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Seems at this late hour the payroll tax adjustment is about all that can get the job done to immediately support demand.

Yes, the banking model is to make loans to individuals and business that become illiquid assets and match that with liabilities that are not at risk either.

So if markets put a discount on bank assets due to liquidity, implied is a premium on the liability side of banking due to its unlimited ability to fund itself.

And yes, it’s when, via securitization, for example, relatively illiquid assets are not ‘match funded’ to maturity, liquidity risk is there.

This same liquidity risk is also there when banks are not provided with secure funding due to errant institutional structure that misses that point regarding the banking model.

Beyond that is the risk of default which is a separate matter.

In the banking model this is determined by credit analysis, rather than market prices.

This is a political decision, entered into for further public purpose, and requires regulation and supervision of asset quality, capital requirements, and other rules to limit risks banks can take with their government-insured deposits.

When banks are deemed insolvent by the FDIC due to asset deterioration, they shut them down, reorganize, sell the assets and liabilities, etc.

When it’s due to excessive risk due to a failure of regulation, regulations are (at least in theory) modified. It’s all a work in progress.

I see this crisis differently than most.

We had two thing happening at once.

First, by 2006 the federal deficit had once again become too small to support the credit structure as financial obligations ratios reached limits, all due to the countercyclical tax structure that works to end expansions by reducing federal deficits as it works to reverse slowdowns by increasing federal deficits.

At the same time, while the expansion was still under way, delinquencies on sub prime mortgages suddenly shot up and it was discovered that many lenders had been defrauded by lending on the basis of fraudulent income statements and fraudulent appraisals.

Substantial bank capital was lost due to the higher projected actual losses reducing the present value of their mtg based assets. This is how the banking model works. The banks were, generally, able to account for these losses due to projected defaults and remain solvent with adequate capital.

Outside of the banking system (including bank owned SIV’s – one of many failures of regulation) market prices of these securities fell, and unregulated entities supported by investors (who took more risk to earn higher returns) failed as losses quickly exceeded capital. And with this non-bank funding model quickly losing credibility, all of the assets in that sector were repriced down to yields high enough to be absorbed by those with stable funding sources – mainly the banking system.

But the banking system moves very slowly to accommodate this ‘great repricing of risk’, and all the while the fiscal squeeze was continuing to sap aggregate demand. The fiscal package added about 1% to gdp, but it hasn’t been enough, as evidenced by the most recent downturn in Q3 GDP, which is largely the result of individuals and businesses petrified by the financial crisis.

So yes, there are both issues: the financial sector stress and the lack of demand. While they were triggered by two different forces (loan quality deteriorating due to fraud and the budget deficit getting too small), it is the combination of the two that is now suppressing demand.

The TARP may eventually alleviate some of the lending issues but only addresses the demand issue very indirectly and even then with a very long lag. Just because a bank sells some assets (at relatively low prices) doesn’t mean it will suddenly lend to borrowers who want to spend. Nor does it mean they will want to fund euro banks caught short USDs that have no fiscal authority behind their deposit insurance and bank solvency, and now appear to be in a worse downward spiral than the US. The slowing US economy has reduced the world’s aggregate demand, which was never sufficient to begin with due to too small budget deficits, via reduced exports directly or indirectly to the US.

In other words, I don’t see how the TARP will restore US or world aggregate demand in a meaningful way.

Yes, the US budget deficit has been increasing, but not nearly enough. It’s only maybe 3% of GDP currently, while the US demand shortfall is currently maybe in excess of 6% of GDP.

Cutting the payroll taxes (social security and medicare deductions, etc.) is large enough (about 5% of GDP) and returns income to the ‘right’ people who are highly likely to immediately support demand as they spend and also make their payments on their mortgages and other obligations to thereby support the financial sector in a way the TARP can’t address.

It is the ‘silver bullet’ that immediately restores output and employment. But we all know what stands in the way – deficit myths left over from the days of the gold standard that are now inapplicable with our non-convertible currency.

The line between economic failure and prosperity is 100% imaginary.

And not to forget that if we do restore output and employment (without an effective energy policy) we increase energy consumption and quickly support the forces behind much higher energy prices, which reduces are real terms of trade and works against our standard of living.


5 Responses

  1. Obama has a $500 payroll tax cut in his plans. It’s not hard to imagine the lame duck congress passing that after the election.

    Unfortunately he would pay for this and other tax cuts for middle incomes by raising income on higher brackets. But as Warren said, they still believe a lot of deficit myths.

  2. I haven’t heard seen anything in the press.

    I do know some of my readers have proposed it in committees but don’t know if it is gaining any traction

  3. Warren says: “doesn’t mean it will suddenly lend to borrowers who want to spend.”

    Yes hoover couldn’t understand why the economy didn’t pick back up after recapitalizing the banks, the banks didn’t want to lend anymore and the borrowers no longer wanted to borrow, people’s minds and hearts were not going to be changed with financial wizardry.

    It took a long time for things to pick up again, I think the warren buffet types rushing in right now not taking maybe a 30 year view are going to be fooled. I have heard too many people on bloomberg say that credit as we knew it is gone forever, no more leverage like the old days.

    Warren says: “Nor does it mean they will want to fund euro banks caught short USDs that have no fiscal authority behind their deposit insurance and bank solvency, and now appear to be in a worse downward spiral than the US.”

    My friends at the CFR think a unified europe is better than a bunch of small nation states, when I think of irish bombings of margareth thatchers car I tend to agree. But then the founding fathers said those that will trade liberty for security will get niether. I like being able to walk out my door and not worry that my car is going to blow up. So even though lots of illegal funny business is going on behind the scenes right now, perhaps things will work out for the best.

    Warren says: “Yes, the US budget deficit has been increasing, but not nearly enough. It’s only maybe 3% of GDP currently, while the US demand shortfall is currently maybe in excess of 6% of GDP.”

    Many of my republican friends are sure that the obama administration is going to expand government spending.

    Warren says: “Cutting the payroll taxes (social security and medicare deductions, etc.) is large enough (about 5% of GDP) and returns income to the ‘right’ people”

    Hold up Warren, I need you to define why the WORKERS are the right people? To the politicians who get voted in, the big companies who make campaign contributions are the right people, and the rich old seniors who don’t work anymore but are very focused VOTERS are the right people. To certain blue states big labor unions with inefficient workers getting 30 dollars an hour are the right people. I read an article at techstreetstation once that the REAL problems is that we need 250 states, that our government has not expanded enough to keep up with the growing population, 100 senators concentrates too much power into too few people and makes them less influenced by each individual voting agent, that until we have 500 senators and a couple thousand congressman who are all more concerned about individual votes, nothing will change.


  4. Warren you make many good points and I think of the “cycle” traders who talk about really long cycles – 100 year cycles where it takes whole new generations of people to really start deficit expansion programs again. Government policies to steer the herd is easier when the herd is willing. All the people being frightened by what is going on now will have long memories and it may take a new generation of humans to forget the fear (justified or not). So given that and looking at the big picture, how can we design a government that would have prevented the lost decade after the 30’s depression and the lost decade after japan’s financial crisis? If the job of the government is to smooth the peaks and troughs, but they can only get fresh new humans with no memories with long cycles – then it seems the cycle traders are right and certain policies can only exist when the current crop of humans die off and new humans replace them. (think of abolishment of slavery – what seemed sensible to southern cotton farmers seems silly to today’s country – but it took lots of new humans with new ideas to make this change)

    AS a scifi buff I support fully what you are trying to do, steer the herd in a direction that can lead them to paradise on cycles lasting longer than the span of a human lifetime – 100 years at most. Perhaps however the limiting force in nature to how much prosperity you can bring the herd is the length of their individual lifetimes and individual memories, and trying to design socities that take 1000 year timeframes of planning and government policy but those societies are made up of individuals who only live 100 years long is just not possible. Designing a society that will benefit the energy and social needs of people 1000 years into the future probably is never going to matter to people who only live 100 years – there was a guy in Germany trying to build a project – atlantropa I think it was called that had really long term civil engineering goals – but he couldn’t get enough people to buy into the long term cycles.

    So I say the BEST way to do what you want to do is to start developing life extension technology so people live longer, then longer term goals will matter to them. Fewer traders enamored with the “fetish of liquidity” and more bioscience and medical researchers. It saddens me when people like cutcheon say NO he aint gonna do that because currently he is financially rewarded more to be the trader than the bioscientist, but this is someone not seeing the forest for the tree and thinking outside the box. So what cutcheon if you get a “few dollars more” because your government and society rewards you for being a finance type instead of a medical type, it seems to me the medical type can extend your life. Don’t we all want more life?

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