq war. And actually, you did have a similar situation there, and lots of people, including a lot of liberals, used essentially the same thought process I'm using.

The administration's case for action was thin. But the urgency with which they were making the case led a lot of people to say "well, if the White House really thinks this is such a giant emergency, there must be something there."

Obviously that didn't work out too well. So I recognize that this type of thinking doesn't have a great track record. But here's why I think this situation is a little different.

In the case of the Iraq War, the administration was acting in bad faith. They wanted a war for their own reasons and they thought they had a decent enough case to sell the war, so they pretended there was a lot more urgency than there was.

In this case, it's squarely against Paulson's interest to handle this proactively if waiting is an option. He's undertaking a super-unpopular, drastic course of action four months before this becomes someone else's problem. Why?

The intuitive answer, at least to me, is that there is a serious potential of commercial banks starting to fail. Paulson and Bernanke can't say that - after all, I'm a calm guy, and I understand that the money is insured, but if the Treasury Secretary and the Fed chair started talking about commercial banks failing I'd certainly start keeping a couple hundred bucks cash in the house.

Herr Gokmop said...

Raul --- It seems to me the obvious solution, assuming that's the ONLY problem, is for Treasury and the Fed to force firms to disclose how much of Big Shitpile they own. Then, balance-sheet insolvent institutions can be allowed to fail in an orderly fashion, while cash-flow insolvencies can be bailed out on a case-by-case basis.

That presumes that those banks know themselves how much shit they own. I don't think that they do.

Go back to the basics of how the bad mortgages were securitized in the first place. Let's use some made-up numbers. Say I make 10,000 loans. 5,000 of them are going to utterly fail and cost huge amounts of money. 5,000 of them are just fine, and are probably going to pay out as expected. Now let's say I shuffle those 10,000 loans into 1,000 securities of 10 loans each. Using a little bond rating agency magic, (that gets complicated and it's better explained elsewhere) they all get rated as very good credit risks, even if they're not.

Some of those securities may contain 80% bad debt, others 10% bad debt. The security holder doesn't necessarily have insight into the *specific* loans, only insight into its risk-profile composition (i.e. "these are all decent loans") which was a lie perpetrated by the bond rating agency.

Now you go to ask a bank to disclose how much shit it has in its assets, and it can't even tell you. If it has an 80% bad debt security, it's worth some large negative number (not even 0, because as Uncle Kevin pointed out, some of those loans are worth more than the house they're on -- the debtors are "underwater"). If you have a 10% bad debt security, it might be worth, say, 70% of what the market priced it at 6 months ago. Not really all that bad.

Except you can't tell which is which. The security holder can't tell which is which. (They don't administer the loan, they hold a security, and the company that does administer the loan does the same for 100,000 loans across thousands of securities).

One step further - let's say that the security holder could or should know the composition of their securities (which I don't believe is the case here). Even in that case, their information would only be as good as what was provided on the mortgage app by the consumer. We know now that in some casts, mortgage brokers openly encouraged people to lie to get the loan, so the broker would get the origination fee.

Net result: the owners of the securities don't know what they're holding, and can't disclose it to calm the jitters of their prospective lenders.

Herr Gokmop said...

He's undertaking a super-unpopular, drastic course of action four months before this becomes someone else's problem. Why?

The intuitive answer, at least to me, is that there is a serious potential of commercial banks starting to fail.


It's clear to me that he thinks this is serious, and something has to be done now.

I'm completely baffled why you keep saying that because he's taking this seriously, it must then follow that he's concerned that commercial banks will fail.

Maybe they will fail, and maybe they won't. I don't know, and I doubt that Paulson knows for sure either.

Why must it be the case that Paulson thinks commercial banks are going to fail? If he thought that everything in the universe was going to fail, but that commercial banks would remain unscathed, how is that not dire enough to justify his decisions of late?

And again -- watch out for your distinction between "investment banks" and "commercial banks". That line is fuzzy.

Uncle Kevin said...

What I hear everyone saying is that no one, including the debt holders, know how bad the situation is, or where the bad debt is. As such, I don't see how Paulson, in the short term, can buy his way out of the problem. Short of buying every piece of debt out there, the owners of this crap will still have some percentage of their holdings with unknown levels of quality. They'll own a smaller total pile of it, but it could be left with the same level of toxicity, just on a smaller total quantity.

The intent of this bailout is to try to quickly affect the credit markets. But it seems almost more likely, in the short term, to actually spook the markets than calm them. Make up some numbers and it is hard to see how any set of numbers particularly comes out good, especially over the next few months.

I'd guess that some huge portion of real estate has been mortgaged in the last 5 years. That's alot of money. Some large portion of that is probably for values for which the land has since fallen below. How much of the debt out there does Paulson have to buy to capture a meaningful percentage of those over leveraged assets? How quickly does he have to buy it? And the toughest question, how soon will anyone believe he has succeeded?

Herr Gokmop said...

More information on Collateralized Debt Obligations (CDOs). Specifically, CDOs are the "toxic debt" we keep talking about.

Interesting quote: "Some institutions buying CDOs lacked the competency to monitor credit performance and/or estimate expected cash flows. On the other hand, some academics maintain that because the products are not priced by an open market, the risk associated with the securities is not priced into its cost and is not indicative of the extent of the risk to potential purchasers.[1] As many CDO products are held on a mark to market basis, the paralysis in the credit markets and the collapse of liquidity in these products led to substantial write-downs in 2007. Major loss of confidence occurred in the validity of the process used by ratings agencies to assign credit ratings to CDO tranches and this loss of confidence persists into 2008."

Raul Groom said...

I'm sorry if I'm not being clear. My first take on the situation was that it was self-evident that Paulson and Bernanke thought the commercial banking system was in jeopardy.

I now see that it is not self-evident. Nonetheless it is still my intuitive judgment that they do believe the commercial banking system is in jeopardy, because I can't see another plausible reason for their conduct.

You bring up a hypothetical in which the entire economy collapses except the commercal banking system and note that in that case it would still be a major crisis worthy of immediate action. The only trouble with that example is that it's totally implausible.

What's not implausible (to me) is that the collapse of the investment banking system would lead to liquidity crises and cash-flow insolvency for commercial banks. That's especially true for the reason you note, which is that since the middle of the Clinton presidency, it's no longer required that commercial banks stay out of investment banking.

There may be many crises not involving commercial banks that would warrant this action. I just can't think of them, or more specifically what mechanism would cause them. It could be a failure of imagination on my part. But to overcome that, I need the help of a second imagination!

I'm sympathetic to your position. You're arguing against a bailout, using sound arguments, and people arguing against the bailout have been subjected to a lot of sneering contempt that is unwarranted. Your position is completely rational, and in fact probably has a sounder rational basis than any case I've seen anyone make for the bailout (including mine.)

The sticking point is, I am still in favor of the bailout for reasons that I will admit are a bit ephemeral.

If I could boil my position down to one concise statement it would be this:

The key to this crisis is the instability and illiquidity of short-term interbank markets. Depending on the severity of this crisis and the underlying solvency of the banking system as a whole, one of three things needs to happen (listed from not-that-severe to very severe):

1) Insolvent banking institutions should be allowed to fail and be swallowed up by other banks in an orderly fashion (the business-as-usual approach.)

2) Marginal and failing banks should be recapitalized by the US treasury (the Dodd/Frank approach.)

3) The entire banking system should be nationalized (which I guess we could call the Nuclear Option.)

In my view, if you try #1 and the problem is too big, you risk losing the chance to try #2 and move straight to #3. That's the argument I'm making and while you may not agree, hopefully now it's clear what I'm trying to say.

Herr Gokmop said...

There may be many crises not involving commercial banks that would warrant this action. I just can't think of them, or more specifically what mechanism would cause them.

Specifically, businesses completely outside of the financial sector failing as a result of lack of access to daily credit (i.e. the payroll bridging example I provided), caused banks being extremely tight on all lending due to inability to assess their risk exposure and that of their trading partners.

In the comments that I've made, I have not anywhere argued against the bailout. I've only been arguing for an accurate understanding of the actual issues, and the positions of the people who are involved in it.

If I was pinned down on what Bernanke and Paulson should do, I simply don't know. Any course of action that they would take would presume a certain set of principles. By principles here, I mean that their course of action would inherently be trying to maximize one set of things, and minimize another set of things. (For example, maximize short-term liquidity, and minimize medium-term institutional failure might be one set of "principles" here). One might reasonably also choose a different set, which would lead to a completely different discussion. For example, government might decide to try and maximize long-term health of the economy, irrespective of short-term consequences (yeah right). Alternately, they could minimize cost to the government or taxpayer involvement.

The course is unclear, because I don't think there's any agreement on what principles should be used for crafting a bailout plan. The principles are the strategy if you will; the bailout plan is merely the tactics employed towards the pursuit of that strategy.

I'm not very interested in arguing about whether Bernanke and Paulson are right. I'm pretty sure that it's not possible that they're right, because the strategy hasn't been vetted or discussed anywhere. In a sense, it is like the Iraq situation you brought up. At that time, there was the presumption that attacking Iraq was the right way to go, and people just wanted to argue about the tactics of pursuing that strategy. The most talented and dangerous rhetoricians out there know how to control the options: frame the debate as a discussion of which tactics to use on the road to the strategy I've already selected for you.

I suppose it's not going to be a very popular position on the bailout though that the entire discussion is framed the wrong way for anything meaningful to come out of it. But that's the truth.

Your option #2 seems reasonable for what we're facing, but it would substantially redefine the government's role in the economy. It seems prudent to have a discussion about what that role should be before we go re-arranging the economy as a knee-jerk reaction to a crisis. While it's true that something probably needs to be done fast (where "fast" means on the order of months), the idea that something needs to be done on the order of days is likely political gamesmanship by people who know that if you want to move something through Congress and you don't have ultra-momentum, you'll get bogged down and your pet rocks will get compromised out of the bill. Witness the fact that Congress didn't get it done last week, and Armageddon has not yet happened.

So I guess here's my summation -- don't you have the slightest feeling like you're being bamboozled when you are forced into taking a position on the Paulson plan?

Raul Groom said...

Generally I worry that I'm being bamboozled when I see it as being in someone's interest to bamboozle me. I guess that's the piece I'm not getting about your skepticism.

What is your intuitive judgment about 1) what Paulson hopes to accomplish (you can frame it in terms of principles if you like, or just posit a likely outcome) and 2) why it is he wants to cram this bailout through right now?

That's the part where the Iraq analogy breaks down - it was obviously in Bush's interest to invade Iraq. It's much harder for me to see how it's in Paulson's interest to cram this bailout bill, which is super-unpopular, through congress.

Herr Gokmop said...

When I say that Paulson is trying to bamboozle people and push his own bill through, I don't mean that he's acting in bad faith. (Speculating) he thinks it's the right thing to do, and the end of getting the bill passed justifies the means of bamboozling people (specifically, the artificial time crunch and the ultra-dire predictions) to get it done.

Similarly, I believe Bush thought he was acting in good faith on the Iraq issue. He wasn't sitting in his room cackling at the thought that he was pushing through an some obviously evil agenda, he thought he was doing the right thing. And that end justified the means of forcing Congress to do what he wanted.

In both cases, the mens' interest is in pushing forward a policy agenda that they really think is in the best interests of the country. My skepticism doesn't extend to some kind of crazy claim that this is a conspiracy or that they would personally benefit. I'd consider them both honest, well-meaning, and (at least in the case of W, but maybe not Paulson) irrational and misguided.

As for my intuitive judgment on Paulson's principles, I'm not in the habit of applying my intuition to people I've never met and massively complicated international banking systems. I put no weight on my intuition's ability to be right in that arena.

But if you're asking me for my uninformed opinion, I can certainly provide that. :) I think that Paulson is semi-panicking, and hasn't clearly thought through his principles. He's crisis-focused, and is doing the best he can to alleviate a short-term crunch. I doubt seriously that he has any kind of plan or perspective on what this will do in the long run. If he does have a sense of what this will do in the long run, he probably waves it off with something along the lines of "we have to accept whatever long-run consequences there may be (and attempt to address them down the line)...and however bad that will be probably pales in comparison to what will happen today if we don't move". So I'd state his principles to be "minimize short-term failures of institutions irrespective of the cost to government or the structure of the economy, and long-term, well, ????"

In other words, I think he's acting in good faith and at least somewhat believes in the artificial deadline he tried to set for Congress.

The bamboozle is in forcing the discussion into the realm of tactics around a pre-ordained strategy, whose principles are not defined or articulated, and doing that within an artificial time-frame designed to prevent discussion of the strategy and principles.

Look, Paulson knows way more about the banking system than both of us combined. I'd never go head to head with him in an argument on the mechanics of such a system and claim to be in the right. I just don't think that he's operating off of soundly considered experience and judgment right now. He is ultimately the person who should probably choose the strategy, so I'm not saying that Congress and the public should have a never-ending, open-ended discussion of what strategy the nation should choose. (This goes back to our earlier point that it's probably OK to nominally trust a guy in his position)

But the public and Congress has the right to a detailed, specific explanation of why he thinks this will work, what other alternatives he considered, and why they were rejected. My (uninformed opinion) is that he hasn't presented such information because it doesn't exist. If he presented a reasoned choice amongst non-strawman alternatives, I'd defer to his judgment, but I feel no obligation to defer to what is potentially an irrational knee-jerk, even if it comes from a very learned and respectable man.

Raul Groom said...

You're setting the bar on "bad faith" pretty high here.

Bush certainly was not "cackling" over his devious Iraq plan. That doesn't really happen. People acting in bad faith don't do that, with very rare exception.

What happened with regard to the Iraq war is that the Bush administration's foreign policy arm believed that it was in the US' interests to invade and occupy Iraq. They knew, however, that there was not enough popular support for that strategy absent some crisis, so they went looking for one. That's a matter of public record at this point, confirmed by several people who were members of the administration at the time.

The analogy with Iraq doesn't line up well in this sense, because the Iraq "crisis" was wholly invented. There was literally no crisis.

Here, there's definitely SOMETHING going on in interbank markets that could be termed a crisis. It's not as if everything was fine and one day Paulson came along talking about mushroom clouds.

It may be we have a different definition of "bad faith." But if I have evidence it's going to rain next week and I burst into the room shouting that there's going to be a hurricane tomorrow, that's bad faith.

If I did that, you would assume (I would think) that I had some personal interest in seeing people panic.

Raul Groom said...

Since there was a whole other section of your recent comment to which I didn't respond, allow me to take a second bite at the cherry:

I agree that this is a bit of a panic move. I think the reason is as you say - no one really has experience with this. We've put together a shocking string of very bad policy mistakes (some having only limited connection to the economy) and we're now facing a financial situation that ranges from "unusual" to "unprecedented" depending on how you look at it.

The reason I guess I don't feel "bamboozled" in the sense you mean is that I think "Let's discuss a strategy for dealing with the instability in the financial sector" would have been a great conversation to have, say, three months ago.

Now that things are seriously under strain, though, I think the proper function of an executive is to say "here's what we're doing" and Congress can amend it at the margins to improve it. It chafes somewhat for the reason I mentioned before (Paulson's been talking about how thinks are A-OK for months before this), but I think it's proper for that to be the way the conversation shapes up now.

As with a GREAT many things that have happened in the last 8 years, I wish very much that the people who were in charge of coming up with these plans were better at their jobs. But you go to war with the Treasury Secretary you have, not the Treasury Secretary you wish you had.

In the end I guess it does hinge on the very sticky question of "How bad is it right now?" which is an extremely difficult question that really nobody alive is totally qualified to answer, given the lack of information about the true financial state of many important companies, both financial and non-financial.

My intuition is that Paulson and Bernake think it's very bad, and my personal intuition has reflected that for some time as you know.

The Paulson plan looks like "triage" to me as well. I don't think anybody has a long-term outlook on how to fix the seizeup in interbank markets or prevent a steep global recession.

One reason for that, unfortunately, is a structural paradox having to do with what brought this situation about. The crisis arose in part because cheap, free-flowing credit created an economy that is so highly leveraged that financial markets are reacting to a significant but non-catastrophic decline in asset prices as if the sky were falling.

The trouble is, in the short term the only piece of the problem anybody can get their head around is "how can we make sure that credit continues to be cheap and free-flowing?" Obviously you can't fix the underlying problem of an overleveraged economy that's in decline merely by repairing the credit markets.