The last opportunity for effective action before disaster strikes

Summary:  The Paulson Plan is already irrelevant.  New and larger measures are needed immediately.  This is the second post in a series describing their size and scope.  We are only weeks away from disaster.  Fortunately, I am certain that Secretary Paulson and Chairman Bernanke know this.  Bernanke, as an expert on the Great Depression, certainly understands the need for fast and effective action.

Situation report

The end of the post-WWII debt supercycle started with the collapse of the mortgage brokers in December 2006.  Since then the government has made aprox 15 initiatives to stop the deterioration of our financial system.  The super SIV, 3.25% in cuts to the federal funds rate, FHA Secure, Hope Now, a $120 billion tax rebate, massive expansion of access to the Fed’s discount “window”, TAF auction, TSLF, PDCF, the Bear Stearns bailout, the nationalization of the GSE’s and AIG … and now the TARP (aka the Paulson Plan).  Don’t bother looking up the acronyms, they will all soon be forgotten.

All too small, too late.  Incremental and reactive, responding to critical problems of last month — irrelevant to the current situation.  This is a recipe for disaster.  Like in the US 1929-1933 and Japan 1989-1996 — delaying the necessary large-scale response until the problem was no longer manageable.

Now the US financial system is seizing up.  The machinery remains, but the gears no longer turn.  Most of you have no idea to what I am referring, but you will learn over the next few weeks.  To use a bad medical analogy, the financial system has had a cardiac arrest.  Rather than describe the problem, this post describes solutions.

What must be done now

Recommendations from A solution to our financial crisis, 25 September 2008:

  1. Stabilize the financial system.
  2. Stabilize the economy.
  3. Arrange long-term financing for steps #1 and #2 with our foreign creditors.

 This post discusses step #1 — how to stabilize the financial system.

Restarting the necessary flows through the business credit system must be done immediately, and will require drastic measures. The following indicate the broad scope and scale of the necessary action, not the specifics.

(A)  Broad guarantees of the securities for the financial sector.  Not just banks and brokers, but also leasing companies and lenders of every flavor.  Confidence in these securities must be restored now.

The Paulson Plan is only a small first step in this direction.  More is needed, fast.  The Fed is pumping vast sums into the financial system (“Wall Street”), but the money is not reaching “Main Street.”  Disintermediation is necessary.

(B)  Direct lending to business.  For example,

(1)  Direct loans to corporations by the Fed (e.g., Fed purchases of commercial paper from companies).   Update:  the Fed has begun doing this, per this announcement.

(2)  Fast loans from the Small Business Administration on simple security (personal guarantees and net assets of the business).  As were made to families after Katrina.

The full effects of the recession will hit in the next few quarters, and the current financial crisis has exacerbated it.  We should prepare for something longer and deeper than 1973-75 or 1980-82 (the worst since the 1930’s).  Let’s not wait to begin mitigation efforts.  Anyone asking “Dude, where’s my recession” should be banned from the Internet for life.

(C)  Massive fiscal stimulus.  Government spending on valuable infrastructure.  Expanded education programs.  Fast cash disbursements to local social service agencies.  Avoid the usual chaotic rush — begin setting them up now, as their lead times are long.  The alternative is dropping money from helicopters later.  This is essential, but logically part of recommendation #2:  stabilize the economy.


This is triage.  Immediate aid to those who can survive.  Fairness and equity are now irrelevant luxuries.  Punishment of the innocent and rewards to the guilty can wait until the immediate crisis has passed.

This is just first aid.  The recession is coming.  None of these measure will speed its end or lay a foundation for an economic expansion afterwards.  Such measures must wait for the new Administration.  The timing of the crisis, in the midst of a critical national election, could not be worse.  Let’s hope our leaders can put aside their partisan differences to take the necessary steps.  Let’s promise electoral death to those who cannot manage to do so.

I doubt we can take these measures without prior agreement of our creditors.  The additional — and larger — measures necessary next year will certainly require their money, so let’s consult them now — rather than arouse anger by assuming their cooperation.  For years they have provided vendor financing — loaning us the money to buy their goods.  Now we ask them for much larger loans to mitigate the results of our past imprudence.  Without their aid we cannot simultaneously obtain the necessary funds, keep interest rates low, and avoid a collapse of the US dollar.

This is one of the major inflection points of American history.  The outcome will be shaped to a large degree by the skill and values of the new Administration.  Please do all you can to help America make that decision.  Donate your time and money.  Get involved in discussions.  Write and talk about it with everybody you know.

What should we do next, after applying First Aid?

That is a complex question.  For a simple answer see the following (you will not like the answers):

  1. A solution to our financial crisis.
  2. America has changed. Why do so many foreigners see this, but so few Americans?

Other sources saying similar, if milder, things

  1. From central bank to central planning?“, Prof Delong (Economic, Berkeley), BusinessDay, 29 September 2008
  2. UC Berkeley economists think through the crisis“, San Francisco Chronicle, 2 October 2008
  3. Edge of the Abyss“, Paul Krugman, op-ed in the New York Times, 2 October 2008
  4. Transcript of Charlie Rose’s interview of Warren Buffett“, Bloomberg, 2 October 2008
  5. Financial and Corporate System is in Cardiac Arrest: The Risk of the Mother of All Bank Runs“, by Nouriel Roubini, RGE Monitor, 3 October 2008

Krugman and Roubini are among America’s top economists; Buffett is one of our top businessmen.  Their warnings deserve close attention.  Esp note Buffett’s comments:

We have a terrific economy. It’s like a great athlete that’s had a cardiac arrest. And it’s flat on the floor, and paramedics have arrived. And they shouldn’t argue about whether they put the resuscitation equipment a quarter of an inch this way or a quarter of an inch that way. Or they shouldn’t start criticizing the patient because he didn’t have blood pressure tests or something like that.

They should do what’s needed right now and I think they will. I think the Congress will do the right thing. I think that they’ve gotten into certain arguments and then they start worry about assessing blame and there’s a little demagoguery. But in the end, something this important, they’ll do the right thing. This is really an economic Pearl Harbor. That sounds melodramatic, but I’ve never used that phrase before, and this really is one.

Esp note this:  “Libor Rises, Commercial Paper Slumps as Credit Freeze Deepens“, Bloomberg, 2 October 2008 — Except:

The crisis deepened after the worst month for corporate credit on record. Leveraged loan prices plunged to all-time lows, short-term debt markets seized up and even the safest company bonds suffered the worst losses in at least two decades as investors flocked to Treasuries. Credit markets have frozen and money-market rates keep rising even after central banks pumped an unprecedented $1 trillion into the financial system.

“The credit window is closed,” Jim Press, president of Chrysler LLC, the third-largest U.S. automaker, said today at the Paris Motor Show. … “It’s going to get much, much worse,” said Gregory Peters, head of credit strategy at Morgan Stanley in New York. “The credit markets are effectively shut, the CP market, which there’s not enough focus on, is under complete duress. That can’t be sustained, as that’s the lifeblood of corporations funding themselves.”

Commercial banks and bond dealers borrowed $348.2 billion from the Fed as of yesterday, an increase of 60 percent from the prior week amid the worsening credit freeze.

The market for commercial paper plummeted $94.9 billion to $1.6 trillion for the week ended Oct. 1 as banks and insurers were unable to find buyers for the short-term debt amid the worst U.S. financial crisis since the Great Depression. Financial paper accounted for most of the decline, plunging $64.9 billion, or 8.7 percent, to a two-year low.

…”The purge is broad and is impacting issuers with far more predictable cash flows — regular run-of-the-mill companies in need of working capital,” Crescenzi wrote today in a note to clients.  “The declines add to the urgency for fixes to the credit crisis and bolster the case for a Fed rate cut.”

The U.S. market for short-term debt backed by assets including mortgages and car loans fell $29.1 billion, or 3.9 percent, this week to a seasonally adjusted $724.7 billion, according to the Fed.


If you are new to this site, please glance at the archives below.  You may find answers to your questions in these, such as the causes of the present crisis.  I have been writing about these events for several years; since November 2007 on this site.  As you will see explained in these posts, the magnitude of the events now happening is beyond what most Americans have — or can — imagine.

Please share your comments by posting below.  Please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling). 

Some FM posts about the current crisis

For a full listing see the FM reference page about the Financial crisis – what’s happening? how will this end?.

A few of the most important posts warning about this crisis

This crisis has long been forecast by many, including in articles on this site.  Even now that we are in the whirlwind, these provide valuable background material on its causes — and speculation about the results.  To see the all posts on this subject, go to the FM reference page about The End of the Post-WWII Geopolitical Regime.  Here are some of those posts.

  1. A brief note on the US Dollar. Is this like August 1914?, 8 November 2007 — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
  2. The post-WWII geopolitical regime is dying. Chapter One, 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
  3. We have been warned. Death of the post-WWII geopolitical regime, 28 November 2007 — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
  4. Death of the post-WWII geopolitical regime, III – death by debt, 8 January 2008 – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
  5. Geopolitical implications of the current economic downturn, 24 January 2008, – How will this recession end?  With re-balancing of the global economy, so that the US goods and services are again competitive.  No more trade deficit, and we can pay out debts.
  6. A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
  7. What will America look like after this recession?, 18 March 208  — The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
  8. The most important story in this week’s newspapers , 22 May 2008 — How solvent is the US government? They report the facts to us every year.
  9. The World’s biggest mess, 22 August 2008 — A brillant ex pat looks at America from across the ocean.

78 thoughts on “The last opportunity for effective action before disaster strikes”

  1. I never figured you for a flaming Leftist. The most extreme views posted in this thread have been YOURS. The problem is that we have too much debt–too much Government debt, too much corporate debt, and too much personal debt. The last thing we need in the United States is more debt, yet that is exactly what you are proposing in order to stave off a recession. More debt is only going to add fuel to the fire and prolong the inevitable. You’re pretty good at asking others to provide evidence for their positions. It is now my turn. I demand to see proof that YOUR solutions will not make things worse.
    Fabius Maximus replies: I was speaking of extreme views vs. conventional economic theory. With respect to recommendations you are correct. But the news flow suggests I may not be an extreme view for long, as seen in the articles I list by Warren Buffet and Professors Krugman and Roubini. As others recognize the danger, they give similar advice.

    I obviously agree with you about the debt problem, as seen in the five dozen articles I have written about this over the past year (for a list see “End of the post-WWII geopolitical regime“).

    But the flow of money through our economy is stopping, as in the “cardiac arrest” so often mentioned. This must be restarted fast or the consequences will be horrific.

  2. It is heartening to see 40 comments (so far) on this thread; that translates to some much higher number of readers. I don’t understand all that F.M. writes and do not agree with all of that which I do ken. But he has done an excellent job of identifying broad questions and challenges, and placing them in a historical context.

    To the skeptics who followed a link here (from where?), I offer one example of an important question that F.M. has posed, but that the mainsteam media and the blogosphere have yet to address:

    America is in the process of contacting its foreign creditors, asking them to fund the Paulson Plan with the first installment of some trillions of dollars in additional loans. Most of these powers are unfriendly to us, to varying degrees. What makes this exchange attractive from their point of view? What concessions must we be prepared to offer?

  3. Fabius:

    This is an amazing thread and my crystal ball is as cloudy as anyone else’s. But realistically, the steps you call for – or something substantially similar – just aren’t going to happen at least between now and next January.

    I used to snark that discussions of how future historians would judge the Bush administration were fanciful because they over-optimistically assumed that the future would have historians.

    Now I grit my teeth.
    Fabius Maximus replies: That is also my fear. But we do have not that much time. Let’s hope that the sight of the gallows focuses the minds of our leaders, and impels them to action. Chairman Bernanke certainly understands these things, and the need for fast powerful action.

  4. Update: Transcript of Charlie Rose’s interview of Warren Buffett, Bloomberg, 2 October 2008 — Excerpt:

    “We have a terrific economy. It’s like a great athlete that’s had a cardiac arrest. And it’s flat on the floor, and paramedics have arrived. And they shouldn’t argue about whether they put the resuscitation equipment a quarter of an inch this way or a quarter of an inch that way. Or they shouldn’t start criticizing the patient because he didn’t have blood pressure tests or something like that.

    “They should do what’s needed right now and I think they will. I think the Congress will do the right thing. I think that they’ve gotten into certain arguments and then they start worry about assessing blame and there’s a little demagoguery. But in the end, something this important, they’ll do the right thing. This is really an economic Pearl Harbor. That sounds melodramatic, but I’ve never used that phrase before, and this really is one.”

  5. WSJ on Paul Ryan, a fierce anti-Fannie critic for years. Supporting the bailout.

    They call it leadership. I have to agree, leading me to flop around some more. Against big gov’t, big bailouts — but especially against BIG recession. Other European Central Banks are rescuing their own overexposed banks (German guy to eat some crow?) — Euro over-regulation wasn’t enough, either.

    Whatever I learned in 8 years of investment banking is already obsolete. I still think faster purchasing/ offering to buy all foreclosed houses at 50% of prior mortgage would be a huge help.

    Other speculation: The Fed is loaning money — why not Factoring, too? Let the Fed buy short term GE receivables at 90% of nominal value, so GE gets cash?

    Time for the Fed to help real companies directly, and NOT use the now-clogged imploding financial institutions. Prior Tax rebate loans — for all companies that paid tax last year, they can directly borrow from the Fed an equal amount of the prior year’s tax (at the high AIG bailout interest rate).
    Fabius Maximus replies: This is largely what I recommended in my post (It would have been polite of your to acknowledge that in your comment).

    “Time for the Fed to help real companies directly”
    That is almost exactly what I said.

    “Let the Fed buy short term GE receivables at 90% of nominal value”
    Fed buying of commercial paper from companies is fast and easy direct unsecured lending, faster and easier then secured lending (such as buying receivables).

  6. Warren Buffet is investing new money in GE. Wells Fargo, one of the best run banks in the world that avoided toxic debt, is in a bidding war with Citicorp over insolvent Watchovia. So you think those two purchasers feel that there will soon be a financial meltdown and total liquidity starvation? You can;t buy cheep assets with other cheep assets, cash is king when there is no liquidity. Both of these entities are betting on assets (with their own money) being more valuable in the future than now.
    Fabius Maximus replies: People with cash go shopping during panics. To see this at work watch the early scenes of “It’s a wonderful life.” Mr. Potter has cash to buy up Bedford Falls, while everyone else suffers. That’s a natural element of a crash, but does not make the crash less real to the 95% who cannot so benefit from it.

    Trivia note: Buffett did not “invest” in GE. He loaned money to them, with an option to invest in the future. They are two different things.

  7. Buffet also invested in Goldman Sachs, which will heavily benefit from the bailout. He, like Soros, has been touting the bailout. There is a kind of vulture capitalist play going on here, too tricky for me to unravel.

    I have nothing but admiration for Fabius, a free market advocate and a believer in the Roman as well as American founders’ ideal of citizenship, who, in this serious national crisis, is clear-minded and non-ideological enough to see that massive state intervention is needed and unavoidable.

  8. If the US Government cannot get enough foreign credit on suitable terms then I presume it would only be able to support essential industries directly. The remainder would fail and then we’d be left with a command economy.

    The pattern repeats world-wide. Perhaps I’m depressing myself unduly, but this recession could last decades, because where would be the mechanism and leadership to restore international trade?
    Fabius Maximus replies: The US economy borrows aprox 5% of its income. In a recession the borrowing goes to near zero. So a decrease in new loans would hurt, but not to the extent implied by this comment.

    The pattern does not repeat world-wide because the world is not a net debtor.

    Recessions are cyclical events. They are part of the normal economic cycle. To use a bad metaphor, the economy must both inhale and exhale. The natural vitality of a normal economy restores itself in a downturn as the imbalances that produced the downturn are corrected.

    The situation is bad, but can be managed with cooperation and calm thinking. Let’s not be like the fictional savages that worry each winter that the days will grow ever shorter, until we have 24 hours of night. Eventually the solstice comes, and the days grow longer.

  9. One is amazed at the dogmatism of some people who simply do not understand how the economy actually works. There is a very good and utterly factual article at the NYT today that very explicitly pinpoints part of the regulatory failure that got us here: “Agency’s ’04 Rule Let Banks Pile Up New Debt“, NY Times, 2 October 2008.

    The notion that some sort of economic Darwinism would produce perfection is folly. Civilization by definition means moving beyond tooth and claw. The uninformed should be silent, or become informed. And how naive is it to even imagine that there won’t be those who benefit from the attempt to solve the crisis? ‘Twas ever thus. That is no reason not to act.

  10. Thank you for everything you’ve done so far, Fabius. Get some decent food and some rest because it looks like you’re in for a busy weekend.

    This far exceeds my worst-case predictions of what would happen. I was strongly against the bail-out because I didn’t understand how quickly things could go to heck in a handbasket (I figured it would take at least a month for things to deteriorate this far). Now I guess I’ll have to be a flip-flopper and support the damned thing.

  11. Nicholas Weaver

    Actually, technically, Buffett invested in capitol (stock), not a loan, for both Goldman and GE. But only technically.

    Its super-duper preferred stock, that guarentees a 10% dividend and can be rebought for 10% over the issue price/current price (whichever is higher), plus a boatload of options that can be exercised later.

    Which means he’s in the least senior position in case of bankrupcy (below unsecured creditors). There are no requirements for principle payments, just a dividend payment (potentially forever).

    But at the same time, the terms are really REALLY rapacious. If the credit market hadn’t frozen up and there was no alternative, and also a need for a “buffett stamp of approval”, there is no way a sane company would take those terms.

  12. I’m just surprised Fabius is for Paulson’s plan of thowing money at the Ivy League educated geniuses that put us this mess to begin with.

    And as for Sage of Nebraska, he’s full of fecal matter when he states ““We have a terrific economy. It’s like a great athlete that’s had a cardiac arrest. And it’s flat on the floor…” Its a terrific economy for players like him who can game the system because of
    their vast wealth. And of course he’d be for the bailout because he’s well situated to exploit it.

    For working and middle-class people OTOH the economy hasn’t been “terrific” or even good for to for a long time. Save for the easy credit, it stinks.

    This is why among other reasons they are aginst Paulson’s bailout.
    Fabius Maximus replies: Perhaps you should read the post more carefully before commenting. The very first line of this post is “The Paulson Plan is already irrelevant.”

    At the end you would see the titles of the two posts discussing the Paulson Plan. Even without reading them, the titles might suggest you have incorrectly characterized my view of the Plan.

    * “Slowly more voices are raised about the pending theft of taxpayer money

    * “America appoints a Magister Populi to deal with the financial crisis

  13. For an excellent treatment of a despair from a Christian perspective, see Kierkegaard’s “The Sickness Unto Death.”

    For Kierkegaard the consummate dialectician (and also the Father of Modern Existentialism), despair can take at least three forms.

  14. Short comment on GE: On top of the Buffet deal they will issue $12 billion of common stock to the public.

    That GE have not been able to raise $15 billion somewhere on planet Earth is bad. GE is not limited to just the US financial market. They are a global company.

  15. Nicholas Weaver


    Berkshire/Hathaway owns a fair amount of stock. The market price, as of 1/08, is $75 billion. Out of a total market capitalization of $220 billion. But these are, for the most part, big blue-chip stodgy companies, which are ones you interact with every day. Wells Fargo. Coca Cola. American Express. Kraft Foods. Etc.

    But thats only part of it, the rest of the value, some $145 billion worth, is the company’s core businesses, which are insurance (with particular care to prevent counterparty risk and systemic risk), manufacturing, and services.

    THis is his real wealth: If the US economy grows strong fundamentally, Berkshire/Hathaway is strong. If it collapses, B/H collapses. How much money do you think Dairy Queen, Acme Brick, Geico Insurance, Clayton Homes, or See’s Candy will make if the economy is in the toilet?

    And he’s actually poised to make nothing on the direct bailout: Berkshire/Hathaway is one of the few companies considered a good risk, doesn’t have toxic crap to unload, avoided counterparty risk, and the ability to make rapacious investments (like the GE and Goldmam investments) actually goes away if the bailout is succesful.

  16. Nicholas Weaver

    Another BIG danger sign: The State of California!?! is having liquidity problems: “Calif. leaders hope bailout loosens credit market“, AP, 3 October 2008.
    Fabius Maximus replies: Most people have no idea about the terrible condition of State and local budgets. They have become dependent on highly cyclical sources of income — e.g., income taxes instead of property taxes — while their expenditures have become more cyclical (e.g., social services grow faster than basic services). The result will not be pretty during the next recession.

    I suspect that many States will run large deficits, which they will not be able to meet by cutting services. Federal aid will be needed. Few will care about the Consitutional requirements for a balanced budget.

  17. Would a guy like Tonto of tv fame go out and get drunk at a time like this or cross the stream back to his teepee and tell Mrs. Tonto, “our god’s are really looking out for us. Whiteman will now have to live in a teepee same as us”.

    Several bankers in Mainland China will be toasting each other with ” Three Giant Leaps for China in one year. First the Olympics, then the astronauts walk in space and now holding America by the short hairs”.

    And Dudes in Arizona will form a posse and wear tee shirts with “Shit happens” on them while drinking green beer while herding goats.

    In Hollywood old Frank Capra scripts will undergo re-writes and voila angesl will fly down and do what angels do best. Sprout wings.

    Welcome to the Brave New World.

  18. Forget Wall Street! Forget DC! What about pensioners? The wife and I live on SS. When Russia and Argentina went thru their seizures, pension payments ceased. I am trying to figure out how we are going to heat the house and stock the frig. Fortunately, we have no mortgage, but what about those who do? The 700bn has to come from somewhere. Note how quick the defense budget has passed. That leaves the only other available pool of cash in the SS trust fund. I can see myself fighting with my neighbor for a cardboard box to sleep in, and a dumpster to dive in.
    Fabius Maximus replies: The bankruptcy of the Federal pension and medicare systems lies in the future. Even then the problem can be managed by means-testing and taxing benefits, with reasonable restrictions on benefits (such as “unneccessary” medical care). It is not as dire as some project. This will involve breaking the “promises.” But anyone who believes such promises is bound to be disappointed in life, one way or another.

  19. you write “The US will probably not have a sufficient savings rate to fund such a large fiscal deficit. We are almost totally reliant on foreign central bank lending, which they have done to finance our purchases of their goods. But this borrowing will be different, for internal consumption not trade finance. Will they share your complacency about funding a large piece of $2 trillion dollars in 2009 borrowing (10% of $14,000 b plus $500 b in maturing debt)?”

    the federal governemnt is not reliant on foreign central banks or domestic savings to “fund” itself. when the federal government spends it debits the treasuries account at the federal reserve and credits a member bank’s account. bond sales and taxes are reserve drains. the federal government does not collect taxes or sell bonds before spending. the money used to pay taxes and buy bonds comes from govenment spending.

    foreign central banks have accumulated dollar reserves as a result of their foreign exchange policy. should they no longer which to accumulate dollar assets they will have made a decision to alter their fx policy – not alter our ability to run a deficit.

    the pubilc sector deficit is exactly equal to private sector (including foreign private sector) savings.
    deficit spending can be inflationary but the federal government is not revenue constrained.
    Fabius Maximus replies: This is totally incorrect, but too complex to discuss on this site. Much as if you decided to question gravity.

  20. Extermle choices are always bad , for example extermely unregulated markets or planned economies both proved to be non sustainable

    just one thing

    “Fairness and equity are now irrelevant luxuries” ?? In the US you have a weird culture that considers the disadvantaged as unproductive, and it is clear that Fairness , improved public schooling ,and better social services are Eternal Luxuries , while a 600 Billion Dollars Defence expenditure is a neccessity.
    Fabius Maximus replies: That was meant in a narrow sense, as to which capitalists to bail out. It was not a broad discussion of allocating funds to provide basic social services, not even remotely mentioned in the post.

  21. btw, the largest systemic risk in the world now is europe, who as trichet noted, do not have a federal budget to deal with the same issues the us is facing. they have mandated budegt deficit limits that prevent counter cyclical government spending. spain and italy are in terrible shape and can add nothing to a pan europen bail out type plan. will the french and the germans be willing to bail out the rest of the union? the eu may very well not survive this – certainly not in their current form.
    Fabius Maximus replies: I very much doubt that is true. With one exception: the risk of the EMU itself fragmenting, as discussed in “Can the European Monetary Union survive the next recession?.” That level of systemic risk the US does not have, fortunately.

  22. nice read: “The Real Great Depression“, SCOTT REYNOLDS NELSON, The Chronicle of Higher Education, 17 October 2008 — “The depression of 1929 is the wrong model for the current economic crisis”

    In the end, the Panic of 1873 demonstrated that the center of gravity for the world’s credit had shifted west — from Central Europe toward the United States. The current panic suggests a further shift — from the United States to China and India. Beyond that I would not hazard a guess. I still have microfilm to read.

    I guess it is time to stock up on canned goods.
    Fabius Maximus replies: I cannot see how you arrive at your exteme conclusion from anything in this article (which is clever, but that’s about all IMO).

  23. To take up Buffett’s analogy to Pearl Harbor: If we were being threatened by a foreign power, Fabius would advocate peacefully surrendering to their tyranny – because fighting to protect our freedom would result in massive human suffering.

    So much for the argument for surrendering (what’s left of) our economic freedom to government intervention.
    Fabius Maximus replies: Please share with us how you arrive at this bizarre conclusion.

  24. Update: it is not only business that suffer when the credit tap is shut off

    California may seek Treasury financing“, Reuters, 3 October 2008 — Excerpt:

    California Gov. Arnold Schwarzenegger has told U.S. Treasury Secretary Henry Paulson that the most populous U.S. state may need the federal government to buy $7 billion of debt the state is unable to sell due to weak credit markets- and that California may not be alone.

    The $7 billion issue of revenue anticipation notes would raise cash to tide California over the near term until it gets expected revenues, but the plan to sell the debt is in peril because the municipal debt market is frozen, State Treasurer Bill Lockyer said earlier this week.

    “This is not a normal year,” said Lockyer spokesman Tom Dresslar on Friday, adding that the state was preparing the issue but that markets were in turmoil: “The paralysis lingers.”

    The municipal bond market, where California hopes to sell its short-term notes, has all but frozen up over the past three weeks as buyers have been scarce and tax-exempt yields have skyrocketed. Few deals have been priced, while scores of issuers such as states, hospitals, school districts and others, have postponed their bond sales awaiting a market turn around.

    … If the state could not sell the notes, it would have to adopt measures to cut spending, such as delaying salaries of teachers and other state employees.

  25. “California may seek Treasury financing“ – substitute italy or spain or belgium for california and they don’t have a europen treasury to go to and you get an idea of what is facing the eu. add to that the banks are all short usd and have no way to obtain them apart from via the ecb who get them from swap lines with the fed.

    my view is the euro will soon break 100.

  26. “Fabius Maximus replies: Please share with us how you arrive at this bizarre conclusion.”

    Please share with me what’s bizarre about it.
    Fabius Maximus replies: Why? You made the statement, and should have some basis for it.

    However, to spell it out, it bears no visible relationship to anything I have posted on this site.

  27. “Fabius Maximus replies: Why? You made the statement, and should have some basis for it.”
    You said it was bizarre. You should have some basis for that.

    “However, to spell it out, it bears no visible relationship to anything I have posted on this site.”
    You haven’t advocated government intervention in the economy?
    Fabius Maximus replies: So you believe that everyone who advocates government intervention in the economy (a mainstream belief in economics since WWI) would “if we were being threatened by a foreign power, advocate peacefully surrendering to their tyranny – because fighting to protect our freedom would result in massive human suffering.”

    WWII is a counter-example to your theory, since millions of men and women who voted for Hoover and FDR went off to fight, not surrendering to tyranny. (Hoover initiated many of the programs expanded by FDR).

    Also, many veterans and current members of the US armed forces are, for example, members of the Democratic Party — and “advocates of government intervention in the economy.” Please be polite when throwing this accusation at them face-to-face.

  28. Fabius Maximus replies: This is totally incorrect, but too complex to discuss on this site. Much as if you decided to question gravity

    please tell me what is totally incorrect. it is factualy correct in terms of treasury fed operations and represents an accounting identity in terms of public sector debt vs private sector savings.
    the notion that we borrow from foreign central banks to fund the federal deficit is naieve at best.

    from a greenspan interview re. solvency of social security

    GREENSPAN: “Well, I wouldn’t say that the pay-as-you-go benefits are insecure, in the sense that there’s nothing to prevent the federal government from creating as much money as it wants and paying it to somebody. The question is, how do you set up a system which assures that the real assets are created which those benefits are employed to purchase.”

    notice nothing about the federal gov’t being dependant on taxes or foreign central banks or any other foreign or domestic private entity to fund itself. we have a fiat currency and spend at the federal level by debiting the treasuries account at the fed and crediting a member bank account. that is indeputable fact. if you pay your taxes in cash the traesury will burn the cash, they wont say great now we can pay some social security benefits ….. bond sales are an offset to the newly created cash and represent a reserve drain as do taxes.
    Fabius Maximus replies: Yes, both Greenspan and Bernanke have talked about printing money as the last resort of the government. “Helicopter Ben” they call him after his famous “the U.S. government has a technology, called a printing press, that allows it to produce as many U.S. dollars as it wishes at essentially no cost” speech.

    The limiting factor to currency creation is inflation. Remember Weimer, the extreme case? Hyperinflation? It never recovered, and in less than a decade Germany was being run Hitler.

    Please, this is basic economics, hence off-topic for this site — which discusses geopolitics. You can choose to agree or disagree as you choose, but debate it elsewhere. There are other places on the web for this.

  29. “The limiting factor to currency creation is inflation”

    exactly , not china’s or anyone elses willingness to lend. its an enormously important distiction for economic and geopolitical reasons. we need to be clear that we are not beholdant to china or the middle east. we are entering a defaltionary period and the inflattionary impact of a larger deficit should not be viewed as a constraint.

    thank you for your resonses.

  30. Important Update:

    Today the Fed announced that is it doing 1 above, making direct unsecured loans to non-financial companies (e.g., buying their commercial paper). I see no alternatives at this time. This is good news, but will require massive funding to have the necessary effect.

    See this press release from the Fed for details.

  31. Fabius, are you some kind of hyperintelligent AI supercomputer with unlimited resources and patience? I am surprised and impressed by your cool equanimity in the face of these aggresive, wilfully ignorant comments.

    Onto your actual post, I agree that urgent action is required and the scope will be unprecedented. Most commentors so far seem to have no idea as to the scale of the problem.

    Your comment above mentions the need for “massive funding” for the “stage 1” treatment to have the necessary effect. I think we can all take it as read that the US’s creditors are now taking a very serious interest in the situation and I would be very surprised if there was not a lot of talk going on behind the scenes. Would be very interesting to be a fly on the wall at that meeting.

    One wonders what the credit line necessary for the stage 1 action is. One also wonders what the appropriate next step for the US Govt could possibly be. Given the extent of the cancer and the lateness of the day I am beginning to think that nothing less than granting basically unlimited emergency powers to the treasury to take whatever actions they see fit will do the trick. Pointing fingers and assigning blame can come later; nothing now is more important than getting the system back on its feet.

    If only the people posting their simplisitc, ideologically-motivated comments here would realise that if the system is not fixed, NOW, that we could see martial law in the USA by the end of the year. Now, the implementation of Fabius’s step 1 makes that a lot less likely, of course. But the nightmare scenario of millions of businesses suddenly folding, leaving even more millions suddenly unemployed and needing food, is real and plausible. That situation must be avoided by any means necessary.

    Since this is nominally a geopolitical blog, I wonder if you have any speculation on “concessions” which have already been agreed in condition to further lending. Your posts discuss such conditions as if they’re far-future hypotheticals; given the astonishing speed at which this situation is unfolding I cannot help but suspect the “concessions” are already on the table. Rumours are flying around, I would love to hear your take. The recent semi-official murmurs that the yuan is about to appreciate are perhaps revealing in their timing.

    Another thing I’d love to hear your view on is the astounding development that default risk is now seemingly being priced into 10yr T-bills.

    Thanks for all your work.
    Fabius Maximus replies: I doubt if international coordination is that advanced yet. More likely they are discussing more technical matters, focused on restarting global commercial capital flows.

    “that we could see martial law in the USA by the end of the year.”

    A more reasonable worst case outcome — and worst case outcomes by definition almost NEVER happen (I cannot repeat that too often) — would be nationalization and direct government control of the financial system. This is a finanical problem only. The nation’s human and physical resources remain untouched, so no massive social disorder need result. No martial law, riots, and such. We did not see that even in the 1930’s, a far greater event in most ways.

    “the astounding development that default risk is now seemingly being priced into 10yr T-bills.”

    The credit market mechanisms have gone bonkers under the stress. This is seen by some private companies having credit default swap rates better than that of the US Treasury, which can print money (source). It’s a malfunction.

  32. Update: advice similar to item (A) in my post: ”

    Getting the interbank market going again: the central bank as counterparty of last resort“, Willem Buiter, blog of the Financial Times, 5 October 2008 — Excerpt:

    “The interbank markets, secured and unsecured are, respectively, moribund and dead. The reason banks don’t lend to each other in the interbank market is counterparty risk – fear of default of the party they are lending to. Unsecured interbank lending (for which Libor or Euribor are common price measures) has effectively vanished, even at the overnight maturity.

    “… When banks don’t lend to each other, they are also unlikely to lend to economic agents that matter intrinsically: households and non-financial corporations. This has been a problem for a while in the US and the UK as regards bank lending to households, to developers and to firms in the construction sector. It is now spreading rapidly, in the US, the UK and in the rest of Europe, to the non-financial sector as a whole, starting with SMEs, but not stopping there.

    “To get interbank lending going again, banks must have confidence in each other’s solvency and liquidity. How can we restore trust in these interbank relationships? There are a number of options.

    “(1) Nationalise the banks. When they have a common majority owner (the state), the state can simply instruct the banks to lend to each other. Problem solved. It may come to that in any case, but for those who are not ready for such measures, here are a couple more.

    “(2) Guarantee interbank lending. Here the Treasury guarantees interbank transactions, both secured and unsecured. This should be done against fees that ensure the Treasury an acceptable risk-adjusted rate of return on this activity.

    “(3) Have the central bank interpose itself as the universal counterparty for interbank transactions. This is effectively already the case in the overnight market in the UK and the euro area. When the Fed starts paying interest on reserves (commercial bank deposits with the Federal Reserve System), we will see the same phenomenon there.”

    About Prof Willem Buiter:

    Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

  33. Fabius: obviously I meant the worst case scenario, which would involve not only business failures en masse but also a massive collapse in the dollar. Nationalisation wouldn’t help in that nightmare scenario. And 1930 is not directly comparable, because the US was not a net debtor nation at that time – it would be more like the financial situation in 1930 plus the oil shock in the 70s.

    Anyway obviously that is a highly unlikely scenario that no-one wants to precipitate, least of all the creditors! I simply wanted the previous commentors to realise that the situation was a lot more serious than they seemed to assume, and government action was not an arbitrary gift to their financial buddies, but urgent and absolutely necessary emergency first aid to the very basics of the nation’s economy.

    Oh and by the way, it seems international coordination got a lot more advanced in the mere hours between replies here…
    Fabius Maximus replies: I understood that you meant a worst case scenario. I replied that a social collapse is not realistic even in the most extreme scenarios, IMO.

    Why do you say that “international coordination got more advanced in the past few hours.” I wrote my reply after the news about the 6 nation rate cut. As I noted in this post, this is small step towards coordination, nothing compared to what is required.

  34. Update: “to inject capital into financial institutions” was the first item that Hank Paulson listed as his priority in his press conference yesterday, thus suggesting that now the US, like the UK, will undertake a partial nationalization of its distressed banks.

    For an explanation of this major development, see Nouriel Roubini’s new article at RGE Monitor — Excerpt:

    “The reality is that the TARP legislation passed by Congress (formally the Emergency Economic Stabilization Act) does not in any explicit way allow for such recapitalization of banks via injection of public capital. The US Treasury has initially resisted including explicitly such authority in the Act for several reasons: the banking industry that helped drafting the legislation was against it; there was ideological resistance to the idea of the government taking equity – however preferred – in financial institutions; there was concern that being explicit about public recap of banks would lead to banks’ resistance to participate in the toxic asset purchase program. That is why the Treasury formally resisted putting any explicit wording of public recapitalization of banks into the legislation.

    “So how come Treasury now says that its first priority is to inject public capital in banks? And where is Paulson getting such authority since there is nothing formally explicit in the Act to allow such recapitalization?

    “This is a fascinating story that is worth telling in full detail. Here are below those details…”

  35. Came across this post in the WSJ forum: “The Government Is Contributing to the Panic“, 11 Oct 2008 —

    “THE CORRECT WAY TO HANDLE CDS SYSTEMIC RISK, from a former bankruptcy attorney as well as former General Counsel to a Mortgage-Backed Securities Issuer:”

    “Markets will not resume rational behavior until the nuclear threat of credit default swaps has been rendered harmless. There are $55 Trillion of these private, non-regulated insurance agreements outstanding involving every major money center bank, investment house and major insurer worldwide. There are two ways to take away counterparty risk. One is to guaranty their performance. The other is to render them unenforceable or of only limited enforceability. …”
    Fabius Maximus replies: We are living out the 4 blind men and the elephant fable. One feels the leg and says “It’s a tree!” …

    Most of the folks wisely comment on the technical aspects of the crisis were unaware of these things a year ago. Now they have the simple plan to save the world. It’s a normal defense mechanism to boil a large, complex event into one easily understood marble — and prescribe the cure. Tom Grey says it is ALL ABOUT home prices. This guy says it is ALL ABOUT CDS. Others say it is ALL ABOUT the interbank lending mechanisms (fix LIBOR and you fix the world!). All share undeserved confidence in their prescriptions.

    This is absurd. We are experiencing a systemic failure due to the accumulated imbalances of 50+ years, most esp the buildup of more debt than the system can handle. To use a metaphor, this induces “torque” on the finanical system, under which many components are failing. Each failure increases the stress on the system.

    There are no magic bullets, no simple cures. Many things need to be done. Some are quickly effective. Some have long lags, but must be done now because we will need their action ASAP — even it it is 2009.

  36. The above is a variation on the theme of hyper corporations spanning a hyperspace of hyper functionality. GE is a perfect example. GE makes jet engines and locomotives, while GE capital functions as a bank, currency trader, and for all we know has dabbled in CDS’s. Like AIG, even though only one segment gets into trouble, the whole entity is too big to fail. The above post rings true in the sense that world governments need to disentangle this hyper structure with hyper laws which can selectively bankrupt targeted activities without bankrupting the hyper entity. One nice thing about being “the government” is you can change the law as well as run the printing press.

  37. FM note: At 1486 words this post was far over the comment policy’s limit of 250 words. I have edited it down to a still-too-long 423 words. You can see the full comment here.

    Max, you write that the “cause” of this debacle doesn’t matter. All that matters is effective action.

    I can’t disagree strongly enough. If your home has water in the basement and you start throwing fixes at the problem without accurately diagnosing the cause, how can you imagine that your fixes will work? A successful “fix” only comes from knowing from where the water comes.

    … The cause of the current crisis is widespread and continuous violation of Say’s Law. The central bank creates credit out of thin air, credit that is (in optimistic times) borrowed and multiplied through fractional reserve banking to become marketplace demand. … If this theory is correct, the government and Federal Reserve are, when they propose to throw ever more of their “money” (it’s credit backed by NOTHING, no capital creation at all) at bad loans and bailouts, in actuality revealing more and more of the fraud that held together the “House Of Cards” (as President Bush referred to the U.S. economic system recently).

    There are two conclusions (perhaps there are others) one can draw from markets selling off in response to each new proposal and each new bailout. One is yours, that their proposals are simply too small, and that a much more massive amount of intervention is needed to get lenders to lend and borrowers to be solvent and borrow again. The other, mine, is that the confidence that used to greet government fiat credit creation is gone.

    … Everything you propose for politicians and bureaucrats to do will not have any benefifical effect. … Sadly, since misdiagnosis of this disease is nearly universal the “cures” will continue until the patient is nearly dead. … Then will be revealed the truth: That we were always on our own and that those who trusted their rulers to “take care of them” were the worst kinds of fools for their awe of men and women whose primary qualification for power was naked ambition.

    All the prescriptions for fixing this and fixing that, even if they recognize that this crisis was 50 (or more) years in construction, are based on what is fundamentally an incorrect grasp of cause and effect in the affairs of men.

    … Let’s get back together in a decade and see which of us is alive and relatively wealthy, and which of us lost everything we had and suffered mightily. I’ll follow my own path, and you go with the herd.
    Fabius Maximus replies: All sites discussing any of the social or physical sciences get comments like these, in effect saying that the foundations of this field are wrong. Sometimes they are correct, but the odds are fairly solidly on the other side. A rebuttal to this is beyond my abilities and outside the scope of this site.

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