Wednesday, May 12, 2010

The bailout problem in a nutshell

Professor James Hamilton writing at Econbrowser:

And, as was the case in the 2008 difficulties, one can either view this primarily as a liquidity problem, for which we simply need the central banks to step in boldly to arrest the jitters, or as a solvency problem, in which case the policy decision is how to allocate the unavoidable capital losses among bank owners, bank creditors, and the government so as to minimize collateral damage to innocent bystanders. The fundamentals facing Greece suggest there is an overwhelming solvency component to the current problems. And the policy response so far seems to be choosing to allocate 100% of losses to the European and U.S. taxpayers.

It is not the role of the ECB, IMF, or Federal Reserve to bail out banks. These measures are profoundly unpopular with voters in countries such as Germany and the United States. I think it is incumbent on the architects of these measures to communicate what is the structural defect in banking regulation that made such intervention necessary, and what reforms have been implemented to ensure that such measures won't be needed again.

I have yet to see a convincing case that the financial reform legislation in Congress accomplishes such a task. Go read the whole (short) thing.


D said...

I will venture to say that anyone using the term 'liquidity problem' is automatically unqualified to speak on the issue of central banking, though that may be hyperbole.
Newsflash: YES, it IS the role of the Fed and IMF to bail out banks. In fact, that is what the term 'lender of last resort' (LOLR) means. That is the genesis of the moral hazard and the source of the problem as it relates to reckless behavior. Every politically connected financial institution knows they will be bailed out, and thus have absolutely no reason to be responsible. This is socializing losses while privatizing profits.
The problem is not which 'regulations' to put in place (as if any more regulations are necessary than the natural market regulations) how much fiat money needs to be printed up, or which LOLR needs to step up. The problem is thus: First, Central banks are pure fraud. They have balance sheets, and yet they start with ZERO capital. They are pure counterfeiters, and nothing more. Second, the central bank system creates moral hazard and institutionalizes fraud in other banks, ie) fractional-reserves. Third, States and businesses that refuse to act responsibly cannot be allowed to continue. It is unethical, immoral, and counterproductive to rob innocent third parties for their poor stewardship.
It always amazes me when political operatives calling themselves economists fail to treat the cause and focus only on symptoms. They refuse to trace problems back to the ultimate given: Where did the artificially low interest rates, inflation, and endless credit come from? And how does inflation and debt cure inflation and debt?

J. Strupp said...

"In fact, that is what the term 'lender of last resort' (LOLR) means. That is the genesis of the moral hazard and the source of the problem as it relates to reckless behavior."

I don't buy it for one second. History tells us that financial crisis, as a result of reckless, risky behavior, has existed for hundreds if not thousands of years, well before the idea of the modern day LOLR was even considered.

This financial crisis is no different than all the others in terms of human behavior: Wall Street didn't make risky trades because they thought they would be bailed out by Uncle Sam if they went south. Wall Street thought they had figured a way in which they couldn't lose. The moral hazard argument is all the rave these days but it's not the source this crisis or any other financial crisis in our history.

The Mises people finally found your blog Jeremy.

Dad29 said...

We are not impressed with pseudo-intellectualoid rants, "D". Yappaflappa all you want, the Fed is here and will stay.

As to causes:

In the 1960's/early '70's, national banks' loan-to-deposit ratios were held around 80% (sometimes as high as 85%.) More than that and you were in deep doodoo with the examiners.

STATE banks were allowed even less--around 75% or so.

Look at the L/D ratio of M&I before the crash: it exceeded 100%, and that was allowed by Fed and FDIC.

That's just one minor example.

Greenspan led that dance, although the Exec and Legis branches were certainly partying hearty, too. the FRB had all kinds of control mechanisms which he simply did NOT exercise.

IOW, he was 'irrationaly exuberant' about the bankers.

D said...

J, please expound on 'financial crisis,' - They have not existed for thousands of years. "Depressions" certainly have existed, though in economies that by no stretch of the imagination could be called modern. Depressions caused by a lack of food (in turn caused by a lack of production and alternatives) are not the same thing as the business cycle.
"Wall Street didn't make risky trades because they thought they would be bailed out by Uncle Sam if they went south."
Most certainly and especially in the last two decades, this is precisely the case. They even have a term for it, the "Greenspan put."
"Wall Street thought they had figured a way in which they couldn't lose."
Please explain where the credit came from. It didn't come from Wall Street. It came from the one-two punch of a central bank that literally prints money out of thin air, and a government that allows legalized fraud through banks that claim to be able to meet all obligations on demand, yet are not 100% reserve.
I fully understand the 'derivative' argument. The question you need to answer is why this product became necessary. Who was buying subprime mortgages? GSE's. Who runs credit agencies? Government.
The freedom is evil, anyone who doesnt work the government is a crook argument is in vogue right now, but fortunately this myth has been debunked since Menger.

D said...

To which control mechanisms do you refer? He certainly did have control mechanisms he chose not to exercise, among them:
He could have refrained from massively inflating the money supply,
he could have enforced 100% reserves rather than allowing institutionalized fraud,
he could have restrained himself from buying government debt to be used for bankrupt programs and wars,
he could have not lent money to banks buying phony assets,
he could have done a whole world of things.
In praxeology, we must seek the ultimate given. Of course it was the fault of individual banks for buying into this phony system. However, that phony system wouldn't exist with a legitimate, sound money and legal banking of 100% reserves. Convince me otherwise.