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Deleveraging involves nothing more than ‘reintermediation’ back to the banking system (as described in more detail previous posts).

The government has failed to facilitate this transition back to a banking model to allow it transpire in an orderly fashion.

All that needed to happen was for credit spreads to go to levels that represented competitive returns on equity for banks, as banks picked up loans and securities no longer wanted by the non bank entities.

The move to mark to market from mark to model for banks, however, effectively added ‘spread risk’ to holding longer term loans and securities.

This mark to market risk also effectively raised bank capital requirements (as required by bank investors) in order to invest in the suddenly higher volatility investments.

This also increased the risk to investors of banks already holding securities that were subject to mark to market accounting.

The Fed allowed this risk to interfere with banks ability to fund their liabilities, as the Fed lends to member banks only against specific collateral.

Faced with a potential liquidity crisis, banks were compelled to respond by restricting lending that would otherwise have been considered profitable.

This led to the (continuing) downward spiral of the real economy.

The downward spiral is also characterized by a general (deflationary) inventory liquidation of housing and commodities.

I have been proposing (for the last 15 years) the Fed as Congress to remove the collateral requirement for member bank borrowing (it’s redundant in any case).

I have also proposed they extend their lending to member banks to include longer dated lending to set the term structure of rates as desired.

The Fed continues to slowly move towards this ‘target’ with it’s ‘new lending facilities’ and polices, but it continues to fall short.

The failure to act on the mark to market issue keeps risk for bank shareholders ‘artificially’ elevated which keeps credit spreads wider than otherwise.

I have also stated that while taking the right steps to facilitate the ‘great repricing of risk’ and the reabsorbtion of lending by the banking system would end the ‘financial crisis,’ it does not address the accelerating shortage of aggregate demand that’s been evidenced by rising unemployment and the widening output gap.

The near universal belief that lower interest rates sufficiently add to aggregate demand to restore output and employment and the numerous ‘deficit myths’ have delayed the substantial fiscal adjustment required to sustain aggregate demand at full employment levels in the current environment.

I have therefore proposed a ‘payroll tax holiday’ where the Treasury makes all FICA, medicare, etc. payments for employees and employers, along with a $300 billion revenue sharing program for the States to immediately fund operations and infrastructure programs.

Additionally, any economic recovery not associated with a program to reduce crude oil consumption risks a sudden shortage of supply and re escalation of prices.

Our govt’s ongoing mismanagement of the economy since q2 08 can be entirely attributed to a fundamental lack of understanding of our monetary system by govt, the mainstream financial and academic economic community, and the media that promotes this misunderstanding to the political leadership and general public.


12 Responses

  1. On CNBC this morning Goldman’s Abby Joseph Cohen and Pimco’s Paul McCauley both nominated Bernanke for Time’s Man of the Year for his handling of the crisis.

    If things get any worse, he could be up for Man of the Century!

  2. Truly amazing. And great post.

    After beginning to understand how money works, reading the financial press is extremely depressing. Before, I thought it was horribly written with many simply wrong ideas being propagated. Now, it starts to seem like they are talking about a different planet.

    When I read hard core Austrians, they seem like malice filled haters of humanity. When I read libertarians, they seem blissfully unaware of the role of demand in an economy. When I read monetarists, they seem to not understand the difference between bank money and base money.

  3. It’s not the financial press that depresses me: it’s the employees of the Federal Reserve who don’t seem to have the slightest idea how their own institution operates that depresses (and horrifies) me…

  4. As I said to Mike Norman today, he’d be feeling a lot better about the fed’s actions if he’d never met me.

    yes, it’s that bad out there. At age 59 I now suspect I won’t live to see a govt that understands its own monetary system.

  5. Jim,

    It is almost comical how little they know, plus they are just simply making sure goldman makes it out ok. It is criminal.

    And Warren, you are exactly right. I was saying to my wife not 5 months ago “Bernacke knows how to fix this mess, and Paulson is acting like he has wants the economy to survive.” Now, I think that Bernacke is clueless and Paulson is so evil he doesn’t even realize the complete blackness of his soul.

    We need an answer of how much stimulus is necessary to get the economy healthy. (Why? so we can correctly trade the markets when it isn’t enough) Obama is talking about spending $1T over 2 years, and I suspect this isn’t nearly enough…

    I was thinking that the amount of stimulus should equal wealth destroyed by the asset price collapse / some leverage multiple


    S = Wlost/LevMult

    As a leverage multiple, is 12 to 1 the correct ratio? I know you want to eliminate the reserve requirement, but clearly there is some number here that makes sense. Was the number 20T in wealth, if so the stimulus is like 1.7T

    But another model might be simply be GDP and unemployment and plug them into Okun’s law. If we reach 11% unemployment and we assume 5% natural rate of unemployment, then Okun means that 6%* 2 = 12% of GDP to get back on track, which means like $1.4T to get back to a functional economy.

    Each of these models is really dependent on the amount of demand destruction that is occurring right now, and god are they back of the envelope. I was hoping to inspire Warren and Mike to chime in…

  6. we’re already running a deficit of maybe 5% of gdp, and the total payroll taxes amount to about 1t per year, or about another 6.5% of gdp. Toss in my proposed 300 billion for state revenue sharing and that’s another 2% of gdp. So we’re pretty close.

    With my payroll tax holiday, it puts a halt on taking 20 billion per week from employees and employers, and it can always be reinstated should the politicians feel the economy is overheating, or replaced with some other method of reducing demand if they deem demand is too high.

    I like the flexibility

  7. I do really like that flexibility of the payroll tax holiday.

    I think the strongest part of payroll tax holiday though would relate to the Keynes chapter 12 “Animal Spirits” and expectations. A payroll tax holiday has an expectation component built into the plan – you are going to get some extra money next week and the week after, too. During a time when savings will likely be rising, this expectation of increased income is very important for personal and business planning.

    I wanted to start getting hard numbers into the discussion rather than percents, as this is what people are going to see in their newspapers and newscasts. 6.5% of GDP doesn’t mean much to people, while $1.3T to $1.7T is a number they can use as a benchmark.

    A large stimulus that not many people see in their own paycheck – say infrastructure rebuilding – will not restore confidence across the entire population. Also, infrastructure spending is by necessity be geographically located, which further limits the effectiveness.

  8. All that needed to happen was for credit spreads to go to levels that represented competitive returns on equity for banks, as banks picked up loans and securities no longer wanted by the non bank entities. I don’t get this. With credit spreads increasing, it means the value of non-treasury fixed income products decreased while the yield increased. Isn’t it more attractive to buy fixed income when it is cheaper? Why aren’t the returns competitive.

    his mark to market risk also effectively raised bank capital requirements (as required by bank investors) in order to invest in the suddenly higher volatility investments.
    Does raising capital requirements mean banks have to have high higher levels of reserves? What do banks do to raise so-called capital? examples?

  9. 9. Yes, what i meant was securities cheapen to levels that make them attractive to banks. I think we are saying the same thing.

    the effectively higher capital requirements due to higher volatility meant lower appropriate leverage- capital ratios- for those assets.

  10. W, not following. Today the spreads between risky and non-risky fixed income products are very wide. How does this effect banks?

  11. they get wide as the new buyers, the banks, and any remaining non bank buyers, can only own them at the wider spreads due to risk adjusted return on equity (capital) demands by investors

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