Friday, September 26, 2008

The Two Major Issues in this Crisis

There are two major issues that have to be confronted in this crisis. First, there is the pricing of assets. Second, there is the issue of capital. In my mind, the two need to be kept separate.

The first concern is that there are many securities that, at present, don’t have a market and hence their prices cannot be determined. This is primarily a short run issue. Typically in a situation like this the Federal Reserve provides sufficient support for the financial markets so that the markets stabilize and trading can once again take place. We are beyond that situation now and so we have to look further into what kind of problem might exist.

The situation we are in now is related to what economists call “the accelerator model”, a way of looking at things that Ben Bernanke is particularly fond of. On the up-side, the accelerator model helps explain what Charlie Kindleberger, an economist at MIT, popularized as the “mania” portion of a bubble. (See Kindleberger’s book, along with Robert Aliber, titled “Manias, Panics, and Crashes…a classic.) The problem with manias…and panics…is that they are cumulative. That is, they build on themselves.

The “accelerator model” in modern terms has a feedback mechanism in it that can create cumulative movements in asset prices. The particular channel this feedback mechanism works through is individual wealth. As the economy expands, asset prices rise. As asset prices rise, the wealth of individuals increase and they spend more out of this increased wealth. This additional spending raises asset prices further, credit grows to support this increase, and this leads to another round in which wealth grows further…an so on and so on.

Adherence to this model helps to explain Bernanke’s fear of inflation before last August.

But, the “accelerator model” works on the downside as well. The downside result has often been referred to as “deleveraging” or as a period of “debt deflation.” Here, as the economy slows or asset prices dip, the wealth of individuals declines. People reduce their spending and asset prices fall further. As asset prices decline, credit is tightened and this exacerbates the drop. This, obviously, is cumulative in behavior.

Just as Bernanke was concerned about the possibility of inflation in the spring and summer of 2007 he became extremely concerned about the possibility of debt deflation a week to ten days ago.

Did Chairman Bernanke panic? Did he over react? Only time will tell.

The issue before Congress now is whether or not they should enact a bailout plan that will help to stabilize the asset prices of a vast quantity of securities. Setting aside $700 billion in funds to help stabilize the market is the primary goal of the proposal.

ASIDE: whether or not the total is $700 billion or $1 trillion or $2 trillion is irrelevant. Supposedly when ask, a Treasury official said that there was no good reason for the choice of $700 billion, it was just that the number had to be quite large. This, of course, did not build confidence for the Paulson plan. However, in my judgment the answer is the correct one. No one knows how big the number needs to be. The crucial thing in a debt deflation is that those that are attempting to get out ahead of the situation need to have a lot of “chips” to play with. Whatever the number was it had to be a big one!

Return to message: is a proposal like this needed? Will such a proposal work? As I said in my Monday post…this is decision making under uncertainty…and this is beyond graduate school!

Another question that is being raised by House Republicans is whether or not this bill is philosophically (or ideologically) correct. The model these members of Congress work with initially cause them to reject such government interference with the market place. They have their arguments and we need to hear them before a final bill is passed. Any bill that is passed must have the general support of all members of Congress.

The second issue has to do with capital adequacy. It is argued that many financial organizations do not have sufficient capital to absorb the losses that exist on their balance sheets and will find it extremely difficult to continue business as usual if they are under-capitalized.

This issue is completely different from the first issue discussed above.

There are two choices here…either the market is allowed to work in the re-capitalization of these institutions or we allow the government to “invest” in these firms and become “owners”. The latter solution would mean that these institutions would be nationalized and we would, explicitly, socialize the financial system.

I guess we could call a combination of the two a possibility, but this would really be just bastard socialization…once you start this you have a socialized system regardless of how much of the system is in private hands.

To me there is no choice. I argue that the market should be allowed to determine who stays and who goes. What this will mean, however, is that more and more capital for American institutions will come from off shore. That is, the “wonderful” support for United States debt that has been accelerating in recent years, along with the decline in the value of the dollar, will lead to more and more foreign ownership of America’s assets.

Given this scenario, the major reason that might be given for a socialization of American finance is to keep it under American ownership, even if that ownership is coming from the government.

These two issues are the most important ones being faced in the current crisis. All the other things, to me, are secondary and should not muddy the waters of the debate going on.

ANOTHER ASIDE: I cannot agree with those that believe that this crisis was caused or exacerbated by “mark-to-market” accounting. I firmly believe in “mark-to-market” accounting because it increases the transparency of an institution’s decisions. Yes, it the market is moving around a lot there will be a lot of changes recorded on the balance sheet of a company, but, it was the management’s decision to have acquire such assets and the affect of these decisions should be obvious to shareholders and others. Riskier assets will require more marking to market. That is the choice of management. That choice should not be hidden.

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