The Alternate View

Several people I know have argued with my "do nothing" approach to the current mortgage and liquidity mess.  Their argument is that the current crisis has frozen the short term money market, with banks refusing to lend to each other, and only doing so via central banks.  The problem, they claim, is that this could lead to an extended drying up of business to business credit.  For example, two people both used the fuel retailing example, arguing that inventory purchases are made on credit, and paid off as the inventory is sold.  The logic, I assume, is that businesses have all reduced their working capital, and so a drying up of short term business credit will cause the economy to lock up, with producers and retailers unable to buy components and inventory.  One such argument here.

I guess the questions are 1) for how long and 2) how best to fix it.  To the first question, this is by no means the first time in my lifetime that short-term credit has dried up.  Liquidity eventually returns, mainly because lenders need to lend as much as borrowers need to borrow.  As to the second question, central banks are currently handling this by increasing the amount of money they will lend short term.  Rather than lend to each other directly, bank A deposits with the Fed and then the Fed lends to bank B.  The cycle ends NOT when every bank is healthy but when banks and other institutions are confident they know which banks are healthy.  All the bailout is doing is delaying this reckoning.  I don't think it matters that banks and certain financial institutions survive, I think it matters that the ones who are not going to survive are identified quickly so the rest can start lending again to each other.

Given these concerns, I reiterate my position that if the government is going to inject liquidity and create new financial asset insurance programs, it makes more sense to me to do it at the point of concern, i.e. in the credit market to main street businesses, rather than dumping the money into the toxic sludge of credit default swaps. 


  1. Mark:

    In some ways I do not disagree. The RTC's problem during the S&L crisis was much easier because they were essentially liquidating already failed companies. This is more of a dynamic problem.

    The reason why I support a "bail out" in some form is that the government was complicit in this problem. Fannie Mae and Freddie Mac guaranteed about $5.4 trillion in mortgages. Now, the government essentially owns these two GSEs. WIthout these entities, and other government action such as the expanded Community Reinvestment Act, I doubt there is such a crisis.

  2. ruralcounsel:

    The other point which I think your analysis fails to factor in is the psychology of the markets, which won't wait it out for this realignment of the credit markets to occur.

    People will eventually panic, which will spread the collapse to other venues, some of which are none too strong or healthy.

    Like Mark says, the housing bubble has its roots in the Clinton administration's expansion of subprime mortgages so that the poorer socio-economic segments of society could get into homeownership. And then the massive fraud of Fannie Mae under the "leadership" of Franklin Raines and Jim Johnson. The government created a hot potato, and the financial industry tried to pass it around as mortgage backed securities ... boom!

    But that's history now ... we need to figure out how to keep these incredibly poor governmental policies and the law of unintended consequences from dragging us all down.

    Like I said, the government created this hot potato, it's only fair that it fall back in to their laps! And it's our job as voters and taxpayers to make sure they don't pass the buck back to us. We need to use this as leverage to force a smaller government with fewer notions of social engineering and more limited budgets.

  3. Michael Adams:

    I came here via Maxed Out Mama, who I think is utterly brilliant. My wife and I love to listen to anyone geek out, about most any topic. We get that thrill running up the leg, and,at our age, any thrill is welcome. MoM maintains that the problem started with S&P and Moody's doing corrupt evaluations of mortgages. As I have said, I think MoM is brilliant, a quantitative genius, so it is with some trepidation that I disagree with her. Still, the fakery started when the banks were already in trouble, and so they sought to find a corruptible appraiser, who'd let them keep that bad paper moving. The connection to your topic here is that we can probably get through the liquidity crisis by reversing the way we came in, making lending transparent, which will restore trust, and, with some pain, the problem will be solved. I am a homeowner, who might find even my eighteen year old mortgage "upside down." I shall be one of those who feel that pain. Well, I've been there before, albeit at a younger age. I'm just one of those jumped-up peasants who forms the American middle class, and I guess what I really want to say is,"Bring it on."

  4. Yoshidad:

    Wrecking, Wrecking, Wrecked
    --Thomas Frank here:

    The great fear that hung over the business community in the 1970s was death by regulation, and the great goal of the conservative movement, as it rose to triumph in the 1980s, was to remove that threat--to keep OSHA, the EPA, and the FTC from choking off entrepreneurship with their infernal meddling in the marketplace.

    Defunding those agencies was one way to stop the killer bureaucrats; another was to stuff them full of business-friendly personnel who would go easy on regulated. The signature conservative regulatory idea became "voluntary enforcement", because everyone now knew that efficient markets regulated themselves. Bad practices or tainted products drove away consumers; therefore firms had an incentive to behave, an incentive far more powerful than some top-down scheme in which big brother told them what to do.

    Whether people ever truly believed this nonsense or not, its application over the years makes up the basic story of conservative governance as I tell it in my book, The Wrecking Crew. This is the philosophy by which conservatives gutted the EPA and the Labor Department, turned over the Interior Department and the FDA to the industries they were supposed to regulate, let the CEO of Enron advise the vice president on energy policy, and generally came to regard business, not the public, as government's "customer" (a word that crops up with disturbing frequency in conservative regulatory history).

    But it is only now, as we watch the financial system crumble around us, that we can really see the devastating consequences of this folly. It turns out the Securities and Exchange Commission (SEC), which was responsible for regulating investment banks, did a significant part of its job through a voluntary program which firms could participate in or not as they saw fit. As the New York Times told the story on Saturday, this system had--of course--been pushed for by the investment banks themselves, who wanted it in order to avoid the stricter rules from European governments that they would otherwise have had to obey.

    And now, as a consequence, the SEC has almost no industry left to regulate. Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs, Morgan Stanley: All of them are gone or restructured. At business's urging, business was left up to its own devices; its own devices turned out to be precisely the things that our grandparents set up regulatory agencies to guard against: euphoria that leads to panic; perverse incentives that lead to fraud; boom that leads to bust.

    As you watch the world crumble, try taking your Armageddon with this sprinkling of irony: Over the last three decades, business has got virtually everything it wanted, and its doomsday scenario from the 1970s has come true because of it. The regulators have indeed killed the regulated--not by intrusive meddling but by doing nothing, by taking a nap while the financial sector puffed up the bubble and blew itself to pieces.

  5. Dr. T:

    I agree with most of Coyote's points except where to inject liquidity. I don't believe there is a liquidity crisis. There is an "I'm afraid to invest in anything." problem. That will resolve when someone muzzles Chicken Little Paulson's cries of "The economy is falling, the economy is falling!"

    To prevent the dreaded 'domino-effect' among financial institutions, all the Federal Reserve Bank has to do is guarantee that it will pay the short-term debts of any financial institution that goes into bankruptcy. (It will recover the money later in the bankruptcy process.) By making the short-term debt payments of bankrupt institution A, it prevents institutions B and C (who are owed money by A) from failing. This simple modification to our existing bankruptcy process would let the worst actors (with bad mortgage portfolios and other bad investments) fail, let the good institutions survive, and cost the taxpayers nothing.