Belmont Club

Cold Turkey

The fundamental problem with any government attempt to the fix financial industry is how to stabilize it without getting involved in it. The New York Times summarized the opening arguments of both the President and his critics on the proposed financial “reform” bill. Obama depicted his proposals as a step toward reducing government liability for finance industry losses.

Mr. Obama argued that he was advocating “a common-sense, reasonable, nonideological approach” that would strengthen consumer protection, limit the size of banks and the risks they can take, enforce greater transparency for derivatives and other complex securities, and impose more scrutiny of executive compensation.

Republicans says it will accomplish the opposite: by multiplying the hooks which bind the government and the industry, it will institutionalize the bailout of failing financial institutions.

“President Obama says he believes in the power of free markets but his policies prove otherwise,” said Representative Spencer Bachus of Alabama, the senior Republican on the House Financial Services Committee. “Under the Democrat plan, certain financial institutions have no freedom to fail, and are instead propped up by taxpayer bailouts and government loan guarantees.”

The financial system is so important that Bachus’ point may be moot. For political reasons it has no real freedom to fail. That’s why the real cost of managing the financial sector’s problem is astronomical.  An early version of the bill featured a $50 billion “liquidation fund” that rapidly became a target of Republican critics who portrayed it as another bailout kitty. The administration attacked the fund, saying that any costs of liquidation should be borne by the financial industry. But according to Nicole Gelinas of, that was beside the point. What government is always in on the line for is the cost of keeping the financial market from crashing.  It is not primarily the cost of picking up the pieces but holding a collapsing edifice together. “The true tab is not the retroactive cost. Rather, it’s what investors demand at the time of an acute crisis so as not to flee the unknowable risks of a financial system in meltdown, precipitating depression.”

Think about everything that Washington has done in the past two years. TARP was $700 billion; that’s easy. Outside of TARP, the Treasury said it would guarantee $3.4 trillion worth of money-market funds in the fall of 2008. The Fed has purchased $1.25 trillion in mortgage-backed securities over the past year or so — providing a floor to avoid deeper housing-price declines and bank losses. It also offered $1.8 trillion to commercial-paper markets.

The FDIC guaranteed up to $940 billion in financial-firm bonds and committed another $700 billion in expanded deposit guarantees, which allowed banks to avoid selling off assets at crisis-level prices. Taking Fannie and Freddie into conservatorship and guaranteeing other housing agencies and their debt? Another $7 trillion. Other sundry programs add up quickly

These huge government expenditures were ostensibly used to keep the system from crashing, to maintain confidence, to keep things together. The government could simply not abide the collapse of the financial, auto, housing industries — including government controlled corporations — so it propped them up. Unless the President’s financial “reform” package can tie the government’s own hands to prevent a repeat of this ‘help’ then taxpayer liability won’t be reduced by a single iota. Only by adopting strict limits — both on financial firms and government spending — can there be any hope of bounding the problem. Once a financial crisis is in full swing all thoughts turn to preventing a collapse.

But during the lulls the last word anybody wants to hear is “no”.  Everybody is addicted to business as usual. Neither Wall Street, nor the Federal Government, nor California want to be put on short leash. Ask the public service unions. The Greek debt crisis (Greece being one place where public service unions are particularly strong) showed how difficult it was to put a stop to profligacy. Demonstrators took to the streets to demand an end to the crisis, by which they meant ‘pay us our salaries’. The Economist writes that the EU and the IMF must bail out Greece even though Athens shows no sign of stopping its wayward ways. Otherwise another weak Eurozone country may be the next domino to go over. Yet that “will provide only temporary relief”.  But it must be done to keep the system from crashing. Like an addict who must get what he needs the entire universe collapses to the horizon of the next fix.

Baseline Scenario writes that more taxpayer money must be infused now or things will really start to fall apart. The Greek crisis, which was never supposed to get this far, must not be allowed to go further. The catch is that the solution is guaranteed to make things go not just further, but all the way.

Irrespective of the next move – which lies this weekend with the International Monetary Fund and the ministers of finance meeting in Washington for the Fund’s spring meetings – this looks like the moment when the Greek problems really start to generate contagion across the eurozone region. … And this is the heart of the problem: Will Germany and other European nations be prepared to provide the large sums needed to refinance several peripheral nations? Will these nations then take the painful austerity measures needed in the midst of recessions in order to get out of this? …

Yesterday was also a wake-up call for the United States. It is no longer reasonable or responsible to say: “US banks have no exposure to Greece”. US banks are heavily exposed to Europe, and this is turning into a serious Europe-wide problem. The US badly needs to make sure this does not spread beyond Greece and Portugal/Ireland.

To restore confidence in buying Spanish and other major European nation bonds, it would surely help to have clear signals that President Obama himself, and the Federal Reserve, are taking an active stance now on making sure this does not spread to become another threat to global financial stability. A broader wall of preventive financing must now be put in place – after all, this is exactly why (in principle) the IMF was recapitalized this time last year.

Although the “Wall Street versus Main Street” meme may be a good administration sound bite to push financial “reform”, the idea that governments will rein in irresponsible traders is about as plausible as leaving two drunks in a warehouse full of whiskey to watch over each other. Governments are the among the most profligate borrowers of all. The Financial Times described the biggest driver of public debt as unfunded healthcare and pension liabilities.

But a March 2010 Bank for International Settlements (BIS) working paper, The future of public debt: prospects and implications, which examines various developed countries including the UK, presents a more worrying picture. The BIS argues that the fiscal problems confronting industrial economies are bigger than suggested by official debt figures that show the implications of the financial crisis and recession for fiscal balances. A greater danger arises from a rapidly ageing population and the related unfunded pension and healthcare liabilities. …

For the BIS, one conclusion is very clear: “It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far”. Experience would suggest, however, that bond investors would be wiser to expect complacency rather than radical action.

That “free” healthcare, that “cap and trade”, that “immigration reform”, why even that financial “reform” might turn out to cost money. Where’s it going to come from? Who knows? Who cares? Both government and the financial industry have set up a gigantic problem for which they share a degree of mutual responsibility. The complicating factor is that both government and the finance industry have found it in their interest to abet each other’s reckless behavior. Given this incentive structure, it is not entirely clear whether the two left together can find a way out of the mess. What is more likely to happen is that each will keep helping itself somehow to the stash of monetary whiskey until they’ve either drunk the warehouse dry or some political upheaval forces them to clean up their act.

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